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Key challenges facing central banks

Adapting to a new era

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Contents

Foreword

Key challenges facing central banks

Reputational risk

Accounting framework challenges and harmonization

Valuation challenges

Managing currency in circulation

Confidentiality versus transparency

Governance, risk management and compliance functions

10

Attracting and retaining people

12

Conclusion

13

Editors

15

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Foreword

Since the inception of the Bank of England in 1694,1 a central banks core duty has been the sustainable
development of a nations economy. Over the years and across different geographies, the role of central banks
has evolved to cater to different socio-economic needs. Today, although there are numerous differences between
central banks around the world, they are commonly the lenders of last resort and lynchpins of economic stability.
In times of economic crisis, there is a heightened awareness and scrutiny of central banks and their accountability
to a nation at large, and the impact their decisions have on the stability of the global financial system.
Central banks face many challenges. Some of these issues include detailed operational and internal control matters,
preparation of financial reporting and disclosure statements, and continued action via monetary policy and financial
stability measures to improve a nations economic health. These cross-organizational issues rank high on the
agendas of central banks governing committees.
This report is based on consultations with central banks around the world and highlights key challenges that are
faced by many central banks. Not every challenge will apply to every central bank and there are other challenges
not explored herein. In summary, the key challenges identified are:
1. Reputational risk
2. Accounting framework challenges and harmonization
3. Valuation challenges
4. Managing currency in circulation
5. Confidentiality versus transparency
6. Governance, risk management and compliance functions
7. Attracting and retaining people

Frank Dubas
Global Leader Sovereign Financial Institutions
Deloitte Touche Tohmatsu Limited
As used in this communication, Deloitte means Deloitte Touche Tohmatsu Limited and its member firms.

1 About the Bank History

http://www.bankofengland
.co.uk/about/history/index.
htm, Bank of England,
2010
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Key challenges facing

central banks
Reputational risk
The reputation of a central bank is possibly its most
important asset. Reputational risk may be the most
difficult risk to manage compared with other types of
risks. Central banks face significant reputational risk,
especially during times of crisis, and reputational
damage to a central bank could take decades to repair.
The Bank for International Settlements defines
reputational risk as occurring when there is a
mismatch between public perceptions and the actual
objectives and resources of the central bank.2
Reputational risk can arise from failure to effectively
manage any, or all, of the other risks. Other risks
include operational risk such as staff ethics and
misconduct, transactional processes and information
technology (IT) systems, portfolio risks, such as interest
rates and exchange rates, credit risk and liquidity risk.3
Managing reputational risk is a vital component of a
sound risk management framework at any financial
institution. For commercial banks, risk management
tends to be more advanced for financial risks than
non-financial risks. The latter are important, however,
in that they can flow through into profit and loss.
Central banks too are not limited to financial risks.
Indeed, given the increasing importance of a central
banks credibility in todays world, it is reputation that is
key. Financial loss is important in that it can impinge on
how the central bank is regarded, and hence on its
ability to achieve its remit, but non-financial risks may
more directly affect reputation. While financial risk
management has typically been more formalized than
that of other risks, safeguards over the latter have been
extensive, and are increasingly being brought within a
more structured framework. Many central banks are
integrating risk management frameworks to ensure
consistency across all levels of the bank.

2 Issues in the Governance

of Central Banks, Bank for
International Settlements,
May 2009
3 Reserve Bank of Australia
Annual Report 2008,
Reserve Bank of Australia,
August 2008
4 Bank of England Annual
Report 2010, Bank of
England, June 2010
2

Examples of non-financial risks that might affect a

central banks reputation are numerous. Some represent
prospective analytical weaknesses which might lead to
inappropriate policies being developed. Others could be
operational risks that are particularly potent in a central
bank context, such as weaknesses in security and/or
data protection, problems in key IT systems or poor
business continuity planning. Some will be more in
the nature of standard operational risks, such as
dependence on key staff or errors in processing.
In all these areas, there is increasing focus on the
performance of public authorities in general, and
central banks in particular.
At the Bank of England, risks are managed under an
overarching framework designed to ensure consistency,
efficiency and transparency of risk management across
the organization. Within this framework three high-level
categories have been established: a) strategic, such as
policy risks, governance issues or external factors which
directly impact the Banks ability to meet its core
purposes; b) operational, such as risks from weaknesses
in business processes, systems, or through staff or thirdparty actions which affect the delivery of the Banks key
business functions or its reputation; and c) financial.
For each category the intention is that decisions to
accept or mitigate risks are taken expediently and
transparently, with risk tolerance levels set, exceptions
monitored, risks and incidents reported and actions
taken where necessary. Underpinning this is a set of risk
standards that articulate how key categories of risk are
identified, assessed, controlled and monitored within
the Bank, and detailed governance arrangements.4

Central banks face significant reputational risk, especially

during times of crisis, and reputational damage to a central
bank could take decades to repair.

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Accounting framework challenges and

harmonization
Central banks are required to comply with their nations
Central Banking Act or equivalent act (hereafter Central
Banking Act). A Central Banking Act typically defines
the role of a central bank in managing monetary policy,
controlling inflation, facilitating payment systems
(e.g., wire, securities settlement), and supervising
financial institutions. Generally, the Central Banking Act
does not address the specific financial reporting or
internal control reporting frameworks to be adopted.
Many central banks are permitted by their Central
Banking Act to adopt a national or global accounting
standard, or to develop their own specific financial
reporting rules to accommodate the unique
circumstances of central banks. Consequently, there is a
divergence in accounting frameworks that have been
adopted by central banks globally. The divergence in
accounting frameworks for central banks creates
challenges around comparability of financial reporting
across central banks, and challenges for central bank
management, governing committees and their external
auditors.
In addition, a Central Banking Act may include very
prescriptive accounting rules, which are not consistent
with generally accepted accounting principles (GAAP).
An example may be the treatment of unrealized foreign
currency gains. A Central Banking Act may require these
currency gains to be recorded directly in equity and not
be subjected to distribution. This treatment potentially
differs from International Financial Reporting Standards
(IFRS) where unrealized foreign currency gains are
recognized in the income statement. Where a Central
Banking Act includes rules that diverge from GAAP, this
creates additional challenges for central banks
management for benchmarking between central banks
as well as creating challenges during the external audit.
Central banks external auditors may struggle to opine
on financial statements that are based on a unique
financial reporting framework.
One impact the global financial crisis had on central
banks concerned the application of appropriate
professional judgment (in accordance with the relevant
accounting rules) to situations where rescue packages
and programs created a variety of atypical investments
and other unique financing structures. These

Many central banks are permitted by their

Central Banking Act to adopt a national or
global accounting standard, or to develop
their own specific financial reporting rules
to accommodate the unique circumstances of
central banks.
investments raised consolidation and control issues that
required significant discussions between management,
governing committees and external auditors to
determine the appropriate accounting, reporting and
disclosures for the programs and related investments, as
well as the unwinding of the programs.
Another financial reporting challenge is where a central
bank functions as administrators or agents for its local
Ministry of Finance. For example, Banque de France acts
as France's fiscal agency for World Bank Group and
regional development banks and aid organizations.5
Several central banks may have certain assets and
classes of transactions with international agencies,
such as aid agencies and development banks, which
result in assets being held by the central banks.
However, the central banks may not enjoy the benefits
of those assets nor are they susceptible to the risks of
ownership. It is important to apply appropriate
professional judgment in accordance with the relevant
accounting framework in assessing the accounting
treatment for these transactions, which are unique and
likely not addressed in typical accounting frameworks.
The global financial crisis has led central banks to want
to be able to compare themselves to their peers on a
global scale through harmonization of accounting
methodologies. Central banks are increasingly moving
towards the adoption of IFRS. Although this may improve
the comparability of central bank financial statements,
the adoption of IFRS accounting principles developed for
commercial entities may create other challenges for
central banks management and stakeholders.

5 Organisation and
activities Foreign
exchange policy and
international relations
http://www.banquefrance.fr/gb/instit/sebc/4a.
htm, Banque de France,
2004

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Related party transactions

Central banks may also face challenges regarding numerous related
parties and related party transactions. This can be a challenge where
there are transactions with other government entities, government
controlled entities, and central bank controlled entities or entities that
share common directors with the central bank. In addition, the amount of
lending to government entities may be defined or prohibited by the
Central Banking Act. The challenge is not only to ensure that appropriate
disclosures have been made in the financial statements, but also that the
central bank complies with the regulatory framework and that proper
controls are in place to safeguard against fraud.
Management should give appropriate consideration as to whether
transactions are on an arms-length basis and whether there are any
recognition, valuation or disclosure issues. The sufficiency of disclosures
in reporting related party transactions continues to be an important
debated subject.

6 Guideline of the ECB of

10 November 2006 on the
legal framework for
accounting and financial
reporting in the European
System of Central Banks
(ECB/2006/16), Official
Journal of the European
Union, European Central
Bank, 2006
7 Appendix V: Differences
between the accounting
and reporting principles in
the Eurosystem and the
International Financial
Reporting Standards
(IFRS), IMF Working
Paper WP/05/80
Transparency in Central
Bank Financial Statement
Disclosures, International
Monetary Fund, April 2005
8 Annual Accounts of the
Banco De Espaa, Annual
Report 2009, Banco de
Espaa, May 2010
9

About CEMLA
http://www.cemla.org/
about.htm, CEMLA, 2010

10 Technical Notes
Proposal to the IAS
(standards such as IAS 2,
7, 21, 37)
http://www.cemla.org/
Budgetary.htm, CEMLA
4

One measure that may address harmonization concerns

is for the sector to develop a Statement of Recommended
Practices (SORP) to supplement IFRS. SORPs augment
existing accounting, legal and regulatory regimes when
unique situations or transactions are undertaken by a
particular industry or sector. A SORP could act as a
compendium of guidance for central banks that want
to adopt IFRS but also want to maintain some level of
comparability with other institutions. This would allow
central banks to benchmark their performance against
their peers. However, a one size fits all approach may
not work due to the special characteristics of the
operations and functions of central banks around the
world. Without a global coordinated effort to address
central banks special characteristics, inconsistencies in
central bank accounting frameworks will develop due to
valid socio-economic and local requirements.
The European System of Central Banks (ESCB) has
harmonized some of the divergent financial reporting
practices across Europe through the European Central
Bank (ECB) Guideline.6 The ECB Guideline is a legally
binding instrument in the European Union, and
European national central banks that belong to the
Eurozone are obliged to adopt these Guidelines.

The ECB Guideline is generally consistent with IFRS and

contains detailed guidance where the ECB practices
diverge from IFRS.7 For example, the Bank of Spain has
adopted the accounting guidelines published by the
ECB in its internal rules and the annual accounts are
prepared in accordance with the accounting principles
established for the European national central banks of
the Eurozone.8 Consequently, the financial information
of central banks belonging to the Eurozone is
comparable.
Likewise, central banks in Latin America, through the
Center for Latin American Monetary Studies (CEMLA),
have made some progress towards the development of
a SORP. Established over 50 years ago, CEMLA conducts
research and disseminates knowledge on central banking
matters.9 The recommended practices are contained in
the Budgeting Committees Technical Notes Proposal to
the IAS10 and include recommendations such as the
accounting treatment by central banks for gold and
derivatives.
Guidelines such as SORP may help address the
challenge of comparability across central bank financial
statements and provide additional useful information
to management and key stakeholders. Again, a one
size fits all approach may not work, but harmonization
across central banks is likely to have a positive overall
impact.

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Valuation challenges
Valuation became one of the most difficult issues for
financial institutions to deal with during and following
the financial crisis. Not only have the markets made it
very difficult to price transactions, but numerous
accounting and auditing guidance statements have also
been issued in an attempt to provide clarity. The reality is
that this has continued to be one of the most
challenging areas for central banks.
One key area of concern is that the initial
assumptions used to design financial models have
been based on a historical trend of economic growth
and stability. These may not be relevant in todays
world. Analysts could point out that the conclusions
drawn from these models may not be appropriate
given the increased interconnectedness, the increased
sensitivity to systemic failure, and the increased risk
of a recession that we face in todays globalized
economy. Model risk has become an issue in some
central banks where rescue packages launched
following the recent financial crisis resulted in a
variety of atypical assets on the balance sheets of
central banks.
One example would be Maiden Lane LLC (ML LLC),
which was created as a financial vehicle by the Federal
Reserve Bank of New York in March 2008 to facilitate
JPMorgan Chase & Co.s (JPMC) merger with Bear
Stearns Companies Inc. (Bear Stearns), and to prevent
the likely severe impact of Bear Stearns collapse on
market functioning and the broader economy.
The Federal Reserve Bank of New York loaned
approximately US$28.8 billion to ML LLC in the form of
a senior loan, which, together with funding from JPMC
of approximately US$1.15 billion in the form of a
subordinate loan, was used to purchase a portfolio
from Bear Stearns of mortgage-related securities,
residential and commercial mortgage whole loans and
associated hedges (derivatives).11 At 31 December 2009,
ML LLC held approximately US$9 billion of assets for
which the determination of fair value was based on
proprietary valuation models because external price
information was not available. Key inputs to the models
considered factors such as market spread data for each
credit rating, collateral type, collateral value, and other
relevant contractual features.12

A key risk area for many

financial institutions is the
allowance for loan losses.
A key risk area for many financial institutions is the
allowance for loan losses. Typically this has not been a
significant risk area for central banks given the low or
nonexistent loss history. However, during the financial
crisis, many central banks significantly expanded their
lending facilities to their member banks. For most
financial institutions, the allowance analysis involves
robust processes resulting in a comprehensive quarterly
allowance analysis. As a result of the financial crisis,
the increased lending volume, and the shifts in credit
profiles of member banks, there is an increasing need
for central banks to maintain a robust loan allowance
analysis. Central banks may not have the processes,
methodologies, or systems to prepare such loan
allowances. A lender of last resort should also consider
the quality of collateral accepted in its lending activity
since its value may deteriorate during periods of
financial turmoil. Any potential loss or impairment
needs to be reflected in the allowance analysis.
Additionally, central banks may not have robust internal
controls, analytical tools, and data sources to value
illiquid/thinly traded collateral.
Other valuation issues may result from situations where
the central bank sets interest rates, and is, in substance,
behaving as the clearing house or the market for certain
asset classes. Arguably, the rates the central bank earns
on its own assets may be considered to be market rates
because the central bank is the market. This becomes
more of a risk for central banks operating in smaller
economies where there is weak-form market efficiency
and an illiquid market with a low volume of trades.
Under these circumstances, a potential for mis-pricing of
assets may exist. In developing economies, central banks
internal systems and processes may not be robust or
reliable enough to accurately price securities.

11 Fed Says Bear Stearns

Portfolio Declines $2.7
Billion, Bloomberg,
23 October 2008
12 Maiden Lane LLC
Supplemental Report,
2009 Annual Report,
Federal Reserve Bank of
New York
http://www.newyorkfed.
org/aboutthefed/annual/
annual09/MaidenLanefins
tmt2010.pdf, June 2010

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Valuation of collateral of a central bank plays a key role

in protecting a central bank against loss. The Bank of
England suggested in its Financial Stability Report
(December 2009) that significant improvements in
disclosure of valuation, such as explanation of fair-value
techniques, is desirable.14 For example, the Bank of
England assesses the validity of a model price by
comparing it to similarly traded securities and drawing
on relevant market intelligence from market
participants.15 Engaging valuation experts to assist in
testing the assumptions underlying the models,
reasonableness of the results produced, and a review of
the reasonableness of the input source data will provide
additional support for central bank valuation positions.

13 About the Bank of

Latvia Buildings
http://www.bank.lv/en/
about-the-bank-oflatvia/bank-of-latvia-sbuilding, Bank of Latvia,
2010
14 Section 3 Safeguarding
stability, Financial
Stability Report, Issue
No. 26, Bank of England,
December 2009
15 Fisher, P. Central bank
policy on collateral,
Bank of England,
14 April 2011
6

Another potential valuation challenge impacting central

banks is where a central bank owns and conducts its
operations in a landmark building or building of
significant historical value. The potential risk is that the
central bank may have maintenance costs which are
significantly higher than is typical in a given market.
Management may find it challenging to justify the
recorded value based on market comparisons, and this
may lead to difficult valuation and/or impairment
discussions. For example, historical buildings such as the
Bank of England and the Bank of Latvia may present
valuation challenges. The historical building of the Bank
of Latvia is actually listed as a monument, showing the
historical significance of the building to Latvia.13 Valuation
experts would need to use skill and judgment to make
adjustments to reflect the landmark status of the
building, but also to reflect any costs of maintenance
that are higher than other buildings. Valuation practice
would be to adopt a more prudent figure when valuing
for financial statements of a central bank.

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Managing currency in circulation

One of the most significant balance sheet liabilities for
many central banks is the nations money supply in
circulation. The liability is an accumulation of currencies
issued into circulation less those withdrawn from
circulation. Due to the rapidly moving and changing
nature of this balance, it is not feasible to count directly.
It is often challenging to design control procedures that
can provide reasonable assurances to central bank
management, governing committees, stakeholders,
and external auditors to the completeness of this
liability as no third-party assurance is possible.
In order to reflect currency in circulation accurately,
central banks will, or should, implement controls similar
to inventory controls in a manufacturing environment.
For example, this would include controls around the
receiving and shipping of the currency inventory, and
appropriate controls for the systems tracking the
movement and cutoff at financial year end. This may
also include controls over the review of invoices from
currency printers, ensuring that stock movements are
tracked accurately. Having independent, robust and
reliable currency tracking systems in place is key for
management to ensure that currency in circulation is
accurately reported.
However, many central banks may not have internal
controls that are robust enough for their stakeholders
to deem reliable. This poses a challenge for management
teams and auditors to be comfortable with such a
significant liability balance that is so crucial to a central
banks core functions.

This situation warrants, and typically results in, an

ongoing dialogue between the management team,
the governing committee, and auditors to determine
how best to evaluate the accuracy of the currency in
circulation. For external auditors, it requires designing
procedures specific to the circumstances, often
involving very detailed and extensive testing.
One of the key challenges for a central bank with
currency in circulation is controls over currency
inventory marked as destroyed or earmarked for
destruction. For example, how does a central bank
ensure that the currency is in fact destroyed? Currency
on hand and destruction of currency are areas with
significant potential fraud liability, and accordingly, need
to be an area of focus with robust control measures.
For example, the Central Bank of Perus currency control
department periodically identifies currency that does
not meet quality standards either through automated or
manual methods. The Committee of Destruction,
composed of specialists that manage the currency and
concurrent controls, sample the currency to be
destroyed, validate the quantity, authenticate the state
of deterioration, and verify the destruction. If the
Committee of Destruction identifies any currency not
meeting the destruction criteria, the destruction process
is suspended. Notes for destruction are destroyed inside
the Bank in presence of the Committee of Destruction.
Coins are destroyed outside the Bank and similar
controls are applied.

One of the most significant balance sheet liabilities for many

central banks is the nations money supply in circulation.

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In recent years the destruction process has become

more demanding as the need to destroy notes no
longer deemed suitable for circulation increases.
The Committee of Destruction is managing this growing
need by prioritizing the lowest denominated notes for
destruction, and by also enhancing the dissemination
of best practices on the use of coins and notes in order
to reduce their deterioration. There is also a focus to
ensure committee members with the proper skills are
appointed to define the standards for destruction and
oversee the process.
The controls to combat counterfeiting are key to
managing currency. Five years ago, Peru passed a
regulation that facilitated the creation and function of a
Central Office to combat counterfeiting of currency,
called OCN. The OCN comprises professionals assigned
by the Bank that include members of the police and
prosecutors. The OCN combats counterfeiting through
cooperation agreements with international agencies
and rewards for information about counterfeit crime.
To combat counterfeit currency more effectively, central
banks should be aligned with the judicial system,
interact frequently with international agencies, and
strengthen the security features of currency.16

16 Central Office for

combating counterfeiting
of currency, Banco
Central de Reserva del
Per (BCRP)
8

Central banks could manage currency costs more

efficiently by creating an annual production/destruction
plan that is aligned to real demand by forecasting
future requirements of a specific currency and tracking
system performance. In addition, cost accounting
systems could be implemented as an effective tool to
control related expenses and support audit trails.
The design and implementation of key controls
surrounding a central banks currency inventory need to
be well understood and documented. A central bank
should be in a position to provide support for its control
processes and be open to discuss potential issues where
the control environment may need improvement.

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Confidentiality versus transparency

Transparency, as it relates to central banks and financial
agencies, refers to an environment in which the
objectives of policy, its legal, institutional, and economic
framework, policy decisions and their rationale, data
and information related to monetary and financial
policies, and the terms of agencies accountability, are
provided to the public on an understandable, accessible
and timely basis.17

Central banks may want to add a Management

Discussion and Analysis section to the financial
statements to better explain what financial and
monetary stability actions they have taken or may be
contemplating. Increased frequency and timing of
financial reporting could also benefit financial statement
users. Such additional disclosure can help to address the
unique challenges in applying an accounting framework
and producing transparent financial statements.

In summary, transparency enables the public and

investors to make judgments about the integrity and
stability of a nations financial system. Furthermore, the
need for transparency is even greater during times of
economic crisis, as a lack of information from central
banks may exacerbate doubts about the health of an
economy and jeopardize an economys recovery cycle.
Conversely, central banks may need not to disclose
certain information that may be viewed as sensitive,
such as the creditworthiness of borrowers. It is this
balance between weighing the publics need for
transparency and the desire for confidentiality that
presents a significant challenge in determining
appropriate disclosure by a central bank.
It should also be noted that not all central banks are
keen to publish a full set of audited financial statements.
Although it is understandable that there may be
confidentiality concerns, this lack of transparency may
raise many more concerns. Publishing audited financial
statements is a best practice and it is also commonly a
requirement of a nations Central Banking Act.
An example of transparency and public availability of
information can be seen with the Bank of Spain.
The annual accounts of the Bank are available on their
website, together with information regarding the
structure of the Bank, the members of the Governing
Body, as well as a detailed report of approximately
300 pages with an analysis of the economic situation
of Spain. In addition, on a monthly basis, a statistical
report is issued including an abridged balance sheet for
the month of the study and several breakdowns about
the assets in the balance sheet classified under different
criteria: residence, type of financial instrument, currency,
and so on.18

17 Code of Good Practices

on Transparency in
Monetary and Financial
Policies: Declaration of
Principles, International
Monetary Fund,
September 1999
18 Publications
http://www.bde.es/webb
de/en/secciones/informes/,
Banco de Espaa, 2010
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Governance, risk management and compliance

functions
Top-down, sound business risk approaches require
significant attention to an organizations governance
structures, risk management practices, and internal
controls. Proper governance typically includes the
existence and effectiveness of a governing committee
(usually in the form of an audit committee), an appropriate
internal audit function, and overall risk management
functions.
The roles of a central bank are to control inflation,
stabilize the financial system and promote macroeconomic
development according to its nations specific needs.
The financial crisis required central banks in many
countries to be more visibly involved in stabilizing the
overall financial system in cooperation with other
regulatory agencies. This may be the natural outcome as
central banks in many countries are the only
organizations that have access to solvency and liquidity
information for individual financial institutions, while
regularly monitoring the macroeconomic situation and
overall financial market. However, this new objective
provides central banks with enormous challenges to
governance as it could cause a conflict with their most
important mission price stability. Furthermore, this shift
may facilitate the intervention by politicians into central
banks activities, thus jeopardizing their political
independency, a long assumed component of
governance of central banks.

19 On-Site Examination and

Off-Site Monitoring, and
Credit Extension as the
Lender of Last Resort,
Functions and Operations
of the Bank of Japan,
December 2000
20 Pikkarainen, P. Central
bank liquidity operations
during the financial
market and economic
crisis: observations,
thoughts and questions,
Bank of Finland
Discussion Papers
20/2010, December 2010
10

For example, the massive liquidity injection in order to

dispel the concerns of market liquidity evaporation from
several major central banks during 2008 and 2009 could
have threatened the price stability of some countries.
At the same time, the quantitative easing policies to prop
up the macro economy required central banks to
purchase risky assets or make investments in companies
deemed too big to fail. Central banks have historically
been expected to be the lender of last resort when large
market players face critical liquidity problems, which
could lead to systemic risk. After the Japanese banking
crisis in the 1990s, the Bank of Japan introduced the
four principles to its lender of last resort function
indicating the systemic risk exception, meaning that the
Bank of Japan would act as lender of last resort only
when there is a possibility of systemic risk.19

This lender of last resort function, however, may come to

end if the era where too big to fail is gone forever. Thus,
a central bank could face extreme pressure when faced
with a decision to bail out a large market player facing
collapse.
In addition to the increasing pressures to demonstrate
good governance, the expansion of the scope and scale
of central bank operations has increased their exposures
to risk. The most significant risk facing a central bank is
possibly reputational risk, however, other risks include
market and credit risk such as:1) counterparty risk
associated with money market transactions; 2) market
and credit risks associated with collateral accepted by
central banks against funds provision; and 3) foreign
exchange risks associated with the foreign exchange
reserves.
Traditionally, central banks risk management has been
dominated by the idea of zero-tolerance of risk.
However, the environment surrounding risk management
of central banks has been changing rapidly. First, central
banks have purchased a variety of risky assets to increase
their fund provision under the (quasi-) zero interest rate
condition. For example, central banks such as those of
Sweden, Switzerland, the United Kingdom and the
United States have seen their risks increase due to a
significant change in the composition of the asset side
of their balance sheets.20 Second, the implementation
of Basel II, which includes operational risk management,
left no room for central banks to keep their distance from
the risk management that they advocate for commercial
banks. It may be possible to marginalize market and
credit risks taken by central banks but next to impossible
to do the same for operational risk, in particular, in
countries where central banks experienced scandals.
Third, due to their own post-crisis reform agenda, central
banks could become less dependent on credit rating
agencies.

13281A lb Key Challenges A4_13281A lb Key Challenges A4 16/09/2011 11:55 Page 11

In the new environment, the transparency of central

bank risk management systems could be challenged.
The limitation of holding government bonds as a certain
proportion of cash issued by central banks is one
example of traditional protection against the deterioration
of asset quality. However, there are no externally
transparent limits on other much riskier assets such as
securitization products or REITs. What is defined is that
each central bank is expected to have its own risk
assessment system and to assess its adequacy of capital.
For example, the European Central Bank decided to
increase its capital by 5 billion Euros to 10.76 billion
Euros in December 2010 against the increasing risk of
quality deterioration due to the purchase of
governmental bonds of crisis-ridden member countries.21
It was also reported that the Bank of Japan considered
increasing its capital as a provision against the increase
in risk of its newly purchased assets including exchange
traded funds.22 Still, there are no disclosures as to how
central banks assess risks of holding assets and the
related adequacy of capital.

In the new environment, the

transparency of central bank
risk management systems
could be challenged.
These enhancements in risk management and
governance will increase confidence in central banks
ability to manage the financial sector, set an example
for financial institutions to follow, improve the general
quality of the financial system, and possibly lessen the
severity of future banking crises.

Consequently, in the area of risk management, central

banks may be required to:
1) Enhance risk management to properly assess potential
assets to be purchased without depending on credit
rating agencies, and assess operational risks in
accordance with the same methodologies that central
banks advocate for private banks;
2) Enhance accountability of risk management and of
the process of assessing their own capital adequacy,
through disclosure of the framework, process, and
analysis of their risk management; and
3) Enhance disclosure of policy board minutes that
discuss the issues of prudential policies.

21 ECB to nearly double

capital with 5 billion
euro hike, Reuters,
16 December 2010
22 BOJ plans capital boost
to provision against
losses, Reuters,
8 May 2011
Key challenges facing central banks Adapting to a new era

11

13281A lb Key Challenges A4_13281A lb Key Challenges A4 16/09/2011 11:55 Page 12

23 Central Bank Of Ireland

Strategic Plan 20102012, Central Bank of
Ireland
24 Ibid.
25 Knowledge services,
Reserve Bank of New
Zealand Annual Report
2010, Reserve Bank of
New Zealand, October
2010
12

Attracting and retaining people

In most industries, businesses are able to benefit by
applying best practices observed in the marketplace and
knowledge from trusted advisors. However, in the case
of central banks, there is a limited pool of benchmark
organizations to draw best practices given that there
is typically only one central bank in each country.
Central banks may find it difficult to develop, nurture,
and institutionalize a depth of specialization in the
particular issues that central banks typically face.

The need for the CBI to focus on continual training and

development of their employees and actively managing
the talent they have attracted and recruited is highlighted
in the CBIs Strategic Plan 2010-2012.23 The plan states
that CBIs objective of implementing a human resources
strategy aligned with their responsibilities will be
addressed by carrying out the following:

Central banks face diverging issues when it comes to

talent. In some countries staff turnover tends to be
extremely low at central banks, and this drives the
question of how central banks can develop a culture of
change that is needed in todays fast-changing
environment. In many countries the recent passage of
regulatory reform introduces a premium on people with
regulatory experience with a central bank or other
supervisory entity. This demand in the market will make it
even more difficult to attract and retain talented people.

Implement a program of training and development for

all staff, focusing on developing core competencies.

This is the challenge that is currently being faced by the

Central Bank of Ireland (CBI). The CBI has undergone
significant change in organizational and governance
structure since the start of the economic crisis. The Bank
has taken renewed ownership of responsibilities for
financial regulation in Ireland due to perceived past
weaknesses in supervision, particularly in banking.
Additional resources were granted to the Bank to
implement improvement. The recruitment drive is proving
successful in that a number of people have been
attracted to the CBI from professional services and from
industry. The current challenge for the CBI is in
successfully integrating a large number of new hires into
the organization. In the near to medium term the
challenge for the CBI will be to retain this expertise in
face of the likely demand from industry for regulatory
knowledge.

In addition, systems and technologies may help with

improving operational efficiency and developing people.
Banks can use technology to enhance performance
management systems to align employee work plans with
business objectives, to deliver training programs, and to
develop knowledge management systems. For example,
the Reserve Bank of New Zealand has a knowledge
management group that implements tools, such as its
intranet, to allow sharing of information and to provide a
forum for employees to engage in open communication.25

Undertake a program of recruitment to substantially

increase our manpower and supplement our skills.

Enhance the performance management system to

align personal work plans with business objectives.
Improve internal communication to aid achievement
of strategic priorities.
Monitor and review our policies to retain staff. 24

Central banks that have both an effective knowledge

management system and a formal training program are
better placed to manage the limited resource pool.
With this organizational capability in hand, central banks
are able to widen their ability in which to draw
prospective recruits and new employees. Furthermore,
when this infrastructure is in place, central banks not only
improve their ability to draw in new talent, but can also
improve their ability to incorporate best practices from
outside sources.

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Conclusion

This report highlights several challenges faced by central

banks. Central banks, as lenders of last resort, have
indeed been called upon many times during the
financial crisis to stabilize markets and prevent contagion
by injecting liquidity to capital markets and purchasing
preferred stock of newly nationalized banking groups.
As the global financial services industry evolves and
adapts to the general publics demand for safer markets
and new regulations to ensure market stability, central
banks should not only be prepared to support the new
changing financial landscape but should also lead by
example.

Global and local jurisdictional regulatory reforms are

moving forward. How these regulations will affect the
global financial services industry and the role of central
banks is yet to be seen. One thing is certain the
previously well-understood nature of central banks will
need to change, and central banks will need to adapt
to a new era. Central banks around the world will not
only need to expand their toolkits of monetary policy
in order to deal with financial contagion at the
macroprudential level, but will also need operational
effectiveness and expertise to deal with financial
uncertainty.

Ben Bernanke, Chairman of the United States Federal

Reserve, commented in late 2009, Our supervisory
approach should better reflect our mission, as a central
bank, to promote financial stability. The extraordinary
pressure on financial firms last fall [2008] underscored
how profoundly interconnected firms and markets are in
our complex, global financial system. Thus, any effort to
address systemic risks will require a more system wide, or
macroprudential, approach to the supervision of
systemically critical firms. More generally, supervisors must
go beyond their traditional focus on individual firms and
markets to try to identify possible channels of financial
contagion and other risks to the system as a whole. 26

Central banks will continue to be the lenders of last

resort in times of economic crisis to the nations they
serve and to the greater good of global markets.
The evolving landscape, especially through a heightened
scrutiny and transparency, will place pressure on central
banks to ensure that they are perceived to be prepared
and equipped when called to execute extraordinary
measures for the stability of local and global financial
systems.

One thing is certain the

previously well-understood
nature of central banks will
need to change, and central
banks will need to adapt to a
new era.

Central banks face many challenges, which rank high

on the agendas of central banks governing
committees. However, not all central banks face the
same challenges. In order to serve their nations
effectively, central banks must overcome the challenges
that may weaken their ability to fulfill their role within
the financial markets both on the individual financial
institution level and on a systemic level.

26 Financial Regulation
and Supervision after
the Crisis: The Role of
he Federal Reserve,
speech by Chairman
Ben S. Bernanke at the
Federal Reserve Bank of
Boston 54th Economic
Conference, Chatham,
Massachusetts,
23 October 2009
Key challenges facing central banks Adapting to a new era

13

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Deloitte Central Banking Network

In response to the demand for specialized services for
central banks, Deloitte member firms have mobilized a
global network of over 700 professionals in more than
80 countries who have relationships with some of the
worlds largest central banks. The experience we have
gained in serving these central banks for many years is
complemented by our skills and knowledge in the global
financial services industry (GFSI), where Deloitte member
firms serve many of the sectors leading financial
institutions. Our GFSI network provides global resources
and global capabilities, yet our presence is local with a
clear understanding of a clients market and way of
doing business in each particular country. This experience
has given us an intimate understanding of the
environment in which central banks operate and the
unique challenges and opportunities they encounter.

Deloitte member firms currently

audit over 25 central banks,
spanning four continents, from
the largest economy in the world
to one of the smallest.

14

Deloitte member firms currently audit over 25 central

banks, spanning four continents, from the largest
economy in the world to one of the smallest.
Leveraging our global network and multi-disciplinary
service capabilities, Deloitte member firms also provide
a market leading breadth and depth of advisory services
to central banks.
Deloitte member firms address the unique challenges of
central banks by sharing experience, leading practices,
methodologies, and resources through the Deloitte
Central Banking Network. Our network is key to sharing
information and knowledge amongst member firm
audit and advisory professionals.

13281A lb Key Challenges A4_13281A lb Key Challenges A4 16/09/2011 11:55 Page 15

Editors

Authors
Karen Bowman
Hong Kong
+852 2852 6786
[email protected]
Karen Grieve
Tokyo
+81 90 6560 5580
[email protected]
David Pulido
New York
+1 212 436 2420
[email protected]
Key contributors
Pengiran Izam Ryan Bahrin
Singapore
+65 6538 6166
[email protected]
Miguel Angel Bailon
Madrid
+34 9 1514 5000 x1734
[email protected]
Frank Dubas
New York
+1 212 436 4219
[email protected]

Mary Fulton
Dublin
+353 1 4172379
[email protected]

Aase-Aamdal Lundgaard
Oslo
+47 23 27 92 82
[email protected]

Roger Furholm
Oslo
+47 23 27 93 27
[email protected]

Tara Matthews
Richmond
+1 804 697 1828
[email protected]

Ana Maria Grande

Madrid
+ 34 915 145 000 x1927
[email protected]

Alastair Morley
London
+44 20 7303 4785
[email protected]

Norela Jimnez Mendez

Cali
+57 2 524 7027 x3001
[email protected]

Tsuyoshi Oyama
Tokyo
+81 90 9834 4302
[email protected]

Martin Kopatschek
Frankfurt
+49 69 75695 6105
[email protected]

Andre Salz
New York
+1 212 436 4545
[email protected]

Michael Lait
Moscow
+7 495 787 0600 x2303
[email protected]

Clifford Smout
London
+44 20 7303 6390
[email protected]

Carol Larson
Pittsburgh
+1 412 338 7210
[email protected]

Henrik Woxholt
Oslo
+47 23 27 93 42
[email protected]

A special thanks to many others in the Deloitte Central Banking Network who also contributed to this report.

Key challenges facing central banks Adapting to a new era

15

13281A lb Key Challenges A4_13281A lb Key Challenges A4 16/09/2011 11:55 Page 16

Notes

16

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13281A lb Key Challenges A4_13281A lb Key Challenges A4 16/09/2011 11:55 Page 18

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