Risk manager: National Bank of Georgia

In the wake of the financial turmoil unleashed by the Covid-19 pandemic, the National Bank of Georgia successfully stabilised the Georgian lari, and the country’s financial markets, while preserving the reserves portfolio. This was partly the result of a robust risk management framework, which stress-tests the portfolio’s liquidity performance in the most adverse scenarios.

This was the consequence of the long-term planning that Georgia’s central bank had implemented in the wake of the global financial crisis over a decade ago.

“Back then, we really started thinking strategically about upgrading and modernising our reserves management process,” says Giorgi Laliashvili, head of financial markets at the NBG.

“The ultimate objective was to better manage reserves in order to have them readily available when the country needed them the most.”

Covid-19 tested these enhanced capabilities in an unprecedented way. Between March 18 and 27, 2020, the Georgian lari fell by 20.2% against the dollar. This required the central bank’s immediate intervention. Additionally, the NBG needed to deploy US dollars to sustain the functioning of the internal market and the financial system. By April 18, the currency had recovered 11% of its value, and, by June 7, 17.2%.

The central bank has a traditional asset allocation, prioritising liquid assets (around 70% of the portfolio) to meet capital outflows.

“We had to mobilise cash to support local markets. We imported sizeable amounts of US dollar banknotes from abroad. And, of course, we also carried out substantial foreign exchange interventions,” says Olga Kutaladze, head of the NBG’s FX reserves management division.

However, in spite of these interventions, the reserves portfolio remained stable. In fact, it grew from $3.4 billion in March to $3.6 billion in June.

Future options

This partly reflected shrewd options operations, which began two years ago. Prior to the pandemic, the central bank used exchange-traded Eurodollar future options to take a number of trading positions. Among these, it implemented risk reversal strategies using call spreads at very low cost. These served to hedge positions against unfavourable bond price movements.

“It means buying insurance at a cost close to zero,” said Alexander Khazaradze, head of risk management and control division at the NBG.

“We bought and sold call contracts with different strike prices. It meant that if the market went bearish, we would lose only the amount we paid. But if it went bullish, the owner of that position collects sizeable profits. These low-cost issuance strategies worked extremely well in February and March, when Eurodollar futures prices increased dramatically.”

Portfolio managers decide the insurance cost of their positions based on the size of the portfolio, risk and duration.

“The fact that the eligible options instruments are exchange-traded means there is zero settlement risk,” says Laliashvili.

“Price transparency and liquidity – the most typical risks that would prevent us considering options for inclusion in the eligible instruments list – are under control.”

He points out that, although options are not a traditional tool for central banks, these position are based on interest rate futures: “We stay within the traditional area of central bank reserve investments. We just enhance it. We have new tools to express our views about the yield curve movements in a more elaborate way.”

Liquidity stress test

The portfolio’s increase was also partly due to its resilience in extreme scenarios. “We were long in high-quality credit products, and spreads widened close to breaching our limits,” says Kutaladze. “As a result, we had to choose whether to liquidate positions or keep our positions and temporarily suspend the limits. We decided to suspend the limits to avoid unnecessary liquidations while having ample liquidity.”

The central bank operates with three different tranches: working capital, liquidity and investment. The first two tranches were invested in cash and cash-like instruments, thus creating a significant liquidity buffer. Nevertheless, in order to be ready for even higher liquidity needs, the financial markets department “removed the minimum allocation requirements of Treasuries, suspended duration limits, tracking error limits and spread duration limits”, says Kutaladze.

At first sight, this appears to be a risky strategy. But it was informed by the implementation of stress tests on its liquidity and investment tranches. As a result, easing limits on a set of fronts was not an unforeseen development. The limits removed were designed to operate in a business-as-usual environment, but the portfolio was able to operate under much harder conditions.

The risk department’s scenarios include liquidity completely drying up and the central bank still having enough cash to carry out its operations for one month.

“Any event related to immediate outflows, interventions or payments would have been covered by our cash, even if liquidity dropped to zero in the US Treasury market,” says Khazaradze.

“That’s why we could do everything we did, the FX and internal market interventions, all cash requirements were satisfied without any fire sales or any kind of losses.”

In addition to its own resources, Georgian authorities enhanced international liquidity lines. In April, the central bank established a $200 million swap facility with the European Bank for Reconstruction and Development. The next month, the International Monetary Fund approved an extension of its Extended Fund Facility with the country to almost $690 million. Additionally, in December 2020, the central bank struck a deal with the European Central Bank to launch a €100 million ($119 million) repo line that will be in force until June 30, 2021.

The Central Banking Awards were written by Christopher Jeffery, Daniel Hinge, Dan Hardie, Rachael King, Victor Mendez-Barreira, William Towning and Alice Shen