Risk management for central banks and other public investors

Cover......Page 1
Half-title......Page 3
Title......Page 5
Copyright......Page 6
Contents......Page 7
Figures......Page 12
Tables......Page 14
Boxes......Page 17
Foreword......Page 19
Introduction......Page 22
Structure of the book: Investment vs. policy operations; different risk types......Page 23
Part I: Investment operations......Page 25
Part II: Policy operations......Page 26
Part III: Organizational issues and operational risk......Page 27
Part I: Investment operations......Page 29
1. Introduction......Page 31
2. Public institutions' specificities as investors......Page 32
3. How policy tasks have made central banks large-scale investors......Page 38
3.1 Banknotes issuing and payment systems......Page 39
3.2 Monetary policy implementation......Page 40
3.3 Foreign exchange policies and reserves......Page 41
3.4 Financial stability functions......Page 44
4. Optimal degree of diversification of public institutions' financial assets......Page 45
5.1 The general usefulness and 'industrial organization' of active portfolio management......Page 51
5.2 Public institutions and central banks as active investors......Page 54
6. Policy-related risk factors......Page 57
6.1 Banknotes, seignorage, and liquidation risk......Page 58
6.2 Monetary policy interest rates......Page 60
6.3 Foreign exchange reserves and exchange rate changes......Page 61
7. The role of central bank capital – a simple model......Page 62
8.1 Integrated financial risk management in general......Page 69
8.2 Integrated risk management issues for public investors......Page 71
9. Conclusions......Page 76
1. Introduction......Page 77
2. A primer on strategic asset allocation......Page 78
2.1 General principles of SAA methodologies......Page 79
2.2 Evolution of SAA methodologies......Page 80
2.2.1 Internalization of the SAA process......Page 82
2.2.2 Building views into the SAA framework......Page 84
2.2.3 Integration of different risks......Page 85
2.2.4 Portfolio optimization: Markowitz and beyond......Page 86
3. Components of the ECB investment process......Page 96
4. Forward-looking modelling of the stochastic factors......Page 103
4.1 A macro model for multiple currency areas......Page 105
4.2 The yield-curve model......Page 108
4.3 A model for credit migrations......Page 111
4.4 Modelling exchange rates......Page 114
4.5 Instrument pricing and calculation of returns......Page 115
5. Optimization models for SAA under a shortfall approach......Page 117
5.1 Multi-currency model......Page 121
5.1.1 Discretization......Page 123
5.2 Single market model......Page 125
6.1 The investment universe......Page 127
6.2 The objective function and constraints......Page 128
6.3 Using the models......Page 129
6.4.1 Macroeconomic scenarios and starting yield curves......Page 132
6.4.2 Yield-curve projections and expected returns......Page 133
6.4.3 Optimal portfolio allocations......Page 138
6.5.2 Yield-curve projections and expected returns......Page 139
6.5.3 Optimal portfolio allocations......Page 142
1. Introduction......Page 145
2. Credit risk in central bank and other public investors' portfolios......Page 146
3.1 Motivation......Page 150
3.2 Analytical results......Page 153
3.3 Simulation approach......Page 156
3.4 Probabilities of default/migration......Page 161
3.4.1 Distinction between sovereign and corporate ratings......Page 162
3.4.2 Probabilities of default for highest ratings......Page 163
3.4.3 Default probabilities for low duration assets......Page 164
3.5 Recovery rates......Page 168
3.6 Correlations......Page 169
3.7 Credit spreads......Page 170
4. Simulation results......Page 171
4.1 Portfolio I......Page 173
4.2 Portfolio II......Page 178
4.3 Sensitivity analysis......Page 181
5. Conclusions......Page 183
1. Introduction......Page 185
2. Overview of the distribution of portfolio management tasks within the Eurosystem......Page 187
3.1 Defining limits......Page 189
3.2 Market risk limits......Page 190
3.2.1 The ECB's market risk control framework......Page 193
3.3 Credit risk limits......Page 194
3.3.1 Credit quality and size as key inputs to limit setting formulas......Page 195
3.3.2 Exposure calculation......Page 200
3.3.3 The ECB's credit limits......Page 201
3.4 Liquidity limits......Page 204
3.5 Maintenance of risk limits......Page 206
4.1 Limit compliance monitoring......Page 207
4.2 Valuation - validation of end of day prices......Page 209
4.3 Validation of prices transacted at......Page 210
4.4 Dealing with backdated transactions......Page 214
4.5 Maintenance and regular checks of static and semi-static data......Page 215
4.6 Maintenance of strategic benchmarks......Page 216
5. Reporting on risk and performance......Page 217
5.1 Characteristics of a good reporting framework......Page 218
5.2 Making sure the necessary data is available......Page 219
5.3 Reporting for ECB investment operations......Page 221
6. IT and risk management......Page 224
6.2 The integrated risk management system......Page 225
6.4 Systems support and operations......Page 227
6.5 Projects......Page 231
6.6 Build or buy......Page 232
6.7 Complete outsourcing of IT systems – application service provider solutions......Page 234
1. Introduction......Page 235
2. Rules for return calculation......Page 236
2.1 Basic formulae......Page 237
2.2 Trade-date versus value-date approach......Page 239
2.3 Actual versus all-cash basis......Page 240
3.1 Capital Asset Pricing Model as a basis......Page 241
3.2 Total performance: Sharpe ratio......Page 242
3.3 Passive performance: Treynor ratio......Page 243
3.4 Extension to Value-at-Risk: reward-to-VaR ratio......Page 244
3.5 Active performance: information ratio......Page 245
4. Performance measurement at the ECB......Page 247
1. Introduction......Page 250
2.1 Arbitrage Pricing Theory as a basis......Page 252
2.2 Parameterizing the model: choice of risk factors......Page 254
2.3 Fitting to practice: empirical multi-factor models......Page 255
3. Fixed-income portfolios: risk factor derivation......Page 256
3.1 Risk factor: passage of time......Page 258
3.2 Risk factor: change of yield to maturity......Page 260
3.3 Risk factor: movement of basis government yield curve......Page 262
3.4 Risk factor: narrowing/widening of sector and euro country spreads......Page 268
4. Performance attribution models......Page 269
4.1 Fundamental types of performance attribution models......Page 273
4.2 Fixed-income performance attribution models......Page 277
5. The ECB approach to performance attribution......Page 285
6. Conclusions......Page 295
Part II: Policy operations......Page 297
1. Introduction......Page 299
2. The collateral framework and efficient risk mitigation......Page 302
2.1.2 Credit quality and easy availability of credit assessment......Page 303
2.1.5 Available amounts and prospective use......Page 304
2.2 Risk mitigation techniques – the Eurosystem approach......Page 305
2.3 Collateral eligibility and risk control measures in inter-bank transactions......Page 307
2.4 Monitoring the use of the collateral framework and related risk taking......Page 310
3.1 A simple model......Page 312
3.2 Empirical estimates of the effect of eligibility on yield: normal times......Page 319
3.2.1 Measuring the effect on spreads of a change in eligibility......Page 320
3.2.2 Spread between collateralized and uncollateralized inter-bank repurchase operations......Page 322
3.2.4 Collateral for central bank operations and for inter-bank repurchase markets......Page 323
3.3 The eligibility premium in times of a liquidity crisis: the 'sub-prime turmoil' of 2007......Page 325
3.4 Effects of eligibility on issuance......Page 327
4. Conclusions......Page 328
1. Introduction......Page 331
2.1 Scope and elements......Page 335
2.1.1 Rating agencies......Page 336
2.1.2 Central bank's in-house credit assessment systems......Page 337
2.1.3 Counterparties' internal ratings based (IRB) systems......Page 339
2.2 The Eurosystem Credit Assessment Framework......Page 341
3. Collateral valuation: marking to market......Page 343
4. Haircut determination methods......Page 346
4.1 Basic VaR-related haircuts......Page 349
4.2.1 Exogenous liquidity risk......Page 351
4.2.2 Endogenous liquidity risk......Page 353
4.2.3 Yield-curve differentials......Page 355
4.2.4 Effective supply and average issue size......Page 357
4.2.5 Bid-ask spread......Page 358
4.2.6 Defining liquidity categories......Page 359
4.3 Credit risk-adjusted haircuts......Page 361
5. Limits as a risk mitigation tool......Page 365
6. Conclusions......Page 366
1. Introduction......Page 368
2.1 Types of operations......Page 370
2.2 Common principles......Page 371
2.3 Choices of the overall operational framework......Page 373
2.4 External constraints......Page 375
3. Eligibility criteria......Page 376
4.1 Credit risk assessment framework......Page 381
4.3 Risk control measures......Page 382
5. Conclusions......Page 385
1. Introduction......Page 387
2. Simulating credit risk......Page 388
2.1 Default probabilities and recovery rates......Page 390
2.2 Default correlation......Page 393
3. Simulating liquidity-related risks......Page 394
4. Issues related to concentration risks......Page 396
4.1 Concentration on the level of counterparties......Page 397
4.2 Concentration on the level of collateral......Page 399
4.3 Concentrations in collateral from a single counterparty......Page 402
5. Risk measures: Credit Value-at-Risk and Expected Shortfall......Page 404
6. An efficient Monte Carlo approach for credit risk estimation......Page 407
6.1 Importance sampling......Page 408
6.2 Quasi-Monte Carlo methods......Page 410
6.3 Empirical results on variance reduction......Page 412
7. Residual risk estimation for the Eurosystem's credit operations......Page 415
7.1 Expected shortfall in a base case scenario......Page 416
7.2 Stability of risk calculations in terms of assumptions......Page 417
7.3 Risk development over time......Page 420
8. Conclusions......Page 421
1. Introduction......Page 422
A Equal access FCM measures......Page 424
C Organize emergency/solvency assistance to be provided by other financial institutions......Page 426
3.1 Key lessons retained from nineteenth-century experience......Page 427
3.2 The nature of liquidity problems of banks......Page 429
3.3.1 Negative externalities of illiquidity (and bankruptcy)......Page 431
3.3.2 Central bank is only economic agent not threatened by illiquidity......Page 432
3.3.4 Superior ability of the central bank to secure claims......Page 433
3.3.5 Haircuts as powerful risk mitigation tool if credit risk is asymmetric......Page 434
3.4 ELA provided by other banks, coordinated by the supervisor or the central bank......Page 435
3.5 Moral hazard......Page 436
3.6 Constructive ambiguity......Page 439
3.7 At what rate to provide special lending in a crisis situation?......Page 442
4. Financial stability role of central bank operational framework......Page 444
5. The inertia principle of central bank risk management in crisis situations......Page 446
6.1 Emergency liquidity injections through open market operations......Page 450
6.2 Narrowing the spread of the borrowing facility vis-à-vis target rate......Page 455
6.3 Widening of collateral set......Page 456
6.4 Other equal access FCM measures......Page 459
6.5 Conclusions: the role of equal access FCM measures......Page 460
7. FCM measures addressed to individual banks (ELA)......Page 462
8. Conclusions......Page 465
Part III: Organizational issues and operational risk......Page 469
1. Introduction......Page 471
2. Relevance of the risk management function in a central bank......Page 472
3. Risk management best practices for financial institutions......Page 473
4.1 Independence of the risk management function......Page 476
4.2 Separation of the policy area from the investment area of the central bank – the role of risk management (Chinese walls principle)......Page 478
4.3 Transparency and accountability......Page 479
4.4 Adequate resources......Page 482
4.5 Responsibilities of the risk management division......Page 483
4.6 Risk management culture......Page 485
5. Conclusions......Page 487
1. Introduction......Page 488
2.1 Non-financial objectives......Page 491
2.2 Not-for-profit values and incentives......Page 492
3. Definition of operational risk......Page 493
3.2 Normal business conditions vs. worst-case scenarios......Page 494
3.4 Inherent risk vs. worst-case scenario......Page 495
4. ORM as overarching framework......Page 496
5. Taxonomy of operational risk......Page 497
6. The ORM lifecycle......Page 499
7. Operational risk tolerance policy......Page 500
7.1 Foundation: the risk impact-grading scale......Page 501
7.2 Implication: risk tolerance guidelines......Page 502
8.1 Objective and scope......Page 504
8.2 Approach......Page 505
8.3 Output and lessons learned......Page 506
9.1 Objective and scope......Page 507
9.2 Approach......Page 508
9.3 Bottom-up risk assessments vs. BPM and TQM......Page 509
10. ORM governance......Page 511
11. KRIs and ORM reporting......Page 512
11.2 Current developments at the ECB......Page 513
12. Conclusions......Page 516
References......Page 518
Index......Page 535