A keynote address by Daniel Mminele,
Deputy Governor of the South African Reserve Bank,
at the Asset and Risk Management Forum
South African Reserve Bank, Pretoria
15 June 2018
Good morning, ladies and gentlemen.
It gives me great pleasure to welcome you to this second day of the Asset and Risk
Management Forum.
Yesterday's sessions touched on some pertinent and topical issues, as well as
on the
risks facing us as central-bank reserve managers. I hope that you have found
yesterday's sessions and I am sure today's session will be equally so.
informative,
In some sense, as the era of low policy rates and quantitative easing seems to be
drawing to a close, we are entering new and unchartered territory. While the landscape
in front of us appears ever-changing, complexities continue to abound. As such,
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opportunities to engage with peers opportunities such as this forum are proving to
be invaluable.
In keeping with information exchange and peer learning being one of the objectives of
this forum, I thought that I should use my key note address this morning to focus on a
topic that was the subject of one of the panels yesterday, namely strategic asset
the South African Reserve Bank's
allocation, and share with you the evolution of
(SARB) approach to the SAA over the last few years, and what we are currently up to.
The importance of an appropriate SAA framework cannot be overemphasised.
The asset allocation decision is widely regarded as one of the most important
investment decisions to be made, and in support of this view, numerous studies have
also shown that the asset allocation decision is one of the key determinants of
performance.1
For reserve managers, the asset allocation decision does not start with optimising for
performance. Its first objective is to ensure capital preservation and liquidity. As such,
the SAA process becomes ever more important but also ever more complex. Only
once capital preservation and liquidity have been adequately provided for, will
considerations of return be incorporated. The process governing the SAA becomes
vital to ensure that this non-trivial and important tool is implemented efficiently.
South African Reserve Bank's
The strategic asset allocation framework
SARB's
The management of the official gold and foreign exchange reserves is
governed by our Investment Policy, which provides a framework for our risk appetite
and defines the criteria for the management of reserves. The policy specifies, among
other things, the governance structures, the aggregate risk tolerance levels, and the
eligible asset classes.
However, on its own the Investment Policy can be seen as nothing more than a wish
the Investment Policy's
list. The SAA is a process which aims to ensure that objectives
and targets are implemented successfully. In this sense, it serves as the key vehicle
through which the investment policy is pursued.
At a high level, the SAA is presented as a set of long-term target currency and asset
allocations with the highest likelihood of achieving long-term investment goals within
certain risk constraints, as defined by the Investment Policy. In a way, this presents
SAA as a pure optimisation problem. However, a purely quantitative solution does not
always lend itself to practical implementations.
Consequently, the SAA process also contains an important qualitative assessment,
which can result in a portfolio construction that sits below the efficient frontier but which
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can efficiently be invested in and which reflects practical considerations.
From an overarching perspective, this seems simple enough: run an optimisation
across a set of benchmarks and select that portfolio which is as close to the efficient
frontier as possible but is also practically implementable. However, this description
masks the myriad of complexities and moving parts within a truly successful SAA
process. As is often the case, theory and practice are not perfectly aligned!
For us at the SARB, SAA is an ever-evolving process, refined through experience and
learning. As a result, our SAA process has developed over time, both in response to
various crises but also as we have become more aware of the specific challenges and
as managers of the country's
requirements that face us reserves.
the South African Reserve Bank's
Background to strategic asset allocation
framework
As an introduction to our most recent SAA review, and to give some context, allow me
to provide a brief history of reserves management in the SARB. It was not until 2004
that the SARB actively managed parts of its own reserves through its internal portfolio
management team. Prior to that, we had exclusively made use of external fund
managers. This started in 1999, with a programme of US$500 million managed
between five private sector fund managers. Three years later, in 2002, the programme
size would increase to US$1 billion.
It is important to note that, at this stage, we had not implemented an SAA yet and that
a large portion of the reserves was borrowed funds. The goal was to preserve capital,
including the cost of holding reserves. At the time, the benchmark was the London
Interbank Offered Rate, or LIBOR, plus 30 basis points to cover our borrowing costs,
and another 20 basis points to cover fund management fees. We soon realised that
achieving this target of LIBOR plus 50 basis points was not possible given the
conservative nature of the mandates we had provided to the external fund managers.
Around 2002, we started a rather informal relationship with the World Bank Treasury.
It was during this interaction that initial steps were taken to consider developing an
SAA, which was eventually implemented four years later, in 2006. Needless to say,
this required a revamp of our systems' capabilities and also led to our first Investment
Policy being designed. We began separating the reserves into two tranches: the
investment tranche and the liquidity tranche.
With more insight and exposure gained through the interaction with external fund
managers and the World Bank, the SARB launched its first internally managed global
government bond portfolio in 2004. At this stage, we had not yet formally joined the
World Bank's Reserves Advisory and Management Programme
(RAMP), but we had
come to the realisation that, with net reserves in positive territory and having gained
knowledge from the external fund managers, we needed a much more objective and
quantitative approach to our investment decisions. In view of this, the SARB, with the
assistance of the World Bank Treasury, dedicated the most part of 2005 to capacity-
building initiatives around reserves management. That same year, we joined RAMP.
The aim of our partnership was to ensure that foreign reserves were managed as
efficiently as possible. RAMP assisted with all aspects of reserves management,
including governance structures, reporting lines, risk management and analytical
capabilities, as well as the design of an SAA framework.
In fact, in the following year, the SARB would complete a comprehensive review of its
Reserves Management Investment Policy, and implemented its first SAA. At that
stage, reserves showed good growth and net reserves sat at approximately US$25
billion. In our first SAA, we had begun structuring the foreign reserves into three
tranches: the liquidity, buffer and investment tranches. However, given the good
growth in reserves and the fact that the liquidity and buffer tranches were sufficient to
cover both known and unexpected outflows, we started to increase our risk appetite
by setting the investment tranche to target higher returns.
Of course, shortly thereafter, in 2008, the global financial markets would be roiled by
a global financial crisis. Notwithstanding this, our SAA actually enjoyed good
performance given the global investor flight to quality that ensued.
Securities lending
Although the robust SAA framework shielded the performance of the actively managed
portfolios, both during and even after the global financial crisis, challenges were
experienced in the area we had viewed as the most conservative part of the reserves:
the securities lending programme.
On the cash collateral reinvestment part of the programme, we had limits on the
duration of the instruments into which the securities lending agent could deploy the
cash collateral but there was less of a restriction on credit quality. Through this
reinvestment, and at the height of the global financial crisis, we found ourselves with
some debt that would eventually trade at a few cents on the dollar. The losses, most
of which were valuation losses at the time, raised many questions and provoked
intense introspection on our part. However, we later recouped the bulk of the valuation
losses and eventually settled for a small realised loss on the paper in question. This
experience led to an overhaul of the controls around our securities lending
programme, with one of the key lessons being that every element of the reserves
management value chain should be actively monitored and stress-tested.
In 2015, we completed a formal review of our securities lending programme. We
concluded that the securities lending activity should be viewed as a value proposition
in its own right and, as a result, in 2016 we transitioned to a third-party securities
lending agent model.
South African Reserve Bank's
The second and third strategic asset allocation
the SARB's
Returning to my discussion on the evolution of SAA, the gradual growth
in reserves over the years created a need to review the SAA implemented in 2006.
Taking into consideration the valuable lessons learnt from our first SAA, and the
significant amount of infrastructure and skills development picked up through our
partnership with RAMP, we drafted our second SAA in 2009, which preceded the
second review of our External Fund Management Programme.
The 2009 SAA performed relatively well but was not without its own challenges, this
time in the form of the eurozone crisis. At the time, we had modelled Europe as one
single entity in our SAA process and not as individual countries. As a result, and given
our allocation to the eurozone as a whole, we had exposures to Greece, Ireland, Italy,
Portugal and Spain.
With spreads widening dramatically, a decision was made to exclude these countries.
This resulted in a number of challenges. Firstly, a decision had to be made on whether
to sell the existing positions or hold them to maturity. Secondly, all the benchmarks
used for the European portfolios had to be customised, a process which took a
considerable time while spreads continued to widen daily.
This event also started an important discussion on when and how a breach of the
investment guidelines would be handled. Eventually, a defined breach management
process was deemed necessary to be included in the investment management
agreements.
The SARB's
third SAA, implemented in 2013, marked an important turning point in a
number of areas. At that time, gross reserves were close to US$50 billion and we now
needed to seek a balance between accumulating reserves and the cost of holding
foreign reserves. During this time, we had migrated to a much more defined approach
to tranching, using the Jeanne-Ranciere model as a guide to the optimal amount of
reserves to hold.
As a result, the three tranches were reduced to two tranches. The liquidity and buffer
tranches were consolidated into one tranche, whose purpose was to provide insurance
against a sudden stop in capital flows. Any excess reserves were allocated to the
investment tranche, the purpose of which was to recoup the cost of holding the now
singular buffer tranche. The investment tranche, however, remained subject to the
constraints of capital preservation and liquidity.
A number of other important changes were made in our third SAA framework. We
expanded the investment universe for internal portfolio managers to include Australia,
China, Japan, South Korea and Sweden.
The aim of these changes was to include higher-yielding assets and high-quality
commodity currencies. Furthermore, we introduced new asset classes: United States
(US) mortgage-backed securities, dollar-denominated supranational bonds, euro-
covered bonds, and the use of bond futures to enhance the efficiency of internal
portfolios as global yields normalised.
At that stage, however, the existing systems could not effectively support the
expansion of the reserves into additional asset classes and markets. The new asset
classes also came with a requirement for more sophisticated risk analytics. As a result,
the SARB commenced a process of systems renewal, which also included a total end-
to-end solution supporting reserves management, treasury operations and third-party
payments. The first phase was rolled out a few years later.
We had come a long way at that point, both in terms of the size of our reserves and in
terms of the approach and processes around how we managed those reserves. As a
sign of this improvement, in 2015 the SARB was given the CentralBanking.com
'Reserve Manager of the Year' award in recognition of the measures
it had taken to
ensure resilience during a challenging year for the emerging markets and in
addressing the fundamental change in perceptions of risk and return under which
reserve managers operate in a post-crisis world.
As alluded to during my earlier remarks on our securities lending programme, we also
undertook a complete review of our custody model after the roll-out of the 2013 SAA.
At that stage, we were making use of two custodians, but this led to some efficiency
challenges when it came to risk and performance reporting. This review was
completed in 2015 and resulted in the appointment of a single custodian, with a second
custodian acting as a shadow custodian should the active custodian become
inoperative. This review provided us with great new insights into custodian services
and led to a much-improved overall service offering. We concluded that custodial
services should also be subjected to a regular review exercise. However, given the
complexities of transitioning between custodians, the cycle would be longer than for
external fund managers or securities lenders.
The selection of fund managers
I would now like to take a moment to touch on the process we follow when selecting
our fund managers.
At a strategic level, we believe that we should maintain a combination of internal and
external fund managers. This provides benefits such as greater diversification of
portfolio returns, the transfer of key skills and expertise, and a means to benchmark
internal portfolio managers.
Internally, portfolios are allocated according to their complexity, size and intended level
of active management. More passively managed portfolios are allocated to junior
portfolio managers under the supervision of a senior portfolio manager. More
complicated and more actively managed portfolios are allocated to senior portfolio
managers.
Our external mandates, however, typically aim to generate alpha. As a consequence,
almost no external mandates are passively managed. Given the focus on active
management, external fund managers are usually given slightly more freedom, in
terms of credit and currency allocations for example, than internal portfolio managers.
Our External Fund Management Programme is also aimed at diversifying reserves
into asset classes which we do not have the required resources to manage internally,
in terms of both systems and human capital. This includes specialist asset classes
such as corporate bonds, asset-backed securities and mortgage-backed securities.
In line with our most recent SAA review, which started in 2016, we also decided on a
different approach to enhance the way in which we selected our external fund
managers. This time around, we decided to focus more intensely on the value
proposition and value-add the fund manager presented on a specific investment
mandate. While the final selection was based on the value proposition in managing a
specific mandate, capacity building remained a key consideration in our fund manager
selection.
We have maintained our three-stage selection process. In the first step, a 'Request for
Information' is used to survey the landscape of fund managers and to identify those
fund managers that have sufficient experience in the required asset classes as well as
in the management of central-bank portfolios. The second stage, which takes the form
of a 'Request for Proposal', is considerably more detailed. Here, we conduct an in-
depth investigation of fund manager suitability with regards to organisational
capabilities in areas such as risk management and organisational stability. We also
request participants to select the mandate or mandates which suit their strongest skill
set. Importantly, we ask them to submit detailed performance track records in those
areas. These track records are then analysed in detail by our risk managers. The
subsequently shortlisted candidates are asked to present only on the mandates that
they had proposed as their strongest and where we felt, given their track record, they
could add the most value. In the panel interviews, the candidates are asked to present
their value proposition in their respective mandate in very specific terms, and also to
comment on and commit to an outperformance target within a proposed risk limit.
This approach has been followed to enhance the efficiency of our selection process
and to expose ourselves to those managers who have real and verifiable specialities.
This is important not only in terms of optimising performance, but also in terms of skills
transfer between the external fund managers and ourselves.
The South African Reserve Bank's
current strategic asset allocation framework
As I've mentioned, the most recent appointment of external fund managers was
concluded with the implementation of the current SAA in 2017. If you recall, in our
previous SAA, developed in 2013, we had started following the Jeanne-Ranciere
model as a guide to the optimal amount of reserves to hold. As a result, we had
implemented a tranching methodology which consisted of two tranches: the buffer
tranche and the investment tranche. The buffer tranche is invested in a highly
conservative manner, while the investment tranche is aimed at generating excess
returns, albeit subject to the same constraints of capital preservation and liquidity.
In developing our latest SAA framework, we were, however, faced with a completely
different set of circumstances to those that had prevailed in 2013. The end of the
quantitative easing programme in the US, their move to tighter monetary policy and
the consequential rising rates presented us with a new set of risks. However, the
divergent macroeconomic policy stances of the developed markets, the volatility in the
emerging markets, other risky assets which seemed overvalued at the time, the
uncertainty around China's soft
landing, and the possibility of the Brexit all posed a
myriad of other, also significant, risks.
As such, this most recent SAA was constructed to prioritise capital preservation and
to reduce tail risks rather than to focus on return enhancement. To encapsulate this,
we placed greater emphasis on the conditional value at risk, or CVaR. Unlike the often-
used value at risk (VaR) metric, CVaR is the expected return given that the portfolio
has failed to achieve even the lowest return as per the VaR metric. In other words, the
CVaR aims to estimate the average loss in extreme events which fall below the VaR
threshold. Our optimisation goal was focused on those portfolios that satisfied the
capital preservation criteria or, more specifically, those that defined as the probability
of zero negative returns with a 99% confidence level.
This resulted in a number of changes, the most important of which was a significant
reduction in overall portfolio duration and the introduction of a new asset class at an
SAA level, namely the US Treasury Inflation Protection Securities.
Strategic asset allocation simulation
Our most recent SAA involved a tremendous amount of rigor and numerous
engagements, both internally and externally, to ensure that it encapsulated the latest
developments in investment management. However, every process has room for
reflection and improvement. With this in mind, we have this year embarked on an SAA
simulation exercise.
The purpose of this exercise is to re-engineer the full value chain of the SAA through
a simulated but abbreviated SAA process to ensure that the process itself is
appropriately structured and meets the right governance standards. This value chain
starts with the formulation of the Investment Policy and runs through a review of market
identification, asset optimisation, the expression of risk appetite in Investment
Guidelines, and the ultimate roll-out of the portfolios. Among other things, the
simulation aims to ensure that each subcomponent of the greater SAA exercise is
owned, that timelines are accurate and effective, and that each procedure is well
documented by owners in a complete and up-to-date procedure manual.
In doing this, we hope to create a separate environment and process where we can
focus solely on the SAA process itself, removed from the overarching deadlines which
are present in real-life SAAs. In this way, we aim to create a more robust operational
framework for future SAAs.
Governance
As I approach the end of my speech, I would like to take a moment to discuss the role
of governance. Not only do reserve managers have to contend with the challenges
and complexities of managing foreign exchange reserves efficiently; it is also
imperative that we do so with an appropriate level of transparency and with
accountability. Sound governance structures go a long way to ensuring that we meet
these high standards. The Governor briefly touched on this in his opening remarks
yesterday.
The governance structure surrounding foreign exchange reserves management at the
SARB is separated at different levels. At the highest level, the Governors' Executive
Committee (GEC), which is responsible for overall risk tolerance at the SARB,
approves the Investment Policy, the Financial Risk Management Policy and SAA.
SARB's
The Risk Management Committee plays another vital role in the governance
structure. The committee, which reports to the GEC, oversees the risk management
process in the SARB and reviews the Financial Risk Management Policy to ensure its
relevance to current business activities. Furthermore, the Risk and Ethics Committee
of the SARB's Board of Directors also reviews
the status of risk management in the
SARB as well as the effectiveness of risk management activities, key risks, and the
mitigating measures to address them.
Certain elements of the risk oversight role, however, are delegated to the Reserves
Management Committee (RESMANCO), which is chaired at Deputy Governor level.
RESMANCO approves investment guidelines and allocates the active risk budget to
portfolios in order to limit deviations from the benchmarks. In addition, the committee
also has the delegated authority to appoint and/or remove external fund managers,
custodians and securities lending agents.
While RESMANCO's role is one of
oversight, portfolio management activities,
however, are conducted within the Financial Markets Department and, in line with
principles of sound internal governance, the Bank has separated the activities of
portfolio management, financial risk management, and operational risk management.
While these activities all reside within the Financial Markets Department, the Head of
Financial Risk has a dotted reporting line to the Deputy Governor: Markets and
International and the Head of the Risk Management and Compliance Department.
These measures ensure adequate segregation of duties to prevent any conflicts of
interest while at the same time allow for operational efficiency.
Furthermore, in an effort to promote and improve transparency around reserves
management, in 2016 the South African Reserve Bank began publishing the Official
the Bank's
Gold and Foreign Exchange Reserves Management Investment Policy on
website.
These governance structures are vital to ensure that the Investment Policy, through
the SAA in this instance, is implemented effectively and lends credibility to the SAA
process itself.
Conclusion
To conclude, I would like to paraphrase a quote attributed to Saint Francis of Assisi:
"Start by doing what's do what's
necessary. Then possible. And suddenly you are
doing the impossible."
Looking back at where we started in 1999 to where we are now, we have progressed
considerably in terms of our approach to investing our reserves. We have achieved
what might have seemed impossible back then. Our current SAA simulation initiative
is a combination of the latest thinking in investments, lessons learnt, and all the
challenges we have faced along the way. Of course, as with any process, there are
areas for improvement, and I am sure that, through future iterations, our SAAs will be
even more robust and more effective.
the SARB's foreign exchange
I hope that this journey through the history of reserves
management, and the SAA's vital role therein, has been informative, and that it has
given you an idea of the challenges and opportunities we have faced along the way.
I look forward to engaging with you all in the session that follows, and hope that you
enjoy the remaining sessions today.
Thank you.