Daniel Mminele: Establishing a proper governance framework for central
bank reserves management
Address by Mr Daniel Mminele, Deputy Governor of the South African Reserve Bank, at the
Institutional Investor, Africa Sovereign Funds Roundtable, Cape Town, 7 March 2013.
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1. Introduction
Good morning ladies and gentlemen.
Thank you to Institutional Investor for inviting me to address this roundtable meeting, and for
choosing to host it in Cape Town. I trust those of you visiting South Africa or Cape Town for
the first time will have an opportunity to see the exceptional beauty that this part our country
offers.
Judging by the agenda, I have no doubt that the discussions will be rich, as the topics being
covered are all pertinent, and should allow us to exchange views and gain valuable insights
to inform the work in our respective institutions in strengthening sovereign funds
management operations and their oversight.
I have been asked to talk on the topic of governance for central bank reserves management.
With the increase in reserves assets observed in recent years, there has come a higher level
of scrutiny with regard to how these assets are managed, in particular heightened interest
around proper governance structures. As public investment managers we should welcome
this trend, because reserves are public assets, which should be seen to be managed
prudently and carefully while achieving appropriate returns.
As some of you may be aware, the South African Reserve Bank (the Bank) has made
significant progress in recent years in enhancing our governance framework.
2. Evolution of reserves management in South Africa
Before I talk about the governance aspects of foreign exchange reserves management, I
would like to first provide a brief history of the build-up of reserves in South Africa, and the
evolution of reserves management activities.
In 1998, South Africa had gross reserves of just US$6 billion, but was running an oversold
forward book and consequently had a negative net open foreign currency position (NOFP) of
US$25 billion. This huge forward dollar commitment left the country in a precariously
dangerous and vulnerable external position and resulted in our currency being deemed a
one-way downward bet. The Bank and the National Treasury embarked on a drive to reduce
the NOFP to zero, and to build up the reserves of the country, with the former being achieved
in March 2003. Subsequently, there was a rapid build-up of reserves over the years, made
possible by a combination of purchasing the proceeds of Government's foreign bond issues;
taking advantage of large FDI related inflows; and purchasing foreign exchange in the open
market, when conditions were deemed to be favourable. At the end of February 2013, South
Africa's gross gold and foreign exchange reserves amounted to US$50.4 billion and the
international liquidity position of US$47.2 billion.
While South Africa does not target a specific optimal level of reserves, we do look at various
measures that inform what could be deemed an acceptable level of reserves for the country,
taking into account factors such as the balance of payments position and debt dynamics.
Much as by international comparison, when looking at other emerging market countries or
similarly rated countries, our reserves are still relatively low, the level of foreign exchange
reserves exceeds short term foreign exchange commitments of the country, and we broadly
satisfy commonly accepted reserve adequacy measures. The build-up of foreign exchange
reserves will continue when market conditions are conducive, and taking into account a
careful cost/benefit analysis. A higher reserves cushion will not only make South Africa more
resilient in crisis situations and in the wake of volatile capital flows, but should also help to
increase policy flexibility, for example, if exchange rates are perceived to have deviated
significantly from what is considered "fair value" as suggested by macro-economic
fundamentals.
It goes without saying then, that with the increase in reserves their efficient management
became a key focus area of the Bank. The Bank graduated from being a pure liquidity
manager to building what by now has become a relatively sophisticated investment
management operation. In the process, our investment objectives have not really changed,
still conforming to the old definition contained in the 2001 IMF guidelines, and guided by the
placing emphasis on capital preservation, such that
classical trilogy of objectives,
investments are undertaken in a manner that seeks to preserve the capital of portfolios over
the investment horizon; liquidity to enable the Bank to meet its day-to-day foreign-exchange
commitments as well as for unforeseen circumstances, without incurring significant penalties
when liquidating the investments; and return having a lesser emphasis, but the objective of
which is to enhance the returns on the Bank's official reserves within an acceptable
risk-return framework and to help defray the costs of acquiring and holding reserves.
The reserves are separated into various tranches, around which specific portfolios have
been constructed, with the abovementioned objectives in mind, to ensure an appropriate
balance between them. Each portfolio's objectives have specific liquidity requirements and
investment horizons. In determining the size, liquidity requirements and investment horizons
of these tranches, foreign exchange liquidity needs of the Bank and the National Treasury
are taken into account. While return has always been a lesser objective, it has received more
prominence in recent years, given the increase in reserves globally and the low yielding
environment in which the reserves are invested in.
The Bank, like many other central banks, complements its internal reserves management
activities with a carefully structured external fund management programme. The first group
of external fund managers were employed in 1999. We have refined the external fund
management programme as we went along, with the most recent review initiated in 2012,
with a view to completing this process by September 2013. Apart from delivering excess
returns against set benchmarks, this programme also has at its core a skills and technology
transfer component. Our staff members have benefited vastly from the knowledge transfer,
which now allows them to manage more complex portfolios. But, over time our initial
objective changed and we now also look at external fund managers with diversification in
mind, allowing them, given their higher level of professional expertise, to do things that we
can't do. In this respect, they get more leeway in terms of risk taking and asset classes they
can invest in.
The Bank established its first formal Reserves Management Investment Policy (IP) in 2007,
to provide the strategic and operational framework and to define the investment criteria for
the management of reserves. The aim of the process was to set investment objectives and
related parameters for the reserves portfolios. In this, relevant target durations and
benchmarks which are consistent with the Bank's risk tolerance were established. The
evolution of the Bank's reserves management activities has necessitated the review and
enhancement of the IP. The first such review took place in 2010, and apart from being a
governance related review, provided an opportunity to not only take into account some of our
own lessons learnt from the crisis, but also to align the policy with emerging best practices.
The 2010 IP review led to the strengthening of the governance structure for reserves
management and a reconfiguration and strengthening of the Reserves Management
Committee (Resmanco). Other initiatives currently under way involve improving our IT
infrastructure, and upgrading our risk management tools, monitoring, compliance and
reporting systems. The IP has been reviewed again in 2012/2013, during which time we also
undertook a benchmarking exercise, the results of which revealed some further areas of
improvement, which we are taking on board where appropriate.
To align the investment of reserves with the objectives of holding the reserves, the Bank
employs a Strategic Asset Allocation (SAA). The first SAA programme was developed in
2007, the purpose of which was firstly to calculate/agree on a tracking error consistent with
the Bank's risk tolerance, and secondly, to establish strategic benchmarks against which
reserves would be managed. The SAA for the various tranches is meant to ensure that the
tranches maintain sufficient liquidity while maximizing returns, subject to a low probability of
capital loss over a given investment horizon. We are currently in the process of reviewing our
SAA to be in line with the IP and to take into account the changing financial markets
environment, with a view to greater diversification in terms of investment destinations, so as
to improve the risk-return profile of the reserves. It will be rolled out later in the year following
the approval of the IP and to coincide with any changes deemed necessary emanating from
our external fund management review.
3. Governance, accountability and oversight of investment management
Sound governance and oversight around the management and investment of foreign assets
has become a critical discussion point in central banks and governments globally, especially
so following the financial crisis. The ability of central banks to make decisions and respond to
specific market developments within a sound risk management framework were tested
during the 2008 financial crisis, when capital markets malfunctioned and liquidity became a
major constraint. At the time, potential systemic risks in the banking sector required a
tightening of risk management guidelines, placing greater emphasis on liquidity
considerations in terms of the asset classes in which reserves portfolios are invested. Central
banks generally have a large proportion of reserves invested in highly liquid fixed income
assets which include short-term bank deposits. At the peak of the financial crisis, default risk
was high and central banks withdrew their investments in the banking sector, which was in
desperate need of funding.1 Although these actions were plausible from an individual reserve
manager's perspective, the collective withdrawal exacerbated the already tight funding
situation of commercial banks. This pro-cyclical behaviour of reserves managers during
crises may conflict with central bank's objective of maintaining financial stability, which again
highlights the need for sound governance and oversight in the investment of reserves. Clarity
of mandates and objectives is an important part of the governance framework, especially in
more recent times when a balance has to be struck between not taking too much risk, and
the expectation of higher returns.
The Bank's reaction to the global financial crisis centred on a risk-averse philosophy and we
responded to the deterioration in liquidity by tightening investment guidelines to reduce credit
risk by limiting counterparty exposures. When a second wave of the crisis emerged in
Europe through potential sovereign defaults, the Bank decided to rebalance its portfolios in
order to manage exposures to affected peripheral euro area countries.
Foreign exchange reserves make up a significant component of total assets of central bank
balance sheets. Due to this concentration, central banks are subject to stringent reporting
requirements from the general public, and more specifically, governments and shareholders.
To this end, central banks have been developing sound governance structures, improving
accountability through more transparency and introducing a culture of higher risk awareness
across all their operational activities. Efficient management of foreign exchange reserves has
become vital for maintaining sound perceptions of central bank credibility. Undoubtedly, a
loss of reputation through bad governance could undermine the ability of a central bank to
perform its primary tasks of ensuring price and financial stability.
Good governance and sound functional organisational structures are therefore necessary for
the efficient management of reserves. In establishing these structures, clear decision-making
processes; appropriate delineation of roles and responsibilities, clear execution guidelines,
and accountability through adequately transparent regular reporting, should be well defined,
documented, adopted and institutionalised. It goes without saying that there is no one correct
way of establishing a governance framework, and that country- and institution-specific
circumstance must be taken into account, while not compromising on the principles.
Borio et al note that there are two dimensions to consider in governance - vertical and
horizontal governance.2 Vertical governance ensures that decisions are taken at the right
level (senior executives), that is, where the strategic direction of the organisation is
established. Senior management of the institution should carry out the responsibility of
oversight on the investment process and management of reserves. Horizontal governance
ensures that business areas and reporting lines are organised in a way that minimises the
potential for conflicts of interest. The senior governing body needs to provide overall strategic
direction through an investment management policy, which encapsulates the risk tolerance
for the institution, while an investment committee should be responsible for the tactical
position and for establishing the investment guidelines, and whereas day-to-day trading
activities and taking active positions should be the responsibilities of portfolio managers
within a control environment which separates them from middle office functions of risk and
reporting, as well as accounting and settlement functions.
What is of critical importance is to insure that investment committee members are
competent, have relevant skills, and bring the right level of commitment. This can be a
challenge for central banks that are busy building professional investment management
operations, and when the traditional skills-set in a central bank has been around
macroeconomics, monetary and exchange rate policies. A structured programme needs to
be developed to capacitate investment committee members, and which seeks to
continuously enhance their expertise as part of making the governance structure more solid.
We have found that the external fund management programme provides a good opportunity
and can be used very effectively for skilling up investment committee members.
The Bank has a three-tier governance structure where the responsibilities for executive
authority, strategic management and the actual portfolio management are clearly
segregated. This comprises of the Governors' Executive Committee (GEC), the Reserves
Management Committee (Resmanco) and the Financial Markets Department (FMD). The
GEC is responsible for making decisions such as the risk tolerance of the organisation and
policies on reserves accumulation and management. The Resmanco is the investment
committee which functions within the parameters set-out by the GEC, and provides
guidelines on the framework of reserves management and approves the SAA. In other
words, Resmanco designs the investment policy and guidelines for the portfolio and risk
management functions, and submits them for approval by the GEC. Portfolio management
activities are carried out in the Financial Markets Department. In line with principles of sound
internal governance, the Bank has separated portfolio management activities from those of
performance measurement, risk control and compliance, accounting and settlement.
Figure 1
SARB Structure and responsibilities in governance structure
Review and approve Investment Policy
Approve the Terms of Reference of RESMANCO
GEC Approves the appointment and removal of external fund managers
Approves the appointment of custodians & SLAs
Approves benchmarks and guidelines and risk management limits and procedures
Approves target tranche sizes and currency composition of tranches within IP
parameters
Approves the SAA
Resmanco Approves the investment guidelines
Approves deviations from benchmarks within approved risk budget and asset
classes
Evaluates performance and future strategies
FMD Portfolio and risk management activities
On an annual basis, the Internal Audit Department provides the GEC with a report on the
adequacy of internal policies, procedures and processes around reserves management,
while at the same time a report is prepared for the Board of Directors. The latter report
focusses on the current investment of the reserves including matters such as duration, credit
risk, asset class and currency composition, as well as the results of the investment
management activity over the year.
As I mentioned earlier, some very useful contributions were received from the benchmarking
exercise undertaken, which may result in some adjustments to the governance structure.
4. Current challenges in reserves management
As I come to the end of my remarks, let me leave you with what could be the challenges that
reserves managers will have to deal with going forward, and I am sure some of these issues
will feature in the discussions over the next two days of your programme:
(i) Do central banks need to redefine what an acceptable risk-return balance for official
reserves is and think differently about risk tolerance?
(ii) As we are central banks, what is an acceptable level of trade-off between risk
management and financial stability? A recent IMF paper dealt with this and I alluded
to it earlier, pointing to the pro-cyclical behaviour of central banks when withdrawing
deposits from commercial banks during the crisis. Do there need to be rules around
how central bank reserves managers need to behave in a crisis so as not to make
matters worse?
(iii) Should there be a greater segregation between reserves that are held for policy
purposes (i.e. monetary policy, intervention, etc.) and those that are purely for
investments and who is best placed to manage those, central banks or other
dedicated public entities?
The low return environment has exacerbated the opportunity costs of holding reserves and
induced a debate amongst central banks about ways of enhancing returns by moving higher
on the risk-return frontier. Considerations of seeking excess returns (or alpha) carry with
them challenges of balancing central banks trilogy of objectives and the related financial risk
management issues which will arise with the inclusion of riskier asset classes in the portfolio.
Added to this is also the potential for global monetary policy normalisation which may cause
bond yields to rise and hurt the return on fixed income investments.
Furthermore, there are large carry costs (the interest rate differential between the domestic
and foreign economy multiplied by the change in reserves) associated with foreign currency
accumulation. Whenever foreign currency is purchased in the domestic foreign exchange
market, local currency liquidity is injected into the domestic money market and due to the
related potential inflationary impact, in most cases central banks have to sterilise these
purchases. Indeed, sterilised purchases of foreign exchange can be expensive when the
central bank earns a lower interest rate on the foreign currency reserves than it pays on the
instruments that are issued in the sterilisation process.
Finally, the complex and changing regulatory framework in financial markets could make the
investment landscape for reserves even more challenging given all the uncertainties related
to new requirements and potential impact on asset prices.
What does this all mean? Could the outcome be that the pendulum swings all the way back
to the other extreme? Are central banks going to become overly risk-averse? Are we going to
find it difficult to retain staff members that were attracted to central banks, because of the
increased level of sophistication, which they may feel is going to go into reverse?
5. Conclusion
The pressing need for good governance and oversight in reserves management has been
emphasised during this financial crisis. The crisis impacted portfolio performance and as a
result tighter risk management frameworks had to be implemented. Given the rising
challenges faced by reserves portfolios in this low global interest rate environment, the
investment processes must remain guided by sound investment principles and solid risk
management policies which are supported by effective information technology platforms.
I trust that you will glean useful information over the next two days and that you will assist
your respective institutions in overcoming some of these challenges which are faced by
central banks in reserves management.
Thank you.