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. 1  BIS Review 38/2000  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.