Ranking, Risk-Taking and Effort: An Analysis of the ECB’s Foreign Reserves Management

44 Pages Posted: 4 Mar 2012

Date Written: February 2, 2012

Abstract

We perform an empirical study on the management of the ECB’s foreign reserves, which are representative of the under-researched class of the official foreign exchange reserve portfolios, globally worth over 10 trillion US dollars. The ECB reserves are invested in US dollars and yen by a network of portfolio managers in the Eurosystem’s national central banks. Their performance is periodically assessed against a common benchmark, subject to monthly revision by the ECB. Monetary reward for the best performers is almost absent, and compensation comes as reputational credit following the transmission of the annual report to the Governing Council. Employing new data on individual portfolios during 2002-2009, we study this peculiar tournament and show the existence of risk-shifting behaviour by reserve managers related to their year-to-date ranking: interim losers increase relative risk in the second half of the year, in the same way as mutual fund managers. In the dollar case, risk-shifting is asymmetric: the adjustment to ranking is generally reduced or offset if reserve managers have achieved a positive interim performance against the benchmark. Yen reserve managers that rank low show a tendency to increase effort, as proxied by portfolio turnover. We also find that reserve managers who ranked low in the previous year tend to reduce risk significantly. Our evidence is consistent with a reserve managers’ anecdote, according to which they obtain a concave reputational reward within their national central banks, which induces risk aversion and explains the observed low usage of the risk budget. Since reserve managers should have a comparative advantage over the tactical benchmark within a monthly horizon, possible enhancements to the design of the tournament might involve an increased reward for effort and performance by means of a convex scoring system linked to monthly, rather than annual, performance.

Keywords: foreign exchange reserves, tournament, incentives, effort, portfolio management

JEL Classification: G11, E58, D81

Suggested Citation

Scalia, Antonio and Sahel, Benjamin, Ranking, Risk-Taking and Effort: An Analysis of the ECB’s Foreign Reserves Management (February 2, 2012). Available at SSRN: https://ssrn.com/abstract=2014843 or http://dx.doi.org/10.2139/ssrn.2014843

Antonio Scalia (Contact Author)

Bank of Italy ( email )

Financial Risk Management
Via Nazionale 91
Rome, 00184
Italy
+39 06 4792 3390 (Phone)

Benjamin Sahel

European Central Bank ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

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