Literature Review

The goal of risk management at the central bank is to improve the efficiency of the execution of
monetary policy, and in some cases, financial supervision, and to facilitate the optimal allocation
of the national foreign exchange reserves. This risk management framework is usually developed
in line with best market practices (Sangmanee and Raengkhum, 2!.
Risks to which central banks are exposed can be categori"ed as financial and non#financial risks.
$n the context of the central bank, financial risks arise from managing the national foreign
reserve and exposure to financial market operations while non#financial risks arise from bank
operations and the execution of monetary policy.
%hile central banks usually have &uantifiable risk management frameworks to monitor financial
risks, non#financial risks are no less important. %hile the main focus of the study will generally
be about the financial risk that faces the balance sheet, reputational risk will be discussed as it
remains the greatest threat to the central bank's international credibility. (entral banks are
typically exposed to a variety of risks. )s its reputation is vital to properly execute the functions
of a central banks, their risk appetites have traditionally been relatively low. (entral banks, given
their role within the financial system tend to be risk averse. (onse&uently, as technology and
model techni&ues continue to advance, central banks are now benefiting from risk management
techni&ues that arise from more conscious assessment of the risks. *any (entral banks integrate
risk management framework to ensure consistency on all levels.
The central bank's balance sheet is useful in clarifying the various transmission channels. (aruana (2++!
focused on the specific risks related to the balance sheet. )ny accumulation of assets implies an increase
in corresponding liabilities. $n addition, the purchase of domestic assets will directly affect their prices,
and therefore credit spreads term premia and long term interest rates. )n increase in monetary liabilities,
for example, reserve money, will have implications for li&uidity of the banking sector in the short run, and
this may undermine the price stability in the medium term. ,ut an increase in long term liabilities could
also crowd out lending to the private sector. Taking into account these transmission channels, it is &uite
clear that large expansions of central bank balance sheets have implications both for financial and non#
financial sectors of the economy.Sangmanee and Raengkhum (2++! noted that the central bank in
Thailand, clearly defined benchmarks are used. so that any deviation from the target can be
detected. The risk tolerance level is embedded in the benchmark through the risk ad-usted target.
They assessed asset#liability, li&uidity and investment portfolio using the value#at#risk method to
capture the relevant market risk and to create a common unit of risk measurement.
.ugee (+//0!, states that from a risk control viewpoint, the most obvious feature of a central bank's
balance sheet is that it carries unavoidable currency risks as the ma-ority of the liabilities are in domestic
currency. $n addition, to currency risk central banks face unavoidable interest rate risks as most he
liabilities are floating rate. (entral banks have used its balance sheet to play a salient role in
financial history especially during crises. )s such they are given a monopoly on note issuance
and the role of lender of last resort. ,agehot (as cited in (aruana, 2++! clearly understood this
privileged position vis#1#vis the rest of the financial sector in the +/th century. 2uring times of
financial distress, only the central bank could be a credible lender of last resort. $ts ability to
create monetary liabilities could be used to provide li&uid assets to a bank in difficulty. $t is
because of this vital role, central banks expand their balance sheet to meet these unexpected
events, while seeking to maintain its ultimate ob-ective of price stability.
Risks on balance sheets of central banks have significantly increased since the start of the 20#
23 financial crisis, with potential negative conse&uences for the financial system. 4nhanced
li&uidity provision, relaxation of collateral rules, and si"able asset purchases have led to
increases in the absolute si"e of central bank balances sheets, an increase in the duration and
diversity of assets, and a decline in asset &uality. These changes pose risks, valuation changes as
a result of changes in interest rates. These could result in the decline in operating income when
central banks increase their holdings of long#dated securities in addition topossible impairment
losses on assets with credit risk .The extent to which the various central banks are exposed to
these risks differs, depending on the scope and nature of their policies.
The global expansion of central bank balance sheet is exceptional. (entral banks have showed
competence in using their balance sheet to prevent crisis. This expansion of their balance sheet
means that it becomes more exposed to market developments such as a fall in the value of
foreign assets or a rise in long term interest rates, which could reduce the value of their assets
while leaving the value of their liabilities intact exposing the central bank to both market and
credit risk.
5ilardo and 6etman (2+2! states that the use of central bank balance sheets to effect change
creates a number of policy risks such as the negative effects of inflation on interest rates and
price stability. *oreover, it poses a risk to financial stability with possibilities of market
distortion. 7e also argued, however, that because the materialisation of such risks is not
inevitable, prudence dictates caution and vigilance.
)n increase in the bank's local currency assets, which is a ma-or counterpart of the increase in
the foreign currency reserves, can lead to excessive credit expansion, since there seems to be
some correlation between credit growth and foreign exchange accumulation. )n analysis by
(ook and 6etman (2+2! argues that there is growing evidence of incomplete sterilisation which
reinforces credit risk in the market. The threat to financial stability from an increase in bank
lending is greater when credit growth is already robust and inflation pressure is picking up.
5ilardo 8 9renville (2+2! state that large balance sheets leave central banks vulnerable to large
financial losseswhich impact the central bank's return on its foreign assets as reserves may yield
less than the costs of central bank bills and the interest rate paid on excess reserves.
5inally, (hen et al, (2+2! explored the similarities and differences in risks to the balance sheet
for different financial institutions. They examined four financial ratios: capital, leverage, asset
li&uidity and funding. These ratios would measure the risks to the balance sheet for the financial
institution. They also discuss how these risks have evolved over the decades and describe
relevant development in the banking sector regulation that could have contributed to the
observed change. This paper will adopt these risk indicators, in addition to foreign exchange and
interest rate risk indicators. These indicators were chosen because they are not complex and can
be easily compiled from the information presented on the ,;<'s balance sheet.