Gazi Erçel: Risk management - within reserve management policies
Opening remarks by Mr Gazi Erçel, Governor of the Central Bank of Turkey, in the Conference titled
"Current issues in reserves management for central banks in Europe, Middle East and North Africa"
which has been organized by the World Bank Treasury in Istanbul on 4-5 May 2000.
* * *
I am delighted to be with you today to offer some general remarks about reserve management, and our
approach to risk management, at the Central Bank of Turkey. Before starting my speech, I would like
to thank the World Bank for organizing this conference which, I believe, will be most beneficial to all
of us. I am sure most of the important subjects related to new developments in reserve management
will be covered in detail at this meeting. However, let me briefly comment on recent developments in
managing risk within reserve management and share our experience at the Central Bank of Turkey
with you.
A string of disaster stories dominated the financial news coverage during the last two decades. A
variety of factors could be cited as possible causes of these events. They include shortcomings in
economic policy, inadequate supervision and, in most cases, poor risk management by the market
players themselves. Beyond that, the basic issue is the financial system's vulnerability to unforeseen
events. We all learned much from these bad experiences but we are living in a changing world. These
changes can be good or bad for those affected by them. Change therefore leads to risk, the prospect of
gain or loss and the risk of loss is something that we must all be aware of. To be aware of risks does
not mean eliminating them from our lives, which is certainly impossible, nor does it mean that we
should do nothing about risks and accept consequences fatalistically. It means: we must manage risk.
To manage risks we must decide what risks to avoid and how we can avoid them; what risks to accept
and on what terms to accept them; what new risks to take on and so on.
Both theory and practice of risk management have developed enormously in the last two and a half
decades. The theory has developed to the point where the risk management is now regarded as a
distinct sub-field of the theory of finance and risk management has become a separate subject in the
master's and MBA programs. The subject has attracted a huge amount of intellectual energy not just
from finance specialists but also from specialists in physics. The most important factor contributed to
this transformation of risk management was, as I mentioned at the beginning, the high level of
instability in financial markets. The other factors were rapid developments in information technology,
huge increase in trading activity and development of new financial instruments, namely, derivative
instruments.
As a result of these developments along with the globalization of financial markets, every trading
institution has become more exposed to changes all over the world economies and financial markets.
This has led all institutions including central banks to develop new processes in their organizations to
manage the risks in a more systematic way, although they used to have had implicit risk management
practice. Parallel to these developments in risk management, the practice of reserve management by
most of the central banks has changed significantly over the last decade. Once characterized by
passive short-term investment strategies to preserve principal value and maintain maximum liquidity,
many central banks now use a broad range of instruments, extend their portfolio duration and develop
performance benchmarks. This increased attention to risk management and new approach to reserve
management by central banks has come about not because of any change in central bank missions, but
because of the growing recognition that the conduct of core businesses inevitably involve exposure to
financial risks and also because of increased attention to the contribution of central bank profits to
national treasuries. Advances in financial risk management brought more scope for central banks to
consider increasing their portfolio returns together with maintaining the desired level of liquidity,
which is the primary target for central banks.
Then, the important question of how an effective risk management system can be developed, comes
out. The answer to this question does not change depending on the objectives and the size of the
institution. Only for more complex organizations, a more extensive technological infrastructure is
needed. Let's come to the answer to the question then. To have a well established, in other words,
efficient risk management system, first we need to develop the risk culture within our organizations
meaning that we need to make sure that at all levels every person understands the risks the institution
is exposed to. It is the responsibility of top management to provide that kind of information by having
a clear approach to risk, its appetite for risk and assigning responsibility for assuming and controlling
risks. Therefore, the first step in risk management process is to identify the risks the institution is
exposed to and to quantify those risks. Effective risk management requires that a consistent
methodology be developed for analyzing risk. Important steps in risk management analysis are as
follows:
• identifying the key financial flows;
• determining the appropriate time horizon;
• setting a benchmark;
• defining the institution's return objectives and views toward risk.
As you all know, most progress has been made in the measurement of market risk and much work is
now being done in many places to construct models for a better management of credit risk. Difficulties
with credit risk measurement lies in the lack of statistics about individual default probabilities. Even if
these default probabilities can be estimated reasonably accurately, it is still rather difficult to combine
them into portfolio assessments. The reason for that partly stems from the lack of statistical knowledge
about the interaction between variables. Therefore, the models mostly tend to rest on simplified
assumptions based on subjective judgments. I do not want to go into details about the technical aspects
of the risk measurement methods, but I would like to emphasize that it is necessary to combine them
with sound judgment and common sense. Since these models are no more than simplified and limited
images of the real world, they are better to be used having this fact in mind and the decisions must be
taken not solely relying on the results of these models. The results should be supported with scenario
analysis, stress testing and most importantly with the sound judgment of the decision makers.
Another important aspect of risk analysis is that it should be integrated, meaning that the analysis
results for different risk types should be comparable with each other to facilitate decision making. It
necessitates that the assumptions, data, valuation models used in analyzing different types of risks be
the same or at least consistent with each other. Organizationally, the integration of risk analysis
requires that there be a single, common risk management authority for the whole organization.
At the beginning, it might not be easy to look at risk on an institution wide basis. Since it requires a
considerable amount of capital to be invested either in terms of technology, or in terms of staff.
Besides that, the risk management system must be flexible enough to adjust to the rapid developments
in this area. So, at the end, the risk management system should be established in a way to allow the
management to compare risk on a consistent "apples for apples" basis even for those risk factors such
as operational and legal risk, where limited data is available.
As I mentioned earlier, the management not only has to set standards for its risk policies but also has
to ensure that they are disseminated to and understood by the staff who are affected by them. I think
this point is worth restressing since it is impossible to launch the risk culture without ensuring those
kind of communication channels in the organization.
At this stage, I would like to say a few words about reporting and monitoring which are important
steps to complete the risk management process. Reporting and monitoring is really important to check
the system's efficiency. Because of this, the risk management function has to have an independent
reporting line to provide assurance that the institution is assessing its risks effectively, and is
complying with its own risk management standards. With this functionality, reporting is the key
component of any risk process, because it is basically the window into the risk management results
and the means of communicating risks the institution is exposed to. Therefore, data collection and
processing need to be highly efficient so that accurate risk results are available in time and within the
necessary level of confidentiality.
At the Central Bank of Turkey, we established a risk management division about two years ago. The
need for such a division came as a result of multiple factors. These factors can be grouped into two as
external and internal. The external ones as I have just mentioned in the first part of my speech are
rising volatilities in financial markets, rapid developments in information technology, huge increase in
trading activity and development of new financial instruments along with the globalization of financial
markets. The internal factors are accumulation of net reserves starting from 1997 and the increased
responsibility of our bank in terms of its leading role in the Turkish financial markets.
As our work on risk management has progressed during the establishment process, we have seen that
our reserve management needed to be restructured to have an efficient risk management. Within this
context, although we did not change our primary objectives of having enough liquidity and preserving
safety, we decided to consider the return factor also. Therefore, we separated our reserves into
different tranches serving different purposes, one for operational, one for liquidity and one for
investment as in the case of most central banks changing their approach to reserve management.
Within this framework, we developed a performance benchmark for our reserves to evaluate our
performance on a risk-adjusted basis. The benchmark reflecting the neutral position has been
constructed in line with the objectives, the asset-liability structure and the liquidity needs of the bank
for a one-year period. And it is going to be reconsidered periodically.
The Risk Management Division in the Central Bank of Turkey is in the process of establishing a
system to carry out risk analysis and to feed the results to the appropriate units. For the last year or so,
duration and Value at Risk (VaR) figures reflecting interest rate and currency risks of the FX reserves,
and liquidity indicators such as current ratio (percentage of liquid assets in total of liabilities) are being
observed. However, these reports are not yet part of a comprehensive risk measurement and control
system. Although they give an idea of the general level of market and liquidity risk levels, the actual
risk exposure will be clearly seen only after the reserves portfolio is restructured and the benchmarks
are included in these reports.
The risk management process related to market risk that we plan includes daily marking to market of
benchmark portfolios; monitoring risk limits determined in terms of currency and duration limits;
daily measurement of actual portfolio's VaR figures for currency and interest rate exposure;
monitoring liquidity ratios and reporting these figures to the top management weekly including stress
testing report. There is no specified global risk tolerance limit but our institutional objectives and
constraints are reflected in portfolio benchmarks. In terms of performance evaluation comparison of
actual and benchmark portfolios returns are going to be monitored daily and reported to the top
management periodically.
For credit risk management side, a transaction limit is assigned to each counterparty, covering all
types of credit risks and market risks. The limits are marked to market daily and reflect the amount of
exposure that the bank is willing to take with each counterparty. The credit limits are set by employing
an internal scoring model that incorporates the counterparty's external credit ratings, financial
information, and some other qualitative information such as the quality of relationship with our bank
and the support status, ie the possibility of getting help from the government in case of financial
difficulty. The credit rating of the country in which the bank operates is also considered. Reports about
limit monitoring are produced regularly.
I would like to conclude my remarks by underlining once again how important it is to have an efficient
risk management to protect our reserves from financial instabilities all over the world. We need to
watch the rapid changes in reserve management in terms of technological developments and in terms
of economic conditions very closely and adapt our institutions to these changes right away.