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For Reserve Bank of India, Patna

April - June, 2013

Report On

Risk Management in Context to RBI with Emphasis on Sovereign Risk for Foreign Reserves

For Reserve Bank of India, Patna

Guided by Shri Manoj Kumar Singh, Manager, RBI

Prepared By: Saurav Singh PGDM 2012-14 CIMP, Patna

April June 2013

ACKNOWLEDGEMENT Every journey is an enlightening experience, an Ithaca in itself. These are but my sentiments as I reflect back at my Summer Internship period at Reserve Bank of India, Patna. The role of proper facilitation and conducive environment is sine-qua-non for any study to successfully take place. I would like to sincerely thank RBI, as an organization for providing me the same. In this regard, I would like to express our special gratitude to Shri P.K Jena, Regional Director (Bihar & Jharkhand), RBI for providing me the opportunity of doing my summer internship project in esteemed organization. I express our gratitude and sincere thanks to Shri Manoj Kumar Singh, Manager, RBI, my mentor for the project for his able guidance and continuous support in ensuring a smooth journey for me in the project. At the same time, I also drew a lot of exposure from his enriching experience in this field. I would also like to thanks Shri Praveen Kumar, Manager, RBI for his valuable suggestion and inputs to my project. Last but not the least, I thank my faculty members and friends for their continuous support and guidance.

Saurav Singh

Declaration of Fidelity and Secrecy

I SAURAV SINGH s/o Shree Priya Ranjan Kumar, pursuing M.B.A from CIMP,Patna do hereby declare that I will faithfully, truly and to the best of my skill and ability execute and perform the duties required of me as a Summer Intern of the RBI,Patna. I further declare that I will not communicate or allow to be communicated to any person not legally entitled thereto any information relating to the affairs of the RBI or to the affairs of any person having any dealing with the RBI; nor will I allow any such person to inspect or have access to any books or documents belonging to or in the possession of the RBI and relating to the business of the RBI or to the business of any person having any dealing with the RBI.



I have always wondered whether it is possible to understand What Risk is? and whether we can ever be so capable as to understand the new forms in which risk can emerge. The curiosity of analyzing risk and how risk management can help in decision making, evoked me to do my project in risk management. The following studies are partially based on my own understanding of risk and partially based on expert opinion on the subject. I know study of risk can be highly technical but I have tried my best to be as simple as possible. My project titled Risk Management in context to RBI, with emphasis on Sovereign Risk for foreign reserves. is divided in two parts. First part deals with basic understanding of risk, types of risks, risk management in Central banks and Risk Management system at Central banks including RBI. Second part is focused on Sovereign Risk for managing foreign reserves. Optimum foreign reserves, cost of maintaining foreign reserves and indicators of sovereign risk that has to considered while deploying foreign reserves. Based upon the comparative study I have tried to analyze risks faced by different department of RBI while performing its core functions. I have tried to compare risk mitigation measures taken by RBI with risk mitigation measures of other central banks. I have concluded with common risk model in order to access risks faced by RBI on whole.

There are many factors that determine the demand placed on the forex reserves. The exchange rate regimen adopted by a country, the extent of openness of its economy and the nature of the markets operating in that country, together determine how forex reserves are held, and are used in dealing with other countries. Central banks throughout the world have sometimes cooperated in buying and selling official international reserves in an attempt to influence exchange rates. The guidelines of Forex reserve management in India are similar to those of many central banks in the world. I have tried to analyze optimum reserves amount for India based upon various available literatures. I have also found out cost associated with holding foreign reserves.

With the onset of the sovereign debt crisis in 2008 which is still unfolding, sovereign risk management has assumed importance in recent times. Reserve bank of India being the central bank of the country is the custodian of nations foreign exchange reserves. It deploys foreign reserves in different permissible assets such as balances/ deposits with other central banks, top rated foreign commercial banks, and with BIS; treasury bills and dated securities issued by top rated sovereign nations. Deployment of reserves in the above mentioned instruments were so far considered as risk free. However, with the onset of debt crisis, the role of central bank as an investor and manager of foreign reserves has become very challenging. Right now liquidity, safety and return are prime factors that RBI looks for placing its foreign reserves among various components. While deploying its reserves among treasury bills and bonds of sovereign nation, there is possibility of defaulting of nation. I have tried to find out various factors that fund manager of foreign reserves may consider for mitigating the sovereign risks associated with the investment. For this purpose I have compared various economic parameters of ten defaulting nations at time of their defaults and find out prime factors to be considered. Based upon my study, I have also prepared a tree map for predicting sovereign external debt crisis. Analysis and opinions done in my project are based on secondary data available on websites. I hope my present study is able to identify the challenges being faced by central banks across globe.


SL. No.

Acknowledgement Executive Summary Introduction 1.1 Risk and Risk management 1.2 Financial Risk Management 1.3 Risk Management for RBI Approach of Central Banks towards Risk 1.4 Management Risk Management System- Importance to Central 1.5 banks 1.6 Foreign Reserves What is need of holding it. 1.7 Sovereign Risk for Foreign Reserves

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2 3 4 5 6

Scope ,Objectives and Methodology of Project Literature Review Analysis Recommendations Bibliography

Last month I decided to take a flight to New Delhi for an urgent work. The flight got cancelled due to bad weather and finally I was not able to complete that work. I have incurred heavy loss due to it. Then I realized there was always uncertainty involved in completion of my work. Then there was another incident when my father invested his savings in shares and after some time he informed us that he has incurred heavy loss. After these incidents I realized that there was always uncertainty in happening of the expected outcomes. This uncertainty is termed as Risk. 1.1 Risk and Risk management Before we move on to any formal definition of risk or risk management, I would like to narrate one personal experience. One of my friend is having a motorcar and for him owning a motorcar is an opportunity to become more mobile and gain the related benefits. However there are uncertainties in owning a motorcar that are related to maintenance and its repair. He may also get involved in accidents due to his motor car, so there are obvious negative outcomes that can occur. When I enquired him about his experience of owning a motorcar, he simply told me that there is risk in owning a motorcar. Examining his situation, the first lesson regarding risk is that you can best learn only through experience. However learning through experience may entail its own cost, so the smartest way to learn is to learn through experience of others. Risk may be defined as an event with the ability to impact, inhibit, enhance or cause doubt about the mission, strategy, projects, routine, operations, objectives, core processes, key dependencies and /or the delivery of stakeholder expectations.(IUPJ-2012)1

The IUP Journal of Financial Risk Management, Vol. IX, No. 4, 2012

Definitions of risk can be found from many sources and some key definitions can be summed up as, Sl.No. Organization 1 ISO Guide 73 ISO 31000 Institute of Risk Management(IRM) "Orange Book" from HM treasury Institute of Internal Auditors,USA Definition of risk Effect of uncertainty on objectives. An effect may be positive, negative or a deviation from the expected. A risk is often described by an event, a change in circumstances or a consequence. Risk is the combination of the probability of an event and its consequence. Consequences can range from positive to negative Uncertainty of outcome, within a range of exposure, arising from combination of the impact and the probability of potential events. The uncertainty of an event occurring that could have an impact on the achievement of the objectives. Risk is measured in terms of consequences and likelihood.

Many more definitions can be listed but I really wonder whether any of them can effectively capture essence of risk in all its dimension. Whatever we do and whatever we dont do carries some risk . Even in our day to day activities we are exposed to various types of risks and we have been taking it either willingly or unwillingly. Sometimes our action of not doing results in positive outcome and sometimes our action results in negative outcome. However it also happens that our action leads to uncertainty. Risk may have positive or negative outcomes or may simply result in uncertainty. Risk management may be defined as coordinated activities to direct and control an organization with regard to risk. (ISO GUIDE 73, BS 3110) Risk management is basically all about evaluating risks and taking measures to either mitigate them or changing our decision if possible. However at times it may be possible that decision has to be made, in that case we try to minimize the loss based upon assessment of risk.

Establishing the Context

The context describe and help to understand which risks will be.

Risk Assessment

To identify, analyze and evaluate the risk.

Monitor and Review

Selecting and implementing measures to modify the risk

Risk Treatment Communication

To monitor and review the risk treatment measures.

Selecting information and communicating to stakeholders.

Fig No.1


1.2 Financial Risk Management Financial risk is probability of occurrence of such events which will cause loss of money. (IUPJ-2012) Process of identifying and managing financial risk in order to avoid losses is known as financial risk management. Depending upon the nature of organization and its activity many financial risks can be managed. Be it individual or be it organization, no one wants to incur loss due to bad decisions. This financial risk and its management is not new, it is being their right from ancient days. Even then security was required for giving loans or loans were given to those people who were having worth. This action of asking for security is actually risk management measure in lieu of loan taker may default. However in the era of globalization where financially events are dependent upon each

other, even USA presidential election results can lead to favorable or unfavorable movement in SENSEX in India. It is very difficult to analyze financial risk and its consequences. For an individual or an organization financial risks can be analyzed depending upon market environment and other factors. Since my project is based upon risk management in prospective of a central bank, it would be better to define various financial risks in context to central banks RISKS TO BE MANAGED (For central banks)
*Based upon general understanding of workings of central banks around the globe Financial Risks Non-Financial Risks

Market Risk

Liquidity Risk Credit Risk Reputational Risk

All risks that doesnt cause any financial loss to organization are called non-financial risks. These risks basically include all those events whose occurring may lead to non-occurrence of events that doesnt have financial impact. It includes legal risk, IT &systems risks, internal control risks etc.

Systemic Risk Operational Risk Volatility Risk

Settlement Risk


Credit Risk Credit risk is defined as the potential that a borrower or counterparty will fail to meet its obligation in accordance with agreed terms.1 Being a lender to last resort, Central banks has to give short term loans to banks operating in their countries and hence have to bear this risk. Also Central banks are responsible for investing their foreign reserves in form of bonds /treasury bills. There is risk that these bonds or treasury bills issuing entity may default and likewise the risk involved will be credit risk. Market Risk Market risk is the risk of losses in positions arising from movements in market prices. Market risk for a multi-currency portfolio represents the potential change in valuations that result from movements in financial market prices, for example, changes in interest rates, foreign exchange rates, equity prices and commodity prices. The major sources of the market risk for central banks are currency risk, interest rate risk and commodity price risk (movement in gold prices).2 Currency risk arises due to change in price of one currency in comparison to other, change in ask rate or bid may result in increased or decreased portfolio return. Interest rate risk arises due to movement in interest rates of bonds or other investment of Central banks. It happens when Central banks principal and interest cash flows from assets do not coincide with the principal, interest and benefit cash flows derived from liabilities. Commodity price risk arises due to movement in price of commodity (as gold).As per the recent report by Bloomberg gold comprises of major portion of reserves of Central banks and any change in price of gold may lead to risk to banks.


Liquidity Risk Liquidity risk involves the risk of not being able to sell an instrument or close a position when required without facing significant costs. The reserves need to have a high level of liquidity at all times in order to be able to meet any unforeseen and emergency needs. Any adverse development has to be met with reserves and, hence, the need for a highly liquid portfolio is a necessary constraint in the investment strategy.1 The choice of instruments determines the liquidity of the portfolio. For example, in some markets, treasury securities could be liquidated in large volumes without much distortion of the price in the market and, thus, can be considered as liquid. Except fixed deposits with the BIS, foreign commercial banks and central banks and securities issued by supranational, almost all other types of investments are highly liquid instruments which could be converted into cash at short notice. Volatility Risk Volatility risk arises due to change of price of a portfolio as a result of changes in the volatility of a risk factor.3 Central Bankss have diverse portfolio depending upon their need, however change in volatility of risk factors upon which portfolio is based may lead loss or decrease in return. Reputational Risk Reputational risk arises when there is a mismatch between public perceptions and the actual objectives and resources of the central bank. Central banks face significant reputational risk, especially during times of crisis, and reputational damage to a central bank could take decades to repair.4 In general there is expectations among people of nation for Central Banks. Whether it be coming up with monetary policy or be it be simple regulatory measure, any lapses either in policy making or regulatory actions leads to reputational risk.


Settlement Risk Settlement risk arises when a counterparty does not deliver a security or its value as per agreement when the security was traded after the other counterparty or counterparties have already delivered security or value as per the trade agreement.5 Central banks foreign exchange transaction bears transactional risk. As foreign exchange reserves are deployed among various instruments for different purposes, sometimes it becomes mandatory to deploy funds in specific instrument and neglect transactional risk involved in it.

Operational Risk Operational risks arises due to system and processes through which Central bank operates. Any fraud, misleading conduct or predefined procedure may lead to operational risk.6 These risks are basically due to activities of Central banks and with proper control and monitoring it can be avoided to great extent. Systematic Risk Systematic risk arises from market structure or dynamics which produce shocks or uncertainty faced by all agents in the market; such shocks could arise from government policy, international economic forces, or acts of nature. One of key role for central banks is to use their panoramic view of the financial system to identify system-wide vulnerabilities. Central banks are well placed to recognize risks and prioritize them within a framework that maps potential weaknesses and traces the chain of cause and effect throughout the system.7 In context to systematic risk, we can say that lapses in identifying any of the risks associated with central bank and failing to mitigate those risks may lead to systematic risk. Central banks generally identifies key factors across macroeconomic and microeconomic environment that may lead to systematic risk. Central banks use to continuously measure these factors and consider these factors while policy making.

1.3 Risk Management for RBI Talking about risk and risk management for RBI, It would be interesting to first analyze the role and function of RBI. Each of the functions of RBI may expose it to an altogether different kind of risk. (Reserve Bank of India Brochure, November, 2012)

1. Monetary Authority
Main objective of RBI for its role of monetary authority is to maintain price stability and ensure adequate flow of credit to productive sector. For this RBI use to formulate, implement and monitor the monetary policy.

2. Issuer of Currency
The Reserve Bank is the Indias sole note issuing authority. Along with the Government of India, it is responsible for the design and production and overall management of the nations currency, with the goal of ensuring an adequate supply of clean and genuine notes. The Reserve Bank also makes sure there is an adequate supply of coins, produced by the government. 3. Banker and Debt Manager to Government Managing the governments banking transactions is a key RBI role. Like individuals, businesses and banks, governments need a banker to carry out their financial transactions in an efficient and effective manner, including the raising of resources from the public. As a banker to the central government, the Reserve Bank maintains its accounts, receives money into and makes payments out of these accounts and facilitates the transfer of government funds. RBI also act as the banker to those state governments that have entered into an agreement with it. The role as banker and debt manager to government includes several distinct functions: Undertaking banking transactions for the central and state governments to facilitate receipts and payments and maintaining their accounts. Managing the governments domestic debt with the objective of raising the required amount of public debt in a cost-effective and timely manner. Developing the market for government securities to enable the government to raise debt at a reasonable cost, provide benchmarks for raising resources by other entities and facilitate transmission of monetary policy actions.

4. Banker to Banks
Like individual consumers, businesses and organizations of all kinds, banks need their own mechanism to transfer funds and settle inter-bank transactions such as borrowing from and lending to other banks and customer transactions. As the banker to banks, the Reserve Bank fulfills this role. In effect, all banks operating in the country have accounts with the Reserve Bank, just as individuals and businesses have accounts with their banks. As the banker to banks, RBI focuses on: Enabling smooth, swift and seamless clearing and settlement of inter-bank obligations. Providing an efficient means of funds transfer for banks. Enabling banks to maintain their accounts with us for purpose of statutory reserve requirements and maintain transaction balances. Acting as lender of the last resort.

5. Regulator and supervisor of the financial system

Prime objective of RBI for this role is to maintain public confidence in the banks of system, protect depositors interest and provide cost -effective banking services to the public. The regulation and supervision of the financial system in India is carried out by different regulatory authorities. The Reserve Bank regulates and supervises the major part of the financial system. The supervisory role of the Reserve Bank covers commercial banks, Urban Cooperative Banks (UCBs), some FIs and NBFCs.

6. Manager of Foreign Exchange

With the transition to a market-based system for determining the external value of the Indian rupee, the foreign exchange market in India gained importance in the early reform period. In recent years, with increasing integration of the Indian economy with the global economy arising from greater trade and capital flows, the foreign exchange market has evolved as a key segment of the Indian financial market. In this role objective of RBI is to facilitate external trade and payment and promote orderly development and maintenance of foreign exchange market in India.

7. Regulator and Supervisor of Payment and Settlement Systems

Payment and settlement systems play an important role in improving overall economic efficiency. They consist of all the diverse arrangements that we use to systematically transfer money currency, paper instruments such as cheques, and various electronic channels.

8. Maintaining Financial Stability

Pursuit of financial stability has emerged as a key critical policy objective for the central banks in the wake of the recent global financial crisis. Central banks have a critical role to play in achieving this objective. The approach adopted by the Reserve Bank to maintain financial stability is multi-pronged: maintenance of overall macroeconomic balance through monetary policy; improvement in the macro-prudential functioning of institutions and markets; and strengthening micro-prudential institutional soundness through regulation and supervision. In this regard, the RBI has been working in close coordination with other domestic regulators.

There is a separate department for Risk management, namely Risk Monitoring department at central office, Mumbai being headed by Mr. N. Krishna Mohan, C.G.M. Though there is separate department for risk management in spite of it risk assessment of different departments are done at their own end. Core function of Risk monitoring department is to monitor the risk involved with various banks operating in India and facilitates Risk Based Supervision.

1.4 Approach of Central Banks towards Risk Management On a general level, the Central Banking Publications survey in 2005 found that risk awareness in central banks is at a fairly low level; only 15% of central banks surveyed have an independent risk-management unit. Formal responsibility for monitoring and management of risk is still generally decentralized at departmental or head of function level. This results in a focus on the control of risk rather than active management of it. Many would argue that it is not for a

central bank to actively manage risk for its own benefit, since this may conflict with its statutory objectives associated with ensuring stability of the financial system and defending the currency. It is particularly in the context of foreign exchange and foreign exchange reserves management that this issue is relevant for a central bank. However, in wake of recent global crisis, risk-management practices, including the existence of a central risk management function, are only now being developed in many central banks. The monitoring and/or management of risk, including reporting to risk committees on daily risk exposures, limits etc., usually lies in the financial markets area and in the reserve management department. Only a few central banks seem to have a separate risk management function responsible for central bank-wide risk. Several developing countries central banks are in the process of implementing a separate risk management department that monitors the central bank-wide risks. Some of these countries include Australia, Ireland, and Brazil etc.

1.5 Risk Management System- Importance to Central banks For central banks, because of their reputation and emphasis on stability, risk management assumes a greater prominence than other institutions active in the financial sphere. Central banks are well known for their conservative, risk-averse approach to all aspects of their operations. This is a natural consequence of their primary function, which is the pursuit of financial stability. Although different central banks have differing objectives and emphases, these objectives generally revolve around financial stability; in particular, the stability of money and the stability of the financial system. For a central bank to succeed in delivering this stability, it is very important that it earns, and then retains, the confidence of other market operators as a secure, stable and reliable institution itself.1 Central banks face a variety of risks in their operations, both financial and nonfinancial. Non-financial risks are best controlled by the adoption of appropriate management procedures and checks, and the naturally risk-averse nature of central bank senior management is well suited to these. However, financial risks are too complex, and in many cases too fast-moving, to be left entirely to the natural conservatism of the central bank ethos.


Lorenzo Bini Smaghi, former Member of the Executive Board of the ECB, sees the three main risks facing central banks as: A major financial institution becoming insolvent, giving rise to tensions in the financial markets and further interventions to mitigate these risks. This could also lead to balance sheet losses. A major sovereign debt restructuring or default, with impact on the balance sheet and contagion to other assets. Central bank money is not withdrawn sufficiently quickly to avoid inflation creeping up, with impact on inflation expectations and long-term interest rates. The best way of lowering these risks, Bini Smaghi says, is to take appropriate risk control measures for the assets in the banks balance sheet; tighten supervision over the banking system and the process of de-leveraging; and prepare adequate instruments to absorb liquidity ahead of emerging inflationary pressures, including the issuance of certificates of deposit or term deposits by the central bank, and standing ready to tighten monetary conditions. In tackling risks associated with their operations, Central banks are nearly in privileged position to amend and modify their strategy. However, while managing its reserve management operations, central banks are exposed to same kind of financial risks as other market participants. So like other participants central banks has to also access for themselves the level of risk they are ready to bear. Christian Noyer1 points out that financial risk can be increased by virtue of policy decisions on foreign currency exposure, in particular reserve assets, for currency management reasons. This, together with exposures to domestic and foreign interest rates, is the main source of financial risk. For most institutions, where the end objective is the pursuit of financial return, this is an exercise in comparing risks(i.e. financial losses) and rewards (i.e. financial gains), which therefore makes the judgment mainly a financial one. If the rewards for an operation do not justify the risk, the institution will usually withdraw from that operation. For a central bank, however, the end objective of its operations is usually the pursuit of a chosen policy (for example, maintaining the exchange rate at a certain level), rather than merely financial gain. In this case, it may be unwilling or unable to withdraw from an operation, even if a simple financial cost-benefit analysis suggests that it is unfavorable. The very act

of holding net foreign exchange reserves entails an unavoidable currency risk, as the liabilities that fund the net reserves will be denominated in domestic currency. This risk cannot be reduced without reducing the holdings of the reserves themselves. Similarly, other risks (for example credit risk, liquidity risk, interest rate risk, currency risk and cross-country spread risks) constitute an integral part of holding reserve assets, and cannot be wholly avoided. 1

1.6 Foreign Reserves What is need of holding it. The International Monetary Fund defines foreign exchange reserves as external assets that are readily available to and controlled by monetary authorities for direct financing of external payments imbalances, for indirectly regulating the magnitudes of such imbalances through intervention in exchange markets to affect the currency exchange rate, and/or for other purposes.2 According to RBI Act 1934, reserves refer to both foreign reserves held in gold and foreign currency assets (held by issue department) and domestic reserves in the form of bank reserves. Monetary authority acts as a custodian for the sovereign government which is a principal of the foreign reserve.

There are principally three distinct motives of holding reserves. According to BIS Economic Papers, No. 38 1993, these four motives can be applied to the holding of reserves by central banks. Transaction needs: It includes financing the foreseeable foreign exchange demands of public and private sector in the country such as a government wishing to repay a maturing foreign loan. The transaction need of forex reserve is more prevalent in the countries where access to international capital market is limited. Many developing and under developed countries have very restricted access to External Commercial Borrowing (ECB). In such cases borrowing to finance current account deficit is more costly than drawing from reserves. Hence transaction needs are more dominant in the developing countries than developed countries.


Intervention needs: This corresponds to precautionary demand for money required for effective intervention in the foreign exchange market. It helps the central banks to intervene i.e. buy or sell foreign exchange in the market to influence the value of currency. Forex reserves are held for this purpose is prevalent in the countries which have relatively open market for goods and capital and/or has fixed exchange rate regime (ERM). The intervention needs can be further divided into very Short term and Medium term. Very Short term ERM: Generally Central banks of countries with very open capital market apply very short term ERM. Such interventions typically in Sterilized nature used to offset the effects of volatile and short term speculative capital movement which does not relate to underlying economic fundamentals. Typically central banks of developed countries apply very short term ERM. Medium term ERM: Unsterilized medium term ERM are used as an instrument with the objective macro-economic macroeconomic stabilization policy with regard to prices and output. There are basically two ways of implementing monetary policy response to exchange rate movement. One being directly intervening in the domestic monetary system by changing interest rate and other being indirectly impacting interest rate by intervening in the foreign exchange rate market. Typically developing countries central banks employ medium term ERM. Buffer Needs: A substantial foreign exchange reserve serves as a buffer against international financial shocks and crises. Wealth diversification: Most central banks consider safety, liquidity and return as the major reserve management objectives. Wealth considerations influence decisions on the compositions of the reserves. It is important to note that countries usually diversify their currency portfolio into US dollar, EURO, sterling, Japanese yen etc. Gold is often held for the same reason of diversification only. When the sovereign government has net foreign currency debt, central bank typically build forex reserves to maintain or enhance countrys international credit worthiness.


Foreign Reserves and Financial Assets of Central Banks, 2007

Different reasons for holding foreign exchange reserves importance attributed by reserve managers according to a JPMorgan survey in April 2008,


In case of India, broadly the objectives of holding foreign exchange reserves can be encapsulated as: (Indias Foreign Exchange Reserves: Policy, Status and Issues, Y. V.

Maintaining confidence in monetary and exchange rate policies. Enhancing capacity to intervene in forex markets. Limiting external vulnerability by maintaining forex reserve liquidity to absorb trade or capital shocks. Maintaining credit worthiness in the international credit markets Boosting confidence of market participants by demonstrating backing of domestic assets by external assets. Latest Foreign Exchange report of RBI (September 2012), shows that reserves stood at US$ 294.4 billion as at end-March, 2012. During the half year under review, it came down to US$ 286.0 billion at the end of May 2012 after which it followed upward trend and increased to US$ 294.8 billion at the end of September 2012.

From Foreign Exchange report, RBI (September 2012)


Although both US dollar and Euro are intervention currencies and the Foreign Currency Assets (FCA) are maintained in major currencies like US dollar, Euro, Pound Sterling, Japanese Yen etc., the foreign exchange reserves are denominated and expressed in US dollar only. Movements in the FCA occur mainly on account of purchases and sales of foreign exchange by the RBI in the foreign exchange market in India, income arising out of the deployment of the foreign exchange reserves, external aid receipts of the Central Government and the effects of revaluation of the assets. In its report RBI also states that, adequacy of reserves has emerged as an important parameter in gauging the ability to absorb external shocks. With the changing profile of capital flows, the traditional approach of assessing reserve adequacy in terms of import cover has been broadened to include a number of parameters which take into account the size, composition and risk profiles of various types of capital flows as well as the types of external shocks to which the economy is vulnerable.

1.7 Sovereign Risk for Foreign Reserves With the onset of recent global crisis lot of talk and measures are being taken in order to manage sovereign risk. Central banks across globe being custodian to countrys foreign exchange reserves deploy foreign reserves in different permissible assets such as balances/ deposits with other central banks, top rated foreign commercial banks, and with BIS; treasury bills and dated securities issued by top rated sovereign nations. However these deployments were considered to be risk free as it was believed that any sovereign nation can hardly default its obligations but as the recent European debt crisis has shown, central banks are forced to change their perception and consider this sovereign risk while deploying foreign reserves. IMF has defined sovereign risk as the risk that a government may default on its debt obligations. In general, when governments have bonds that are due to mature, they dont have sufficient tax receipts on hand to repay all the debt, so they re-enter the market to raise further money via a bond issuance. Sovereign risk thus includes refinancing risk, when a g overnment is unable to raise sufficient new debt in the market (i.e. at reasonable market prices and in sufficient volume) to repay upcoming bond maturities. RBI, being a custodian to foreign reserves have to access the risks while deploying its foreign reserves among various options.


A. Scope of the project Central banks, in performing their policy tasks, are exposed to a variety of financial and non-financial risks, which they may want to manage. One such key risk concerns foreign reserves, because central banks main activity, namely ensuring price stability, needs to be backed by an adequate financial position. Revolution of risk management techniques and best practices during the last fifteen years, the investment and risk management policies and procedures of central banks have undergone a profound transformation. My project is an attempt to understand need and implementation of risk management practices in RBI. The project covers different types of risks RBI is exposed to, the risk mitigation measures taken by RBI, risks and costs involved in holding foreign reserves. The project analyses basic economic indicators that plays major role in determining sovereign risks while deploying foreign reserves. B. Objectives The chief objectives of the study were as follows: To analyze various types of risks RBI is exposed to. To compare risk mitigation measures of RBI with that of other Central banks. To develop risk assessment tree for RBI. To find out adequacy of foreign reserves and cost involved in holding foreign reserves. To find out various factors that may be looked upon while deploying foreign reserves in order to mitigate sovereign risks on it.


C. Methodology

My project is basically exploratory in nature. Primary data was collected through interviews of officials and observations. Secondary data were collected from public websites of RBI and other Central banks. Objectives Methodology

To analyze various types of risks RBI is exposed to and develop risk assessment tree for RBI. To find adequacy of foreign reserves and cost involved in holding foreign reserves.

ISO 31000 and IEC 31010 techniques for risk assessment. Interview of Officials and Observation. Various literatures and Quantitative techniques.

Factors indicating sovereign risk.

Event Study analysis, CART technique


3. Literature Review

There are very few literatures available in context to central banks. However there has been many events and conferences where problems of central banks has been discussed and their solutions has been derived. In my project I have taken references of many such speeches given by governors and other executives. I am reviewing some of the literatures from where I have drawn references and my analysis is based upon.

1. ISO 31000:2009, Risk management Principles and guidelines

It provides principles, framework and a process for managing risk. These principles and guidelines can used by any organization regardless of its size, activity or sector.

While all organizations manage risk to some degree, this Standard establishes a number of principles that need to be satisfied before risk management will be effective. This Standard recommends that organizations should have a framework that integrates the process for managing risk into the organization's overall governance, strategy and planning, management, reporting processes, policies, values and culture. Risk management can be applied across an entire organization, to its many areas and levels, as well as to specific functions, projects and activities. Although the practice of risk management has been developed over time and within many sectors to meet diverse needs, the adoption of consistent processes within a comprehensive framework helps ensure that risk is managed effectively, efficiently and coherently across an organization. The generic approach described in this Standard provides the principles and guidelines for managing any form of risk in a systematic, transparent and credible manner and within any scope and context.


The relationship between the principles for managing risk, the framework in which it occurs and the risk management process described in this Standard is shown in Figure

Fig : Relationship between risk management principle, framework and process 28

2. IEC 31010:2009 ,Risk management -- Risk assessment techniques

It is a dual logo IEC/ISO, single prefix IEC, supporting standard for ISO 31000 and provides guidance on selection and application of systematic techniques for risk assessment. All activities of an organization involve risks that should be managed. The risk management process aids decision making by taking account of uncertainty and the possibility of future events or circumstances (intended or unintended) and their effects on agreed objectives. Risk management includes the application of logical and systematic methods for communicating and consulting throughout this process; establishing the context for identifying, analyzing, evaluating, treating risk associated with any activity, process, function or product; monitoring and reviewing risks; reporting and recording the results appropriately. Risk assessment is that part of risk management which provides a structured process that identifies how objectives may be affected, and analyses the risk in term of consequences and their probabilities before deciding on whether further treatment is required. Risk assessment is the overall process of risk identification, risk analysis and risk evaluation. The manner in which this process is applied is dependent not only on the context of the risk management process but also on the methods and techniques used to carry out the risk assessment. Risk assessment requires multidisciplinary approach since risks may cover a wide range of causes and consequences. Risk identification Risk identification is the process of finding, recognizing and recording risks. The purpose of risk identification is to identify what might happen or what situations might exist that might affect the achievement of the objectives of the system or organization. Once a risk is identified, the


organization should identify any existing controls such as design features, people, processes and systems. The risk identification process includes identifying the causes and source of the risk events, situations or circumstances which could have a material impact upon objectives and the nature of that impact. Risk identification methods can include evidence based methods (checklists and reviews of historical data). Various supporting techniques can be used to improve accuracy and completeness in risk identification, including brainstorming, Delphi methodology and top-down approach. Risk analysis Risk analysis consists of determining the consequences and their probabilities for identified risk events, taking into account the presence (or not) and the effectiveness of any existing controls. The consequences and their probabilities are then combined to determine a level of risk. Risk analysis normally includes an estimation of the range of potential consequences that might arise from an event, situation or circumstance, and their associated probabilities, in order to measure the level of risk. Methods used in analysing risks can be qualitative, semi-quantitative or quantitative. The degree of detail required will depend upon the particular application, the availability of reliable data and the decision-making needs of the organization. Qualitative assessment defines consequence, probability and level of risk by significance levels such as high, medium and low, may combine consequence and probability, and evaluates the resultant level of risk against qualitative criteria. Risk evaluation Risk evaluation involves comparing estimated levels of risk with risk criteria defined when the context was established, in order to determine the significance of the level and type of risk. Risk evaluation uses the understanding of risk obtained during risk analysis to make decisions about future actions. Ethical, legal, financial and other considerations, including perceptions of risk, are also inputs to the decision.

Fig: Contribution of risk assessment to the risk management process

3. Risk Management in Central Banking, Speech by Lorenzo Bini Smaghi, Member of the Executive Board of the ECB, International Risk Management Conference 2011, Free University of Amsterdam, 15 June 2011

In his speech Mr. Smaghi has talked about role of central banks as liquidity providers and lenders of last resort. He explained there is difference between risk management approach as employed in other organizations and that employed in Central banks. According to him, for central banks prime objective is to maintain price stability while for other organization prime objective may be profit maximization or increase of shareholders wealth. He has talked about ALM framework for central banks and has backed collateral risk control framework.


4. Risk Management system at European Central Bank, Report on the

audit of risk management of the European Central Bank for the financial year 2012. European Central Bank (ECB) has taken its place on the central banking stage to form a triumvirate of key global central banks alongside the Federal Reserve and the Bank of Japan. The ECB is unique as it is a supranational central bank at the heart of the Euro system. The Euro system comprises the ECB and the 12 national central banks (NCBs) of the sovereign states that have agreed to transfer their monetary sovereignty to the European Community level. The bank is located in Frankfurt am Main, Germany, and was established together with the European System of Central Banks (ESCB) on 1 June 1998 in the run-up to the launch of the euro. The ECB has its own legal personality and acts as the hub within both the ESCB (comprising the 15 NCBs of the EU Member States) and the Euro system (comprising the ECB and the 12 NCBs of the EU Member States which have adopted the euro). The basic tasks of the Euro system are the definition and implementation of the monetary policy of the euro area, the conduct of foreign exchange operations, the holding and management of the official foreign reserves of the Member States, and the promotion of the smooth operation of payments systems. The Euro system is governed by the decision making bodies of the ECB, namely the Governing Council and the Executive Board. At the ECB each organizational unit is responsible for managing its own risks and controls. Two functions/divisions support organizational units in the risk management process: 1. The Operational Risk Management (ORM) function, responsible for methodological maintenance, coordination of all operational risk related activities, as well as proactive advice to business areas. 2. The Risk Management division (RMA) deals with financial risks. The Risk Management division is responsible for proposing policies and procedures and organizational support on risk management for all financial market operations conducted by the ECB or by the Euro system on behalf of the ECB. The division is organized in two units: Risk Analysis and Risk Strategy sections.


The charter of the ECBs Risk Management Division states that it shall: 1. Provide organizational support and propose policies and procedures on risk management for the range of operations conducted by the ECB or the 12 NCBs of the Euro system on behalf of the ECB. 2. Manage market risk and credit risk in relation to the ECBs investment operations, credit risk in relation to the monetary policy and foreign exchange operations of the ECB, and operational risk for all operations conducted by the ECB or the 12 NCBs of the Euro system on behalf of the ECB. The Risk Management Division contains two principal operational fields: risk management issues related to the implementation of Euro system monetary policy operations, and risk management issues related to the management of the foreign currency reserves and the ECBs own funds. Risk management issues related to the implementation of Euro system monetary policy operations In order to control the credit risk in its monetary policy operations (as well as in the intraday credit extended for payment systems purposes), the Euro system relies on high-quality collateral provided by its counterparties. Euro system opted for a policy of accepting a broad range of high quality assets as collateral. This was seen as necessary in order to ensure sufficient availability of collateral. A broad range of collateral was also seen as conducive to equal treatment of counterparties, promoting the development of markets for private paper, and as a means of ensuring that the NCBs could continue with established practices. It appears that the Eurosystem accepts a wider range of asset types as collateral in its monetary policy operations than any other central bank in the world. This fact in itself poses a major challenge for the ECBs Risk Management Division. The Eurosystem distinguishes between two categories of assets eligible for its monetary policy operations, which it categorizes as tier one and tier two. Tier one consists of marketable debt securities that fulfil certain eligibility criteria established by the ECB. The criteria endeavor to ensure that tier one assets consist of high quality marketable securities with high liquidity that can easily be traded on a cross-border basis. Tier two consists of additional assets (currently including, inter alia, non-marketable securities and equities) which are of particular importance to the national financial markets or banking systems. The precise criteria for tier two assets are proposed by each NCB according to certain minimum standards established by the ECB. However, tier two assets must at least meet the same high credit standards as tier one assets.

The risk managers assist in fine-tuning the protection provided by the collateral by calculating various haircuts to be applied to the monetary policy repos. Market and liquidity risks are the main risks addressed in developing these risk control measures. Risk management issues related to the management of the foreign currency reserves and the ECBs own funds The foreign currency reserves are invested in high-quality and liquid assets, and are split among the 12 NCBs of the Eurosystem. The size of each portfolio is based on the capital key of each NCB. The ECB has a two-tiered benchmark system for the foreign currency reserves with a strategic benchmark for each relevant currency, reflecting the long-term investment objectives of the ECB. This is supplemented by a tactical benchmark set by the ECBs portfolio managers and organizationally separated from the Risk Management Division. NCB portfolio managers, who in practice manage the actual portfolios, are permitted to take positions within a predefined band around this tactical benchmark, which is, in turn, restricted to a band around the strategic benchmark. There is a credit policy and limits system that restricts the instruments, countries, issuers and counterparties that NCBs may use. The Risk Management Division is responsible for analyzing and reporting the performance of both the benchmarks and the NCB portfolio managers. A similar although less elaborate structure exists for the ECBs own funds (the counterpart of capital and reserves), which is managed by a dedicated Portfolio Management Division within the ECB. In terms of investment operations, the risk management area has three key areas of responsibility: risk management measures and compliance, analysis and reporting of investment performance, and strategic asset allocation.

5. Risk Management system at Reserve Bank of Australia, Public Website, Reserve Bank of Australia,

The Reserve Bank of Australia (RBA) is Australia's central bank, which was continued in existence under, and derives its functions and powers from the Reserve Bank Act 1959. Its duty is to contribute to the stability of the currency,

full employment, and the economic prosperity and welfare of the Australian people. It does this by setting the cash rate to meet an agreed medium-term inflation target, working to maintain a strong financial system and efficient payments system, and issuing the nation's banknotes. The RBA provides certain banking services as required to the Australian Government and its agencies, and to a number of overseas central banks and official institutions. Additionally, it manages Australia's gold and foreign exchange reserves. The aim of the Reserve Bank's risk management policy is to ensure a coordinated approach to managing non-policy risks within the Reserve Bank of Australia that is consistent with the Bank achieving its policy and operating objectives in an effective way. In doing so, it follows accepted standards and guidelines for managing risk, particularly those used by public and financial institutions. The general philosophy underpinning the Bank's approach is that risk management is an integral part of the management function in the organization and, as such, is the clear responsibility of management. The Bank is committed to ensuring that effective risk management remains central to all Reserve Bank activities, and a core management competency. The aim is to ensure that risk management is embedded in the Bank's processes and culture, and that this activity makes an effective contribution to achieving the Bank's core objectives. In common with most central banks, the Reserve Bank of Australia is an institution that seeks to manage risk carefully. This reflects the view that satisfactory fulfilment of its important public-policy responsibilities would be seriously jeopardized if poorly managed risks were to result in significant financial losses and/or damage to the Bank's reputation. The Bank's management is aware of the high standards that the community expects of its central bank. The Reserve Bank recognizes that it cannot eliminate the risks involved in all its activities completely. Rather, the Bank manages those risks against the backdrop of its risk appetite. RBAs risk management policy covers the full spectrum of financial, market, credit, operational, reputational and other risks, but not the risks inherent to the Bank's core monetary, financial stability and payments policy functions, which remain the responsibility of the Governor and the Reserve Bank and Payments System Boards. The risks associated with the ownership of Note Printing Australia and Securency are also covered by this


policy, though the day-to-day activities of these entities are the responsibility of their respective management and boards. The Governor, as the chief executive of the Reserve Bank, has overall responsibility for management of the organization, but day-to-day management of the various groups and departments in the Bank (including risk management) is delegated to the respective Assistant Governors or department heads in charge of those groups or departments. The Risk Management Committee (RMC) oversees the Bank's overall risk management practices via a formal delegation from the Governor. The Committee comprises several senior officers and is chaired by the Deputy Governor. Its role is to ensure that the Bank's risks are identified, assessed and managed in accordance with this Policy. The Risk Management Committee provides minutes of its meetings to the Board's Audit Committee. The Risk Management Unit (RMU) facilitates, co-ordinates and advises on the risk management process to help groups and departments manage their risk environment in a manner that is broadly consistent across the Bank. The Unit does not, however, conduct risk management on behalf of groups and departments or assume ownership of, and responsibility for, those risks. From a governance perspective, the RMU reports to the RMC, and the Head of Risk Management, or an alternate, attends all meetings of the RMC. Bank management in each group and department remains responsible for the management of risks, including associated controls and ongoing monitoring processes. Risks noted as part of this framework, which may have implications for other areas of the Bank, should be reported immediately to the RMU and the relevant departments. Additionally, reports on experiences that might assist the Bank in compiling and maintaining its risk profile (Incident Reports) should be promptly communicated to the RMU. The RMC may establish working groups to develop strategies for the management of some Bank-wide risks, such as business continuity. The Committee retains oversight of these areas, from a risk management perspective, and the RMU ensures appropriate co-ordination across the Bank. The Risk Management Committee may request the RMU to conduct one -off risk reviews of either a process or across functional lines if that is judged appropriate (e.g. Bank-wide handling of sensitive information/data). Audit Department co-ordinates closely with (but remains separate from) the RMU. Audit provides independent assurance that the Bank's risk management

policy is adhered to. In addition, Audit independently reviews departmental procedures to assess if they provide effective control. This work draws on risk documentation and reports of core business areas to help ensure that the approach reflected in these documents is both risk focused and consistent with the views of management in the areas being audited. Audit reports independently to the Board's Audit Committee on both the risk profiles of groups and departments as well as the effectiveness of relevant controls. Copies of these reports are made available to the RMU. The RMU falls within the scope of internal audit reviews. An external independent review of its function may also be commissioned by the RMC.

Framework for Managing Risk The Bank's framework for managing risks is consistent with the accepted Australian standard, and comprises several basic steps: 1. Identifying and analyzing the main risks facing the Bank. 2. Evaluating those risks making judgments about whether they are acceptable or not, and prioritizing unacceptable risks for action. 3. Treating unacceptable risks taking action to reduce the probability or consequences of an event and/or transferring the risk to another party. 4. Acknowledging residual risk and, where appropriate, forming contingency plans. 5. Documenting these processes, with summary tables (risk registers) the main forms of documentation, supplemented by risk manuals or related documents as appropriate. 6. Ongoing monitoring, communication and review. While the framework is applied consistently across the Bank, individual groups and departments continually identifies and analyzes the risks in their own areas, assess the controls in place to deal with those risks, and make decisions about whether to mitigate a particular risk (fully or partially) given its effects and the costs of mitigation. If a residual risk is judged unacceptable, the owner group or department is responsible for developing and overseeing a remedial plan. Where risks are considered cross-sectional, i.e. owned by one area and managed by another (e.g. IT-related risks), a process is established for ensuring the risks are both communicated, and action agreed, between the areas concerned.



A Framework for Strategic Foreign Reserves Risk Management, Stijn

Claessens & Jerome Kreuser, February 13, 2003 This paper has presented a framework for foreign exchange reserves management that combines asset allocation considerations with broad macroeconomic, macro-prudential risk and sovereign debt management considerations. Literature has highlighted how private debt management and financial sector vulnerabilities can affect public debt and reserve management. Less macro-economic or balance-sheet oriented approaches and more microeconomic oriented approaches to reserves management are feasible when monetary policy, exchange rate and debt management issues are of less concern, and when vulnerabilities in the financial and corporate sectors are small. In context to RBI, where liquidity is primary concern this paper is apt for designing the framework for deployment of foreign reserves.


Foreign Exchange Reserves Management in India: Accumulation and

Utilization, M. Rama Krishna Prasad and G. Raghavender Raju, Department of Economics, Sri Sathya Sai University.

According to the literature on the rationale of accumulating forex reserve by developing countries, there are principally two explanations namely, Competitiveness and Self Insurance. Competitiveness: Most of the Asian countries with their pursuit to build export competitiveness built large current account surplus. Their export driven growth was instrumental in accumulating large forex reserve. In these countries, benefit of stable and managed exchange rate regime (currency devaluation) exceeded the cost of holding excess forex reserve. Self Insurance: More dominant rationale of accumulating forex reserve by large number of developing countries is self-insurance against hard landing of capital and trade accounts. This motive became more relevant after 2008 subprime crises where trade and capital shock ill effects were contained by the large liquid forex reserve held by various developing countries including India and China. In the wake of risks raised our of deep financial integration and

exposure to global financial instability, the self-insurance motive of holding foreign exchange reserve has gained significance in spite of the costs associated with holding the same. These motives in fact correspond to the precautionary demand money discussed in BIS Economic paper. It is now well accepted that such precautionary demand should be higher if the proportion of the short term or volatile capital inflow are higher. There is an argument regarding the accumulation of forex reserve with selfinsurance motive. They argued that why developing countries accumulated forex reserve to shield themselves from the financial instability instead of reducing the financial integration. He argued that prudential capital regulation can itself minimize the risk of financial instability. Hence the key question was whether it is possible to reduce the risk of financial instability by reducing financial integration and thus reducing the cost of self-insurance. 8. Indias Foreign Exchange Reserves: Policy, Status and Issues, Y.V.

Reddy, Deputy Governor, RBI, 2003. The literature focusses on rising foreign reserves of India and discusses nearly all issues related to foreign reserves. As per the literature there are alternative frameworks for determining appropriate level of foreign reserves. The literature identifies four sets of indicators to assess adequacy of reserves, and each of them do provide an insight into adequacy though none of them may by itself fully explain adequacy.

Adequacy of reserves 1. Money based Indicator, Reserves to Broad Money Supply Reserve to Broad Money Supply(R/M3) ratio could be used to compensate internal conditions. R/M3 ratio is not a good indicator of reserve adequacy where demand of money supply is stable and financial markets are strong. Bench mark: 20% of Money Supply (Rodrik and Velasco Rule) Reserves in this range are considered adequate to support confidence in the value of local currency and reduce the risk of capital flight. This benchmark is most relevant to countries with managed exchange rates.


2. Trade based indicator, Reserves to Imports Ratio The economic crisis of South-East Asia in 1997 reflected several deficiencies involved in keeping R/M ratio as a criterion of reserves adequacy. Bench mark: 3 Months of Import Cover The reserves to imports ratio is considered most relevant to low income countries exposed to current account shocks and lacking significant access to capital markets. 3. Debt based indicator, a. Reserves to Short term External Debt (R/STED) Ratio It has been Short term external debt accumulation in access is a common feature in all recent crisis. It gives us the information about how quickly a country will adjust the external sector if it is unable to access external flows. Also it acts as the indicator for losing investor confidence. Studies have shown that it could be the single most important indicator of reserve adequacy in countries with significant but uncertain access to capital markets. Bench mark: 100% of Short-term Debt (Greenspan and Guidotti rule) This benchmark is the most preferred measure for measuring risk of a capital account crisis. During a financial crisis countries have found that they are unable to rollover short-term debt. The GuidottiGreenspan rule states that a country's reserves should equal short-term external debt (oneyear or less maturity), implying a ratio of reserves-to-short term debt of 1. The rationale is that countries should have enough reserves to resist a massive withdrawal of short term foreign capital. b. Reserves to Total External Debt This ratio tells us the possibility of covering the total external debt using the foreign reserves. Benchmark: 100% of Total External Debt


4. Combination of current-capital accounts, Reserves to GDP Ratio This says that reserves should be kept to a level that is at least some percentage of the GDP. Benchmark : 10% of GDP (Jeanne and Ranciere Rule)


Ben-Bassat, A. and Gottlieb, D 1992, Optimal International Reserves

and Sovereign Risk, Journal of International Economics, vol. 33,

Central banks maintain foreign currency reserves to facilitate international trade and intervene in the open markets to maintain exchange rates. The total demand for foreign currency reserves depend on multiple factors such as import percentage of trade, opportunity cost of holding reserves, exchange rate arrangements etc. However the composition of foreign currency reserves would depend on real rate of returns and volatility of the currency. So, basically once the optimum level of forex reserves are determined, the question remains as to how to maintain the most efficient portfolio adding up to the optimum reserve. Theories on Currency Composition of FX reserves: 1. Mean Variance Theory 2. Transaction Theory Mean Variance Theory This theory originates from Harry Markowitz work on Portfolio Selection (1952). It starts with a critique of Williams (1939) that says that an investor will design a portfolio such that the discounted anticipated or expected returns are maximized. Markowitz argues that in addition to risk, an investor is also concerned with the risk associated with the portfolio. Investors portfolio choice problems will involve calculation of the so called efficient portfolios, which is the combination of assets that would make the mean return from the portfolio as large as possible for a given level of risk. Basically Markowitz suggests that diversification of portfolio helps in reducing the risk. Mathematically the returns of the portfolio is given as

And the risk is given as

Hence the risk of the portfolio depends on the variances of the returns of the assets from the mean. The risk of a two asset based portfolio will be lower than a single asset portfolio if the covariance of the two assets is negative. Hence the selection of portfolio depends not only on the number of assets but also on the interaction of the assets such that the covariance will be negative.

For a two asset portfolio:


Hence for a two asset based portfolio an efficient frontier can be defined and using the above differentials, asset allocations can be made to achieve the efficient frontier. For portfolios having more than two assets also, lagrangian multipliers can be used to determine efficient allocations. In the context of foreign exchange reserves, the central banks objective should be to select the most appropriate composition of foreign currencies so as to minimize risks at the same time to be able to facilitate trade and foster growth. Optimal Portfolio

I1, I2 and I3 represent indifferent curves. The convexity of the indifference curves represents the risk aversion of the investor. Here a higher indifference curve signifies a higher utlity. The point at which the indifference curve is tangential to the efficient frontier (point A) gives the point where the investor should operate. Sharpe Ratio line Since the indifference curves are often not known, Sharpe (1964) and Lintner (1965) suggested that from the intercept on the return axis at the point of risk free returns, a tangent be drawn on the efficient frontier. The point of tangency represents the optimal portfolio.

Further study on Ben-Bassets methodology and applicability on India Ben-Basset used the following equation to calculate the risk and returns

The return on currency I is given as

Where E is the rate of change of currency I in relation to the import currency basket. Using the above equations of risk and return, we can calculate different levels of risks and returns for a particular portfolio holding and by varying the holdings we

can determine the efficient frontier. Using the sharpe ratio line, we can get the optimum holdings.

10. Rules of Thumb for Sovereign Debt Crisis, Paolo Manasse and Nouriel Roubini, Converted by Manmohan S. Kumar

The literature finds that most debt crises can be classified in three types: episodes of insolvency (high debt and high inflation) or debt unsustainability due to high debt and illiquidity; episodes of illiquidity, where near default is driven by large stocks of short-term liabilities relative to foreign reserves; and episodes of macro and exchange rate weaknesses (large overvaluation and negative growth shocks). Conversely, a relatively risk-free country type is described by a handful of economic characteristics: low total external debt relative to ability to pay, low short-term debt over foreign reserves, low public external debt over fiscal revenue, and an exchange rate which is not excessively overvalued. Political instability and tight monetary conditions in international financial market aggravate liquidity problems. The approach suggests that the unconditional thresholds, for example, looking at debt to output ratios in isolation, are of little value per se for assessing the probability of default; it is the particular combination of different types of vulnerability that may lead to a sovereign debt crisis.


4. ANALYSIS AND FINDINGS Risk Assessment for RBI

I have used top-down approach to access all the risks that RBI has to face. For this I have started from core functions of RBI and then investigated the contribution of each department towards its core function. With knowledge of both I have tried to find out various risks RBI has to face while performing its functions. 1 Monetary Authority .To maintain price stability and ensure adequate flow of credit to productive sector. For this RBI use to formulate, implement and monitor the monetary policy. .As a policy maker RBI has to fulfill market expectations keeping in view long term impact of policies. Objectives of monetary policy in India are Price Stability, Controlled Expansion Of Bank Credit, Promotion of Fixed Investment, Restriction of Inventories, Promotion of Exports and Food Procurement Operations, Desired Distribution of Credit, Equitable Distribution of Credit, To Promote Efficiency and Reducing the Rigidity.

In this role RBI has to fulfill the market expectations and at the same time it has to look after price stability. There is always risk involved in failing to either of its objective. RBI not only carries out monetary policy operations but also supervises banks, manages foreign exchange reserves, and operates the core of the national payments system. In this course it may happen that Contractionary or Expansionary monitory policy may pose risk to its other role. It may be possible that while fulfilling one of its objective others objectives are neglected. Risk assessment of each of its objectives can be done in detailed manner. However failure of identifying these risk can lead to Policy Implementation risk. Monetary policy basically has to be in sync with Fiscal policy.


2 Issuer of Currency .The Reserve Bank is the Indias sole note issuing authority. Along with the Government of India, it is responsible for the design and production and overall management of the nations currency, with the goal of ensuring an adequate supply of clean and genuine notes. The Reserve Bank also makes sure there is an adequate supply of coins, produced by the government.

As a Central bank and countrys sole note issuing authority RBI has to cope up with risk of counterfeit notes in circulation. Circulation of counterfeit notes in transactions poses severe threat to currency and payment system standards. In consultation with the government, RBI routinely address security issues and target ways to enhance security features to reduce the risk of counterfeiting or forgery. Lot of programs and public awareness campaign are being conducted by RBI.

Counterfeit currency notes in circulation


Banker and Debt Manager to 3 Government

Undertaking banking transactions for the central and state governments to facilitate receipts and payments and maintaining their accounts. Managing the governments domestic debt with the objective of raising the required amount of public debt in a cost-effective and timely manner. Developing the market for government securities to enable the government to raise debt at a reasonable cost, provide benchmarks for raising resources by other entities and facilitate transmission of monetary policy actions. In India, debt management is currently carried out by the RBIs Internal Debt Management Department (IDMD), which is functionally separate from monetary policymaking. The debt management strategy is formulated by the Monitoring Group on Cash and Debt Management, which is the apex coordinating body between the RBI and the Ministry of Finance. The Reserve Bank manages the public debt and issues new loans on behalf of the Central and State Governments. It involves issue and retirement of rupee loans, interest payment on the loan and operational matters about debt certificates and their registration. In union budget Central govt. decides about the annual borrowing need. The Reserve Banks debt management policy aims at minimizing the cost of borrowing, reducing the roll-over risk, smoothening the maturity structure of debt, and improving depth and liquidity of Government securities markets by developing an active secondary market. When asked, RBI uses to advice Central govt.about the various factors affecting public debt. Various risks are associated with these functions of RBI. Major risk is roll over risk. This risk arises due to increased interest rate for refinancing debt at lower interest rate. In order to mitigate this risk, the Government and the Reserve Bank take into account a number of factors while formulating the borrowing programme for the year, such as, the amount of Central and State loans maturing during the year, the estimated available resources, and the absorptive capacity of the market.

4 Banker to Banks As the banker to banks, RBI focuses on: Enabling smooth, swift and seamless clearing and settlement of inter-bank obligations. Providing an efficient means of funds transfer for banks. Enabling banks to maintain their accounts with us for purpose of statutory reserve requirements and maintain transaction balances. Acting as lender of the last resort.

As Lender of the last resort, RBI provides liquidity to banks unable to raise short term liquid resources from the inter-bank market. Like other central banks, the Reserve Bank considers this a critical function because it protects the interests of depositors, which in turn, has a stabilizing impact on the financial system and on the economy as a whole. Acting as lender to last resort, RBI is supposed to bear more risk by funding to banks which are already in liquidity crunch. Being as lender to banks, RBI has to bear credit risk. Each bank is graded based upon supervision inputs and limit to which loan can be given is decided.

Regulator and supervisor 5 of the financial system

The primary role of RBI is to prevent systemic risk, avoid financial crises and protect depositors interest and reduce asymmetry of information between depositors and banks. Being as regulator and supervisor its responsibility of RBI to take necessary steps towards providing stable environment to public.

RBI has to face lot of reputational risk in this role. Being as independent and reputed organization, there is common belief among countrymen that RBI will achieve its policy task of maintaining price stability. Or, as banking supervisors, they impose high governance standards on banks, and search for weaknesses of banks to intervene against them. Any lapses in these regards leads to reputational loss of RBI.


Fig: Financial Regulation Approaches, Measures and Objectives in India 2000 and beyond

A strong capital base is imperative to enable the banks to acquire resilience to withstand shocks. By prescribing capital adequacy norms, the banks ability to withstand shocks has been strengthened. After complying with the Basel I requirements, the Indian banks are now moving towards the New Capital Adequacy Framework (Basel II) regime. The RBI has accepted to adopt the Basel II in principle and have taken necessary steps to ensure these norms are being adopted by banks. In order to deal with issues of reputational risk and other internal risk attributes, RBI has Internal Inspection Department. Using its knowledge, skills and professional competence, the Inspection Department carries out inspections to examine, evaluate and report on the adequacy and reliability of existing systems and follow-up to ensure that: Laws, Regulations, Internal Policies and Procedures are meticulously followed Assets are properly maintained/utilized/safeguarded Financial crisis is avoided; operational and Reputational Risks are averted Adequate safeguards are taken for Bank's physical/operational/IT security

The regulation and supervision policies pursued by the Reserve Bank have been successful in ensuring that the broad objectives of regulation are met. The regulatory gaps have been continuously monitored and plugged through appropriate measures from time to time. The Indian public has trust in the soundness of the banking system going by the fact that they consider bank deposits absolutely safe. Consequent on two spells of bank nationalization in 1969 and in 1980, public sector bank ownership has contributed to this strong sentiment. The sound financial position and strength of the banking system reflects the effectiveness of the Reserve Banks regulatory and supervisory approaches.

Manager of Foreign 6 Exchange

With the transition to a market-based system for determining the external value of the Indian rupee, the foreign exchange market in India gained importance in the early reform period. In recent years, with increasing integration of the Indian economy with the global economy arising from greater trade and capital flows, the foreign exchange market has evolved as a key segment of the Indian financial market. In this role objective of RBI is to facilitate external trade and payment and promote orderly development and maintenance of foreign exchange market in India. Manages the Foreign Exchange Management Act, 1999. While doing so RBI has to deal with specific risks related to deployment of foreign exchange including credit risk, market risk, liquidity risk, interest rate risk, currency risk and operational risk. The Reserve Bank has been extremely sensitive to the credit risk it faces on the investment of foreign exchange reserves in the international markets. The Reserve Bank's investments in bonds/treasury bills represent debt obligations of highly rated sovereigns and supranational entities. Further, deposits are placed with central banks, the Bank for International Settlements (BIS) and select foreign banks.


In order to manage market risk, gains/losses on valuation of foreign currency assets and gold due to movements in the exchange rates and/or price of gold are booked under a balance sheet head named the Currency and Gold Revaluation Account (CGRA).The balances in CGRA provides a buffer against exchange rate/gold price fluctuations which in recent times have shown sharp volatility. Foreign dated securities are valued at market prices prevailing on the last business day of each month and the appreciation/depreciation arising therefrom is transferred to the Investment Revaluation Account (IRA). The balances in IRA is meant to provide cushion against changes in security price over the holding period. For managing currency risk, decisions are taken regarding the long-term exposure on different currencies depending on the likely movements in exchange rate and other considerations in the medium and long-term. The decision making procedure is supported by reviews of the strategy on a regular basis. The crucial aspect of the management of interest rate risk is to protect the value of the investments as much as possible from the adverse impact of the interest rate movements. The interest rate sensitivity of the reserves portfolio is identified in terms of benchmark duration and the permitted deviation from the benchmark. In order to manage Liquidity Risk, RBI closely monitors the portion of the reserves which could be converted into cash at a very short notice to meet any unforeseen / emergent needs. In tune with the global trend, considerable attention is paid to strengthen the operational risk control arrangements. Key operational procedures are documented. Internally, there is total separation of the front office and back office functions and the internal control systems ensure several checks at the stages of deal capture, deal processing and settlement. The deal processing and settlement system is also subject to internal control guidelines based on the principle of one point data entry and powers are delegated to officers at various levels for generation of payment instructions. There is a system of concurrent audit for monitoring compliance in respect of all the internal control guidelines. Further, reconciliation of accounts is done regularly. In addition to annual inspection by the internal machinery of the Reserve Bank for this purpose and statutory audit of accounts by external auditors, there is a system of appointing special external auditors to audit the dealing room operations.


Regulator and Supervisor of Payment and Settlement 7 Systems

Payment and settlement systems play an important role in improving overall economic efficiency. They consist of all the diverse arrangements that we use to systematically transfer money currency, paper instruments such as cheques, and various electronic channels. In this role, RBI focuses on the development and functioning of safe, secure and efficient payment and settlement mechanisms. RBI has to deal with all the risks involved in these systems and provide risk free settlement system to public.

Maintaining Financial 8 Stability

The notion that a central bank should have responsibility for financial stability is deep rooted in the history of central banking. Financial instability has been sufficiently prominent over the last couple of decades to rise to the top of the international policy agenda (Claudio, 2002). Pursuit of financial stability has emerged as a key critical policy objective for the central banks in the wake of the recent global financial crisis. Central banks have a critical role to play in achieving this objective. The approach adopted by the Reserve Bank to maintain financial stability is multipronged: maintenance of overall macroeconomic balance through monetary policy; improvement in the macro-prudential functioning of institutions and markets; and strengthening microprudential institutional soundness through regulation and supervision. In this regard, the RBI has been working in close coordination with other domestic regulators.


The maintenance of macroeconomic stability to prevent financial crises is a major concern of the RBI. Containing inflation and stabilizing inflation expectations through its monetary policy, the Reserve Bank has also helped in fostering financial stability. To ensure financial stability and to protect the banking system from untoward financial crisis, instructions on exposure norms, credit exposure on derivative products, Know Your Customer and Anti Money Laundering have been issued. Moreover, in order to access systematic risks in context to India, RBI uses to conduct systematic risk survey half yearly. In its Financial Stability report, different parameters of systematic risks are measured and compared with previous values. The These report reflects the collective assessment of the Sub Committee of the Financial Stability and Development Council (FSDC) on risks to financial stability.

Various Risks identified in Systemic Risk Survey October 2012, RBI


Monetary Authority

Issuer of Currency

Banker and Debt Manager to Government

Banker to Banks

Regulator and supervisor of the financial system

Manager of Foreign Exchange

Regulator and Supervisor of Payment and Settlement Systems

Maintaining Financial Stability

Policy Implementation Risk

Risk of counterfeit ing or forgery

Roll over risk

Credit risk

Regulatory risk Supervision risk Reputational risk

Credit risk Market risk Liquidity risk Interest rate risk Currency risk

Settlement risk

Systematic risk


Credit risk Market risk Liquidity risk Currency risk Interest rate risk Operational risk. Risk of counterfeiting or forgery Policy Implementation Risk Roll over risk Regulatory risk Supervision risk Reputational risk Settlement risk Systematic risk

Fig: Risk assessment tree of RBI


Risk Matrix for RBI Individually I have arrived to score of each risks as per the historical datas available. Each risk has maximum of 25 points and minimum of 1 point. Risks are graded on scale of Likelihood (5) x Impact (5)

Fig: ISO 3010, Risk Matrix Grading

Impact Credit Risk

Insignificant(1) Almost Certain(5) Minor(2) Moderate(3) Major(4) Castastrophic(5)


Likely(4) Possible(3) Unlikely(2)



Impact Market risk

Insignificant(1) Almost Certain(5) Minor(2) Moderate(3) Major(4) Castastrophic(5)


Likely(4) Possible(3) Unlikely(2) Rare(1)


Impact Liquidity risk

Insignificant(1) Almost Certain(5) Minor(2) Moderate(3) Major(4) Castastrophic(5)


Likely(4) Possible(3) Unlikely(2) Rare(1)

Impact Currency risk

Insignificant(1) Almost Certain(5) Minor(2) Moderate(3) Major(4) Castastrophic(5)


Likely(4) Possible(3) Unlikely(2) Rare(1)


Impact Interest rate risk

Insignificant(1) Almost Certain(5) Minor(2) Moderate(3) Major(4) Castastrophic(5)


Likely(4) Possible(3) Unlikely(2) Rare(1)

Impact Operational risk.

Insignificant(1) Almost Certain(5) Minor(2) Moderate(3) Major(4) Castastrophic(5)


Likely(4) Possible(3) Unlikely(2) Rare(1)

Risk of counterfeiting or forgery Insignificant(1)

Almost Certain(5)

Minor(2) Moderate(3) Major(4) Castastrophic(5)


Likely(4) Possible(3) Unlikely(2) Rare(1)



Policy Implementation Risk Insignificant(1)

Almost Certain(5)

Minor(2) Moderate(3) Major(4) Castastrophic(5)


Likely(4) Possible(3) Unlikely(2) Rare(1)

Impact Roll over risk

Insignificant(1) Almost Certain(5) Minor(2) Moderate(3) Major(4) Castastrophic(5)


Likely(4) Possible(3) Unlikely(2) Rare(1)

Impact Regulatory risk

Insignificant(1) Almost Certain(5) Minor(2) Moderate(3) Major(4) Castastrophic(5)


Likely(4) Possible(3) Unlikely(2) Rare(1)


Impact Supervision risk

Insignificant(1) Almost Certain(5) Minor(2) Moderate(3) Major(4) Castastrophic(5)


Likely(4) Possible(3) Unlikely(2) Rare(1)

Impact Reputational risk

Insignificant(1) Almost Certain(5) Minor(2) Moderate(3) Major(4) Castastrophic(5)


Likely(4) Possible(3) Unlikely(2) Rare(1)

Impact Settlement risk

Insignificant(1) Almost Certain(5) Minor(2) Moderate(3) Major(4) Castastrophic(5)


Likely(4) Possible(3) Unlikely(2) Rare(1)


Impact Systematic risk

Insignificant(1) Almost Certain(5) Minor(2) Moderate(3) Major(4) Castastrophic(5)


Likely(4) Possible(3) Unlikely(2) Rare(1)


Scores of each identified risks (5x5)

Type Credit risk Market risk Liquidity risk Currency risk Interest rate risk Operational risk. Risk of counterfeiting or forgery

Score(out of 25) 12 12 9 8 9 9 16

Type Policy Implementation Risk Roll over risk Regulatory risk Supervision risk Reputational risk Settlement risk Systematic risk

Score(out of 25) 8 6 6 9 4 9 15

Putting risk tolerance level of 10, Major risks that has to be considered while making risk management policies.

Credit risk Market risk

Risk of counterfeiting or forgery Systematic risk


Adequacy of foreign reserves and cost involved in holding foreign reserves

Governments accumulate reserves for a variety of reasons. A small amount of foreign currency reserves may be needed for day-to-day transactions including debt repayments, payments to international organizations, and payments for imports. The latter may be most important for low income countries. Countries with pegged exchange rates need to hold reserves to offset downward pressure on their currencies. Even economies with flexible exchange rates hold some reserves in order to intervene in foreign exchange markets to prevent a disorderly depreciation of their currency. Governments also hold reserves to provide a defense against substantial and rapid capital outflows that could cause a loss of investor confidence and a currency crisis. This self-insurance motive has received the most attention in recent years and is often seen as one reason for the increase in global reserves since the financial crises of the late 1990s



Cost of Excess Reserves Holding cost of the excess reserves will definitely come into picture due to the size of the reserves. Reserves have a fiscal opportunity cost because they could alternatively be used to finance public capital expenditure or to pay down external debt and reduce the interest bill. In addition, they create a benefit or loss through the financial return on reserves, a lower government interest bill if reserves and interest rate spreads are negatively correlated, and often a sterilization cost. Combined, these factors can have a substantial (quasi-)fiscal impact through interest expenditure, central bank profits, andindirectlya lack of funds for public investment. Various methods have been suggested in theory: Hauner1 (2006) measured the Fiscal cost of foreign reserves for 100 countries. This is a significant technique but due to lack of data on sterilization costs and composition of various currencies in the reserves this technique has limitations. Rodrick (2006) measured the social cost as the difference between the return on the foreign currency assets (FCA) and interest rate on external commercial borrowing2. For calculating the Fiscal cost of reserves we taken the spread between weighted average of interest rate on central government dated securities (as the data on the sterilization costs is not available) and return on reserves. Below graph shows the

A Study of Adequacy, Cost and Determinants of International Reserves in India, International Research Journal of Finance and Economics - Issue 20(2008)


cost of holding these reserves in percentage of GDP terms and in terms of billion US Dollars.

For calculating the Social Cost we require the interest rate on short term external borrowings for which we dont have the exact data available. Although we can take an indicative figure from the interest rates available for long term external borrowings.



Factors that may be looked upon while deploying foreign reserves in order to mitigate sovereign risks on it

Event Study Analysis For analyzing prominent factors I have accessed event of sovereign debt crisis for 10 countries. Country Years in crisis Crisis Episode (entry-exit) Algeria 6 1991-97 Chile 8 1983-91 Costa Rica 10 1981-91 Egypt 1 1984-85 El Salvador 16 1981-97 Uruguay 2 1990-92 Russia 3 1998-01 Indonesia 1 2000-01 Mexico 1 1995-96 Thailand 1 1997-98

The potential explanatory variables are largely drawn from a list of usual suspects. In particular, I have use various measures of external debt and public debt, measures of solvency and liquidity, regressors included in the IMFs currency crisis EWS as there is a possible link between currency crisis and sovereign debt crisis, other macroeconomic variables, as well as fiscal flow variables. The various measures of external debt (including debt servicing) are relatively low in noncrisis years followed by another noncrisis year. They increase in the year before crisis entry, and most measures increase even further within crisis. The measures drop again in the year before a country exits from crisis, though they are still higher than before the crisis. The measures of public external debt follow the same pattern, suggesting that public external debt is a possible driving force behind external debt developments (as in many countries a large fraction of external debt is public external debt).


The macroeconomic variablesincluding those from the IMFs currency crisis EWSindicate a worsening of the macroeconomic situation in the run-up to a crisis and within a crisis, and an improvement in the situation when exiting from crisis. For example, the current account deficit increases in the year immediately preceding a crisis entry, stabilizes within the crisis, and improves further in the year before exiting a crisis. Real growth falters in the year before crisis entry while inflation spikes. The overall balance as well as primary balance deteriorate in the run-up to crisis. It is interesting to note that both the LIBOR as well as the U.S. treasury bill rate increase in years preceding a crisis, suggesting that tight monetary conditions in the G7 area may reduce capital flows to emerging market economies and thus contribute to debt servicing difficulties (as it happened in 1982 for example). Taken together, the descriptive statistics depict a worsening of the debt situation as well as the overall macroeconomic situation in the run-up to a crisis, and an improvement in these indicators before exiting from crisis. Of course, such descriptive statistics are suggestive at best, and the indicated relationships require more rigorous statistical or econometric testing.

Event study figures are generated through regression of the respective variable on a set of seven dummies for the three years preceding crisis entry (exit), the crisis entry (exit) year itself, and the three years following crisis entry (exit). The estimated constant is the mean of all non-default episodes, depicted as the broken horizontal line. The estimated coefficients on the dummies give the difference from the non-default episode mean to the respective event (crisis entry or exit). Hence, the mean for the respective event episode is calculated by adding the estimated constant and the estimated coefficient on the dummy. The confidence interval that indicates whether the means of the event is significantly different from the noncrisis means is calculated from the confidence interval around the estimated event episode dummies, by adding the lower and upper bound of the confidence interval to the estimated constant. This is a simple graphical representation of the test whether the coefficients on the dummies are significantly different from zero and thus whether the means of the event episodes are significantly different from the noncrisis mean.




The total external debt as well as the public external debt-to-GDP ratio increase in the run-up to a crisis and are significantly higher than during noncrisis episodes in the year before entry. In the year of exit from crisis, there is a peculiar spike. In general, both total and public external debt remain noticeably higher in crisis countries even after exiting from crisis compared to noncrisis episodes. In terms of dynamics, public external debt appears to be the driving force behind the developments of the total external debt-to-GDP ratio. Short-term external debt relative to reserves also increases in the run-up to an entry into debt crisis and is significantly higher than in noncrisis episodes in the year before entry. This holds for short-term debt on an original as well as for short-term debt on a remaining maturity basis. After entering into crisis, short-term debt falls to the level of noncrisis episodes, possibly reflecting difficulties defaulters face in borrowing externally and/or the conversion of short-term debt into longer debt in restructuring episodes. At the time of exit from crisis, short-term debt relative to reserves remains around the level observed in noncrisis episodes. Debt service on external debt relative to reserves and interest on short-term external debt relative to reserves are higher than in noncrisis episodes in the year before entry into crisis. Both indicators fall to the level of noncrisis episodes after exit from crisis. Debt service on external debt shows a little spike just before exit from crisis that could reflect resumption of payments close to the time the default episode is resolved. On the external side, the current account deficit is larger before entry into crisis than in noncrisis episodes, and reserves growth plummets in the year before entry. As the sum of the current account deficit and short-term debt, the external financing requirement relative to reserves is significantly higher in the year before entry into crisis than in noncrisis episodes. At the time of exit from crisis, these indicators fall back to levels observed during noncrisis episodes, with reserves growth spiking in the first year after exit. The exchange rate shows a large depreciation against the U.S. dollar in the year of entry into crisis (as many debt crises are associated with concomitant currency crises) and a large appreciation against the U.S. dollar in the year of exit from crisis. For entry, this depreciation contributes to the increase in total external debt relative to GDP. Domestic developments are adverse before crisis entry and show a return to normal after exit. Real GDP growth is below that observed in noncrisis episodes and plummets in the entry year, pointing to the real costs of debt crisis for the economy. With inflation rising substantially in the entry year, nominal GDP growth also jumps up. The dramatic swings in the inflation rate and the slow stabilization in the three years after exit from a crisis

point to the domestic imbalances associated with external debt crises. Interestingly, the overall budget balance in the run-up to crisis does not differ significantly from noncrisis episodes, though there seems to be a modest improvement in the overall balance before exit from crisis. Following economic indicators shows resemblances in fluctuations during debt crisis. total external debt in percent of GDP ; short-term debt on a remaining maturity basis to reserves; public external debt to revenue; inflation; exchange rate overvaluation and the number of years before a presidential election.


As per guidelines of IMF, there should be separate department in RBI for risk management. Though RBI risk management measures are taken locally at each department, the whole system should be centralized in order to evaluate risk exposure at any point of time and predict major risks. As the risk of counterfeiting or forgery is significantly high, RBI should take more efficient measures in order to mitigate that risk.

Since returns on FCA as stated by RBI are nominal INR denominated rate of returns. If same is appropriated by inflation factor (5%), it is found that these returns are negative. RBI should consider return also as an important parameter while deploying its FCA and diversify its portfolio for at least minimum return that Govt. bonds use to provide. RBI may deal in any types of derivatives in order to maximize its returns and mitigate risks.


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