Interview: Jarno Ilves

The editor spoke with the head of asset management at the Bank of Finland in late April 2021.

It seems to me there have been four broad themes influencing reserve management at the Bank of Finland over the last few years: membership of the Eurosystem, naturally; historically low yields in global markets; active engagement with responsible investing; and then, of course, the Covid-19 crisis last year. I am sure there are others, but could you begin by commenting on those?

To be honest, those are the things that come to my mind as well. First, joining the Eurosystem 20 years ago was the most profound change we have experienced as it not only changed the way we manage reserves, but it also gave us the leeway to change. Prior to joining the euro, we had the Finnish markka, which could be a volatile currency, and we needed to be able to intervene at any time. That meant, of course, that our investments needed to be very conservative – ie, government bonds in the most liquid markets.

When we entered the Eurosystem, our domestic currency became steadier visà-vis other currencies. This meant that we could relax our safety and liquidity requirements – carefully. We did not remove them, but step by step relaxed them a little as we didn’t have to have intervention on our minds all the time. That was very profound.

The second element with the Eurosystem has been the monetary policy purchase programmes. These have reshaped our balance sheet over the past five or six years. As a result, we started to think about using asset/liability techniques to analyse the balance sheet as a whole, instead of merely optimising the reserve portfolio. Increasingly, we wanted to look at the overall picture, not just one part of the balance sheet. Also, that part – the reserves – was declining as a share of the balance sheet because monetary policy portfolios became so big in the Eurosystem.

And low yields?

Yes, low yields, even negative yields, came into the picture at about the same time as the other balance-sheet issues. At that time, we anticipated that fixed income returns would decrease heavily because interest rates were so low. We therefore decided to look at other asset classes. The idea was to look for assets that have low correlations to bonds and so behave in a different way to bonds. Simply put, we thought: if interest rates go up, we have nothing in the balance sheet that would perform. While it is not completely certain equities will do that all the time, they are better than having bonds. The idea was to protect the returns of the bank in different future economic environments.

It was the same thinking for real estate, which I know is an unusual asset for reserve management, only on the yield side. Here we looked at what we could do to create “old-fashioned” bond-like returns and yet not be a bond. We see real estate funds as an asset that gives us 3–5% a year return, but where the price remains stable. We don’t particularly expect the investment to appreciate.

Third, there is socially responsible investing (SRI), which has obviously been a very important issue for all institutional investors for a long time, perhaps ten to 15 years. However, central banks have only recently started to venture into this area. As an industry trend, it is moving forward, which is good, but we central banks are a bit late. We are later than other investors as our duties as central banks require safety and liquidity in the portfolio. This has meant we typically invest in governments. As central banks have diversified their investments, however, responsible investing has become more of an issue, and that’s a good thing. In the Nordic region, as we are at the Bank of Finland, responsible investing is a big issue politically and socially. We wanted to be proactive instead of reactive, and it has worked really well – we haven’t been targeted over this, put it that way.

Then, of course, there is Covid-19. Although that’s more of an operational than investment question, it is obviously a major issue for everyone.

Let’s turn first to socially responsible investing. How has the Bank of Finland incorporated SRI into its reserve management?

I’d like to start with the term “SRI”. What we prefer to use is a bit, if I dare say, more modern: “sustainable and responsible investing”. Although it is still SRI, we want to add “sustainable” because the focus is on climate issues. However, the social issues are still there and are important for us.

We use norm-based screening, as a negative screening strategy, for our portfolios on human rights issues, money laundering, and so on. This is not based on the sector of the issuer or the equity. We use UN Global Compact (UNGC) norms, and we expect our investments to abide by them. That’s our first strategy: exclusion. Then, second, we have environmental, social and governance (ESG) integration and, thirdly, we make thematic investments.

I want to mention two things we have done recently in ESG which are very important. First, we hired an ESG specialist last summer, who helped write our responsible investment principles. The board approved the principles, which are on our website.¹¹ https://www.suomenpankki.fi/en/monetary-policy/management-of-reserves/responsible-investmentprinciples/. This was important because in the market there can be quite a lot of talk but not much action on SRI generally. Central banks, on the other hand, often don’t talk about what they do, we can be reticent. Therefore, we went against two trends here! Second, we signed the United Nations Principles for Responsible Investment (UNPRI) in 2019, one of the first central banks to do so. We didn’t do it just so we could say we were one of the first; we did it because we wanted to get some guidance to help us navigate through the issues. Which signing up did.

How do you screen?

First, we gather data from an external service provider on the norms and the companies we invest in. Second, we have a quarterly meeting where a separate responsible investment committee decides which companies to exclude from the portfolio, or are not eligible for us to invest in. We really stick by this – if we exclude someone, we really exclude them. What’s important is that portfolio managers can use the data in real time to see which companies are close to being excluded, or moving in that direction, and act accordingly.

They can use the data to allocate in the portfolio?

That’s the idea, yes. The portfolio managers do this because it makes sense for them to do it. The worst case for a portfolio manager would be where he or she has a company in the portfolio that then goes to a level where the committee decides to exclude it. This is usually after some news or incident, and the spreads would likely be very wide at that point. The portfolio manager has to sell out the position or all the positions. That would not be a good trade. It is much better to not have those in your portfolio. You learn this very quickly. You don’t have to do it many times before you do!

We also have equities and real estate, which we use external managers for. Of course, for those we don’t make the investment decisions ourselves, so we try to influence the managers to be active owners.

How does that work in practice?

We first conduct ESG analysis of the investment manager before making an investment. Then, we monitor the managers. We follow them through the external data provider I mentioned earlier, and watch what they do in their active ownership strategy. We receive updates from them of course. We expect our external managers to influence the investments. Although we don’t follow an active ownership strategy regarding individual companies in the portfolio, we are active towards the external managers. This active ownership approach tends to be an issue within the central banking community, but we find that as our equity investments are done through an external fund manager, it is not material or relevant for us to be active shareholders, but we do follow how the external managers conduct their stewardship activities. The way we are doing it is sort of a third way, where we use someone in the middle. If we think that they need to be active, we discuss that with them.

Do you screen sovereigns?

We only invest in developed market governments in practice – just in the bonds of the countries that issue the currencies we have in our foreign exchange reserves. These countries tend to score well in various international human rights and governance rankings, and for that reason screening sovereigns has not been necessary so far.

The equities are not in an ESG-screened fund?

No. There are, of course, products we could use, but even €500 million or €1 billion is quite a large amount for these funds. We don’t want to be a big investor in one. However, the funds are getting better, and the industry is still young and things are changing rapidly. So far, we haven’t decided which investments we want to make or which screened funds we want to use, but we will get into that later on, I’m sure. These are things we are investigating.

What about benchmarking?

For bonds, we decided that norm-based screening for ESG should only relate to the portfolio. Therefore, it doesn’t affect the index or the benchmark in any way. This is perhaps also the operationally easy way to do it. The important thing is not what your index is, or what your benchmark is, but what your investments are. It is the portfolio that matters.

Presumably there has to be some explanation to the board or senior management around that, that the benchmark can include some things that you can’t invest in?

This is something that the reserve management division has had to accept. I have said that we need to be able to invest in the characteristics of the benchmark, if not every bond in the benchmark. If in reserve management we see that we are not really able to compete with the benchmark by buying different bonds, then that would be an issue. However, I don’t see that now and I don’t see it happening in the future. Also, this was actually a decision we made earlier when we went from an in-house benchmark to an index benchmark. At that point, the benchmark had many more bonds than the portfolio, so this was not a new thing.

What has SRI meant in terms of resourcing for the reserve management area?

For the first five years or so, we did what we did without any additional headcount. When we signed up to the PRI, we decided that it is no longer really doable without specialist ESG knowledge. Also, without a specialist ESG person you don’t really get all the benefits from ESG – you don’t have the energy that you get with someone for whom this is their speciality and who wants to promote ESG everywhere.

Is it one person or a team now?

We hired a specialist, but that person also needed someone to discuss and throw ideas around with, so it became one plus one other, if you like. However, I have just changed it so that, going forward, every portfolio manager will also be the number two ESG person in their particular field. Therefore, we have this ESG person in the middle, and then we have a corporate bond portfolio manager as the number two ESG person in corporate bonds, or equities, and so on. That will advance integration. More broadly, our team also actively participates in Eurosystem working groups, and others such as the Network for Greening the Financial System (NGFS).

What do you see as the next steps?

The first step is to set our climate targets for the future, both in the long term and short term. They may be different – there can be long targets, but there is also the path towards that target. This helps us make and explain decisions. We aim to have the target settled this year. As part of this work, we have become a Task Force on Climate-related Financial Disclosures (TCFD) supporter and aim to increase TCFD reporting. Another step is to increase investments in green bonds and sustainability bonds. We are really determined to do this.

What are the challenges here?

There is the problem that many of these are government or government-related bonds, so we cannot invest in them in the primary market if they are issued by another member of the Eurosystem. We have to wait for them to come to the secondary market, at which point everything is priced up. And the sector is heavily weighted towards euro-denominated issuance. These bonds are also often very long. Our durations are typically lower than two years: one to one-and-a-half-year durations. If you want to buy 25-year green bonds, your duration is quite easily going to be a bit more than one and a half years. They don’t really fit the portfolio.

To summarise, you have a hurdle to do with participation, and then you have a bit of a currency mismatch as well, and also a maturity mismatch?

Yes, everything is wrong! Well, what it comes down to is that it is tough to buy. The supply is much lower than the demand, and then there are the internal problems I mentioned.

Do you see any issuers or any evidence in the market of things going in the right direction?

There’s hope. I see hope in the market that things can get better. Over the past year we’ve been able to buy a tiny bit more than usual. Whether that’s something that we can keep doing remains to be seen, but we are determined to increase our share of green and sustainability bonds.

Is there a sustainability question mark around gold?

Gold is not actively invested at the Bank of Finland. It hasn’t been for a while now. We used to do gold deposits and swaps, but because of the very low rates we took the view that it was not worthwhile.

However, our aim is to cover everything with our SRI policy. With gold, it is not so clear. Obviously, if the gold is new there are issues around mining it. With the Bank of Finland’s gold, it is actually difficult to know where it came from since it has been there for so long. If we wanted to be more active with gold, we would have to come to terms with this issue as well as ESG.

Could you see responsibility, or sustainability perhaps, being added to the traditional reserve management aims of safety, liquidity and return?

In my opinion, it already is. At least for us, it’s right in the middle of everything we do in portfolio management. That is where we want it to be too: that’s ESG integration. Whether you want to add it as another word is more a matter of how you want to show this to the rest of the world, but it is already in place.

What has been the impact of the Covid-19 crisis on reserve management at the Bank of Finland from a portfolio point of view, but also operationally?

Continuity of operations was key for last year. If you succeeded in that, you succeeded. For us in reserve management, the main thing was to get operations working in a new environment. We had started early on to prepare for remote working, and so when Finland went into lockdown in mid-March we in reserves were ready to go home and start working remotely. That was surprisingly smooth. There were challenges, of course, but these were at the individual level, not an institutional one. It may sound like a small thing, but we had already switched from desk PCs to laptops, which made a big difference. I’m really happy that our IT department was forward-looking in this respect.

What about trading?

People were allowed to trade from home as well when they were given permission to. However, the bank provided traders with an extra screen so they didn’t have to trade on their laptop screen. The most challenging aspect is around developing things, making something new. It’s easy to do what you are told to, or to do things that come to you with the message “Please read this and then comment.” They’re fine, but to invent something, or come up with something new, and then discuss it with somebody else is a challenge in the world of remote working.

Did it set work back on SRI, for example, or conversely accelerate it as some have said?

I would agree with those who say there was an increase in ESG in 2020. We have made significant progress in our ESG work in the past year or so. It didn’t set back our ESG work at all.

Your annual report notes a division of reserves into “fixed income” and “long-term” investments. Can you describe the structure you have in place for managing reserves, and the thinking behind this?

This goes back to when we started looking at the reserves from an asset-liability management (ALM) perspective. What was noticed first was we only have bonds in the portfolio, and these were quite short-term assets. At the same time, we could see we had liabilities that were very long – we have capital in the balance sheet that won’t ever go away. This was a mismatch: a very long-term liability and very few assets against it. We took the view that because we have this type of liability, we can invest in the longer term. We can invest in something that is not so liquid but which gives more return because we want to have some return for our capital.

We already had equities and a very small real estate exposure in the portfolio for our pension fund. We used to manage this pension fund separately, but we decided to bring it into the reserves when we looked at the balance sheet as a whole. It didn’t make sense to have this in-balance sheet pension fund making its own investment decisions. Therefore, we moved the pension fund investments to the reserves. These investments are not earmarked in any way, but the pension liability is one of the liabilities that we have these long-term investments against.

When we did the ALM exercise I mentioned earlier, we saw an opportunity to invest long term in better-returning assets such as equities and real estate. These serve a different purpose than the fixed income portfolio, which is more like a traditional central bank portfolio.

Is there a demarcation between the pension funds and the reserves?

No. If there was, then it wouldn’t have made any sense to do what we did. There is no earmarking. The fixed income and long-term investments make up the reserves. These are assets of the central bank. And it has a range of liabilities.

Can I ask how you determine the currency allocation and asset allocation of the reserves?

The currency allocation is a policy decision, not an investment decision. It is a function of the duties that we have as a central bank. It is there for crisis management, intervention, and so on. Every three years, our specialists in monetary policy, financial stability, risk management and investment management come together and work out an amount of each currency that we think that we need, or may need, in crisis situations in the future. That is the allocation of currencies. It’s strictly defined: nothing more, but also nothing less. The currencies are the dollar, sterling, yen and the euro, and we don’t hedge the currency risk. In my view, if you really think you need these currencies, you must own them. To be able to carry the currency risk involved, you need a strong balance sheet. We have accumulated revaluation accounts and provisions for this purpose for many years.

There are several stages to our asset allocation decision. First we take into account our risk taking capacity, which is derived from the ALM work we do continuously. Secondly, we analyse the opportunities the market presents and long term return forecasts of asset classes. This process is done annually.

After that, we decide the size of the reserves in the sense that, as a central bank, we can choose whether we want to invest into our own currency or not. We invest in euros only if we think it is worthwhile. Currently, we don’t invest at all because why would we buy negative yields? I realise this is different for regular market investors who have euros, but we can decide how much we want to invest, which is another major decision.

We then look at the markets, and finally do quantitative analysis on the investments. The final decision of the investment policies is more like a logical decision-making problem. We don’t take the model and say that this strategy has the best expected return and least risk, so let’s take that. It’s more than that – it comes more from our analysis of the market and our analysis of our capacity to take risk.

Staying with currencies, your bank’s view is that you don’t have, say, so-called commodity currencies because you won’t need them for intervention. Does the same also hold for the renminbi, where there’s been a lot of interest as well?

Yes, from time to time when others have been talking about, say, the Australian dollar, we in reserves have been asked: “Why don’t we do that as well?” Then we go back to the drawing board, and examine the currency and look at the cost of swapping out of it back to euros. Then we remember again why we don’t do it, because it is never worthwhile. Every time we’ve done the analysis it hasn’t worked, and so we haven’t even done the analysis for a while.

The renminbi is more like a policy decision, I would say. My personal opinion is that it’s not yet an intervention currency. It is an international currency and getting bigger, but it’s not an intervention currency, so we don’t have it.

Turning to equities, it was a very good year in 2019: according to your latest annual report, the portfolio delivered a 29% return. But what has been the Bank of Finland’s experience with equities since it first moved into the asset class in 2015?

Well, yes, that was good! Better than negative returns on German government bonds. Let me say two things that really explain how we get exposure to this sector. First, we cannot manage the equities in-house since we would need more people for that. Second, we don’t want to have a segregated account with an asset manager because of all the record-keeping and accounting that entails. These two constraints mean that we go into funds or exchange-traded funds (ETFs).

We hold two ETFs that together make a “developed world index” portfolio. These ETFs are cost-efficient from an operational and accounting perspective, and are also liquid. If you want to do asset allocation changes, for example, you can. These are in the long-term portfolio, so we don’t envisage we would need to use them at any point for our central banking duties. They are there to make sure that the value of our capital remains, and are therefore very long term. They are also easy to manage as you only have to look at one number each day. Regarding returns, we are of course very happy with them currently, especially in the US, which is at least 60% of the index.

How was last year?

This is an important point, as last year was a very good test of our investment strategy. Even if we want to improve our returns in certain market situations, we still have to keep in mind our primary duties as a central bank. A central bank needs to be able to take risks when others cannot. This means that investments as a whole need to be countercyclical.

A central bank should not invest in a way that leaves it with so much in equities that, when markets go down, the central bank is in any way under pressure. The central bank needs to be the one that can hold equities, even when they are down something like 40%, as they were last year at their worst. A central bank needs to be able to help its country or its currency at a time when others need it. That is why central banks exist, or at least one of the reasons why. If you mess that up and you are in trouble yourselves at that point, that’s not a good thing. This means there is a limit to how much a central bank wants to have procyclical investments. It is very important, at least to me, not to change the central bank into something akin to an investment fund that cannot help its country when needed.

I wanted to ask about real estate, is that managed through a fund as well?

Yes, several funds. It’s not something that many central banks have, but one of the reasons we do is we used to have this sector in our pension portfolio. In fact, we used to have Finnish real estate companies. We don’t anymore, as they didn’t fit the new strategy that we started five years ago. However, the experience gave us confidence that we knew what we were getting into with real estate. We look for stable, bond-like returns from rental return, really. We don’t expect price appreciation – our view is that we get 4% of rent every year, and that’s it.

How do you achieve that?

We invest in very large European “core strategy” open-ended funds. This means investing in the best locations, usually in the centres of the biggest cities in Europe. They are the least risky you can have, which is important to us. Last year, when the real estate market was in a place where you didn’t know what was going to happen next, we saw that money rotated inside the sector towards the core market. It moved from the opportunistic part to the core instead of going from core real estate to, say, bonds.

What’s your experience been with their performance? Have they behaved like an old-fashioned bond portfolio over the last three or four years?

We don’t have long enough data yet to make reliable conclusions. What we have observed so far is that they have performed as expected.

Are there any assets or asset classes you’re thinking about now or are under consideration?

Not really. We have had a programme to buy small amounts in equities every month and then real estate over the past three years. The originally planned allocation to these asset classes has been reached, and now we are looking at our portfolio as a multi-asset portfolio and making strategic allocation decisions every year. What that means is that we do the analysis on bonds, real estate and equities, but we also bring into the analysis high-yield and emerging market bonds, and so on. From that analysis, it is possible that something could come up and then we’ll invest next year. However, last year nothing came up.

What about corporate bonds?

We manage corporate bonds ourselves – we have portfolio managers who invest in corporate bonds directly. The reason is that this way we can really manage the credit risk that is associated with these bonds. We can be very specific in how we want the portfolio to be constructed. If you go to external managers, they’ll do what they want to do, and there will be some rules that you don’t like. We don’t want that, we want to have it in our own hands all the time. That is really a key decision. This, of course, also means we have a lot of different kinds of metrics and risk limits that we abide by. They are really the framework.

We rely on the risk management framework to be efficient enough so that we won’t get into trouble. At the same time, we have to accept that there is no free lunch. You cannot go into corporate bonds and say “none will ever go bankrupt”. Luckily, we haven’t really experienced that, and we’ve invested in the sector for 20 years. However, the risk is there and things will happen, things like Enron. We probably should have had that name in the portfolio if we followed an index. But we didn’t.