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REPORT ONRISK MANAGEMENT

IN CONTEXT TO RBI

WITH EMPHASIS ON

SOVEREIGN RISK FOR

FOREIGN RESERVES

For Reserve Bank of India, Patna

April - June, 2013


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Report

On

Risk Management in Context to RBIwith Emphasis on Sovereign Risk

for Foreign Reserves

ForReserve Bank of India, Patna

Guided by Shri Manoj Kumar Singh, Manager, RBI

Prepared By:

Saurav SinghPGDM 2012-14

CIMP, Patna


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April June 2013

ACKNOWLEDGEMENT

Every journey is an enlightening experience, an Ithaca in itself. These are butmy sentiments as I reflect back at my Summer Internship period at Reserve

Bank of India, Patna.

The role of proper facilitation and conducive environment is sine-qua-non for

any study to successfully take place. I would like to sincerely thank RBI, asan organization for providing me the same. In this regard, I would like toexpress our special gratitude to Shri P.K Jena, Regional Director (Bihar &Jharkhand), RBI for providing me the opportunity of doing my summerinternship project in esteemed organization.

I express our gratitude and sincere thanks to Shri Manoj Kumar Singh,Manager, RBI, my mentor for the project for his able guidance andcontinuous support in ensuring a smooth journey for me in the project. Atthe same time, I also drew a lot of exposure from his enriching experience inthis field.

I would also like to thanks Shri Praveen Kumar, Manager, RBI for hisvaluable suggestion and inputs to my project.

Last but not the least, I thank my faculty members and friends for theircontinuous support and guidance.

Saurav Singh


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Declaration of Fidelity and Secrecy

I SAURAV SINGH s/o Shree Priya Ranjan Kumar, pursuing M.B.A fromCIMP,Patna do hereby declare that I will faithfully, truly and to the best of myskill and ability execute and perform the duties required of me as a SummerIntern of the RBI,Patna.

I further declare that I will not communicate or allow to be communicated to anyperson not legally entitled thereto any information relating to the affairs of theRBI or to the affairs of any person having any dealing with the RBI; nor will Iallow any such person to inspect or have access to any books or documents

belonging to or in the possession of the RBI and relating to the business of the

RBI or to the business of any person having any dealing with the RBI.

Signature


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EXECUTIVE SUMMARY

I have always wondered whether it is possible to understand What Risk is?

and whether we can ever be so capable as to understand the new forms in which

risk can emerge. The curiosity of analyzing risk and how risk management canhelp in decision making, evoked me to do my project in risk management.

The following studies are partially based on my own understanding of risk andpartially based on expert opinion on the subject. I know study of risk can be

highly technical but I have tried my best to be as simple as possible.

My project titled Risk Management in context to RBI , with emphasis on

Sovereign Risk f or f oreign reserves. is divided in two parts. First part deals

with basic understanding of risk, types of risks, risk management in Centralbanks and Risk Management system at Central banks including RBI. Second part

is focused on Sovereign Risk for managing foreign reserves. Optimum foreignreserves, cost of maintaining foreign reserves and indicators of sovereign risk

that has to considered while deploying foreign reserves.

Based upon the comparative study I have tried to analyze risks faced by differentdepartment of RBI while performing its core functions. I have tried to compare

risk mitigation measures taken by RBI with risk mitigation measures of othercentral banks. I have concluded with common risk model in order to access risks

faced by RBI on whole.

There are many factors that determine the demand placed on the forex reserves.

The exchange rate regimen adopted by a country, the extent of openness of its

economy and the nature of the markets operating in that country, together

determine how forex reserves are held, and are used in dealing with other

countries. Central banks throughout the world have sometimes cooperated in

buying and selling official international reserves in an attempt to influence

exchange rates. The guidelines of Forex reserve management in India are similar

to those of many central banks in the world. I have tried to analyze optimum

reserves amount for India based upon various available literatures. I have also

found out cost associated with holding foreign reserves.


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With the onset of the sovereign debt crisis in 2008 which is still unfolding,

sovereign risk management has assumed importance in recent times. Reserve

bank of India being the central bank of the country is the custodian of nations

foreign exchange reserves. It deploys foreign reserves in different permissible

assets such as balances/ deposits with other central banks, top rated foreigncommercial banks, and with BIS; treasury bills and dated securities issued by top

rated sovereign nations. Deployment of reserves in the above mentioned

instruments were so far considered as risk free. However, with the onset of debt

crisis, the role of central bank as an investor and manager of foreign reserves

has become very challenging.

Right now liquidity, safety and return are prime factors that RBI looks for

placing its foreign reserves among various components. While deploying itsreserves among treasury bills and bonds of sovereign nation, there is possibility

of defaulting of nation. I have tried to find out various factors that fund manager

of foreign reserves may consider for mitigating the sovereign risks associated

with the investment. For this purpose I have compared various economic

parameters of ten defaulting nations at time of their defaults and find out prime

factors to be considered. Based upon my study, I have also prepared a tree map

for predicting sovereign external debt crisis.

Analysis and opinions done in my project are based on secondary data availableon websites. I hope my present study is able to identify the challenges being faced

by central banks across globe.


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CONTENTS

SL. No. Particulars Page no.

Acknowledgement 03

Executive Summary 05

1 Introduction 08

1.1 Risk and Risk management 08

1.2 Financial Risk Management 09

1.3 Risk Management for RBI 13

1.4Approach of Central Banks towards RiskManagement 17

1.5Risk Management System- Importance to Centralbanks 18

1.6 Foreign ReservesWhat is need of holding it. 20

1.7 Sovereign Risk for Foreign Reserves 24

2 Scope ,Objectives and Methodology of Project 25

3 Literature Review 274 Analysis 46

5 Recommendations 73

6 Bibliography 74


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1.INTRODUCTION

Last month I decided to take a flight to New Delhi for an urgent work. The flightgot cancelled due to bad weather and finally I was not able to complete that work.

I have incurred heavy loss due to it. Then I realized there was always uncertaintyinvolved in completion of my work. Then there was another incident when myfather invested his savings in shares and after some time he informed us that hehas incurred heavy loss. After these incidents I realized that there was alwaysuncertainty in happening of the expected outcomes. This uncertainty is termed as Risk.

1.1 Risk and Risk management

Before we move on to any formal definition of risk or risk management, I wouldlike to narrate one personal experience. One of my friend is having a motorcarand for him owning a motorcar is an opportunity to become more mobile andgain the related benefits. However there are uncertainties in owning a motorcarthat are related to maintenance and its repair. He may also get involved inaccidents due to his motor car, so there are obvious negative outcomes that canoccur. When I enquired him about his experience of owning a motorcar, hesimply told me that there is risk in owning a motorcar. Examining his situation,the first lesson regarding risk is that you can best learn only through experience.

However learning through experience may entail its own cost, so the smartestway to learn is to learn through experience of others.

Risk may be defined as an event with the ability to impact, inhibit, enhance or

cause doubt about the mission, strategy, projects, routine, operations, objectives,core processes, key dependencies and /or the delivery of stakeholder

expectations.(IUPJ-2012)1

1 The IUP Journal of Financial Risk Management, Vol. IX, No. 4, 2012


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Definitions of risk can be found from many sources and some key definitions canbe summed up as,

Sl.No. Organization Definition of risk

1ISO Guide 73ISO 31000

Effect of uncertainty on objectives. An effect maybe positive, negative or a deviation from theexpected. A risk is often described by an event, achange in circumstances or a consequence.

2Institute of RiskManagement(IRM)

Risk is the combination of the probability of anevent and its consequence. Consequences canrange from positive to negative

3"Orange Book"from HM treasury

Uncertainty of outcome, within a range ofexposure, arising from combination of the impactand the probability of potential events.

4Institute of InternalAuditors,USA

The uncertainty of an event occurring that couldhave an impact on the achievement of theobjectives. Risk is measured in terms ofconsequences and likelihood.

Many more definitions can be listed but I really wonder whether any of them caneffectively capture essence of risk in all its dimension.

Whatever we do and whatever we dont do carries some risk. Even in our day today activities we are exposed to various types of risks and we have been taking iteither willingly or unwillingly. Sometimes our action of not doing results in

positive outcome and sometimes our action results in negative outcome. Howeverit also happens that our action leads to uncertainty. Risk may have positive ornegative outcomes or may simply result in uncertainty.

Risk management may be defined as coordinated activities to direct

and control an organization with regard to risk. (ISO GUIDE 73, BS 3110)

Risk management is basically all about evaluating risks and taking measures toeither mitigate them or changing our decision if possible. However at times itmay be possible that decision has to be made, in that case we try to minimize theloss based upon assessment of risk.


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Fig No.1 RISK MANAGEMENT PROCESS, AIRMIC, ALARM, 2002

1.2Financial Risk Management

Financial risk is probability of occurrence of such events which will cause loss of

money. (IUPJ-2012)

Process of identifying and managing financial risk in order to avoid losses is

known as financial risk management. Depending upon the nature of organization

and its activity many financial risks can be managed.

Be it individual or be it organization, no one wants to incur loss due to bad

decisions.

This financial risk and its management is not new, it is being their right from

ancient days. Even then security was required for giving loans or loans were

given to those people who were having worth. This action of asking for security

is actually risk management measure in lieu of loan taker may default. However

in the era of globalization where financially events are dependent upon each

Establishing the

Context

Risk

Assessment

RiskTreatment

Monitor andReview

Communication

The context describe and help to understand which riskswill be.

To identify, analyze and evaluate the risk.

Selecting and implementing measures to modify the risk

To monitor and review the risk treatment measures.

Selecting information and communicating to stakeholders.


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other, even USA presidential election results can lead to favorable or unfavorable

movement in SENSEX in India. It is very difficult to analyze financial risk and

its consequences.

For an individual or an organization financial risks can be analyzed dependingupon market environment and other factors. Since my project is based upon risk

management in prospective of a central bank, it would be better to define various

financial risks in context to central banks

RISKS TO BE MANAGED (For central banks)

Credit Risk

Volatility Risk

Market Risk

Systemic Risk

Liquidity Risk

Operational Risk

Financial Risks

Reputational Risk

Settlement Risk

*Based upon general understanding of workings

of central banks around the globe

Non-Financial Risks

All risks that doesntcause any financial loss toorganization are callednon-financial risks.

These risks basicallyinclude all those eventswhose occurring may leadto non-occurrence ofevents that doesnt havefinancial impact.

It includes legal risk, IT&systems risks, internal

control risks etc.


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Credit Risk

Credit risk is defined as the potential thata borrower or counterparty will fail

to meet its obligation in accordance with agreed terms.1

Being a lender to last resort, Central banks has to give short term loans to banks

operating in their countries and hence have to bear this risk. Also Central banks

are responsible for investing their foreign reserves in form of bonds /treasury

bills. There is risk that these bonds or treasury bills issuing entity may default and

likewise the risk involved will be credit risk.

Market Risk

Market risk is the risk of losses in positions arising from movements in marketprices. Market risk for a multi-currency portfolio represents the potential change

in valuations that result from movements in financial market prices, for example,

changes in interest rates, foreign exchange rates, equity prices and commodity

prices. The major sources of the market risk for central banks are currency risk,

interest rate risk and commodity price risk (movement in gold prices).2

Currency risk arises due to change in price of one currency in comparison to

other, change in ask rate or bid may result in increased or decreased portfolioreturn.

Interest rate risk arises due to movement in interest rates of bonds or other

investment of Central banks. It happens when Central banks principal and

interest cash flows from assets do not coincide with the principal, interest and

benefit cash flows derived from liabilities.

Commodity price riskarises due to movement in price of commodity (as gold).Asper the recent report by Bloomberg gold comprises of major portion of reserves

of Central banks and any change in price of gold may lead to risk to banks.


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L iquidity Risk

Liquidity risk involves the risk of not being able to sell an instrument or close a

position when required without facing significant costs. The reserves need to

have a high level of liquidity at all times in order to be able to meet any

unforeseen and emergency needs. Any adverse development has to be met withreserves and, hence, the need for a highly liquid portfolio is a necessary

constraint in the investment strategy.1

The choice of instruments determines the liquidity of the portfolio. For example,

in some markets, treasury securities could be liquidated in large volumes without

much distortion of the price in the market and, thus, can be considered as liquid.

Except fixed deposits with the BIS, foreign commercial banks and central banks

and securities issued by supranational, almost all other types of investments arehighly liquid instruments which could be converted into cash at short notice.

Volatil ity Risk

Volatility risk arises due to change of price of a portfolio as a result of changes

in the volatility of a risk factor.3

Central Bankss have diverse portfolio depending upon their need, however

change in volatility of risk factors upon which portfolio is based may lead loss or

decrease in return.

Reputational Risk

Reputational risk arises when there is a mismatch between public perceptions

and the actual objectives and resources of the central bank. Central banks face

significant reputational risk, especially during times of crisis, and reputational

damage to a central bank could take decades to repair.4

In general there is expectations among people of nation for Central Banks.

Whether it be coming up with monetary policy or be it be simple regulatory

measure, any lapses either in policy making or regulatory actions leads to

reputational risk.


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Settl ement Risk

Settlement risk arises when a counterparty does not deliver a security or its

value as per agreement when the security was traded after the other counterparty

or counterparties have already delivered security or value as per the trade

agreement.5

Central banks foreign exchange transaction bears transactional risk. As foreign

exchange reserves are deployed among various instruments for different

purposes, sometimes it becomes mandatory to deploy funds in specific

instrument and neglect transactional risk involved in it.

Operational RiskOperational risks arises due to system and processes through which Central

bank operates. Any fraud, misleading conduct or predefined procedure may lead

to operational risk.6

These risks are basically due to activities of Central banks and with proper

control and monitoring it can be avoided to great extent.

Systemati c RiskSystematic risk arises from market structure or dynamics which produce shocks

or uncertainty faced by all agents in the market; such shocks could arise from

government policy, international economic forces, or acts of nature. One of key

role for central banks is to use their panoramic view of the financial system to

identify system-wide vulnerabilities. Central banks are well placed to recognize

risks and prioritize them within a framework that maps potential weaknesses and

traces the chain of cause and effect throughout the system.7

In context to systematic risk, we can say that lapses in identifying any of the risksassociated with central bank and failing to mitigate those risks may lead tosystematic risk. Central banks generally identifies key factors acrossmacroeconomic and microeconomic environment that may lead to systematicrisk. Central banks use to continuously measure these factors and consider thesefactors while policy making.


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1.3Risk Management for RBI

Talking about risk and risk management for RBI, It would be interesting to first

analyze the role and function of RBI. Each of the functions of RBI may expose itto an altogether different kind of risk. (Reserve Bank of I ndiaBrochure,November, 2012)

1.Monetary AuthorityMain objective of RBI for its role of monetary authority is to maintain price

stability and ensure adequate flow of credit to productive sector. For this RBI use

to formulate, implement and monitor the monetary policy.

2.Issuer of CurrencyThe Reserve Bank is the Indias sole note issuing authority. Along with theGovernment of India, it is responsible for the design and production and overallmanagement of the nations currency, with the goal of ensuring an adequate

supply of clean and genuine notes. The Reserve Bank also makes sure there is anadequate supply of coins, produced by the government.

3.Banker and Debt Manager to GovernmentManaging the governments banking transactions is a key RBI role. Like

individuals, businesses and banks, governments need a banker to carry out their

financial transactions in an efficient and effective manner, including the raisingof resources from the public. As a banker to the central government, the ReserveBank maintains its accounts, receives money into and makes payments out ofthese accounts and facilitates the transfer of government funds. RBI also act asthe banker to those state governments that have entered into an agreement with it.

The role as banker and debt manager to government includes several distinctfunctions:

Undertaking banking transactions for the central and state governments tofacilitate receipts and payments and maintaining their accounts.

Managing the governments domestic debt with the objective of raising therequired amount of public debt in a cost-effective and timely manner.

Developing the market for government securities to enable the governmentto raise debt at a reasonable cost, provide benchmarks for raisingresources by other entities and facilitate transmission of monetary policyactions.


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4.Banker to BanksLike individual consumers, businesses and organizations of all kinds, banks needtheir own mechanism to transfer funds and settle inter-bank transactions such as

borrowing from and lending to other banks and customer transactions. As the

banker to banks, the Reserve Bank fulfills this role. In effect, all banks operatingin the country have accounts with the Reserve Bank, just as individuals andbusinesses have accounts with their banks.

As the banker to banks, RBI focuses on:

Enabling smooth, swift and seamless clearing and settlement of inter-bankobligations.

Providing an efficient means of funds transfer for banks. Enabling banks to maintain their accounts with us for purpose of statutory

reserve requirements and maintain transaction balances. Acting as lender of the last resort.5.Regulator and supervisor of the financial system

Prime objective of RBI for this role is to maintain public confidence in the banksofsystem, protect depositors interest and provide cost-effective banking servicesto the public.The regulation and supervision of the financial system in India is carried out by

different regulatory authorities. The Reserve Bank regulates and supervises themajor part of the financial system. The supervisory role of the Reserve Bankcovers commercial banks, Urban Cooperative Banks (UCBs), some FIs and

NBFCs.

6.Manager of Foreign ExchangeWith the transition to a market-based system for determining the external valueof the Indian rupee, the foreign exchange market in India gained importance in

the early reform period. In recent years, with increasing integration of the Indianeconomy with the global economy arising from greater trade and capital flows,the foreign exchange market has evolved as a key segment of the Indian financialmarket.In this role objective of RBI is to facilitate external trade and payment and

promote orderly development and maintenance of foreign exchange market in

India.


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7.Regulator and Supervisor of Payment and Settlement SystemsPayment and settlement systems play an important role in improving overall

economic efficiency. They consist of all the diverse arrangements that we use to

systematically transfer money currency, paper instruments such as cheques, andvarious electronic channels.

8.Maintaining Financial StabilityPursuit of financial stability has emerged as a key critical policy objective for the

central banks in the wake of the recent global financial crisis. Central banks have

a critical role to play in achieving this objective.

The approach adopted by the Reserve Bank to maintain financial stability ismulti-pronged: maintenance of overall macroeconomic balance through monetary

policy; improvement in the macro-prudential functioning of institutions andmarkets; and strengthening micro-prudential institutional soundness through

regulation and supervision. In this regard, the RBI has been working in closecoordination with other domestic regulators.

There is a separate department for Risk management, namely Risk Monitoring

department at central office, Mumbai being headed by Mr.N. Krishna Mohan,C.G.M. Though there is separate department for risk management in spite of it

risk assessment of different departments are done at their own end. Core function

of Risk monitoring department is to monitor the risk involved with various banks

operating in India and facilitates Risk Based Supervision.

1.4Approach of Central Banks towards Risk Management

On a general level, the Central Banking Publications survey in 2005 found thatrisk awareness in central banks is at a fairly low level; only 15% of central banks

surveyed have an independent risk-management unit. Formal responsibility for

monitoring and management of risk is still generally decentralized at

departmental or head of function level. This results in a focus on the control of

risk rather than active management of it. Many would argue that it is not for a


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central bank to actively manage risk for its own benefit, since this may conflict

with its statutory objectives associated with ensuring stability of the financial

system and defending the currency. It is particularly in the context of foreign

exchange and foreign exchange reserves management that this issue is relevant

for a central bank.However, in wake of recent global crisis, risk-management practices, including

the existence of a central risk management function, are only now being

developed in many central banks. The monitoring and/or management of risk,

including reporting to risk committees on daily risk exposures, limits etc., usually

lies in the financial markets area and in the reserve management department.

Only a few central banks seem to have a separate risk management function

responsible for central bank-wide risk. Several developing countries central

banks are in the process of implementing a separate risk management departmentthat monitors the central bank-wide risks. Some of these countries include

Australia, Ireland, and Brazil etc.

1.5 Risk Management System- Importance to Central banks

For central banks, because of their reputation and emphasis on stability, riskmanagement assumes a greater prominence than other institutions active in the

financial sphere. Central banks are well known for their conservative, risk-averseapproach to all aspects of their operations. This is a natural consequence of their

primary function, which is the pursuit of financial stability. Although differentcentral banks have differing objectives and emphases, these objectives generallyrevolve around financial stability; in particular, the stability of money and thestability of the financial system. For a central bank to succeed in delivering thisstability, it is very important that it earns, and then retains, the confidence ofother market operators as a secure, stable and reliable institution itself.1

Central banks face a variety of risks in their operations, both financial and non-

financial. Non-financial risks are best controlled by the adoption of appropriatemanagement procedures and checks, and the naturally risk-averse nature ofcentral bank senior management is well suited to these. However, financial risksare too complex, and in many cases too fast-moving, to be left entirely to thenatural conservatism of the central bank ethos.


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Lorenzo Bini Smaghi, former Member of the Executive Board of the ECB, seesthe three main risks facing central banks as:

A major financial institution becoming insolvent, giving rise totensions in the financial markets and further interventions to mitigate

these risks. This could also lead to balance sheet losses. A major sovereign debt restructuring or default, with impact on the

balance sheet and contagion to other assets.

Central bank money is not withdrawn sufficiently quickly to avoidinflation creeping up, with impact on inflation expectations and

long-term interest rates.

The best way of lowering these risks, Bini Smaghi says, is to take appropriaterisk control measures for the assets in the banks balance sheet; tighten

supervision over the banking system and the process of de-leveraging; and

prepare adequate instruments to absorb liquidity ahead of emerging inflationarypressures, including the issuance of certificates of deposit or term deposits by thecentral bank, and standing ready to tighten monetary conditions.

In tackling risks associated with their operations, Central banks are nearly inprivileged position to amend and modify their strategy. However, whilemanaging its reserve management operations, central banks are exposed to samekind of financial risks as other market participants. So like other participantscentral banks has to also access for themselves the level of risk they are ready to

bear.

Christian Noyer1 points out that financial risk can be increased by virtue ofpolicy decisions on foreign currency exposure, in particular reserve assets, forcurrency management reasons. This, together with exposures to domestic andforeign interest rates, is the main source of financial risk.

For most institutions, where the end objective is the pursuit of financial return,

this is an exercise in comparing risks(i.e. financial losses) and rewards (i.e.financial gains), which therefore makes the judgment mainly a financial one. Ifthe rewards for an operation do not justify the risk, the institution will usuallywithdraw from that operation. For a central bank, however, the end objective ofits operations is usually the pursuit of a chosen policy (for example, maintainingthe exchange rate at a certain level), rather than merely financial gain. In thiscase, it may be unwilling or unable to withdraw from an operation, even if asimple financial cost-benefit analysis suggests that it is unfavorable. The very act


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of holding net foreign exchange reserves entails an unavoidable currency risk, asthe liabilities that fund the net reserves will be denominated in domesticcurrency. This risk cannot be reduced without reducing the holdings of thereserves themselves. Similarly, other risks (for example credit risk, liquidity risk,interest rate risk, currency risk and cross-country spread risks) constitute anintegral part of holding reserve assets, and cannot be wholly avoided. 1

1.6 Foreign ReservesWhat is need of holding it.

The International Monetary Fund defines foreign exchange reserves as externalassets that are readily available to and controlled by monetary authorities fordirect financing of external payments imbalances, for indirectly regulating the

magnitudes of such imbalances through intervention in exchange markets to

affect the currency exchange rate, and/or for other purposes.2

According to RBI Act 1934, reserves refer to both foreign reserves held in goldand foreign currency assets (held by issue department) and domestic reserves inthe form of bank reserves. Monetary authority acts as a custodian for thesovereign government which is a principal of the foreign reserve.

There are principally three distinct motives of holding reserves. According to BIS

Economic Papers, No. 38 1993, these four motives can be applied to theholding of reserves by central banks.

Transaction needs: It includes financing the foreseeable foreign exchangedemands of public and private sector in the country such as a governmentwishing to repay a maturing foreign loan. The transaction need of forexreserve is more prevalent in the countries where access to internationalcapital market is limited. Many developing and under developed countrieshave very restricted access to External Commercial Borrowing (ECB). Insuch cases borrowing to finance current account deficit is more costly thandrawing from reserves. Hence transaction needs are more dominant in thedeveloping countries than developed countries.


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Intervention needs: This corresponds to precautionary demand for moneyrequired for effective intervention in the foreign exchange market. It helpsthe central banks to intervene i.e. buy or sell foreign exchange in themarket to influence the value of currency. Forex reserves are held for this

purpose is prevalent in the countries which have relatively open market forgoods and capital and/or has fixed exchange rate regime (ERM). Theintervention needs can be further divided into very Short term and Mediumterm.

Very Short term ERM: Generally Central banks of countries with veryopen capital market apply very short term ERM. Such interventionstypically in Sterilized nature used to offset the effects of volatile and shortterm speculative capital movement which does not relate to underlyingeconomic fundamentals. Typically central banks of developed countries

apply very short term ERM.

Medium term ERM: Unsterilized medium term ERM are used as aninstrument with the objective macro-economic macroeconomicstabilization policy with regard to prices and output. There are basicallytwo ways of implementing monetary policy response to exchange ratemovement. One being directly intervening in the domestic monetarysystem by changing interest rate and other being indirectly impactinginterest rate by intervening in the foreign exchange rate market. Typically

developing countries central banks employ medium term ERM.

Buffer Needs: A substantial foreign exchange reserve serves as a bufferagainst international financial shocks and crises.

Wealth diversification: Most central banks consider safety, liquidity andreturn as the major reserve management objectives. Wealth considerationsinfluence decisions on the compositions of the reserves. It is important tonote that countries usually diversify their currency portfolio into US dollar,EURO, sterling, Japanese yen etc. Gold is often held for the same reason of

diversification only. When the sovereign government has net foreigncurrency debt, central bank typically build forex reserves to maintain orenhance countrys international credit worthiness.


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Different reasons for holding foreign exchange reservesimportance attributed by reservemanagers according to a JPMorgan survey in April 2008,

Foreign Reserves and Financial Assets of Central Banks, 2007


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In case of India, broadly the objectives of holding foreign exchange reserves canbe encapsulated as: (Indias Foreign Exchange Reserves: Policy, Status andI ssues, Y. V.Reddy)

Maintaining confidence in monetary and exchange rate policies. Enhancing capacity to intervene in forex markets. Limiting external vulnerability by maintaining forex reserve liquidity to

absorb trade or capital shocks. Maintaining credit worthiness in the international credit markets Boosting confidence of market participants by demonstrating backing of

domestic assets by external assets.

Latest Foreign Exchange report of RBI (September 2012), shows that reservesstood at US$ 294.4 billion as at end-March, 2012. During the half year under

review, it came down to US$ 286.0 billion at the end of May 2012 after which itfollowed upward trend and increased to US$ 294.8 billion at the end ofSeptember 2012.

From Foreign Exchange report, RBI (September 2012)


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Although both US dollar and Euro are intervention currencies and the ForeignCurrency Assets (FCA) are maintained in major currencies like US dollar, Euro,Pound Sterling, Japanese Yen etc., the foreign exchange reserves aredenominated and expressed in US dollar only. Movements in the FCA occurmainly on account of purchases and sales of foreign exchange by the RBI in theforeign exchange market in India, income arising out of the deployment of theforeign exchange reserves, external aid receipts of the Central Government andthe effects of revaluation of the assets.

In its report RBI also states that, adequacy of reserves has emerged as animportant parameter in gauging the ability to absorb external shocks. With thechanging profile of capital flows, the traditional approach of assessing reserveadequacy in terms of import cover has been broadened to include a number of

parameters which take into account the size, composition and risk profiles of

various types of capital flows as well as the types of external shocks to which theeconomy is vulnerable.

1.7 Sovereign Risk for Foreign Reserves

With the onset of recent global crisis lot of talk and measures are being taken inorder to manage sovereign risk. Central banks across globe being custodian tocountrys foreign exchange reserves deploy foreign reserves in different

permissible assets such as balances/ deposits with other central banks, top ratedforeign commercial banks, and with BIS; treasury bills and dated securitiesissued by top rated sovereign nations. However these deployments wereconsidered to be risk free as it was believed that any sovereign nation can hardlydefault its obligations but as the recent European debt crisis has shown, central

banks are forced to change their perception and consider this sovereign risk whiledeploying foreign reserves.

IMF has defined sovereign risk as the risk that a government may default on itsdebt obligations. In general, when governments have bonds that are due to

mature, they dont have sufficient tax receipts on hand to repay all the debt, sothey re-enter the market to raise further money via a bond issuance. Sovereignrisk thus includes refinancing risk, when a government is unable to raisesufficient new debt in the market (i.e. at reasonable market prices and insufficient volume) to repay upcoming bond maturities. RBI, being a custodian toforeign reserves have to access the risks while deploying its foreign reservesamong various options.


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2. SCOPE, OBJECTIVES AND METHODOLOGY

A.Scope of the project

Central banks, in performing their policy tasks, are exposed to a variety offinancial and non-financial risks, which they may want to manage. One such keyrisk concerns foreign reserves, because central banks main activity, namelyensuring price stability, needs to be backed by an adequate financial position.Revolution of risk management techniques and best practices during the lastfifteen years, the investment and risk management policies and procedures ofcentral banks have undergone a profound transformation.

My project is an attempt to understand need and implementation of riskmanagement practices in RBI. The project covers different types of risks RBI isexposed to, the risk mitigation measures taken by RBI, risks and costs involvedin holding foreign reserves. The project analyses basic economic indicators that

plays major role in determining sovereign risks while deploying foreign reserves.

B.Objectives

The chief objectives of the study were as follows:-

To analyze various types of risks RBI is exposed to. To compare risk mitigation measures of RBI with that of other Central

banks.

To develop risk assessment tree for RBI. To find out adequacy of foreign reserves and cost involved in holding

foreign reserves.

To find out various factors that may be looked upon while deployingforeign reserves in order to mitigate sovereign risks on it.


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C. Methodology

My project is basically exploratory in nature. Primary data was collected through

interviews of officials and observations. Secondary data were collected frompublic websites of RBI and other Central banks.

Objectives Methodology

To analyze various types ofrisks RBI is exposed to and

develop risk assessmenttree for RBI.

ISO 31000 and IEC 31010 techniques for riskassessment. Interview of Officials and

Observation.

To find adequacy of foreignreserves and cost involvedin holding foreign reserves.

Various literatures and Quantitative techniques.

Factors indicatingsovereign risk.

Event Study analysis, CART technique


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3.Literature Review

There are very few literatures available in context to central banks. However

there has been many events and conferences where problems of central banks hasbeen discussed and their solutions has been derived. In my project I have taken

references of many such speeches given by governors and other executives.

I am reviewing some of the literatures from where I have drawn references and

my analysis is based upon.

1.

ISO 31000:2009, Risk management Principles and guidelines

It provides principles, framework and a process for managing risk. These

principles and guidelines can used by any organization regardless of its size,

activity or sector.

While all organizations manage risk to some degree, this Standard establishes a

number of principles that need to be satisfied before risk management will beeffective. This Standard recommends that organizations should have a

framework that integrates the process for managing risk into the organization's

overall governance, strategy and planning, management, reporting processes,

policies, values and culture. Risk management can be applied across an entire

organization, to its many areas and levels, as well as to specific functions,

projects and activities. Although the practice of risk management has been

developed over time and within many sectors to meet diverse needs, the

adoption of consistent processes within a comprehensive framework helpsensure that risk is managed effectively, efficiently and coherently across an

organization. The generic approach described in this Standard provides the

principles and guidelines for managing any form of risk in a systematic,

transparent and credible manner and within any scope and context.


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The relationship between the principles for managing risk, the framework in which it occurs and the risk

management process described in this Standard is shown in Figure

Fig : Relationship between risk management principle, framework and process


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2.I EC 31010:2009 ,Risk management -- Risk assessment techniques

It is a dual logo IEC/ISO, single prefix IEC, supporting standard for ISO 31000and provides guidance on selection and application of systematic techniques forrisk assessment.All activities of an organization involve risks that should be managed. The riskmanagement process aids decision making by taking account of uncertainty andthe possibility of future events or circumstances (intended or unintended) andtheir effects on agreed objectives. Risk management includes the application oflogical and systematic methods for

communicating and consulting throughout this process; establishing the context for identifying, analyzing, evaluating, treating risk

associated with any activity, process, function or product;

monitoring and reviewing risks; reporting and recording the results appropriately.

Risk assessment is that part of risk management which provides a structured

process that identifies how objectives may be affected, and analyses the risk in

term of consequences and their probabilities before deciding on whether further

treatment is required.

Risk assessment is the overall process of risk identification, risk analysis and risk

evaluation. The manner in which this process is applied is dependent not only on

the context of the risk management process but also on the methods and

techniques used to carry out the risk assessment. Risk assessment requiresmultidisciplinary approach since risks may cover a wide range of causes and

consequences.

Risk identification

Risk identification is the process of finding, recognizing and recording

risks. The purpose of risk identification is to identify what might happen or

what situations might exist that might affect the achievement of the

objectives of the system or organization. Once a risk is identified, the


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organization should identify any existing controls such as design features,

people, processes and systems.

The risk identification process includes identifying the causes and source

of the risk events, situations or circumstances which could have a materialimpact upon objectives and the nature of that impact.

Risk identification methods can include evidence based methods (check-

lists and reviews of historical data). Various supporting techniques can be

used to improve accuracy and completeness in risk identification,

including brainstorming, Delphi methodology and top-down approach.

Risk analysisRisk analysis consists of determining the consequences and their

probabilities for identified risk events, taking into account the presence (or

not) and the effectiveness of any existing controls. The consequences and

their probabilities are then combined to determine a level of risk.

Risk analysis normally includes an estimation of the range of potential

consequences that might arise from an event, situation or circumstance,

and their associated probabilities, in order to measure the level of risk.

Methods used in analysing risks can be qualitative, semi-quantitative or

quantitative. The degree of detail required will depend upon the particular

application, the availability of reliable data and the decision-making needs

of the organization. Qualitative assessment defines consequence,probability and level of risk by significance levels such as high,

medium and low, may combine consequence and probability, and

evaluates the resultant level of risk against qualitative criteria.

Risk evaluationRisk evaluation involves comparing estimated levels of risk with riskcriteria defined when the context was established, in order to determine the

significance of the level and type of risk. Risk evaluation uses the

understanding of risk obtained during risk analysis to make decisions about

future actions. Ethical, legal, financial and other considerations, including

perceptions of risk, are also inputs to the decision.


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3.Risk Management in Central Banking, Speech by Lorenzo BiniSmaghi, M ember of the Executive Board of the ECB, I nternational Risk

Management Conference 2011, Free University of Amsterdam, 15 June

2011

In his speech Mr. Smaghi has talked about role of central banks as liquidity

providers and lenders of last resort. He explained there is difference between risk

management approach as employed in other organizations and that employed inCentral banks. According to him, for central banks prime objective is to maintain

price stability while for other organization prime objective may be profit

maximization or increase of shareholders wealth. He has talked about ALM

framework for central banks and has backed collateral risk control framework.

Fig: Contribution of risk assessment to the risk management process


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4.Risk Management system at European Centr al Bank, Report on theaudit of r isk management of the European Central Bank for the

f inancial year 2012.

European Central Bank (ECB) has taken its place on the central banking stage toform a triumvirate of key global central banks alongside the Federal Reserve andthe Bank of Japan. The ECB is unique as it is a supranational central bank at theheart of the Euro system. The Euro system comprises the ECB and the 12national central banks (NCBs) of the sovereign states that have agreed to transfertheir monetary sovereignty to the European Community level. The bank islocated in Frankfurt am Main, Germany, and was established together with theEuropean System of Central Banks (ESCB) on 1 June 1998 in the run-up to thelaunch of the euro. The ECB has its own legal personality and acts as the hubwithin both the ESCB (comprising the 15 NCBs of the EU Member States) and

the Euro system (comprising the ECB and the 12 NCBs of the EU Member Stateswhich have adopted the euro). The basic tasks of the Euro system are thedefinition and implementation of the monetary policy of the euro area, theconduct of foreign exchange operations, the holding and management of theofficial foreign reserves of the Member States, and the promotion of the smoothoperation of payments systems. The Euro system is governed by the decisionmaking bodies of the ECB, namely the Governing Council and the ExecutiveBoard.At the ECB each organizational unit is responsible for managing its own risksand controls. Two functions/divisions support organizational units in the riskmanagement process:

1. The Operational Risk Management (ORM) function, responsible formethodological maintenance, coordination of all operational risk related

activities, as well as proactive advice to business areas.

2. The Risk Management division (RMA) deals with financial risks.TheRisk Management division is responsible for proposing policies and

procedures and organizational support on risk management for all

financial market operations conducted by the ECB or by the Euro

system on behalf of the ECB. The division is organized in two units:Risk Analysis and Risk Strategy sections.


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The charter of the ECBs Risk Management Division states that it shall:1. Provide organizational support and propose policies and procedures on risk

management for the range of operations conducted by the ECB or the 12

NCBs of the Euro system on behalf of the ECB.

2.

Manage market risk and credit risk in relation to the ECBs investmentoperations, credit risk in relation to the monetary policy and foreign

exchange operations of the ECB, and operational risk for all operations

conducted by the ECB or the 12 NCBs of the Euro system on behalf of the

ECB.

The Risk Management Division contains two principal operational fields: riskmanagement issues related to the implementation of Euro system monetary policyoperations, and risk management issues related to the management of the foreign

currency reserves and the ECBs own funds.

Risk management issues related to the implementation of Euro systemmonetary policy operations

In order to control the credit risk in its monetary policy operations (as well as inthe intraday credit extended for payment systems purposes), the Euro systemrelies on high-quality collateral provided by its counterparties.Euro system opted for a policy of accepting a broad range of high quality assetsas collateral. This was seen as necessary in order to ensure sufficient availabilityof collateral. A broad range of collateral was also seen as conducive to equaltreatment of counterparties, promoting the development of markets for private

paper, and as a means of ensuring that the NCBs could continue with establishedpractices. It appears that the Eurosystem accepts a wider range of asset types ascollateral in its monetary policy operations than any other central bank in theworld. This fact in itself poses a major challenge for the ECBs Risk

Management Division.The Eurosystem distinguishes between two categories of assets eligible for itsmonetary policy operations, which it categorizes as tier one and tier two. Tier oneconsists of marketable debt securities that fulfil certain eligibility criteriaestablished by the ECB. The criteria endeavor to ensure that tier one assets

consist of high quality marketable securities with high liquidity that can easily betraded on a cross-border basis. Tier two consists of additional assets (currentlyincluding, inter alia, non-marketable securities and equities) which are of

particular importance to the national financial markets or banking systems. Theprecise criteria for tier two assets are proposed by each NCB according to certainminimum standards established by the ECB. However, tier two assets must atleast meet the same high credit standards as tier one assets.


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The risk managers assist in fine-tuning the protection provided by the collateralby calculating various haircuts to be applied to the monetary policy repos. Marketand liquidity risks are the main risks addressed in developing these risk controlmeasures.Risk management issues related to the management of the foreign currency

reserves and the ECBs own funds

The foreign currency reserves are invested in high-quality and liquid assets, andare split among the 12 NCBs of the Eurosystem. The size of each portfolio is

based on the capital key of each NCB. The ECB has a two-tiered benchmarksystem for the foreign currency reserves with a strategic benchmark for eachrelevant currency, reflecting the long-term investment objectives of the ECB.This is supplemented by a tactical benchmark set by the ECBs portfolio

managers and organizationally separated from the Risk Management Division.

NCB portfolio managers, who in practice manage the actual portfolios, arepermitted to take positions within a predefined band around this tacticalbenchmark, which is, in turn, restricted to a band around the strategic benchmark.There is a credit policy and limits system that restricts the instruments, countries,issuers and counterparties that NCBs may use. The Risk Management Division isresponsible for analyzing and reporting the performance of both the benchmarksand the NCB portfolio managers. A similar although less elaborate structureexists for the ECBs own funds (the counterpart of capital and reserves), which is

managed by a dedicated Portfolio Management Division within the ECB.In terms of investment operations, the risk management area has three key areas

of responsibility: risk management measures and compliance, analysis andreporting of investment performance, and strategic asset allocation.

5.Risk Management system at Reserve Bank of Australi a, Publ ic Website,Reserve Bank of Austral ia,

http: //www.rba.gov.au/about-rba/structure/r isk-mgmt-poli cy.html

The Reserve Bank of Australia (RBA) is Australia's central bank, which was

continued in existence under, and derives its functions and powers from the

Reserve Bank Act 1959. Its duty is to contribute to the stability of the currency,


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full employment, and the economic prosperity and welfare of the Australian

people. It does this by setting the cash rate to meet an agreed medium-term

inflation target, working to maintain a strong financial system and efficient

payments system, and issuing the nation's banknotes. The RBA provides certain

banking services as required to the Australian Government and its agencies, andto a number of overseas central banks and official institutions. Additionally, it

manages Australia's gold and foreign exchange reserves.

The aim of the Reserve Bank's risk management policy is to ensure a coordinated

approach to managing non-policy risks within the Reserve Bank of Australia that

is consistent with the Bank achieving its policy and operating objectives in an

effective way. In doing so, it follows accepted standards and guidelines for

managing risk, particularly those used by public and financial institutions.

The general philosophy underpinning the Bank's approach is that risk

management is an integral part of the management function in the organization

and, as such, is the clear responsibility of management. The Bank is committed to

ensuring that effective risk management remains central to all Reserve Bank

activities, and a core management competency. The aim is to ensure that risk

management is embedded in the Bank's processes and culture, and that this

activity makes an effective contribution to achieving the Bank's core objectives.

In common with most central banks, the Reserve Bank of Australia is aninstitution that seeks to manage risk carefully. This reflects the view that

satisfactory fulfilment of its important public-policy responsibilities would be

seriously jeopardized if poorly managed risks were to result in significant

financial losses and/or damage to the Bank's reputation. The Bank's management

is aware of the high standards that the community expects of its central bank.

The Reserve Bank recognizes that it cannot eliminate the risks involved in all its

activities completely. Rather, the Bank manages those risks against the backdrop

of its risk appetite. RBAs risk management policy covers the full spectrum of

financial, market, credit, operational, reputational and other risks, but not the

risks inherent to the Bank's core monetary, financial stability and payments

policy functions, which remain the responsibility of the Governor and the

Reserve Bank and Payments System Boards. The risks associated with the

ownership of Note Printing Australia and Securency are also covered by this


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policy, though the day-to-day activities of these entities are the responsibility of

their respective management and boards.

The Governor, as the chief executive of the Reserve Bank, has overall

responsibility for management of the organization, but day-to-day management of

the various groups and departments in the Bank (including risk management) is

delegated to the respective Assistant Governors or department heads in charge of

those groups or departments.

The Risk Management Committee (RMC) oversees the Bank's overall risk

management practices via a formal delegation from the Governor. The Committee

comprises several senior officers and is chaired by the Deputy Governor. Its role

is to ensure that the Bank's risks are identified, assessed and managed in

accordance with this Policy. The Risk Management Committee provides minutes

of its meetings to the Board's Audit Committee.

The Risk Management Unit (RMU) facilitates, co-ordinates and advises on the

risk management process to help groups and departments manage their risk

environment in a manner that is broadly consistent across the Bank. The Unit does

not, however, conduct risk management on behalf of groups and departments or

assume ownership of, and responsibility for, those risks. From a governance

perspective, the RMU reports to the RMC, and the Head of Risk Management, or

an alternate, attends all meetings of the RMC.

Bank management in each group and department remains responsible for the

management of risks, including associated controls and ongoing monitoringprocesses. Risks noted as part of this framework, which may have implications for

other areas of the Bank, should be reported immediately to the RMU and the

relevant departments. Additionally, reports on experiences that might assist the

Bank in compiling and maintaining its risk profile (Incident Reports) should be

promptly communicated to the RMU.

The RMC may establish working groups to develop strategies for the management

of some Bank-wide risks, such as business continuity. The Committee retains

oversight of these areas, from a risk management perspective, and the RMU

ensures appropriate co-ordination across the Bank.The Risk Management Committee may request the RMU to conduct one-off risk

reviews of either a process or across functional lines if that is judged appropriate

(e.g. Bank-wide handling of sensitive information/data).

Audit Department co-ordinates closely with (but remains separate from) the

RMU. Audit provides independent assurance that the Bank's risk management


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policy is adhered to. In addition, Audit independently reviews departmental

procedures to assess if they provide effective control. This work draws on risk

documentation and reports of core business areas to help ensure that the approach

reflected in these documents is both risk focused and consistent with the views of

management in the areas being audited. Audit reports independently to the Board'sAudit Committee on both the risk profiles of groups and departments as well as

the effectiveness of relevant controls. Copies of these reports are made available

to the RMU.

The RMU falls within the scope of internal audit reviews. An external

independent review of its function may also be commissioned by the RMC.

Framework for Managing Risk

The Bank's framework for managing risks is consistent with the acceptedAustralian standard, and comprises several basic steps:

1. Identifying and analyzing the main risks facing the Bank.2. Evaluating those risks making judgments about whether they are acceptable

or not, and prioritizing unacceptable risks for action.

3. Treating unacceptable risks taking action to reduce the probability orconsequences of an event and/or transferring the risk to another party.

4. Acknowledging residual risk and, where appropriate, forming contingencyplans.

5. Documenting these processes, with summary tables (risk registers) the mainforms of documentation, supplemented by risk manuals or related documents

as appropriate.

6. Ongoing monitoring, communication and review.While the framework is applied consistently across the Bank, individual groups

and departments continually identifies and analyzes the risks in their own areas,

assess the controls in place to deal with those risks, and make decisions about

whether to mitigate a particular risk (fully or partially) given its effects and the

costs of mitigation. If a residual risk is judged unacceptable, the owner group ordepartment is responsible for developing and overseeing a remedial plan.

Where risks are considered cross-sectional, i.e. owned by one area and managed

by another (e.g. IT-related risks), a process is established for ensuring the risks are

both communicated, and action agreed, between the areas concerned.


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6. A F ramework for Strategic Foreign Reserves Risk Management, Sti jn

Claessens & Jerome Kreuser , Februar y 13, 2003

This paper has presented a framework for foreign exchange reservesmanagement that combines asset allocation considerations with broadmacroeconomic, macro-prudential risk and sovereign debt managementconsiderations. Literature has highlighted how private debt management andfinancial sector vulnerabilities can affect public debt and reserve management.

Less macro-economic or balance-sheet oriented approaches and more micro-economic oriented approaches to reserves management are feasible whenmonetary policy, exchange rate and debt management issues are of lessconcern, and when vulnerabilities in the financial and corporate sectors aresmall.

In context to RBI, where liquidity is primary concern this paper is apt fordesigning the framework for deployment of foreign reserves.

7. Foreign Exchange Reserves Management in I ndia: Accumulation and

Uti li zation, M . Rama Kr ishna Prasad and G. Raghavender Raju, Department

of Economics, Sri Sathya Sai University.

According to the literature on the rationale of accumulating forex reserve bydeveloping countries, there are principally two explanations namely,Competitiveness and Self Insurance. Competitiveness: Most of the Asian countries with their pursuit to build

export competitiveness built large current account surplus. Their export drivengrowth was instrumental in accumulating large forex reserve. In these countries,

benefit of stable and managed exchange rate regime (currency devaluation)

exceeded the cost of holding excess forex reserve. Self Insurance: More dominant rationale of accumulating forex reserve by

large number of developing countries is self-insurance against hard landing ofcapital and trade accounts. This motive became more relevant after 2008subprime crises where trade and capital shock ill effects were contained by thelarge liquid forex reserve held by various developing countries including Indiaand China. In the wake of risks raised our of deep financial integration and


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exposure to global financial instability, the self-insurance motive of holdingforeign exchange reserve has gained significance in spite of the costs associatedwith holding the same. These motives in fact correspond to the precautionarydemand money discussed in BIS Economic paper. It is now well accepted thatsuch precautionary demand should be higher if the proportion of the short termor volatile capital inflow are higher.There is an argument regarding the accumulation of forex reserve with self-

insurance motive. They argued that why developing countries accumulated forexreserve to shield themselves from the financial instability instead of reducing thefinancial integration. He argued that prudential capital regulation can itselfminimize the risk of financial instability. Hence the key question was whether itis possible to reduce the risk of financial instability by reducing financialintegration and thus reducing the cost of self-insurance.

8. Indias Foreign Exchange Reserves: Policy, Status and Issues, Y.V.

Reddy, Deputy Governor , RBI , 2003.

The literature focusses on rising foreign reserves of India and discusses nearlyall issues related to foreign reserves. As per the literature there are alternativeframeworks for determining appropriate level of foreign reserves. Theliterature identifies four sets of indicators to assess adequacy of reserves, andeach of them do provide an insight into adequacy though none of them may by

itself fully explain adequacy.

Adequacy of reserves1. Money based Indicator, Reserves to Broad Money Supply

Reserve to Broad Money Supply(R/M3) ratio could be used to compensateinternal conditions. R/M3 ratio is not a good indicator of reserve adequacywhere demand of money supply is stable and financial markets are strong.

Bench mark: 20% of Money Supply (Rodrik and Velasco Rule) Reserves in this range are considered adequate to support confidence inthe value of local currency and reduce the risk of capital flight. This

benchmark is most relevant to countries with managed exchange rates.


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2. Trade based indicator, Reserves to Imports RatioThe economic crisis of South-East Asia in 1997 reflected severaldeficiencies involved in keeping R/M ratio as a criterion of reservesadequacy.

Bench mark: 3 Months of Import CoverThe reserves to imports ratio is considered most relevant to low incomecountries exposed to current account shocks and lacking significant accessto capital markets.

3. Debt based indicator,a.Reserves to Short term ExternalDebt (R/STED) Ratio

It has been Short term external debt accumulation in access is a common

feature in all recent crisis. It gives us the information about how quickly acountry will adjust the external sector if it is unable to access externalflows. Also it acts as the indicator for losing investor confidence. Studieshave shown that it could be the single most important indicator of reserveadequacy in countries with significant but uncertain access to capitalmarkets.

Bench mark: 100% of Short-term Debt (Greenspan and Guidottirule)

This benchmark is the most preferred measure for measuring risk of acapital account crisis. During a financial crisis countries have found thatthey are unable to rollover short-term debt. The GuidottiGreenspan rulestates that a country's reserves should equal short-term external debt (one-year or less maturity), implying a ratio of reserves-to-short term debt of 1.The rationale is that countries should have enough reserves to resist amassive withdrawal of short term foreign capital.

b. Reserves to Total External Debt

This ratio tells us the possibility of covering the total external debt using

the foreign reserves.Benchmark: 100% of Total External Debt


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4. Combination of current-capital accounts, Reserves to GDP RatioThis says that reserves should be kept to a level that is at least some

percentage of the GDP.Benchmark : 10% of GDP (Jeanne and Ranciere Rule)

9. Ben-Bassat, A. and Gottlieb, D 1992, Optimal I nternational Reserves

and Sovereign Risk, Journal of International Economics, vol. 33,

Central banks maintain foreign currency reserves to facilitate international tradeand intervene in the open markets to maintain exchange rates. The total demandfor foreign currency reserves depend on multiple factors such as import

percentage of trade, opportunity cost of holding reserves, exchange ratearrangements etc. However the composition of foreign currency reserves woulddepend on real rate of returns and volatility of the currency.So, basically once the optimum level of forex reserves are determined, thequestion remains as to how to maintain the most efficient portfolio adding up tothe optimum reserve.

Theories on Currency Composition of FX reserves:

1. Mean Variance Theory2. Transaction Theory

Mean Variance TheoryThis theory originates from Harry Markowitz work on Portfolio Selection

(1952). It starts with a critique of Williams (1939) that says that an investor will

design a portfolio such that the discounted anticipated or expected returns aremaximized.

Markowitz argues that in addition to risk, an investor is also concerned with therisk associated with the portfolio. Investors portfolio choice problems will

involve calculation of the so called efficient portfolios, which is the combinationof assets that would make the mean return from the portfolio as large as possiblefor a given level of risk.

Basically Markowitz suggests that diversification of portfolio helps in reducingthe risk. Mathematically the returns of the portfolio is given as


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And the risk is given as

Hence the risk of the portfolio depends on the variances of the returns of theassets from the mean. The risk of a two asset based portfolio will be lower than asingle asset portfolio if the covariance of the two assets is negative. Hence theselection of portfolio depends not only on the number of assets but also on the

interaction of the assets such that the covariance will be negative.

For a two asset portfolio:


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Hence for a two asset based portfolio an efficient frontier can be defined andusing the above differentials, asset allocations can be made to achieve theefficient frontier. For portfolios having more than two assets also, lagrangian

multipliers can be used to determine efficient allocations.In the context of foreign exchange reserves, the central banks objective should

be to select the most appropriate composition of foreign currencies so as tominimize risks at the same time to be able to facilitate trade and foster growth.

Optimal Portfolio

I1, I2 and I3 represent indifferent curves. The convexity of the indifferencecurves represents the risk aversion of the investor. Here a higher indifferencecurve signifies a higher utlity. The point at which the indifference curve is

tangential to the efficient frontier (point A) gives the point where the investorshould operate.

Sharpe Ratio line

Since the indifference curves are often not known, Sharpe (1964) and Lintner(1965) suggested that from the intercept on the return axis at the point of risk freereturns, a tangent be drawn on the efficient frontier. The point of tangencyrepresents the optimal portfolio.


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Further study on Ben-Bassets methodology and applicability on India

Ben-Basset used the following equation to calculate the risk and returns

The return on currency I is given as

Where E is the rate of change of currency I in relation to the import currencybasket.Using the above equations of risk and return, we can calculate different levels ofrisks and returns for a particular portfolio holding and by varying the holdings we


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can determine the efficient frontier. Using the sharpe ratio line, we can get theoptimum holdings.

10. Rules of Thumb for Sovereign Debt Crisis,Paolo M anasse andNouri el Roubin i, Converted by Manmohan S. Kumar

The literature finds that most debt crises can be classified in three types: episodesof insolvency (high debt and high inflation) or debt unsustainability due to highdebt and illiquidity; episodes of illiquidity, where near default is driven by largestocks of short-term liabilities relative to foreign reserves; and episodes of macroand exchange rate weaknesses (large overvaluation and negative growth shocks).

Conversely, a relatively risk-free country type is described by a handful ofeconomic characteristics: low total external debt relative to ability to pay, lowshort-term debt over foreign reserves, low public external debt over fiscalrevenue, and an exchange rate which is not excessively overvalued. Politicalinstability and tight monetary conditions in international financial marketaggravate liquidity problems. The approach suggests that the unconditionalthresholds, for example, looking at debt to output ratios in isolation, are of littlevalue per se for assessing the probability of default; it is the particularcombination of different types of vulnerability that may lead to a sovereign debtcrisis.


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4.ANALYSIS AND FINDINGS

Risk Assessment for RBI

I have used top-down approach to access all the risks that RBI has to face. For

this I have started from core functions of RBI and then investigated the

contribution of each department towards its core function. With knowledge of

both I have tried to find out various risks RBI has to face while performing its

functions.

1 Monetary Authority

.To maintain price stability andensure adequate flow of credit to

productive sector. For this RBI use toformulate, implement and monitorthe monetary policy.

.As a policy maker RBI has to fulfillmarket expectations keeping in viewlong term impact of policies.

Objectives of monetary policy inIndia are Price Stability, ControlledExpansion Of Bank Credit,Promotion of Fixed Investment,Restriction of Inventories, Promotionof Exports and Food ProcurementOperations, Desired Distribution ofCredit, Equitable Distribution ofCredit, To Promote Efficiency andReducing the Rigidity.

In this role RBI has to fulfill the marketexpectations and at the same time it has tolook after price stability. There is alwaysrisk involved in failing to either of itsobjective. RBI not only carries outmonetary policy operations but alsosupervises banks, manages foreignexchange reserves, and operates the coreof the national payments system. In this

course it may happen that Contractionaryor Expansionary monitory policy may

pose risk to its other role.

It may be possible that while fulfillingone of its objective others objectives areneglected. Risk assessment of each of itsobjectives can be done in detailedmanner. However failure of identifyingthese risk can lead to PolicyImplementation r isk. Monetary policy

basically has to be in sync with Fiscalpolicy.


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Counterfeit currency notes in circulation

2 Issuer of Currency

.The Reserve Bank is the Indias

sole note issuing authority. Alongwith the Government of India, it isresponsible for the design and

production and overallmanagement of the nationscurrency, with the goal of ensuringan adequate supply of clean andgenuine notes. The Reserve Bankalso makes sure there is anadequate supply of coins, produced

by the government.

As a Central bank and countrys sole note

issuing authority RBI has to cope up withrisk of counterfeit notes in circulation.Circulation of counterfeit notes intransactions poses severe threat tocurrency and payment system standards.

In consultation with the government, RBIroutinely address security issues andtarget ways to enhance security featuresto reduce the risk of counterfeiting or

forgery. Lot of programs and publicawareness campaign are being conducted

by RBI.


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3

Banker and Debt Manager to

Government Undertaking banking transactions for the

central and state governments to facilitate

receipts and payments and maintaining theiraccounts. Managing the governments domestic debtwith the objective of raising the requiredamount of public debt in a cost-effective andtimely manner. Developing the market for government

securities to enable the government to raisedebt at a reasonable cost, provide benchmarksfor raising resources by other entities andfacilitate transmission of monetary policyactions.

In India, debt management is currently carriedout by the RBIs Internal Debt Management

Department (IDMD), which is functionallyseparate from monetary policymaking. Thedebt management strategy is formulated by the

Monitoring Group on Cash and DebtManagement, which is the apex coordinating

body between the RBI and the Ministry ofFinance.

The Reserve Bank manages thepublic debt and issues new loans

on behalf of the Central and StateGovernments. It involves issueand retirement of rupee loansinterest payment on the loan andoperational matters about debtcertificates and their registrationIn union budget Central govtdecides about the annual

borrowing need. The ReserveBanks debt management policyaims at minimizing the cost of

borrowing, reducing the roll-overrisk, smoothening the maturitystructure of debt, and improvingdepth and liquidity ofGovernment securities markets bydeveloping an active secondarymarket. When asked, RBI uses toadvice Central govt.about the

various factors affecting publicdebt.Various risks are associated withthese functions of RBI. Major riskis roll over r isk. This risk arisesdue to increased interest rate forrefinancing debt at lower interestrate. In order to mitigate this risk,the Government and the ReserveBank take into account a numberof factors while formulating the

borrowing programme for theyear, such as, the amount ofCentral and State loans maturingduring the year, the estimatedavailable resources, and theabsorptive capacity of the market.


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4 Banker to BanksAs the banker to banks, RBI focuses on:

Enabling smooth, swift and seamlessclearing and settlement of inter-bankobligations. Providing an efficient means of funds

transfer for banks. Enabling banks to maintain their

accounts with us for purpose ofstatutory reserve requirements andmaintain transaction balances. Acting as lender of the last resort.

5

Regulator and supervisorof the financial system

The primary role of RBI is to preventsystemic risk, avoid financial crises and

protect depositors interest and reduceasymmetry of information betweendepositors and banks. Being asregulator and supervisor itsresponsibility of RBI to take necessary

steps towards providing stableenvironment to public.

As Lender of the last resort, RBIprovides liquidity to banks unable to

raise short term liquid resourcesfrom the inter-bank market. Likeother central banks, the ReserveBank considers this a criticalfunction because it protects theinterests of depositors, which in turn,has a stabilizing impact on thefinancial system and on the economyas a whole. Acting as lender to lastresort, RBI is supposed to bear more

risk by funding to banks which arealready in liquidity crunch.Being as lender to banks, RBI has to

bear credit risk. Each bank is gradedbased upon supervision inputs andlimit to which loan can be given isdecided.

RBI has to face lot of reputationalrisk in this role. Being asindependent and reputedorganization, there is common beliefamong countrymen that RBI willachieve its policy task ofmaintaining price stability. Or, as

banking supervisors, they impose

high governance standards on banks,and search for weaknesses of banksto intervene against them. Anylapses in these regards leads toreputational loss of RBI.


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Fig: Financial Regulation Approaches, Measures and Objectives in India2000 and beyond

A strong capital base is imperative to enable the banks to acquire resilience towithstand shocks. By prescribing capital adequacy norms, the banks ability to

withstand shocks has been strengthened. After complying with the Basel Irequirements, the Indian banks are now moving towards the New Capital AdequacyFramework (Basel II) regime. The RBI has accepted to adopt the Basel II in

principle and have taken necessary steps to ensure these norms are being adopted bybanks.

In order to deal with issues of reputational risk and other internal risk attributes, RBIhas Internal Inspection Department. Using its knowledge, skills and professionalcompetence, the Inspection Department carries out inspections to examine, evaluateand report on the adequacy and reliability of existing systems and follow-up to

ensure that: Laws, Regulations, Internal Policies and Procedures are meticulously

followed

Assets are properly maintained/utilized/safeguarded Financial crisis is avoided; operational and Reputational Risks are averted Adequate safeguards are taken for Bank's physical/operational/IT security


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6Manager of ForeignExchange

With the transition to a market-basedsystem for determining the externalvalue of the Indian rupee, the foreignexchange market in India gainedimportance in the early reform period. Inrecent years, with increasing integrationof the Indian economy with the global

economy arising from greater trade andcapital flows, the foreign exchangemarket has evolved as a key segment ofthe Indian financial market.In this role objective of RBI is tofacilitate external trade and payment and

promote orderly development andmaintenance of foreign exchange marketin India.Manages the Foreign Exchange

Management Act, 1999.

The regulation and supervision policies pursued by the Reserve Bank have beensuccessful in ensuring that the broad objectives of regulation are met. The regulatorygaps have been continuously monitored and plugged through appropriate measuresfrom time to time. The Indian public has trust in the soundness of the banking

system going by the fact that they consider bank deposits absolutely safe.Consequent on two spells of bank nationalization in 1969 and in 1980, public sector

bank ownership has contributed to this strong sentiment. The sound financialposition and strength of the banking system reflects the effectiveness of the ReserveBanks regulatory and supervisory approaches.

While doing so RBI has to deal with

specific risks related to deployment

of foreign exchange including credit

risk, market risk, liquidity risk,

interest rate risk, currency risk and

operational risk.

The Reserve Bank has beenextremely sensitive to the credit riskit faces on the investment of foreignexchange reserves in theinternational markets. The ReserveBank's investments in bonds/treasury

bills represent debt obligations ofhighly rated sovereigns andsupranational entities. Further,

deposits are placed with centralbanks, the Bank for InternationalSettlements (BIS) and select foreign

banks.


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In order to manage market risk, gains/losses on valuation of foreign currencyassets and gold due to movements in the exchange rates and/or price of gold are

booked under a balance sheet head named the Currency and Gold RevaluationAccount (CGRA).The balances in CGRA provides a buffer against exchange

rate/gold price fluctuations which in recent times have shown sharp volatility.Foreign dated securities are valued at market prices prevailing on the last

business day of each month and the appreciation/depreciation arising therefromis transferred to the Investment Revaluation Account (IRA). The balances inIRA is meant to provide cushion against changes in security price over theholding period.

For managing currency risk, decisions are taken regarding the long-termexposure on different currencies depending on the likely movements inexchange rate and other considerations in the medium and long-term. Thedecision making procedure is supported by reviews of the strategy on a regular

basis. The crucial aspect of the management ofinterest rate riskis to protect thevalue of the investments as much as possible from the adverse impact of theinterest rate movements. The interest rate sensitivity of the reserves portfolio isidentified in terms of benchmark duration and the permitted deviation from the

benchmark. In order to manage Liquidity Risk, RBI closely monitors the portionof the reserves which could be converted into cash at a very short notice to meetany unforeseen / emergent needs.

In tune with the global trend, considerable attention is paid to strengthen theoperational risk control arrangements. Key operational procedures aredocumented. Internally, there is total separation of the front office and backoffice functions and the internal control systems ensure several checks at thestages of deal capture, deal processing and settlement. The deal processing andsettlement system is also subject to internal control guidelines based on the

principle of one point data entry and powers are delegated to officers at variouslevels for generation of payment instructions. There is a system of concurrentaudit for monitoring compliance in respect of all the internal control guidelines.Further, reconciliation of accounts is done regularly. In addition to annualinspection by the internal machinery of the Reserve Bank for this purpose andstatuto

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