sou · GVB351 · 2008-01-01 00:00:00 — In Section 4.2, we discussed the currency risk that arises because the Riksbank holds a foreign exchange reserve and can be expected to intervene on the foreign exchange market in certain circumstances. The Commission made the judgement that the currency risk posed by this activity should be neutralised. However, it was established that certain risks could not be fully neutralised, these are discussed below. Furthermore, there are other financial risks in asset management, first and foremost interest rate risk, which are dwarfed by the much larger currency risk. Nevertheless they exist, and if the currency risk is neutralised they will become more visible. With the currency risk neutralised the rest of the asset management will need a different focus. There is no point in discussing this on the basis of the current interest rate risk. The Commissions view of the asset managements focus and risk tolerance is discussed in Chapter 6. The Riksbanks gold reserve amounts to over billion. To a certain extent this is a hangover from the old days, however it can also be seen as a valuable asset in times where other assets are not accepted. Currently the Riksbank considers its holdings in gold to be too large.TPF FPT But gold is not managed in the same way as foreign currency assets. Because central banks hold a significant proportion of the worlds gold, their trade on the gold market is potentially very significant for its price. the central banks generally to be more interested in selling gold, which they have been recently, there is a risk of the price plummeting in a way that would be unfortunate for the central banks themselves. A number of the worlds major central banks have therefore agreed how the gold trade should be carried on by setting out the volumes at which gold can be sold. Until now this agreement has run for five years at a time. The agreement also states that there must be no trade on derivative markets that circumvents the agreed value of gold transactions. For this reason it is not possible to neutralise the value of the gold reserve on derivative markets or to reduce the Riksbanks position in gold at a rate that it chooses itself. Thus the gold position should be seen as remaining open. The Riksbank calculates a VaR measurement of 99 percent confidence for the gold reserve. The capital need for the risk of loss in line with this measurement amounts to billion. This should be seen as an exceptionally large price risk, as it corresponds to a fall in the price of gold of almost 60 percent. The volatility of the price of gold has been high in the past year and, as this volatility to a large extent drives the VaR measurement, there is cause to look at the price from a slightly longer perspective. In the longer term the annual rate of change has also varied considerably (see Figure 10). However, were we to look at the greatest annual price change in the 40 year period reported, instead of the VaR measurement, we would see that this was approximately 35 percent. 36TP PT According to the 2006 annual report. Development of the price of gold expressed as an annual percentage change A drop in price of 35 percent would result in a loss of approximately billion. We consider this a more reasonable risk of loss to consider. The Riksbank has build up a substantial reserve in the form of gold price effects booked into the revaluation account. In 2006 this reserve amounted to over billion, which has significance for the management of the gold price risk (this is discussed in more detail in Chapter 6). Nevertheless, the gold price risk must be viewed as a serious risk which cannot be insured against. At the same time, the problem is getting smaller as the Riksbank is selling gold at the rate at which it is allowed in line with the international agreement that it signed. The current agreement runs for several more years, but it is likely that a new agreement will be signed after that. At the end of 2006 the Riksbank held approximately 160 tons of gold. The current agreement allows the sale of between 10 and 15 tons annually (this is varies year on year). If sales continue for 15 more years and the Riksbank uses its opportunity to sell at the permitted rate, the entire gold reserve would have been sold. Continued sales seem probable, if the Riksbank shares the view of the Commission that it is difficult to see any value in the Riksbank holding gold. This would also reduce capital need over time. Another undertaking that the Riksbank has no hold over, is its undertaking to the IMF. This consists of three main components. Firstly the Riksbank has financed the IMF by being conferred IMF issued special drawing rights (SDRs). SDRs are like a currency which can be used by the IMF to provide financing. In 2006 the Riksbanks SDR assets amounted to billion. An amount corresponding to the SDRs originally conferred by the IMF is reported as a liability; billion in the 2006 annual report. item and liability item do not cancel each other completely (see table 4), but they do not fluctuate enough to warrant being viewed as a loss risk with a specific capital need. Secondly the Riksbank has paid a capital contribution to the IMF, the quota. This receivable is netted in that there is a total capital contribution (which was billion in 2006), against which the IMFs Swedish krona account (which at the same date had a negative balance of billion) is deducted. The net receivable for this item is therefore billion. The size of this item net is primarily governed by the IMFs activities as a credit provider. When the IMF lends money, funds are taken out of the IMFs account in Swedish krona. Because payment to the IMF is in foreign currency, the Riksbanks currency assets are reduced by an equivalent amount. So in the Riksbanks balance sheet the item Reserve position in the IMF increases while currency assets decrease correspondingly. Thus there is no effect on the profit and loss account or own capital. When the IMF needs to lend a more substantial amount of money, the item Reserve position in the IMF thus increases. This mainly happens when the IMF acts in conjunction with a major crisis in a country, for instance the Russian crisis. Here the Riksbank has a potential exposure of the entire amount, billion. The IMF has no intention of using the entire amount, and has a guideline that no more than 25 percent should be utilised. Just as in other currency assets there is a currency risk in this position. Just as the other currency assets discussed in Section 4.2, it should be possible to neutralised this using derivatives or borrowing in counterpart currencies. There is also a credit risk in this position, as the IMF lends to countries with financial problems. However, up to now the IMF has not incurred losses to the degree that this has affected the member states financially. This is probably because the risk when lending to central governments, even those with financial problems, is small, and also that the IMF can bear some capital losses in its own balance sheet. Because central governments cannot be bankrupted, final losses should only arise if the debts are written off, which normally takes place after negotiations between lenders and debtors. The credit risk should therefore be seen as small. These two types of receivable from the IMF thus have a total net position of billion (if the Miscellaneous item is added). While this item is small, it can vary with the value of the Swedish krona in relation to other currencies in SDRs, and with how the IMF controls its operational activities (see Table 4). Receivables and liabilities with the IMF in the Riksbanks balance sheet 1999- 2006 Receivables from the IMF Reserve position in the IMF Liabilities to the IMF Thirdly, in addition to the direct funding of the IMF mentioned above, the Riksbank has undertaken to part-finance financial support which the IMF may provide in extraordinary circumstances, in a financial crisis for example. This undertaking can mean that the Riksbank may need to lend a maximum of approximately billion in certain situations.TPF FPT Currently there are no loans made. However, minor specific credit commitments have been made. When these loans are made, the currency and credit risk inherent in these loans should be seen in the same way as the Reserve position in the IMF. It should be possible to hedge the currency risk and the credit risk should be limited for the reasons set out above. In summary, the Commission concludes that present exposure to the IMF is not large, that it should not become large given the restrictions on the undertaking, and that the risk of losses should be viewed as limited. no capital need is specifically identified. It should be possible to bear potential losses using the capital for other risks identified by the Commission. A summary of the other risks Judgement of the Commission: A maximum capital of billion should cover the Riksbanks other risks. The Commission has identified other risks in the form of gold price risk, operational risk, along with certain credit risks caused by the Riksbanks undertakings in relation to the IMF. The gold price risk is estimated to generate a billion capital need after taking account of the fact that the revaluation accounts bear some degree of losses. Operational risks should not exceed billion. Risks in relation to the IMF have not been quantified but should be seen as limited. The Commission concludes that a total capital need of billion will cover these other risks. 37TP PT These pledges were made within the framework of special programs known as the General to Borrow () and New Arrangement to Borrow (NAB). Capital structure in other central banks This Chapter contains a short summary of the Commissions international comparison. The data is based on a questionnaire which was sent out and answered in the summer of 2006 and on details from the annual reports of central banks. The summary covers the central banks in the following countries: , , , the , the , , and . As a comparison the same information is presented for the Riksbank. The aim of the comparison is to show that there are similarities and differences between the Swedish Riksbank and its foreign equivalents. Above all the comparison shows that the way in which the Riksbanks capital structure has been formed is not the only possible alternative, and that in certain respects there are entirely different ways of organising and funding a central banks operations, and that this affects the structure of the balance sheet. 5.1.The main tasks of central banks Observations of the Commission: It is not necessarily the case that the main components of the Riksbank balance sheet are contained in the balance sheets of the central banks of other countries. In the there is a separate balance sheet for currency in circulation and in the foreign exchange reserve is not part of the central banks balance sheet. , it is fully possible to have a situation where neither the foreign exchange reserve not the currency in circulation are included in the central banks balance sheet. In general the main tasks of central banks are quite similar. Basically they have three tasks: Issue banknotes, and sometimes coinTPF38FPT For all central banks maintaining price stability includes setting the repo rate (or the equivalent) in order to keep inflation at a low level. Most central banks are also tasked with a foreign exchange reserve so as to be able to conduct currency interventions. Exceptions are the central banks of the and where the foreign exchange reserve is separated from the central bank. However, these central banks are still deeply involved with the administration and governance of the foreign exchange reserves. 38TP PT In many countries the national central bank is not responsible for issuing coin. This task lies with a separate mint. This was the case in until 1986. It goes back to a tradition that allowed the king (government) the right to issue coin. In encouraging financial stability all the banks can be said to include being able to act as lender of last resort, though how clearly this task is formulated by the central bank varies. All central banks also have the task of issuing legal tender, that is banknotes. Here the central bank in the has a special structure which means that currency in circulation along with the assets in which this capital has been invested, are reported Besides these main tasks, certain central banks also have particular tasks such as administering central government debt or central government funds. This applies to such central banks as those of and . 5.2.National central banks balance sheets To make the comparison simple table below contains the most important items in the central banks balance sheet. 39TP PT The requirement for currency in circulation to be reported separately stems from legislation from 1844. There are separate balance sheets, the difference between which is that the profit from note issuance goes directly to central government. Summary of several items in the balance sheets of central banks at the end of 2005. as a % of (31/12/05) (30/06/06) (31/12/05) (31/12/05) (31/12/05) (31/12/05) (28/2/06) (31/12/04) (30/06/05) *The figures reported are related to banking operations. The separate balance sheet which contains the issuing of banknotes and coin is not reported here. ** The official foreign exchange reserve is not contained in the central banks balance sheet and is therefore not reported here. Own capital includes the following items: : Own capital, revaluation account, provisions (for example pension liabilities). Differences to amounts reported elsewhere in the inquiry are due in part to this table referring to 2005 and in part because another definition of own capital has been used. : Own capital (including a revaluation account known as the adjustment fund). Own capital is currently below the statutory target. : Own capital (including a revaluation fund and the General ). : Own capital, revaluation account, provisions : Own capital, revaluation account, provisions : Own capital, revaluation account, provisions : Own capital : Own capital : Own capital 5.3.National central banks own capital Observations of the Commission: The size of own capital as a share of the balance sheet total varies significantly between the different central banks. The Riksbank has a high share (39 percent) while others have a very low share (0.06 percent). These central banks have a slightly different focus but also appear to have a different view of the need for own capital. The central banks, with the exception of , apply marking to market of assets and liabilities. The Euro-zone countries and the Riksbank follows the reporting rules of the Euro-system which specifies that unrealised gains shall not be recognised as income, but transferred directly to a revaluation account – that is to say not included in the distributable profit either. Unrealised losses shall be taken to the profit and loss account when exceeding previous revaluation gains registered in the corresponding revaluation account. The Riksbank has a balance sheet total of billion. Own capital corresponds to 39 percent of the balance sheet total. has a balance sheet total of the equivalent of billion, not including the pension fund. Own capital corresponds to 20 percent of the balance sheet total. This is divided into the adjustment fund (like a revaluation account) and a transfer fund. Currently there is no capital in the transfer fund as the adjustment fund is below its target level. has a balance sheet total of the equivalent of approximately billion. Own capital corresponds to about 13 percent of the balance sheet total. Of this 13 percent, a over 12 percent is in General , which is comparable with provisions. has a balance sheet total of the equivalent of billion. Own capital corresponds to 8 percent of this. In addition there are provisions corresponding to over 14 percent and revaluation accounts equivalent to almost 5 percent. Own capital, as discussed here, is therefore equivalent to 28 percent of the balance sheet total. has a balance sheet total of the equivalent of billion. Reported own capital, divided between primary capital and a reserve fund, is equivalent to over 9 percent of the balance sheet total. In addition there is a revaluation account equivalent to over 14 percent, plus negligible provisions. The total capital buffer therefore corresponds to 23 percent of the balance sheet total. Deutsche has a balance sheet total of the equivalent of approximately billion. Reported own capital, is divided between primary capital and a reserve fund, and is equivalent to 1.5 percent of the balance sheet total. In addition there is a revaluation accounts corresponding to almost 13 percent and provisions equivalent to 1.5 The total capital buffer therefore corresponds to 16 percent of the balance sheet total. has a balance sheet total corresponding to billion for its banking operations, i.e. not including the department responsible for issuing banknotes and coin. Own capital corresponds to 7 percent of the balance sheet total, of which over 1.5 percent is in a reserve fund. has a balance sheet total of the equivalent of billion. Own capital corresponds to 0.06 percent of the balance sheet total. of has a balance sheet total of the equivalent of billion. Own capital corresponds to 12 percent of the balance sheet total. Regulation of the central banks own capital and profit allocation Observations of the Commission: It is unusual for central banks to have a statutory level for the size of their own capital, in addition to the relatively small primary capital or the equivalent. This is also the case inside the Euro-zone, which is surprising given the criticism directed at in the convergence reports. It appears that the extra payments of 2001 and 2002 are the main reason for the requirements made on because it became clear that there was no statutory regulation of how the Riksbanks profit distribution should be determined. It is not the case that other countries have strict statutory requirements in this area. For information about the Riksbank, see Chapter 4. Banks own capital is regulated by royal decree. It is made up of a transfer fund and an adjustment fund. According to the regulation the adjustment fund should correspond to 5 percent of the banks receivables in Norwegian securities plus 40 percent of the banks net foreign exchange reserve. If the capital in the fund exceeds the prescribed amount the excess is transferred back to the profit and loss account. surplus from operations is transferred to the transfer fund unless the adjustment fund is less than the prescribed size; if that is the case the surplus is transferred there. There is no limit to how small own capital can be and there is no regulation of what happens if own capital decreases drastically. If the adjustment fund is less than 25 percent of the banks net foreign exchange reserve the capital may be transferred back from the transfer fund to the adjustment fund until the prescribed size of the fund has been reached, of course this presupposes that there is capital in the transfer fund. year a third of the transfer fund is paid to the Norwegian central government. Currently the adjustment fund is still less than the prescribed size, which is why no capital is being allocated to the transfer fund. It should be noted that lets exchange rate fluctuations affect results, both realised and unrealised. The size of the adjustment fund is determined on the basis of what is necessary in order to cover several subsequent years of losses with a confidence level of 95 percent. Nationalbanks own capital is only regulated in law in as far as profits must be distributed to central government unless it goes to the reserve fund or general reserve. This also stipulates that net capital should be a certain size, however this amount is no longer relevant as the paragraph was written in 1936. Instead profit distribution is carried out according to the following principles. 30 percent of profit is transferred to the general reserves and 70percent can be distributed to central government. However, this has not always been followed. In 2002 the profit was distributed 20/80 for example. own capital is not regulated with regards size. The Act on states the following: shall have primary capital and a reserve fund. The reserve fund can be used for increasing the primary capital or for covering losses, ... Provisions can be made in the annual accounts if necessary for safeguarding the real value of the Banks funds or for smoothing out variations in profit or loss arising from changes in exchange rates or market values of securities. Profit allocation is regulated in law as follows: Half of the profit, following allocation of the monetary income that has accrued within System of Central Banks, shall be transferred to the reserve fund. The remaining profit shall be made available for use in accordance with the needs of the state. may decide on use of the profit for other purposes if this is justifiable because of the Banks financial condition or the size of the reserve fund. Parliament shall decide on the disposal of the profit made available for use in accordance with the needs of the state. If the Banks annual accounts show a loss, the loss must be covered out of the reserve fund. If the reserve fund is insufficient to cover part of the loss, the uncovered part of the loss may be left temporarily uncovered. profits in subsequent years shall be used first to cover such uncovered losses. The law also prescribes that the final decision on profit allocation lies with the , which has the right to deviate from the main rule. It should also be noted that out its own calculations of the need for and has drawn up a memorandum (2001) to support the decision regarding profit distribution, a decision based on proposals from the banks Board. The memorandum states that needs buffer capital for three reasons: to cover interest rate risk and foreign exchange rate risk in the foreign exchange reserve to cover any credit losses in emergency liquidity assistance to commercial banks to be prepared to take measures under Emergency Powers Act De Nederlandische Banks own capital is not regulated by law. Profit allocation is not regulated by law either, but the DNB has an agreement with the Dutch about how it should take place. This agreement means that 95 percent of the profit, reduced by realised profit from the sale of gold, is to be paid to central government and the remaining 5 percent transferred to provisions. A loss (excluding realised profit from the sale of gold) is covered in that it reduces the profit for the six subsequent years by an equal amount. It should also be noted that when the DNB made the agreement on profit distribution with the Dutch a statistical simulation was carried out with 1,000 random scenarios based on the necessity that the financial independence of the DNB must not be threatened. own capital comprises a base fund and reserve fund, provisions and value adjustments. There is nothing in law about the size of the banks total own capital. On the other hand profit allocation is regulated by law. It states that: 20 percent of the banks profit, but at least million, shall be transferred to the reserve fund until it contains billion. The remainder of the profit should be allocated to central government. The bank has the right to independently decide on provisions (for the risk of losses due to exchange rate fluctuations). It should also be noted that when the banks management annually determines the size of provisions they take account of VaR calculations at various confidence intervals. Currently provisions have been set as 7 percent of the acquisition value of the net foreign currency position.