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2023 | OriginalPaper | Chapter

The Strategic Allocation and Sustainability of Central Bank Investments

Authors : Davide Di Zio, Marco Fanari, Simone Letta, Tommaso Perez, Giovanni Secondin

Published in: Financial Risk Management and Climate Change Risk

Publisher: Springer Nature Switzerland

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Abstract

In recent years, the extensive recourse to unconventional monetary policy measures and the growing importance of the transition process towards a sustainable economy have given rise to new challenges for the Eurosystem’s central banks in managing financial risks. In this context, central banks’ investment strategies, whose goal is to reinforce capital strength, have been combined with the adoption of criteria aimed at fostering a sustainable growth model. This work describes the strategic allocation process for investment developed by the Bank of Italy and the methodology adopted for applying sustainability criteria to some of the portfolio’s asset classes.

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In particular, art. 123 of the Treaty on the Functioning of the European Union (TFEU) prohibits the monetary financing of governments by the Eurosystem central banks. The ECB is responsible for verifying compliance of the NCBs with the provision of the TFEU. In practice, it is not permitted to subscribe public securities on the primary market. Purchases are permitted on the secondary market within maximum thresholds linked to the GDP of each country.

The ‘monetary income’ is defined as the annual income obtained from the assets held against the banknotes in circulation and deposit liabilities to credit institutions (Bank of Italy 2022b).

See the box ‘Rules on risk sharing on monetary policy operations’ in Bank of Italy (2022b).

Usually through the estimate of covariance matrix among variables, possibly resorting to its factorization. In most cases, factorization of the covariance matrix make use of Cholesky decomposition (e.g., Strang 2016).

In recent years, global VAR models (GVAR) have also been developed to describe the trend of the global economy and financial markets (Pesaran et al. 2004).

See for instance Green (2000); for the applications of BVAR methods see in particular Ciccarelli and Rebucci (2003).

Through Bayes’ theorem, the prior distribution and the probability distribution assumed on the data – also called likelihood – are combined to obtain a posterior distribution. The more the prior distribution differs from empirical evidence, the more the posterior distribution deviates from the prior distribution. The appropriate statistics of the posterior distribution will provide the estimates of the parameters of interest and their variability.

If the generating process is stationary, VAR and BVAR projections generally converge over the medium- or the long term to the unconditional mean, or equilibrium state, of the process.

Unlike trimming in which the extreme observations are removed, winsorization does not reduce the sample size while preserving large part of historical information. The value of α used in Fig. 1 is 20 per cent.

This is strictly true for local currency equities, while non-euro equities need to be converted into euro using the simulated exchange rates.

The investment portfolio includes financial investments in euros and in foreign currencies not related to monetary policy. It includes government bonds of the euro area and other public institutions, corporate bonds, shares, and other equity instruments.

Adverse scenarios are identified with respect to the distribution of terminal values of net economic capital.

These are mainly banks, insurance companies and social security institutions that have accrued the right to a dividend in accordance with the provisions of the Statute of the Bank of Italy, reformed with law no. 5 of 29 January 2014.

Dividend is calculated on the profit arisen from the traditional balance sheet items, not on the economic result of the integrated balance sheet.

According to the Bank of Italy’s Statute, the general risk provision covers risks connected with the Bank of Italy’s overall activity, including those that cannot be determined individually or allocated objectively (Bank of Italy 2022b).

Gold is historically held by central banks. It performs the function of protecting their financial strength in extreme scenarios. The share of gold that central banks should hold is a subject of debate. Zulaica (2020) shows that, in addition to purely financial reasons, qualitative considerations play a fundamental role in this choice.

The Bank’s sustainable investment policy refers to: (a) the principles of the United Nations Global Compact, the Sustainable Development Goals of the United Nations 2030 Agenda and the 2015 Paris Climate Agreement; (b) the recommendations of the NGFS; (c) the common position of the Eurosystem for NMPPs (see, Bank of Italy 2021; the press release by the ECB, ‘Eurosystem agrees on common stance for climate change-related sustainable investments in non-monetary policy portfolios’, 4 February 2021).

Exclusion criteria are based on: (a) the eight fundamental conventions of the International Labour Organization (ILO) that require compliance with fundamental rights, including the elimination of forced labour, freedom of association, the abolition of child labour and of discrimination in employment; (b) international treaties on chemical, biological and nuclear weapons, anti-personnel mines, cluster munitions, weapons with non-detectable fragments, incendiary weapons and blinding laser weapons. Tobacco producers are also excluded.

TEV is a measure of a portfolio’s risk relative to a benchmark, calculated as the standard deviation of the portfolio’s differential returns relative to that of the benchmark over a given time-horizon.

The indices for IP and EP, as well as the replicating portfolios, exclude the shares of banks and insurance companies, to avoid possible conflicts of interest. For IP, the shares of the media sector are also excluded.

BIRR is an acronym for Burmeister, Ibbotson, Roll, and Ross.

The methodology for constructing ESG scores is based on the analysis of indicators referring to different macro areas for each of the three pillars: the environmental pillar (E); the social pillar (S); and the corporate governance pillar (G). The final score is determined by weighting all indicators with weights defined at the level of each firm, although largely equal for firms in the same sector. Carbon intensity is measured by the ratio between tons of greenhouse gas emissions and turnover.

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Title: The Strategic Allocation and Sustainability of Central Bank Investments
Authors: Davide Di Zio
Marco Fanari
Simone Letta
Tommaso Perez
Giovanni Secondin
Publisher: Springer Nature Switzerland
Book: Financial Risk Management and Climate Change Risk
Print ISBN: 978-3-031-33881-6

Electronic ISBN: 978-3-031-33882-3

Copyright Year: 2023
DOI: https://doi.org/10.1007/978-3-031-33882-3_9