## 1. A Taxonomy of Constraints for Institutional Asset Owners ## Source details **Canonical URL:** [1. A Taxonomy of Constraints for Institutional Asset Owners](https://www.imf.org/-/media/files/publications/wp/2018/wp1831.pdf) ## Other formats - [Markdown version](/-/media/files/publications/wp/2018/wp1831.pdf.md) - [Structured JSON version](/-/media/files/publications/wp/2018/wp1831.pdf.json) --- ### I. Introduction — context and key lesson - Historical posture: central bank reserve management was traditionally conservative, focused on non-yielding bullion and short-term bills, operational cost control, and administrative duties. - Shift post-Bretton Woods and before the 2008 crisis: - Unprecedented growth in reserve assets and increasing concentration. - Greater risk tolerance and convergence toward private institutional investor behavior. - Core argument/lesson from the global financial crisis: - Rational panic behavior by individual reserve managers (cutting security losses, pulling unsecured bank funding, demanding liquidity) can amplify negative externalities for the international financial system when: - International reserve assets are large and concentrated; and - Portfolio actions by reserve managers synchronize procyclically with each other and with private investors. - The stabilization burden can increase on central banks of reserve-currency issuing countries. ### II. The evolution of reserve management — institutional drivers and practices - Institutional constraints and objectives: - Reserve managers are liability-driven, with strong emphasis on liquidity and safety. - Motives for holding reserves: precautionary insurance (defend exchange rate, emergency FX liquidity assistance, lean against disorderly markets) and operational functions (international payments, collateral for borrowing, monetary operations). - When reserves are surplus to liability-hedging needs, opportunity costs rise and risk tolerance increases. - Observable changes in reserve management practices (convergence with private institutional investors): - Growing allocations to higher-yielding and more complex asset classes. - More prevalent use of derivatives in tactical overlays and tactical trading strategies. - Use of securities lending programs to enhance returns on high-quality low-yielding securities. - Greater reliance on specialist external asset managers. - Increased tranching of reserves into short-term liquidity and longer-term investment portfolios. - Rising interest in total return (benchmark-agnostic) strategies. ### III. Procyclical reserve management in the crisis — documented behaviors and impacts - Massive retrenchment of deposits with foreign commercial banks: - From Q2-2007 to Q4-2010, reserve manager deposits with foreign commercial banks more than halved, a decline of more than US$300 billion. - Around half of surveyed central banks pulled deposits; 85 percent reduced deposit terms to facilitate withdrawals at short notice. - BIS reduced uncollateralized exposure to commercial banks by around US$140 billion in the year to Q1-2009. - Heavy net sales of U.S. government agency debt and other short-dated spread product: - Combined holdings of agency debentures and bills were cut by US$360 billion, or more than half, over the two years to June 2010. - Treasury bill holdings surged from US$177 billion in December 2006 to a peak of US$607 billion in August 2009. - Share of total outstanding Treasury bills held by foreign official investors rose from 19 to 29 percent. - Forced sales and suspension of rebalancing due to reliance on credit ratings: - Percentage of central banks deeming bank debt, mortgage and asset backed securities investable fell by around half relative to 2007 levels. - Around one third of surveyed central banks cut exposure to government bonds that were downgraded. - Rating downgrades were the leading trigger for major asset allocation changes. - Curtailment of externally managed securities lending programs: - Securities lending programs fell from US$340 billion in August 2008 to US$150 billion in the first half of 2009. - Between one quarter and one half of lending programs were shut down entirely or materially de-risked. - Shifts in gold holdings: - Central banks turned from net sellers to net buyers of gold during QE; EM central banks accounted for 10–15 percent of total incremental world gold demand. - Signaling and coordination failures: - Just over half of surveyed reserve managers conceded their crisis responses highlighted a policy conflict between stabilization objectives and their own investment actions. - Few surveyed reserve managers, particularly in EM, contacted reserve-issuing central banks before reallocating assets during the crisis. ### IV. Looking ahead — balance of vulnerabilities since the crisis - Grounds for cautious optimism (post-crisis improvements): - Reduced uncollateralized deposit exposure: - Deposits with foreign commercial banks fell from 15 percent of portfolios in 2006 to 3 percent. - Deposits at other central banks and the BIS rose from 2 to 7 percent. - Greater attention to contingent liquidity needs and liquidity buffers; improved understanding of liquidity vs. credit risk. - Expansion of swap-line network from temporary bilateral lines to a broader standing network among six central banks (Bank of Canada, Bank of England, Bank of Japan, European Central Bank, the Federal Reserve, Swiss National Bank) and other open-ended arrangements. - Improved oversight of securities lending: focus on reinvestment risk, prescriptive eligibility, intrusive supervision, and stronger counterparty controls. - Accounting changes (IAS39 to IFRS9) may moderate procyclicality: - IFRS9 allows forward-looking credit loss provisioning and removes the ‘tainting rule’ that forced mark-to-market of entire hold-to-maturity portfolios after a single pre-maturity sale. - Remaining and emerging vulnerabilities: - Rising size and concentration of reserves: - Foreign exchange reserves have risen 55 percent, or US$4 trillion, since Q1-2009. - The share of global reserves overseen by a small number of countries has again risen: three countries manage nearly half, and ten nearly three-quarters. - Elevated foreign official ownership shares in key asset classes: - Foreign official ownership share of U.S. sovereign debt remains elevated. - Ownership share has risen for non-traditional reserve issuing country debt and is rising in riskier (procyclical) asset classes. - Growing exposure to non-traditional reserve currencies: - Share of world FX reserves in non-traditional currencies (e.g., AUD, CAD, RMB) has risen (figures shown for 2007–2017). - Reach for yield and duration extension: - Foreign official duration exposure in the U.S. rose for both U.S. Treasuries and U.S. spread product (agencies, corporates, MBS/ABS); share of holdings > 1 year maturity increased. - Approved asset classes for reserve managers expanded over time (1999–2017), including equities. - Limited reduction in mechanistic reliance on credit ratings: - More than 80 percent of respondents indicated FSB/G20 Principles had not changed their investment policies; three quarters reported not reducing reliance on ratings. - Just under half of reserve managers continue automatic divestment when minimum credit thresholds (typically double-A or single-A) are breached. - Uncertainties over swap-line effectiveness: - Effectiveness depends on operational readiness, conditionality, political constraints; historical initiatives (e.g., Chiang Mai) show mixed activation records. - Evidence of persistent dysfunction in FX swap markets (wide cross-currency basis) and less appetite among central banks to intervene via swap lines. - Evidence from post-crisis mini-shocks: - In episodes of euro area breakup concerns (2011), taper tantrum (2013), and RMB ‘devaluation’ (2015), reserve managers again sold risk assets and withdrew deposits from foreign commercial banks—though on a smaller scale than during the global financial crisis—suggesting moderation but not elimination of procyclical tendencies. ### V. Dampening procycality — what can be done? - Corner solution: - Purge credit and liquidity risk from reserve portfolios and manage them exclusively in savings-based SWFs with a single objective function (return generation). - Caveats: may be impractical, raise intractable institutional design issues, or not materially change procyclical investment impulses. - Principle: - Bolster resilience by taking remedial steps ahead of trouble so reserve managers are not left with suboptimal crisis choices that exacerbate tensions between domestic and international financial stability. Governance and communication challenges - Finding: - Holding procyclical exposures through-the-cycle requires governance able to accommodate periods of volatility, especially as reserve growth increases sensitivity of central bank profits and capital to portfolio valuation fluctuations. - Behavioral/incentive problem: - Asymmetric reputational outcomes (quiet praise for profits; loud criticism for losses) can entrench herd behavior in stress. - Two elements to address sensitivities: - Internal: increase formal engagement of the executive when strategic reserve decisions (definition of investable universe, target allocations, delegation and counterparty guidelines, etc.) are framed in the context of acceptable institution-wide risk-return trade-offs so reserve managers have confidence of institutional support for actions that may generate valuation losses. - External: adopt a policy of preemptive external stakeholder engagement to communicate the rationale for accepting certain risks and the volatility/unrealized losses the institution may experience over a cycle to mitigate knee-jerk reactions and threats to political independence. - Disclosure tradeoff: - Optimize between legitimacy-enhancing transparency and the pressure to divest rationally held exposures in times of stress. - Observations: - There are no internationally binding disclosure practices for reserve management; practices are left to national authorities. - The IMF’s Special Data Dissemination Standard (SDDS), Guidelines on Foreign Exchange Reserve Management, and Code of Good Practices on Transparency in Monetary and Financial Policies come closest. Tranching - Finding: - More central banks reported problems with the liquidity of their reserves than with the level per-se. - Recommendation: - Tranch reserves into liability-immunizing and riskier investment portfolios with careful calibration. - Warning: - Too few resources in the liability-immunizing tranche forces sales of less liquid, procyclical assets at the worst time. - Implementation notes: - Estimate tail risk and regime-switching variables like market liquidity, and strengthen analysis of time-varying microstructure conditions. - Use stepped up market surveillance and formal portfolio stress testing techniques. Procyclical risk management and rebalancing - Finding: - Crisis-era reliance on inputs tightly covarying with the economic cycle—credit ratings, CDS spreads, price volatility—drove forced selling and increased concentration risk. - Alternatives: - Combine procyclical indicators with slower-moving fundamental inputs in risk management and benchmarking. - Use threshold breaches to trigger risk reviews rather than automatic selling. - Spread asset sales across a rating corridor rather than concentrating sales at a single binary threshold. - Guiding quote (from IMF Revised Guidelines for FX Reserve Management): - “The management of credit risk should aim at not relying solely and automatically on the assessment of credit rating agencies. Reserve managers that have the capacity need to internally analyze and understand the amount of credit risk to which they may be exposed as a result of reserve management activities, in order to avoid overreliance on credit rating agencies. Accordingly, they may put in place internal credit risk assessment systems for assessing and monitoring their counterparties—both sovereign and non-sovereign.” Customized benchmarks - Problem: - Capitalization-weighted benchmarks embed procyclicality; in fixed income, heavily indebted issuers attract the most capital. - Recommendation: - Allow deviation from cap-weights via: - Discretionary tactical decisions (subject to constraints), or - Customized benchmarks calibrated to the central bank’s liability profile and preferences. - Trade-offs: - Active management: informative for market surveillance but empirical record mostly unpersuasive and vulnerable to behavioral biases. - Customized benchmarks: transparent, scalable, immune to emotional vagaries, and better align institutional expectations with outcomes. Duration targets - Finding: - When duration targets are set on fixed return objectives rather than liability hedging, this can lead to maximum risk taking when spreads are tightest and policy rates lowest. - Recommendation: - Let the structure of liabilities be the key determinant of duration exposure, especially in hedging portfolios. - Periodically reset return targets for riskier investment portfolios in the context of prevailing risk-free yields to reduce pressure to reach for yield. Countercyclicality - Public policy case: - Leaning into persistent flow imbalances in reserve currencies can be beneficial. - Example: - A wide cross currency basis from imbalanced market conditions (one-way flows) can make hedging costs prohibitive and prompt unhedged currency risk-taking by investors and corporations. - Recommendation: - By leaning into a widening basis, reserve managers can harvest additional yield in reserve currencies and help rebalance markets, encouraging prudent hedging of cross-border capital flows. - Empirical note: - “Around one quarter of surveyed reserve managers have done just this since 2016 (Carver and Glass, 2017).” Vulnerabilities and contextual observations - Footnote evidence: - Large official sector sales of U.S. Treasuries during the 2015 RMB devaluation scare reportedly exceeded $200bn, but TIC data point to a decline in combined official and private Chinese holdings of Treasuries of just $32bn during the period. - Underprovisioning concern: - Sharp increase in foreign currency borrowing by EM corporates since the crisis raises sudden stop risk for large firms lacking formal ex-ante access to central bank liquidity facilities but that may receive support in extremis. - Limitation: - Foreign exchange swaps, as a form of foreign debt, cannot replace fundamental balance of payments adjustment; their treatment in restructuring and Fund-supported programs has yet to be determined. ### VI. Conclusion - Summary findings: - Reserve managers’ procyclical actions during the global financial crisis inadvertently likely made stabilization efforts of reserve-currency issuing central banks more difficult (even if at the margin). - Some grounds for cautious optimism exist, but vulnerabilities suggest a benign outcome in the next period of financial turbulence cannot be assured. - Policy implication: - As reserve management evolves toward increased size, risk taking and complexity, policy advice must adapt. - There are formidable difficulties provisioning for crisis-like environments; most central banks lack established track records managing considerable investment and illiquidity risk and the related governance challenges. - Research agenda: - Further guidance on ‘constrained discretion’ principles for reserve management and analysis of conditions under which synchronized investment practices of reserve managers reinforce private institutions’ actions are worthy avenues for future research. - Ongoing challenge: - Ensure reserve managers take measures in good times that permit smoother navigation through periods of turmoil. *Source: IMF Working Paper wp1831 — 1. A Taxonomy of Constraints for Institutional Asset Owners (chapter and references).* ### 1. A Taxonomy of Constraints for Institutional Asset Owners .................................................7 ### 1. A Taxonomy of Constraints for Institutional Asset Owners ### Figures included in the chapter - Figure 1. Official World Foreign Exchange Reserve Holdings - Figure 2. Central Bank Exposures to Foreign Commercial and Central Banks - Figure 3. Decline in Bank Deposits of Official Monetary Authorities - Figure 4. Foreign Official Net Purchases of U.S. Securities - Figure 5. Approved Asset Classes for Reserve Managers - Figure 6. Trigger for Major Asset Allocation Changes by Reserve Managers in the Crisis - Figure 7. Gold Prices and Central Bank Gold Holdings - Figure 8. Reserve Manager Deposits - Figure 9. Concentration of World FX Reserve Holdings - Figure 10. Foreign Official Ownership Share of Market Cap - Figure 11. Foreign Official Ownership Share of Sovereign Debt - Figure 12. Foreign Official Ownership Share of Sovereign Debt: Procyclical Asset Classes - Figure 13. Share of World FX Reserves: Non-Traditional Currencies - Figure 14. Foreign Official Duration Exposure in the U.S. - Figure 15. Approved Asset Classes for Reserve Managers - Figure 16. Official Net Flows in Stress Events ### Implied focal areas (based on figure topics) - Measurement and composition of official world foreign exchange (FX) reserve holdings. - Exposure channels between central banks and foreign commercial and central banks. - Dynamics of official monetary authorities’ bank deposits. - Foreign official flows into U.S. securities and sovereign debt. - Approved asset classes and allocation decision triggers for reserve managers, including crisis responses. - Role of gold: prices and central bank holdings. - Concentration and currency composition of world FX reserves, including non-traditional currency shares. - Foreign official ownership shares across market capitalization and sovereign debt, with attention to procyclical asset classes. - Duration exposure of foreign official holders in the U.S. market. - Official net flows during stress events. ### Structural notes for AI ingestion - The chapter is heavily figure-driven; each listed figure captures a distinct empirical or institutional dimension relevant to institutional asset owners and reserve management. - Two figures repeat the theme "Approved Asset Classes for Reserve Managers" (Figures 5 and 15), indicating emphasis on permissible investment universes. - Comparisons across ownership shares, concentration, and flows suggest analysis of systemic implications of official asset management behaviors. *Source: wp1831 - 1. A Taxonomy of Constraints for Institutional Asset Owners (chapter figures list).* ### References ............................................................................................................. ### wp1831 - References ............................................................................................................. ### I. Introduction — context and key lesson - Historical posture: central bank reserve management was traditionally conservative, focused on non-yielding bullion and short-term bills, operational cost control, and administrative duties. - Shift post-Bretton Woods and before the 2008 crisis: - Unprecedented growth in reserve assets and increasing concentration. - Greater risk tolerance and convergence toward private institutional investor behavior. - Core argument/lesson from the global financial crisis: - Rational panic behavior by individual reserve managers (cutting security losses, pulling unsecured bank funding, demanding liquidity) can amplify negative externalities for the international financial system when: - International reserve assets are large and concentrated; and - Portfolio actions by reserve managers synchronize procyclically with each other and with private investors. - The stabilization burden can increase on central banks of reserve-currency issuing countries. ### II. The evolution of reserve management — institutional drivers and practices - Institutional constraints and objectives: - Reserve managers are liability-driven, with strong emphasis on liquidity and safety. - Motives for holding reserves: precautionary insurance (defend exchange rate, emergency FX liquidity assistance, lean against disorderly markets) and operational functions (international payments, collateral for borrowing, monetary operations). - When reserves are surplus to liability-hedging needs, opportunity costs rise and risk tolerance increases. - Observable changes in reserve management practices (convergence with private institutional investors): - Growing allocations to higher-yielding and more complex asset classes. - More prevalent use of derivatives in tactical overlays and tactical trading strategies. - Use of securities lending programs to enhance returns on high-quality low-yielding securities. - Greater reliance on specialist external asset managers. - Increased tranching of reserves into short-term liquidity and longer-term investment portfolios. - Rising interest in total return (benchmark-agnostic) strategies. ### III. Procyclical reserve management in the crisis — documented behaviors and impacts - Summary of procyclical behaviors during the global financial crisis and magnitudes: - Massive retrenchment of deposits with foreign commercial banks: - From Q2-2007 to Q4-2010, reserve manager deposits with foreign commercial banks more than halved, a decline of more than US$300 billion. - Around half of surveyed central banks pulled deposits; 85 percent reduced deposit terms to facilitate withdrawals at short notice. - BIS reduced uncollateralized exposure to commercial banks by around US$140 billion in the year to Q1-2009. - Heavy net sales of U.S. government agency debt and other short-dated spread product: - Combined holdings of agency debentures and bills were cut by US$360 billion, or more than half, over the two years to June 2010. - Treasury bill holdings surged from US$177 billion in December 2006 to a peak of US$607 billion in August 2009. - Share of total outstanding Treasury bills held by foreign official investors rose from 19 to 29 percent. - Forced sales and suspension of rebalancing due to reliance on credit ratings: - Percentage of central banks deeming bank debt, mortgage and asset backed securities investable fell by around half relative to 2007 levels. - Around one third of surveyed central banks cut exposure to government bonds that were downgraded. - Rating downgrades were the leading trigger for major asset allocation changes. - Curtailment of externally managed securities lending programs: - Securities lending programs fell from US$340 billion in August 2008 to US$150 billion in the first half of 2009. - Between one quarter and one half of lending programs were shut down entirely or materially de-risked. - Shifts in gold holdings: - Central banks turned from net sellers to net buyers of gold during QE; EM central banks accounted for 10–15 percent of total incremental world gold demand. - Signaling and coordination failures: - Just over half of surveyed reserve managers conceded their crisis responses highlighted a policy conflict between stabilization objectives and their own investment actions. - Few surveyed reserve managers, particularly in EM, contacted reserve-issuing central banks before reallocating assets during the crisis. ### IV. Looking ahead — balance of vulnerabilities since the crisis - Grounds for cautious optimism (post-crisis improvements): - Reduced uncollateralized deposit exposure: - Deposits with foreign commercial banks fell from 15 percent of portfolios in 2006 to 3 percent. - Deposits at other central banks and the BIS rose from 2 to 7 percent. - Greater attention to contingent liquidity needs and liquidity buffers; improved understanding of liquidity vs. credit risk. - Expansion of swap-line network from temporary bilateral lines to a broader standing network among six central banks (Bank of Canada, Bank of England, Bank of Japan, European Central Bank, the Federal Reserve, Swiss National Bank) and other open-ended arrangements. - Improved oversight of securities lending: focus on reinvestment risk, prescriptive eligibility, intrusive supervision, and stronger counterparty controls. - Accounting changes (IAS39 to IFRS9) may moderate procyclicality: - IFRS9 allows forward-looking credit loss provisioning and removes the ‘tainting rule’ that forced mark-to-market of entire hold-to-maturity portfolios after a single pre-maturity sale. - Remaining and emerging vulnerabilities: - Rising size and concentration of reserves: - Foreign exchange reserves have risen 55 percent, or US$4 trillion, since Q1-2009. - The share of global reserves overseen by a small number of countries has again risen: three countries manage nearly half, and ten nearly three-quarters. - Elevated foreign official ownership shares in key asset classes: - Foreign official ownership share of U.S. sovereign debt remains elevated. - Ownership share has risen for non-traditional reserve issuing country debt and is rising in riskier (procyclical) asset classes. - Growing exposure to non-traditional reserve currencies: - Share of world FX reserves in non-traditional currencies (e.g., AUD, CAD, RMB) has risen (figures shown for 2007–2017). - Reach for yield and duration extension: - Foreign official duration exposure in the U.S. rose for both U.S. Treasuries and U.S. spread product (agencies, corporates, MBS/ABS); share of holdings > 1 year maturity increased. - Approved asset classes for reserve managers expanded over time (1999–2017), including equities. - Limited reduction in mechanistic reliance on credit ratings: - More than 80 percent of respondents indicated FSB/G20 Principles had not changed their investment policies; three quarters reported not reducing reliance on ratings. - Just under half of reserve managers continue automatic divestment when minimum credit thresholds (typically double-A or single-A) are breached. - Uncertainties over swap-line effectiveness: - Effectiveness depends on operational readiness, conditionality, political constraints; historical initiatives (e.g., Chiang Mai) show mixed activation records. - Evidence of persistent dysfunction in FX swap markets (wide cross-currency basis) and less appetite among central banks to intervene via swap lines. - Evidence from post-crisis mini-shocks: - In episodes of euro area breakup concerns (2011), taper tantrum (2013), and RMB ‘devaluation’ (2015), reserve managers again sold risk assets and withdrew deposits from foreign commercial banks—though on a smaller scale than during the global financial crisis—suggesting moderation but not elimination of procyclical tendencies. *Source: IMF Working Paper (content unit: wp1831 - References).* ### conclusions. An optimistic interpretation would be that the reduced magnitude of procyclical ### wp1831 - conclusions. An optimistic interpretation would be that the reduced magnitude of procyclical ### V. Dampening procyclicality—what can be done? - Corner solution: - Purge credit and liquidity risk from reserve portfolios and manage them exclusively in savings-based SWFs with a single objective function (return generation). - Caveats: may be impractical, raise intractable institutional design issues, or not materially change procyclical investment impulses. - Principle: - Bolster resilience by taking remedial steps ahead of trouble so reserve managers are not left with suboptimal crisis choices that exacerbate tensions between domestic and international financial stability. ### Governance and communication challenges - Finding: - Holding procyclical exposures through-the-cycle requires governance able to accommodate periods of volatility, especially as reserve growth increases sensitivity of central bank profits and capital to portfolio valuation fluctuations. - Behavioral/incentive problem: - Asymmetric reputational outcomes (quiet praise for profits; loud criticism for losses) can entrench herd behavior in stress. - Two elements to address sensitivities: - Internal: increase formal engagement of the executive when strategic reserve decisions (definition of investable universe, target allocations, delegation and counterparty guidelines, etc.) are framed in the context of acceptable institution-wide risk-return trade-offs so reserve managers have confidence of institutional support for actions that may generate valuation losses. - External: adopt a policy of preemptive external stakeholder engagement to communicate the rationale for accepting certain risks and the volatility/unrealized losses the institution may experience over a cycle to mitigate knee-jerk reactions and threats to political independence. - Disclosure tradeoff: - Optimize between legitimacy-enhancing transparency and the pressure to divest rationally held exposures in times of stress. - Observations: - There are no internationally binding disclosure practices for reserve management; practices are left to national authorities. - The IMF’s Special Data Dissemination Standard (SDDS), Guidelines on Foreign Exchange Reserve Management, and Code of Good Practices on Transparency in Monetary and Financial Policies come closest. ### Tranching - Finding: - More central banks reported problems with the liquidity of their reserves than with the level per-se. - Recommendation: - Tranch reserves into liability-immunizing and riskier investment portfolios with careful calibration. - Warning: too few resources in the liability-immunizing tranche forces sales of less liquid, procyclical assets at the worst time. - Implementation notes: - Estimate tail risk and regime-switching variables like market liquidity, and strengthen analysis of time-varying microstructure conditions. - Use stepped up market surveillance and formal portfolio stress testing techniques. ### Procyclical risk management and rebalancing - Finding: - Crisis-era reliance on inputs tightly covarying with the economic cycle—credit ratings, CDS spreads, price volatility—drove forced selling and increased concentration risk. - Alternatives: - Combine procyclical indicators with slower-moving fundamental inputs in risk management and benchmarking. - Use threshold breaches to trigger risk reviews rather than automatic selling. - Spread asset sales across a rating corridor rather than concentrating sales at a single binary threshold. - Guiding quote (from IMF Revised Guidelines for FX Reserve Management): - “The management of credit risk should aim at not relying solely and automatically on the assessment of credit rating agencies. Reserve managers that have the capacity need to internally analyze and understand the amount of credit risk to which they may be exposed as a result of reserve management activities, in order to avoid overreliance on credit rating agencies. Accordingly, they may put in place internal credit risk assessment systems for assessing and monitoring their counterparties—both sovereign and non-sovereign.” ### Customized benchmarks - Problem: - Capitalization-weighted benchmarks embed procyclicality; in fixed income, heavily indebted issuers attract the most capital. - Recommendation: - Allow deviation from cap-weights via: - Discretionary tactical decisions (subject to constraints), or - Customized benchmarks calibrated to the central bank’s liability profile and preferences. - Trade-offs: - Active management: informative for market surveillance but empirical record mostly unpersuasive and vulnerable to behavioral biases. - Customized benchmarks: transparent, scalable, immune to emotional vagaries, and better align institutional expectations with outcomes. ### Duration targets - Finding: - When duration targets are set on fixed return objectives rather than liability hedging, this can lead to maximum risk taking when spreads are tightest and policy rates lowest. - Recommendation: - Let the structure of liabilities be the key determinant of duration exposure, especially in hedging portfolios. - Periodically reset return targets for riskier investment portfolios in the context of prevailing risk-free yields to reduce pressure to reach for yield. ### Countercyclicality - Public policy case: - Leaning into persistent flow imbalances in reserve currencies can be beneficial. - Example: - A wide cross currency basis from imbalanced market conditions (one-way flows) can make hedging costs prohibitive and prompt unhedged currency risk-taking by investors and corporations. - Recommendation: - By leaning into a widening basis, reserve managers can harvest additional yield in reserve currencies and help rebalance markets, encouraging prudent hedging of cross-border capital flows. - Empirical note: - “Around one quarter of surveyed reserve managers have done just this since 2016 (Carver and Glass, 2017).” ### Vulnerabilities and contextual observations - Footnote evidence: - Large official sector sales of U.S. Treasuries during the 2015 RMB devaluation scare reportedly exceeded $200bn, but TIC data point to a decline in combined official and private Chinese holdings of Treasuries of just $32bn during the period. - Underprovisioning concern: - Sharp increase in foreign currency borrowing by EM corporates since the crisis raises sudden stop risk for large firms lacking formal ex-ante access to central bank liquidity facilities but that may receive support in extremis. - Limitation: - Foreign exchange swaps, as a form of foreign debt, cannot replace fundamental balance of payments adjustment; their treatment in restructuring and Fund-supported programs has yet to be determined. ### VI. Conclusion - Summary findings: - Reserve managers’ procyclical actions during the global financial crisis inadvertently likely made stabilization efforts of reserve-currency issuing central banks more difficult (even if at the margin). - Some grounds for cautious optimism exist, but vulnerabilities suggest a benign outcome in the next period of financial turbulence cannot be assured. - Policy implication: - As reserve management evolves toward increased size, risk taking and complexity, policy advice must adapt. - There are formidable difficulties provisioning for crisis-like environments; most central banks lack established track records managing considerable investment and illiquidity risk and the related governance challenges. - Research agenda: - Further guidance on ‘constrained discretion’ principles for reserve management and analysis of conditions under which synchronized investment practices of reserve managers reinforce private institutions’ actions are worthy avenues for future research. - Ongoing challenge: - Ensure reserve managers take measures in good times that permit smoother navigation through periods of turmoil. *Source: IMF Working Paper wp1831 — conclusions.* ### REFERENCES ### wp1831 - REFERENCES ### Reserve management frameworks and risk management - Aliber, Robert Z., 2011, “Financial Turbulence and International Investment,” BIS Papers No 58, in ‘Portfolio and Risk Management for Central Banks and Sovereign Wealth Funds,’ Proceedings of a Joint Conference Organised by the BIS, ECB and World Bank, Basel. - Bernadell, Carlos, Pierre Cardon, Joachim Coche, Francis X. Diebold, and Simone Manganelli, 2004, “Risk Management for Central Bank Foreign Reserves,” European Central Bank, Frankfurt. - Borio, Claudio, Jannecke Ebbesen, Gabriele Galati, and Alexandra Heath, 2008a,: “FX Reserve Management: Elements of a Framework,” BIS Papers No 38, Basel. - Borio, Claudio, Gabriele Galati and Alexandra Heath, 2008b, “FX Reserve Management: Trends and Challenges,” BIS Papers No 40, Basel. - Hong Kong Monetary Authority, 1997, “Styles of Risk Management in Central Bank Reserves Management,” Quarterly Bulletin, Hong Kong. - McCauley, Robert N., 2008, “Choosing the Currency Numeraire in Managing Official Foreign Exchange Reserves”, in Pringle, Robert, and Nick Carver (eds), ‘RBS Reserve Management Trends 2008,’ Central Banking Publications, London. - McCauley, Robert N., and Jean-François Rigaudy, 2011, “Managing Foreign Exchange Reserves in the Crisis and After,” BIS Papers No 58, in ‘Portfolio and Risk Management for Central Banks and Sovereign Wealth Funds,’ Proceedings of a Joint Conference Organised by the BIS, ECB and World Bank, Bank for International Settlements, Basel. ### Procyclicality, structural trends, and institutional behavior - Bank of England, 2014, “Procyclicality and Structural Trends in Investment Allocation by Insurance Companies and Pension Funds,” Discussion Paper, London. - Jones, Bradley A., 2016, “Institutionalizing Countercyclical Investment: A Framework for Long-term Asset Owners,” IMF Working Paper 16/38, Washington DC. - Jones, Bradley A., 2017, “Leaning With the Wind: Long-term Asset Owners and Procyclical Investing,” Journal of Investment Management, Vol 15, No 2: 16-38. - Pihlman, Jukka, and H van der Hoorn, 2010, “Procyclicality in Central Bank Reserve Management: Evidence from the Crisis,” Working Paper 10/150, Washington D.C. - Carver, Nick, 2013, “RBS Reserve Management Trends, 2013,” Central Banking Publications, London. - Carver, Nick, and Emma Glass, 2017, “HSBC Reserve Management Trends, 2017,” Central Banking Publications, London. - Pringle, Robert, and Nick Carver, 2008, “RBS Reserve Management Trends, 2008,” Central Banking Publications, London. - Pringle, Robert, and Nick Carver, 2009, “RBS Reserve Management Trends, 2009,” Central Banking Publications, London. - Nugée, John, 2015, “Current Issues in Central Bank Reserves Management,” Proceedings of the Oesterreichische Nationalbank Conference on Asset-Liability Management, Vienna. ### Crisis, swap lines, dollar funding, and global banking stresses - Allen, William, Gabriele Galati, Richhild Moessner, and William Nelson, 2017, “Central Bank Swap Lines and CIP Deviations,” De Nederlandsche Bank Working Paper No. 566, Amsterdam. - Baba, Naohiko, Robert N. McCauley, and Srichander Ramaswamy, 2009, “US Dollar Money Market Funds and Non-US Banks,” BIS Quarterly Review, March, Basel. - Fleming, Michael J., and Nicholas J. Klagge, 2010, “The Federal Reserve’s Foreign Exchange Swap Lines,” Vol 16, No 4, Federal Reserve Bank of New York, New York. - McGuire, Patrick, and Goetz von Peter, 2009, “The US Dollar Shortage in Global Banking and the International Policy Response,” BIS Working Paper No 291, Basel. - Obstfeld, Maurice, Jay C. Shambaugh, and Alan M. Taylor, 2009, “Financial Instability, Reserves, and Central Bank Swap Lines in the Panic of 2008,” American Economic Review, Vol 99, No 2: 480-86. - Borio et al. (2008a, 2008b) — see above entries on FX reserve management and trends. ### Reserve adequacy, guidance, and IMF materials - International Monetary Fund (IMF), 2013, “Guidelines for Foreign Exchange Reserve Management,” International Monetary Fund, Washington D.C. - International Monetary Fund (IMF), 2014, “How Do Changes In The Investor Base And Financial Deepening Affect Emerging Market Economies?” Global Financial Stability Report, Chapter 2, April, International Monetary Fund, Washington D.C. - International Monetary Fund (IMF), 2015, “Assessing Reserve Adequacy—Specific Proposals,’ International Monetary Fund, Washington D.C. - International Monetary Fund (IMF), 2016, “Guidance Note on the Assessment of Reserve Adequacy and Related Considerations,” International Monetary Fund, Washington D.C. - Morahan, Aideen, and Christian Mulder, 2013, “Survey of Reserve Managers: Lessons from the Crisis,” Working Paper 13/99, International Monetary Fund, Washington D.C. - Jones, Bradley A. (IMF Working Paper 16/38) — see above entry under Procyclicality. ### Safe assets, global currency history, and long-run reserve composition - Bordo, Michael, and Robert N. McCauley, 2017, “A Global Shortage of Safe Assets: A New Triffin Dilemma?” Atlantic Economic Journal, Vol 45, No 4: 443-451. - Eichengreen, Barry and Marc Flandreau, 2016, “A Century and a Half of Central Banks, International Reserves and International Currencies,” in Michael D. Bordo, Oyvind Eitrheim, Marc Flandreau and Jan F. Qvigstad (eds), ‘ Central Banks at a Crossroads: What Can We Learn from History?’ Cambridge University Press, Cambridge. - Eichengreen, Barry, Livia Chitu, and Arnaud Mehl, 2016, “Stability or Upheaval? The Currency Composition of International Reserves in the Long Run,” IMF Economic Review, Vol 64, No 2, Washington D.C. - Dooley, Michael P., David Folkerts-Landau, and Peter M. Garber, 2003, “An Essay on the Revived Bretton Woods System,” NBER Working Paper No 997, Cambridge. - Dooley, Michael P., David Folkerts-Landau, and Peter M. Garber, 2008, “Asia, Interest Rates, and the Dollar,” Deutsche Bank Global Markets Research, London. - Dooley, Michael P., David Folkerts-Landau, and Peter M. Garber, 2014, “The Revived Bretton Woods System's First Decade,” NBER Working Paper No. 20454, Cambridge. ### Asset management, institutional investors, and structural vulnerabilities - Financial Stability Board, 2017, “Policy Recommendations to Address Structural Vulnerabilities from Asset Management Activities,” Basel. - Organization for Economic Cooperation and Development (OECD), 2014, “Institutional Investors and Long-term Investment,” Project Report, Paris. - Rodrik, Dani, 2006, “The Social Cost of Foreign Exchange Reserves,” International Economic Journal, Vol 20, No 3: 253-266. - Truman, Edwin M. and Anna Wong, 2006, “The Case for an International Reserve Diversification Standard,” Working Paper 06–2, Institute for International Economics, Washington D.C. - La Porta, Rafeal, Florencio Lopez-de-Silanes, Andrei Schleifer and Robert W. Vishny, 1998, “Law and Finance,” Journal of Political Economy, Vol 106, No 6: 1113–55. *References list as provided in WP/18/31.* --- _Source: https://www.imf.org/-/media/files/publications/wp/2018/wp1831.pdf_