Resisting temptations Guest contribution published in "Bulletin"

Benefits from the segregation of duties

At the end of March 2018, Germany’s official reserve assets were €166bn ($206bn), of which €117bn, or 70%, was invested in gold and €49bn in foreign currency reserves, including the Special Drawing Right and claims against the International Monetary Fund. These assets include a large amount of gold because of the Bundesbank’s obligation to act under various exchange rate regimes throughout the last century. Under the Bretton Woods system, foreign exchange purchases became necessary whenever the D-mark appreciated against the dollar.

The reserves also act as precautionary holdings and enhance confidence in the stability of the currency. In recent years, multilateral swap lines between the world’s major central banks have extended their capacity to provide foreign exchange liquidity and to fund intervention, such as to alleviate tensions in the financial system.

For some time, many centralbank reserve managers have been looking at alternative currencies and instruments to improve risk/return relationships. Private market participants have championed mortgage-backed securities or corporate bonds to increase returns. These investments are often outsourced to external managers. After 2008, alternative reserve assets and currencies came into greater focus among central bank reserves managers on account of the prevailing low interest rate environment, and the use of derivatives has become standard practice.

The cost of holding reserves on their balance sheets puts pressure on reserve managers to enhance returns. There is always a temptation for portfolio managers to extend the investment to achieve a better return, as they are tasked with optimising the return within a given framework. Their willingness to accept more risk is often in contrast to the overall objective of controlling risk.

These differing views are the result of a typical segregation of duties within reserve management. Ultimately, this provides stability. Since the Bundesbank has always been guided by the principles that currency reserves must remain secure and highly liquid, it has been indispensable to perform in-depth checks before new instruments and assets are adopted, rather than quickly following trends. A deviation from these principles might have resulted in more active reserve management, investments in higher-yielding asset classes or the implementation of an optimised and active investment framework. This would have generated more credit risk, more reputational risk and, in many cases, sacrificed foreign exchange liquidity.

Avoiding risk

The investment policy within the Bundesbank’s reserve management has not primarily been geared towards diversifying risk. Rather, the objective has been largely to avoid risks that are not necessarily determined by policy goals. This entails the acceptance of exchange rate risk resulting from the decision to hold reserves, and the acceptance and management of a degree of interest rate risk within currency portfolios. The experience of the financial crisis has underpinned this analysis.

Reserves need to perform under difficult circumstances and it is imperative to judge them from their performance in crisis situations. An investment policy for foreign reserves should not be procyclical. For instance, while being in line with a narrow interpretation of the IMF reserves definition, this has prevented the Bundesbank from investing its foreign exchange reserves with issuers or entities of banks in its domestic currency area. Basing an investment policy mainly on the criteria of security and liquidity could come under criticism for being too orthodox, but the resulting asset mix has served the Bundesbank well during periods of market stress.

Of course, a certain degree of optimisation was still being considered even while a careful approach was being applied. To this end, the Bundesbank reviewed its gold storage and cautiously added further currencies to its reserves – the Australian dollar was a first step.

Investment policy for the Bundesbank’s foreign reserves is based on the classic tenets of security and liquidity. The Bundesbank has been relatively immune to temptations from the asset management industry to mirror private investor behaviour. The validity of the decision cannot be tested in a normal market environment. Instead, it will be tested under stress scenarios.