Costs incurred in strengthening risk management in investing the Exchange Fund are money well spent.
The Asian financial crisis of 1997-98 underlined the general need for the proper management of risks arising from the globalisation of financial markets, which have become much more volatile than before because of the revolution in information technology. As readers are aware, the HKMA has always devoted much effort to promoting and strengthening risk management in the financial system of Hong Kong and in our own operations, given the wide variety of financial activities we undertake and the role we play as the banking regulator. For example, we started risk-based supervision of banks a few years ago and next year we will be implementing Basel II, which is built upon this risk-based approach. We have made use of the helpful Financial Stability Assessment Program report on Hong Kong by the International Monetary Fund and have taken forward all of the recommendations concerning the activity of the HKMA. I have also been risk conscious in this column, sharing my thoughts on financial market trends, development and outlook with readers whenever I felt it might assist those involved in assessing risks to have an alternative perspective to the mainstream view.
The investment management of the Exchange Fund is another activity of the HKMA, where we have strengthened risk management. While we have continued to achieve investment returns higher than those of the benchmark portfolio of the Exchange Fund determined by the Financial Secretary with the advice of the Exchange Fund Advisory Committee, there has been no mishap or incident arising from our investment management that adversely affected the financial interests of the Exchange Fund. Considering the volatility seen in recent years in the international financial markets in which the Exchange Fund is invested, this effort in improving risk management has been worthwhile.
This greater emphasis on risk management has affected the engagement of external managers in the investment of the Exchange Fund in several ways over the years:
(a) Multi-currency fixed-income portfolios have been gradually re-structured into specialised single-market portfolios so that the external managers can make use of their focussed and in-depth knowledge of risks and opportunities in specific markets rather than spreading their attention across several markets.
(b) The investments of the Exchange Fund have been expanded to include a wider range of management styles and markets through the employment of additional external managers to gain market depth, increase diversification, and improve returns. Diversification helps reduce the reliance on any individual external manager. Limits have also been set on the amount that can be placed with each external manager, in terms of both the absolute amount and the proportion of total funds managed by the external manager - an external manager should also not be overly dependent upon business from the Exchange Fund.
(c) More stringent reporting and monitoring of the activities of external managers have been introduced to ensure that they manage the Exchange Fund in accordance with our well-established guidelines and operate within limits of deviation from the benchmark (which involve a degree of risk) allowed in the investment guidelines.
(d) Greater use has been made of custodians to monitor compliance by the external managers.
The strengthening of risk management in the activities of our external managers was undertaken, with the approval of the Financial Secretary after consultation with the Exchange Fund Advisory Committee, with the aim of avoiding problems as far as possible before they occur. There are, of course, costs involved in the form of higher fees charged by the external managers and custodians. The higher costs are commensurate with the greater attention required in managing the Exchange Fund portfolios. The engagement of more external managers, with each managing smaller amounts of funds, also means a reduction in the volume discount that can be achieved. But we consider the higher costs for strengthening the risk management money well spent because the potential financial losses from a mishap could be quite large, not to mention the possible loss of public confidence and credibility in Exchange Fund management, a matter to which the HKMA attaches great importance. I would also like to point out that the fees charged by the external managers and custodians, despite some increases in recent years, have been kept well below the fees paid by other comparable investors in the market.
Joseph Yam
11 May 2006
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