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Contents List of figures List of tables List of boxes List of contributors Foreword(Gonz lez-P ramo, J. M.) Part I:Investment operations Chapter 1:Central banks and other public institutions as financial investorsBindseil, U. 1.Introduction 2.Public institutions' specificities as investors 3.How policy tasks have made central banks large-scale investors 3.1Banknotes issuing and payment systems 3.2Monetary policy implementation 3.3Foreign exchange policies and reserves 3.4Financial stability functions 4.Optimal degree of diversification of public institutions' financial assets 5.How actively should public institutions manage their financial assets?; 5.1The general usefulness and 'industrial organization' of active portfolio management 5.2Public institutions and central banks as active investors 6.Policy-related risk factors 6.1Banknotes, seignorage, and liquidation risk 6.2Monetary policy interest rates 6.3Foreign exchange reserves and exchange rate changes 6.4The central bank as financial crisis manager 7.The role of central bank capital - a simple model 8.Integrated risk management for public investors 8.1Integrated financial risk management in general 8.2Integrated risk management issues for public investors 9.Conclusions Chapter 2:Strategic asset allocation for fixed-income investorsKoivu, M., Monar Lora, F. and Nyholm, K. 1.Introduction 2.A primer on strategic asset allocation 2.1General principles of SAA methodologies 2.2Evolution of SAA methodologies 3.Components of the ECB investment process 4.Forward-looking modelling of the stochastic factors 4.1A macro model for multiple currency areas 4.2The yield-curve model 4.3A model for credit migrations 4.4Modelling exchange rates 4.5Instrument pricing and calculation of returns 5.Optimization models for SAA under a shortfall approach 5.1Multi-currency model 5.2Single market model 6.The ECB case: an application 6.1The investment universe 6.2The objective function and constraints 6.3Using the models 6.4Application to a normal scenario 6.5Application to a non-normal scenario Chapter 3:Credit risk modelling for public institutions' investment portfoliosVan der Hoorn, H. 1.Introduction 2.Credit risk in central bank and other public investors' portfolios 3.The ECB's approach towards credit risk modelling: issues and parameter choices 3.1Motivation 3.2Analytical results 3.3Simulation approach 3.4Probabilities of default/migration 3.5Recovery rates 3.6Correlations 3.7Credit spreads 4.Simulation results 4.1Portfolio I 4.2Portfolio II 4.3Sensitivity analysis using individual sets of parameters 5.Conclusions Chapter 4:Risk control, compliance monitoring and reportingManzanares, A. and Schwartzlose, H. 1.Introduction 2.Overview of the distribution of portfolio management tasks within the Eurosystem 3.Limits 3.1Defining limits 3.2Market risk limits 3.3Credit risk limits 3.4Liquidity limits 3.5Maintenance of risk limits 4.Portfolio management oversight tasks 4.1Limit compliance monitoring 4.2Valuation - validation of end of day prices 4.3Validation of prices transacted at 4.4Dealing with backdated transactions 4.5Maintenance and regular checks of static and semi-static data 4.6Maintenance of strategic benchmarks 5.Reporting on risk and performance 5.1Characteristics of a good reporting framework 5.2Making sure the necessary data is available 5.3Reporting for ECB investment operations 6.IT and risk management 6.1IT architecture and standards 6.2The integrated risk management system 6.3The risk management IT team 6.4Systems support and operations 6.5Projects 6.6Build or buy 6.7Complete outsourcing of IT systems - application service provider solutions Chapter 5:Performance measurementBourquin, H. and Marton, R. 1.Introduction 2.Rules for return calculation 2.1Basic formulae 2.2Trade-date versus value-date approach 2.3Actual versus all-cash basis 3.Two-dimensional analysis: risk-adjusted performance measures 3.1Capital Asset Pricing Model as a basis 3.2Total performance: Sharpe ratio 3.3Passive performance: Treynor ratio 3.4Extension to Value-at-Risk: reward-to-VaR ratio 3.5Active performance: information ratio 4.Performance measurement at the ECB Chapter 6:Performance attributionMarton, R. and Bourquin, H. 1.Introduction 2.Multi-factor return decomposition models 2.1Arbitrage Pricing Theory as a basis 2.2Parameterizing the model: choice of risk factors 2.3Fitting to practice: empirical multi-factor models 3.Fixed-income portfolios: risk factor derivation 3.1Risk factor: passage of time 3.2Risk factor: change of yield to maturity 3.3Risk factor: movement of basis government yield curve 3.4Risk factor: narrowing/widening of sector and euro country spreads 4.Performance attribution models 4.1Fundamental types of performance attribution models 4.2Fixed-income performance attribution models 5.The ECB approach to performance attribution 6.Conclusions Part II:Policy operations Chapter 7:Risk management and market impact of central bank credit operationsBindseil, U. and Papadia, F. 1.Introduction 2.The collateral framework and efficient risk mitigation 2.1Desirable characteristics of eligible collateral 2.2Risk mitigation techniques - the Eurosystem approach 2.3Collateral eligibility and risk control measures in inter-bank transactions 2.4Monitoring the use of the collateral framework and related risk taking 3.A cost-benefit analysis of a central bank collateral framework 3.1A simple model 3.2Empirical estimates of the effect of eligibility on yield: normal times 3.3The eligibility premium in times of a liquidity crisis: the 'sub-prime turmoil' of 2007 3.4Effects of eligibility on issuance 4.Conclusions Chapter 8:Risk mitigation measures and credit risk assessment in central bank policy operationsGonz lez, F. and Molitor, P. 1.Introduction 2.Assessment of collateral credit quality 2.1Scope and elements 2.2The Eurosystem Credit Assessment Framework 3.Collateral valuation: marking to market 4.Haircut determination methods 4.1Basic VaR-related haircuts 4.2Liquidity risk adjusted haircuts 4.3Credit risk-adjusted haircuts 5.Limits as a risk mitigation tool 6.Conclusions Chapter 9:Collateral and risk mitigation frameworks of central bank policy operations - a comparison across central banksTabakis, E. and Weller, B. 1.Introduction 2.General comparison of the three collateral frameworks 2.1Types of operations 2.2Common principles 2.3Choices of the overall operational framework 2.4External constraints 3.Eligibility criteria 4.Credit risk assessment and risk control framework 4.1Credit risk assessment framework 4.2Valuation 4.3Risk control measures 5.Conclusions Chapter 10:Risk measurement for a repo portfolio - an application to the Eurosystem's collateralized lending operationsHeinle, E. and Koivu, M. 1.Introduction 2.Simulating credit risk 2.1Default probabilities and recovery rates 2.2Default correlation 3.Simulating liquidity-related risks 4.Issues related to concentration risks 4.1Concentration on the level of counterparties 4.2Concentration on the level of collateral 4.3Concentrations in collateral from a single counterparty 5.Risk measures: Credit Value-at-Risk and Expected Shortfall 6.An efficient Monte Carlo approach for credit risk estimation 6.1Importance sampling 6.2Quasi Monte Carlo methods 6.3Empirical results on variance reduction 7.Residual risk estimation for the Eurosystem's credit operations 7.1Expected shortfall in a base case scenario 7.2Stability of risk calculations in terms of assumptions 7.3Risk development over time 8.Conclusions Chapter 11:Central bank financial crisis management from a risk management perspectiveBindseil, U. 1.Introduction 2.Typology of financial crisis management measures AEqual access FCM measures BIndividual access FCM measures COrganize emergency/solvency assistance to be provided by other financial institutions. 3.Review of some key results of the literature 3.1Key lessons retained from nineteenth-century experience 3.2The nature of liquidity problems of banks 3.3Motivations for FCM, and in particular ELA 3.4ELA provided by other banks, coordinated by the supervisor or the central bank 3.5Moral hazard 3.6Constructive ambiguity 3.7At what rate to provide special lending in a crisis situation?; 4.Financial stability role of central bank operational framework 5.The inertia principle of central bank risk management in crisis situations 6.Equal access FCM measures 6.1Emergency liquidity injections through open market operations 6.2Narrowing the spread of the borrowing facility vis-à-vis target rate 6.3Widening of collateral set 6.4Other equal access FCM measures 6.5Conclusions: the role of equal access FCM measures 7.FCM measures addresses to individual banks (ELA) 8.Conclusions Part III:Organizational issues and operational risk Chapter 12:Organizational issues in the risk management function of central banksTabakis, E. 1.Introduction 2.Relevance of the risk management function in a central bank 3.Risk management best practices for financial institutions 4.Six principles in the organization of risk management in central banks 4.1Independence of the risk management function 4.2Separation of the policy area from the investment area of the central bank - the role of risk management (Chinese walls principle). 4.3Transparency and accountability 4.4Adequate resources 4.5Responsibilities of the risk management division 4.6Risk management culture 5.Conclusions Chapter 13:Operational risk management in central banksSevet, J.-C. 1.Introduction 2.Central bank specific ORM challenges 2.1Non-financial objectives 2.2Not-for-profit values and incentives 3.Definition of operational risk 3.1Risk as a distribution 3.2Normal business conditions vs. worst-case scenarios 3.3Danger of the classical likelihood/impact matrix 3.4Inherent risk vs. worst-case scenario 4.ORM as overarching framework 5.Taxonomy of operational risk 6.The ORM lifecycle 7.Operational risk tolerance policy 7.1Foundation: the risk impact-grading scale 7.2Implication: risk tolerance guidelines 8.Top-down self-assessments 8.1Objective and scope 8.2Approach 8.3Output and lessons learned 9.Bottom-up self-assessments 9.1Objective and scope 9.2Approach 9.3Bottom-up risk assessments vs. BPM and TQM 10.ORM governance 11.KRIs and ORM reporting 11.1Theory vs. practice 11.2Current developments at the ECB 12.Conclusions References Index

Library of Congress Subject Headings for this publication:

Banks and banking, Central.

Risk management.

Portfolio management.