Archived - External Review of the Reserves Management Framework
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The Department of Finance values the work of Professor Kryzanowski in the preparation of this report and is moving to address the issues raised within the report. We are pleased to note that Professor Kryzanowski expressed the opinion that the EFA is well managed in that its practices generally compare well with the best practices of other sovereigns and private financial institutions.
The issues presented here are summaries of recommendations contained in the document above and in the technical background paper submitted to the Department of Finance with this document. Specific management responses to issues raised are:
1. The government should consider adding some minimum Euro sub portfolio liquidity requirements to the investment guidelines for the EFA.
Euro sub portfolio liquidity requirements are not part of the guidelines (contrary to the US-dollar sub portfolio where a number of liquidity requirements and limits are included in the guidelines) because promotion of orderly conditions in the Canadian dollar in foreign exchange markets in the past has taken place on the C$/US$ cross (the most liquid market for the Canadian dollar). The program's managers will review the value of formal Euro sub portfolio liquidity requirements.
2. The government should continue to eliminate the asset-liability gap of the EFA as soon as possible, and within its expected "near future" time frame. This would allow the EFA to be more completely immunized against foreign exchange or FX risk.
Consistent with program management's policy of immunizing currency and interest rate risk in Canada's reserve program, reducing the asset-liability gap has been one of its main priorities included in its foreign-currency debt strategy in recent years. In December 1998, the program's managers took steps to close the gap by implementing a program of purchases of US dollars in the foreign exchange markets. The gap currently stands at US$1.7 billion, down from its peak of US$13 billion in 1998-99. The remaining gap is expected to be closed in the 2003-04 Fiscal Year.
3. The managers of the EFA should estimate the sensitivities of the market value changes for the asset and corresponding liability sub portfolios for each of the three currency denominations, and conduct an attribution analysis using interest rate and currency indices at reasonably short intervals with the longer term goal of doing such on a daily basis.
The sensitivities of the portfolio market value in response to interest rate changes are reported periodically through the Bank of Canada's Risk Management Unit. The implementation of a new portfolio management information and reporting system at the Bank of Canada, currently underway, will enhance capabilities in this respect. The EFA's policy of matching asset and liability currency and market risk exposure means that, on balance, there is relatively little net exposure to these risk factors.
4. More extensive reporting of counterparties with split ratings that exceed one rating notch should be considered.
The program's managers have a clear policy in place with regards to counterparties with split credit ratings, which applies to ratings split by one or more notches. The program's managers do not see a need to implement a different rule for split ratings that exceed one rating notch; however, counterparties in this situation will be identified clearly in its management reports.
5. The current investment guidelines on eligible counterparties should be reviewed.
The Department's investment guidelines are reviewed annually. The latest review of the guidelines led to an amendment to the guidelines that allows the Government to conduct business with A-rated financial institution (FI) counterparties, in an effort to diversify and reduce the Government's exposure to business counterparties. Exposure limits were implemented for A-rated counterparties and the existing exposure limits for AA and AAA-rated counterparties were lowered in 2002. In addition, the EFA investment guidelines were amended to allow the program managers to invest limited amounts in A-rated sovereign bonds. As part of the ongoing review of the guidelines, the program's managers are currently studying the possibility of broadening the types of asset classes eligible for EFA investments. The analysis, which started in late 2002, will be completed later in 2003.
6. At a minimum, a complete review of the costs and benefits of the current extremely low EFA risk positioning should be quantified and addressed in terms of its desirability.
The program's managers plan to examine the risk positioning of the EFA portfolio as part of a broader review of the investment policy.
7. The term-to-maturity bucket definitions and the guidelines for in-bucket yield curve minimization should be clarified in terms of their ease of implementation.
Maturity buckets were implemented in an effort to ensure asset-liability duration matching across the EFA portfolio. However, the program's managers recognize that past experience has proven that the maturity buckets may have been too narrowly defined as a measure of compliance, thereby making perfect "bucket matching" sometimes difficult, and irrelevant. The program's managers will be reviewing the usefulness of, and possible improvements to, the maturity buckets.
8. Any funding performance evaluations relative to Libor should be based on Libor explicitly (and not implicitly) adjusted for the yield spread between benchmarks of A-rated instruments and instruments with a rating equivalent to that of Canada for a term-to-maturity equivalent to the issue being evaluated.
The funding performance of different groups of borrowers is regularly monitored as part of the EFA fund managers' gathering of market information, and the evaluation of funding opportunities is based on Libor explicitly and relative to other comparable borrowers.
9. While DOF and the BoC are studying the use of additional metrics to measure the performance of the EFA internally, this process needs to be accelerated. Several risk-adjusted cost of carry (CoC) types of performance measures should be developed, and EFA performance standards should become compliant with those of AIMR-GIPS and AIMR-PPS.
The program's managers recognize that the current measure of "carry" is an accounting-based measure which includes several limitations and that additional metrics to measure performance of the EFA could be useful. As a result, the program's managers are currently developing a market-based approach to measure performance. The recent implementation of the Open Link trade-processing system will facilitate the implementation and use of such a measure, which would be compliant with AIMR standards.
10. The government should determine an appropriate target cost of carry based on the amount of factor risk exposure that it is willing to bear in the EFA.
The Department's policy is to minimize the cost of carry of reserves, given the risk and investment guidelines for the EFA. We plan to examine the risk positioning of the EFA portfolio, and the portfolio return given its risk positioning, as part of a broader review of the investment policy.
11. The RMU should continue to move towards a fully integrated approach to risk management, and accelerate its work towards including the impact of market stress on liquidity and credit spreads when assessing the impact of market risk on the market values of assets and liabilities.
Current work by the Bank of Canada is addressing this recommendation.
12. The government should consider the establishment of committees comprised of external (i.e. outside government) advisors for its debt management, including the EFA.
The Department and the Bank of Canada are currently reviewing the funds management governance structure, including a possible role for external advisors.
13. The EFA should review its marking-to-market procedure, including the methods of doing so and the frequency at which assets and liabilities are simultaneously marked-to-market.
The implementation at the Bank of Canada of the Open Link portfolio management reporting system will allow the government to address this recommendation in the near future.
14. Internal procedures for monitoring and addressing process errors/problems associated with transactions executed by external service providers need to be reviewed, and the implementation of the "penalty box" concept needs to be considered.
The frequency of process errors/problems (which are mostly caused by the counterparties rather than the Bank of Canada) has been very low. Depending on the circumstances, the government will impose financial penalties on the counterparty. The procedures in place at the Bank to monitor and identify these failures quickly are regularly reviewed. There has not been one particular counterparty causing errors repeatedly, therefore avoiding the need to develop a "penalty box" concept. However, we would consider the concept in the future.
15. The technical hurdles associated with the end-of-month pricing of assets and liabilities need to be addressed.
With the recent implementation of Open Link, these technical hurdles should be eliminated.
16. An attempt should be made to formalize a composite principles function for the EFA that clearly specifies the relative importance of each individual principle in this composite function and how the individual principles are combined.
In 2003, the Department, in collaboration with the Bank of Canada, will be undertaking analytical work to address this recommendation.