Reserve management at the National Bank of Slovakia

Reserve management at central banks around the globe has many similarities, as the main goals are generally common. However, each central bank has its own preferences and unique requirements or constraints, which mean the setup and performance of foreign exchange reserve management differ across central banks.

Introduction to the NBS

The National Bank of Slovakia, one of the 20 national central banks of the eurozone, conducts reserve management governed by a comprehensive legal framework established under the Act of the National Bank of Slovakia. This legislation mandates the NBS to hold and manage foreign reserve assets, including both gold and foreign exchange assets. It also mandates the central bank to execute foreign exchange operations, adhere to the Eurosystem’s operational rules, and fulfil other relevant obligations and norms. For the purposes of this chapter, reserve management extends beyond the traditional framework to include the management of euro-denominated investment portfolios.

NBS reserve management framework and investment policy

Strategic decisions and policy implementation in 2023

Last year, the NBS undertook a series of strategic decisions that profoundly influenced both the structural and operational aspects of reserve management. Key among these decisions was the adoption of a new investment policy, provided in a freshly formulated Investment Policy Statement (IPS). This pivotal document outlines the bank’s updated investment strategy and establishes a foundation for strategic asset allocation. Such allocation is carefully designed to align the central bank’s investment portfolios with its newly refined objectives and risk-return preferences, marking a significant pivot in the central bank’s approach to managing reserves.

Main objective: enhancing risk-return efficiency and governance

The primary objective of these modifications was to update the central bank’s risk-return preferences, enhance the efficiency of reserve management through upgrading its institutional framework, and improve governance.

Historical context and strategy evolution

To enhance understanding of the scope and magnitude of the recent changes, a brief overview of the investment strategy up to this point is provided below. The last time the NBS fundamentally revised its investment policy was at the time of the Slovak Republic’s entry into the eurozone, an event that marked the NBS’s integration into the Eurosystem. The revised version of the investment policy, approved at the end of 2008, was primarily a response to the changed external environment (the adoption of the euro) as well as a shift in the NBS’s role, which transitioned away from being the direct guarantor of price stability and exchangeability of the domestic currency.

The investment strategy, approved upon adopting the euro, clearly exhibited a conservative character. It reflected the negative equity position of the NBS resulting from the local currency’s appreciation prior to euro accession and high sterilisation costs associated with monetary policy operations aimed at achieving a firm inflation target.

These losses gained a more permanent character with entry into the eurozone, particularly from the perspective of fixing the EUR/SKK exchange conversion rate. The NBS found itself in the position of being the only central bank in the eurozone with negative equity. This circumstance, coupled with the fact that nearly all foreign exchange reserves were allocated to settle obligations from monetary operations with local banks, was the rationale for advocating for a conservative investment strategy.

The conservative character of reserve management was reflected in targeting a positive economic result on a one-year horizon, fundamentally impacting the risk profile of the investment strategy and thus expected returns.

Following the adoption of the euro, asset and liability management emerged as the prevailing approach to managing investment reserves. The NBS shifted its focus towards measuring net returns, defined as returns exceeding the cost rate of corresponding liabilities. Additionally, the cost and availability of refinancing were integrated as critical factors in shaping the investment strategy. In pursuit of reducing the likelihood of negative returns annually, a comprehensive risk mitigation strategy was employed. This included conservative management of currency risk and the adoption of a fully currency-hedged approach for bond portfolio management. Similarly, duration risk, known for its significant risk potential, was managed with heightened caution.

In profiling the investment strategy, the NBS sought to maximise its investor advantages, stemming from its position as a national central bank of the eurozone. This primarily involves utilising the collective agreement on net financial assets and the limited need for highly liquid assets. These elements allowed for the construction and management of a multi-currency bond portfolio focused on systematically collecting moderate credit and liquidity premiums, while flexibly adjusting the size of investment reserves depending on market conditions.

Credit exposure in acquired portfolios was mitigated through a framework of concentration limits to guarantee requisite diversification. A supplementary mechanism involved the utilisation of a predefined rating spectrum, stratified by the maturity profiles of individual bonds. This rating protocol permitted the acquisition of lower-rated securities (up to an A+ threshold) on a conditional basis, contingent upon shorter maturity specifications and adherence to concentration parameters. The procurement of specific bonds was vested in the discretion of portfolio managers, predicated on compliance with established limits and on both anticipated returns and assessed creditworthiness of the issuers. Upon acquisition, bonds were systematically hedged against interest rate volatility and, for non-euro-denominated securities, against foreign exchange variability.

Realised returns were notably consistent, except during the European debt crisis epoch, which brought heightened volatility in portfolio valuations. Given the portfolio management approach and hedging mechanism against interest and currency risk described above, both expected and realised returns were relatively low, commensurate with the risks undertaken.

Strategic re-evaluation and policy update

The investment policy of an institutional investor, such as the NBS, is primarily based on existing legal framework, but is also tilted, based on the views and expert opinions of the bank’s main stakeholders. A key decision in this context is the definition of an acceptable level of risk and expected returns. These views can change over time, whether due to objective changes (eg, changes in the external environment, legislative changes) or due to natural personnel rotation within the leadership of the institutional investor.

Gradual personnel changes in the NBS Bank Board, especially after 2018, led to a change in the perception of the NBS as an investor, mainly its ability to function as a long-term investor. At the same time, the gradual inclusion of new asset classes into investment reserves revealed that the NBS lacked a comprehensive and robust framework for asset allocation at a strategic level. Clear rules and responsibilities that would govern a regular and comprehensive review of the investment strategy, to ensure it matches the goals, risk appetite and constraints of the NBS, were also missing. Such a framework and process are necessary for institutional investors to effectively set an investment strategy. For this reason, a review of the central bank’s investment strategy began in 2020. It included numerous discussions among members of the NBS Bank Board, meetings within the NBS Investment Committee, intensive discussions among relevant expert units, as well as consultations with external advisers (eg, the World Bank).

Objectives of reserve management

The rationale for maintaining reserves has remained substantially consistent with the principles outlined in the preceding investment policy. However, much greater emphasis is placed on generating net income for the NBS and reducing negative equity, with the aim of strengthening financial stability and the independence of the NBS.

Another rationale for reserve management is the conservative management of gold reserves while keeping their volume unchanged. The last defined goal is to guarantee the fulfilment of a potential obligation to increase the foreign exchange reserves of the European Central Bank through an additional transfer of USD liquidity, if needed. This obligation arises from the NBS’s accession agreement to the European System of Central Banks, and is related to the unlikely case of a potential foreign exchange intervention by the ECB.

Risk management and investment horizon

Evolution of the NBS’s investment approach

The investment horizon of the central bank has significantly evolved. Previously, the NBS’s investment approach was largely short-term, with return expectations set on a one-year basis, mirroring the cycle for financial reporting. However, given its central banking role, grounded in legal and international frameworks – particularly within the eurozone – the NBS now adopts a long-term perspective. This shift necessitates aligning the NBS’s investment operations with its long-term outlook in the revised investment policy. A prolonged investment horizon offers enhanced prospects for expected returns from reserve management, providing greater flexibility, increased tolerance for return volatility, and the capacity to undertake investment risks in exchange for higher average risk premiums. The duration of this investment horizon is not strictly defined in years, setting the NBS apart from individual investors who may liquidate investments at the end of their investment period. Instead, the NBS views its investment horizon as a continuously renewing cycle, subject to ongoing monitoring and assessment against investment goals.

The term ‘long-term investment horizon’, or an investment period exceeding five years, accurately describes the NBS’s approach. This strategy is common among central banks, particularly those not facing immediate pressures on foreign exchange liquidity, such as the Eurosystem banks that have delegated currency exchange rate defence to the ECB. Despite a long-term focus, the NBS actively monitors and adjusts for expected returns and risks, ensuring readiness to address unexpected market conditions.

Asset allocation and strategy

Tranche-based portfolio division

While certain segments of the investment reserves – such as the foreign exchange reserves earmarked for potential interventions and the gold reserves – are fixed in size, the overall size of the investment reserves portfolio may vary in response to changes in market conditions and the NBS’s assessment of expected returns and risks within capital markets. To facilitate the attainment of specified objectives, the total portfolio is divided into two tranches:

1) Fixed-size tranche (index-based investment tranche)

The size of this tranche is fixed. The Strategic Asset Allocation (SAA) for this segment of the portfolio is based on well-established global financial market indices, considering long-term forecasts for returns and risks in capital markets. This tranche represents a stable, long-term strategic risk exposure that is expected to yield compensation over the long term. Portfolio management within this tranche adheres to standard practices of benchmark-based portfolio management. Additionally, for certain portfolios, a tactical management layer is integrated, which is detailed further below. The primary risk factors addressed in this tranche include duration risk, equity risk and gold risk. Moreover, the USD intervention portfolio, aimed at addressing potential liquidity requirements, is also incorporated within this tranche.

2) Variable-size tranche (rules-based tranche)

The size of the tranche may vary within the lower and upper limits established in the SAA document, influenced by market conditions and the availability of investment opportunities. The SAA for this segment of reserves should account for potential excess returns from global credit markets and their correlation with the comprehensive reserves portfolio, including gold and foreign exchange reserves. The portfolio management approach for this tranche is predominantly discretionary, adopting a total return strategy. This approach capitalises on the tranche’s size flexibility, applies the specified rules effectively and utilises the active risk budget allotted to it.

Investment risks and decision-making principles

Expansion of risk types and management

The NBS’s proposed investment policy anticipates an expansion in the types of risks (and their differential weighting) that the central bank is willing to expose itself to collect the corresponding risk premium. Previously favoured spread (credit) and liquidity risks are now complemented by interest rate (duration) risk, equity market risk, and, to a reasonable extent, currency risk. Over time, additional risks may be considered depending on the ability to measure, monitor and manage these risks.

Currency risk holds a specific position. The NBS has declared that it does not intend to act as a speculative investor in currency exchange rate predictions on the markets. However, it acknowledges that unsecured currency exposure can be justified in certain situations from a cost perspective or in terms of diversification benefits.

Among other accompanying risks of the investment process, the investment policy emphasises the need to minimise legal risk by utilising standard documentation. In managing credit risk, it highlights the principles of diversification and adopts a rigorous stance in selecting trading counterparts. For liquidity risk, a lower level of liquidity is accepted, except for the liquid USD intervention portfolio designed to cover potential demands from the ECB.

Collective investment beliefs

The NBS’s IPS includes a set of investment beliefs that represent collective viewpoints on critical parameters of the investment process. The articulation of these collective beliefs aims to unify interpretation, enhance clarity and ensure consistency in both internal and external communication regarding the management of investment reserves. Selected investment beliefs focus primarily on terms and concepts that have multiple opinions or interpretations in the financial world.

Among the most significant investment beliefs highlighted in the IPS is perception of the NBS’s negative equity and its impact on the central bank’s behaviour as an investor. The longstanding view that negative equity fundamentally limits risk-taking in managing investment reserves and predicates a significantly conservative investment strategy has evolved considerably after several internal discussions within the NBS’s leadership and consultations with experts from the World Bank and ECB.

The updated view on this matter relies on a combination of the long-term investment horizon and the central bank’s specific legal status, which allows operation without fundamental restrictions even in a negative-equity environment. The existence of negative equity does not imply a significant limiting barrier to taking investment risks in reserve management, and does not cause an undue shortening of the investment horizon.

Another important collective investment belief is that capital markets operate efficiently over the long term. The SAA process should consider the broadest possible market exposure, emphasising maximisation of diversification benefits. However, in shorter horizons, temporary market dislocations offer additional investment opportunities that can be capitalised on by a professionally prepared level of tactical allocation with a sufficiently large risk budget.

A core principle guiding the management of investment reserves at the NBS is the commitment to continually elevate the expertise of the personnel tasked with this responsibility.

Governance structure and changes

Enhancements in decision-making and committee roles

The governance system is currently undergoing significant changes, which are also documented in the IPS. A key development is the enhancement of the decision-making tree for the management of investment reserves, specifically, the division of the function of the previous Investment Committee into two committees: the NBS Risk Management Committee; and the ‘new’ NBS Investment Committee. The NBS Risk Management Committee will be tasked with preparing strategic decisions for the NBS in the area of investment reserve management (mainly setting investment policy, SAA allocation and division of the risk budget) and proposing strategic benchmarks, setting rules and associated limits. The newly constituted NBS Investment Committee will be primarily responsible for preparing tactical benchmarks with the aim of optimising the use of the allocative risk budget through active management.

Institutionalising reserve management layers

A second fundamental change is being prepared in the process of institutionalising three layers of reserve management:

• The highest layer represents decisions on SAA and other key principles adopted by the Bank Board supported by proposals from the NBS Risk Management Committee.
• The tactical layer is managed by the NBS Investment Committee, which is responsible for selecting tactical benchmarks and implementing specific active management procedures.
• The operational layer consists of portfolio management with a defined level of active risk relative to tactical benchmarks.

External management and comprehensive reporting

The SAA process

In the upcoming period, the investment policy will not significantly expand the list of currently permitted asset classes. However, after completing the SAA, there’s scope for gradual expansion of the instrument universe for risk factor and market sector hedging, or risk-taking, for example, with total return swaps. The SAA, which is crucial for setting return expectations and the risk profile of managed investment reserves, draws from long-term capital market assumptions across asset classes. Optimisation efforts aim to identify portfolio compositions that optimally meet risk-return requirements and NBS’s specific constraints. The approved portfolio composition serves as a baseline for rebalancing under predefined conditions, with detailed rebalancing policies to be specified in relevant documents. SAA is subject to annual monitoring to identify fundamental assumption shifts, although significant SAA adjustments are advised only over multi-year intervals, barring major market changes.

Role of external management and reporting framework

Internal asset management remains the primary approach for the NBS’s investment reserve management, with possible outsourcing to external managers for segments in which the NBS lacks market segment experience or seeks investment management style diversification.

The management of investment reserves is supported by a comprehensive framework for ensuring adherence to rules and measuring performance. This framework includes the use of a trade capture IT system for monitoring compliance with limits and an internally developed RiskHouse database for performance reporting. This approach guarantees impartial and secure dissemination of information to all stakeholders. Given the increased complexity of the reserve management framework, and the risk management and reporting systems, there may be a need for enhancements to fully support the achievement of stated objectives.

Challenges and strategic outlook

The new investment strategy anticipates the development of two distinct reserve management frameworks: discretionary; and benchmark-based. It also envisages active utilisation of the risk budget for active positioning against strategic benchmarks, tactical benchmarks or through macro-overlay trades within discretionary portfolios.

These ambitious objectives present significant challenges from multiple perspectives, particularly in terms of IT infrastructure and the high professionalism required from involved employees. With the increasing complexity of the investment strategy, there is a natural demand for the most modern IT systems for portfolio management, risk measurement, reporting, compliance, profit decomposition and other functions. Acquiring suitable IT solutions – which is often intensive in terms of financing, integration and maintenance – is generally more challenging in a public institution environment compared with purely commercial entities.

In a similar vein, central banks are recognised as institutional investors characterised by less flexible staffing policies, thereby hindering their capability to attract premier talent. Furthermore, the drive towards active management frequently calls for more specialised compensation models than those typically available in central banks. Addressing personnel challenges effectively is crucial across all facets of reserve management, fundamentally influencing the achievement of strategic objectives and ambitions.