Sustainable investment in uncertain times:
The future of public sector asset management
Speech by L. Federico Signorini
OMFIF Roundtable for Public Sector Asset Managers
London, 6 February 2020
In these remarks, I shall take the point of view of the central bank as an investor, rather
than a monetary policy authority. My contribution may thus be seen as complementary
to those of other speakers in this session. While profit maximising is not their ultimate
objective, central banks do manage substantial funds and have a duty to manage them
well, within the limits and for the purpose dictated by their institutional function.
In the last few years, the investment profile of central banks has changed significantly
because of the substantial expansion of their balance sheets, which in turn was due to the
unprecedented scale and non-standard nature of monetary policy actions. As a result, the
risks borne by central banks have increased, both quantitatively and qualitatively. Many
central banks have begun, or returned to, dealing with less traditional assets, markets
and counterparties.
This development has raised the profile of asset (and liability) management within
central banks, and it has arguably made the management of official reserves and own
funds more similar to that of diversified private funds, with a greater focus on controlling
risks and enhancing returns.
However, there are certain key constraints that central banks must respect. First,
while reputation is relevant for private managers as well, it is absolutely essential for
central banks to protect their public image and hence their credibility, integrity and
independence. Second, as they need to retain the ability to perform their mandates
indefinitely and in all sorts of circumstances, central banks must take the long view
and adopt an investment strategy that is robust to extreme events over an extended
horizon. Finally, two further constraints are generally applied by central banks because
of their public nature: neutrality (i.e. interfering as little as possible with market resource
allocation, except insofar as monetary policy dictates); and - a point that may be more
rarely noticed - 'lightness of touch' in daily operations (i.e. avoiding market disruption
due to the sheer size of their trades).
Let me start with a just a few words on the last topic. Central banks, in particular
those managing a large pool of assets, need to pay due attention to market conditions
and adopt appropriate trading practices so as to minimise the impact of their trades
and avoid generating unintended signalling effects. With this in mind, for instance, we
at the Bank of Italy have been gradually reducing the average size and holding period
of our active positions in foreign reserve management, while increasing the frequency
of trades. Furthermore, we reinvest large bond redemptions by distributing purchases
over an entire trading session. Such issues, though highly technical, do have significant
implications for the conduct of investment activity at major central banks.
Most of the remainder of this speech will be devoted to a couple of topics relating
to the 'long view' in central banks' investment: (i) sustainable finance and (ii) strategic
asset allocation.
The importance of the first issue was underlined during the long, lively discussion
of this topic during the previous session. Let me make one point clear from the outset.
General policy matters are for governments rather than central banks; in democracy,
decisions about broad societal aims are best left to elected politicians. Nevertheless,
central banks have been increasingly indicating that they are taking environmental, social
and governance (ESG) risk factors more fully into account as investors, that is, in their and
risk management strategies.1 Why? There are two reasons for doing so, both linked to the
constraints I just mentioned. One is reputation: central banks' investment policies must
be seen as beyond reproach. The second is that, as long-term investors, central banks
need to take the long-term sustainability of their investments seriously into account.
The discussion on sustainable finance often revolves around a perceived trade-off
between 'doing good' (to the Earth, or society at large) and 'doing well' (for shareholders,
or, in our case, the public as the ultimate 'owner' of the bank). While shareholder value
is certainly not our main concern, this debate applies to a certain extent to central banks
too. The concept of sustainability, however, appears to provide a link between doing
good and doing well in the long run. Recent experience has indeed shown that, so far,
ESG-compatible investment has not underperformed compared with unconstrained
investment strategies. (Of course, past performance is no guide to future performance,
as they say; we need to keep alert to fashionable bias, and choose carefully.)
The Bank of Italy values sustainability in its asset allocation.2 Last year, we announced
a new investment strategy that integrates ESG profiles into the management of our direct
euro-area equity portfolios. These portfolios total around €9 billion and include shares
in about 140 listed companies. Two ESG criteria have been added to the principles of
diversification and market neutrality, which were already embedded in our previous
strategy. The first principle is to exclude companies that belong to sectors that do not
comply with the United Nations Global Compact.3 The other is to give preference to
companies with the best ESG scores.4
In this way, we have already significantly improved the environmental footprint
of our equity investments. Our staff has provided me with very detailed statistics on
this. The total greenhouse gas emissions of companies included in the new portfolio are
about one quarter lower than those recorded in the previous portfolio. Energy and water
consumptions are down by about one third and one fifth respectively.5
Looking ahead, the Bank of Italy intends to enhance its ESG profile further for equity.
We are considering the integration of ESG criteria for equity investments in US and
Japanese companies through collective investment schemes. In addition, we are about
to conclude an in-depth analysis for introducing ESG criteria for managing corporate
bond portfolios, in both dollars and euro. Finally, the Bank already considers green bonds
issued by supranationals as eligible for its investment portfolio. The size of a potential
strategic allocation to these instruments will take into account the liquidity of the market,
which is still inferior to that of conventional bonds.
Our ESG framework in the equity space has been discussed within the Network for
Greening the Financial System (NGFS), an organisation that brings together central banks,
supervisors and observers from countries responsible for half of the world's greenhouse
gas emissions. As a member of the Network, the Bank contributed to the NGFS guide for
central banks' portfolio management, published last October.6 In this guide, the Bank's
first-hand experience in sustainable finance is one of seven case studies used as practical
examples to ease the introduction of ESG practices among central banks.
Let me now turn to the issue of strategic asset allocation (SAA). Due to the increased
complexity of the financial system, it has become crucial for central banks and other
public-sector financial institutions to base their activities on a sound, comprehensive risk
management framework.7 This can be provided by a formal SAA model-based procedure
at the centre of the investment process. An SAA takes into account the whole range of
risks and opportunities faced by the investor. Note also that having a consolidated view
of all significant risks on both sides of the balance sheet is a cornerstone of the IMF's
recently revised 'Guidelines for Foreign Exchange Reserve Management'.8
3
Details on the United Nations Global Compact are available at www.unglobalcompact.org.
4
Lanza et al (2019) show that the ESG scores of individual firms are very heterogeneous across agencies
compared, for example, with credit ratings. There is also evidence of significant biases in ESG scores,
which tend to be overestimated for companies that are larger and belong to specific industrial sectors
and geographic regions.
5
These improvements are equivalent to the annual impact of a number of households from 120,000 to
190,000, depending on whether you consider greenhouse emissions or energy or water consumption.
6
NGFS (2018).
7
Bindseil et al. (2009) present a comprehensive structured framework for risk management in central
banks. The authors explicitly address the need to overcome the widespread practice of segregating
central bank risk management tools between investment and policy portfolios. Yet they refrain
from introducing a comprehensive quantitative approach whereby the strategic asset allocation is
contingent on the core policy functions of a central bank.
8
IMF (2013).
At the Bank of Italy, the SAA risk management framework stands on three pillars.9
First, a single analytical approach integrates all assets and liabilities. Second, we employ
a statistical model that estimates the expected return distributions of a wide range of
financial asset classes across many currencies, and considers interdependencies and
comovements across output, inflation, foreign exchange rates, interest rates, equity prices
and so on. And third, we adopt an explicit objective function with related constraints, which
aims at preserving the value of the financial resources required to pursue our institutional
functions in an effective way and an independent manner, over the long run and especially
in adverse scenarios. The theoretically optimal composition of our investment portfolio
minimises the average expected loss in the worst 1 per cent of scenarios over a 10-year
horizon, subject to two short-term (one year) constraints aimed to avoid the risk of (i) a
depletion of financial capital, and (ii) the emergence of accounting losses.
Of course, this formal exercise is not used in a mechanical way to determine actual
investment decisions. It is, however, a key benchmark against which all our decisions are
discussed.
The optimal SAA for the investment portfolio takes into account the natural
exposure of a central bank to systemic and business cycle risks stemming from its core
policy functions. The central bank's financial structure has to be robust, especially in those
adverse circumstances in which its institutional duties may require exceptional risks to be
taken. This leads us to consider countercyclical and low credit risk assets for inclusion in
the SAA. Such a risk-based approach tends to produce an SAA that is consistent with the
conservative bias that we want to impart to risk management.
Moreover, by taking a forward-looking and long-term (i.e. through-the-cycle)
approach, with clearly defined portfolio rebalancing rules, our optimal SAA also
contributes to reducing any procyclical bias in portfolio management. Exposure towards
countercyclical assets reduces selling pressure in times of crisis, when these assets tend to
appreciate. This is not just theory. Our experience of the last crisis showed that investing
in countercyclical assets, such as long-term government bonds and foreign reserves,
while maintaining a low exposure to credit risk, paid off in periods of financial distress
and provided positive risk-adjusted returns.
As a final remark, it may be worth mentioning that the issue of the cyclicality of
market investment is not just a concern for the Bank as a manager of its own funds: in
our capacity as a macroprudential authority, we also see it as one of the main fronts on
which financial stability action should advance.10
Financial markets naturally tend to be procyclical. During booms, higher asset
valuations provide investors with more collateral to raise funds and ampler financial
resources to invest. Because of herd behaviour, inflows to asset managers, i.e. to markets,
tend to increase when prices are on the rise. Both mechanisms, of course, work in reverse
during bust phases and may amplify price volatility.11
Not even central banks' financial investment has been immune from such
behaviour; the issue of procyclical investment by central banks has indeed been widely
debated.12 Some argue that financial stability objectives should not interfere with reserve
management. The IMF's Guidelines for Foreign Exchange Reserve Management (last
updated in 2013) neither directly address the issue of procyclicality, nor do they say
that financial stability should in itself be an objective of reserve management. However,
there is broad agreement in principle that due attention should be paid to the risk of
a potentially disruptive impact of central banks' investments on credit and financial
markets.
The impact of central banks' investment strategies and the importance of sound
practices are now widely recognised in markets where central banks have become
key players and their actions are closely followed by market participants. The recent
experience of the euro-area sovereign debt crisis is indicative, not only of the ample
space that is available to long-term players to act as (selective) contrarian investors, but
also of the profitability of doing so.
References
Adrian Tobias, Hyun Song Shin (2010), "Liquidity and leverage", Journal of Financial
Intermediation, 19: 418-437.
Bindseil Ulrich, Fernando Gonzáles, Evangelos Tabakis (2009), "Risk Management
for Central Banks and Other Public Investors", Cambridge University Press.
Brunnermeier Markus K. (2009), "Deciphering the Liquidity and Credit Crunch 2007-
2008", Journal of Economic Perspectives, 23: 77-100.
Fanari Marco, Gerardo Palazzo (2019), "The strategic asset allocation of the investment
portfolio in a central bank", paper presented at the Bank for International
SettlementsWorld Bank-Bank of Canada-Banca d'Italia Seventh Public Investors Conference held in
Rome at the Bank of Italy on 22-23 October 2018.
IMF, International Monetary Fund (2013), Revised Guidelines for Foreign Exchange
Reserve Management, IMF, 1 February.
Lanza Ariel, Enrico Bernardini, Ivan Faiella (2019), "Mind the gap, Machine learning
ESG metrics and sustainable investing", paper presented at the CEMLA Conference on
Climate Change and its Impact in the Financial System, Mexico City, 5-6 December.
NGFS, Network for Greening the Financial System (2019), "A Sustainable and
Responsible Investment Guide for Central Banks' Portfolio Management".
Pihlman Jukka, Han van der Hoorn (2010), "Procyclicality in Central Bank Reserve
Management: Evidence from the Crisis", IMF Working Paper No. 150.
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held at the Euromed Workshop on "Non-Bank Finance and Financial Intermediation",
Naples, 18 June.
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banks", Speech held at the 18th International Conference for Credit Risk Evaluation
"Assessing and Managing Climate Change Risk: Opportunities for Financial Institutions",
Venice, 26 September.