Domestic Bond Markets

	Table of Contents
p. 8 of 13 BACK | NEXT Cover Page Introduction Executive Summary Chapter 1: Government Policies Chapter 2: Regulatory Framework Chapter 3: Market Infrastructure Chapter 4: Liquidity Chapter 5: Risk Management Working Papers Workshop Participants Appendix 1: Introduction Appendix 1: Executive Summary Appendix 1: Findings and Recommendations

Chapter 4
Risk Management

Risk Management from the Issuer’s Perspective

93. In addition to having proper government policies, regulatory framework, market infrastructure and measures to enhance liquidity as discussed in the previous chapters, the fifth and equally important element conducive to domestic bond market development is effective risk management. This is particularly so for governments as key issuers in the bond market. As the Asian financial turmoil has demonstrated clearly, inadequate risk management by governments and major private sector issuers in respect of their bond programmes could make them vulnerable to shocks that disrupt the functioning of financial markets at times of distress. More specifically, an over-dependence on volatile short-term foreign capital flows to finance long-term projects can result in both currency mismatch and maturity mismatch. Under such circumstances, once there is a general loss of confidence in the domestic currency or a burst of asset price bubbles, the short-term foreign capital will be repatriated rapidly. Consequently, there would be added pressure on both currency value and asset prices.

94. As a first step, there should be effective information system to facilitate risk management by bond issuers who should accurately assess the risks that they face. Risk management can be achieved through conducting a risk audit of various categories of risk exposures, e.g.

1. risks related to foreign borrowing, including global interest rate risk, and country-specific shifts in market sentiment (liquidity risk);
2. global business cycle shocks;
3. financial market dislocations; and
4. in the case of governments, risks originating from guarantees for regional or local governments or public sector companies.

95. Major global financial institutions have a great deal of expertise in evaluating such risks, since these firms monitor these risks as part of their own risk management programmes. Bond issuers could draw on such expertise to identify and quantify the risks that they face.

Element 30: Governments as well as private issuers should conduct a risk audit to identify the exposure of its bond programme to various risk categories such as liquidity, maturity and currency mismatch risks, as well as risks arising from explicit and implicit government guarantees.

96. After assessing the risks involved, it is important for bond issuers to reduce their vulnerability to market shocks by properly managing the risks identified. Using public debt as an example, the general tendency to rely on short-term funds can be explained partly by the fact that the goal of public debt management has often been viewed narrowly as getting the lowest possible cost of funds. While keeping today’s interest payments low definitely helps today’s budgetary situation, an over-reliance on short-term funds can increase the risk of financial crisis in the future through the need for frequent roll-over of short-term debts. An effective sovereign debt management programme should therefore also take into account the ability to finance the required amount at a time when it is needed while being consistent with the macroeconomic programme.

97. Some simple rules for managing the risks inherent in sovereign debt programmes can be derived from a range of risk management frameworks. Governments could usefully follow three basic tenets. First, the average maturity of their external liabilities should exceed a certain medium-term threshold (such as three years). Secondly, liabilities should not be concentrated in foreign currency. Thirdly, governments should hold sufficient liquid reserves to ensure that they are always able to cope without new foreign borrowings over a short horizon (such as for up to one year).

98. These simple rules can be defined through the use of more complete sovereign debt risk management frameworks, such as the asset and liability management ("ALM") approach. The ALM framework places the sovereign debt management on the sovereign balance sheet, and provides a tool to analyse the risk of current debt portfolio, establish future funding policies, repayment policy etc. The risks are managed by matching the assets and liabilities in terms of the maturity structure.

99. The approach to sovereign risk management described above is a generally static arrangement. Over the longer horizon, it would be more important for governments to deploy a dynamic and more sophisticated ALM approach to manage risks. This would require governments to move towards a system that takes into account the probability distribution of foreseeable risks. Such techniques and stress testing are useful for governments to adjust their risk profile by taking into account losses that would be incurred in possible, though less probable, future states of the world. One could assess the "liquidity-at-risk" by calculating a country's liquidity position under a range of possible outcomes with different probabilities for relevant financial variables (e.g. exchange rates, commodity prices, credit spreads etc.). In addition, governments should hold sufficient liquid reserves to ensure that they could avoid new borrowing, for example, for one year within 95% confidence limits.

100. It may be noted that much of the above discussions would also apply, mutatis mutandis, to private sector issuers.

Element 31: Governments and private issuers should maintain a debt profile that provides protection against temporary market disruption. Simple rules relating to the maturity and currency structure of debt, and to liquid reserves, can be employed. At a later stage of development, the Asset and Liability Management approach can be used as a conceptual framework for dynamic as well as static risk management.

101. In the process of managing the risks they face, bond issuers should investigate how, and at what price, they could reduce or hedge those risks through financial contracting with other market participants. With such financial contracting, bond issuers can effectively reduce their risk exposure by transferring risks to other private market intermediaries. This can be thought of as purchasing insurance against adverse market conditions. To shift risk to the financial markets would of course involve a price to be paid by the "insured" party. Thus, the amount of risk reduction must be balanced against the costs, which could be substantial. Furthermore, the use of financial contracting for risk sharing should be supported by the capability to identify and monitor such activities, including the potential risks arising therefrom. Examples of financial contracting for such purposes are:

1. to issue bonds the repayment of which is linked to commodity prices;
2. to arrange credit facilities that allow the issuer to borrow at a predetermined interest rate or interest rate spread in times of crisis; and
3. to purchase options in order to hedge risks as part of a sophisticated risk management arrangement.

Element 32: Government and private issuers may try to conduct risk-sharing through financial contracting to hedge against the potential costs arising from adverse market conditions. They could consider using derivatives securities for this purpose but they should fully understand the risks involved and implement appropriate risk management systems.

Risk Management from the Investor’s Perspective

102. The major risks related to fixed-income investments are:

1. credit risk (counterparty risk, borrower risk and sovereign risk);
2. market risk (interest rate risk, price risk, currency risk and correlation risk);
3. liquidity risk, operational risk, fiduciary risk, legal risk, concentration risk etc.

103. For an investor to effectively monitor, measure, and control the above risks, a core set of sound risk management practices is a necessity and such practices should be promoted at least among the major bond investors, public or private. While the size, scope, and complexity of an investor’s fixed-income holdings and risk management programmes may differ, there are six key components that are essential to all sound risk management programmes.

104. The first component is that the Board and senior management of institutions that invest in bonds must provide an effective oversight of the fixed-income investment portfolio. Effective Board and senior management oversight is indispensable for a sound risk management programme. Therefore, the Board and senior management must understand and exercise respective authorities to manage and control the risks related to its securities portfolio. Communication is a strong deterrent to covering up losses and thus the Board should always be kept fully updated by the senior management.

105. The second component is that the institution should have an effective mechanism and delegation of responsibility to different units to implement the investment and risk management policies. Investment policies and guidelines provide the basic framework for managing the securities portfolio. Policies should delineate the responsibilities of the Board and senior management, pinpoint key objectives, constraints, guidelines for acquiring and ongoing monitoring of portfolios, and reporting requirements. In terms of division of responsibility, while the senior management would be responsible for operational management, the Board should be responsible for approving all relevant investment and risk management policies. Policy guidelines should also assign the responsibilities of the front office (primarily responsible for dealing functions), the back office (for settlement and accounting functions) and the middle office (with independent risk oversight and audit, and performance measurement and analysis functions). In addition, the policy guidelines should also outline the stress testing framework and frequency, accounting guidelines, and a mechanism to review all new fixed-income products to be purchased. Policies should clearly articulate an institution’s risk appetite by setting benchmark with preferred neutral positions for foreign currencies and maturity profile, and limits on exposure to credit, market, settlement and liquidity risks etc.

106. The third component is that institutions should develop robust risk measurement, identification and reporting systems. In order to obtain the institution’s overall risk profile, an institution’s system for measuring credit, market and liquidity risks of its fixed-income portfolio should be aggregated across securities positions and integrated with similar exposures arising from other business activities. Risk measurement standards should be established for pre- and post-purchase analysis. Timely and accurate risk reporting is another essential tool to manage domestic bond portfolios. Management reports should summarise all investment activities and have the capability to convey information on the risks, returns, and overall performance of an institution’s fixed-income portfolio.

107. The fourth component is that institutions should periodically conduct stress test on their fixed-income portfolios and consider the results when establishing risk limits. Institutions should conduct stress testing, which involves revaluing the entire portfolio under extreme conditions. Institutions should also seek to identify the combination of credit and market events that could produce substantial losses or liquidity problems. Stress testing should be conducted independently of the portfolio management function.

108. For fixed-income products, stress testing should identify an institution’s sensitivity to interest rates, prepayment risk, changes in credit spreads, yield curve shifts and other relevant factors. Stress testing should not be limited to quantitative methods, because they are not able to capture qualitative factors such as market liquidity and changes in market sentiment, etc. Successful stress testing methodologies address these issues with non-quantitative techniques, such as scenario analysis.

109. The fifth component is that institutions should provide for a strong internal control and audit system, including the establishment of an independent review of the fixed-income portfolio. Institutions should staff the operations area with skilled personnel and establish a documentation/record keeping system that is commensurate with the scope of its investment activities. A rigorous internal control and audit framework contains three fundamental parts:

1. maintaining an appropriate segregation of duties;
2. conducting independent reviews of the fixed-income management function; and
3. enforcing official lines of authority.

110. Individuals responsible for risk measurement, monitoring and control should be independent of the risk-taking units. An independent and vigilant risk oversight department, comparing the middle office responsible for risk management and compliance suggested in paragraph 105, with direct reporting line to the senior management or the Board, is another key component of a strong risk management programme.

111. The sixth and the final component is that institutions should periodically review and update their risk management programmes. Many institutions have established the best risk management systems available at the time and designed new reports, but have then failed to realise that the systems are static, while the markets and their portfolios are not. One of the challenges facing financial institutions is that prudent best practices change with time and financial institutions need to upgrade their systems and risk management programmes accordingly. The frequency of the reviews should reflect the nature of an institution’s bond holdings and the pace of market innovations in measuring and managing risk. Reviews by external auditors or other qualified outside parties can often supplement internal evaluations which can usually be done by the middle office or a similar oversight department.

Element 33: Bond investors should formulate sound investment and risk management policies, with clear delineation and segregation of duties and responsibilities between risk-taking and risk-monitoring, and robust internal control systems.

Credible Risk Assessments

112. When the capacity of investors to analyse credit is not well developed, governments are often tempted to set a minimum rating for issuers. This, it is thought, will prevent the worst of the borrowers from coming to the market. Such a policy has several drawbacks. First, it can simply divert the issuance into an unregulated channel. For instance, issuers unable to sell bonds may issue commercial paper, thereby actually raising the financial risk profile of the borrower by shortening the maturity profile of its debt. Secondly, such a policy creates a strong demand for easy graders. Finally, such a policy, by vesting in the rating agencies the power to deny access to the marketplace, may raise the potential costs of any analytic errors in the rating process.

Element 34: Government should avoid setting minimum credit rating requirements for bond issuers in order not to divert issuance into unregulated channels that may ultimately raise the overall financial risk profile.

113. Ratings-based regulations have proliferated because they allow sensible distinctions to be made while leaving public authorities at a distance from the responsibility for making those distinctions. In some cases, governments could well find it useful to specify minimum ratings for public policy reasons, e.g. for the purpose of repo transactions or regulating access to discount window facilities. In other cases, however, ill-conceived or badly executed policies based on ratings can induce "competition in laxity", leading to the development of rating agencies specialising in high ratings. In particular, regulations that treat all ratings equally in the face of evidence of systematic differences are problematic. More generally, regulations can distort the ratings business from one ultimately grounded in credibility with investors to one driven by the convenience of issuers and regulatory arbitrage. Although a market process may ultimately ensure that bad raters do not survive, such a process works over business and asset cycles and much damage could be done in the meantime. There may be a tragedy of the commons: each regulator may feel that his use of ratings is the best available choice, but the accumulation of regulatory uses may spoil the rating business. Governments should therefore avoid an over-reliance on credit rating agency assessments. In particular, governments should avoid seeking minimum credit rating requirements for the investment portfolios held by private sector investors.

Element 35: Government should avoid an over-reliance on credit rating agency assessments and, when considering any ratings-based regulations, should carefully evaluate the potential implication for the financial system and financial market participants, including credit rating agencies.

114. Credit rating agencies owned by issuers of securities have an inherent credibility problem. Whether the ownership is vested in governments, corporations or banks, the ability of the rating agency to treat its owners or their competitors fairly will inevitably be under question. Similarly, a rating agency staffed by bankers on secondment will not be seen as credible in assigning ratings to their former and future employers. Ratings reviewed by a committee of executives including those from the firms being rated will also suffer credibility in the marketplace. Thus, credit rating agencies should avoid conflict of interests in their ownership, staffing and decision-making processes.

115. Credit rating agencies recognise the value of consulting issuers in order to obtain their perspective and outlook, as well as to gain access to non-public information. The rating agencies should maintain the highest degree of objectivity in their rating assessments. Sharing drafts with the issuers actually serves the rating agency’s own interest in quality control and prevents the disclosure of non-public information. In addition, to the extent that differences of opinion arise between rating agencies and the issuers concerned, access to the draft opinions will permit the issuers to formulate a public response and thereby contribute to an informed public assessment of the credibility and reliability of the ratings. It must be recognised, however, that the flow of events at times will preclude any prior discussion of rating changes. Rating agencies also need to prevent the abuse of any prior knowledge of rating changes, which can have value in the marketplace. Subject to these constraints, a high level of transparency should be maintained for the rating process.

116. While most major rating agencies publish unsolicited ratings, practice with respect to the identification of them as such varies. Some agencies believe that the users of ratings have the right to know that the rating is merely based on information in the public domain, while others resist the implication that the opinion expressed in the rating is somehow less well-founded or reliable than ratings issued after consultations with the issuers, which may include access to non-public data. Credit rating agencies should state their policies on unsolicited ratings so that users of a rating should be able to know the policy of any particular agency.

Element 36: Credit rating agencies should be encouraged to maintain and improve their credibility and reputation by avoiding conflict of interests in their ownership, staffing and decision-making processes; allowing issuers to comment on draft rating opinions when possible; maintaining the highest possible level of transparency and objectivity in the rating processes; and publicly disclosing their policies on unsolicited ratings.

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