1. Reserve Management Challenge: Stability Vs. Return
When we were discussing about the outline of the presentation on reserve management from the perspective of the central bank, we thought that it would have been more appropriate to focus on the trade-off between the objective of the stability of the country from one side and the challenge of the returns from the reserves portfolio, on the other side. The returns are considered necessary to ensure the central bank’s independence from the Ministry of Finance, in terms of having enough revenues to cover the bank’s expenses. With this concept in mind, we finalized the outline of the presentation as it follows: firstly, we give a general framework of the reserve management; afterwards, we present the tranching structure, the currency composition, the risk exposure, our future plans, and some conclusions that we derive from our recent experience in the management of the reserves portfolio.
2. Reserve Management
I will start quoting the IMF Guideline for Foreign Exchange Reserve Management, with which we comply. The guideline defines reserve management as “the process that ensures that adequate official public sector foreign assets are readily available to and controlled by the authorities for meeting a defined range of objectives for a country or union.” The main idea behind this concept is that we need to be certain/clear that the reserve management, from the point of view of the central bank/public institutions, is different from reserve management at private institutions.
As a matter of fact, our main objective is to have adequate official public sector reserves that can be ready and available at any time that they are needed. In fulfilling our purpose, we have also established the priorities that should guide our reserve management. They are shown in Figure 1. The first priority is liquidity. When we say liquidity, we mean that we need to have available funds for two main reasons. The first reason is to implement the monetary policy of the central bank and, the second one, to safeguard financial stability and to cover any needs Albania might have, should the circumstances require it.
The second priority is to preserve the capital. This priority shapes the reserve optimization process. In this regard, we take into consideration a set of risks that I am going to elaborate in greater detail later in my presentation.
The third priority is to generate reasonable returns in the medium to long term. Nevertheless, this objective is subordinated to fulfillment of the primary objectives, namely liquidity and safety.
3. Portfolio Investment From a Central Bank Perspective
When we turn at the difference between portfolio management from a central bank’s perspective vis-à-vis portfolio management from a private investor’s perspective, the main difference is the objective of holding reserves. In our case, the main objective is to have enough liquidity for fulfilling the needs that may come at any time.
Regarding risk tolerance, our risk tolerance is typically low or conservative and it is defined by the Supervisory Board.
One of the main obstacles that we have had so far is the investment horizon that, in our case, is up to one year. From previous presentations, I learned that the National Bank of Hungary is allowed to invest in equity and corporate debt. But, if we take into consideration our law, we are not allowed to invest in equity and corporates, but only in government securities. So, this is another obstacle, which limits our strategy in terms of diversification of the reserves portfolio.
And last, but not least, is the reputational risk the central bank is facing in the reserves management process. In this regard, what I am referring to, it is the transparency of the reserve management process; how this reserve management process is understood from the public and from the parliament and how the public and the parliament will react if the results of reserve management, the return of the reserve portfolio, are negative. Certainly more education, communication, and transparency are needed to mitigate this risk.
4. Review of the FX Reserves Policy and Holding Purposes
During 2016, we revised our regulation “On the policy and management of foreign exchange reserves.” The main reason for the review was to redefine the purpose of holding reserves. In the previous regulation, our only purpose was the implementation of monetary policy, but, now, we have also added the purpose related to the stability of the banking system. The latter was also taken into consideration when we built the reserve adequacy optimization model.
We looked into the currency composition of each tranche and decided to move the government’s obligations, in terms of the size and the currency composition, from the liquidity tranche only to the liability tranche to avoid accounting for it twice.
Moreover, we decided to take into consideration the negative return that we can have on our euro investments in terms of risk budget. Hence, our expected return is negative from the beginning of the process and we wanted to take this into account.
Pursuant to this revision, the regulation now stipulates that Bank of Albania reserves’ holding purposes are: (1) to implement and support the monetary policy and exchange rate policy; and (2) to safeguard financial stability or cover the country’s needs in times of crisis.
5. Governance Framework
Regarding the governance framework, I think it is more or less similar to all central banks. The Supervisory Board sets qualitative criteria on the strategic objectives of the central bank and risk constraints.
We have the Investment Committee that translates these qualitative criteria into quantitative limits and also defines the benchmarks that are used for the implementation of investment decisions.
Then, we have the operational monitoring framework that is compliant with all the limits that are approved by the Investment Committee and the Supervisory Board.
6. Reserves’ Stock
Figure 2 shows the trend of the reserves of the central bank, and I purposely put it on a gross basis and on a net basis. In terms of gross figures, we have an increase of the reserves, which mainly is due to the extra funds that are coming from the Ministry of Finance and the banking system. But, on a net basis, we have more or less a stability in the level of our reserves. This leads us not to make big changes in the risk profile of how we manage the reserves. So, net reserves that are managed by the central bank have been stable starting from 2015. Being stable, the utility function of holding reserves for this part of the reserves remains almost the same.
7. Eligible Instruments
Now the other question is, “Where can we invest these reserves?” Due to our policy regarding the currency composition of the reserves, we are forced to hold the major part of the reserves in euro. Taking into consideration market conditions (for example, investing in Germany and France), we are obliged to invest this part of the reserves in negative territory.
On the other side, in Figure 3, we have the green-colored line that reflects the behavior of the yield of the two-year US dollars Treasury Note, which is in positive territory. The negative impact of the euro portion of the reserves was more than offset by the dollar portion of the reserves.
With these two factors in mind, the level of the reserves and the investment alternatives, we start internally the reserve management optimization/implementation process. We start with the first requirement that we have defined above: the management of the liquidity risk.
8. Reserve Management Tranching
To manage the liquidity risk, we divide the reserves in different tranches as shown in Figure 4.
The liability tranche represents the portion of reserves that do not belong to the central bank. However, the central bank is responsible for its management.
The net reserves are divided into three tranches: the working capital tranche, the liquidity tranche, and the investment tranche. Except for the working capital tranche, which has an investment horizon of just one month, the other two tranches have an investment horizon of one year. Even for the liability tranche, we decided to maintain an investment horizon of one year to fit it in some way with the risk budget that we have as allowance in taking position/exposure to interest rate movements.
When we implement the tranching structure, we take into consideration factors like: (1) what will be the cash flows of the central bank and the Ministry of Finance for the coming year, (2) trade balance, and (3) the amount of imports that we need to cover when and if needed.
More specifically, the liability tranche does include everything that is related to the Ministry of Finance, reserve requirements of the banking system, and other liabilities of the central bank. The working capital tranche is covering any need the central bank might have in the event of market interventions and the monthly current account deficit. For the liquidity tranche, we have an investment horizon of one year and the upper limit is the amount of three months of imports. Finally, the investment tranche includes everything in excess of the liquidity tranche. In the investment tranche, we have the flexibility to take more risk in terms of duration.
In Figure 5, the trend of the investment tranche is shown by the red bars and the trend of the liquidity tranche is shown by the blue bars.
Up to 2015, the size of the investment tranche was declining, whereas the size of the liquidity tranche was going up. This reflected the maturity of a Ministry of Finance’s Eurobond in 2015. We, as the central bank, took precautionary measures in advance of this payment. But, after that, we realized that the way we had managed this contingent event was not the right one. We decided that similar future events need to be managed with appropriate instruments (repo transaction). That is, if the Ministry of Finance needs to pay its debt, and it has no liquidity, we can repo out our securities to get liquidity from the international market and lend the necessary amount to the Ministry of Finance.
By doing this, we avoid many exchange rate transactions and the movements of funds from the investment tranche to liquidity tranche, and thereby avoid unnecessary exchange rate risk (currency composition of two tranches isn’t the same).
And, as we can see from Figure 5, during 2016, the trend has reversed. This is the reason the investment tranche is higher than the liquidity tranche.
9. Reserve Management Currencies
Regarding the currency composition, we keep our reserves in six currencies. Euro and US dollars are the most important ones. GBP, JPY, RMB, and AUD are the other currencies composing the reserves and are included only in the investment tranche. The inclusion of AUD and the SDR in the currency composition for the investment tranche is, among others, the result of the diversification strategies implemented by the Bank.
More than 50 percent of reserves are in euro. This reflects mainly the liability side of our balance sheet. The Ministry of Finance increased the holdings/deposit of its foreign currency at the central bank with the purpose of having more buffers to reduce the rollover risk. At the same time, we have the commercial banks that have increased their EUR holdings with us. Such increase reflects not only mandatory reserves in foreign currency but also the excess reserves held by the banking system in excess of the mandatory reserves.
The currency composition of the liquidity tranche, after the changes we made, is based only on the imports of Albania (80 percent of our imports are in euro and around 20 percent are in US dollars). As a result, due to these two factors, we are obliged to have more euro in our reserves compared to other currencies.
Given the above-mentioned criteria, we are not active on the currency exposure. This means that the Investment Committee approves the limits in compliance with the criteria, and we manage only the discrepancy between the actual exposure and the benchmark for the composition of the foreign currency reserves.
10. Currency Diversification
During 2016, as a result of the RMB inclusion in the SDR basket, we decided to take exposure not only in RMB but also in Australian dollars. The exposure in RMB is much lower than its weight in the SDR basket. This decision reflects our uncertainties regarding market transparency and market functioning in China. To make up for the reduced exposure of the RMB in the SDR basket, we decided to introduce AUD as an emerging market representative. With time, we shall evaluate whether it is appropriate to increase the exposure of RMB and reduce the exposure of the Australian dollar to fully reflect/match the SDR basket currency composition.
As you can see from Figure 6, the percentage of euro in our total reserves is going up from 55 percent to 63 percent. As previously mentioned, the underlying reason for this trend is the euro mandatory reserve requirements and excess reserves held by commercial banks as well as the euro buffer on the Ministry of Finance account.
In order to minimize the negative impact of this trend in our profit and loss account, we took some steps. The first step was in 2016, when we decided to negatively remunerate the euro reserve requirement of the banking system, by setting the remuneration rate equal to the rate of the deposit facility of the European Central Bank, that is, −40 basis points. The second step was related to the remuneration rate applied to excess reserves, and we decided to remunerate them at a rate equal to the ECB deposit facility rate minus 25 basis points (this is more or less the market rate of the euro currency in the short term). As related to the euro holdings of the Ministry of Finance, we decided to swap the foreign currency in Albanian lek. In pricing the swap, we took into consideration the cost of holding euro in the cash account with our counterparties.
11. Reserve Management – Interest Rate
What I have discussed so far were the liquidity risk and the exchange rate risk. The next step is managing the interest rate risk. This is done through an optimization exercise incorporated in the strategic asset allocation process. The main objective is to maximize returns in one-year investment horizon. Our risk constraint is stated at VaR 99 percent. It means that we need to have a 99 percent confidence level of not losing more than the budget of risk that the Supervisory Board has approved.
In this case, we are active managers, meaning that each portfolio manager has its own tactical risk budget. The result from active management so far has been really impressive in terms of risk-adjusted returns (sharp ratio).
12. Market Risk with Negative Interest Rates
Regarding our reaction to the negative interest rates environment, when we discussed how we should adapt our allocation, we exploited the possibility of taking more credit risk in our benchmarks. I am referring to Italy and Spain, and the fact that we decided to include these countries in the benchmark up to a certain ratio. At the same time, we moved from a single country benchmark to a multi-country benchmark in order to be exposed not only to one country, but also to other eurozone countries.
The second step, given the negative rates, was to make adjustments in the budget of risk, especially for the euro currency, and to treat the level of negative rate as an extra in terms of risk budget. This means that the risk budget is what the Supervisory Board approved plus the negative rate. When taking this approach, our strategic assets allocation model indicated to us that the duration should be low, with the expectation that the interest rate in the euro area has more probability to go up than down. We decided to include also cash in our benchmark and to hold the cash up to the moment that we think the interest rate environment will start to normalize.
13. Reserve Management – Credit Risk
Regarding the credit risk, we increased the credit risk appetite, but, at the same time, our intention was to strengthen our internal credit risk model.
We analyzed what would be the extra value if we were more aggressive in terms of credit risk, for example, going from AA- threshold to A-. Our data analysis was showing that the pick-up from the widening of the credit risk limits was not justified in terms of risk-adjusted returns. So, we decided to maintain the same risk thresholds in our exposure to financial institutions. In the meantime, regarding government exposure, especially the governments of euro area member countries, we decided to move down the threshold, including the whole investment grade to BBB-. At the same time, we improved our credit risk models to monitor on a daily basis the situation of our portfolio exposures. So, for governments, the new threshold was BBB-, and for the rest, we remained, as we were at the beginning, at AA-.
14. Reserve Management – Other Risks
We have paid special attention to the new guidelines of the IMF regarding the other risks that proved to be important during the recent crisis. Based on this, we started taking into consideration other risks, such as: custodial risk, settlement risk, and legal risk. The frameworks for these risks are going to be elaborated further by the responsible departments.
A risk that we especially need to be more alert to is legal risk. I am stating this, because probably we are not feeling it, but at the moment that we would need to have something to protect us, it may be too late.
15. Eligible Asset Classes
On the asset classes, more or less, it is the same, but what I would like to stress here, is that due to the changes in the banking requirements from the supervisory authorities, we are facing difficulties to operate with financial institutions. Part of the problem is related to the futures clearing account. we had the option to use this facility before, but not now because the financial institutions are facing higher costs due to stringent/higher capital requirements. As a result, they are not inclined to work with and offer their services and products to small central banks. So, we are looking to establish facilities with other financial institutions, but it is still difficult to find the banks that are ready to cooperate and cover our needs for investing in instruments that we are ready to use for the management of the reserves portfolio.
16. Going Forward
What we plan to do is to exploit the possibility of expanding the number of the instruments that we are eligible to use. The first one are covered bonds, the second are repurchase and reverse repurchase agreements. We would like to use the repo instrument more in respect to hedging ourselves, especially regarding the unexpected demands from the government. If we manage to implement it, we will have more possibilities to improve as well our strategic asset allocation. So far, we implement our strategic asset allocation on a single currency basis. We are currently looking to shift the strategic asset allocation decision-making process to a tranche level. What we foresee at this stage, as result of this, is to have more diversification in the currencies, which compose the tranches. Except this, what we are thinking to do is to extend the investment horizon and to include hold-to-maturity strategies.
17. Conclusions
The first conclusion is that our main requirement/objective is stability and not return. As a consequence, we are obliged to hold our reserves in euro and to protect ourselves from different vulnerabilities, coming either from the banking system or due to macroeconomic factors and trade relationships.
The stringent regulatory framework causes a lot of burden in our business relationship with counterparties. This has significantly increased our maintenance costs, because it asks for a lot of information exchange and we need to spend a lot of time to fulfill these requirements, rather than exploiting more possibilities in terms of credit risk. Furthermore, this is a difficult time to widen the scope of collaboration with our existing counterparties. So, if we decide to include more instruments, it will be difficult to implement them given the current environment.
We trust there should be an understanding from the European Central Bank, in that it should not treat in the same way the central banks and other private investors. This is because the euro that the central banks keep in their balance sheets have different purposes compared to those of the private financial institutions. Hence, in my opinion, for the cash that the central bank is obliged to hold, the ECB can offer some facilities to cover at least the cost of negative return that we have in euro.
On the other side, the negative rates in euro have also been a contributing factor to the financial stability since the banking system has less incentive to keep euro. Moreover, the negative interest rate environment probably will contribute to de-euroization of the country and to improvements in the monetary policy transmission channels.
As a summary conclusion, I would like to stress that, in our view, from a central bank’s perspective, the paramount priority should be stability, and such priority should inspire all risk/return considerations.
