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About this book

In response to the Global Financial Crisis and the COVID-19 pandemic, central banks have used all available instruments in their monetary policy tool-kit to avoid financial market disruptions and a collapse in real economic activities. These actions have expanded the size of their balance sheets and altered the composition of the asset-side. This edited book highlights how these assets are managed, providing an intellectual and practical contribution to an under-researched field of central bank responsibilities. It first reviews the sources and uses of domestic and international assets and how they complement—or possibly conflict with—the implementation of monetary policy goals. Next, the book examines the asset management mandate in a balance sheet context before turning to the investment decision-making process from strategic and tactical asset allocation to investment strategies, risk management, governance, reporting and control. Finally, it presents new developments in the field of managing assets at central banks. The individual chapters are written by central bankers, academics, and representatives from International Financial Institutions, each representing a particular aspect of the asset management practice.
Practical and powerful insights from a hall of fame of investors, central bankers and scholars, are packed into this one volume. If you could have only one book on central bank asset management, this would be it. —Peter R. Fisher, Clinical Professor, Tuck School of Business at Dartmouth
Jacob Bjorheim draws on his long experience in sovereign asset management to pull together a rich collection of insights from a broad range of expertise. Asset management at central banks has evolved and expanded considerably over the past decade. This book is a timely source of information and guidance. —Guy Debelle, Deputy Governor, Reserve Bank of Australia
Central bank balance sheets have grown at a tremendous pace over the last decade and a half. Drawing on contributions from scholars and experienced central bankers from around the world, this timely and insightful book sheds light on how central banks are, and should be, managing their growing balance sheets. —Kjell G. Nyborg, Chaired Professor of Finance, University of Zurich, Author of Collateral Frameworks: The Open Secret of Central Banks
Central banks and monetary authorities are charged with, and being held accountable for, managing portfolios of foreign currency assets of unprecedented size. The essays in this admirable book, written by some of the worlds most highly experienced officials, cover the full range of why and how this is currently being done and how new developments are affecting old practices. Interesting conceptually and immensely useful practically. —William White, Senior Fellow at the C.D. Howe Institute, former Head of the Monetary and Economic Department with the Bank for International Settlements (BIS) and chairman of the Economic and Development Review Committee at the OECD
An excellent and timely review of modern international reserve management, which ought to be read by everyone working with, or simply interested in, international asset management and finance as well as monetary and economic policy. The spectrum of authors is broad and their combined insight is very valuable. —Tom A. Fearnley, Investment Director, Norwegian Ministry of Finance
With “Asset Management at Central Banks and Monetary Authorities”, Jacob Bjorheim has achieved an editorial tour de force. The book assembles the insightful views of the leading experts in the field, both from an academic and practitioners’ perspective. It bridges the gap between the macroeconomics of central banks and the financial management of their reserves. A must read to understand how central banks are special in the group of institutional investors. —Eric Bouyé, Head of Asset Allocation and Quantitative Strategies, Treasury Department, The World Bank
The balance sheet is a large and important toolbox for any central bank and specifically the foreign exchange reserves constitute one the more powerful of these tools. This book provides excellent insight in the various perspectives of managing reserves at a central bank. —Heidi Elmér, Director of Markets Department, Severiges Riksbank
The world of international reserves has changed since the global financial crisis. In this volume, Jacob Bjorheim has assembled a stellar cast of experts to explain how and what that means for reserves management. With chapter authors like Andrew Ang, Jennifer Johnson-Calari, Robert McCauley, Ravi Menon, Simon Potter and Philip Turner, it is a book that every reserve manager must read. —Eli Remolona, Professor of Finance and Director of Central Banking, Asia School of Business in collaboration with MIT Sloan
Jacob Bjorheim has succeeded in bringing together a first-class team of experts, and organising their contributions in an articulated journey from the central banks’ policy mandate to their asset management practices. An indispensable post-crisis update of the subject and a a required reading for anyone professionally involved with central bank’s asset management, or simply curious about a topic benefitting otherwise from limited research. —Louis de Montpellier, Former Global Head, Official Institutions Group, SSGA, and former Deputy Head, Banking Department, Bank for International Settlements (BIS), Basel
At last, a book that shares with a wider audience, deep insight in a unique, challenging and ethical approach of asset management developed and implemented in the secretive world of central banks. If you wonder how to manage funds that stand ready for use at short notice in times of stress then this book is for you. Two features make it such a valuable read and a must-have reference: First, the very comprehensive list of themes covered from a rich diversity of angles. Second, the very impressive list of prominent institutions and authors that have contributed and shared their analysis and practical approaches of the issues presented. What is better than to get the information directly from first-hand practitioners, experts and managers themselves in their own words? —Jean-Pierre Matt, Former Head of Financial Analysis at the Bank for International Settlements (BIS) and founder of Quanteis
This book holds the promise to become the go-to guide for anyone wishing to learn more about the management of official foreign exchange reserves. Central bankers in particular, but also those providing services to central banks, will find benefit from the broad scope in subject matter and varied perspectives being presented. I am yet to see a compendium on official reserve management with similar reach in subject matter. —Leon Myburgh, Former Head Financial Markets Department, South African Reserve Bank (SARB), Pretoria
This is an immensely timely book at a time when central bank operations, and their balance sheets, remain “larger for longer”. Following the Financial Crisis 10 years ago, and with the Covid-19 Recession about to break, central bank balance sheets are at the forefront of the authorities’ response to economic issues as never before. Yet the management of their now large-scale assets remains a little known and little studied area. The authors of this book combine extensive technical and practical experience, and their observations will fill an important gap in the literature at a critical time. —Freyr Hermannsson, Former Head of Treasury, Central Bank of Iceland, Reykjavík

Table of Contents


Chapter 1. Introduction

Central banks and monetary authorities are public sector institutions, established by law, and given specific mandates to fulfill. Of these mandates, monetary policy is the primitive. It is conducted to keep the real economy growing, level of employment high, long-term interest rates moderate, inflation low, and the financial system stable. Everything else the central bank does is subsumed under this monetary policy mandate.
Jacob Bjorheim

Mandate, Balance Sheet and Reserves


Chapter 2. Central Banks: Gatekeepers of Monetary Stability and Guardians of Public Interest

This chapter presents the main elements of central banks’ traditional functions as gatekeepers of monetary and broader financial and economic stability and outlines some emerging considerations relating to central banks’ enhanced role as guardians of public interest. With regard to the central banks’ emerging enhanced role, the analysis focuses on their (1) heightened policy coordination need with fiscal, regulatory, and debt management authorities to increase the efficiency of the monetary policy transmission mechanism and the overall efficacy of economic policy making, (2) principal role in the establishment of a sovereign asset and liability management framework to identify, monitor, and manage sovereign balance sheet risks on a consolidated basis, which also helps monetary policy through a more accurate estimation of sovereign risks and consequently a more appropriate interest rate setting, (3) active role in the development of domestic capital markets to enhance the country’s funding sources and reduce its foreign exchange risk exposure, as well as to help the effectiveness of open market operations in targeting interest rates and in turn affecting the real economy, and (4) envisaged implicit role as protectors against emergent financial disruptions.
Michael G. Papaioannou

Chapter 3. Larger Central Bank Balance Sheets: A New Normal for Monetary Policy?

In the “new normal” for monetary policy, central bank balance sheets are likely to be larger and used more actively than before the Global Financial Crisis. Those who manage assets for central banks should take account of the asset and liability choices of many other policy-makers—those responsible for monetary policy, Treasury debt management and financial regulators. Large, diversified and less traditional central bank balance sheets have advantages.
Srichander Ramaswamy, Philip Turner

Chapter 4. How Countries Manage Large Central Bank Balance Sheets

Central banks often hold far more assets, and issue more liabilities to finance those assets, than is necessary to provide their domestic payments systems with adequate liquidity. That is to say, their balance sheets are “large” (See Stella (2010) Minimising monetary policy (BIS Working Paper 330)). Frequently central banks are large owing to their holdings of foreign reserves. Yet there is an interesting heterogeneity in how central banks finance large balance sheets. Those with lengthy experience managing large balance sheets almost invariably finance “excess assets” with non-monetary liabilities while those who are relative novices have relied heavily on monetary liabilities—bank reserves. This chapter examines a variety of practice managing large balance sheets since the global financial crisis (GFC). We argue that the recently expanded balance sheet countries may benefit from adopting the policies of their more experienced colleagues who have already “learned by doing.” In financial terms, experienced central banks have found that financing their balance sheets either directly or indirectly with a mix of government securities that are tradable among banks and non-banks is generally more efficient than financing excess assets with bank reserves—fungible only among banks. That is, over time, as central banks gain experience managing a large balance sheet, they tend to adopt more sophisticated and efficient financing strategies. Those financing strategies provide central banks greater scope for managing the risk and duration of their assets.
Peter Stella

Chapter 5. Reserve Accumulation, Sovereign Debt, and Exchange Rate Policy

In the past decade, foreign participation in local-currency bond markets in emerging countries increased dramatically. Additionally, emerging countries are increasingly deviating from inflation targeting regimes, managing their exchange rate and engaging in exchange-rate accumulation. In light of these trends, we revisit sovereign debt sustainability, and the choice of the optimal exchange-rate regime, under the assumptions that countries can accumulate reserves and borrow internationally using their own currency. As opposed to traditional sovereign debt models, asset valuation effects occasioned by currency fluctuations act to absorb global shocks and render consumption smoother. Countries do not accumulate reserves to be depleted in “bad” times. Instead, issuing domestic debt while accumulating reserves acts as a hedge against external shocks. We propose that a “pseudo-flexible regime,” to be the best policy alternative for emerging nations that face international shocks. A quantitative exercise suggests this strategy to be effective for smoothing consumption and reducing the occurrence of default and obtains that optimal reserve holdings turn out to be as large as those presently observed.
Laura Alfaro, Fabio Kanczuk

Chapter 6. The Cost of Holding Foreign Exchange Reserves

Recent studies that have emphasized that the costs of accumulating reserves for self-insurance purposes have overlooked two potentially important side effects. First, the impact of the resulting lower spreads on the service costs of the stock of sovereign debt, which could substantially reduce the marginal cost of holding reserves. Second, when reserve accumulation reflects “leaning-against-the-wind” sterilized interventions, the actual cost of reserves should be measured as the sum of valuation effects due to exchange rate changes and the local-to-foreign currency exchange rate differential (the inverse of a carry trade profit and loss total return flow), which yields a cost that is typically smaller than the one arising from traditional estimates based on the sovereign credit risk spreads. We document those effects empirically to illustrate that the cost of holding reserves may have been considerably smaller than usually assumed in both the academic literature and the policy debate.
Eduardo Levy-Yeyati, Juan Francisco Gómez

Domestic and Foreign Currency Assets


Chapter 7. Saudi Arabian Monetary Authority: Why Do Central Banks Hold Domestic and Foreign Currency Assets?

This chapter explains how domestic and foreign exchange reserves are accumulated and why they are held by central banks. Following a summary of trends in global foreign exchange reserves, this chapter provides a brief review of the benefits and costs associated with holding reserves. It then describes recent IMF work in refining traditional reserve adequacy frameworks. For practical illustration, the author draws on Saudi Arabia’s experience in accumulating foreign exchange reserves, considering the country’s fixed exchange rate regime and broader macroeconomic backdrop. The author sheds light on the pivotal role played by the central bank’s holding of foreign exchange reserves in maintaining monetary and financial stability for Saudi Arabia. He concludes that the costs associated with holding a sizeable pool of liquid assets are outweighed by a number of key benefits, including having the capacity to service an evolving set of liabilities and providing access to a countercyclical spending buffer, not least, during the country’s ongoing economic transition.
Talal Al-Humoud

Chapter 8. Safe Assets and Reserve Management

Managers of official dollar reserves are bound to pay attention to the debate over safe assets: their investment portfolios operationally define such assets. This chapter argues that reserve managers need not worry about a shortage of safe assets. The debate turns first on whether demand for dollar safe assets is likely to grow as rapidly as emerging market economies. Second, it turns on whether the supply of dollar safe assets can only grow with US fiscal deficits. Neither holds. On the demand side, emerging market economies’ growth does not require dollar reserves to grow at the rate observed in the early 2000s. In retrospect, rapid dollar reserve growth reflected emerging market economies’ response to dollar depreciation. When the dollar cycle turned to appreciation, foreign exchange reserves stopped growing. On the supply side, law and policy extend state backing to various IOUs and thereby make safe assets. US government support for the housing agencies Fannie Mae and Freddie Mac makes their debt into safe assets, albeit with wobbles. US government support for banks, including Federal Reserve liquidity, Federal Deposit Insurance Corporation insurance, and, in 2008, Treasury equity can make US bank liabilities safe. In the rest of the world, government support of non-US banks allows ones from well-rated countries to compete with US banks in selling safe dollar deposits. Moreover, international and interregional organizations, non-US sovereigns and agencies all compete with the US Treasury in selling safe dollar bonds. In allocating their dollar foreign exchange reserves, central bank reserve managers make room for all such competitors. In particular, they invest more than a third of their dollar reserves outside of US Treasury securities.
Robert Neil McCauley

Chapter 9. Expansion and Contraction of Central Bank Balance Sheets: Implications for Commercial Banks

Reserves and institutional asset managers have to constantly monitor and assess risk-return trade-offs in the markets where they invest. Among the various tools and indicators that they employ, understanding the balance sheet strength of commercial banks is indispensable. This is because of the role of banks as credit intermediaries for financing economic activity and their important function in the payment and market infrastructures for financial transactions. As central banks have embarked on many, new unconventional monetary policy measures, it is important to ask what the impact on commercial banks is, and whether this enhances or inhibits their traditional credit intermediary role. This chapter examines these questions and considers what hidden risks might be building up as central banks accumulate assets.
Srichander Ramaswamy, Philip Turner

The Investment Decision Making Process


Chapter 10. Management of Canada’s Foreign Exchange Reserves

Canada’s foreign exchange reserves are owned by the federal government, but jointly managed under a relatively unique framework that is based on a partnership between the government and the central bank. This partnership is supported by a well-defined governance structure that ensures that the reserve portfolio is appropriately structured to meet its strategic objectives, that the government’s risk tolerances are respected, and that associated costs and risks are carefully managed. Canada’s reserves are primarily held to help meet the government’s prudential liquidity objectives. The foreign currency holdings also support the market’s general confidence in Canada. Given these objectives, Canada’s focus is on liquidity and safety of principal. Return, while important, is a secondary focus. To help manage risks in the portfolio, the asset structure is guided by a number of strategic portfolio parameters. These parameters ensure that the reserve assets support the strategic priorities of liquidity and safety of principal while also striving to minimize the cost of holding reserves. To better manage interest rate and foreign exchange risks, Canada manages its reserves using an asset and liability matching framework. Under this approach, every foreign currency asset is funded by a liability of the identical currency and term-to-maturity. This effectively hedges the portfolio’s foreign exchange and interest rate exposures, although significant basis risk can remain. The asset and liability matching framework has served Canada extremely well, effectively eliminating foreign exchange and interest rate risk at relatively low cost. There are a number of factors that explain this. First, Canada has a floating exchange rate with very infrequent intervention. As a result, the reserve portfolio stays hedged. Second, Canada’s high credit quality and well-developed capital markets mean that it can fund the foreign exchange reserves relatively cheaply, both directly and synthetically. This allows the portfolio to meet its liquidity and capital preservation goals and, typically, earn a positive net return.
Grahame Johnson

Chapter 11. How Singapore Manages Its Reserves

Singapore’s reserves serve three objectives—as a buffer against crisis, as an endowment to finance current needs, and to maintain confidence in Singapore’s exchange rate-centered monetary policy. The reserves are managed in three pots—the Monetary Authority of Singapore (MAS), as the central bank, manages the official foreign reserves (OFR) and invests them mainly in safe and liquid assets; the GIC, a fund manager to the government, manages a diversified portfolio with a higher risk profile to achieve sustainable long-term returns; Temasek, an investment company wholly owned by the government, is an active equity investor which seeks to deliver long-term shareholder value. MAS’ approach to managing the OFR encompasses robust risk management, balanced asset allocation, and an efficient investment process. Risk management involves the setting of liquidity and risk tolerance levels, and employing stress tests to assess the risks to the portfolio. To achieve a balanced asset allocation, the OFR is diversified across geographic regions, asset classes, and currencies. The investment process includes judicious benchmark selection and customization, and tapping into specialized external investment expertise.
Ravi Menon

Chapter 12. European Central Bank: The Investment Decision-Making Process and Its Governance

This chapter describes the foreign reserve management framework of the European Central Bank (ECB) and the related decision-making process. The ECB’s decentralized foreign reserve management system is unique among central banks around the world, as it involves all of the national central banks which are part of the Eurosystem. This special characteristic influenced the design of the framework, as well as its functioning and governance. The distinctive features of and roles played by the three investment management layers (i.e., the strategic and tactical benchmarks, as well as the actual portfolios) are covered in detail, including the decision-making structure of each level. The chapter describes the evolution of the ECB’s reserve management framework over time which has been shaped by the aims to create incentives to enhance performance and promote risk-taking at various levels, encourage open information and knowledge sharing, as well as support inclusiveness within the Eurosystem. The framework has been periodically adjusted as a result of the inclusion of new members in the Eurosystem and has also contributed to enhancing the absolute return on the ECB’s foreign reserves.
Torsti Silvonen, Etienne Port

Asset Allocation in a New Context


Chapter 13. Reserve Management at Danmarks Nationalbank: Combining Liquidity Tiers with an Adaptive Risk Budget

Over the recent years, Danmarks Nationalbank has transformed its approach to reserve management. The new framework is organized around two main pillars—a tiered liquidity management framework and an overall risk budget. Together they provide a framework for handling large balance sheet fluctuations—a consequence of the fixed exchange-rate policy—while aligning long-term exposure to investment risk with the primary policy objectives. The anchoring of the risk budget to a “policy portfolio” clarifies the risk and return implications of the bank’s multiple objectives and highlights the rationale for diversification.
Morten Kjærgaard, Rasmus Vahle, Jacob Wellendorph Ejsing

Chapter 14. The Swiss National Bank’s Investment Decision-Making Process from a Safe-Haven Currency Perspective

Defining an investment policy at the Swiss National Bank (SNB) has a long history and tradition. Strategy definition is a two-stage process. As a first step, the investment policy framework is drawn up, comprising all aspects of central banking, reputation, and risk policy, and a detailed, feasible long-term asset allocation strategy is formulated. In the second step, an investment strategy for the following 12–15 months is then prepared on the basis of this “neutral” allocation. Any deviations from the LAA are solely attributable to market valuation estimates. The SNB reports in a safe-haven currency, i.e. the Swiss franc. This has far-reaching implications for investment policy: the SNB can hold a higher proportion of risk assets relative to other central banks, while the diversification effect of risk assets is less pronounced and that of bonds stronger. The gradual expansion of the investment universe over the last 20 years has been accompanied by an ongoing improvement in the portfolio’s risk and return profile, even against the backdrop of the significant expansion in the SNB’s balance sheet. Ultimately, it has also alleviated the issue of excessive concentration in certain markets, which had become ever more problematic in light of this substantial balance sheet growth.
Sandro Streit, Patrick A. Muhl

Chapter 15. The Strategic Asset Allocation Framework of Banco de México

The strategic asset allocation framework (SSA) of Banco de México has evolved dramatically over the last few years. It has involved a long learning process that required a deeper technical training of its personnel and significant research. In this chapter, we will describe the evolution of the strategic asset allocation process used by the Central Bank of Mexico (CBM) to construct their benchmark for the investment of the international reserves portfolio.
Gerardo Israel García López, Rafael Jiménez Padrón, Andrea San Martín Kuri Breña

Chapter 16. Dynamic Strategic Asset Allocation at the National Bank of Belgium: Why and How to Implement It in a Central Bank

The management of central bank foreign exchange reserves is a topic in which best practices do not remain constant but evolve. For a number of countries, the international reserves have become a significant national asset. For other countries, the reserves are still seen in the context of monetary policy implementation. In most cases, however, the reserves are higher today than they were 10 years ago. Furthermore, new capital markets have opened up and a broader range of financial instruments have been added to the universe of acceptable reserves assets. In all cases, the task of managing these reserves has changed and become more complex. At the same time, public interest has increased and reserves management activities—and their resulting returns—have become more visible. The asset management units within central banks, therefore, do not only have responsibilities towards their own senior management. They are also market participants and public servants. This attention is both legitimate and important. But in all this, their day-to-day portfolio management activities are primarily guided by the traditional trilogy of objectives, i.e. “safety first”, then “liquidity” and finally “return”. These objectives have guided reserves managers over the years and are still valid. But they need an update and an extension in order to meet new multi-faceted challenges. This chapter seeks to show one possible way forward.
Etienne Lavigne

Chapter 17. Central Bank of Lithuania: Asset Allocation in a Risk Parity Framework

This chapter reviews the Strategic Asset Allocation (SAA) at the Bank of Lithuania (BoL) and presents its transformation from a capital preservation approach based on historical data to a new framework which rests on three pillars: a forward-looking regime aware asset return simulation procedure, a risk budget, and a risk parity concept. A comprehensive review of the theoretical and practical aspects of the new framework is presented, paying special attention to the analysis of advantages and disadvantages based on practical experience in a central bank context. The potential of the current SAA framework at the BoL to strike the balance between the diversification, search for yield and the risk-on and risk-off nature of the markets is demonstrated. The analysis explores potential directions for further development of risk parity-based asset allocation. The considerations are given to merits of moving from an asset-based risk parity toward one that is founded in risk factors or in a hierarchical clustering. The possibility of replacing the volatility diversification with a tail risk diversification approach is emphasized as a way of alignment of asset allocation with the fact that central bank’s investment portfolio is, in its essence, a portfolio for “rainy days”.
Jonas Kanapeckas

Governance and Risk Management


Chapter 18. Good Governance: Principles, Pitfalls, and Best Practice

Good governance is a holistic concept that extends beyond legislators and supervisors to encompass all central bank functions—from the setting of investment policy to database management. The three main channels of governance comprise the legal authorizing environment, the top-down delegation of authority, and bottom-up transparency and accountability for outcomes. In this chapter, the authors review the principles underlying good governance, recognizing that the actual structure and organization may differ amongst institutions. The authors then describe the major challenges typically facing public sector asset managers, drawing on their experience working globally with public sector asset managers over decades. Some of these issues include the role of the Investment Committee within the decision-making hierarchy, accountability through meaningful reporting, and enhancing returns while mitigating reputational risk. The chapter ends with four initiatives that in many cases have led to more effective asset management operations: (1) implementing holistic change management practices; (2) regular strategic review of investment policy and guidelines; (3) clearly distinguishing between economic (investment) and accounting results when assessing investment outcomes; and, (4) developing a communication strategy for external stakeholders on the investment framework and performance indicators
Jennifer Johnson-Calari, Isabelle Strauss-Kahn

Chapter 19. Central Bank of Brazil: Investment Decision-Making in an Integrated Risk Management Framework

Risk management is an evolving discipline. Its contribution to protect the integrity of an organization is well-known. The primary objective of the risk function is to establish a structural and process-driven environment that facilitates the achievement of the organization’s objectives, mitigate risks whenever possible, and control residual risks. Combined, they improve the organization’s resilience in case of risk incidents. Nevertheless, the risk function today goes beyond its traditional role of reporting and controls. It plays a fundamental role in the organization’s operational and strategic decision-making processes. A pro-active approach therefore creates, collects, and disseminates information about all organizational risks. Risk information properly intertwined in the decision-making process, combined with a robust governance can minimize decisions biases and, consequently, foster a better alignment between strategic objectives, risk appetite and decisions. This chapter discusses how risk information can substantially impact the investment decision-making, improving decision quality and increasing transparency.
Isabela Ribeiro Damaso Maia

Chapter 20. Governance, Risk Management, Reporting, and Control at the Central Bank of Colombia

There are several factors that can lead to successful outcomes in asset management at central banks and monetary authorities. For instance, having a robust asset allocation model, highly experienced portfolio managers, and sophisticated quantitative tools for implementing investment strategies. Nonetheless, in this chapter I will argue that governance, risk management, reporting, and control can be even more important than any of the factors mentioned above. That is true for any asset management operation but it is even more so for central banks, given the amount of reserves that they manage and the importance of their functions.
This chapter discusses some general principles related to governance, risk management, reporting, and control. As an illustration, I will explain how those principles are implemented in the reserve management function at the Central Bank of Colombia. However, I will also attempt to show that the principles discussed here can be implemented differently in other organizations.
The first section of this chapter explains very broadly how the Central Bank of Colombia manages foreign exchange reserves. The second section deals with governance, the third with risk management, and the fourth with reporting and control. The fourth section discusses the process-based management framework as a way to put the whole process together. The final section concludes.
Marco Ruiz

Chapter 21. Foreign Exchange Reserves – Protection Connected with Financial Risks

Foreign exchange reserves are indispensable for fulfilling the central banks’ statutory mandates. For some central banks their investment is in addition a major source of profit. However, holding the foreign exchange reserves exposes central banks to financial risks. Some of these risks are unavoidable and can be challenging to manage. Such risks may increase when central banks decide to invest part of their foreign reserves on the markets beyond the traditional scope of assets that hitherto have been perceived as safe and highly liquid. The increasing awareness of financial risks explains the popularity of dividing the reserves assets into sub-portfolios, i.e. tranching and a risk budgeting concept. Such frameworks are not a panacea for avoiding potential financial losses but could support well-structured financial risk management processes and assure more stable risk profile. But this framework works only with efficient decision-making process, adequate risk measures, and proper IT support—these are the classic challenges that central banks’ risk managers have to address.
Ewa Szafarczyk

Chapter 22. Central Banks as Bankers to Each Other: Overview, Trends, and Future Directions in Global Official Sector Service Provision

The choice of custodial and banking relationships is an underappreciated but important consideration for reserve managers in managing their overall risk profile. The major reserve currency central banks have long served as correspondent banks, transactional agents, and custodians for the safekeeping of foreign reserves for each other and the global central banking community. The ability of central banks to provide each other with safe, confidential, and reliable banking and custody services (BCS) has provided important public benefits, aiding in central banks’ execution of foreign reserve management, monetary policy implementation, financial stability operations, and other mission-critical central bank activities. In the decade since the global financial crisis, and demonstrating the continued strong policy rationale for the inter-central bank provision of BCS, official BCS volumes have continued to grow, reflecting broader global reserve accumulation patterns, the impact of regulatory reforms, counterparty risk perceptions, correspondent bank de-risking, official cross-border financial stability initiatives, and other trends. More recently, the increasingly dangerous cyber threat to wholesale payments security has led central bank providers of BCS and their central bank clients to adapt in order to better protect foreign reserve assets from criminal actors.
Simon Potter, Matthew Nemeth, Mark Choi

New Trends in Asset Management


Chapter 23. Modern Central Bank Reserves Management: Introduction and Overview

The management of central bank reserves is a subject in which best practice does not remain constant but is continually evolving. As markets develop and overall levels of central bank reserves have grown, so the task of managing them has changed and becomes more complex. New instruments have been added to the universe of acceptable assets, and more markets have become open and investable for international investors. For a number of countries, the reserves have become a significant national asset and potential income generator that needs to be invested wisely and profitably, and public scrutiny of the activities of central bank reserves managers in these countries is both legitimate and important. Even for countries whose reserves are more policy-orientated and less a store of national wealth, the reserves management function has often grown in significance, and today’s reserves managers have responsibilities to their own senior management, to their wider national public, and to markets and other market participants.
The traditional trilogy of objectives of “Security, Liquidity and Return” that has guided reserves managers over the years is still valid. But it needs updating and extending for today’s more complex and multi-faceted challenges. This chapter seeks to do so.
John Nugée

Chapter 24. Bank of Israel: Integrating Equities into the Foreign Exchange Reserves

Recently a number of central banks, including the Bank of Israel (BOI), have started to add risky assets such as equities to the traditional investment assets. This chapter elaborates on BOI’s motivations to add equities to its portfolio, describes the process of its move into investing in equity, and reports on the contribution of equity investment to its portfolio performances. This chapter also describes the BOI investment philosophy, which has guided its investment decisions in the process of moving into equity.
Andrew Abir, Golan Benita

Chapter 25. Renminbi Securities in Portfolios of Official Institutions: A Perspective from the Hong Kong Monetary Authority

The management of central bank reserves is a subject in which best practice does not remain constant but is continually evolving. As markets develop and overall levels of central bank reserves have grown, so the task of managing them has changed and become more complex. New instruments have been added to the universe of acceptable assets, and more markets have become open and investable for international investors. For a number of countries the reserves have become a significant national asset and potential income generator that needs to be invested wisely and profitably, and public scrutiny of the activities of central bank reserves managers in these countries is both legitimate and important. Even for countries whose reserves are more policy-orientated and less a store of national wealth, the reserves management function has often grown in significance, and today’s reserves managers have responsibilities to their own senior management, to their wider national public, and to markets and other market participants. The traditional trilogy of objectives of “Security, Liquidity and Return” that has guided reserves managers over the years is still valid. But it needs updating and extending for today’s more complex and multi-faceted challenges. This chapter seeks to do so.
Martin Matsui

Chapter 26. Responsible Investment and Central Bank Asset Management

Over the last decade, responsible investment—the consideration of environmental, social and governance (ESG) issues in investment decision-making—has spread widely throughout the financial sector. Its adoption is due to its perceived usefulness in identifying risks and opportunities, particularly among larger asset owners, support from regulators and a vigorous supply-side response from investment service providers. Approaches pursued by investors include negative screening, thematic investing, ESG integration and active ownership. This chapter reviews recent trends in responsible investment and discusses how institutional investors are applying its techniques to both directly managed and third party-run portfolios. For the former, approaches vary by asset class. Responsible investment practices are more developed for listed equity, but they are becoming increasingly applied in corporate and sovereign fixed income and alternative investment markets. For indirectly managed portfolios, responsible investment practice is focused on managing the relationship between the asset owner and the investment manager to ensure the former effectively communicates expectations, and the latter is able to deliver against them.
Archie Beeching, Anna Georgieva, Justin Sloggett

Chapter 27. BlackRock: Reserves Management with Factors and Reference Portfolios

Factors—historically broad and persistent sources of return—can be used with simple equity-bond Reference Portfolios to meet the multiple challenges facing official reserve institutions. First, Reference Portfolios can be constructed to reflect the risk appetite of stakeholders, provide clear accountability, and benchmark the value added by institutional management. Second, institutions can use strategies designed to harvest factor premiums transparently and at low cost. When used at the total portfolio level, factors can inform the structure of a Strategic Portfolio, and help manage stakeholder expectations with scenario analysis. Factors can also be used at a more tactical level, in combination with other active strategies to seek incremental returns in excess of strategic benchmarks.
Andrew Ang, David Chua, Katelyn Gallagher, Stephen Hull
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