20 United Kingdom
- International Monetary Fund
- Published Date:
- April 2005
Reserve Management Objectives and Coordination
983. United Kingdom official holdings of international reserves are owned by Her Majesty’s Treasury (HMT) and comprise gold, foreign currency assets, International Monetary Fund (IMF) Special Drawing Rights (SDRs), and the U.K.’s Reserve Tranche Position (RTP) at the IMF. With the exception of the RTP, these reserves are held in the Exchange Equalization Account (EEA). The Bank of England manages the reserves as agent for HMT, as well as providing advice on reserves management issues, including liability management.
984. The EEA was established in 1932 as a fund for stabilizing the exchange value of sterling. Any U.K. government exchange rate intervention would therefore be conducted through the EEA.54 The EEA also provides foreign currency services to Government Departments and Agencies, i.e., sales of foreign currency to Departments with foreign currency obligations and purchases of foreign currency from Departments with foreign currency receipts.
985. The U.K. Government has published a Service Delivery Agreement (SDA) target to minimize the cost of holding reserves while reducing risk. The performance relative to this target is reported in detail in HMT’s annual report on the expenditure plans of the Chancellor of the Exchequer’s Departments.
Institutional framework—the annual Remit
986. The Bank of England manages the reserves in accordance with criteria set out by HMT in an annual Remit, the main text of which is published in the Debt and Reserves Management Report, which is published by HMT at the time of the Budget. The Remit summarizes the benchmarks that the reserves are actively managed against; the investment constraints within which the Bank operates; the framework for risk control; and the arrangements for the audit of the EEA. The Bank is also set a profit target, net of management costs, for active management against the benchmark; this target is not published.
Administration and control
987. The Bank reports to HMT on investment performance at a monthly meeting chaired by the head of HMT’s Debt and Reserves Management team. The Bank’s Foreign Exchange (FED) and Risk Analysis and Monitoring (RAMD) divisions account for the returns made, and for market and credit risks incurred. Any outstanding operational or policy issues are also discussed. Every six months, there is a meeting at which the EEA Accounting Officer and the Bank of England’s Executive Director for Market Operations or delegated senior officials review investment performance, discuss strategy, and agree upon analysis to be commissioned by HMT and undertaken by the Bank. Meetings to discuss individual issues, including changes to the Remit, may be proposed at any time by HMT or by the Bank.
988. Every quarter, an independent opinion of the adequacy and effectiveness of the system of internal and financial control is provided to the Bank’s Executive Director for Market Operations by the Head of the Bank’s Internal Audit. The Bank’s Executive Director sends these reports to the EEA Accounting Officer. At the same time, the Executive Director provides the Accounting Officer with a management report on the operation of the control framework. Separately, the U.K. National Audit Office undertakes an external audit of the EEA on an annual basis.
Bank of England reserves management structure
989. The reserves management operation is ultimately headed by the Executive Director for Market Operations, to whom the heads of FED and RAMD report. It is an important principle that neither the middle office (RAMD) nor the back office report to the front office (FED).
990. FED and RAMD senior management are responsible for implementing and reporting the results of the strategy agreed between HMT and senior management at the Bank. Decisions on specific investments and the degree of latitude for individual portfolio managers, in addition to general staffing and budget issues, are taken at this level.
991. Dealers and portfolio managers within FED provide active day-to-day management of the foreign exchange and asset portfolios, involving tactical positioning and direct contact with market counterparts. Market positions and overall investment performance are formally reported to senior management and to HMT on a monthly basis.
992. This delegation of responsibilities and decision making is captured within the formal benchmark process, where higher levels of management shape the benchmark for the next level down. This approach enables the attribution of overall returns to the decisions taken at each level and provides a direct and highly visible link between decisions made and profits earned. This gives essential feedback in analyzing performance and acts as an important motivator for reserves managers.
993. As well as reporting directly to the Executive Director for Market Operations, RAMD has a reporting line to the Deputy Governor for Financial Stability in the latter’s capacity of Chairman of the Bank’s Asset and Liability Committee. This reinforces the independence of the middle office. The operational independence of RAMD is considered to be an important prerequisite for its effectiveness.
994. RAMD is responsible for legal, regulatory, and ethical issues of compliance (external control) as well as risk measurement and monitoring (internal control). It ensures that detailed benchmarks, limits, and controls are in place that are consistent with the risk limits set by HMT in the Remit. It also establishes the compliance and reporting procedures that managers should follow and sets up all the necessary legal agreements and documentation.
995. Operational procedures are documented in a handbook that is frequently updated and made available to all staff involved in the management of reserves. These include new products procedures, to ensure that investment managers and dealers trade only in instruments that can be handled by settlement, risk, accounting, and IT systems. The rules governing insider dealing and the declaration of personal financial transactions are also circulated. All staff employed in the management and control of the reserves are required to sign these declarations on a frequent basis.
996. RAMD is responsible for ensuring that investments are correctly recorded and for monitoring any breach of limits, controls, or other elements of compliance. All breaches are reported to senior management. In addition, RAMD calculates the profit and loss figures, which are reported to senior management and HMT.
Training and retaining staff
997. The Bank of England devotes considerable resources to training its staff in the specialist skills required for reserves management. This includes regular participation in internal and external courses in finance and portfolio management techniques. Like other bank employees, staff involved in reserves management have their basic salary structure enhanced by a flexible package of financial and nonfinancial benefits, and individual effort is rewarded through a system of discretionary bonuses (though as a considerably smaller proportion of total remuneration than in the private sector).
Transparency and accountability
998. The presentation and accounting basis of the U.K. reserves has changed radically in recent years. The United Kingdom has been at the fore-front internationally in promoting openness and transparency in reserves data. In September 1997 the Chancellor of the Exchequer announced that he was “opening up the books” on the U.K. reserves of foreign currency and gold. The ensuing quarterly report, which was initially published with a two-month lag, provided a breakdown of assets and liabilities into broad currency blocs, SDRs, and gold. Since April 2000, reserves data have been published on a monthly basis in accordance with the IMF/G10’s Special Data Dissemination Standard (SDDS). Data from July 1999 onward can be found on the Bank of England website. These data record the value and composition of the U.K.’s gold and foreign currency assets, liabilities, and derivatives on a “marked-to-market” basis (that is, using current market valuations). The press release also reports the size(s) and date(s) of any intervention in the foreign exchange markets, either by the EEA or by the Bank of England, and gives an explanation of any intervention carried out.
999. As a further enhancement of transparency, in January 2000, the first set of EEA annual accounts was published, covering 1997–98; these financial statements are audited by the National Audit Office. HMT now has a statutory obligation, as set out in the Finance Act 2000, to publish a full set of financial accounts for the EEA every year and, after examination and certification by the Comptroller and Auditor General, to lay the accounts before each House of Parliament by the January 31 following the end of the financial year to which the accounts relate. The financial accounts for 2000–01 were the first to be published within this framework. Although this is the fourth year for which the accounts have been published, it is the first time they have been published under accruals accounting consistent with U.K. Generally Accepted Accounting Practice (U.K. GAAP).
Establishing a Capacity to Assess and Manage Risk
An asset/liability approach
1000. HMT’s foreign exchange assets and liabilities are managed jointly on a day-to-day basis by the Bank of England. However, whereas the assets are held in the EEA the liabilities are liabilities of the National Loans Fund (NLF), which funds the EEA’s assets through a combination of sterling and foreign currency borrowing. The Exchange Equalization Account Act does not permit the EEA to borrow.
1001. Any NLF exposures relating to the foreign currency reserves are managed alongside those of the EEA by the Bank of England, which also acts as HMT’s agent for foreign currency liability management. For example, when the NLF borrows in a foreign currency to fund the reserves it assumes the currency and interest rate risk as it sells the foreign currency to the EEA for sterling. Through its investments the EEA will take an offsetting currency and interest rate position so that the government’s exposures as a whole are hedged.
1002. EEA reserves fall into two differently funded categories: “borrowed reserves” on which the currency exposures have been hedged and “net reserves,” which are funded out of unhedged sterling.
Funding the borrowed reserves
1003. The “borrowed” reserve assets are financed both by foreign currency and sterling-denominated liabilities, the latter swapped into foreign currencies. Cost is the main determinant of whether the foreign currency reserves are funded by issuing foreign currency liabilities or by sterling swapped into foreign currencies. The least-cost method of funding can be determined by comparing, on a swapped basis, the cost of issuing bonds of a given maturity and nominal amount in dollars, euros, and yen with the cost of issuing a similar bond in sterling. The EEA seeks to control the exposure in these borrowed reserves by matching the risk characteristics, for example maturity, of its foreign currency assets to those of the foreign currency liabilities. Any residual risk is managed by swapping the exposure of the asset into that of the liability through currency or interest rate swaps.
Recent trends in financing the borrowed reserves
1004. Since March 2000 a program was implemented that replaced maturing foreign currency debt issues with sterling debt swapped into foreign currencies to finance the reserves. At prevailing interest rates and swap rates this offered a more cost-effective means of financing than borrowing directly in foreign currency. As central government net cash requirements for 2000–01 were revised down substantially, further swaps were undertaken to prefinance some of the foreign currency debt maturing in 2001 to 2003. This policy continued through 2001–02.
1005. Prefinancing led to a temporary rise in the gross reserves but did not increase the U.K.’s net foreign currency exposures, because all transactions were hedged. As the prefinanced liabilities are redeemed, the level of gross reserves will fall back. Redemption of the longest-dated prefinanced foreign currency obligation in January 2003 is expected to bring the level of gross reserves down to $35 billion by the end of March 2003, from a recent high of $43 billion at the end of September 2001.
1006. The net currency reserves are effectively financed by unhedged sterling, and by the EEA’s net SDR liability. HMT sets a benchmark for net currency exposures that takes into account past patterns of risk and return, as well as other macroeconomic factors such as trade flows and the likely currencies used in any intervention. In 2001–02, this was 40 percent U.S. dollars, 40 percent euros, and 20 percent Japanese yen (excluding SDRs), which has been unchanged since accounts were first published in 1997–98.
1007. Interest rate risk in the net reserves has largely been managed by investing in short-dated instruments. Recently, however, the duration of some of the net reserves benchmark has been extended to reflect a revised view about the best trade-off between risk and return.
Composition of reserve assets
1008. Under the Exchange Equalization Act, funds in the EEA may be invested in any assets denominated in the currency of any country; in the purchase of gold; or in the acquisition of SDRs.
1009. In May 1999, the Government announced a restructuring of the reserves involving a program of gold sales by auction to achieve a better balance in the portfolio by increasing the proportion held in currency. This program continued until the end of 2001–02. Following each auction, the proceeds of gold sales were invested in foreign currency interest bearing assets and retained in the reserves broadly in the proportion of 40 percent dollars, 40 percent euros, and 20 percent Japanese yen.
Securities and other eligible instruments
1010. The statutory obligation of the EEA dictates that investments must be highly liquid, so they may be made available quickly for intervention purposes if necessary. They must also carry acceptable credit risk. Essentially this means that the bulk of the assets are securities issued by the national governments of the United States, euro area countries, and Japan.
1011. The EEA also makes use of other instruments, however, including:
(i) Bonds issued by highly rated supranational organizations and selected official sector agencies;
(ii) Foreign currency spot, forward, and swap transactions;
(iii) Interest rate and currency swaps;
(iv) Bond and interest rate futures;
(v) Forward rate agreements;
(vi) Gold deposits, gold loco, and gold quality swaps;
(viii) Certificates of deposit and bank and corporate commercial paper; and
(ix) Bank deposits.
1012. Options are not currently permissible investments for the EEA.
1013. To determine the benchmark asset allocation for the EEA, the Bank employs an asset allocation model that explicitly trades off liquidity and return: the model determines an asset mix that maximizes expected return for given levels of expected liquidation costs. Potential liquidation costs include both bid-offer transaction costs, which are dependent on the size of liquidation, and price movements, which are primarily driven by market conditions at the time of liquidation. Liquidation costs are incurred only if there is a call on the reserves. A “call” on the reserves is defined by three parameters: the size of the call, the probability of the call occurring, and the length of time available to meet the call. In the absence of such a call, the reserves are assumed to be held to maturity and yields between asset classes can be compared on a spread-to-LIBOR basis (taking into account the basis swap if assets are denominated in different currencies). Various call scenarios are assumed, based on historic events and future potential needs. A core level of liquidity is also specified in the model, leading to minimum holding thresholds in particular asset classes such as U.S. Treasury bonds.
1014. The results of the liquidity model are used to determine the neutral position of the borrowed reserves, and this forms the benchmark for active management.
Active management benchmarks
1015. The Bank actively manages both the borrowed and net reserves in order to enhance returns relative to benchmarks. Deviations from benchmarks are capped by the VaR limits set each year by HMT in its annual Remit. The benchmark returns on borrowed reserves comprise the returns to the hedge portfolios held against the NLF foreign currency and returns generated by the sterling swaps program.
1016. The benchmarks for active management are adjusted for any positions taken by higher levels of management such that the returns to active risk taking are properly identified for each portfolio. Such management positions count against the overall VaR limits.
1017. Portfolios are divided into major currency blocs—dollars, euros, and yen—and portfolio managers establish tactical positions by buying and selling securities against their individual currency benchmarks. They are also permitted to establish positions using derivatives including futures and swaps although not, currently, options.
1018. A range of positions including outright longs and shorts, curve positions, spread switches, and relative value switches are taken at the active level. The decision to take profits on trades and to unwind loss-making positions, in most instances, belongs to the portfolio manager although, exceptionally, senior management may ask for positions to be closed in order to avoid a buildup of unacceptable risks. Positions are monitored on a frequent basis by the direct line management of the active traders.
1019. Market risk is the exposure to movements in market variables. For the EEA, these variables are primarily interest rates and exchange rates. Since 1999 the Bank has monitored and controlled market risk using a VaR model, which predicts, at a specified confidence level, the maximum likely loss for the portfolio over a certain time period. The Bank applies a 99 percent confidence interval and a ten-day holding period, which predicts that in 99 ten-day periods out of a hundred, losses should not exceed those suggested by the model. These VaR estimates are based on the past volatility of returns on different asset classes and on how the returns on each asset class are correlated with other positions held in the portfolio.
1020. The Bank measures the EEA’s VaR exposure on a regular basis throughout the day. It also calculates the Delta exposure at the same frequency. Delta measures the change in value of the portfolios for each one-basis-point shift in the relevant yield curve. It supplements the VaR measure, and helps to test the sensitivity of the portfolio to changes in interest rates. Market risk reports are produced daily.
1021. Furthermore, the Bank conducts regular stress tests, to explore the vulnerability of the EEA to hypothetical severe market movements and to estimate the potential losses in these extreme conditions. The results of these tests are reported to senior management.
1022. The management of the reserves involves exposure to the creditworthiness of banks and of the issuers of sovereign, supranational, or commercial paper. The creditworthiness of these banks and issuers is subject to regular scrutiny by the Bank. Although the Bank takes account of published Agency ratings, it sets its own internal limits, which limit the maximum exposure to each bank and issuer in terms of both amount and maturity. Such exposures are monitored in real time against the limits. A report of any limit excesses is sent to HMT each month. In addition, there are limits to contain exposure to each country’s banking system and on instrument types.
1023. Where bonds are owned by the EEA, but held by custodians, these custodians may be authorized to use them in their bond lending programs. These programs involve lending the bonds against collateral consisting of either other bonds or cash. The authorized custodians are permitted to invest cash collateral in money market instruments. The investment of this cash collateral is subject to credit limits determined by the Bank. The amounts delegated to the custodians are deducted from the limits available to the Bank for its own EEA management activities. Any maturity mismatch between the collateral held and the corresponding investments is strictly limited. Daily reports are received by the Bank, which allows compliance with the investment constraints to be checked.
1024. The EEA also exercises its right to call collateral each time exposures to swap or repo counterparties rise above contractually defined thresholds. Unsecured credit risk on such transactions is thereby kept to a minimum.