Geoff Bascand: Central bank performance, financial management and
institutional design
Speech by Mr Geoff Bascand, Deputy Governor and Head of Operations of the Reserve
Bank of New Zealand, to the National Asset-Liability Management Europe Conference,
London, 12 March 2015.
* * *
Accompanying figures can be found at the end of the speech.
Introduction
A central bank's performance needs to be assessed on how well it meets its statutory policy
mandate. But policy outcomes are only one measure of performance and institutional
credibility. Central banks incur substantial financial risk and are an important part of overall
public sector finances. Maintaining the privilege of operational independence requires a
record of successful policy outcomes and sound and prudent financial management.
Therefore, financial arrangements and performance expectations are important components
of overall central bank institutional design.
These issues are even more important today. In the Global Financial Crisis (GFC) many
governments became guarantors of last resort, and undertook investments that were well
beyond their traditional risk habitat. Central banks were asked to do much more - either
through pursuing multiple targets, directing credit flows, or by adopting unconventional
monetary policies. Some central banks' balance sheets have expanded enormously (see
Figure 1). Central bank capital has been more at risk from some of these activities, and we
have seen reinvestment by governments to build capital levels in some central banks.
This paper sets out some broad financial and institutional design considerations and
illustrates these with reference to the Reserve Bank of New Zealand's (RBNZ's) financial
arrangements, balance sheet structure, and risk management. It explains their rationale and
discusses some avenues we are exploring for future enhancements.
Diversity of responsibilities and financial arrangements
Monetary policy responsibilities are common to all central banks, albeit with widely varying
operational approaches and performance targets. A mandate for financial stability is
common, but the form and extent of these responsibilities can vary significantly.
Lender-oflast-resort responsibility (emergency liquidity to the banking system) is inherent, but the
responsibilities of central banks vis a vis finance ministries, regarding the resolution of
institutions in financial difficulties or the provision of broader support to the financial system,
vary widely. Prudential policy and oversight may or may not be a function of the central bank.
Some central banks manage the country's foreign reserves and others do not (see Figure 2).
The diverse nature of these responsibilities flows through into a wide variety of financial
arrangements. Financial risks and results are sensitive to the operational and policy
responsibilities of the central bank.
Historically, central banks have been considered profitable through their responsibility for
money issuance. However, even here there are differing degrees of financial control or
independence over seigniorage revenues. Seigniorage revenues have become both more
predictable and constrained as a result of price stability goals. At the same time, increased
policy mandates and portfolio exposures taken on by central banks can overwhelm these
revenue streams through valuation changes1.
Does financial performance matter?
Generally speaking, the performance of central banks is judged by the public and
government in terms of its policy mandate. Financial performance tends to be in the
background when the impact and performance of the central bank is debated. But they are
not completely separable. Occasional and moderate financial loss is unlikely to seriously
impair a central bank's operations. But sustained loss and diminution of equity, or a very
large, even if exceptional, negative income (P&L) impact on public finances is likely to erode
the institution's credibility and policy freedom.
Governments are beneficial owners2 of central banks, and conceptually the central bank's
cash flows and the equity investment in the central bank can be consolidated into broader
whole-of-government finances. This is the case in New Zealand. Conceptually, a central
bank's net asset position is part of the public sector's balance sheet, irrespective of whether
a consolidated balance sheet is prepared. For example, policy decisions that influence the
size of the central bank's balance sheet (e.g. through accumulation of assets, or
commitments in the nature of contingent obligations, such as guarantees to a distressed
institution) expose the central bank's equity to risk, and therefore the value of the
government's ownership interest in the central bank.
Sound management of the central bank's balance sheet is also important to maintain the
central bank's standing and credibility as a regulator and supervisor (if it has these
responsibilities). The financial risks of central banks should be managed in a business-like
way similar to our expectations of commercial banks. Failure to do so may result in a central
bank's operational discretion being fettered by institutional rules, removal of decision-making
authority, or in extreme circumstances by intervention in the management of the central
bank.
At the same time, there needs to be recognition by all stakeholders of the significant financial
risks that central banks take. They manage what are often among the largest foreign asset
portfolios in the economy, and can have extensive credit exposure to individual financial
intermediaries. I turn now to how the RBNZ seeks to manage these risks.
New Zealand's institutional arrangements are designed to limit the very large financial risk
that the central bank could incur from its foreign exchange operations, and also to avoid the
bank acquiring substantial contingent liabilities on behalf of the government ("the Crown")
through its liquidity and lender-of-last-resort operations. Nevertheless, there is still material
financial risk inherent in the bank's operation that is managed through the bank's capital
holdings, reserves/asset management, and best-practice risk management. The following
sections describe how these arrangements and practices are managed at the RBNZ.
RBNZ institutional and financial arrangements
The New Zealand institutional framework is designed to balance policy and operational
independence with accountability for policy and financial performance. Financial
accountability and other expectations (e.g. reporting to Parliament) were strengthened in
1989 when the RBNZ was given greater policy independence.
The Reserve Bank of New Zealand Act 1989 established the central bank as a body
corporate whose primary function is to formulate and implement monetary policy for the
purposes of achieving and maintaining price stability. The RBNZ (which I will also refer to as
"the Bank") is also mandated to promote the soundness and efficiency of the financial
system. The Bank is owned by the Crown and capital is provided by the government, to
whom dividends are returned. The Act grants the Bank the right to deal in foreign exchange,
issue currency, and act as lender of last resort if it deems it necessary3. These arrangements
and powers underpin the Bank's financial strength and its risk exposure. Income is assured
through the authority to invest proceeds from the sale of currency and bank capital, and may
be earned (or lost) through trading or investment in debt securities, money market
instruments, derivatives, and foreign exchange.
New Zealand has a floating exchange rate, and prescribed limits on foreign reserve holdings
contain the Crown's risk exposure. By law, the Minister of Finance sets limits (a range) on
the foreign reserve holdings of the Bank, and the Bank then manages them to achieve policy,
liquidity and risk-return objectives. A Memorandum of Understanding with the Minister
provides further guidance to the Bank on foreign exchange operations4. Even though with a
pure floating rate currency, foreign exchange reserves conceptually may not be required,
foreign reserves are held in the event that the Bank may be required to intervene in foreign
exchange markets, for example where there is disorder in the currency markets or the
currency is materially out of line with fair value. Foreign exchange intervention has been
infrequent.
Liquidity provision to troubled banks and lender of last resort functions are at the discretion of
the Bank, including the terms and cost of borrowing. In the GFC, liquidity was provided by
the RBNZ at the cost of the Official Cash Rate (OCR) and with interest rates falling, the Bank
made positive returns from its lending. Ostensibly, the Bank incurs credit risk in these
circumstances, mitigated through collateralisation. However, the major cost of financial
stability support does not fall upon the Bank, but instead upon the fiscal authority (the
Treasury). Whilst the Bank has responsibility as prudential supervisor to recommend the
appropriate action if a financial institution fails, critical decisions on statutory management,
capital injections or guarantee schemes are ultimately for the Minister of Finance to make,
and would be expected to take the form of fiscal measures.
Accountability is accomplished through public and parliamentary reporting requirements and
monitoring via the Bank's Board as agent of the Minister of Finance and on financial matters
by the Treasury. The Bank must publish a Statement of Intent on its strategic and
performance objectives for the coming three years, and publish an audited Annual Report for
the previous year that includes information on policy, operational and financial performance.
The SOI and the Annual Report are both tabled in Parliament and subject to the scrutiny of
Parliament's Finance and Expenditure Select Committee.
The Bank observes the accounting standards imposed by the External Reporting Board (a
statutory body). From this financial year, the Bank is required to apply New Zealand
Equivalents to International Public Sector Accounting Standards (NZ-IPSAS) rather than
International Financial Reporting Standards (IFRS). The change in financial reporting
framework will not have a significant impact on the Bank's financial reporting, although
NZIPSAS and IFRS could diverge over time.
The final piece of the RBNZ's operating framework is the funding agreement. The RBNZ Act
requires the Minister of Finance and the Governor to enter into a five-year funding agreement
that specifies the amount of the Bank's income that may be applied in any year towards
meeting the operating expenses incurred by the Bank in carrying out its functions. The
Funding Agreement must be ratified by Parliament, prior to the commencement of its funding
period.
The five-year funding agreement is a key mechanism that reinforces operational
independence. The Bank does not have to seek an annual funding allocation from
Parliament in the same way that government departments do, and its operating budget is not
subject to annual variation in net income. On the other hand, the process of negotiating a
five-year agreement is intensive in terms of establishing value for money, agreeing on
strategic priorities for the Bank, and forecasting future demands on the Bank. Variations to
the funding agreement within the five-year window are feasible, for example if the Bank
acquires new functions, as it did in the last funding period for supervision of insurance and
anti-money laundering.
The RBNZ's capital expenditure is within the discretion of the Bank's management, but is
controlled in part through the moderating impact on depreciation expense from the limit on
total operating expenses in the funding agreement. Higher depreciation resulting from higher
fixed investment would, therefore, imply lower expenditure on other items, such as
personnel. Capital expenditure is also constrained by the Bank's equity and dividend
requirements, which are explained below. Large, unwarranted (and low yielding) capital
expenditure could infringe upon these principles.
By way of illustration, with the Bank introducing new banknotes in 2015, significant capital
expenditure was required that could be financed within the balance sheet from cash and
working capital. However, the operating expense incurred from issuing new notes and the
obsolescence of the existing series was projected to be greater than could be
accommodated within the funding agreement, requiring the Bank to seek the Minister of
Finance's approval for additional expenditure. In practice, the expenses span two different
funding agreements, requiring more complex negotiations than normal.
New Zealand's institutional arrangements are now 25 years old and have proven robust to a
number of tests, including significant volatility in exchange rates with material foreign
exchange gains and losses, negative P&L results, expansion of functions, and changes in
government administration. They work well because they are transparent and the Bank
works closely with the Treasury to share analysis and information; because they have
evolved in response to new mandates (e.g. through MOUs on foreign reserves and foreign
exchange intervention, most recently in 2007, and on the level of Crown equity in the Bank,
most recently adjusted in 2013); and because of strong performance standards (e.g.
benchmarking the Bank's reporting and capital adequacy against best international practice).
How do we assess financial performance?
Our financial strategy is primarily guided by our need to fulfil our functions, rather than
financial results. This doesn't mean we are indifferent to expected return or actual financial
outcomes, but rather that we generally take a conservative approach to risk to ensure we
have the capacity to carry out our statutory functions. Our financial strategy entails
considered decisions on asset allocation and investment strategy, with greater weight on risk
diversification and liquidity than on return; maintaining adequate capital for the risks we face;
and measuring our investment performance against relevant benchmarks.
Excluding exceptional circumstances, our objectives for reserves and liquidity management
are to manage our financial performance as efficiently as possible, out-perform what other
similar portfolios would achieve, and deliver a positive return on equity.
Risk management and capital adequacy
From the balance sheet perspective, financial risks arise from the Bank's key investment
portfolios of domestic (NZD) securities that support monetary policy operations and foreign
reserve assets that can be used to finance market intervention, with the latter much greater
in size and variability. Figure 3 depicts a stylised picture of the RBNZ balance sheet.
While central bank balance sheets and financial performance can be very volatile, in
constructing our balance sheet, we have taken strategic decisions that impose some limits
on the potential volatility in reported financial performance. The balance sheet is partially
immunised from major foreign exchange risk, and we have taken a conservative approach to
credit and interest rate risk in foreign reserve activities. We also manage operational risk
closely and are alert to the potential cost of operational errors.
Asset holdings and the scale of the RBNZ's balance sheet are primarily determined by: the
amount of foreign reserves RBNZ holds to maintain its foreign exchange (FX) intervention
capacity; trading banks demand for liquid assets, primarily to facilitate daily interbank
payments; Treasury's management of the Crown Settlement (cash) Account with the RBNZ;
and the public's demand for notes and coins.
Financial risks arise from:
• The RBNZ's open FX position and associated foreign exchange risk, which is
mitigated by limits on the position and holdings of a diversified basket of reserve
currencies;
• Interest rate risk arising from domestic market operations and from foreign reserves
management, mitigated through duration and risk limits;
• Credit risk arising from foreign currency assets, which is mitigated by investing in
high grade debt instruments; and
• Credit risk arising from derivative transactions, which is mitigated by holding high
quality collateral.
Investment policies control market and credit risk exposure through hedging policies, liquidity
and investment ratings requirements, and counterparty credit limits.
Perhaps the most significant of these is the restriction on unhedged foreign reserves. By
agreement with the Minister of Finance, the open FX position is limited to a specified range,
a subset of the total foreign reserves limit, with the remaining foreign reserve assets hedged
from an FX perspective. New Zealand differs from many countries in this respect. The
majority of foreign currency assets are funded through long-term foreign exchange swaps,
and therefore hedged from foreign exchange risks or through long-term foreign currency
borrowings (which have been originated by the Treasury and on-lent to RBNZ). Reserves
and portfolio management is expanded upon below.
Credit risk is mitigated by investing foreign assets in high-quality sovereigns,
nearsovereigns, and international agencies. In terms of domestic lending, credit risk is mitigated
by lending on a collateralised basis with banks providing RBNZ high-quality collateral, and
the Bank applying discounts, with daily monitoring of collateral values and collateral calls to
ensure the value of collateral is appropriate for the amount lent.
The Bank has several sources of interest rate risk that are mostly controlled through risk
caps and duration limits. On hedged foreign reserves, some interest rate risk arises through
mis-match of duration of assets and liabilities. Reported earnings are subject to volatility from
mark-to-market value of long-term liabilities. Another source of interest rate risk is due to
changes in New Zealand's short-term interest rates. Essentially, through FX swaps, RBNZ is
investing at short-term interest rates, and variations in these rates from forecast levels impact
earnings. The interest rate risk on unhedged foreign reserves is managed through strategic
decisions and periodic review of asset allocation (i.e. our duration target for foreign currency
reserve portfolios is managed strategically through the business cycle). The RBNZ also
incurs interest rate risk from its holdings of government bonds, but in this case there is a
corresponding impact within the Treasury, and this has no net impact on the Crown's overall
balance.
Capital adequacy
Notwithstanding a conservative financial strategy and investment policies that limit financial
risk, the Bank's income and balance sheet remain subject to some volatility. In order to
manage this variation in annual financial performance and avoid the credibility risks
associated with low levels of equity, the Bank has adopted a policy for holding a prudent
level of capital and developed a framework for determining the appropriate level of capital.
The RBNZ chooses to hold capital in line with both normal commercial practice and standard
public sector arrangements in New Zealand. The Bank is not subject to regulatory capital
requirements and thus determines its capital adequacy in agreement with its owner (the
government), reflecting its balance sheet and business risks. Having capital is explicit
recognition by the government that income from the Bank's business will be volatile, and a
buffer is required to absorb that volatility. It also supports the credibility of the central bank as
regulator and supervisor of financial institutions. Assessment of the potential financial
consequences of the risks facing the Bank determines the appropriate amount of capital the
Bank should hold.
Also relevant is the dividend policy. The Act requires the Bank to recommend an annual
dividend to be paid in line with the principles set out in the Bank's annual SOI, and the
Minister of Finance decides upon the final dividend figure. The dividend principles state that
the Bank should maintain sufficient equity for the financial risks it faces, and that excess
equity should be returned to the Crown. They are also tempered by the requirement that
unrealised gains on investments should be retained until they are realised in New Zealand
dollars. Thus surplus capital is returned as dividends, while the onus is on the Bank to
determine the appropriate amount to be held to maintain sound capital adequacy.
The Bank consults closely with the Treasury on these matters, with the intention of coming to
an agreed recommendation that is submitted to the Minister for decision. If ultimately the
Bank disagrees with the Minister's determination of the appropriate dividend, the Bank is
required to publish its recommendation. In 2014, the Bank introduced a new Note to its
financial accounts setting out the Bank's approach to determining required capital, its
dividend recommendation, and the basis of calculating the recommended dividend.
The Bank's capital adequacy framework5 evaluates credit, market and operational risks
associated with the Bank's balance sheet, investment policy, and operations. It considers
possible correlations between these risks, and establishes the necessary capital to meet the
possible loss associated with each of these risks, given its risk likelihood (see Figure 4).
As noted, we aim to run capital modelling methods that align with best practice, and can
choose models that address our balance sheet risks. As a result we are focused on evolving
our modelling of market, credit and operational risk, and are less concerned about liquidity
elements (as we invest heavily in high-quality liquid assets).
Market risk is the possible loss of value of an asset or liability due to variation in exchange
rates, interest rates, credit spreads or basis spreads. Market risk capital is the largest
component of the Bank's required capital. The Bank uses value-at-risk (VaR and stressed
VaR) models to assess market risk capital, and has set the target probability of (total) loss at
1 in 10006. Our models currently capture October 2008 to April 2013 as the stressed period.
The second component of required capital is for coverage of credit risk. The Bank evaluates
credit risk using the Basel II credit VaR approach, drawing on historical data including
consideration of sovereign and bank default probabilities during various periods of stress.
Updating to various Basel III credit risk modelling techniques is a future development
objective.
As noted earlier, if a deep financial crisis arises, the Bank may incur credit risk through its
lender-of-last-resort responsibilities, albeit lending is not expected to be contemplated
without appropriate collateral arrangements. This risk is not incorporated in our economic
capital modelling.
The final, minor, element of our capital adequacy requirement is the buffer held for potential
operational risks such as misconduct, property loss, systems failures, contractual disputes,
etc. Perhaps the largest operational risks arise from the Bank's responsibilities as the
operator of New Zealand's interbank payment and settlement system, and as the current
owner and operator of the securities settlement system.
The Bank has a number of controls to minimise the likelihood and impact of operational risks,
including a highly developed enterprise risk management framework, formal operational
investment policies and limits, an active (internal and external) audit programme, and a
proactive problem management (incident reporting) regime.
Portfolio management
The Bank manages its foreign reserves in two separate pools, an un-hedged pool (exposed
to changes in interest rates and FX rates) and a hedged pool. The primary purpose for both
pools of reserves is to maintain crisis intervention capability. The un-hedged pool of reserves
serves a secondary purpose of allowing the Bank to lean against (on a modest scale)
extreme cyclical peaks and troughs in the exchange rate that are judged inconsistent with
economic fundamentals. In contrast to most central banks, a large portion (currently
75 percent) of the Bank's foreign reserves is in the hedged pool (100 percent prior to 2007)
which helps to keep the return on foreign reserves relatively stable across time.
For foreign reserves to be effective in meeting their purpose they need to be allocated across
a diversified set of instruments that will maintain deep liquidity in both normal times and times
of crisis or stress. The allocation of hedged and un-hedged reserves is collectively described
as the Strategic Asset Allocation (SAA) and is set by the Bank's Assets and Liabilities
Committee. The SAA has a large influence on the Bank's financial risk profile, given foreign
reserves comprise a large part of the Bank's balance sheet. I will now describe the
characteristics of each pool of reserves in more detail and the SAA as it applies to hedged
and un-hedged reserves.
The first pool of reserves, hedged reserves, is what distinguishes the Bank's approach to
reserves management from most other central banks. The Bank borrows foreign currency
(through long-dated cross currency basis swaps and also foreign currency loans from the
New Zealand Treasury) to fund investments primarily in US, European, and Japanese
sovereign debt markets. Borrowing in foreign currency reduces currency risk, but it generates
refinancing risk. The Bank manages this refinancing risk by borrowing for long maturities (up
to 15 years) and ensuring that maturities are staggered as much as possible. The duration of
borrowing is matched to the duration of investments to reduce interest rate risk (i.e. if
borrowing is on a three-month floating basis, investments are matched to mature in three
months). This structure allows the Bank to maintain a stable return and low risk profile on its
hedged reserves through time, whilst maintaining effective intervention capability. This stable
return and low risk profile is in contrast to un-hedged reserves, which I will describe shortly.
The SAA for hedged reserves is presented in Figure 5. Allocation weights are defined such
that reserve managers can adjust the allocation dynamically (using FX swaps and cross
currency basis swaps) to take advantage of favourable (funding) spreads across time.
Performance is carefully measured, but it is not compared to a benchmark (given the
complexity of benchmarking long-dated borrowing that is transacted on an irregular basis).
The second pool, un-hedged reserves, is invested in sovereign debt markets with deep
liquidity and across currencies with high FX turnover. These reserves are funded by the
Bank's New Zealand dollar liabilities so are exposed to changes in New Zealand dollar FX
rates against each of the six currencies. The position has a high carry cost (due to the high
cost of New Zealand dollar funding relative to the return on reserve investments) and returns
are volatile given exposure to FX rates (and interest rates to a lesser extent). These reserves
are expected to perform well in times of crisis or stress, both in terms of return and providing
the most effective intervention capability. Within the limits set by the Minister of Finance,
unhedged reserves can be increased or decreased in size allowing the Bank to lean against
extreme cyclical peaks and troughs in the exchange rate that are judged inconsistent with
economic fundamentals.
The SAA for un-hedged reserves is presented in Figure 6. In determining the SAA we first
specify the most appropriate reserve markets (country allocations) for unhedged reserves,
given that allocations are applied to sovereign debt. Currently, the SAA is limited to six highly
traded currencies - a more diversified position than was the case in 2008 (Figure 7). Then
we specify the duration target for each of those markets individually. At this time we have
constrained the instruments to be 2-year government bonds, the shortest duration assets
that meet our liquidity criteria.
The process of determining the SAA for un-hedged reserves is about selecting a portfolio
that balances diversification and liquidity requirements against return or yield under "normal"
market conditions. To ensure that un-hedged reserves are effective in meeting their purpose
we constrain the investment universe and the potential allocation outcomes by strict
diversification, liquidity and credit minima and maxima. Our allocation minimums and
maximums force 70 percent of our allocation, before we optimise the remaining
unconstrained 30 percent using a Markowitz model. For example, the Australian dollar
allocation is capped due to the correlation of New Zealand and Australian currencies and our
inter-related banking sector. While a greater unhedged allocation to Australian assets would
provide good yield enhancement, it may not provide a source of effective reserves assets in
a crisis due to high and positive correlation aspects.
With the aim of keeping our reserves managers active in foreign reserve markets, the Bank
allows reserve managers to deviate from the SAA in terms of FX and interest rate position
(within limits). We measure their performance in doing so against a custom (un-hedged
reserves) benchmark that is set to our SAA. Performance measurement comes in the form of
risk-adjusted return measures, namely Information Ratios (reported for trailing two and five
year periods) and the Sharpe Ratio.
In addition to the hedged and un-hedged reserves described, the Bank has foreign currency
investments in BIS Investment Pool funds (ABF and CNY). The CNY investment was entered
into in 2014 to diversify the Bank's foreign reserves and the ABF investments in 2003 and
2005 to promote development of bond markets in the Asia region. We also have US dollar
investments (often in USD denominated European quasi government paper) as part of our
domestic markets operations. These investments are classified as foreign reserves
(according to IMF Official Reserve Asset measurement) but they do not contribute to the
Bank's intervention capability as they are funded by short-dated FX swaps.
Despite the potential for improved returns, the Bank has resisted investing in equities or gold,
as some central banks do. Our investment policy anticipates a periodic review of the SAA
and risk-return decisions may be re-assessed in future.
Future developments
The Bank is continually seeking ways to enhance its financial management. In recent years,
we have improved our economic capital modelling, reviewed and simplified our portfolio
management and strategic asset allocation, increased transparency, and strengthened our
performance reporting. There is scope to improve further. In particular, with enhancements to
our risk modelling and pricing, we can potentially be more dynamic in our allocation decisions
and improve expected financial returns without incurring significant additional risk. We are
currently assessing our technology base with aspirations to better manage risks and pricing
issues related to OTC derivatives (including bringing risk adjusted pricing and risk adjusted
performance on to reserve managers desktop on a pre-trade basis). Together, these
initiatives should help improve our performance and risk management culture.
Maintaining our conservative liquidity profile (driven by intervention capacity) has an
opportunity cost, and so we must be at least as good as other market participants at
motivating and focusing our portfolio managers - by aligning incentives and trading activity to
draw out these fractional returns (versus our benchmark).
Concluding thoughts
There is a strong link between the financial performance of a central bank and its ongoing
ability to fulfil its objectives. The credibility of the institution and its operational freedom are
contingent upon prudent financial management. Sound financial management can never
ensure the success of a central bank; that will depend on its policy actions and outcomes.
But poor financial management can certainly lead to failure.
Central banking cannot be expected to produce smooth income growth. Constraints on asset
allocation that arise from central bank's responsibilities and the volatility inherent in foreign
exchange and interest rate markets prevent that. Developing a shared understanding with
the finance ministry of the financial risks that the central bank and public sector ultimately
faces is vital. Central banks must build an open and cooperative relationship with the finance
ministry and legislature, seeking clarity around responsibility for quasi-fiscal activities and
returns.
The RBNZ's institutional and financial design