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RISK MANAGEMENT FOR CENTRAL BANKS

RISK MANAGEMENT FOR CENTRAL BANKS

Owing to the unique role and functions of the Bank, risk management is not simply based on institutional risk and return considerations, but also takes into account national interest, in line with the statutory and constitutional responsibility of the Bank. The Bank also functions within an environment characterised by continuous change and uncertainty. This requires constant monitoring and analysis of, and appropriate response to, potential and actual risks emanating from the global political and economic environment.

In common with most central banks, the Bank is a risk averse institution. This reflects the view that satisfactory fulfilment of its role and responsibilities could be seriously jeopardised if there were to be significant disruptions to its operations and/or damage to its reputation.

The executive management of the Bank is intensely aware of the high performance standards that all role-players outside the Bank expect of the central bank. The Bank views risk management as an integral part and an essential element of good corporate governance.

Risk control policy framework

The risk control policy framework governing the Bank’s asset management and monetary policy operations is established by the Commission of the Bank and is reviewed regularly. The framework consists of various risk policies, procedures and limits. Our code of conduct for dealers, settlement staff and decision makers covers potential conflicts of interest, private financial accounts, insider trading, dealing limits and related issues.

Role of our Organisational Risk Division

Our Organisational Risk Division, a formal autonomous Division, is responsible for the measurement, monitoring and reporting of the Bank’s risk exposures and for monitoring and reporting compliance with limits etc. The Division also measures the return on the Bank’s investment portfolios. The measurement of performance involves the attribution of return across portfolios, sectors and instruments. The Bank’s performance in terms of the return achieved on its portfolios is measured against a notional benchmark portfolio that is compiled externally by Bank of America Merrill Lynch.

The Organisational Risk Division is operationally independent of the dealing function and presents regular reports to the relevant decision-making bodies of the Bank including the Commission, the Commission Audit Committee, the Commission Risk Committee, and the Executive Risk Committee.

In addition to the work performed by the Organisational Risk Division, the Bank’s asset management and monetary policy operations are audited by the Bank’s Internal Audit Division, by the Bank’s external auditors – the Comptroller and Auditor General and Deloitte and Touche and by the ECB’s external auditors – Pricewaterhouse Coopers (PwC).

The main risks associated with managing the investment portfolio are;

Currency Risk

Currency risk is the risk of capital losses as a consequence of fluctuations in exchange rates. This risk is managed by minimising our holdings of volatile foreign assets while taking Eurosystem obligations into account. The currency distribution of the portfolio is reviewed periodically using quantitative techniques such as currency optimisation models, Value at Risk (VaR) and stress testing as well as a variety of qualitative factors. We currently manage portfolios denominated in euro and US dollars (hedged against the euro).

Market risk

Market risk relates to the impact of changes in interest rates on the value of the investment portfolio. The management of market risk in the Bank is primarily based on duration, although Value at Risk and stress testing techniques are also used. The duration of a portfolio determines its sensitivity to interest rate changes – the higher the duration the more risk is assumed. Global economic conditions, bond yields, views of market participants, and liquidity requirements are all factors that are taken into account in setting the duration for the investment portfolios.

Table 2 below sets out the VaR on the investment portfolio.

Table 2: Value at Risk Analysis of Investment Portfolio

€m

Interest Rate Risk

Foreign Exchange Rate

Total Risk

       

31 December 2009

144.3

3.6

145.2

31 December 2010

115.6

2.8

116.4

*VaR measures the potential loss at a specific confidence level (e.g. 99%) over a certain period of time (e.g. 1 year). Thus, the figure of €116.4 million implies that at 31 December 2010 there is a 1% chance that the portfolio’s value would be €116.4 million or more below its current value at 31 December 2011.

Credit Risk

Credit Risk relates to the possible loss in asset value due to the default of counterparty banks, issuers of securities or other counterparties. Credit risk is managed by confining exposures to high quality instruments and to counterparties with high credit ratings. All approved counterparties and issuers must have an acceptable credit rating from at least one of the international credit rating agencies. For deposits, maximum limits are set for each counterparty according to its credit rating and the maturity of the deposit.

Liquidity Risk

Liquidity risk refers to the possible losses or difficulties that could arise in converting assets into cash. This risk is managed by ensuring that the investment portfolio is invested in instruments for which deep and active markets exist, such as securities issued by governments and other high-quality issuers and by applying maximum exposure limits.

Operational Risk

Operational risk is the possibility of direct or indirect losses, or of reputational damage, arising from inadequate or failed internal processes, people and systems or from external events. This risk is managed by the segregation of the dealing, settlement and risk management functions; by restricted physical access to the dealing and settlements areas; and by a comprehensive body of controls and procedures aimed at minimising the risk of unauthorised trading.

The Bank’s Executive Risk Committee, chaired by the Deputy Governor (Central Banking), oversees the management of operational risk in the Bank. The operations of each function are reviewed regularly to ensure that potential exposures are identified and that appropriate controls are implemented. A full review of operational risk is furnished to the Commission on an annual basis.

Characteristics of an Ideally Insurable Loss Exposure

 

·Insurability of Commercial Loss Exposures

·Insurability of Personal Loss Exposures

·Government Insurance Programs

Risk Management in Banks

  • Understanding evolving advances in markets and the impending risk management practices
  • Regulation and supervision of microfinance and issues of financial inclusion Risk Management
  • Wide risk management as it pertains to central banks;
  • Market risk particularly foreign exchange risk and interest rate risk;
  • Credit risk analysis and modeling; ability to appraise counterparty risks

Understanding of operational risks;

  • Other risks such as strategic risk and reputational risk
  • To develop a risk management plan and implement it
  • To conduct risks and crisis audits

Disaster preparedness Management

  • To identify the root causes of information disas­ters
  • Humans as primary cause of disas­ters

·Disaster preparedness planning

·Disaster response techniques

  • Designing a disaster preparedness management policy
  • To develop disaster preparedness and management plan

Insurance Operations

  • Classifications of Insurers
  • Insurer Goals
  • Constraints on Achieving Insurer Goals
  • Measuring Insurer Performance
  • Functional View of Insurance
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