Risk management
Danmarks Nationalbank has developed a model for operational risk management. In 2004 a number of activities were carried out to reduce the consequences of errors or negative incidents.
Danmarks Nationalbank's financial risks mainly comprise market risks. The bank is primarily exposed to the development in interest rates, but also in exchange rates and the gold price. Danmarks Nationalbank's market risk, measured as Value-at-Risk, fell from kr. 3.3 billion to kr. 2.5 billion during 2004. This is attributable to smaller interest-rate fluctuations and reduction of the interest-rate exposure of the bank. Danmarks Nationalbank's credit risk is very limited since it only has claims on counterparties with a high credit standing and to a large extent requires collateral to be pledged.
OPERATIONAL RISK
Operational risk is the risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events. Loss of reputation is also a key concern for Danmarks Nationalbank so that this aspect is taken into account when assessing operational risk.
Assessment of operational risk is not a new area. However, the financial sector has gradually developed models and standards that enable a methodical approach to improving the assessment of operational risk.
Danmarks Nationalbank has developed a model for operational risk management.[1]This model comprises standards for assessment of operational risk, standards for procedures, security issues and contingency plans for continuation of Danmarks Nationalbank's tasks. The model is based solely on a qualitative standard and focuses on analysis and monitoring of risk scenarios and reporting of incidents.
Danmarks Nationalbank has also incorporated physical security since a central bank's responsibilities in relation to banknotes and coins involve a number of processes requiring special precautions to prevent financial losses and loss of reputation.
In 2004 a number of activities were carried out to reduce the probability of operational errors at Danmarks Nationalbank. Assessment of operational risk will continue in the coming years, until all significant areas have been reviewed and assessed in relation to the requirements.
Risk assessments and procedures
An analysis has been conducted to classify the degree to which business activities and infrastructure are critical to Danmarks Nationalbank's finances and reputation, assessed on the basis of security criteria such as confidentiality, integrity and availability. The analysis forms the basis for a number of follow-up activities to ensure that risk assessments and procedures match the degree to which the business activities are critical to the bank.
In 2004 operational risk assessments were performed on certain critical business processes relating to trading and settlement, authorised signatories and authority to bind Danmarks Nationalbank, and use of the Internet. In addition, risk assessment has been performed on all cash depots that are part of the cash handling process. Overall, this has led to adjustments of the planning and performance of the processes reviewed.
A number of departments at Danmarks Nationalbank are also reassessing and changing existing procedures to comply with the new standards, which means that all procedures will be available electronically. Consequently, they will be easy to locate, and it will be possible to link related procedures across departments. This facilitates an overview of interdisciplinary procedures and also makes it possible to assess whether undesired incidents and errors are being prevented as appropriate.
Physical security and IT security
With regard to internal security, Danmarks Nationalbank's CCTV[2] system was extended in a number of areas in 2004. The access control system was replaced, and in this connection a number of new security facilities were introduced.
In the area of IT security, Internet threats have been reassessed, and this has led to restructuring and extension of the scanning and logging of employees' use of the Internet.
Business continuity plans for Danmarks Nationalbank
During the year the overall continuity measures for Danmarks Nationalbank were adjusted.
An agreement has been concluded with a foreign mint to enable continued production of Danish coins in the event that production at The Royal Mint is suspended for a prolonged period. In relation to banknotes, a similar arrangement has been made with a foreign banknote printing works.
An upgraded UPS[3] has been installed at Danmarks Nationalbank so that all critical business activities in Danmarks Nationalbank's buildings can continue in the event of an external power outage.
Danmarks Nationalbank's financial result is dependent on several uncertainties, primarily the development in a number of financial markets, but also counterparties' ability and willingness to meet their payment obligations.
To a certain extent, Danmarks Nationalbank's financial risks are a result of its role as monetary authority, which includes managing the monetary and foreign-exchange policy, issuing banknotes and coins and functioning as banker to the banks and to the central government. The risks arising from the role as monetary authority are unavoidable. For example, it is necessary to hold a foreign-exchange reserve in order to conduct a fixed-exchange-rate policy. Other risks reflect that Danmarks Nationalbank as a financial enterprise seeks to achieve a sound return. For instance, the interest-rate risk incurred reflects the weighing of the expected earnings against risk.
Danmarks Nationalbank's choice of risk level is characterised by prudence. A low level of risk reduces the risk of losses to Danmarks Nationalbank and makes it possible to maintain a high degree of solvency even in periods of extreme market conditions.
Danmarks Nationalbank is primarily exposed to market risks such as interest, foreign-exchange and liquidity risk and to a lesser degree to other types of risk, e.g. credit risks. The aim is to completely avoid losses as a result of counterparty failure.[4]
Market risk
The risk of suffering a loss as a consequence of price fluctuations on the financial markets is called market risk. For Danmarks Nationalbank the risk factors primarily comprise interest rates, but also exchange rates and the gold price.
In the assessment of the risk factors' impact on Danmarks Nationalbank's financial result it is important to draw a distinction between exposure and risk.
Exposure is the extent to which a loss is incurred on a given change in a specific risk factor. The interest-rate exposure is expressed as the krone duration, stating the loss in kroner on an increase in the level of interest rates by 1 percentage point. The foreign-exchange exposure can be expressed as the change in market value in kroner on a 1-per-cent change in the exchange rate, or as the market value in kroner of foreign-exchange outstandings.
On compiling the risk, the probability of loss is evaluated by combining exposure with the probability of a change in the risk factor concerned. One of the methods for assessing interest-rate and exchange-rate risk is calculation of Value-at-Risk, VaR, which can be interpreted as the maximum loss under normal market conditions. In addition to VaR, stress scenarios are used that measure losses under extremely unfavourable market conditions.
Interest-rate exposure and risk
A part of Danmarks Nationalbank's assets are fixed-rate bonds, while its liabilities are primarily floating-rate liabilities. Consequently, Danmarks Nationalbank will incur an immediate capital loss in the event of an interest-rate increase. Experience shows that in the long term fixed-rate bonds yield higher returns than placements at floating rate. Over an extended period, Danmarks Nationalbank will therefore increase its return by assuming a certain interest-rate risk.
At the close of 2004 the loss would amount to kr. 1.8 billion on a 1-per-cent increase in the general level of interest rates, cf. Table 11.
The bond portfolio is placed in several markets. The exposure to Danish interest rates is attributable to the portfolio of Danish government, mortgage-credit and Danish Ship Finance bonds. The exposure to foreign interest rates is primarily attributable to the placement of a part of the foreign-exchange reserve in foreign bonds. Spreading the interest-rate exposure over different markets and maturity segments contributes to reducing the interest-rate risk.
Foreign-exchange exposure and risk
Danmarks Nationalbank holds considerable foreign-exchange assets, first and foremost the foreign-exchange reserve, which serves as an intervention reserve. Danmarks Nationalbank obtains an exchange-rate
gain when the krone weakens since the krone value of foreign-exchange assets hereby increases. Similarly, an exchange-rate loss is incurred when the krone strengthens. At the close of 2004 the market value of foreign-exchange outstandings totalled kr. 223 billion, cf. Table 12. Danmarks Nationalbank will thus incur a loss of kr. 2.23 billion if the krone strengthens by 1 per cent.
History shows that from time to time exchange-rate fluctuations can result in substantial losses. Against this background Danmarks Nationalbank has chosen to keep the foreign-exchange risk at a low level. This is achieved by forward sale of dollars, pounds sterling, yen and Swedish kronor against euro. The foreign-exchange exposure to non-euro currencies is thus converted to euro. For example, at the close of 2004 Danmarks Nationalbank held sterling assets for kr. 10 billion, but had sold sterling forward for kr. 10 billion, cf. Table 12. The net sterling exposure was thus eliminated. As the Table shows, Danmarks Nationalbank has retained a minor dollar exposure to be able to intervene in dollars.
The conversion of foreign-exchange exposure to euro exposure is the key element of the management of Danmarks Nationalbank's foreign-exchange risk. In a historical perspective this strategy has reduced the foreign-exchange risk considerably as a result of the fixed-exchange-rate policy vis-à-vis the euro. By interacting with the interest-rate risk, this strategy implies that the interest-rate exposure can be spread over different markets irrespective of an inherent currency risk.
Danmarks Nationalbank is exposed to the development in the gold price in view of its gold stock of kr. 5 billion. Gold is typically quoted in dollars and consequently contributes to the dollar sensitivity in Table 12. When the foreign-exchange exposure is converted from dollars to euro, the gold stock's dollar exposure is taken into account on equal terms with the other dollar-denominated assets. The gold price measured as dollars per ounce has increased during the past four years, cf. Chart 29. Meanwhile, the dollar has weakened relative to the euro. Thus, measured in terms of euro per ounce the gold price has not appreciated to a corresponding extent.
| GOLD PRICE |
Chart 29
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| Source: Danmarks Nationalbank. | |
Danmarks Nationalbank holds the gold stock at a constant level. Most of the gold stock is physically placed in foreign central banks. A part of the stock is lent to banks with a high credit rating. The interest on gold lending is paid in gold, and gold interest is sold on an ongoing basis. In 2004 the interest on gold was so low that gold lending was insignificant.
Measuring market risk
Danmarks Nationalbank uses various measures to evaluate market risk. Individually, these measures give an indication of Danmarks Nationalbank's risks, and together they illustrate its risk profile. The risk level chosen reflects an assessment of the expected yield in relation to a number of different risk measures. The methods for measuring Danmarks Nationalbank's risks are subject to constant development.
Value-at-Risk
Danmarks Nationalbank's market risk is e.g. measured by Value-at-Risk, VaR. This risk measure combines the financial positions with an estimate of the typical volatility in the market conditions, taking into account the covariation between the various risk factors.
At end-2004 Danmarks Nationalbank's VaR[5] was calculated at kr. 2.5 billion, compared to kr. 3.3 billion at end-2003, cf. Table 13. The result indicates that at end-2004, with a probability of 95 per cent Danmarks Nationalbank will not incur a loss exceeding kr. 2.5 billion. Equivalently, the result states that with a probability of 5 per cent Danmarks Nationalbank will experience a capital loss exceeding kr. 2.5 billion. VaR does not indicate the size of the loss.
The sum of the contributions from each group of risk factors – interest rates, exchange rates and the gold price – exceeds the total VaR since the calculation of VaR takes into account that the risk is spread over several risk groups. The reduction, or the diversification gain, is due to the fact that losses on all risks seldom appear at the same time.
The decline in VaR is attributable to a decrease in the interest-rate risk during the year since the interest-rate fluctuations have been smaller and Danmarks Nationalbank's interest-rate exposure has been reduced. Part of the calculated risk relates to the fluctuation of the krone vis-à-vis the euro. The exchange-rate risk in relation to euro is of a special nature. The krone/euro exchange rate is solely influenced in the interest of the fixed-exchange-rate policy and not to increase earnings. Consequently, VaR is also estimated without the exchange-rate risk on the euro, and at the close of 2004 VaR excluding the exchange-rate risk on the euro totalled kr. 1.9 billion.
Viewed in isolation, Danmarks Nationalbank's gold stock contributes kr. 1.1 billion to VaR. In relation to the value of the gold stock this is a large amount. The reason is the large fluctuations in the gold price in dollars. Overall, however, the gold stock only contributes a limited risk since losses on gold (in dollars) are often matched by gains on dollars.
At the close of 2004 Danmarks Nationalbank's net capital totalled kr. 50.3 billion, cf. the balance sheet on p. 129. VaR as a share of net capital was thus 5.0 per cent at end-2004, compared to 6.6 per cent at end-2003.
Stress test
The VaR calculations provide information on the general risk of loss, but not on the extent of the losses in the event of extreme market fluctuations. Stress tests reflecting how extreme, but realistic scenarios of market development affect the value of Danmarks Nationalbank's current portfolio are used for this purpose. It is difficult to set out market conditions that are both realistic and extreme. Danmarks Nationalbank has selected data from sub-periods between 1991 and 2004 in which the development in interest and exchange rates was particularly unfavourable. On the basis of the portfolio structure at end-2004 the losses to Danmarks Nationalbank if this development were to repeat itself are calculated. The following three scenarios have been set up:
- Scenario 1: The one-year period that has given the greatest concurrent total interest and exchange-rate loss.
- Scenario 2: The one-year period that has given the greatest total interest-rate loss, combined with the one-year period that has given the greatest total exchange-rate loss. The losses do not have to be concurrent.
- Scenario 3: The one-year period that for each individual one-year interest-rate segment in each currency has given the greatest interest-rate loss, combined with the one-year period that for each currency has given the greatest exchange-rate loss. The losses do not have to be concurrent.
As the scenarios are set up, scenario 3 will always give at least as great a loss as scenario 1 or 2. With the current portfolio structure, the three scenarios give a total capital loss of between kr. 12 and 16 billion, cf. Table 14. The most pessimistic scenario will thus give the bank a capital loss of around 1/3 of its net capital.
Losses calculated using VaR and stress tests indicate the immediate loss on a change in market conditions. When the risk over a longer period is to be assessed, the impact of market conditions on current earnings must also be taken into account. A large proportion of the losses calculated using VaR and stress tests are attributable to the risk of a general increase in interest rates, but in that case the current earnings of Danmarks Nationalbank also increase, and in the long term it gains from an increase in interest rates since the bank from the outset has more income from interest than interest expenditure.
Liquidity risk
Liquidity risk comprises several factors. For Danmarks Nationalbank, there is first and foremost the liquidity risk that it is not possible to release funds to support the krone, even though the funds are held in reserve.
The principal purpose of the foreign-exchange reserve is to be able to intervene in the foreign-exchange market. In the management of the foreign-exchange reserve it is therefore very important to ensure that the greater part of the reserve can be converted quickly to liquid funds. Therefore, a large proportion of the foreign-exchange reserve is placed in the money market or in bonds with a high degree of security, so that they can easily be realised or used as collateral in various liquid markets.
To manage the liquidity requirement, it must, inter alia, be possible to release a minimum amount of kr. 25 billion within two days.[6]
Danmarks Nationalbank also has several other borrowing options, e.g. access to foreign exchange via the central government's Commercial Paper programme amounting to 12 billion dollars, which is administered by Danmarks Nationalbank. The programme has been used on several occasions, particularly in connection with the foreign-exchange crises in the early 1990s. In accordance with the ERM II agreement, Danmarks Nationalbank also has an opportunity to borrow at the ECB. This facility has not been used, but serves as a safety net. Danmarks Nationalbank moreover has access to the forward foreign-exchange market where it can transact currency swaps between kroner and foreign exchange. However, this possibility has not been used for a number of years.
On placement of the domestic securities portfolio the same weight is not given to liquidity considerations.
Credit risk
The credit risk is the risk of loss due to a counterparty's default on obligations. Credit risk also comprises the risk that the market rating of a counterparty's credit standing drops, resulting in a capital loss. Credit exposure is stated as the market value of the assets. The credit exposure on the foreign-exchange reserve and the domestic securities portfolio was kr. 256 billion at end-2004, cf. Table 15.
At the close of the year, 98.5 per cent of the foreign-exchange reserve and the domestic securities portfolio was placed in supranational institutions or in assets with a rating of Aa3 or higher[7].
The total credit exposure fell from kr. 268 billion to kr. 256 billion in 2004, cf. Table 15. The exposure to government bonds has fallen by kr. 20.6 billion, while the exposure to collateralised banking transactions has increased by kr. 8.6 billion.
To reduce the credit risk Danmarks Nationalbank spreads its assets among counterparties with a high credit standing. Moreover, collateral is required to a large extent. The credit risk is therefore very small.
The credit risk on the foreign claims, i.e. claims on foreign governments, banks, etc., is managed on the basis of the ratings given by international credit rating agencies. Moreover, all significant holdings are subject to maximum limits.
For deposits with foreign banks repo agreements with highly-rated government bonds as collateral are also used. Should a repo counterparty be subject to compulsory liquidation, Danmarks Nationalbank's deposit is covered by the collateral provided.
Danmarks Nationalbank's holdings of foreign bonds are issued by central governments or supranational institutions with a high credit rating, or guaranteed by central governments with a high credit rating.[8]Danmarks Nationalbank thus does not hold corporate bonds or bonds issued by central governments with a low credit rating.
On placement of the domestic securities portfolio great weight is also attached to the high credit standing of the issuers, which is assessed on the basis of rating by international rating agencies. The domestic securities portfolio thus almost exclusively comprises government bonds, mortgage-credit bonds and Danish Ship Finance Bonds.
[1] See Danmarks Nationalbank, Financial Management at Danmarks Nationalbank, 2004, Chapter 11, Operational Risk.
[2] Close Circuit Television, CCTV.
[3] Uninterruptible Power Supply, UPS.
[4] Financial risks and management thereof are described in Danmarks Nationalbank, Financial Management at Danmarks Nationalbank, 2004.
[5] VaR is calculated on the basis of estimated volatilities and correlations between the relevant risk factors on the basis of a weighting of the last 160 days. VaR is determined by combining these estimates with Danmarks Nationalbank's portfolio structure as of end-2004.
[6] The foreign-exchange market operates with two-day settlement, which means that transactions are settled two days after the contract date. Liquidity must therefore be available within two days if it is to be used for intervention purposes.
[7] Loans in connection with monetary-policy operations, the banks' intraday credits and cash depots are solely extended on the basis of collateralised bonds, and are not included.
[8] Government-guaranteed securities included securities with an implicit government guarantee.