A General Concept of Central Bank Wide Risk Management

Transcription

1 1 A General Concept of Central Bank Wide Risk Management By Amporn Sangmanee, Ph.D., CFA** and Jarumanee Raengkhum*** Introduction The goals of risk management at the central-bank wide level are to set a framework for identifying, monitoring and managing risk arising from monetary and financial institutions policy implementation, and to facilitate the optimal resource allocation of foreign exchange reserves. This risk management framework is usually developed in line with best market practices. Central banks can classify central bank wide risks into two major dimensions, including financial risk arising from international reserve management and financial markets operations and strategic risk of financial institutions policy and monetary policy (Figure 1.) While central banks usually have integrated models to monitor financial risks, which are for the most part, quantifiable, nonquantifiable strategic risk is of no less important. The main reason that strategic risk is Figure 1 : Chart of Central Bank Wide Risk Management Central Bank Wide Risk Management Operational Risk Financial Risk Strategic Risk Monetary Policy Banking System Stability * The Drafted Version Was Published in Risk Management for Central Bankers, Central Banking Publications, UK ** Author, Team Executive, Risk Management Division, Bank of Thailand *** Co-Author, Analyst, Risk Management Division, Bank of Thailand The views expressed in this paper are solely those of the authors and do not necessarily represent the views of the Bank of Thailand. We would like to thank Duangmanee Vongpradhip, Aroonrat Ngamjaruspong, Supawadee Punsri, Wongwatoo Potirat, Vachira Aromdee, Ronadol Numnonda, Yoot Khunsihapak and Chotibhak Jotikasthira for invaluable comments. Of course any error and omissions remain ours.

2 2 explicitly defined in this case is due to the limitation of financial risk framework to capture the risk of policy implementation. Moreover, operational risk may post vulnerability to central banks internal systems. At present, the responsibility of the Treasury Risk Management Department at the Bank of Thailand (BOT) is limited to the management of financial risk and strategic risk of financial markets operations. Nevertheless, in this paper, we will briefly touch upon strategic and operational risk management practices, each of which we derive from general framework at central-bank level. This paper is divided into 2 major sections. Section 1 discusses current risk management practices at the BOT, which cover financial and strategic risk management of international reserve management and domestic financial markets operations group. Section 2 discusses other aspects of central bank wide strategic and operational risk management, which is currently not within our scope of risk management practices. Section 1: Risk Management Practices at the Bank of Thailand 1.1 Risk Management of International Reserve Management Treasury Risk Management Department at the BOT is established to facilitate the optimal resources allocation and risk control of the foreign exchange reserves. The Department directly reports to the Assistant Governor of the Financial Market Operations Group (FMOG), who reports to Deputy Governor, Monetary Stability (Figure 2.) Currently, the risk management policy is embedded within the investment decision process of the foreign exchange reserve management. This section starts with the defined risk management objectives that are built around the benchmarking concept. Next, a framework of risk management policies and procedures will be elaborated. The topic of risk management process is, then, broken down into benchmarking, strategy formulation, portfolio construction, risk measurement, monitoring Figure 2 : Organizational Chart Financial Market Operations Group Assistant Governor Treasury Risk Management and Operations Director Financial Market and Reserve Management Senior Director Risk Management Senior Executive Settlement Senior Executive Reserve Management Senior Executive Domestic Financial Markets Director Risk Management Team Executive Compliance and Control Team Executive Investment Data Management Team Executive

3 3 and control, and performance analysis. The final topic provides a brief overview of our future plan of risk management system implementation to handle the upcoming challenges of sophisticated financial instruments Treasury Risk Management Objectives The primary objectives underpinning our treasury risk management practices are the optimal resources allocation (currency and asset), optimal risk allocation of foreign exchange reserves and sufficient liquidity for exchange intervention. Since the onset of the Asian crisis in 1997, the foreign exchange reserve profile has changed dramatically due to the significant increase in future obligations. This has led to structural changes in our benchmarking, which has become our cornerstone in defining risk management policy. Those future obligations have added another risk management objective: minimize tracking error of the assets and liabilities future cash flows A framework of Risk Management The Financial Markets Operations Group oversees the comprehensive framework of risk management policies and procedures. The framework coordinates policies on risks across departments, including modeling and monitoring the key risk factors, evaluating the risk-adjusted performance and its attribution, and allocating risk exposure to achieve strategic reserve management. The framework covers various aspects of risks, notably market, credit, and liquidity risks. Market risk is measured by using the concept of Value-at- Risk. For credit risk management, we apply an expected default frequency and transition matrix to construct credit portfolio models and to set limits. Lastly, we have set a framework in measuring and monitoring liquidity risk by using the distribution of bid-ask spread. Through this framework, liquidity risk can then be estimated and incorporated into Value-at- Risk figure Bank of Thailand s Treasury Risk Management Process A. Benchmarking Benchmarking is the first step in the risk management process. To achieve the risk management objectives, a clearly defined benchmark is required so that the deviation from the target can be detected. The risk tolerance level is embedded into the benchmark through the risk-adjusted target. Each individual portfolio benchmark is established to set the actual portfolio management on the path that aligns with its strategic objectives. Different financial theories have been applied to construct benchmarks for various portfolios according to their objectives (Figure 3.) A1) Active asset-liability management (ALM) concept is employed in liability portfolio management. It allows traders to take view, up to some extent, while maintaining the minimized tracking-error objective. A2) Liquidity portfolio is designed to serve foreign exchange intervention objective. Since the cash inflows and outflows of the portfolio are relatively unpredictable, investments in short-term U.S. dollar denominated instruments would be an appropriate strategy. However, more complex concepts in liquidity management may be needed to better facilitate monetary policy implementation. From risk management perspective, we adopt quite a conservative approach toward liquidity and liability portfolio management.

4 4 Figure 3 : Portfolio Benchmarks Investment Objectives Risk Tolerance Benchmarking Active Portfolio Management Tracking Error Limit Liquidity Investment Liability A3) In contrast, the implementation of investment portfolio benchmark reflects the risk and return preferences of the Reserve Management Committee. Risk-adjusted return benchmark has been applied at the global and country portfolio levels. The major strength of the approach is the integration of modern portfolio theory (MPT) and quantitative risk management concept. B. Strategy Formulation Front-office dealers are primarily responsible for the formulation of the investment strategy based on fundamental analysis. Relative macroeconomic analysis across major industrialized countries is linked to the projected relative term structure of interest rates and projected currency movements. Our typical investment horizon period is three months. C. Portfolio Construction The expected return derived from the formulated strategy for each market and currency, as well as its estimated risk profile, are combined to construct strategic portfolio allocation against the pre-defined benchmark. For portfolio construction, macroeconomics variables from fundamental analysis are inputed into a selected optimization model. The consistency between the strategic portfolio allocation and the subjective views of the markets is required to ensure the validity of the quantitative model. At this point, risk allocation among currencies, assets, and duration is prioritized according to the expected risk-adjusted returns. D. Risk Measurement Value-at-Risk method is employed to capture the relevant market risk and to create a common unit of risk measurement. However, we also use other risk measures including duration and tracking error to enhance our ability to view risks from different perspectives. The focus of risk analysis is on benchmark-relative risk that helps us evaluate the relative performance of the portfolios. An estimation of ex ante tracking error against benchmarks (relative Value-at-Risk) has been used to monitor the risk position of the reserve portfolios. Both the relative VaR and absolute VaR are used primarily for estimating risk-adjusted return on capital (RAROC). The comparison of all portfolio performance is on a risk-adjusted basis. Volatility data sets are downloaded from JP Morgan RiskMetrics. The integration of liquidity risk, credit risk and market risk has not yet been imposed, as

5 5 further research on the validity and robustness of the underlying assumptions and concepts is required. E. Monitoring and Control Compliance team, who is not a part of and does not report to the foreign exchange reserve department, routinely monitors and controls market and credit risks according to the objective-approach investment guidelines. The goal of risk limit setting is to maintain risk exposures within predetermined risk tolerance over the range of possible market movements. Yet the design of limit settings, based on sophisticated financial theories, maintains enough flexibility to capture dynamic return opportunities through risk reallocation process. Three major types of risk limit control that have been implemented are credit risk limit, deviation limit, and credit spread limit. E1) Risk-based limit settings are adopted to replace nominal limit settings by adjusting the maximum exposure of deposits, repurchase, and forward/swap positions according to their expected default frequencies. Such instruments require more complex methodology for estimating market, credit (counter-party) and liquidity risks. Further, the factors, such as the maturity and the currency of the underlying contracts, also determine the limit settings. E2) Benchmark deviation rules are imposed on investment portfolio (currency and asset allocations, duration, and tracking errors) and active asset-liability portfolio management, so that traders don t take excessive views on the market movements. Each benchmark provides portfolio managers with a leeway for taking a view on the market, which is capped within a ban to limit deviation risk exposure. This market risk control is particularly important for preventing excessive over/underexposure from the benchmark. E3) Risk management applies quantitative credit portfolio model concept to determine the maximum level of credit instruments that portfolio managers are allowed to hold for yield-enhancement purpose. F. Performance Analysis The incremental return of each portfolio is measured against a predetermined benchmark. Since benchmarks are constructed on the concept of target risk-adjusted return, the portfolio performance is evaluated accordingly (Figure 4.) To assess the underlying factors that drive the performance, attribution analysis is employed by breaking down the returns into values driven from currency and asset allocation, market timing, duration, yield curve positioning, stock selection, etc. Furthermore, incremental tracking error helps identify the source of risk and strategic concentration of active portfolio management. The performance of the investment portfolio is measured in terms of return on tracking error (relative Value-at-Risk.) The ultimate goal of using the risk-adjusted return (information ratio) methodology is to provide a comparable measure of performance across portfolios and to ensure the consistency of the portfolio strategies with the respective benchmarks. Excess Return Figure 4 : Risk-Adjusted Return 0.05% -0.05% Port 1 (0.01%,0.02%) Port 2 (0.07%,0.01%) Port 4 (0.07%,0.01%) 0.00% 0.00% Port % 0.10% (0.04%,-0.01%) Tracking Error

6 Future Plan The implementation of dealing room system (front-middle-back office straight through processing) in the near future would strengthen our roles, especially in integrating risk management and monitoring compliance, and would expand the scope of investment universe. It is important to remember that the primary objective of risk management is not to structure immense controls, but to balance between control and flexibility and to promote the optimal allocation of reserves capital across asset classes and currencies. The upcoming use of more complex financial instruments in our reserve portfolio management would require a higher level of sophistication and clearer strategic risk management policies on the part of the middle office. 1.2 Risk Management of Domestic Financial Market Operations Group The scope of responsibility of the Treasury Risk Management Department has been extended further to incorporate the risk assessment of the Financial Markets Operations Group (DFMO.) The risks faced by DFMO can be classified into strategic and financial risks of financial markets operations. BOT manages risks of financial market operations group in three major steps (Figure 5): Step 1: Risk Assessment DFMO risk management process starts with risk assessment that involves risk identification, measurement and prioritization. This is a crucial task because unless we can identify and measure risks, we will not be able to effectively manage them. We can classify the risks of DFMO into strategic and financial risks. Unlike in the case of treasury risk management, these risk considerations haven t been embedded within the DFMO decision-making process. 1.1 Strategic Risk of DFMO The risk assessment of domestic financial markets operations employs the analysis of strategic risk covering financial markets volatility caused by financial markets operations and the effectiveness of financial Figure 5 : DFMO Risk Management Process Step 1 Step 2 Step 3 Risk Assessment Risk Monitoring And Control Market- Based Performance Analysis

7 7 market operations. Unlike financial risk management, the analytical techniques to handle strategic risk are built upon more sophisticated quantitative financial theory in risk management. Strategic risk of DFMO could be assessed through foreign exchange option-implied probability density function, implied forward yield curve and a concentration on key risk factors. 1.2 Financial Risk of DFMO The main financial risks arisen from financial markets operations are credit and market risks. BOT measures market risk using Value-at-Risk concept. Market-driven credit risk could be measured based on Valueat-Risk and cumulative losses of outstanding positions or counter-party exposure. In addition, liquidity risk could be assessed by bidask spreads. Step 2: Risk Monitoring and Control The second step of DFMO risk management involves monitoring and controlling strategic, financial and operational risks. 2.1 Strategic Risk Monitoring and Control The term structure of interest rate and foreign exchange option pricing model are employed to construct the frequency distributions that reflect market expectations about inflation and exchange rate movements. 2.2 Financial Risk Monitoring and Control Unlike treasury risk management, financial risk management framework in DFMO normally does not play a key role in the decision-making process, unless the position resulted from an operation is extremely large. At that extreme, an excessively large position could inflict a significant loss and could consequently have an impact on the policy setting. In terms of market risk, we monitor implied uncertainty of market expectations, aggregate risk exposure and the impact of policy implementation on the market. Market risk related to domestic financial markets operations is the risk of incurring a loss due to the movements of interest rates and USD/ THB foreign exchange rate. Market risk of repurchase transactions is embedded in the underlying assets delivered as collaterals. This is managed by applying appropriate risk control measures such as haircuts and margin calls. Moreover, Treasury Risk Management Department also ensures that open market operations do not significantly affects the yield curve. This is crucial for maintaining financial market stability. Credit risk related to domestic financial markets operations is limited by the use of assets provided by counterparties as collaterals pledged to the BOT in the course of repurchase transactions. Only government and state enterprise bonds are eligible for these operations. With regard to swap obligations, market-driven credit risk is monitored using Value-At-Risk. 2.3 Operational Risk Monitoring and Control To some extent, we govern operational risk by ensuring a compliance of work procedures, rules and guidelines. However, operational risk should be monitored and controlled where they are originated because central staffs cannot achieve the level of knowledge and awareness of the operations that local personnel possess.

8 8 Step 3: Market-Based Performance Analysis The last step in DFMO risk management deals with market-based performance analysis. At this step, we analyze the effectiveness of policy implementation based on market responses implied in foreign exchange option pricing, implied forward yield curve and other asset prices. They reflect market participants expectations about the future state of the economy, and contain macroeconomics aggregate information as to how effectively policy implementation channels market expectations into the directions set forth by monetary policy targets. These techniques could shed light on potential strategic risk, which is of concern to central bankers. Nevertheless, the creditability of the analysis highly depends upon the degree of financial market efficiency. Section 2: Central Bank Wide Strategic and Operational Risk Management 2.1Strategic Risk of Policy Implementation While Treasury Risk Management Department focuses on financial and strategic risks of international reserve management and financial markets operations, we realize that central bank risk management is much broader in scope. On the path of fulfilling their objectives, central banks face strategic risk in executing monetary policy and in setting policy to obtain financial system stability. The term, Strategic Risk, is defined as the risk arisen from policy implementations that have a fundamental impact on monetary policy targets. The main objectives of central bank strategic risk management include 1. minimizing the probability of deviation from the policy target and 2. ensuring the stability of the domestic financial system Strategic Risk of Monetary Policy In addition to key macroeconomic risk variables, many central banks evaluate the effectiveness of their monetary policy implementation through the movements of asset prices, such as oil price, yield curve and FX option prices. The prices at which different assets are traded can tell us something about the market s view of future state of the economy. This information is extracted as implied risk-neutral probability density function (Figure 6.) and interest rate term structure. Asset prices may embody more accurate and up-to-date information about macroeconomic variables than what is currently available. Central banks, generally, try to monitor the effectiveness of monetary policy implementation in order to avoid the risk of deviating from the monetary policy target, which may adversely effect the economy. For example, some central banks that use inflation targeting policy are interested to see if the expected inflation level, embedded in the term structure of interest rate and implied currency expectation, is in line with their monetary policy tar- Figure 6 : Implied Probability Distribution of THB/US$ 32 05JUL00 19NOV THB/US$

9 9 gets. If the term structure of interest rate and implied currency expectation reflect that the level of inflation, as expected by the market, is higher than the monetary policy target, the country may be faced with inflation risk since the market expectation is, in general, self-fulfilling prophecy. In addition to directional movements, the distribution of market expectations also implies the probability of large jumps in interest and exchange rates that may create a shock to the economy. For example, as shown in its fat tail and a high degree of dispersion characteristics, the implied probability distribution of THB/US$ on Nov 19, 1997 reflected a probability of large movements in THB/US$ exchange rate. Both distributions implied positive skewness Strategic Risk of Financial Institution Policy The second dimension of strategic risk management focuses on financial sector stability, which is partly influenced by the financial institutions policy and monetary policy operations of central banks. Firstly, one of central banks roles is to set and enforce financial institutions policy. The outcomes of such policy determine the stability of financial sector. Central banks test and set standards to increase the financial institutions ability to absorb systemic shocks, such as the adverse movements of interest and exchange rates. Moreover, central banks around the world promote corporate governance, and are moving in the direction that is in line with international practices. For example, many central banks are working to set capital requirement standard similar to the standard suggested by the Basle Committee, which equates capital requirement as a percentage of Value-at-Risk of risky assets. Secondly, to maintain financial institutions stability, central banks are also faced with strategic risk of monetary policy operations in the sense that monetary policy operations could impact the level of interest and exchange rates. The movements of these two macroeconomic variables could, in turn, impact the stability of the banking sector because the value of banks assets and liabilities are largely vulnerable to such movements. In addition to central banks role as a regulator, central banks should also play a major role in controlling the aggregate level of risks to ensure that the banking system is not overly exposed to interest rate and currency movements. A concentration of exposure in any of these macroeconomic risk factors would increase the probability of a systemic failure if there is a shock in the financial system. To control risk concentration, we would have to identify key risk factors, to which the banking sector may be vulnerable, and to aggregate risk measures of different financial institutions. At the time being, the available risk measures, such as Value-at-Risk, cannot be aggregated as they tend to reveal only the size of an exposure, but not the direction. A basic summation of these risk measures may overstate the actual exposure because different financial institutions may have offsetting positions. For example, the THB/USD exchange rate exposure of Bank A, who borrows USD denominated loan, could be partly offset by the exchange rate exposure of Bank B, who loans out USD to foreigners. Therefore, in aggregating risk measures, we would have to take that into account. Having identified key risk factors and aggregated risk exposure, we can then use scenario analysis to estimate the vulnerability of the banking sector to the changes in key risk factors, which could be reduced in dimensions, using techniques such as Principle Component Analysis.

10 Operational Risk At present, attention has also been devoted to the area of operational risk. While there is no agreed upon universal definition of operational risk, many central banks associate operational risk with macroeconomic model risk, settlement risk, legal risk, human error, internal audit, and last but not least, the risk of information and payment system failure. All of the above-mentioned risks post vulnerability to central banks in different ways. Foremost, central banks are concerned about the risk of flaws in macroeconomic models. Based on historical data, many of central banks macroeconomic models have faced challenges during the periods of structural changes, such as a change from fixed to floating exchange rate regimes. The second type of operational risk is settlement risk. If central banks are unable to fulfill their settlement obligations, they may be considered in the position of default, and may therefore face reputational risk. Moreover, all central banks are faced with legal risk because their policies and actions may impact stakeholders in the economy in a wide variety of ways. In addition, central banks are also concerned with human error and internal audit. To deal with this risk, many central banks emphasize good corporate governance and transparency. Lastly, information and payment system failures are of significance to central banks. Information systems assist the coordination between different divisions, which is required in attaining the ultimate objectives in implementing monetary policy and achieving the stability of financial sector. Central banks are also working to minimize the risk of payment system failure that may create systemic shocks to the whole economy. While the concept of operational risk is still new and unquantifiable, some central banks are in the process of implementing best practices to serve as a guideline to control this type of risk. The last question remains on how the operational risk management function at central banks should be organized. The centralization of operational risk management practices into one unit can help consolidate risk-reporting function, and give a complete picture of overall operational risk exposure. Notwithstandingly, centralization can, in and of itself, create operational risk. This is because central staffs cannot achieve the level of knowledge and awareness that local personnel possess. For example, in controlling legal risk, personnel at the legal department may have superior knowledge regarding central-bank-wide legal risk exposure than do the central staffs, given the level of experience, education and close interactions with several legal entities. In this sense, operational risk should be assessed and controlled where it is located. The costs and benefits of centralizing operational risk management function are still under debate. Currently, BOT is exploring an appropriate degree of operational risk management centralization. Conclusion While the BOT s Treasury Risk Management Department is focusing on financial and strategic risks of international reserve management and domestic financial markets operations, we have explored other aspects of central bank wide risk management. Although strategic risk of central banks policies and operational risk are currently not within the scope of responsibility of the Treasury Risk Management Department, we realize their importance and therefore have summarized these other perspectives in this paper.