Central bank risk management hedging for turbulence

Central bank risk management has become a main focal point as nearly a decade of monetary expansion policies concludes and the monetary tightening phase takes over. Global economies and markets are on edge contemplating potential outcomes. Central banks will be put to the test to mitigate volatility and exposure risk through complex hedging strategies as the world watches.

Central banks as pilots of economies

Like airline pilots who receive little gratitude for landing flights on time, but receive flack for any delays, central banks can relate, as pilots of economies. The nature of their influence makes them a magnet for blame in times of economic turbulence. These times are upon the horizon and the prowess of central bank risk management will surely be put to the test as the stakes grow higher.

Managing expanding collateral asset bases

Since the 2008 global financial crisis, central banks have adopted more accommodating measures expanding the types of acceptable financial assets for collateral to bolster the economic recovery process, as noted by the European Central Bank (ECB). Central banks have transformed into modern-day hedge funds as illustrated by the diverse portfolios, holding assets ranging from highly liquid treasuries to junk bonds, derivatives, real estate and various illiquid assets all to meet the mandate of stabilizing money flow.

Critics of the remedy

Asset purchasing programs, also referred to as quantitative easing (QE), have ballooned balance sheets in exchange for saving and stimulating economies and financial markets, while keeping inflation in check. The decade-long global QE initiatives are largely uncharted territory. Central banks are acclimating for the inevitable monetary tightening phase. The biggest concern is how they will unwind balance sheets during the de-levering process without disrupting the economies and markets.

The ECB has signaled an end to the 30 billion euro monthly asset purchase program by October 2018, with rake hikes scheduled to commence in mid-2019, reports Reuters. Critics question whether the remedy has mutated into a poison for over-administration.

Blowback of ZIRP

Zero interest rate policies (ZIRP) enable zombie corporations, bad actors, industries and even countries to “kick the can” down the road, artificially prolonging lifespans on borrowed time. The landscape completely reverses with rising rates as market forces naturally uncover these entities and accelerate their demise. Uncertainty rises as to the collateral damage from the potential fallout. Fear of repeating the 2008 global financial meltdown can take shape like wildfire, especially when credit markets revolved around confidence. Any disruption in the confidence of counterparties can elevate volatility and perceived systemic risk parabolically. Sentiment remains the key factor. Additional wild cards central banks must contend with are the effects of political events that can trigger market volatility and inflation, like trade wars.

Central banks as hedge funds

Central banks must always mitigate the three kinds of collateral risk: credit risk, market risk and liquidity risk, as the ECB notes. Proper hedging stems from realistic and dynamic valuation of the assets — both intrinsic and extrinsic — and the correlations that may trigger material impact on valuations.

For example, major ratings downgrades from agencies like Standard & Poor’s (S&P) can immediately affect the liquidity and valuation of corporate bonds. Institutional holders are embedded with mandates requiring bonds meet a minimal rating or face liquidation, which in turn, floods the market with supply, causing valuations to drop as yields spike.

Central bank risk management

Central banks must also gauge the impact of non-portfolio assets including derivatives, commodities and currencies. Factoring how rising crude oil prices impact inflation or assessing the potential threat of certain import tariffs on consumer spending are surface level concerns. Central banks can hedge in various ways (i.e., swaps, derivatives, pairs, beta, delta) if they have the tools to make timely and informed decisions. Tools like risk scenario analytics and collateral management systems that integrate data into a single source of truth can augment central banks’ abilities to react quickly and confidently when outliers materialize.

Bolstering efficiency through single source platform integration

To stay on the cutting edge of efficiency, central banks must offset operational risks that can arise from having too many segmented systems causing bottlenecks with crucial decision-making data. Process efficiency is often overlooked until consequences emerge. Integrating a single source of truth that seamlessly collects, connects and converts data into applicable intelligence is the ultimate tool for central banks for optimal risk management engagement. As turbulence approaches, central banks should assess their tools and optimize or upgrade systems to handle the impending volatility and potential disruption that may accompany the monetary tightening phase.