Central banks impact our daily lives in many ways with their role to promote economic and financial welfare of citizens, but their operations are even more critical during a crisis. The global challenges presented by the COVID-19 pandemic make the role of central banks crucial to maintaining economic and financial stability. Central bank reserves provide an essential buffer against uncertain economic outcomes and help protect against economic shocks to promote trade, maintain price stability, and attract foreign investment. Effective reserve management supports the broader mission of central banks to set targets for unemployment, inflation, and interest rates to ensure a healthy economy with full employment and favorable conditions to promote investments and the conducting of business.
Recognizing the importance of central bank reserves, the World Bank Treasury’s Reserve Advisory and Management Partnership (RAMP), a team dedicated to developing asset management capacity across public sector institutions, published its First RAMP Survey on central banks’ reserve management practices in 2018.
The 2018 RAMP survey reported that global foreign exchange reserves have increased nearly six-fold, reaching US $12.6 trillion in 2018. As the size of reserves increases, central banks may seek to increase the return on their portfolios by investing in riskier high yield assets. But greater diversification should go hand-in-hand with prudent reserve management.
The Second RAMP Survey, now published, expands upon previous findings with a focus on central bank governance, current strategic and tactical asset allocation, risk management, and accounting frameworks. The survey found that:
The U.S. dollar represents a large share of central bank reserve portfolios, with smaller allocations in other currencies. The predominance of the U.S. dollar provides stability to reserve portfolios and reserves are likely to increase as central banks confront the uncertainty caused by the COVID-19 pandemic.
Central banks have maintained their preference for low-risk investments in traditional reserve assets such as government bonds, with few central banks diversifying investments in riskier corporate and emerging market bonds. A lack of diversification may lower the return on central bank investments as many developed countries have low or negative interest rates.
Central banks continue to be conservative in their exposure to credit risk. Concentrating investments among high grade assets can reduce the risk of default and improve a central bank’s reputation but may also limit the return on investment.
In addition, while reserve management practices have improved since the First RAMP Survey in 2018, there is still room for improvement across governance, risk management, and accounting frameworks.
Governance can be improved if large and complex central banks delegate more power to investment committees in making operational decisions rather than concentrating decision making within the central bank’s board of directors. Increasing the investment committee’s role would promote faster problem resolution and would allow the board to focus on strategic decision making.
Regarding risk management, the survey finds that many central banks have not adopted more sophisticated measures of credit and market risk despite an increase in diversification of investments. Expanding the use of probabilistic risk measures among central banks is critical to mitigating risks and ensuring a stable supply of reserves in times of uncertainty.
In the area of accounting frameworks, the results indicate that approximately one-third of central banks have not implemented the International Financial Reporting Standards (IFRS), thereby complicating the process of comparing financial reports across central banks, inhibiting transparency, and reducing confidence.
With over 70 members that manage nearly $2 trillion in sovereign assets, RAMP stands well-positioned to evaluate and facilitate more efficient reserve management practices. RAMP supports its member institutions, including 60 central banks, by building human capital, delivering asset management services, and convening a network of practitioners that allows members to share best practices and learn from one another.
The central bank has a responsibility to maintain economic stability during the uncertain times of a global crisis , but an effective response is impossible without proper reserve management. Strengthening governance in decision making, along with improved risk measures, and proper accounting frameworks within central banks are crucial to promote financial stability. But proper reserve management is not only important during times of crisis. As the world economy moves to recover from the consequences of COVID-19, central banks need to continue on the path they’re on to implement sound reserve management practices and develop their capabilities to ensure long-term stability, in good times and in bad. The RAMP team stands ready to help.
World Bank Group and ProfiBusiness.world
July 12, 2021