Risk Management

Like other enterprises, Danmarks Nationalbank is exposed to a number of risks, including operational risks. In the case of Danmarks Nationalbank, these risks are to a large extent related to the services that Danmarks Nationalbank is responsible for providing to society, and to security issues. Other risks are financial risks arising from Danmarks Nationalbank's large financial outstandings. On the one hand there is a risk of loss, but on the other hand there is also the opportunity to make a profit.

Danmarks Nationalbank undertakes operational risk assessments in relation to its core tasks, the individual business activities and systems, and a number of general issues. The risk assessments are the basis for adjustments to the specific performance of its tasks.

Danmarks Nationalbank's financial risks mainly comprise market risks. The bank is exposed to the development in interest rates, exchange rates and the gold price. Danmarks Nationalbank's market risk, measured as Value-at-Risk, was kr. 2.4 billion at the end of 2006, which is unchanged from the beginning of the year. Danmarks Nationalbank's credit risk is very small and it seeks to avoid credit losses completely by solely having claims on counterparties with a high credit standing and by requiring collateral to a significant extent.

OPERATIONAL RISK

Operational risk is the risk of financial 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 this aspect is also taken into account when assessing operational risk.

Danmarks Nationalbank's model for operational risk management includes policies and templates, etc. for assessment of operational risk, preparation of procedures, physical security and IT security measures, as well as business continuity planning – i.e. ensuring continued performance of Danmarks Nationalbank's tasks. Assessment of the operational risks related to a core task, a business activity, a system or another feature is based solely on a qualitative standard. In the risk assessment, the probability of each threat is assessed on a scale from unlikely to very likely, and the consequences are rated from insignificant to disastrous. Likewise, the measures taken to reduce the probability and/or the consequences of a possible incident are described. On the basis of the assessment and analysis, an overall conclusion is made in order to determine the measures to be taken against the threat.

A comprehensive risk landscape
In 2006, work was undertaken to prepare a comprehensive operational risk landscape for Danmarks Nationalbank. Risk assessments are performed in three areas, i.e. in relation to the bank's core tasks, corresponding to its overall objectives, the individual business activities and systems, and a number of general issues.

Risk assessments of the core tasks comprise an assessment of the consequences for Danmarks Nationalbank if the main components in the performance of the individual core tasks are disrupted or inaccessible for a short or long period. The main components might be a building, staff, the banknote printing facilities, IT operations, telecommunications or external electricity supplies. These risk assessments serve especially to ensure that appropriate measures are in place for business continuity in relation to core tasks.

Risk assessments of business activities and systems typically comprise an assessment of the consequences for Danmarks Nationalbank if the business activities are interrupted or performed incorrectly as a result of human error, inadequate or failed internal processes, system errors or external events. The same threats are assessed in relation to general issues such as dissemination of information, the common IT infrastructure, use of the Internet, physical protection of Danmarks Nationalbank's assets, electricity supply and telecommunication. The risk assessments have contributed to reducing the potential financial and reputational loss to an acceptable level should a given incident occur.

Policies and procedures
The overall requirements of Danmarks Nationalbank's contingency measures in relation to operations are managed via policies and guidelines for physical security, IT security and business continuity. In each of these areas, planning is based on international standards and European System of Central Banks, ESCB, guidelines.

Procedures describe how Danmarks Nationalbank's business activities are to be conducted in practice. Previously, the procedures were laid down by the individual departments, but now the layout has been streamlined and all procedures compiled in a single database with the objective of ensuring uniformity across the departments; a clear definition of roles and responsibilities; and descriptions of all current control measures that are part of the work process. At the same time, transparency is increased and dependence on specific key staff members reduced. The transition to the new layout was completed in 2006.

Risk assessments
On the basis of the risk assessments performed in 2006 it has been relevant to introduce certain operational adjustments in relation to Danmarks Nationalbank's tasks. All employees that undertake particularly critical functions at Danmarks Nationalbank are cleared by the Danish Security Intelligence Service, PET. External service and consulting staff that for a period work on Danmarks Nationalbank's premises must also be cleared. In addition, at the recommendation of Danmarks Nationalbank, security has been tightened in relation to a decentralised banknote holding with a bank.

The consequences of avian influenza have been reassessed on the basis of information presented at an international central-bank seminar on this topic. The current prevalence is not alarming, so that Danmarks Nationalbank has not introduced any special measures in this respect. The threats of terrorist strikes against Danmarks Nationalbank and robbery of money transports have also been reassessed in the light of actual events abroad and a general exacerbation of the global threat scenario. Danmarks Nationalbank has incorporated measures to adjust the transport procedures to the new threat scenario.

DANMARKS NATIONALBANK's MANAGEMENT OF FINANCIAL RISKS

Danmarks Nationalbank's financial result is dependent on several uncertainties; especially the development in a number of financial markets, but also counterparties' ability and willingness to meet their payment obligations.

To a large extent, Danmarks Nationalbank's financial risks are a consequence of its regulatory tasks, comprising the management of the monetary and foreign-exchange policy, issue of banknotes and coins, and its function 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. Interest-rate risk is e.g. determined on the basis of a trade-off between expected revenue and risk.

Danmarks Nationalbank's choice of risk level is characterised by prudence. A low level of risk reduces the probability 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's objective is to have a low probability of deficit over a one-year horizon.

Danmarks Nationalbank is primarily exposed to market risks such as interest-rate, foreign-exchange and liquidity risk, and to a lesser degree to other types of risk, e.g. credit risk. The aim is to completely avoid losses as a result of counterparty failure.^[1]

Market risk
Market risk is the risk of suffering a loss as a consequence of price fluctuations in the financial markets. 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 e.g. 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.
• On compiling the risk, the probability of loss is evaluated by combining exposure with the probability of a change in the risk factor concerned. Danmarks Nationalbank applies several different methods to compiling risk, cf. below.

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 a capital loss in the event of an increase in interest rates. Experience shows that in the long term fixed-rate bonds yield higher returns than placements at floating rates. Over an extended period, Danmarks Nationalbank is therefore expected to increase its return by assuming a certain interest-rate risk.

The bond portfolio is placed in several markets, cf. Table 10. The exposure to Danish interest rates is attributable to the portfolio of Danish government, mortgage-credit and Ship Finance bonds. The exposure to international 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.

At the close of 2006, the loss on a 1-percentage-point increase in the general level of interest rates would have been kr. 1.9 billion.

Foreign-exchange exposure and risk
Danmarks Nationalbank holds considerable foreign-exchange assets, first and foremost the foreign-exchange reserve, which serves as an intervenetion 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 2006 the market value of foreign-exchange outstandings totalled kr. 176 billion, cf. Table 11. Danmarks Nationalbank will thus incur a loss of kr. 1.76 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 sales of dollars, pounds sterling and Swedish kronor against euro. The foreign-exchange exposure to non-euro currencies is thus converted to euro. For example, at the close of 2006 Danmarks Nationalbank held sterling assets for kr. 12 billion, but had also sold sterling forward for kr. 12 billion, cf. Table 11. The sterling exposure was thus eliminated. As the Table shows, Danmarks Nationalbank has retained a minor dollar exposure in order to diversify its risk.

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. This strategy also implies that the interest-rate exposure can be spread over different markets irrespective of any inherent foreign-exchange risk.

Danmarks Nationalbank is exposed to the development in the gold price in view of its gold stock of kr. 8 billion. Gold is typically quoted in dollars and consequently contributes to the dollar exposure, cf. Table 11. 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. Danmarks Nationalbank holds the gold stock at a constant level. Virtually all of the gold stock is physically placed in foreign central banks.

Danmarks Nationalbank previously lent part of its gold stock to banks with a high credit standing. The interest on gold lending is paid in gold, and gold interest is sold on an ongoing basis. However, the interest on gold has been around zero for some time, and therefore lending is not worthwhile. Consequently, no gold was lent in 2006.

One of Danmarks Nationalbank's tasks is to function as banker to the central government. In this context an exchange-rate hedging facility was introduced in 2006 for the use of Defence Command Denmark (Ministry of Defence) in connection with its military expenditure denominated in dollars. This facility allows the central government to hedge the value in kroner of its dollar expenditure on military equipment. The exposure thus incurred by Danmarks Nationalbank is hedged as part of its ongoing risk management, so that the exposure in dollars is not affected.

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 overall risk level reflects an assessment of the expected yield in relation to a number of different risk measures. The methods of measuring Danmarks Nationalbank's risks are subject to ongoing development.

Value-at-Risk
Danmarks Nationalbank's market risk is e.g. measured by Value-at-Risk, VaR. This risk measure combines the financial exposures with an estimate of the typical volatility in the market conditions, taking into account the covariation between the various risk factors.

At end-2006, Danmarks Nationalbank's VaR^[2] was calculated at kr. 2.4 billion, which corresponds to the level at the beginning of the year, cf. Chart 30. The result indicates that in 2007, with a probability of 95 per cent, Danmarks Nationalbank will not incur a loss exceeding kr. 2.4 billion. Equivalently, the result states that with a probability of 5 per cent Danmarks Nationalbank will experience a capital loss exceeding kr. 2.4 billion. VaR does not indicate the size of this potential 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 risk factors seldom appear at the same time.

Over a prolonged period, the development in VaR has on the one hand been driven by a fall in the contribution from interest-rate risk, mainly because Danmarks Nationalbank's interest-rate exposure has been reduced. On the other hand, the contribution from the gold stock has increased as a result of the rising market value of the gold stock and the large fluctuations in the dollar price of gold. Viewed in isolation, the gold stock contributes kr. 1.9 billion to VaR. In relation to the gold stock's value of approximately kr. 7.7 billion this is a large amount.

At the close of 2006 Danmarks Nationalbank's net capital totalled kr. 52 billion, cf. the balance sheet on p. 127. VaR as a share of net capital was thus 4.6 per cent, corresponding to the level at end-2005.

VaR calculated without the diversification gain gives an expression of the maximum loss with a probability of 95 per cent, assuming that simultaneous losses are incurred on interest rates, exchange rates and the gold price. This is a more pessimistic measure of VaR. Measured in this way, VaR fell by almost kr. 700 million during 2006 to kr. 4.1 billion at year-end. This is because the contribution to risk from both the interest-rate and exchange-rate risk have decreased as a result of the reduced interest-rate and exchange-rate volatility.

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. It enables Danmarks Nationalbank to influence the exchange rate vis-à-vis the euro. Moreover, Danmarks Nationalbank has the exposure in euro in view of the fixed-exchange-rate policy. Therefore VaR is also estimated without the exchange-rate risk on the euro, and at the close of 2006 VaR excluding this risk totalled kr. 2.3 billion. In general the exchange-rate risk on the euro does not affect VaR much due to the stability of the krone vis-à-vis the euro.

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 up market fluctuations that are both extreme and realistic. Danmarks Nationalbank has selected data from sub-periods between 1993 and 2006 in which the development in interest and exchange rates was particularly unfavourable. In addition, particularly pessimistic scenarios are constructed by combining unfavourable developments in interest and exchange rates from different periods. On the basis of the portfolio structure at end-2006, the loss to Danmarks Nationalbank in the most pessimistic scenario will be around kr. 15 billion, equivalent to 30 per cent of its net capital. Such a loss will typically be related to considerable strengthening of the Danish krone against the euro, as well as a significant rise in interest rates.

Long-term analysis of risk and earnings
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 will also increase, and in the long term it gains from an increase in interest rates since from the outset Danmarks Nationalbank has more income from interest than interest expenditure. The reason is that Danmarks Nationalbank's net capital and banknotes and coins in circulation do not accrue interest, while the counterparts to the net capital and banknotes and coins in circulation do accrue interest.

In order to perform more long-term assessments of the return and risk on different interest-rate exposures, Danmarks Nationalbank has developed a model for its earnings. The model provides a comprehensive view of risk and earnings at different exposure levels, applying various economic scenarios. For a description of the model, see Box 12.

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 a large part of the reserve can be converted quickly into 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 that can easily be realised or used as collateral in various liquid markets.

To manage the liquidity requirement, it must within two days, inter alia, be possible to release a minimum amount of 3 billion euro placed as short-term deposits.^[3] A very large proportion of the remaining foreign-exchange reserve can also be mobilised and used for intervention purposes just as rapidly.

Danmarks Nationalbank also has several other options to raise funds for intervention, including the central government's Commercial Paper programme^[4], which is administered by Danmarks Nationalbank. Up to kr. 12 billion can be raised via this programme, which has been used on several occasions, for example 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.

On the investment of the domestic securities portfolio the same weight is not given to liquidity considerations.

Credit risk
Credit risk is the risk of loss due to a counterparty's default on its obligations. Credit risk also comprises the risk that the market rating of a counterparty's credit standing drops, resulting in a capital loss.

Credit risk is managed on the basis of credit ratings given by international credit rating agencies. Moreover, all significant holdings are subject to maximum limits. The domestic securities portfolio almost exclusively comprises government bonds, mortgage-credit bonds and Danish Ship Finance bonds.

To reduce the credit risk Danmarks Nationalbank spreads its assets among counterparties with a high credit standing. For deposits with foreign banks repo agreements using government bonds as collateral are also applied. 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, or guaranteed by central governments with a high credit standing^[5]. The credit risk is therefore very small.

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. 200 billion at end-2006, against kr. 245 billion at end-2005, cf. Table 12.

At the close of the year, 95 per cent of the foreign-exchange reserve and the domestic securities portfolio was placed in assets with a rating of Aa3 or higher^[6] or in supranational institutions.

The decline in the credit exposure by kr. 45 billion since 2005 is predominantly attributable to the reduction of the foreign-exchange reserve. Changes in the size of the foreign-exchange reserve typically take place in the collateralised banking transactions.