- International Monetary Fund
- Published Date:
- April 2005
Governance and Institutional Framework
Reserve management objectives and coordination
238. The objectives of reserves management are subordinated to Banco Central do Brasil’s monetary and foreign exchange policies. Brazil has a floating currency regime and interventions are infrequent with no sizable changes in reserve holdings.
239. The main objectives in holding external reserves are to:
Support monetary policy.
Control excessive volatility of the foreign exchange market.
Guarantee payment of foreign exchange debt.
240. Based on these objectives, reserves are managed to ensure safety, liquidity, and profitability.
Institutional framework and decision-making structure
241. Banco Central do Brasil (BCB) is the sole authority empowered by the Constitution to manage Brazilian foreign exchange reserves. No other government agency can hold foreign currencies. Regarding the allocation of roles, the BCB Board of Governors is responsible for the reserves strategic allocation and defining the investment policies. Therefore, they have established a detailed benchmark and guidelines and opted for an active management of the reserves. The Vice Governor responsible for the monetary policy—Dipom—is responsible for the active management, as decided by the Board. The International Reserves Operations Department—Depin—executes the necessary transactions to follow up the benchmark and Dipom’s active strategies. Depin is also responsible for suggesting modifications in the benchmark according to changes in long-term market conditions and/or other factors, and for providing Dipom with market updates and strategy proposals. An Investment Policy Committee for active management meets monthly to analyze the market scenarios and to propose active strategies.
242. The Investment Policy Committee was created by a board decision, while the investment process was defined by a formal document signed by the Vice Governor of Monetary Policy. The following officers participate at the meetings as voting members:
—Vice Governor responsible for Monetary Policy (retains veto power);
—Head of International Reserves Department;
—Deputy Head of International Reserves Department;
—Head of International Reserves Investment Division;
—Head of Foreign Exchange Division;
—Interest Rate Portfolio Managers (1 joint vote);
—Foreign Exchange Portfolio Manager;
—Interest Rate Strategists (1 joint vote); and
—Foreign Exchange Strategist.
243. Active management positions may be taken at strategic and tactical levels. Strategic positions have an investment horizon of 1 to 3 months and are subject to discussion and decision at the Investment Policy Committee.
244. Depin is organized in three distinct areas: front office (trade desks), middle office (compliance, risk management, performance evaluation, pricing, and IT), and back office (accounting and settlement).
245. In the middle office, a compliance area checks all guidelines defined by the Board on a daily basis and is responsible for standardizing procedure manuals. This area is also responsible for checking transaction prices against market prices in order to identify any kind of mismatching. A new area was recently created to ensure correct asset pricing and to verify data integrity and correctness by performing checks of other numerical variables such as VaR, returns, etc.
246. An Ethics Code, which outlines standards for the conduct of civil servants, was implemented in 2001. In addition to this, all civil servants must present their annual income tax returns.
247. The BCB Board of Governors defined that the investment strategy should match reserves with sovereign external liabilities in terms of currency exposure. In this way, we have an integrated Asset/Liability Management (ALM) in terms of foreign exchange exposure. The main benefit of this strategy is to prevent a short-term loss of reserves caused by a mismatch in currencies between reserves and short-term obligations.
248. Improper tracking of external liabilities and lack of a formal ALM long-term strategy may cause inefficiencies. Efforts are being made in the direction of unifying strategies and coordinating all sovereign external debt with reserves management.
Transparency and accountability
249. In recent years, Banco Central do Brasil has promoted increased transparency and accountability in managing reserves and reporting results. The main procedures taken to follow these objectives were:
Definition of a detailed and replicable benchmark with clear guidelines and unambiguous sharing of responsibilities within Banco Central do Brasil’s hierarchy;
Public disclosure of reserve management parameters and procedures;
Quarterly performance reports to the Board of Governors;
Hiring of an independent auditing firm;
Adherence to the IMF’s SDDS—Special Data Dissemination Standard.
250. In terms of auditing, there are four separate inspections, which are conducted by the Internal Auditing Department of BCB (Deaud), an external independent auditing firm, the Ministry of Finance, and the Brazilian Court of Accounts (TCU). All these auditing inspections are periodic and have the objective of verifying compliance procedures, accounting systems, IT systems, limits, controls, etc.
251. Banco Central do Brasil’s training program for the reserves management area is made up basically of courses offered by the external managers18 and periodic visits to other central banks and premier commercial banks. In order to obtain qualified staff, the International Reserve Operations Department of BCB—Depin—selects personnel from within the Bank, based on their market experience/skills and quantitative background. In some cases, a deep knowledge of computer systems is required. To retain the staff, Banco Central do Brasil has a defined professional career track and incentives for employees to pursue graduate degrees in Brazil or abroad. However, there is no specific wage/bonus incentive related to market operations or to performance.
252. Banco Central do Brasil has made huge investments in system information resources updating. In fact, technical areas have access to the most sophisticated mathematical and statistical engines available in the market. This policy has been very important to allow financial model improvements and also to retain research-oriented employees.
Capacity to Assess and Manage Risk
253. Banco Central do Brasil investment policy for foreign exchange reserves is based on three pillars—the reference portfolio, investment guidelines, and performance measurement. The first one, also known as the benchmark, is replicable and details unmistakably the included assets. This portfolio reflects the Board of Governors’ risk/ return preferences for the international reserves. The second pillar is the list of guidelines that define operational limits, allowed investment instruments, risk methodologies, and deviation limits for the active management.
254. The third pillar is a quarterly performance measurement report for the Board, which states the results of passive (reference portfolio) and active management. The Association for Investment Management and Research (AIMR) standards, when applicable, are followed for presenting results of benchmark and active strategies policies.
255. The complexity of the benchmark framework imposed the use of information technology tools. Considering the existence of appropriate human and IT resources for the development of a software system, Depin opted for an in-house software solution. The system includes several management tools such as market risk (VaR), credit risk (expected and unexpected default), performance evaluation, performance attribution, reference and active portfolio management, operational risk, and compliance. Besides that, the system gives the possibility of executing stress tests for active strategies. These tests can be based on historical data or stress scenarios defined by the user. Depin is now beginning to perform stress tests for the reserves as a whole on a regular basis.
256. Banco Central do Brasil takes into account market, credit, liquidity, operational, and legal risks. In terms of market risk, the Board has defined a VaR limit for the active management relative to the benchmark, i.e., a differential VaR. This limit is calculated on a daily basis, using RiskMetrics’ methodology with 95 percent confidence level and one-day time horizon. The VaR is back-tested and the results of the methodology adequacy are presented in the quarterly performance reports. The Board defined a VaR limit for the active management, and it is up to the Investment Policy Committee to approve a risk budget among its sub-portfolios, as suggested by portfolio strategists. The VaR limit can be considered small in the sense that returns come basically from the reference portfolio, with active management giving a marginal result.
257. Credit risk is managed using two distinct approaches for the money market portfolio. The first one is for the portfolio as a whole. In this case, a proprietary model was developed based on Creditmetrics and the Merton model. This model uses expected and unexpected default probabilities, and the Board stated limits for these two variables. The main objective of this approach is to impose geographical and counterpart diversification, not to calculate VaR exposure. The second approach is transaction oriented, for which the Board has approved minimum counterpart ratings (short-term and long-term), maximum volume, and maturity exposure based on the counterpart total assets and ratings. For the fixed income portfolio, BCB accepts only federal government, agencies, and supranationals issues restricted to minimum rating. In terms of liquidity risk, the Board approved additional constraints related to the permitted range of investment instruments and maximum exposure in each asset.
258. Operational risk losses in reserves management are tracked with the objective of getting statistics about internal procedures and the relationship with counterparts.
259. The BCB’s legal department analyzes and approves contracts, and together with audit entities ensures that each transaction has the necessary legal support.
260. Regarding external managers’ portfolios, the operational guidelines are basically the same as the ones defined for the self-managed portfolio, except for the VaR limit. Since external managers are restricted to fixed income investments and do not have a money market tranche, they have a larger VaR limit. Banco Central do Brasil receives daily transaction reports and monthly performance reports from the external managers and from the global custody agent and has periodic portfolio reviews with the managers.
261. The reference portfolio, as approved by the Board, is divided into three tranches: gold, emerging markets, and core reserves. The core reserves tranche represents the large majority of the reserves, as the position in gold and emerging markets debt is less than 3 percent of total reserves. This tranche is denominated in three base currencies: the U.S. dollar, euro, and Japanese yen and is divided between money market and fixed income portfolios. Allocation is 60 percent in the fixed income market and 40 percent in the money market.
262. The gold portfolio is divided into two portfolios: one located in Brazil and the other invested in short-term gold deposits in the international market.
263. The emerging markets portfolio is managed using the “EMBI Brazil +” index as a reference. Banco Central do Brasil is restricted to investing in Brazilian sovereign external debt bonds.
264. The money market portfolio has four tranches. A small working capital tranche is fully invested in U.S. dollar overnight deposits. It has the purpose of controlling excessive volatility and providing liquidity for a sustainable domestic foreign exchange regime eventually. The other three portfolios are for each one of our benchmark currencies (U.S. dollar, euro, and Japanese yen). The term of the deposits can go as long as 6 months, but the total duration of the money market portfolio is about 1 month. Eurodeposit is the reference instrument and LIBID is used as the reference index.
265. The fixed income portfolio is divided into two subportfolios, one based in U.S. dollars and the other in euros. J.P. Morgan’s “1–3 years Government Bond Index” is the reference for each respective currency. Minimizing the probability of capital loss over a certain time horizon was one important aspect considered when choosing the 1–3 year index. The fixed income portfolio denominated in Japanese yen is, in fact, allocated in the euro and U.S. dollar portfolios, with currency hedge to Japanese yen.
266. Six external asset managers manage a small part of the reserves, about 3 percent. They have the same benchmark as our fixed income portfolio and similar guidelines. The main purpose of the program is know-how transfer.
267. Market indexes were chosen as references because they represent the industry standard, are replicable, and contain sufficiently liquid assets. In terms of performance, they make the comparison with other managers possible. Regarding maturity, the decision of using the 1–3 year index was made taking into account the risk/ return trade-off, since it has a small probability of quarterly negative return.
268. All portfolios, except money market, are closed portfolios, that is, they have no inflows or outflows, except for coupon and amortization payments. In a normal situation, the money market portfolio absorbs all changes in the size of the external reserves. Portfolios are rebalanced on an annual basis to maintain the proportion between the fixed income and the money market portfolios and also the size of the emerging market portfolio.
269. Regarding the currency hedge, the core reserve replicates the currency distribution of the short-term sovereign external debt up to the amount of the core reserves. In order to implement this strategy, Banco Central do Brasil follows up the external debt currency composition on a daily basis. However, to avoid excessive turnover, the benchmark is rebalanced every time the external debt currency proportion differs by more than 2 percent from the reference portfolio.
270. Investment guidelines have been established for each aspect of risk management. To control market risk, a daily VaR limit is in place for deviations from the benchmark. It is enforced for the active strategies of the whole reserves. Intraday VaR calculation has not been implemented yet. Banco Central do Brasil does not use automatic stop-loss techniques in monitoring market risk limits. In case of any breach of VaR limit, the Investment Policy Committee will meet to decide whether the positions should be kept or not. If the decision is that it is in order to maintain the positions, it must be submitted to the Board of Governors for approval.
271. In terms of liquidity and credit risk, there are different approaches to money market and fixed income portfolios. For the money market portfolio, the Board of Governors has established the following investment guidelines:
Maximum expected and unexpected default probabilities for the actual portfolio deviation from the benchmark;
Minimum rating limits of “A” and “P-1” for each counterpart, according to Moody’s;
Maximum allocation per counterpart calculated as a percentage of the counterpart’s total assets, limited to a certain maximum amount per counterpart; and
Three to six months’ maximum maturity depending on the institution’s rating.
272. For the fixed income portfolio, the restrictions are:
List of permissible countries for investment in terms of sovereign debt. All of them must have a minimum rating of “A” according to Moody’s.
Bonds issued by any country in a currency other than its own are submitted to additional restrictions in terms of rating; and
Investments in “AAA” government-sponsored agencies and in supranational debt are restricted to a maximum percentage of the fixed income portfolio.
273. There are also the following asset concentration limits:
Maximum percentage of the total outstanding amount of any issue; and
Maximum percentage of a single asset contribution to the total fixed income portfolio.
274. There are other limits, such as:
Permissible financial instruments;
Breakdown of gold reserves in Brazil and abroad;
Size of the gold portfolio; and
Size of the emerging market portfolio.
275. Options investments are not allowed, but currency forwards and futures, interest rates and gold futures and swaps, commercial papers issued by financial institutions, CDs, CPs, repos, and reverse repos can be used.
276. Risk and compliance areas are independent from the front office but not independent from active management decisions in the hierarchical structure; we overcome this problem by using a software function that automatically informs the Board of Governors of any breach of limit, at the same time that the compliance area receives the alarm. Afterward a confirmation is delivered to guarantee that it was not a system or a human failure. On the same day, the portfolio managers have to explain the reasons for the occurrence to the Board.
277. Banco Central do Brasil uses a mainframe and a PC-based network system based on Windows NT/2000. The software was entirely developed in-house, except for database management software. The mathematical and financial models were developed based on publicly available technical documentation, so there is no use of financial “turnkey systems.” The only inputs of the system are price data from data providers and transactions put into the system by traders. The software provides tools for:
Performance measurement (including performance attribution models);
Compliance (comprising automatic limit controls);
Trade desk support.
278. The software was developed considering operational and research purposes using both the actual transactions database and the historical database to test new models. A large quantity of documentation, such as BIS and IMF papers, research papers in general, system technical documents, etc., is available online. The software was also designed with audit in mind, having a full revisions control, auditable numbering sequences, and a back-up procedure.
Implementing a new approach in reserves management
279. Reserves management in Banco Central do Brasil has changed dramatically over the past five years. Before 2000, the head of Depin and the trade desks could decide the overall profile of the reserves, since guidelines established by the Board were generic, with no specific rules for performance measurement and an unclear role of each player in the decision-making process.
280. With the incidence of international financial scandals in the nineties, central banks in general became more aware of some risks that they were incurring and so, in 1997, Banco Central do Brasil introduced market risk calculations of the reserves based on the VaR concept (US$). However, there was no type of operational limit. In the following years, the importance of risk management and a detailed benchmark to manage the reserves became increasingly clearer to Banco Central do Brasil. Studies were made considering common market management procedures and, as a consequence, a proposal was developed for a new framework in the time span of about one year.
281. In 2000, Banco Central do Brasil’s Board of Governors approved a benchmark with clear guidelines and performance measurement procedures.
282. The main problems faced during the design and the implementation of the new reserves management concept and their solutions were:
Natural resistance to changes in policy;
—Time to absorb new concepts and to understand the advantages that would come from the new environment, like a clear performance evaluation procedure. From initial ideas to final development, the process took about five years. The main factors that contributed to this delay were international crises and changes of the Banco Central do Brasil executive direction.
Understanding the new roles in each part of the hierarchical structure;
—It took several months of meetings, discussions, and presentations to explain the role of each part of the hierarchy to overcome this problem.
Steep learning curve for the staff to understand risk management, performance, and performance attribution models;
—Well-structured and intensive training program. The program is continuous and started back in 1996.
Lack of an integrated computer platform;
—Acquisition of a new networked hardware and basic software system (operational systems and other support software).
Modifications of the compliance system with the new guidelines;
—Adapt procedures to the new environment.
Changes in accounting system related to the new kind of instruments allowed;
—Adapt accounting system to the new instruments.
Authorization and support to develop a software solution in-house;
—Develop a sound design environment and full documentation of the proposal.
Difficulties in getting consistent asset pricing data, which is fundamental for the robustness of VaR calculations and performance measurement.
—Creation of a new workgroup (area) to check and guarantee asset pricing consistency and new data providers.
283. However, there were some aspects that were essential for the successful design and implementation of the new framework for reserves management:
Human resources with deep knowledge of finance, mathematics, and computer science and previous experience in developing and managing software with large databases;
Existence of an IT area in the International Operations Department—Depin;
Necessary infrastructure resources to implement the system, such as computers, communication lines, data sources, etc.; and
Emphasis on training, including periodic visits to premier financial institutions and other central banks. In this case, our external asset management program was an invaluable tool.
284. The software architecture was structured in independent modules and it is fully upgradable. This approach allowed a modular-based development, i.e., each application module (e.g., market risk, credit risk, reference portfolio, performance attribution, etc.) was developed independently and connected to the system in a later phase. The kernel that was developed initially supported basic portfolio management and had the main software functions encapsulated in a procedural environment.
285. The kernel and the modules of market risk, credit risk, reference portfolios, and compliance were designed and developed in nine months, and another three-month period was necessary for tests. The operations began in July 2001. Afterward, other modules such as operational risk, documentation, and stress testing were included.
286. Improving the software system and the reserves management framework is an endless and continuous task as market practice keeps evolving in time.
287. Nowadays, Depin is focusing on improving stress test procedures, performance attribution models, operational risks statistics, and reference portfolio.