Risk Management

Danmarks Nationalbank applies a model for operational risk management. In 2005, work continued to reduce the probability and potential consequences of operational incidents at Danmarks Nationalbank. No significant operational incidents with a negative impact on the reputation or finances of Danmarks Nationalbank have occurred.

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 2005 and by and large unchanged in relation to end-2004. The risk on the gold stock has, however, increased due to rising gold prices. This increase is to some extent set off by a decline in the bank's interest-rate risk. Danmarks Nationalbank's credit risk is very limited. The bank seeks to completely avoid credit losses by solely having claims on counterparties with 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 that this aspect is also taken into account when assessing operational risk.

Danmarks Nationalbank's model for operational risk management is based on the principles for sound management of operational risk issued by the Bank for International Settlements. The model comprises standards for assessment of operational risk, preparation of procedures, physical security and IT security, as well as business continuity planning.

The model is based solely on a qualitative standard. Operational risk management comprises analyses of various risk scenarios, ongoing management reporting on potential threats and incidents, and assessments of whether the model's requirements are observed within the organisation.

The introduction of measures to counter relevant threats should be viewed in relation to the criticality of the business activities to the bank.

It is assessed that no significant operational incidents with a negative impact on the reputation or finances of Danmarks Nationalbank occurred in 2005.

Risk assessments and procedures
The risk assessment model contributes to identifying and assessing operational risk for given business areas, products, processes or systems. A risk assessment includes an estimate of the probability of an incident occurring, and of its potential impact.

The risk assessments will be gradually extended until all relevant issues have been taken into account. For instance, risk assessments have been prepared for operation of the IT department's back-up system, physical access control and hand-held terminals.

In 2005, Market Operations held a workshop to highlight the risks/ threats that may arise in various phases of the trading process, establish measures to cover these risks and threats, and identify any residual risks. Subsequently an activity plan has been prepared for the improvement of existing and the introduction of new measures.

In connection with the implementation of a number of organisational changes and restructuring of work routines at the Banknote Printing Works, in 2005 a new risk assessment was performed. This mapping of the risk scenario was the basis for various adjustments to the technical and administrative measures.

Physical security and IT security
A review of the policies for physical security and IT security did not give rise to any adjustments.

Danmarks Nationalbank's IT security management is based on ISO 17799, the international code of practice for information security management. ISO 17799 is in accordance with DS 484, which is the mandatory security standard for Danish government institutions, and consequently it is assessed that Danmarks Nationalbank complies with the government's IT security management requirements.

In relation to IT security, the separation of the Internet and the LAN was strengthened via the introduction of a more robust firewall design.

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 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. 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 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 risks. 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 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. 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 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.

At the close of 2005, the loss would have been kr. 1.8 billion on a 1-per-cent increase in the general level of interest rates, cf. Table 10.

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 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 2005 the market value of foreign-exchange outstandings totalled kr. 216 billion, cf. Table 11. Danmarks Nationalbank will thus incur a loss of kr. 2.16 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 and Swedish kronor against euro. The foreign-exchange exposure to non-euro currencies is thus converted to euro. For example, at the close of 2005 Danmarks Nationalbank held sterling assets for kr. 11 billion, but had also sold sterling forward for kr. 11 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 be able to intervene in dollars, and to diversify 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. 7 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. 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. The interest on gold was very low (0.1 per cent) in 2005, and thus did not match even a limited risk. Consequently, no gold was lent in 2005.

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 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 exposures with an estimate of the typical volatility in the market conditions, taking into account the covariation between the various risk factors.

At end-2005, Danmarks Nationalbank's VaR^[2] was calculated at kr. 2.4 billion, compared to kr. 2.5 billion at end-2004, cf. Table 12. The result indicates that in 2006, 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 risks seldom appear at the same time.

The increase in VaR for the gold stock is attributable to the rising market value of Danmarks Nationalbank's gold stock. At the same time, the interest-rate risk has declined as a consequence of smaller fluctuations in interest rates. Viewed in isolation, Danmarks Nationalbank's gold stock contributes kr. 1.9 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. The gold price measured as dollars per ounce has increased during the past five years, cf. Chart 30 . In 2005, the dollar also strengthened vis-à-vis the euro. Thus, measured in terms of euro per ounce the gold price has also appreciated. Losses on gold (in dollars) are often matched by gains on dollars, whereby the gold stock normally contributes to reducing the bank's risk.

At the close of 2005 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 at end-2005, compared to 5.0 per cent at end-2004. VaR has been reduced since 2002, mainly as a result of the lower interest-rate risk. At the same time, Danmarks Nationalbank's earnings potential has decreased, primarily due to lower short-term interest rates and a flatter yield curve.

Part of the calculated risk relates to the fluctuation of the krone vis-à-vis the euro. The exchange-rate risk in relation to the 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 2005 VaR excluding the exchange-rate risk on the euro 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 out market fluctuations that are both realistic and extreme. Danmarks Nationalbank has selected data from sub-periods between 1993 and 2005 in which the development in interest and exchange rates was particularly unfavourable. On the basis of the portfolio structure at end-2005, 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 c oncur-rent 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 periods that for each individual one-year interest-rate segment in each currency have given the greatest interest-rate loss, combined with the one-year periods that for each currency have 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 13. The most pessimistic scenario will 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.^[3]

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 (equivalent to approximately kr. 74 billion), 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. However, it has also been used when the central government needed a short-term loan in order to maintain a positive balance of its account at Danmarks Nationalbank. This was the case in 2005, when approximately kr. 17 billion was raised.

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.

On placement 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 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 exp osure on the foreign-exchange reserve and the domestic securities portfolio was kr. 245 billion at end-2005 against kr. 256 billion at end-2004, c f. Table 14.

At the close of the year, 95 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^[4].

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 bonds, banks, etc., 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. The domestic securities portfolio almost exclusively comprises government bonds, mortgage-credit bonds and Danish Ship Finance bonds.

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^[5]. Danmarks Nationalbank thus does not hold corporate bonds or bonds issued by central governments with a low credit rating.