We refer to the Ministry’s letter of 31 August 2009 with new draft rules for the management of the Government Pension Fund – Global.
The new rules bring together a number of documents governing the management of the Government Pension Fund – Global into a single document. This change makes the overall regulatory framework less complex.
Norges Bank is of the opinion that the changes made to the rules should be based on fundamental considerations which reflect the Fund’s long-term nature. The management of the Fund has undergone two periods of high market volatility and substantial decreases in the value of the Fund during its history, first in 2001-02 and most recently in 2008. In both periods, absolute and relative losses turned relatively quickly into gains. Thus the management of the Fund coped well during both of these periods.
The instruments suited to handling the challenges facing the management of the Fund in 2008 lay well within the Bank’s Executive Board’s area of responsibility. It proved particularly important during the worst of the crisis to retain securities with large recognised losses. The Executive Board has also clarified risk principles and limits for the operational management of the Fund. Thus the governance model has proved both robust and flexible.
The Ministry’s proposed rules confirm that the Fund’s investments are to be broadly invested in global capital markets. The objective that the Fund shall seek to achieve the highest possible return after costs has been retained. The Ministry determines the Fund’s risk profile by defining the benchmark portfolio, while the management of operational risk is delegated to Norges Bank. This is covered in more detail in the new rules, with the Ministry introducing a separate section 5 on valuation, performance measurement, and management and control of risk. These rules provide a broad description of good corporate governance within investment management. They are based on principles and a form of regulation that Norges Bank can largely endorse.
Active management is regulated by a separate limit for relative market risk. Norges Bank believes that it would have been a strength if the Ministry had also clearly expressed the owner’s expectations for return after costs over time when the manager makes use of this limit. A goal of this kind would be a good starting point for the strategic plan for the Bank’s investment management operation.
It is important that the allocation of roles and responsibilities between the Ministry as owner and Norges Bank as operational manager is clear. In the general rules for the Government Pension Fund – Global, the Ministry should express clear goals and give Norges Bank scope to establish principles, operational guidelines and quantitative management parameters on the basis of these goals. The Executive Board’s role is to ensure the appropriate organisation of the investment management operation and, to the extent necessary, to establish guidelines, plans and proposals for budgets for the investment management operation.
In some areas, the Ministry goes too far in proposing detailed regulation of the Bank’s investment management. There must be no doubt as to the role of the Bank and the function of the Executive Board. For the Bank to be able to manage the Fund appropriately, the new rules must not be so detailed that the Executive Board’s role and responsibilities become unclear in relation to the Ministry’s governance. In the long term, excessively detailed rules and reporting requirements will entail a risk of the Ministry effectively assuming the Executive Board’s role. Lines of responsibility will then become muddied, and the governance model less robust in the face of new challenges and financial crises. In this letter, we also describe how Norges Bank has supplemented the current general rules with specific operational rules.
The quantitative restrictions imposed in the general rules should be few in number and mutually independent, as well as robust and easy to communicate. To promote sound oversight and supervision, the Ministry’s limits must be relevant, unambiguous and measurable.
The Ministry is introducing new limits for extreme loss risk in the new rules. Norges Bank agrees that measures other than the limit for relative market risk should be used. The Executive Board has adopted supplementary risk measures for the Bank’s investment management, as discussed in our letter to the Ministry of 12 February 2009 on risk-based supervision of the Bank’s management of the Fund. These address precisely the kind of extreme loss risk that the Ministry is seeking to limit. If the Ministry wishes to set new limits for market risk, we recommend that these limits are based on these measures. In any case, the Executive Board will report on any significant changes to the limits set by the Executive Board for the management of the Fund, and the Ministry could impose a consultation requirement.
The type of estimated risk measure for extreme losses proposed by the Ministry is highly technical. Appropriate use of risk models and estimates of this kind also requires qualitative assessments. Such limits are therefore unsuited to the general rules. The proposed rules would not have sent out signals ahead of the financial crisis that would have affected the portfolio’s actual composition. The various measures proposed are so closely related that they would, essentially simultaneously, have given the same amount of notice when market volatility hit extreme levels during the financial crisis in 2008. These limits would not have stood in the way of the investments made by the Fund from 2005 to 2007. As they are so closely related, the new requirements would, in all probability, have necessitated extensive sales of securities during the crisis and could therefore have brought heavy realised losses upon the Fund.
The long-term objective for real estate management is to establish a well-diversified unlisted real estate portfolio which produces the highest possible return after costs. The real estate portfolio needs to be built up gradually, and the Bank needs to be able to exploit openings in the market. It may prove impossible to invest in real estate in some countries or parts of the real estate market because tax issues may make investments unattractive, because investments result in unacceptable reputational risk, or because investments result in a liability that is hard to quantify. It is doubtful whether it will be possible to comply with the detailed diversification requirements in the proposed rules even in the long term.
We therefore believe that the Ministry could usefully postpone the introduction of these rules until a later date. We recommend that the Ministry expresses a clear requirement that the portfolio is to be invested in private real estate investments which are well-diversified. The Ministry should give the Bank the task of formulating principles for the management of the portfolio and setting concrete requirements for its diversification. Norges Bank will discuss this in more detail in the investment plan that will be submitted to the Ministry. The most important regulatory factors for Norges Bank with our operational planning horizon will be the phasing-in rules announced by the Ministry.
Norges Bank has noted that section 2 of the rules on responsible investment are not currently subject to consultation. We assume that the Bank will be given an opportunity to comment before the final rules in this section are adopted.
The following discusses some of the specific rules proposed by the Ministry and, to some extent, proposals for changes to the wording which can bring the rules more closely in line with the general views that we have expressed.
2. Governance model – allocation of roles and responsibilities
On behalf of the Norwegian government, the Ministry of Finance has given Norges Bank a mandate to conduct the operational management of the Government Pension Fund – Global. This management mandate has been based on clear written guidelines from the Ministry and supplemented with a management agreement. This model has contributed to clear allocation of responsibilities and to transparency and professionalism. These are characteristics which should be retained in the new structure with a single set of rules for the management of the Fund, as discussed in section 1 above. We would also note that this allocation of responsibilities is important in relation to several of the issues raised in the US and Europe in the debate about sovereign wealth funds, a debate driven partly by the IMF.
The Ministry writes as follows in its letter of 31 August on the design of the new rules:
The Ministry is of the opinion that it is appropriate to have a hierarchical regulatory structure, where general guidelines issued by the Storting (Norwegian parliament) are supplemented and filled out by rules laid down by the Ministry of Finance. The Executive Board of Norges Bank may, under these general rules, lay down more detailed rules for [NBIM].
Norges Bank supports this.
The Executive Board has supreme executive authority at Norges Bank. In recent years, the Executive Board has reinforced its oversight of investment management. In 2006, an advisory board was set up under the Executive Board consisting of four experts with extensive international experience from large funds and institutions engaged in investment management.
In 2008, the Executive Board issued a new job description and investment mandate for the Executive Director of Norges Bank’s investment management organisation, NBIM. The chosen structure means that the Executive Director of NBIM has the responsibility and authority of CEO of the organisation, reporting directly to the Executive Board and subject to continuous oversight by the Governor on behalf of the Executive Board.
In 2009, the Executive Board has further reinforced the framework and rules for the Bank’s investment management. The investment mandate for the Executive Director of NBIM establishes rules for what the Fund can invest in and how much risk NBIM can take in its management of the Fund. In June, the Executive Board adopted principles for risk management at NBIM. These principles build on a common framework where risks are divided into four different categories: market risk, credit risk, counterparty risk and operational risk. Within each of these categories, the principles for risk management are to be supplemented with more concrete operational limits laid down at Board level. These concrete limits are set in the Executive Board’s investment mandate for the Executive Director of NBIM. The monthly, quarterly and annual reporting from NBIM to the Executive Board is to reflect the guidelines in the investment mandate.
In 2009, the Executive Board has also set up a remuneration committee as a subcommittee and preparatory body for the Executive Board. The main role of the remuneration committee when it comes to the investment management operation is to prepare recommendations for the Executive Board on the main terms and pay bands for the Executive Director of NBIM and employees of NBIM with managerial responsibility who report directly to the Executive Director of NBIM. The remuneration committee also prepares recommendations for the Executive Board on the principles for performance-based remuneration schemes and, annually, on the overall limits for the payment of performance-based remuneration.
Norges Bank believes that the guidelines and framework for risk management laid down by the Executive Board are in line with recognised international standards and suitably supplement the Ministry’s mandate. The Executive Board’s principles for risk management at NBIM and the job description and investment mandate for the Executive Director of NBIM are enclosed with this letter.
In its letter to Norges Bank of 31 August 2009, the Ministry also writes:
Based on these general considerations, the rules laid down by the Ministry should be relatively detailed where this is necessary to express the Fund owner’s tolerance of different types of risk.
In our opinion, it is important that Norges Bank’s governing bodies have scope to exercise judgement on the basis of business factors, operational conditions, market structure and good corporate governance.
The Ministry’s intentions will often best be realised through the formulation of goals which give the Bank the role of designing the actual detailed management parameters. At a general level, Norges Bank shares the Ministry’s vision for the management of the Government Pension Fund – Global as set out in Report to the Storting No. 20 (2008-2009):
The Government’s ambition is for the Government Pension Fund to be the best managed fund in the world, entailing that best international practice must be sought for in all aspects of its management. The goal for the management of the Government Pension Fund is to achieve maximum financial return with moderate risk.
In keeping with this, it would be natural for the Ministry as owner of the Fund not only to set a maximum limit for relative market risk but also to express its ambitions in terms of excess return.
Clarification of this kind will also be an important premise when Norges Bank develops a strategic plan for its investment management operation for submission to the Ministry. The plan will need to cover the most important tasks that the Bank, as operational manager of the Government Pension Fund – Global, is to perform for the owner. This will promote greater openness about the management of the Fund and a better foundation for and understanding of the management operation. Norges Bank believes that it is not appropriate for the Ministry to attempt to provide, in the general rules, a detailed and almost exhaustive description of what such a strategic plan should contain. Nor, in our opinion, is it appropriate to hive off a small part of the management of the Fund (real estate) into a separate strategic plan.
The rules on rebalancing the weights in the actual benchmark index in line with the weights in the strategic benchmark index are important for the operational management of the Fund. Rebalancing should be regulated and mechanical, but it should be possible to depart from the mechanical rules on the basis of a market assessment. The assessments associated with the implementation of the necessary adjustments to the actual portfolio should be the role of Norges Bank as operational manager within the framework for active management. This will be transparent, and the results will be measured and evaluated.
Norges Bank has always attached great importance to providing extensive, timely and appropriate reports on its management of the Government Pension Fund – Global. The fund’s financial reporting has been expanded significantly in recent years with extensive notes to the financial statements. The Ministry proposes more detailed reporting in the new draft rules. Norges Bank would like to draw attention to the extensive financial reporting required of the Bank by the approved amendments to the Norges Bank Act introducing new accounting and bookkeeping rules for the Bank (see Proposition to the Odelsting No. 58 (2008-2009)). The Ministry’s proposed new consolidated rules for the management of the Fund include reporting requirements which are of the nature of accounting information. We would refer to the fact that the rules on financial reporting were designed specifically to ensure good information for the owner. The accounting data are quality-assured by means of audits. Other figures will have to have a more analytical bias.
The Ministry’s draft requires that the supplementary guidelines for investment management laid down by the Bank are made public. Norges Bank agrees that the principles established by the Executive Board, partly on the basis of the Ministry’s rules, should be published. However, the Bank’s Executive Board must be able to lay down rules that will also include business affairs and should not be disclosed to the general public and other market participants. This will not, of course, prevent the Ministry and supervisory bodies from having access to these documents.
The Ministry proposes changing the method for calculating the Bank’s remuneration for the management of the Fund. Previously the fee has been calculated as a percentage of the Fund’s assets, whereas the Ministry now proposes an annual budget in NOK. Norges Bank agrees that the Ministry should continue to set a limit for the Bank’s remuneration, but we recommend that this takes the form of a decision on a budget calculated relative to the Fund’s assets. We also recommend somewhat greater predictability in the remuneration structure by having the fee set in connection with the Bank’s adoption of its three-year strategic plans.
In introducing new limits for leverage, the Ministry has put itself on a line where the Ministry is expressing an intention in an area which is complex operationally and leaving it to the Bank to set the concrete principles and limits. This is in line with the Bank’s view of an appropriate way of regulating the management of the Fund.
3. New limits for extreme loss risk in the management of the Fund
Norges Bank believes that the restrictions on market risk imposed by the Ministry should be few in number, mutually independent, robust and easy to communicate. The market risk that Norges Bank can take is limited by expected relative volatility, or tracking error, which is the expected standard deviation in the difference between the return on the actual portfolio and the return on the benchmark portfolio. Our view is that this measure is a well-established “industry standard” in international investment management and should be retained as the main measure of market risk laid down by the Ministry.
However, no single measure of risk can capture all relevant market risk factors over time. The new restrictions on market risk proposed by the Ministry in the new rules, namely Value at Risk and expected shortfall, are model-based measures based on price history which are closely related to tracking error. In this letter, we will refer to these new measures as “extreme loss risk”.
The financial crisis has revealed clear weaknesses in the financial sector’s over-reliance on aggregated quantitative and model-based risk measures for extreme losses. The recommendations from authorities and other expert bodies published in the wake of the financial crisis are to attach less weight to these measures and more to aggregates of a number of independent models, and to ensure that institutions combine quantitative measures with qualitative evaluations. We would refer here to the recommendation of the Institute of International Finance:
The risk-management function should explicitly incorporate in its procedures the limitations of risk metrics and models (e.g., VaR) that are used in the firm. Such limitations should be addressed by qualitative means, including expert judgement. Risk-management procedures should explicitly prevent dependence upon single methodologies.
Equivalent recommendations have been made by the regulatory authorities in France, Germany, Switzerland, the UK and the US, among others.
The main experience that Norges Bank has drawn from risk management in the Government Pension Fund – Global during the financial crisis is in line with this. Supplementary risk measures are needed to ensure robust overall management of risk which provides a better understanding of all of the risk elements in the portfolio.
It is important that the framework for risk management is designed in such a way as to give as broad a picture of risk as possible. Norges Bank agrees that measures other than the limit for relative market risk should be used. The Executive Board has therefore established supplementary risk limits in its investment mandate for the Executive Director of NBIM, as discussed in our letter to the Ministry of 12 February 2009 on risk-based supervision of the Bank’s management of the Fund. This mandate is based on the following main dimensions of market risk:
- Deviation from the benchmark index, where the aim is to ensure that the measurement of exposures is not based on a quantitative model
- Risk from price history (statistically-derived risk measures based on volatility and correlation), which combines portfolio exposures and the markets’ statistical properties
- Factor exposures, which describe to what extent a portfolio is exposed to systematic risk factors, such as small-cap companies or emerging markets
- Liquidity exposure, which is to ensure that we have sufficient room to manoeuvre in our investment management to be able to adjust exposure, including the extent to which exposures are liquid and can be sold
Within each of the above dimensions of market risk, the Bank will use different and complementary measurement methods. Multiple approaches to risk and complementary measurement methods are important to ensure an effective and robust structure for risk supervision.
Norges Bank believes that a good model for dealing with extreme loss risk is for the Ministry to express the need for, and purpose of, management of extreme loss risk in relation to market and credit risk. The Bank will then operationalise (in other words, measure, monitor and report) this on the basis of the Ministry’s intentions. This will ensure more flexible and real supervision of this important area, while also providing greater scope for the necessary qualitative judgements and enabling extensive reporting. If the Ministry wishes to set new limits for market risk, we recommend that these limits are set on the basis of some of the measures established by the Executive Board. In any case, the Executive Board will report on any significant changes to the limits set by the Executive Board for investment management, and the Ministry could impose a consultation requirement.
Norges Bank recommended in its letter of 12 February 2009 that the Ministry receives a supplementary quarterly report as well as the public quarterly report. The detailed content of this report would be agreed between the Bank and the Ministry, but all of the main quantitative provisions could be disclosed. We assume that this reporting would meet the Ministry’s need for an overview of the management of the Fund. There would also remain a clear allocation of responsibilities between the Bank and the Ministry.
Further comments on extreme loss risk in the market risk calculations
Understanding extreme loss risk is an important field within risk management, and Norges Bank attaches importance to models and measurement methods which can describe this risk in the management of the Fund for the areas where we take risks.
There is a clear and close relationship between the market risk measures of tracking error, Value at Risk and expected shortfall. While tracking error is an estimate of the expected standard deviation of the relative return, or a “normal” loss if we look at the negative end of the relative return distribution, Value at Risk is an estimate of the size of an “abnormal” loss with a given but small probability significantly further along the tail of the expected relative return distribution. Expected shortfall is defined as the average of the relative losses we might expect if an abnormal loss (beyond the limit for Value at Risk) actually occurs.
The limits that the Ministry is proposing for extreme loss risk express the same risk tolerance as the current limit for tracking error if the expected relative return distribution is normally distributed. However, the Ministry is introducing a requirement that the limit for extreme loss risk is to be based on historical simulation. This contrasts with the current calculation of expected tracking error, which is based on a parametric method and assumes a normal distribution in the relative return distribution. It is a known feature of time series in financial markets that the actual distribution is not normally distributed, but has more frequent observations in the tails of the distribution than the normal distribution (leptokurtosis).
This means that the limit the Ministry sets for extreme loss risk through Value at Risk will dominate as the market risk restriction and so make the current limit for tracking error redundant.
The limit for expected shortfall is based on assumptions as to what happens in the tail of the return distribution in abnormal markets and is in itself very uncertain. With the use of historical simulation to calculate the expected size of an extreme relative loss, the estimate could change significantly when new observations enter the time series. This effect is independent of how long a price history is used for the calculations. On the one hand, overly short time series are affected by noise and instability, and they present challenges in terms of statistical significance; on the other, overly long time series are difficult to interpret on account of changes in company structures due to share and bond issues, mergers and acquisitions, etc. Norges Bank believes that historical simulation based on a three-year period of weekly observations strikes a reasonable balance between these considerations.
From an operational point of view, the calculation of a quantitative expression of extreme loss risk will need, in practice, to use a risk system that encompasses all asset classes and sectors in our benchmark indices. The requirement for historical simulation may mean that additional uncertainty is introduced into the estimate, because price history from different markets needs to be aggregated. It will then be necessary to make a number of approximations and assumptions in the modelling. The uncertainty in the estimate introduced through these approximations is significantly higher when calculating extreme loss risk than for tracking error. In Norges Bank’s opinion, such a set of closely related risk measures is not suitable as an overall limit for the long-term management of the Government Pension Fund – Global.
The operational consequences of the proposed limits for extreme loss risk are considerable. With the same assumptions, the estimates for extreme loss risk will vary far more than the estimate of tracking error. The uncertainty in the estimate of extreme loss risk will mean that the operational management of the Fund will need to significantly restrict its risk-taking.
We refer to the enclosure with a more detailed discussion of these matters.
Modelling market risk
Norges Bank has noted that the Ministry is asking the Bank to establish supplementary guidelines for the modelling of market risk. Several factors are important in this context. In our opinion, it is important that the calculation of expected market risk is estimated on the basis of data series which harmonise with the time horizon for investments and which give a better expression of medium-term market volatility.
The Government Pension Fund – Global is a large fund, and changes in the Fund’s investments have to be gradual. NBIM currently uses a short dataset with considerable emphasis on the latest daily observations in the market. This means that risk estimates react quickly and clearly to short-term changes in market conditions. The Bank is in favour of changing this parameter-setting to a weekly frequency and a three-year estimation period with no half-life, such that it is more the actual absolute deviation from the benchmark index that determines risk levels than short-term market volatility. A three-year estimation period also ties in better with the investment horizon at an aggregated level.
New rules for market risk in the light of the financial crisis
The new quantitative limits proposed by the Ministry for the regulation of market risk are part of a methodological approach which has revealed its limitations during the financial crisis. In the Bank’s opinion, the proposed rules would not have prevented a situation of the kind which faced the management of the Fund during the crisis in 2008, and which may be the reason for the Ministry’s review of the rules. Put another way, risk measures of this kind are not well-suited to capturing the underlying liquidity risk and fair value measurement risk in the management strategy on the fixed income side. This management strategy has since been significantly modified.
Norges Bank fared well during the financial crisis, because we were able to fall back on the portfolio’s actual long-term risk not having changed significantly as a result of increased short-term market volatility. The correct plan of action faced with this crisis was to attach weight to the Fund’s long-term horizon and our ability to weather the volatility without being forced to sell securities. The proposed rules would have increased the likelihood of the Bank having to make adjustments, with the result that the Fund would have realised losses unnecessarily.
Further comments concerning credit risk
Credit risk is an important part of the overall risk picture for the management of the Government Pension Fund – Global, in both absolute and relative terms. Norges Bank agrees that credit risk needs to be regulated. The Executive Board has therefore laid down detailed guidelines in the principles for risk management at NBIM and the investment mandate for the Executive Director of NBIM.
Norges Bank nevertheless believes that credit risk is a specific risk within the framework for the overall management of investment risk, in line with other risk factors which are not subject to specific quantitative regulation by the Ministry. It is wrong to attempt to allocate credit risk some kind of share of current and new market risk limits. Norges Bank therefore believes that introducing a separate quantitative restriction for credit risk in the general rules would result in inappropriate segmentation of Norges Bank’s overall management of investment risk.
The type of limit proposed by the Ministry is reminiscent of the regulation of the banking sector, which aims to ensure that banks have a large enough capital base to withstand unforeseen losses (Basel II). The available third-party systems for calculating credit risk are, in the first instance, designed to calculate capital at risk for banking groups. The Government Pension Fund – Global is not subject to this type of regulation, nor is Norges Bank aware of comparable institutional investment managers having this type of regulation in their overall regulatory framework.
Norges Bank has established principles for the management of credit risk as part of the overall framework for risk management in the management of the Fund. Within the investment management operation, the Executive Director of NBIM has laid down a separate framework for credit risk which specifies concepts and measurement criteria and how this credit risk is to be measured and monitored.
The fund’s benchmark index for the fixed income portfolio is composed of a number of different instruments, and there are no third-party risk systems which can adequately calculate credit risk in all sectors. Uncertain assumptions and approximations need to be made to estimate the credit risk in portfolios of different instruments. For example, the modelling of covered bonds and commercial mortgage-backed securities is not realistic in existing commercial credit risk systems.
Norges Bank is continuously developing its systems to improve the analysis of the credit risk associated with large single investments. This will result in alternative and supplementary analyses of credit risk. The final outcome will not, however, be a single measure of credit risk, but a variety of quantitative measures which need to be combined with qualitative assessments to provide a more complete picture of credit risk in the Fund.
Understanding credit risk is an important field within risk management, and Norges Bank attaches great importance to developing models and methods in order to be better able to describe this risk in the management of the Fund. However, the methodological challenges are considerable here when estimating extreme loss risk. The estimate of credit risk is critically dependent on the choice of model, and uncertainty about the estimate at an aggregated level will be so high that it would not be appropriate to give the estimate a dominant role in operational risk management. In Norges Bank’s opinion, it is inappropriate for the Ministry of Finance now to establish quantitative limits for extreme loss risk related to credit alone, as there is not sufficient information on the level at which the limits should be set in order to reflect the Ministry’s intentions.
Extreme loss risk on the credit side cannot be viewed in isolation from other types of risk analysis and is, in Norges Bank’s opinion, unsuitable as an overall limit for investment management.
4. Comments on the mandate for the management of the real estate portfolio
The Ministry proposes a mandate for the Fund’s upcoming real estate investments in the new rules. In line with the long-term investment strategy, the objective for real estate management must be to establish a well-diversified unlisted real estate portfolio which produces the highest possible return after costs over time.
In its letter, the Ministry gives notice of separate rules on the phasing-in of real estate into the Fund’s portfolio. These rules will serve as the relevant regulatory framework for Norges Bank over the next few years. The speed at which real estate is phased into the overall portfolio will need to be based on Norges Bank’s assessment of specific projects.
Norges Bank believes that the choice of a five-year rolling return for a global real estate index as the long-term return benchmark for real estate investments is appropriate. The return indices supplied by Investment Property Databank (IPD) are based on actual private investments, and the choice of a long evaluation horizon is in line with the investment strategy and the nature of the asset class. We have noted that the Ministry asks for separate input so that it can issue more detailed guidelines on the calculation of the return on the real estate portfolio in such a way as to ensure comparability with the chosen index.
Private real estate investments are a relatively illiquid asset class, and investments will have to be made gradually and exploit openings in the market. The gradual expansion of the portfolio will need to be based on specific sectors and markets, and on the Bank’s choice of investment strategy and an appropriate implementation plan. Norges Bank has noted that the Ministry has asked for such a plan before investments can begin.
It will not be possible to apply the diversification requirements in the rules while the portfolio is gradually being built up. The phasing-in rules must therefore contain the necessary transitional rules. Norges Bank’s assessment of individual markets or sectors may, in some cases, conclude that the market is not investable. This may be because tax issues make investments unattractive, because investments result in unacceptable reputational risk, or because investments result in a liability that is hard to quantify.
Some countries have high taxes on real estate investments, and some even have tax rules that could change the tax status of the Fund’s other investments. As part of its preparations for real estate investments, the Bank has analysed the legal and tax position in a number of key markets. We have discovered complex tax challenges which will take some time to sort out. These include Norges Bank and the Fund’s status as government entities, and whether investments in real estate could impact on the Fund’s tax position.
One important example here is the Bank and the Fund’s potential tax position in the US, where tax legislation is highly complex, and where ascertaining our tax position is proving to be difficult and time-consuming. We refer to the enclosure discussing this in more detail.
Norges Bank supports the Ministry’s intention that the portfolio is invested in private real estate investments which are well-diversified. The Ministry should therefore give the Bank the task of formulating principles for the management of the portfolio and setting concrete diversification requirements for the portfolio. The proposed diversification requirements are, in some cases, so detailed that there is a risk of different parts of the rules coming into conflict with one another or with efficient and professional execution of the mandate. Even in the long term, it is uncertain whether it will be possible to satisfy the rules’ detailed diversification requirements. Some of the requirements may also be difficult to monitor and verify.
From the perspective of supervision and oversight, the Bank believes that it is crucial that the restrictions set for investments are relevant, unambiguous and measurable. With investments in real estate, there are also specific challenges in terms of obtaining information and valuations for underlying investments, either because they are unavailable or because the information cannot be obtained on an ongoing basis. Where real estate investments are made through structures that consist of investments in financial instruments issued by real estate companies, funds or fund-like vehicles, there may be limited opportunities for Norges Bank to influence the composition of the underlying real estate portfolio. With this type of investment, Norges Bank may have only limited opportunities to secure a regular supply of data through contractual negotiations. Where this is possible, it is likely that measurement and verification of the criteria established for investments will be possible only periodically or at specific times, and not on an ongoing basis.
The Ministry proposes giving Norges Bank a particular responsibility where real estate investments “may be associated with a possible liability for environmental obligations”. Norges Bank agrees that environmental considerations, and the potential for liability in this context, are key considerations when Norges Bank reviews investments (due diligence) as required by section 4-6 of the draft rules. However, we do not believe that there is a need for a separate provision concerning this liability (see the Ministry’s proposed section 4-7). Norges Bank believes that environmental considerations can be addressed as a natural part of our active ownership work, where the instruments available will be the exercise of the ownership rights that we have in respect of each individual investment. Environmental considerations can therefore best be regulated together with the regulation of the exercise of ownership rights in general.
5. Other comments
Other comments on the Ministry’s draft rules are presented below.
Section 1. General provisions
We refer to our more general comments about the governance model in section 2 of this letter. We believe that the new draft rules concerning the strategic plan (section 1-3) go further than what the Ministry itself states would be an appropriate allocation of roles and responsibilities between the Bank and the Ministry. We also believe that, if the Ministry is to lay down rules for the Bank’s strategic plan, these must be at a general level and only for a single strategic plan spanning all of the asset classes managed by the Bank in the Government Pension Fund – Global. In the Bank’s opinion, it should be the Executive Board which decides the specific requirements for the content of the strategic plan for the management of the Fund.
Section 2. Responsible investment
We assume that the Bank will be given an opportunity to express an opinion before the final rules in this section are adopted. We also refer to our submission of 12 September 2008 in the consultation on the ethical guidelines for the management of the Government Pension Fund – Global.
Section 3. Management of the equity and bond portfolio
Section 3-2: When calculating the bond index, it should be specified whether the real estate portfolio is to be counted net or gross (see section 4-2). The strategic benchmark portfolio must also contain provisions on investments in Norwegian kroner and Norwegian companies (see section 3-8 (2) of the Ministry’s proposal).
Sections 3-3 to 3-6: These provisions should be part of a separate set of rules which also include rules on rebalancing. We have noted that the Ministry has removed the downweighting rule for Japanese government bonds. In this context, we recommend two minor changes:
• The strategic benchmark index for Asia and Oceania should include all sectors in the Barclays Capital Global Aggregate Bond Index (BCGA) in line with the other regions.
• With effect from 1 January 2010, bonds denominated in Swiss francs will be included in this index, and we recommend that this currency is included in the Fund’s benchmark portfolio for all sectors.
Section 3-5: Norges Bank believes that it should be the Ministry’s responsibility to maintain the actual benchmark portfolio. This would be in line with the fundamental allocation of responsibilities between the Ministry and the Bank. It is good international practice for the principal to maintain the actual benchmark portfolio and issue it to the manager. This means that the return achieved by the Bank relative to the return on the benchmark portfolio can be assessed completely independently.
Section 3-7 (1): This provision needs to be formulated in such a way as to make it clear that the Bank will at all times have an actual portfolio which deviates from the composition of the actual benchmark index. It is not practically feasible or appropriate to replicate the benchmark index in full, especially the bond index where the benchmark portfolio currently contains around 10,500 bonds. We also refer to our letter of 5 February 2008 assessing investments in emerging equity markets, where we stated that the Bank’s review could result in us not investing in countries included in the benchmark index for equities.
Section 3-7 (2): This provision is narrower than the current rules. Norges Bank believes that the Fund must be given the option of investing in financial derivatives and mutual fund units (see section 4 of the current regulations on the management of the Government Pension Fund – Global). We refer to our previous letters to the Ministry explaining this position.
Section 3-8 (3): This provision also needs to contain a formal reference to the Regulation on Special Measures concerning Burma (Myanmar) of 4 July 2003.
Sections 3-10 and 3-11: We refer to our comments in section 3 of this letter above.
Section 3-12: Section 5-5 includes requirements for how the Bank is to measure and manage counterparty exposure which, in our opinion, are adequate for how a provision on counterparty risk should be formulated.
Section 4. Management of the real estate portfolio
We refer to our general comments in section 4 of this letter above.
Sections 4-2 (3) and 4-5 (4): There is reason to believe that “buildings subject to significant changes to leases” are vacant, and so they should be defined as such and not together with buildings that are under development, renovation or conversion.
Section 4-3: Norges Bank recommends a number of changes to the rules. In subsection (1), the Ministry should, besides “listed and unlisted companies, funds or fund-like structures”, also add “legal entities”. The reason for this is that it is standard practice in several markets to organise real estate investments in trusts or other structures which, by Norwegian standards, would not fall under the definition of a company or fund-like structure. There should therefore be greater flexibility in the legal form that a real estate investment may take. Similar flexibility is required for the same reason in subsection (3), where Norges Bank proposes adding “, legal entities, funds or fund-like structures”, and in subsection (4), where we recommend referring back to subsections (1) and (3). This will make the wording consistent throughout section 4-3.
Section 4-3 (2): There are derivatives linked to the IPD index which may be useful for the management of the portfolio in the longer term. The rule should therefore read: “The real estate portfolio may only be invested in derivatives naturally associated with listed or unlisted real estate investments.”
Section 4-3 (5): This requirement is difficult to verify from a management perspective. The limit should be expressed as an intention rather than a quantitative restriction. The prohibition against investments where more than 5 per cent of the investments are in real estate in Norway cannot be enforced or monitored by Norges Bank when it comes to indirect investments in real estate companies, real estate funds and similar structures.
Section 4-5: These limits should not be set now. The Ministry should impose a few general restrictions and require the Bank to lay down limits in areas deemed appropriate by the Ministry.
Section 4-6 (2): The expression “internationally recognised practice” is imprecise in this context.
Section 4-7: We refer to our comments in section 4 above. Norges Bank agrees that environmental considerations, and the potential for liability in this context, are key considerations when Norges Bank reviews investments (due diligence) as required by section 4-6 of the draft rules. However, we do not believe that the proposed provision in section 4-7 is well-suited to addressing these considerations. In our opinion, the proposal is not operationally viable, because it requires the Bank to be able to impose conditions for, or regulate, the operation of underlying properties in order to meet the environmental requirements. It may also place some unintended constraints on our investments. With investments in funds, the Bank, as one of a number of unitholders, will not be in a position to impose this kind of condition when acquiring fund units. We therefore ask the Ministry to reconsider the content of this provision and include a more appropriate formulation in section 4-6.
Section 5. Valuation, performance measurement, and management and control of risk
Norges Bank believes that this section is in line with the fundamental requirements for the rules that we highlighted in section 1 of this letter. We have just one technical comment, on section 5-1 (2), where there should be a reference to “internationally recognised standards” rather than “best international practice”.
Section 6. Budget, remuneration and principles for performance-based pay
Section 6-1: Norges Bank refers to section 29 of the Norges Bank Act requiring the Executive Board to prepare a draft budget each year for the coming financial year. This budget is approved by the Supervisory Council and communicated to the Ministry. The Bank’s budget also covers NBIM, including the budget for operating expenses for the Government Pension Fund – Global.
As the Ministry has previously met the Bank’s operating expenses for the Fund within a budget agreed annually which is calculated as a proportion of the Fund’s assets, these expenses appear as an estimated allocation in the Bank’s budget decision in line with the Bank’s budget rules. We agree that the Ministry should approve in advance the fee to be paid to the Bank, but we recommend that this continues to take the form of a decision on a budget calculated relative to the Fund’s assets. We would also note that this appears to be a common industry standard for comparing the operating expenses of investment managers – see, for example, the annual cost survey carried out for the Ministry by CEM Benchmarking Inc.
A budget defined in absolute NOK terms exposes the Bank to exchange rate risk, as a large share of its operating expenses are denominated in foreign currency. Some of these expenses can be hedged, but far from all, as they depend partly on the size of the Fund’s assets and partly on the level of external management as an element of active investment decisions. We also recommend somewhat greater predictability in the remuneration structure by establishing it in connection with the Bank’s adoption of its three-year strategic plans. In addition, we recommend that the Ministry receives more detailed reporting on the Bank’s actual expenses once the Supervisory Council has approved the annual financial statements. We refer to Enclosure 4 containing proposals for the formulation of this rule.
Section 6-2: Norges Bank recommends that the rules refer to international standards rather than the FSF principles. We would also note that the Executive Board has appointed a remuneration committee (see discussion in section 2 of this letter). This satisfies important elements of the international recommendations. The Bank agrees that the Ministry should lay down detailed requirements for the disclosure of remuneration in this section over and above the requirements of the accounting rules.
Section 7. Reporting
Norges Bank has always attached great importance to providing detailed, timely and appropriate reports on its management of the Government Pension Fund – Global. Both quarterly and annual reports are published in printed form and have been published at press conferences, which have also been broadcast over the Internet in recent years. Due to increased interest from the media and the public in the Fund and Norges Bank’s management of it over the past couple of years, we have stepped up our external communication. The fund’s financial reporting has also been expanded significantly in recent years with extensive notes to the financial statements.
We believe that the content of the Bank’s public reporting in recent years is at an appropriate level and capable of meeting the Ministry’s needs as owner of the Fund. In the Bank’s opinion, some of the additional requirements proposed by the Ministry in section 7 go slightly too far in the level of detail relative to the general requirements that we discussed in section 1 above. We also believe that some of the reporting requirements are already covered by the accounting provisions of the new Norges Bank Act. In this section, the Ministry should only lay down requirements that go beyond the requirements of other legislation and regulations. We have the following comments on the individual provisions:
Section 7-1 (3): The Ministry should refer to internationally recognised standards.
Section 7-2 (3): We believe that many of the reporting requirements are too detailed or are covered by section 7-2 (1), e.g. the last part of letter c) and letters e), f) and g). There needs to be a requirement that deviations in letter i) must be significant before the Ministry is to receive a written report.
Section 7-3: Our comments on section 7-2 also apply to this section.
Section 7-4 (2): We believe that this is an example of excessively detailed requirements considering what is an appropriate management model and allocation of roles and responsibilities between the Bank and the Ministry.
Section 7-5 (1) d) and e): These requirements need to apply to the Bank’s management of the Government Pension Fund – Global.
Section 7-5 (2): We recommend that this provision does not contain a reference to companies that assist the Ministry. Some of this information may well be information that is subject to a duty of confidentiality under section 12 of the Norges Bank Act (typically information on Norges Bank’s business affairs, but perhaps also those of second/third parties) but may be disclosed to the Ministry. The reference to companies in the draft is more problematic, but we must then have it confirmed and assume that the Ministry will take responsibility for the duty of confidentiality being observed by those receiving the information. When it comes to the Bank’s own business affairs, we could decide on an exemption from the duty of confidentiality (see section 12, paragraph 4 of the Norges Bank Act), but we do not have the right to do so when it comes to the business affairs of other parties, such as contracting parties, unless we have negotiated such a right of disclosure or similar.