Acknowledgement

All the acclamation and appreciation is for Almighty Allah the most merciful, gracious
and beneficent who is entire source of all the knowledge and wisdom endowed to mankind. All
the thanks to the name of Almighty Allah, who helped me in setting goals and objectives and
blessed me to reach the destination. Without His assistance none is capable of accomplishment.

I would be doing injustice without mentioning the name of the person who helped me
through out the report and made me understand the major concepts of risk in reserve
management. So my special thanks go to Mr.Austin Ismat.

Heartiest gratitude and compliments to my Parents, without their continuous love and
encouragement I could not complete this task and in the end I would like to thank our worthy
coordinator Mr.Mubashir without him I would not be able to complete this task. The report in
your hand is the collection of my observations and research.

The source of information for the preparation of report includes a thorough research
conducted on the internet, IMF publications, Central bank of Australia, Central bank of Peru.

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 Executive Summary
Talking about the project this contains the basically idea about what is reserve
management that can be defined as the process that ensures the availability of sufficient foreign
reserves readily available and controlled by central monetary body for the purpose of meeting the
objectives of a country. Reserve management has some objectives as liquidity, market and credit
risk.

Risk that is prevailing in every walk of life whether it is investment or any other area.
Risk framework elaborates the various classes and degrees of risk. Basically risk can be defined
as the probability or chances of undesired happenings. So there should be a proper framework
that identifies and try to mitigate the risk. Central banks also consider the risk in their reserve
management practices in the area of liquidity, credit, and exchange risk. I have selected the two
central banks of the world to study their risk management in reserves management. One is the
reserve bank of Australia and the second is central reserve bank of Peru.

These two banks use the different practices to control and mitigate the risk of liquidity,
credit, exchange and interest rate risk after studying the risk management practices I find some
strengths and weaknesses of their risk management system.

At the end of report I also include some suggestion for effective risk management on
foreign reserves of the country that can be helpful for the central bank to enhance the experience
of risk management.

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 CONTENTS
What is reserve management---------------------------------------------------------------------05

Governance -----------------------------------------------------------------------------------------06

Risk --------------------------------------------------------------------------------------------------07

Risk management framework --------------------------------------------------------------------08

Reserve bank of Australia -------------------------------------------------------------------------09

Risk management tools ----------------------------------------------------------------------------11

Portfolio benchmark -------------------------------------------------------------------------------12

Weaknesses in the system -------------------------------------------------------------------------12

Strengths ---------------------------------------------------------------------------------------------13

Central Reserve Bank of Peru ---------------------------------------------------------------------13

Currency composition ------------------------------------------------------------------------------14

Risk management -----------------------------------------------------------------------------------15

Strengths of system ---------------------------------------------------------------------------------16

Weaknesses of the system -------------------------------------------------------------------------16

Recommendations ----------------------------------------------------------------------------------17

References -------------------------------------------------------------------------------------------18

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What is Reserve Management?
Reserve management is a process that ensures that adequate official public sector foreign
assets are readily available to and controlled by the authorities for meeting a defined range of
objectives for a country or union. In this context, a reserve management entity is normally made
responsible for the management of reserves and associated risks.

Reserve Management Objectives, Scope, and Coordination

Objectives

Reserve management should seek to ensure that: (i) adequate foreign exchange reserves
are available for meeting a defined range of objectives; (ii) liquidity, market, and credit risks are
controlled in a prudent manner; and (iii) subject to liquidity and other risk constraints, reasonable
earnings are generated over the medium to long term on the funds invested. Assist the
government in meeting foreign exchange needs and external debt obligations; and maintain a
reserve for national disasters or emergencies.

Scope

Reserves consist of official public sector foreign assets that are readily available to and
controlled by the monetary authorities. Reserve management activities may also encompass the
management of liabilities, other short foreign exchange positions, and the use of derivative
financial instruments.

Reserve management strategy and coordination

Reserve management strategies should be consistent with and supportive of a country's or

union's specific policy environment, in particular its monetary and exchange arrangements.

Evaluation of alternative reserve management strategies and their respective implications

for reserve adequacy are likely to be facilitated by a cost/benefit analysis of holding reserves.
Reserve management strategies may also need to take into account strategies for the management
of external debt for purposes of reducing external vulnerability.

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Transparency and Accountability

Clarity of roles, responsibilities, and objectives of financial agencies responsible for

reserve management.

The allocation of reserve management responsibilities, including agency arrangements,

between the government, the reserve management entity, and other agencies should be publicly
disclosed and explained. The broad objectives of reserve management should be clearly defined,
publicly disclosed, and the key elements of the adopted policy explained

Open process for reserve management market operations

The general principles governing the reserve management entity's relationships with
counterparties should be publicly disclosed.

Public availability of information on foreign exchange reserves

Information on official foreign exchange reserves should be publicly disclosed on a pre-

announced schedule.

Accountability and assurances of integrity by agencies responsible for reserve

management

The conduct of reserve management activities should be included in the annual audit of
the reserve management entity's financial statements. Independent external auditors should
conduct the audit and their opinion on the financial statements be publicly disclosed. General
principles for internal governance used to ensure the integrity of the reserve management entity's
operations should be publicly disclosed.

Governance
Describes the overall management approach through which senior executives direct and
control the entire organization, using a combination of management information and hierarchical
management control structures. Governance activities ensure that critical management
information reaching the executive team is sufficiently complete, accurate and timely to enable
appropriate management decision making, and provide the control mechanisms to ensure that

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strategies, directions and instructions from management are carried out systematically and
effectively

The internal governance structure of the reserve management entity should be guided by and
reflect the principles of clear allocation and separation of responsibilities.

 Effective monitoring of internal operations and related risks should be supported by

reliable information and reporting systems.
 Staff involved in reserve management should be subject to a code of conduct.
 Coordination between the RMC and investment managers is very necessary to ensure the
compliance of rules and regulations.
 There should be limit for every fund manager to invest and also the type of liquid assets
that would be permissible.
 In case of investing beyond the assigned limit the risk management committee should
have independence to report.
 RMC should identify the instruments and the markets that contain the lower risk of
liquidity, credit and market risk.
 There should be a defined range of tracking error.

 RMC also responsible to check out the market volatility in which the managers are going
to invest.
 RMC should be independent in all respects and have no other external or internal
influence.
 The report of performance should be submitted to the Governor rather the immediate
supervisors of the departments.

Risk :
Probability or threat of a damage, injury, liability, loss, or other negative occurrence,
caused by external or internal vulnerabilities, and which may be neutralized through pre-
mediated action.

Definitions of risk framework

A Model of risks in the organization. Risk frameworks typically enumerate the various
classes of risk and the degree of Risk Management expected.

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Risk Management Framework

There should be a framework that identifies and assesses the risks of reserve management
operations and that allows the management of risks within acceptable parameters and levels.

The risk management framework should apply the same principles and measures to
externally managed funds as it does to those managed internally. Risk exposures should be
monitored continuously to determine whether exposures have been extended beyond acceptable
limits.

Reserve managers should be aware of and be able to account for potential financial losses
and other consequences of the risk exposures they are prepared to accept. The risk management
framework should also address risks associated with derivative financial instruments and other
foreign currency operations.

Risk in Reserve Management

External Market-Based Risks

Liquidity risk. The pledging of reserves as collateral with foreign financial institutions as
support for loans to either domestic entities, or foreign subsidiaries of the reserve management
entity, has rendered reserves illiquid until the loans have been repaid. Liquidity risks have also
arisen from the direct lending of reserves to such institutions when shocks to the domestic
economy led to the borrowers' inability to repay their liabilities, and impairment of the liquidity
of the reserve assets.

Credit risk. Losses have arisen from the investment of reserves in high-yielding assets that
were made without due regard to the credit risk associated with the issuer of the asset. Lending
of reserves to domestic banks, and overseas subsidiaries of reserve management entities has
also exposed reserve management entities to credit risk.

Currency risk. Some elements of currency risk may be unavoidable with reserve asset
portfolios. There have, however, been instances where large positions were taken in other
countries' currencies in anticipation of favorable future changes in major cross rates, but where
subsequent adverse exchange rate movements led to large losses.

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Operational Risks

Control system failure risks. There have been a few cases of outright fraud, money
laundering, and theft of reserve assets that were made possible by weak or missing control
procedures, inadequate skills, poor separation of duties, and collusion among reserve
management staff members.

Financial error risk. Incorrect measurement of the net foreign currency position has exposed
reserve management entities to large and unintended exchange rate risks, and led to large losses
when exchange rate changes have been adverse.

Financial misstatement risk. In measuring and reporting official foreign exchange reserves,
some authorities have incorrectly included funds that have been lent to domestic banks, or the
foreign branches of domestic banks. Similarly, placements with a reserve management entity's
own foreign subsidiaries have also been incorrectly reported as reserve assets.

Loss of potential income. A failure to re-invest funds accumulating in clearing (nostro)

accounts with foreign banks in a timely manner has given rise to the loss of significant amounts
of potential revenue. This problem arises from inadequate procedures for monitoring and
managing settlements and other cash flows, and for reconciling statements from counterparts
with internal records.

STUDY OF TWO COUNTRIES

Reserve Bank of Australia
Risk Management Framework

It is generally well accepted that a central bank should adopt the most rigorous risk
management practices in respect of all aspects of its reserves management processes. At the most
general level, this is reflected in the need for the complete separation of functions between the
Front, Middle and Back Offices, the Audit Department, the Accounting Department and the Risk
Management Unit. Separation of these functions is designed to ensure that exposures are within
established limits and to minimize the opportunities for fraudulent behavior. A number of basic
elements should be considered:

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  At the very highest level, the decision-making hierarchy for the investment of reserves
should be clearly defined. This hierarchy would normally be established by the Governor
or Board of Directors and would include the overall objectives of reserves management,
the specification of the investment mandate and would identify who is responsible for
implementing this mandate.
 To reduce the risk of fraud, the separation of functions must be transparent and
enforceable. Most importantly, there should be complete separation of those who initiate
transactions (Front Office) and those who arrange the settlement of transactions (Back
Office).
 The separation of functions extends beyond the separation of the transaction and
settlement functions. Just as important is the separation of the responsibility for managing
financial exposures (Front Office) and measuring them (Middle Office). Specifically, a
Middle Office would be responsible for setting (and reviewing) operational guidelines
and limits would be responsible for performance measurement and attribution and should
be responsible for ensuring the continued relevance of the benchmark.
 The role that the Middle Office plays as an online auditor, provision should also be made
for regular independent audits of the reserves management process.

An important element of any risk management framework is that the management

policies and procedures are clearly understood by all staff involved in the process. This is best
achieved by documenting all aspects of the investment mandate as well as all operational
controls in a single document. Specifically this documentation should include:

 The reporting lines and responsibilities of all functional areas involved in the
management of foreign reserves.
 All limits and controls extended to portfolio managers.
 Details of the performance benchmark and systems used for performance attribution.
 The list of all authorized instruments and any limits that may apply to them.
 The eligibility criteria for the selection of trading counterparties.
 The framework for determining the maximum credit exposures permitted with each
counterparty.
 Details of the methodology for measuring risk exposures (both market risk and credit
risk).
 Clear procedures for notifying senior management of limit breaches or any other
‘exceptional' events relating to the reserves management process.

Procedures also need to be established for how changes can be made to the investment
mandate such as a proposal for the introduction of a new instrument or a change in the
composition of the benchmark. These procedures need to include which level of senior
management is authorized to approve changes and which functional areas need to be consulted
before changes can be implemented.

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Risk Management Tools

At a more operational level, there are a variety of possible risk management tools
available to central banks. Design of the foreign currency benchmark is a decision about the
acceptable level of market, credit and currency risk that a central bank is prepared to accept in
light of its investment objectives and investment universe. In addition to this, central banks may
give their portfolio managers latitude to deviate from these benchmarks. This discretion can be
expressed in many ways – as variations in duration, variations in portfolio composition or
variations in currency shares. A challenge for central banks is to quantify these risks on a
consistent basis and incorporate these measures in the limit processes.

Another related deficiency of dollars-at-risk measures is that they are not necessarily
additive across portfolios as they make no allowance for price volatilities and the correlation in
price movements between securities and between portfolios. For example, although US and
European yields often move in the same direction, the size of the moves will not necessarily be
in the same magnitude. This means that in the event of a global rally in yields, the gains on a
long US security position may not completely offset the loss on a short European security
position. This widely recognized deficiency has, to some extent, been overcome by the increased
reliance on Value at Risk (VaR) measures.

The VaR and dollars-at-risk measures tend to focus on more narrowly measuring the
market risk of portfolio exposures. Neither measure is particularly good at quantifying the risk
that an issuer of securities or a counterparty to a transaction will fail to meet their financial
obligations at maturity or at settlement. There are many dimensions to measuring and managing
credit risk that a central bank needs to consider:

 Individual counterparty limits tend to have two dimensions – the level of capital that a
central bank is prepared to expose to a particular counterparty and the maximum potential
financial loss associated with each instrument type.

Derivative Risk Management

Trading derivative instruments is generally perceived to be more risky than trading

physical securities. This perception tends to be more a reflection of bad risk management
practices in the past than a reflection of the products themselves. At the very basic level, a
futures contract has essentially the same market risk characteristics as the underlying instrument
and, in the case of exchange-traded derivatives, virtually all of the counterparty credit risk
exposure is eliminated by the clearing house.

Operational Risk Management

Aside from the direct financial risks associated with managing a portfolio of assets,
central banks also face a significant range of procedural or operational issues that pose a
significant reputational exposure to the institution.

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 Operational risks are fairly easy to identify and can often be eliminated through system
enhancements and well documented procedures. Identifying and, more importantly, eliminating
these risks isn't costless, however. Introducing new trading and settlement systems may involve a
significant commitment of staff that were previously involved in the reserves management
process and may take several years to fully implement.

Portfolio Benchmarks

United States Europe Japan

Currency allocation (%) 45 45 10
Asset allocation (%) 45 45 10
Duration (Months) 30 30 30

Composition of Individual Portfolio Benchmarks

United States Europe Japan

Asset Class % of Total Asset Class % of Total Asset Class % of Total
Deposits 22 Deposits 30 Deposits 22
Treasury bills 21 Treasury bills 15 Treasury bills 33
Treasury Notes 57 Bonds 55 Bonds 45

Weaknesses in system
 They are allowed to deviate from benchmark in terms of duration, portfolio
composition, variation in currency shares and these deviations of target poses
barriers to measure these kinds of risks and incorporate these measures in limit
process.

 The RBA not going to make any allowance for the purpose of price volatility and
correlation in price movements between securities and between portfolios.

 RBA tend to focus on VaR that is more narrow focus on measuring the market
risk of portfolio exposures.

 This measure does not measure the risk that the issuer of security or counter party
will fail to meet their financial obligations at the maturity or settlement date.

Some operational risks also involved in the system

 Failure to deliver on contractual obligations resulting from trading and settlement

system failures
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  Ineffective backup arrangements in the event of a contingency event;
 Failure to prevent fraudulent behavior or to prevent excessive risk taking
(including executing transactions in ineligible securities or with unauthorized
counterparties).

Strengths
 RBA is using the foreign currency benchmark.
 There is complete separation of duties of front office back office accounting and
audit department and settlement function.
 Separation of functions ensure the risk reduction and transparency.
 This separation ensures that the exposure is in the acceptable limit.
 The hierarchy of reserve management define the overall objectives of the reserve
management.
 The hierarchy is also responsible to identify the responsibility for implementing
the mandate of investment.
 The policies that are devised for the reserve management are clearly understood
by all the staff members.
 All the investment mandate and control system is documented.
 Limits and control of investment are awarded to investment managers is a good
act it can pose some benefits that they can invest according to their desired and
profitable securities within the limit.
 Any required change in procedure and functions need to be consulted with
management before the change is made.

CENTRAL RESERVE BANK OF PERU(BCRP)

Reserves Management

In compliance with article 84 of the Constitution, the Central Reserve Bank of Peru
(BCRP) is in charge of the administration of international reserves. In undertaking this function,
the BCRP follows the security, liquidity and profitability criteria established in article 71 of its
Charter.

International reserves are particularly important in a context of globalization of

international markets, reduction of barriers to capital flows and volatility of financial, foreign
exchange and metal markets.

According to article 72 of the BCRP Charter, international reserves managed by the

BCRP are comprised of:

a. Gold and silver holdings.

b. Foreign banknotes and coins internationally accepted as means of payment.
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 c. Foreign-currency-denominated bank deposits with maturities up to 90 days, in the
opinion of the Board of Directors.
d. Foreign-currency-denominated certificates of deposit with maturities up to 90 days, in the
opinion of the Board of Directors.
e. First-class liquid securities issued by international organizations or foreign public
entities, in the opinion of the Board of Directors.
f. Banker's acceptances with maturities up to 90 days.
g. Special Drawing Rights (SDRs).
h. Gold, foreign currency and SDR subscriptions to international monetary organizations.

Currency composition denomination, term to maturity and credit risk:

Currencies Jun-30- Term to maturity Jun-30- Long term rating Jun-30-

2010 2010 2010

US$ 82.2 0-3 82.2 0-3 Months 43.1 AAA 74.5

months
15.7 3-12 Months 11.9 AA+/AA/AA- 17.5
Other currencies
1/
2.1 <1year 45.0 A+ 8.0
Gold

Benchmark Portfolio

The benchmark or reference portfolio represents a fundamental tool for international

reserves management. The risk-return combination chosen by the Board of Directors is reflected
in the benchmark portfolio's characteristics (liquidity, credit quality, duration and
diversification). The BCRP's asset management involves choosing a risk-neutral and replicable
portfolio, specially when the market is extremely volatile. The BCRP builds its own benchmark
portfolio on the basis of market indices.

Investments of international reserve compose the actual portfolio, which may differ from
the benchmark portfolio regarding investments' maturities, duration, total banking risk and issuer
credit risk. Risk management is oriented towards maximizing return and takes into consideration
the deviation margins authorized by the BCRP's Board of Directors.

The actual and benchmark portfolio are valued daily at market prices. Even though most
investments are held to maturity, the market value of both portfolios is an important indicator of
reserves management efficiency.

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Risk Management

Regarding investment management, the following risks are taken into account:

Liquidity Risk: It arises from the impossibility of redeeming the trading securities timely or due
to the fact of converting them into cash at a very high transaction cost. In order to mitigate this
risk, portfolio managers control the liquidity degree of fixed-income instruments taking into
consideration issue amounts, the participation of the bank investments in each issue and bid-ask
spreads. Additionally, this risk is minimized by distributing assets in four tranches:

a. Immediate availability: very short-term investments, including overnight (one-day)

deposits, to face obligations and unexpected events.
b. Liquidity: Maturities up to one year, including bank deposits with staggering maturities
and highly liquid, internationally tradable fixed-income instruments.
c. Intermediation: Investments that replicate deposits of the public sector in the BCRP.
d. Investment: Maturities longer than one year (mainly bonds), which imply higher price
volatility but also higher return.

Credit Risk: It is associated with the possibility of default on obligations owed to the BCRP due
to insolvency. In order to face credit risk, investments are diversified among the following:

a. Deposits in first class international banks, defined in terms of equity and long-term and
short-term credit ratings (A-1 and A+ as a minimum, respectively) assigned by the most
recognized credit rating agencies such as Standard & Poor’s, Moody’s and Fitch.
b. Fixed-income securities issued or guaranteed by international organizations, governments
and governmental agencies. These obligations must be rated at least AA.
c. Investment in corporate debt issues are not permitted.

Exchange Risk: It is associated with exchange rate fluctuations between the currencies in which
investments are denominated, which could cause losses in the currency used for international
reserves accounting (the US dollar).

Most assets are dollar-denominated, reflecting both the currency denomination of

liabilities (reserve requirements and almost all deposits made by the public sector) and the
BCRP’s currency of intervention in its domestic open market operations. It should be noted that
most of the Peruvian external debt and international trade are denominated in US dollars. The
second hard currency in terms of international reserves' currency composition is the euro.

Interest Rate Risk: It arises as a consequence of unexpected variations in the rates of return of
fixed-income assets held in the portfolio, which could affect their market value before maturity.
The longer the maturity of investments, the greater the impact of changes in the rates of return on
their market value. The measurement of this impact is reflected in the portfolio duration.

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 The BCRP manages this risk adhering to an asset-liability management (ALM) in the
sense of matching the term structure of assets and liabilities. This results in a low portfolio
duration thus minimizing the impact of international interest rates fluctuations on the market
value of the portfolio. Additionally, risk management policy establishes maximum maturities for
longer-term investments, consistent with the market risk profile planned for each instrument of
the portfolio.

Strengths
o The BCRP’s reserve management involves a risk neutral and replicable portfolio even
when the market is very volatile.
o Its portfolio is based on the market indicies.
o Reserve investment can very from the portfolio banchmark in terms of maturity duration
and total banking risk.
o The basic purpose is maximizing the return on investment and latitude also given to the
fund managers.
o Actual and banchmark portfolio is monitored on the daily basis at market prices.
o The BCRP has managed its liquidity risk by diversifying in immediate
availability,liquidity,intermediation,and investments.
o Deposits are held with first class banks long term short terms that are assigned A-1 and
A+ credit rating.
o The BCRP manage their interest rate risk by matching the term structure of assets and
liabilities.
o Most of their investments are in AAA securities that are more secure investment than any
other investment.

Weaknesses in system
o Most of BCRP’s assets and external debts are dollar denominated that poses the great
exchange risk if USD loses its value then it can be a loss of hefty amount.

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 o Their investment in long term income funds that has greater interst but it could affect the
value of asset.

Recommendations for effective risk management in reserves:

o At the very highest level, the decision-making AUTHORITY for the investment of
reserves should be clearly defined. This hierarchy would normally be established by the
Governor or Board of Directors and would include the overall objectives of reserves
management.
o Senior management needs to specify a strategic long-term portfolio that represents the
best available trade-off between the different risks that the reserve management entity is
facing.
o There should be a latitude for fund managers to deviate from benchmark in foreign
placements as provided by the RBA and BCRP(Peru).
o If SBP don’t want to do so then it can transfer the authority to the treasurer to assign extra
limit to their fund managers if they can provide the solid reason to invest so they can
invest in the best interest.
o The benchmarks should not short-term market expectations, but their appropriateness
should be reviewed regularly.
o Investment benchmarks are an important tool for assessing performance and
accoutability. Where managers should be permitted to deviate from the benchmark
portfolio, performance and accountability will occur through the comparison of
performance of the actual portfolio and benchmark.
o Reserve management authorities should also subdivide their reserves portfolio into
"tranches" according to liquidity and investment objectives and policy requirements.
o The risk management framework should apply the same principles and measures to
externally managed funds as it does to those managed internally.
o Sound risk management of externally managed funds begins with the careful selection of
reputable external managers, that is the task of middle office.
o It is necessary to establish a separate unit, or assign a position within the middle office, to
enable the reserve management entity to fully monitor the activities of the external
manager.
o Risk exposures should be monitored continuously to determine whether exposures have
been extended beyond acceptable limits. Monitoring is essential in identifying and
limiting any cumulative losses associated with either deviations from the benchmark.
o Reserve managers should be aware of potential financial losses and other consequences
of the risk exposures they should be prepare to accept.
o Risk mitigation could involve the use of standardized documentation and the
performance of periodic reviews of documentation.

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 o The eligibility criteria for the selection of trading counterparties should be clearly defined
o There should be a framework for determining the maximum credit exposures permitted
with each counterparty.
o Active risk management is good approach to mitigate the risk than passive risk
management practices.

References:

1- http://www.imf.org/external/np/mae/ferm/eng/index.htm#I
2- http://www.rba.gov.au/about-rba/index.html
3- http://www.bcrp.gob.pe/reserves-management.html#Aspectos
4- http://www.imf.org
5- http://en.wikipedia.org/wiki/Governance
6- My own understanding after discussions with my supervisor.

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