We refer to the Ministry of Finance’s letter of 20 October 2008 on risk-based supervision of Norges Bank’s management of the Government Pension Fund – Global, in which the Ministry refers to Ernst & Young’s review of investment management at Norges Bank in 2007 and Norges Bank’s response to Ernst & Young’s report, and raises a number of issues in this context.
In this letter, Norges Bank outlines the changes made to the Bank’s organisation of investment management over the past year. We also comment on specific projects on which the Ministry requests a status report, and we discuss, on a general basis, the framework and guidelines for the management of market risk in the Government Pension Fund – Global. Finally, we address a number of issues relating to the supervision of the Bank’s investment management unit, Norges Bank Investment Management (NBIM), by the Executive Board and Internal Audit.
2. Organisation and oversight of investment management at Norges Bank
The organisation and oversight of investment management at Norges Bank were changed in a number of significant respects in 2008. The Executive Board issued a new job description and investment mandate for the Executive Director of NBIM with additional reporting requirements (see section 6 below).
Until 2008, NBIM was organised into two relatively independent business areas: one for equities and one for fixed income instruments. A variety of central staff functions – including project management, budgeting, IT and a number of reporting and control functions – had gradually been transferred out to the two business areas. As NBIM’s activities grew in size and complexity, however, we saw a need for a greater degree of centralised supervision and control.
The appointment of a new Executive Director of NBIM in 2008 made it natural to review its organisation. At the same time, the global financial crisis had led to a number of changes in the oversight and supervision of the activities. We would like to stress that NBIM will review the organisation of its operations regularly, which means that the description of its organisation below must not be regarded as static.
A new organisation for NBIM was introduced from 1 March 2008. The aim was partly to strengthen and focus its investment functions, and partly to strengthen the overarching control functions. We have drawn a clear distinction between departments responsible for investment decisions and departments responsible for operational and control functions. We have separated responsibility for executing transactions in the markets (trading) from the responsibilities of the portfolio managers, with the result that those taking investment decisions do not themselves perform trades in the markets. The division of roles at this level, with guidelines built into the trading systems, will provide an effective safeguard against the risk of error or irregularity at the level of the individual.
NBIM has reinforced its control functions through recruitment and reorganisation. We have built up a unit for monitoring market risk, credit risk and counterparty risk across the investment units. This unit is now physically located closer to the employees responsible for active risk-taking in the Fund, whereas previously it had more the nature of a staff function. At present, around 20 employees work in this function.
NBIM has also reinforced the control functions that are responsible for ensuring that NBIM complies with market regulations, monitor compliance with investment mandates, interpret investment guidelines, prepare instrument approvals, and have responsibility for the authorisation structure. This function has also been given a broader mandate to monitor NBIM’s non-market risks. In practice, this entails a responsibility for ensuring that the other departments manage these risks, which comprise operational risk, IT/information risk and legal risk, as well as behavioural standards and reputational risk in the broad sense. At present, around 15 employees work in this function.
NBIM has established a formal committee structure which draws on expertise from across the organisation. These committees are advisory and are used by NBIM’s Executive Director to discuss relevant issues before decisions are taken. The committees also play an important role in the design of important guidelines for NBIM’s operations. Currently NBIM has five committees: one for investment universe, one for credit and counterparty risk, one for business policies , one for investment risk, and one for valuation.
Norges Bank has established a new investment mandate structure. The Executive Board has issued a new investment mandate for the Executive Director of NBIM and requirements for more extensive reporting (see discussion below). The content of NBIM’s own mandates has also been overhauled. Risk limits are now issued along many more dimensions than before. First, there are quantitative model-based limits. There are also risk limits that are based not on models but on gross nominal exposures and the level of usage of derivatives. In addition, the new investment mandates contain clear guidance on desired liquidity and limits for systematic exposure to specific market factors.
Many of the risk systems based on quantitative models have not provided useful signals during the global financial crisis that erupted in summer 2007. Our experience is that models or stress tests alone are not sufficient for assessing risk. A combination of different quantitative and qualitative measures and limits should underlie the management of all types of risk in financial management. We believe that the new structure of the investment mandates provides a solid foundation for delegating and verifying more aspects of market risk.
The Executive Board’s supervision and control of NBIM’s operations is discussed in section 6 below.
3. Status of key projects
The following looks at two important projects on which the Ministry requests a status report: independent valuation and measurement of counterparty risk.
3.1 Independent valuation
Norges Bank has agreed with the Ministry that the accounts for the Government Pension Fund – Global are to be prepared in accordance with the Bank’s accounting policies and the 1998 Accounting Act, with a few exceptions. These policies were presented in Norges Bank’s annual report for 2007 and NBIM’s own annual report for 2007. From this starting point, NBIM has introduced more detailed valuation policies, which are to apply to both the preparation of accounts and the measurement of returns.
The aim of the independent valuation project was to establish a solution that ensures that all of the Fund’s holdings are priced, quality-assured and verified by bodies independent of those taking investment decisions, both internally at NBIM and at external managers. Valuations are to comply with generally accepted accounting principles and the requirements set out by the Ministry in section 4.1 of the Guidelines for the Management of the Government Pension Fund – Global.
The independent valuation project was completed in October 2008. New requirements were introduced for both NBIM and our external accounting service providers (currently JPMorgan Chase and Citibank). Further improvements are being made on an ongoing basis.
NBIM’s external accounting service providers play an important role in this solution. They have responsibility for pricing both externally- and internally-managed portfolios using independent price sources. The accounting service providers are to use a pricing hierarchy established by NBIM. In the capacity of pricing coordinator, a control unit in NBIM’s operations area is responsible for pricing the same instruments as the accounting service providers. This unit reconciles its own valuations with the prices received from the accounting service providers.
The control unit is responsible for conducting additional pricing checks at month-end to assure the quality of prices and ensure that the pricing hierarchy is being observed. Spot checks will also be made during the month. Where necessary, the internal control unit will enlist the support of external pricing specialists selected to assist with the pricing of particularly challenging instruments.
NBIM’s valuation committee (see section 2 above) is a forum for discussing significant pricing issues. The committee meets at least once a quarter ahead of the publication of the accounts. Central Bank Audit and its external partner will review price quality and price controls while the quarterly accounts are under preparation.
Norges Bank believes that this structure will ensure both quality and independence in the pricing and valuation of all financial instruments in the Fund.
3.2 Counterparty risk
Norges Bank’s framework for the evaluation and monitoring of counterparty risk has been built up in accordance with the requirements laid down by the Ministry in section 4.2.2 of the Guidelines for the Management of the Government Pension Fund – Global.
When selecting and evaluating counterparties, an external credit rating from the credit rating agencies Moody’s, Standard & Poor’s and Fitch is required. Higher ratings are required for unsecured credit exposure than for secured credit exposure (i.e. exposure secured against other securities or cash). Changes in counterparties’ credit ratings are monitored continuously by an independent control unit.
NBIM’s project for improving and developing its systems for the management of counterparty risk was started up in 2007. We originally assumed that the current system for measuring market risk would also be used for measuring counterparty risk. In 2008, however, we again compared international practice with NBIM’s business model and mapped alternative system solutions. We decided to conduct an international tender process. NBIM expects to have a new framework in place during the first quarter of 2009 and a new system for measuring counterparty risk in place during the second quarter of 2009.
Based on the applicable monitoring and control structure, we have taken a number of steps to reduce counterparty risk, the most important being:
- NBIM has substantially reduced exposure to derivatives and repurchase agreements, and some complex unlisted products are no longer approved instruments
- Requirements that trading in unlisted derivatives can be performed only with counterparties with whom we have entered into a separate agreement, and which safeguard our rights, partly through the counterparty having to provide collateral in the form of securities and/or cash
- Changes in the process for approving counterparties following the reorganisation of NBIM, and closer supervision and monitoring of counterparties
- Decision to cease all new trading, terminate outstanding transactions and monitor developments at a number of key counterparties that ran into problems in 2008
We have focused particularly on credit and counterparty risk since the credit crisis erupted in July 2007. The new framework and system for measuring counterparty risk will be tailored to a narrower range of instruments and a general reduction in the complexity of investment management, especially in internal and external fixed income management.
4. Credit risk
NBIM has issued new guidelines for credit risk specifying how it is to be measured and monitored. As mentioned in section 2 above, we have set up a counterparty and credit risk committee, which is to ensure a multidisciplinary focus on all credit-related aspects of our investment management.
NBIM’s credit risk guidelines provide clear guidance on how credit risk is to be managed at NBIM: from unambiguous definitions of terms to concrete methods and the scope of different measurement criteria. The guidelines require NBIM to establish a framework for measuring and verifying credit risk, both for individual issuers and for the overall portfolio of issuers, including correlations between issuers. Stress tests of credit risk are also to be performed to take account of possible extreme market situations. A concentration analysis for both absolute and relative credit risk is also to be performed for the overall portfolio of issuers with the aim of identifying potential large positions at different levels of the portfolio (sector, currency, region).
In addition, NBIM is to monitor movements in the market’s credit rating for all issuers in the fixed income portfolio. The guidelines also require the establishment of procedures for situations where there is a defined credit event (default).
To meet the increasing requirements for the identification, measurement and verification of credit risk, NBIM has reinforced the department responsible for risk management with new staff with a broad and varied background in the field.
NBIM took a number of steps in 2008 to improve the quantitative model-based side of the measurement and analysis of credit risk. We have taken into use a new third-party model that can be used to monitor credit developments in large individual exposures in our investment portfolio. We are considering extending the use of this model to form the basis of internal modelling, or acquiring a separate system to measure and analyse credit risk for the entire portfolio as a supplement to today’s modelling of market risk in our system for measuring that type of risk (RiskManager).
NBIM also plans to integrate standard stress tests into its periodic calculations of market risk. These tests will be based on defined historical periods with big swings in financial markets. The tests will also include periods where credit risk was high. These stress tests have been defined and are now being assessed. For other parts of the guidelines, processes are ongoing to establish a framework that addresses the different requirements at both company and portfolio level.
5. Market risk
The Regulations on the Management of the Government Pension Fund – Global currently establish a maximum limit for relative market risk:
The expected difference in return between the actual portfolio and the benchmark portfolio measured by tracking error on an annualised basis shall not exceed 1.5 percentage points.
The Ministry has also established additional requirements in section 4.2.1 of the Guidelines for the Management of the Government Pension Fund – Global:
Market risk shall be measured in such a way that compliance with the limit on relative risk in the Pension Fund can be documented. Best practice in the area shall be employed in regard to measuring methods, decomposition and measurement frequency.
In the case of the Government Pension Fund – Global, market risk is measured as expected tracking error, which is the expected value of the standard deviation in the difference between the return on the actual portfolio and the return on the benchmark portfolio. However, no single measure of risk can capture all relevant risk factors for the Fund over time. In addition, the turbulent market conditions since summer 2007 have revealed weaknesses when it comes to predicting risk in such markets. In this context, we also refer to the Bank’s four letters to the Ministry between November 2008 and January 2009 on the measurement of tracking error in the fourth quarter of 2008.
It is important that the framework for risk management is designed in such a way as to provide as detailed a risk picture as possible. The Executive Board has therefore issued a new investment mandate for the Executive Director of NBIM (see section 6 below), which sets out limits for risk management based on the following main categories of risk:
- Deviation from the benchmark index, where the aim is to ensure that the measurement of exposures is not based on a quantitative model. Limits can be set for:
Deviation between the actual and benchmark portfolios broken down by asset class and geographical region
Sector deviation in the fixed income and equity portfolios
Minimum levels of overlap between the actual and benchmark portfolios for the two asset classes
Leveraging of the portfolios
- Risk from price history (volatility and correlation), which combines portfolio exposures and the markets’ statistical properties. Limits can be set for:
Maximum utilisation of market risk as measured by expected tracking error under normal market conditions, so that there is a buffer when unexpected situations occur
Concentration risk in the portfolios
- Factor exposure, which describes to what extent the portfolio is systematically exposed to factors such as small-cap companies or emerging markets
- Liquidity exposure, to ensure that we have sufficient room to manoeuvre to be able to adjust exposure in our investment management, including the extent to which exposures are liquid and can be sold
In each of the above risk categories, there will also be 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 the constraints on market risk imposed by the Ministry should be small in number, robust, and easy to communicate. Our view, therefore, is that the current measure of risk (expected tracking error) is a sound measure which is also the industry standard, and that the Ministry should retain this measure as the sole measure of market risk established by the Ministry. In the current market situation, it appears that all traditional risk models have failed as predictors of developments in market risk. Norges Bank will therefore get back to the Ministry with an assessment of parameter-setting in the modelling of market risk in the RiskManager risk system.
We also believe that credit risk in the portfolio is well-modelled under “normal market conditions”. Previous formal restrictions, such as the requirement for a minimum credit rating, would not have improved risk management in the situation we have had since 2007. NBIM has found that the credit ratings from the three agencies Moody’s, Standard & Poor’s and Fitch have not been good enough.
Nevertheless, it is clear that no single measure can provide a complete picture of the risk to which the Government Pension Fund – Global is exposed. Instead of introducing new risk limits, we recommend that Norges Bank reports risk along more dimensions. These reports should cover deviation from the benchmark index, risk from price history, factor exposure and liquidity exposure (see discussion above of the limits that the Executive Board has established for NBIM). We therefore recommend that the Ministry receives a supplementary quarterly report as well as the public quarterly report. This supplementary report will present returns broken down by area and the status of all key quantitative requirements. The more detailed contents of the report can be agreed between the Bank and the Ministry. We assume that these requirements and the associated reporting will take care of the Ministry’s supervision and oversight of the management of the Fund, and that there will remain a clear division of responsibility between the Bank and the Ministry.
6. Supervision of investment management by the Executive Board and Internal Audit
The Executive Board has reinforced its supervision of investment management at Norges Bank in recent years. In 2007, we established the Executive Board’s audit committee and an internal audit unit. The audit committee comprises three of the Executive Board’s external members and serves as a preparatory body for the Board on matters relating to its oversight functions and responsibility for risk management and internal control. The audit committee discussed eight matters concerning the Bank’s investment management in 2008.
The Executive Board issued a new job description and investment mandate for the Executive Director of NBIM in 2008. The starting point is that the Executive Director of NBIM stands in the same position as the other Executive Directors at Norges Bank. However, the tasks assigned to NBIM are distinct from the Bank’s other activities as a central bank, in the sense that the investment management operation has the characteristics of a commercial undertaking. The management of the Government Pension Fund – Global has been delegated to Norges Bank pursuant to a separate act of parliament and management agreement. There has also been an increasing tendency in recent years for NBIM to be treated as an independent area within the central bank.
The job description sets out the responsibilities and duties of the Executive Director of NBIM with respect to the general public and external relations, including interaction with Norges Bank’s clients and the framework for the responsibility he has for the planning and organisation of NBIM’s operations, supervision and control, etc.
The investment mandate for the Executive Director of NBIM sets out supplementary rules for the individual portfolios within the investment limits established by the Ministry. These cover the investment universe, investment constraints, the delegation of management responsibility, and reporting. The investment mandate also describes the risk profile for investment management that the Executive Board wishes to establish, including the principles and parameters for the management and measurement of risk as well as reporting requirements. We refer to the discussion of the investment mandate for the Executive Director of NBIM in section 5 above. The monthly reporting from NBIM to the Executive Board includes not only returns and any breaches of the investment guidelines laid down by external clients or the Executive Board, but also the status of the additional restrictions that the Executive Board has established for market risk. There are to be reports on deviation from the benchmark index (asset class, geographical region, sector, leveraging, overlap), risk from price history (maximum use of market risk under normal market conditions, concentration risk in the portfolios), factor exposure, and liquidity exposure.
On 1 January 1998, the Executive Board decided to establish a system of internal control based on the Norwegian financial supervisory authority Kredittilsynet’s Internal Control Regulations. Internal control at Norges Bank is defined as all measures, arrangements and systems initiated and implemented by the Executive Board and the Bank’s management and employees in order that we can be reasonably certain of achieving our objectives.
With effect from 1 January 2009, the 1997 Internal Control Regulations were replaced with the new Regulations No. 1080 of 22 September 2008 on Risk Management and Internal Control. These new regulations make more stringent requirements of the role of the board in the design of structures for internal governance and internal organisation. The Executive Board is of the opinion that the principles for internal governance drawn up by the Committee of European Banking Supervisors (CEBS) form an appropriate basis for its assessments. However, the self-assessment form to which the Ministry refers in its letter of 20 October 2008 was developed for commercial banks etc. The Executive Board has therefore adopted principles for internal governance tailored to Norges Bank’s operations as the basis for its annual assessments. These principles have been used in the Executive Board’s assessment of risk management and control in the Bank with effect from the 2008 reporting year. Norges Bank believes that these measures satisfy the new regulations’ requirement for the Executive Board to assess Norges Bank’s risk management and internal control annually.
Internal Audit prioritised risk management and internal control at NBIM in 2008. Among other things, it reviewed the status of the follow-up of Ernst & Young’s report. The aim of this was to provide the Executive Board with confirmation that action has been taken in accordance with Norges Bank’s response to the Ministry.
Internal Audit concluded that NBIM’s new organisational model results in a clearer division of roles and responsibilities in the organisation. Organisational units have been set up to measure and report risk independently of the investment line. Internal Audit considered that these are important organisational measures for ensuring good risk management and internal control.
The new organisation of NBIM’s operations also entails extensive changes to working processes. NBIM is working on tailoring the management of operational risk to its new working processes, and Internal Audit will be monitoring this work closely in the time ahead. In December 2008, an audit was begun at the request of the Executive Board. The focus of this audit is on:
- NBIM’s processes for identifying, prioritising and reporting operational risks
- NBIM’s implementation of risk reduction measures
Norges Bank will keep the Ministry informed of any significant changes in risk management, organisation and supervision in relation to the Bank’s management of the Government Pension Fund – Global.