Reserve Managment Framwork - Australia

8/8/2019 Reserve Managment Framwork - Australia

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Abubakar Riaz - Internee

International Market and Investments Department

State Bank of Pakistan

Karachi

Reserves

Management

Framework-Australia-

Presented to IMID

Hailey College of Commerce

University of the Punjab


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Re s e r v e M a n a g e m e n t F r a m e w o rk A u s

A b u b a k a r R i a z 2 | P a g e

AcknowledgementAll the acclamation and appreciation is for Almighty Allah the most merciful, gracious

and beneficent who isentire source of all the knowledge and wisdom endowed to mankind .

All the thanks to the name of Almighty Allah, who helped me in setting goals and objectives

and blessed me to reach the destination. Without His assistance none is capable of

accomplishment.

This report was carefully guided to me by mysupervisor Miss Asma Yousaf without

whom it would bevery difficult for me to producesuch a unique report. I w ould also like to

thank Mr. Ayaz Aijaz for giving me the outline and showing the overview perspective of

reserve framework. WhereMr. Husnain provided me with thesufficient data and I would also

like to thank to Hafiz Anwaar ul Haq for explaining me through rest of the report making

procedure.


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Re s e r v e M a n a g e m e n t F r a m e w o rk A u s t r a l i a


TABLE OF CONTENTS

EXECUTIVE SUMMARY................................ ................................ ................................ ................... 4

AUSTRALIA................................ ................................ ................................ ................................ ... 5

Objectivesofreserves management................................ ................................ ................................ ... 5

Organizational anddecision-making structure................................ ................................ .................... 6

Institutional Framework ................................ ................................ ................................ ................... 6

Organizational Structure................................ ................................ ................................ .................. 6

Decision Making ................................ ................................ ................................ .............................. 8

Active Management ................................ ................................ ................................ ......................... 9

Transparency and accountability ................................ ................................ ................................ ........ 9

Procedure Manuals................................ ................................ ................................ .......................... 9

Staffing policy ................................ ................................ ................................ ................................ .. 9

Statements ................................ ................................ ................................ ................................ .....10

Audit................................ ................................ ................................ ................................ ...............10

Capacity to Assess and Manage Risk ................................ ................................ ................................ ..10

Benchmark Portfolios................................ ................................ ................................ ......................10

Composition ofBenchmarks ................................ ................................ ................................ ...........11

Cash Repo ................................ ................................ ................................ ................................ .......12

Instruments................................ ................................ ................................ ................................ ........12

Futures Contracts ................................ ................................ ................................ ........................... 13

Stock Lending ................................ ................................ ................................ ................................ .13

Risk andperformance measurement................................ ................................ ................................ .14

Value at Risk (VaR) ................................ ................................ ................................ .......................... 14

Informationsystem ................................ ................................ ................................ ............................ 15

Glossary ................................ ................................ ................................ ................................ ............16

References ................................ ................................ ................................ ................................ ........18


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AUSTRALIA

Australias foreign currency reserves are managed by the ReserveBank of Australia

(RBA). Its Head officea

is in Sydney thevalue of gross reserves portfolios is

SD36,342 Million

on May 2010[7]

Official Reserve Assets[1]

In MillionofUS Dollars

May 2010

Official reserve 36,341.71

(1) Foreign currency reserves (in convertible foreign

currencies)

27,237.72

(a) Securities of which: issuer headquartered

in reporting country but located abroad

21,349.60

(b) total currency and deposits with: 5,888.12

(i) other national central

banks, BIS and IMF of which:

located abroad

580.18

(ii) banks headquarteredoutside the reporting country

of which: located in the

reporting country

5,307.93

(2) IMF reserve position 1,031.15

(3) SDRs 4,585.92

(4) gold (including gold deposits and, if appropriate, gold

swapped)

3,112.53

-volume in millions of fine troy

ounces

2.57

(5) other reserve assets (specify) 374.39

-financial derivatives -0.14

-other 374.54

aAustralia has three dealing centers; New York( S), London( K), Sydney(A S)


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FRAMEWORK

OBJECTIVES OF RESERVES MANAGEMENTAustralias Reserves are held for intervention purpose. The primary role of the

reserves portfolio is to fund foreign exchange market operations that arise as part of the

Banks broader monetary policy function.

Analysis:

The reserves are managed in such a manner that it gives priority to low

levels of credit risk, limited exposure to market risk, while maintaining a high

degree of liquidity. They are managed to achieve the highest returns within defined

risk parameters taking into account the need to ensure funds at short notice when

required for intervention.

ORGANIZATIONAL AND DECISION-MAKING STRUCTURE

INSTITUTIONAL FRAMEWORK

The RBAs responsibility to manage Australias foreign exchange reserves is given

through broad legislative powers that allow the Bank to buy, sell, and otherwise deal in

foreign exchange to achieve monetary policy objectives. Responsibilities are not shared with

other government agencies, reflecting the role of reserves as a source of intervention capital.

The RBA acts independently in its management decisions.

ORGANIZATIONAL STRUCTURE

Responsibility for management of reserves is delegated by the Governor of theBank

to the Financial Markets Group (FMG). Firstly international department was responsible for

both middle and front office function and back office was also located in it. As thescale of

operations increased RBA made flexibility in investment operations . [160]


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R e s e r v e M a n a g e m e n t F r a m e w o r k A u s t r a l i a

A b u b a k a r R i a z 7|P a g e

Figure 1 Organi

ational Structure

160


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DECISION MAKING

Early every transaction in reserves management had to be approved by higher

management. Later it was devised that day-to-day management of reserves should be

delegated to an Investment Committee within the Financial Markets Group. The Committee,

made up ofsenior managers from units involved in reserves management, had discretion to

take sizable positions in currency and asset allocation subject to limits approved by the

Governor. The Investment Committee meets regularly and takes positions largely based on

assessments of the medium-term macroeconomic outlook ofcountries in which the reserves

were invested.[166]

The Governor requires that reserves are accounted for in line with best practice and that the level of

transparency is consistent with that in other parts of the RBAs monetary policy operations. Senior managers

overseeing front office operations are now responsible for day-to-day management of currency and asset

allocation, maintaining the portfolio close to benchmark. They report directly to the Assistant Governor of the

Financial Markets Group. [167]

Analysis:

Approval of transaction from higher management means it maximized

control over the management process, but it makes decision making unwieldy and,

therefore, poorly suited to a more active risk management framework. It also


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constrained initiative at manager levels. So in order to move to more active

management above system was devised and a small and qualified amount of

trading discretion was delegated to managers in trading centers.

ACTIVE MANAGEMENT

No More passive management is observed. Close to benchmark.

Analysis:

Before 2000, Short term investment decision made a positive return from

market. Whereas investment position in medium term macroeconomics

development also made positive returns in some years but negative returns in

others leaving a small positive returns from this activity overall. This significantly

reduced the importance of discretionary management.[158]

TRANSPARENCY AND ACCOUNTABILITYThe RBA publishes statistical information on its reserves and foreign currency

transactions in its monthlyBulletin. Also, since 1992, the Bank has provided an overview of

reserves management operations and return relative to benchmark in its Annual Report. It is

SDDSsubscriber;Special data dissemination standards, as an IMF member country it observes

thestandards and reserves data template approved by IMFsexecutive board.

PROCEDURE MANUAL [170]A keyelement in thecontrol of operational risk has been the development of manuals

detailing investment and risk management procedures.

The manualsspecify;

y The kinds of instruments in which investmentscan be madey The risk parameters for each portfolio, andy The responsibilities ofvarious positions associated with reserves management.

They also specify how risks and returns arecalculated and how officesystemsshould

be used in specific circumstances. Procedures manuals also exist for middle and back office

staff.

STAFFING POLICY

Staffing policy is another key element. The RBA has found considerable benefit in

specialization of professional staff in operational areas. Frequently rotating staff in and out of

these areas in order to provide a breadth ofexperience was felt to be a significant constraint

on maintaining adequate levels ofexperience and knowledge. Over the past ten years, efforts

have been made to maintain a core ofexperience at senior levels within the operational areas

while, at the same time, allowing rotation at junior levels in order to build a foundation of


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experience. Compensation is reviewed regularly to ensure competitiveness with other

organizations and staff isencouraged to participate in a range ofcourses. [171]

STATEMENTSThe RBAs annual financial statements are prepared in accordance with Australian

Accounting Standards and other mandatory reporting requirements contained in the

Commonwealth Authorities andCompanies Act. Thestatements arescrutinized by an external

auditor, the Australian National Audit Office, to ensure that they comply with relevant

standards.[173]

AUDIT

Reserves management functions are audited internallyeach year in accordance with

recommended control frameworks published by the Bank for International Settlements and

requirements set out by the Australian Financial Markets Association. The internal auditreports on compliance with controls and seeks to strengthen management processes where it

sees potential for loss through inadequatecontrol.

CAPACITY TOASSESS AND MANAGE RISK

BENCHMARKPORTFOLIOS

The benchmarks represent the risk-return trade-off acceptable to the RBA over the

long term. Statistical, practical, andjudgmental factors relevant to the RBA are important in

deciding the appropriate composition and they are periodically reviewed for optimal

risk/return trade off. Mean-variance analysis in addition to judgmental factors is used indeciding on the weights assigned to the threecurrencies in the benchmark portfolio.

Thechoice of a duration benchmark of 30 months for each of the asset portfolios was

made on the basis of factorsspecific to the RBA in its responsibility for managing reserves and

analysis of risk and return for each asset.[176]

Table 1 Currency, Asset, and Duration Benchmarks

Unit d St t s Eur p Japan

Curr ncy allocation (%) 45 45 10

Ass tallocation (%) 45 45 10

Duration (Months) 30 30 30

Analysis:

With the aim of maximizing the Banks capacity to intervene, thats way its

decided that a trade weighted basket of currencies would be an appropriate

currency. The decision was taken to spread the composition across the three major

reserve currenciesthe U.S. dollar, deutschemark (later the euro), and Japanese


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Table 2. CompositionofIndividual Portfolio Benchmarks[179]

United States Europe Japan

AssetClass % of

Total

AssetClass % of

Total

AssetClass % of

TotalDeposits 22 Deposits 30 Deposits 22

Treasury bills 21 Treasury bills 15 Treasury bills 33

Treasury Notes 57 Bonds 55 Bonds 45

Analysis:

The desire to maintain a liquid and secure portfolio led the RBA to limit its

benchmark investments to government securities and cash instruments. Typically,

some 75 to 80 percent of the RBAs benchmark foreign investment portfolios are

held in government paper.For the European portfolio, the RBA has decided on a combination of French

and German government securities as the best structure to satisfy requirements for

credit risk and liquidity. In order to limit exposure to price risk, the maximum

maturity of securities holdings is restricted to 10 years in each portfolio.

CASH REPO

Cash invested under repurchase agreements (repo) and deposits with highly rated

banks make up the balance of the asset benchmarks.

Analysis:

The RBA has found the short duration offered by deposits to be attractive in

markets where access to short-term government debt was limited. They have also

been a good, immediate source of liquid funds during episodes of currency

intervention. That said, the proportion of foreign exchange reserves invested in

deposits has declined in recent years, reflecting tighter credit constraints and

changes in cash management practices. The RBA now makes greater use of cash

repo, which has the security advantage of being collateralized with government

securities. [181]

INSTRUMENTSIn addition to the assets held in the benchmark portfolios, the RBAs dealing centers

have discretion to hold a small range of other highly rated instruments.

These include the[183]

y U.K. Gilts,


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y Dutch and Swiss government paper,y Deposits and medium-term notes issued by the Bank for International

Settlements.

Analysis:

With the exception of BIS deposits, these investments have accounted for a

negligible share of total holdings. Discretion to hold U.K., Dutch, and Swiss paper is

a remnant of a period in the 1980s when the composition of Australias official

foreign currency liabilities influenced the composition of the reserves portfolio.

Discretion also exists to hold U.S. Federal Agency debt in the U.S. portfolio as a

source of return enhancement. Total holdings are restricted to a maximum of

US$500 million. [183]

FUTURES

CONTRACTS

In 1994, theBank began trading interest ratefuturescontracts. Futures trading havebeen concentrated in theEuropean and Japanese portfolios. The RBA does not use any over -

the-counter or exchange-traded options in its reserves management activities.

Analysis:

The decision for futures trading was driven by a desire to improve

management of market risk and, in particular, to provide a liquid hedging

instrument to minimize the risk of capital losses when interest rates were rising. An

additional attraction of using futures was the greater liquidity and flexib ility that

they provide in some markets when implementing investment strategies. Some

futures markets are more liquid than their underlying physical bond markets in that

the bid-offer spread is usually much narrower.[184]

STOCKLENDING

Stocklending is also an activity undertaken by the dealing centers.

Analysis:

As stock lending, particularly from the U.S. portfolio has risen to be a majorcomponent of return enhancement. Though the back office workload associated

with this activity can be large. The RBA sees this activity as relatively low risk.


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RISK AND PERFORMANCE MEASUREMENTMarket risk and return enhancement are measured relative to the benchmark

portfolios. For currency and asset allocation, Currency and asset positions are managed

separately within the discretionary band through the use of foreign currency swaps. Thecost/benefit of these swaps is taken into account when measuring the performance of the

asset and currency positions relative to benchmark. Foreign exchange dealers in each of the

three dealing centers have a small amount of discretion set in terms of a maximum open

position that falls within the 1 percent discretionary limit on currency allocation. Breaches of

the limit are reported to Assistant Governor on the day they occur. The dealing centers are

also required to report daily losses that exceed US$1 million to senior management in the

Financial Markets Group.

Analysis:

Risk measurement and trading discretion around the duration benchmark

for each asset portfolio are based on the concept of dollars-at risk. This is the

change in portfolio value arising from a one basis point change in yield. Within each

of the portfolios, the dealing centers are required to maintain dollars-at-risk to

within US$70,000 per basis point at all times. This limit applies to the aggregate

position of the portfolio and to the position undertaken in each maturity bucket of

the portfolio in order to control the amount of curve risk. [187]

VALUE AT RISK(VAR)

The VaR number represents the portfolio loss the RBA could incur once every 20

business days in normal market conditions. Two VaR measures arecalculated each dayonebased on thecorrelation method and the other based on historical simulation methodology.

The assumptions underlying these VaR methodologies are reviewed periodically and their

performance is tested regularly. In accordance with best practice, the RBA also stress tests

the portfolio. This involves simulating and evaluating the impact of extreme market

movements on thevalue of the portfolio.[189]

Analysis:

The dollars-at-risk measure also forms the basis of the Value-at-Risk (VaR)

methodology, which the RBA has used since 1995 to estimate the consolidatedexposure of the Banks foreign currency reserves to market risk. Though the overall

limits to control market riski.e., the discretionary trading bands around the

benchmarkare not defined in terms of VaR, the RBA has found that it nonetheless

provides a useful tool for conveying information about the overall portfolio

exposure to senior management and staff involved in reserves management.[189]


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INFORMATION SYSTEM [190]All international transactionsentered into by the RBA are processed through a main-

frame electronic Global Trading and Settlement System (GTS). This system has been

developed by an external software provider to their specifications.


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Glossary

Back office. The area of reserve

management operations responsible for

confirmation, settlement and in many

cases, reconciliation of reserve

management transactions.

Benchmark. The mix of currencies,

investment instruments, and duration that

reflect the reserve managers tolerance for

exposure to liquidity, credit, and marketrisks.

Benchmark portfolio. A preset list of

securities to be used to compare the

performance of an actual portfolio.[3]

Cash repo. A Repurchase agreement (also

known as a repo or Sale and Repurchase

Agreement) allows a borrower to use a

financial security as collateral for a cash

loan at a fixed rate of interest. In a repo,the borrower agrees to sell immediately a

security to a lender and also agrees to buy

the same security from the lender at a

fixed price at some later date. A repo is

equivalent to a cash transaction combined

with a forward contract.[4]

Credit risk. Probability of loss from a

debtor's default. In banking, credit risk is a

major factor in determination of interest

rate on a loan: longer the term of loan,usually higher the interest rate. Also called

credit exposure.[3]

Foreign exchange reserves. Thoseexternal

assets that are readily available to and

controlled by monetary authorities for

direct financing of 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.

Front office. The area responsible for

initiating investment transactions in

accordance with approved delegations,

limits, and benchmarks and the prompt

and accurateentry of transactions into the

investment management system.

Futures contracts. A contractual

agreement, generally made on the trading

floor of a futuresexchange, to buy or sell a

particular commodity or financial

instrument at a pre-determined price in

the future. Futures contracts detail the

quality and quantity of the underlying

asset; they are standardized to facilitate

trading on a futures exchange. Some

futures contracts may call for physicaldelivery of the asset, while others are

settled in cash.[2]

Middle office. Located between the front

and back offices, the middle offices role is

to monitor that all transactions have been

performed properly, that risks are being

monitored and limits observed, and that

relevant information is available for

management.

Reserve management. The process by

which publicsector assets are managed in

a manner that provides for the ready

availability of funds, the prudent

management of risks, and the generation

of a reasonable return on the funds

invested.


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Stock lending. The act of loaning a stock,

derivative, or other security to an investor

or firm. Securities lending requires the

borrower to put up collateral, whether

cash, security, or a letter of credit. Thecompletion of this transaction requires a

securities lending agreement, which s tates,

among other things, how long the loan

lasts, what fee the lender receives, and the

amount and type ofcollateral.[5]

SDDS. The Special Data Dissemination

Standard (SDDS) was established by the

International Monetary Fund (IMF/Fund)

to guide members that have, or that might

seek, access to international capitalmarkets in the provision of their economic

and financial data to the public. Both the

General Data Dissemination System

(GDDS) and the SDDS are expected to

enhance the availability of timely and

comprehensive statistics and therefore

contribute to the pursuit of sound

macroeconomic policies; the SDDS is also

expected to contribute to the improved

functioning of financial markets. [6]

Stress Testing. A simulation technique

used on asset and liability portfolios to

determine their reactions to different

financial situations. Stress tests are alsoused to gauge how certain stressors will

affect a company or industry. They are

usually computer-generated simulation

models that test hypothetical scenarios.

Stress testing is a useful method for

determining how a portfolio will fare

during a period of financial crisis. The

Monte Carlo simulation is one of the most

widely used methods ofstress testing. [2]

Value atRisk VaR. A technique used toestimate the probability of portfolio losses

based on the statistical analysis of

historical price trends and volatilities. VaR

iscommonly used by banks, security firms

and companies that are involved in trading

energy and other commodities. VaR is able

to measure risk while it happens and is an

important consideration when firms make

trading or hedging decisions.[2]


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Reserve Managment Framwork - Australia