Risk Management For Sovereign Debt

Sovereign Debt Risk Management
Part 1 Risk Management
Chapter 1
Risk Management for Sovereign Debt
Chapter 1 Risk Management for Sovereign Debt
1-1
1-2
Chapter 1
1.1
Introduction ......................................................................................................1-5
1.2
Setting the Goal and Establishing Constraints ...................................................1-5
1.3
Classes of Risk ..................................................................................................1-7
1.4
Risk As a Macroeconomic Problem .....................................................................1-9
1.5
Risk Management of Contingent Obligations ....................................................1-10
1.6
Risk Tolerance and Performance Measurement ................................................1-15
1.7
Procedures for Managing Market Risks and Returns ........................................1-19
1.8
A Structured Approach to Organization and Information Architecture..............1-20
1.9
Organization Structure
1.10
Information Architecture Using Separate but Integrated Databases ................ 1-28
................................................................................1-22
1-3
1-4
Chapter 1
1.1
Introduction
This document provides a framework to help

sovereign debt managers meet their goal
sustained ability to fund scal needs while
remaining within funding policy objectives and
risk targets. This is the context for assessing
whether the compensation for risk exposure is
adequate. This is an optimizing framework.
This framework helps promote efcient
management of the sovereigns debt. Given the
constraints and risk limits, are borrowing costs
as low as feasible and is risk exposure rewarded
appropriately in light of market conditions? But
the relevant concept for the sovereign is not
simply being compensated for risk exposure.
It is far beyond that because sovereign debt
has important macro-economic impact. At one
extreme, an inappropriate exposure structure
in debt and sovereign guarantees has caused
some countries economic downturns to become
crises, whereas a well-implemented optimized
debt and guarantees structure can actually
help promote cyclical stability. Moreover, a well
designed debt structure can help the sovereign
promote its own local currency capital market,
with associated benets for home ownership
and business nancing, and it can help provide
instruments for effective monetary policy
transmission.
This chapter describes the thinking process that
underpins an optimizing approach to sovereign
debt management. It describes the important
rst step, setting the goal and establishing
the limits. It then describes the types of
risks. Effective risk management is one of the
important tests of a borrowers credit rating,
which ultimately inuences the borrowers
availability and cost of funds relative to other
borrowers.
Two of the principal risks facing all debt

portfolio managers are market risk and
operational risk. Market risk can be measured,
which requires a coherent data structure
and tools for measuring and managing risk.
Operational risk arises largely from a weak
organizational structure. Operational risk
can be managed through an organizational
structure that provides for appropriate
separation of responsibilities and uses welldened procedures for accurate and timely
accounting.
This chapter discusses the various types of
risk and how they can be managed. It then
introduces an approach to assessing and
reviewing the structure of the organization and
its information requirements. It proposes an
information management system that suits
each of the two main functions for managing
debt accounting/budgeting and policy/risk
managementin a separate but integrated way.
This chapter also introduces stress testing for
risk measurement and management. Both of
these are discussed in more detail in technical
chapters that follow this one.
1.2
Setting the Goal and Establishing

Constraints
Sovereign debt is an explicit contractual

obligation of the sovereign to repay, usually
with interest and at a specied time, funds
that have been provided to it. The obligation
ultimately takes the form of a contract to
borrow. In one case, the obligation might be
direct, meaning that there are only two parties
involved: the sovereign (as borrower) and the
provider of funds (the lender), and the full
faith and credit of the sovereign supports the
agreed repayment terms. In another case, the
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obligation might be indirect, meaning that a

third party, such as an agency of the sovereign,
might be the nominal borrower and there might
not be a contractual underpinning of the full
faith and credit of the sovereign. A third is that
the obligation might be contingent, meaning
that a third party is the borrower with the
direct obligation to repay, and the sovereigns
obligation to repay contractually arises only
upon some event such as the failure of the
direct borrower to repay. A guarantee is a
contingent obligation.
In any case, the obligation to repay might be in
the sovereigns domestic currency (domestic
currency debt) or it might be in one or more
external currencies (foreign currency debt).
Foreign currency debt may have all the risks
and rewards of domestic currency debt.
Moreover, it has an additional risk/reward
component: there is the potential of either an
adverse or a benecial change in the foreign
exchange rate relative to what was accepted
when the exposure was agreed, resulting in
debt servicing being either more onerous or less
costly than anticipated.
We can think of sovereign debt management
as having two different dimensions that must
be considered. One dimension has all the
aspects of any portfolio management problem.
Where those pertain, the best approach for
asset-liability management as practiced in any
nancial institution can be used. There is one
small technical modication, however, in that
the appropriate measure for a sovereign is the
cash ows the sources of funds to service
the debt and the amount of funds needed to
service the debt. The second dimension is the
macro-economic implications of sovereign debt
management. Both are discussed below.
1.2.1 Risk as an Asset-Liability

Management Problem: From a
Cash Flow Viewpoint
Sovereign debt management shares some
features common to all asset-liability and
portfolio management for nancial institutions.
However, one signicant difference between
sovereign and corporate debt is that sovereign
debt management is viewed in terms of cash
ows. But this does not detract from the
1-6
usefulness of the asset-liability management

approach. The features of that approach
applicable to sovereign debt management
include the need for a clear strategic objective
as well as establishment of constraints and
risk tolerances. They also include a need
for data and procedures to measure debt
portfolio market risk and returns; to manage
debt portfolio market risk and performance;
to manage the legal and other risks of issuing
debt; and to limit debt portfolio operational
risk. Viewed this way, there is a vast literature
and array of best practices and regulatory
standards available to serve as guidelines.
1.2.1.1
The Strategic Objective and the

Setting of Constraints and Risk
Tolerances
Any asset-liability management structure

should be framed in terms of the organizations
objective and mission. This frame ultimately
establishes the goal for portfolio management,
and in the process helps dene the strengths
and weaknesses of the entity. The constraints
similarly provide the boundaries for the portfolio
managers, as do the risk tolerances. Portfolio
management ultimately is an optimization
problem, even though that explicit term is
rarely used. The approach to getting clarity on
the objective, constraints, and risk tolerances
involves achieving consensus, or at least
working agreement, among the stakeholders.
This consensus among stakeholders is
particularly important in managing public
debt. Achieving that clarity of objective and
consensus also requires expertise and technical
sophistication to be able to evaluate and
measure potential risks and returns, as well
as the likely consequences of risk exposures
entailing possibly large losses. Skills also are
needed to communicate these results to nontechnical stakeholders in order to establish
meaningful risk tolerances. A framework of
the strategic objective, constraints and risk
tolerances allows the portfolio managers to
have a real basis for evaluating choices among
instruments or markets, and it provides
their superiors and the public the basis for
meaningful evaluation of performance.
1.3
Classes of Risk
The classic denition of risk refers to exposure

to an event that has some chance of occurring,
causing a gain or a loss. The chance of its
occurrence can be measured reasonably
accurately.1 Uncertainty, in contrast, is the
term used for an occurrence that can result in
unusual gain or loss, but whose probability of
occurrence cannot be measured reliably.
Measurement of risk is a key feature of risk
management as applied to nancial portfolios
and nancial intermediaries. A reliable range
of the probability of gain or loss is an essential
ingredient of successful risk taking and risk
management. That information also permits a
reliable estimate of risk bearing capacity. Such
estimates serve as useful decision tools for
evaluating pricing and risk-adjusted returns on
capital.
Many kinds of nancial risk lend themselves to
measurement and therefore to this quantitative
approach to risk management. Market risk is a
prime example. It includes a range of interest
rate risks yield curve risk, yield levels risk,
basis risk. It also includes uctuations in
the value of currencies against each other,
liquidity risk and market price risk. Funding
risk is another measurable nancial risk.
Some types of credit risk also can be managed
using quantitative techniques if the number
of observations and data records allow. For
example, in the U.S., many types of consumer
loans for home mortgages, cars and credit
cards, for example lend themselves to
quantitative approaches.
Since market risk can be measured and
managed, it is suited to intelligent, focused,
potentially protable risk taking. This
undertaking is supported by estimates
of both an adequate capital base and an
adequate risk-adjusted return on capital.
This is the foundation for successful nancial
intermediation and portfolio management.
Other kinds of risk can involve losses severe
enough even to cause failure but they do not
lend themselves to a quantitative approach
1
to measurement or management. They are

classes of risks that are best managed through
control procedures, and are referred to as
operational risk. Controls and reputation
risks are prime examples. They might arise,
for example, through conict of interest or
from rogue behavior not properly managed or
controlled. They might reect moral hazard,
where something in the reward or performance
structure encourages risk taking without
commensurate risk consequences. Examples
often emerge in the transactions areas, where
they might be as simple as mistakes that go
undetected until too late or other, self-serving,
mistakes that allow an improperly supervised
employee to reap undeserved gains. Operational
risks almost never result in gains to the
organization. They are usually associated with
losses, losses that range from the trivial to the
fatal. As such, they do not lend themselves to
the calculated risk-taking associated with most
market risks, where rewards can be correlated
with risk and where good portfolio management
through techniques such as diversication
and notional risk-capital allocation can
mitigate exposure. Most institutions view
operational risk as a risk to be avoided or at
least minimized. They tend to do this through
organizational structures designed to make the
control mechanisms as effective as possible.
Finally, there is a class of risks termed country
riskrisk that is systemic and beyond the
immediate purview of the manager of the
portfolio or nancial intermediary. These
represent changes in the external environment
that can affect the success of the portfolio.
Unexpectedly high or volatile ination is
one example. Another example might be a
deterioration in a countrys own sovereign
debt rating, since that serves to underpin the
debt rating of any entity from that country
that also is issuing debt in external markets.
Regulatory risk can be systemic, since decisions
taken by regulators can affect the viability of
whole classes of portfolios or intermediaries.
The widespread failures of savings and loan
associations in the United States in the 1980s
were a very expensive example of regulatory risk.
Frank Knight, Risk, Uncertainty and Prot, 1921 republished in Midway Reprint, Chicago:
The University of Chicago Press, 1985.
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In summary, market risk is best managed

quantitatively through reliance on data and on
the tools available to analyze data. Operational
risks are best managed by avoidance where
possible and otherwise by limiting techniques.
Appropriate organization structure tends to
be one of the most effective tools for avoiding
or limiting operational risks. Even though
country risks such as systemic and regulatory
risk might be seen as outside the control
of individual portfolio managers, individual
managers can nonetheless make a contribution
to the management of these macro risks. Their
contribution would be made by evaluating the
consequences of potential decisions through the
same good what if simulations as are used to
manage market risks and then communicating
their ndings to policymakers.
It is helpful to disaggregate the fundamental
risks into specic risks that permit
measurement and effective mitigation actions.
For sovereign debt management, the risks
discussed above take the following forms:
Funding risk - the risk that the ability
to fund new cash needs or to rollover
existing debt will be sharply curtailed as
to quantity, or quantity at terms that can
be accepted.
Market risk - risk that arises from
normal operations in the interest rate and
foreign exchange markets.
Credit risk - risk that partners in
business transactions will not pay as
promptly or as fully as anticipated when
the transaction was agreed.
Operational or controls risk - risk that
arises from administrative processes in
debt issuance, trading, accounting and
redemption operations.
Country risk - risk arising from the
overall nancial economic and political
condition of the country or from a major
failure of controls that damages the
countrys reputation.
These broad categories of risks are

elaborated below.
Funding risk
Volume. The risk that the Ministry of
Finance will be unable to provide sufcient
funds to meet the governments expenditure
and debt reduction targets, on time.
Refunding. The risk that the Ministry of
Finance will be unable to rollover maturing
obligations.
Market risk
Currency. The risk that an adverse change
in the exchange rate would increase the
current debt servicing requirements of
a loan denominated in foreign currency
relative to the funds available to service that
debt.
Liquidity. The risk that securities cannot be
readily converted to cash for their full face
value, despite having short maturities and a
domestic currency denomination.
Marketability. The risk that securities cannot
be readily sold at a reasonable price, even
if not their full face value, either because
of discontinuities in the marketplace or
because the market for those particular
instruments is too thin.
Interest Rate. The risk that, relative to
the funds available to service debt, debt
service costs will increase directly or the
opportunity to reduce debt service costs
will be foregone as a result of adverse price
movements in nancial markets.
Instrument. The risk that an option
embedded in a complex security will
produce costs in excess of those anticipated
at the time the option was created.
Credit risk
Counter-party. The risk of nonperformance
by the obligor to a forward contract or
derivative.
Other Partner. The risk that a partner in a
contract other than that described above,
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such as a borrower, will not pay the full

amount agreed in the contract in a
timely way.
Contingent. The risk that a contingent
obligation would be called, resulting in the
sovereign taking over the debt servicing
obligations of a guaranteed party. The
common cause for a contingent obligation to
be called is the guaranteed entity becoming
unable to service the debt.
Operational (controls) risk
Technical. The risk of inadequate internal
control in debt management operations,
which would allow embezzlement,
fraudulent transfer, or other loss to occur
undetected or with ease.
Settlement. The failure of a business partner
to settle on agreed terms, for reasons other
than the partners credit deterioration.
Country risk
Reputational. The risk that the credit
standing of the sovereign will deteriorate,
resulting in an increase in the interest cost
it would have to pay relative to that paid
by other borrowers. This event could be
associated with a lowered credit rating. At
the extreme, this refers to the risk that in
the wake of a default, an issuer will nd
market access severely curtailed or quite
expensive, or both.
Systemic. The risk arising from a widespread
failure, such as failure of the banking
system that leads to widespread collateral
failures. It might be caused by a failure of
the regulatory system or inadequate stoploss safety mechanisms, for example.
1.4
Risk As a Macroeconomic Problem
There are three principal additional

considerations for sovereign debt management
over and above standard asset-liability
management as practiced in a nancial

institution. The rst the nature of the sources
of funds available to service sovereign debt. The
second is the role of sovereign debt in country
crisis management. And an important third is
the role of sovereign debt issued in domestic
markets as a tool for open market monetary
policy operations and as a basis for developing
capital markets.
Sources of Funds Available to

Service Sovereign Debt
Debt risk management and optimization are
viewed in the context of the ow of funds
available to service the debt. Preserving or
improving the sovereigns highest feasible credit
standing important to achieving the main
goal for sovereign debt management can be
considered in cash ow terms. Credit standing
is strongest when there is a record of making
debt service payments in full and on time
and giving market participants condence
in the countrys continued capacity to do so.
In that regard, the currency composition of
funds ows available to service debt, and the
potential volatility associated with domestic
and external market conditions, are important
pieces of information, as are the size and
growth trend of these funds. Measuring sources
of funds available to service debt is typically
a coordinated effort. The sovereigns budget
and economics statistical functions would
be expected to make forecasts of funding
sources and provide them to the sovereign debt
management team. The central bank is often
the repository of information on quantities of
foreign currency available to make payments
on external debt, and would coordinate
this information with debt management.
Consequently, while important, the sources of
funds available to service debt are not discussed
further in this document as the focus is on
managing the requirements for servicing debt.
1-9
The Role of Sovereign Debt in

Country Crisis Management
Sovereign debt, including guarantees issued
by the sovereign, can play many roles in
country crisis management. Inappropriate debt
structures, such as those not well matched
to the cyclical patterns of funds available to
service debt, can in fact cause or exacerbate
crises. Exposure to contingent obligations
such as guarantees can create added stresses
on the sovereigns cash needs during a
crisis unless these potential calls have been
properly anticipated. Tests of the adequacy
of the margin by which funds sources of
the guaranteed entity exceed debt servicing
requirements provide an indication of the
probable calls on the sovereign. The capacity
to issue new debt as a source of liquidity to
weather a crisis is an important defense: one
goal of appropriate risk measurement and
management is to preserve that capacity. These
considerations need to be incorporated into the
overall goal and constraint setting of sovereign
debt management.
Sovereign Debt as a Policy

Instrument
The sovereign issues debt primarily for the
purpose of nancing a current or past decit.
The goal of debt management is to fund the
scal requirement. But debt management
also operates under a number of constraints
that arise from many aspects of sovereign debt
that inuence an economy. Agreement on
the nature and scope of these constraints is a
signicant part of the debt planning process.
Since government securities are also an
important vehicle for open market operations
conducted by central banks to implement
monetary policy, the central bank would
contribute to this process. Other interests and
agencies of government also are stakeholders in
the consensus building. For example, a desire
to develop a long-term home mortgage market
or longer-term corporate nance markets
also might be represented in establishing the
constraints for sovereign debt management.
The taxing and legislative authorities could have
important contributions to make in constraint
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setting and performance monitoring. The stage

of development of the capital market may be
a constraint. In the process of agreeing on
the goal and setting constraints, countries
should also bear in mind that sovereign debt
issuance and management can play a role in
fostering development of viable, transparent
domestic money and capital markets. Sovereign
debt provides a benchmark yield curve and
instruments for trading. It should also set a
standard for market operations.
During the early stages of a sovereign debt
market, market development is a principal
focus of the debt manager. A key rst step is
to reduce impediments to market development,
such as exposure to crises, liquidity strains,
and excessive volatility. One simple example
is managing the refunding portfolio to avoid
exceptionally large amounts of principal falling
due on a single day. Market development
consists of broadening the universe of investors,,
lengthening the yield curve, removing barriers
to development of the secondary market, and
deepening the primary market so as to permit
full nancing of the decit in the domestic
market in the year in which the decit occurs.
Once these conditions are met, the primary
focus of the debt manager can shift from
market development to risk management in the
debt portfolio. The goal at this point is further
reduction of risks to the state budget, beyond
those described as impediments to market
development.
1.5
Risk Management of Contingent

Obligations
Contingent obligations are a good example

of the intersection of nancial instruments,
nancial risk management, and the special
macroeconomic considerations unique to the
sovereign. In evaluating the benets and costs
of contingent obligations, the sovereign weighs
them not just in a static analysis but also in
terms of their dynamic or cyclical properties.
The sovereign assesses its contingent
obligations in the context of its responsibility to
manage the economy efciently, to avoid severe
cycles and crises, and to have in place effective
tools to manage such events if they do occur.
1.5.1 Sovereign Guarantees

A guarantee is a contract involving three
parties. The lender is one party to the
guarantee. The direct borrower, the guaranteed
party, is the second. And the guarantor is the
third. In this discussion, the guarantor is the
sovereign. The direct borrower is obliged to
repay the lender, as with any loan. However,
the guarantee provides that if certain specied
conditions arise, the guarantor is obliged
to repay the lender in place of the direct
borrower. The specied condition represents
the contingency of the obligation from the
guarantors viewpoint. Once the contingency
has occurred, the guarantors obligation to
repay is conceptually like any other form of debt
issued directly by the guarantor.
A common type of contingent obligation is a
credit substitution guarantee under which
a sovereign agrees to pay one or more of the
debt service payments owed by a third party
to a lender if that third party does not make
the payment on time and in full. This is a
simple substitution of the sovereigns credit
standing for that of the direct borrower,
the guaranteed party. The lender nds this
guarantee valuable because it is less likely
that the sovereign will miss a debt payment
than that the third party would. The usual
reason for the missed payment is a shortage
of funds. An example is a sovereign with AAA
credit rating guaranteeing a third party with
a CCC rating. The contingency to which the
sovereign is exposed in this guarantee is that
the direct borrower does not pay, on time and
in full, the debt-servicing obligation covered by
the guarantee. The size of the payment covered
by the guarantee at the time the contingency
materializes is the amount to which the
sovereign is exposed. That amount is specied
in the guarantee contract, and it might be
limited to one debt servicing payment or it
might extend to as much as the full outstanding
principal balance.
Another class of contingent obligations covers
specied conditions, such as certain acts
beyond any of the three parties control but
which in the end would likely adversely affect
the ability of the guaranteed entities to cover
their debt servicing obligations. Examples are
shortages of commodities, whether manifested

as literal shortages or extreme price increases,
foreign exchange rate instabilities, and civil
strife. The distinction between these two types
of guarantees is that in the former, credit
quality deterioration manifested by missed debt
service payments would lead to a call on the
guarantee without regard to cause.
In the domestic market, a credit substitution
guarantee might occur when small businesses,
agricultural enterprises or homebuyers borrow
from private nancial institutions. These are
examples of common three-party guarantees,
in which the borrower is the guaranteed party,
the sovereign is the guarantor, and a private
nancial institution is the lender. A private
institution is specied because it faces the
consequence of bankruptcy if it makes too
many loans to borrowers who do not repay
principal and interest. In a particular country,
weaknesses in sectors such as farming
and small business might imply frequent
interruptions in timely and full debt servicing
from such borrowers, which would prompt
private lenders to restrict amounts loaned,
limit repayment periods and charge high
interest rates reecting the high credit risk
premium. Those restrictions might be eased if
the sovereign were to backstop weaker credit
sectors with loan guarantees on the assumption
that the guarantees would generate net gains
for the public at large. This would require
that the gains to society resulting from the
guarantees more than cover the sovereigns
costs from the guarantees.
Finally, a fourth entity is sometimes involved
in sovereign guarantees when the sovereigns
own credit standing requires bolstering.
This is often the case with cross-border
transactions. An example might be a AAA
international corporation seeking nancing
for a project to be located in a country in
which the sovereigns own credit rating is
signicantly below AAA. An investors or
lenders project nancing terms typically
reect the probability of an interruption in
debt servicing associated with the weakest
credit, which in this example is the sovereign.
Under such conditions, the sovereigns own
guarantee would be backstopped by a guarantee
from an international nancial institution.
1-11
The sovereign might well conclude that the

public benet from the additional guarantee
would exceed that from any alternative use
of nancing from the international nancial
institution.
This illustrates another very important aspect
of the risk in contingent obligations the
currency in which the called guarantee must
be paid. In three-party sovereign guarantees
linked to the debt of domestic farmers or small
businessmen and owed to domestic private
nancial institutions, the currency of the
contingent obligation typically is the domestic
currency. The sovereign has control over the
supply of that currency, and is therefore able
to pay those claims whether by increasing the
money supply, displacing other government
expenditures, borrowing more or taxing more.
The macroeconomic effects of those choices
are not the same, of course, and the preferred
choice may not be the simplest politically.
But nonetheless, in three-party sovereign
guarantees, the sovereign has access to the
domestic currency to pay domestic contingent
obligations.
1.5.2 The Sovereigns Contingent

Obligations Costs and Risk
Exposure
Event risk is the term used to refer to the
risk that the contingency will materialize.
Contingent obligations are best managed when
the probability associated with event risk can
be forecast with reasonable assurance. Even
so, there inevitably is some margin of error in
calculating the probability of occurrence of the
kinds of events likely to be covered by sovereign
guarantees. Moreover, events triggering calls
on contingent obligations are linked to certain
macroeconomic conditions and neither they,
nor their linkages with calls on guarantees, can
be forecast with complete accuracy.
Some of the benets of a guarantee arise
precisely because of its contingent nature.
Because the guarantor has made a contractual
promise to pay, the guarantor rightly measures
his exposure to the risk of the guarantee
being called as equal to the amount promised.
However, for something less than a one-to1-12
one chance of actually having a cash funding

obligation that is, for only the probable
amount called the sovereign can provide its
support to worthy projects or entities thereby
improving their access to funds or to favorable
funding terms. These benets from the
guarantee might translate to improved success
rates for the projects guaranteed, or to lowered
borrowing costs.
Probable amount called refers to the expected
cash obligation of the sovereign if event risk
materialized that is, if the guarantee were
called. The amount that would be owed
typically is specied contractually under the
guarantee, and is date-specic. The term
probable in this case therefore reects the
product of the probability of the events
occurrence (event risk) and the specied
contractual cash obligation owed at that time by
the sovereign should the event occur (exposure).
Probable loss refers to the probable amount
called on the guarantee, net of the probable
amount of funds, if any, subsequently recovered
by the sovereign from the guaranteed party. The
loss calculation might also include expenses
and some cost for the time value of money
depending upon the nature of the recovery.
Exposure refers to the total amount the
sovereign has promised to guarantee, and
therefore conceivably could be obligated
to fund. It is the maximum possible (not
probable) amount that can be called at any
point currently or in the future. Exposure is
an important risk measurement concept in
the management of contingent obligations. It
is the measure by which the guarantor tracks
its aggregate outstanding promises. As the
maximum guaranteed amount, it represents
the outer extreme of the total amount that
can possibly be called, and possibly lost. Its
probability is not zero. If there were absolutely
no chance a guarantee ever would be called,
the parties in the transaction would nd the
guarantee fee to be not worth paying, and
therefore the transaction would not have been
executed.
Guarantee fee is the compensation paid to the
guarantor for accepting the risks and costs
of a contingent obligation. Sometimes there
are enough independent guaranteed parties
and enough historical data to compute a fee

using an actuarial quantitative approach.
Such an approach would use a large number
of observations to measure probable calls
and losses, their time horizon and potential
impact on funding requirements. It would also
help determine not only the adequacy of the
guarantee fee structure but also the associated
reserves. A long-standing program of sovereign
guarantees on home mortgages would lend itself
to that actuarial type of analysis, for example.
The sovereign also might add a supplement to
the guarantee fee in order to limit any distortion
of competition in a market such as might arise
from extending sovereign guarantees to some
but not all participants.
1.5.3 Sovereign Contingent Obligations:

The Dynamics of Risk Exposure
The sovereign would want to evaluate the
benets and costs of contingent obligations in
terms of their dynamic or cyclical properties,
not just in a static analysis. The sovereign
assesses its contingent obligations in the
context of its responsibility to have in place
effective tools to manage such events if they did
occur. Moreover, probable calls on contingent
obligations should be included in projecting
a sovereigns borrowing program. Each
macroeconomic scenario used to project future
borrowing needs would likely entail a different
volume of calls on contingent obligations.
Any contingent obligation is expected to convey
a benet to the guaranteed party in terms of
a reduced cost of nancing, better nancing
terms, and/or improved access to funds. That
by itself is only a small part of the benet
test for the sovereign when evaluating these
instruments, although it is a prerequisite.
Benets from some contingent obligations are
difcult to quantify. The partial guarantee,
for example, leaves some risk exposure for
private lenders. This improves the credit terms
that they can provide while leaving them an
incentive to make sound credit quality lending
allocation choices. Another such benet is the
civil stability that can accrue from extensive
home ownership as a result of sovereign home
mortgage guarantees. Other benets more
readily lend themselves to measurement,

however. For example, extending the sovereign
guarantee to the debt of small businesses
might improve their viability by lowering their
debt servicing obligations. This might generate
enough associated increases in employment and
income tax revenue to more than compensate
for the sovereigns costs and risk exposure from
extending the guarantees.
The more important benet test for the
sovereign is the likely behavior of contingent
obligations in the context of the unique role
the sovereigns policymakers play on behalf
of the public in managing the macroeconomic
conditions in a country. Under adverse
cyclical conditions, for example, would calls
on contingent obligations exacerbate the cycle
or exert a counter-cyclical inuence? In a
crisis, would calls on contingent obligations
confound crisis management or would they
act as deterrents to further downward spirals?
Under such extreme circumstances, which
sectors in the economy would be protected by
the presence of sovereign contingent obligations
and which sectors or activities might be
damaged? Finally, what is the counter case:
using the same analysis of the extreme cyclical
circumstances or crisis conditions, what would
the results be for the payments system and
overall macroeconomic management if there
were no contingent obligations?
1.5.4 Managing Sovereign Contingent

Obligations
Questions about the costs and benets of
exposure to contingent obligations can be
answered through the insight gained from
a stress testing analysis of a portfolio of
contingent obligations. This approach helps in
evaluating the quantiable benets, risks, cost
and ultimate value to an economy of a sovereign
guarantee program. Stress testing is most fully
accomplished through a simulation model,
but if that is not feasible then even working
through the logic of a stress test is helpful. A
stress test analysis allows examination of two
very important attributes of potential calls from
contingent obligations: their covariance with
other cyclical patterns in the economy, and the
1-13
degree of concentration of these potential claims

that is optimal for macroeconomic management.
It illustrates these attributes because the stress
test takes an extreme case, even if it seems
unlikely, and works through its dynamics and
feedback effects.
When the sovereign contingent obligation
requires a payment in a foreign currency, the
risk analysis of the extreme or crisis condition
is a very crucial part of the sovereigns
evaluation because the foreign currency to
honor the called guarantee must be acquired
at a market price. In a crisis, that price can be
very high in terms of the domestic currency,
and this has been shown even in cases where
the domestic currency had been pegged
under pre-crisis conditions to a strong foreign
currency. Moreover, even when a contingent
obligation has the backstop of a fourth party,
such as an international nancial institution
that would lend the foreign currency to the
sovereign in order to pay the claim, there is a
need for very careful extreme-case risk analysis.
The analysis would consider the conditions
that would contractually permit exercise of the
contingent obligation alongside the plausible
extreme not just the likely macroeconomic
setting under which those conditions might coexist.
Evaluating and managing sovereign contingent
obligations requires careful dynamic risk
analysis. Not every contingent obligation
structure necessarily produces benets that
outweigh risks, although some clearly do.
The successful programs, even when costly at
times, have featured good macroeconomic risk
containment.
Successful management of sovereign contingent
obligations rests on a good quantitative base
built upon a solid information structure that
includes both called and contingent obligations.
That solid information structure underpins risk
analysis, reserves adequacy analysis and setting
the level of the guarantee fee. It helps measure
the linkage between the business cycle and the
cycle of calls.
1-14
The Analytical Database recommended for

risk management and described later contains
modules for contingent obligations that
are designed to facilitate this analysis and
record keeping. The database would contain
information on each uncalled contingent
obligation as follows: the amounts associated
with the underlying debt guaranteed, the
guarantee obligation itself, the associated dates
and identities in the contract, and references to
the events covered by the contingent contract.
A time series section of the database would
store all this information for potential analytical
and ad hoc uses. The database also would
contain information on each called (exercised)
contingent obligation as follows. On each
measurement date, the amount owed directly
by the sovereign through calls would be detailed
in the appropriate section of the database
depending upon how the sovereign honored
the call. For example, if the sovereign borrowed
directly from a multilateral institution to honor
the foreign currency obligation of a four-party
guarantee, the relevant details would be stored
as a borrowing from a multilateral. The cash
ows associated with honoring each called
contingent obligation, as well as the relevant
details of the guaranteed entity and all dates
and amounts due, would be stored in the time
series section of the database.
Chapter 2 describes a simulation model that
further enhances risk analysis. These database
and risk measurement structures would lend
themselves to answering questions like:
Under alternative macroeconomic, scal
and market conditions, how much
additional funding would be required
from probable calls on guarantees? What
would be the impact on the funding plan?
How many calls on guarantees in a
particular economic sector (e.g., small
business) have occurred in the past? How
does the cyclical pattern of those calls
relate to the cyclical pattern of sovereign
funding needs in general? How much has
been recovered in the end from amounts
disbursed on called guarantees?
1.6
Risk Tolerance and Performance

Measurement
Sovereign debt management involves using

the best generic portfolio and asset-liability
management standards. But in addition,
there are considerations of public trust and
macroeconomic management as well as
potentially complicated stakeholder involvement
associated with managing on behalf of the
sovereign. These all come together in the
topics of risk tolerance and performance
measurement.
For example, a private portfolio would be
managed to maximize return for any given
risk exposure, and will be structured to take
on certain risk exposures in order to earn
the associated returns. This is calculated
risk taking. But involved with that is some
probability of loss, which of course might
materialize. Also involved with risk exposures
are the uncertain events that can trigger losses
- these might include extreme political stresses,
nancial crises, international emergencies or
strife.2 When a private portfolio incurs extreme
loss, failure results and for the most part the
consequences of the failure are contained to the
stakeholders of that particular portfolio. There
is no such containment, of course, when the
portfolio is a public portfolio. Serious losses
can have major repercussions throughout the
economy. Moreover, households have no means
to hedge risks taken by the sovereign, but it
is they who ultimately bear the consequences
of the sovereigns risk exposure. With these
considerations, the public debt managers would
set risk tolerance goals that would incorporate
stricter loss avoidance and risk aversion than a
typical private portfolio.
The risk tolerances for public debt management
are complex. They are likely to reect a goal and
a hierarchy of constraints developed through
a consensus-building process among the
major stakeholders in the economy who stand
to gain from good public debt management.
These include the scal authorities; elected
politicians; the central bank and the parties

involved in the conduct of monetary policy;
those elements of the economy who would be
most jeopardized by a nancial crisis; and the
segments of the public who would gain most
from stable, efcient domestic capital markets.
These of course, and others, also stand to lose
from public debt management that entails too
much exposure to crises or to volatility in debt
servicing requirements
For example, a set of risk tolerances for a
sovereign might be structured as follows.
First, minimize the risk of a funding shortfall:
that is, borrow the required volume of funds.
Second, minimize, to the extent feasible, the
risk exposure to undue volatility in debt service
requirements relative to funds available to
service debt: the relevant exposures would
include liquidity risk, market interest rate risk,
currency risk, counterparty and other business
partner risks. Third, undertake borrowing
operations consistent with those risk tolerances
that also limit rollover risk. Fourth, consistent
with the above, borrow funds at the lowest
feasible cost.
These, all reasonable statements and a
reasonable set of conditions for a sovereign,
would ultimately be focused on the cash ow
requirements. The particular focus would be
the near term, but their dynamic path over the
medium term, and their elasticity relative to
that of funds available to service debt, are very
important points of focus. This is one reason
why a benchmark that is constructed to focus
on an outstanding portfolio of debt can be
a very difcult tool for managing toward the
sovereigns goal.
There are several other reasons why a
benchmark constructed in terms of an
outstanding debt portfolio can cause difculties
for sovereign debt managers.3 The sovereigns
debt portfolio is unlikely to be actively managed,
so rebalancing an existing portfolio of funded
debt to accord with a benchmark focused
on portfolio characteristics is likely to be
The word crisis implies a special or infrequent condition. Financial crises associated with sovereign debt in the 1980s
and 1990s were by no means infrequent, however.
Paul Sullivan when he was director of Strategic and Risk Management for the National Treasury Management Agency of
the Republic of Ireland, said, all benchmarks should carry a government health warning.
1-15
costly at the least. The likelihood of a need

to rebalance may be low if a sovereign has a
well-established debt management operation
and stable operating constraints. The chance
of needing to rebalance may be quite high,
on the other hand, for a sovereign whose
starting debt position is quite different from
the desired, and it is very likely to be high for
a sovereign in a transition status wanting also
to accomplish efcient market development.
Moreover, rebalancing a domestic debt portfolio
could interfere with market development. Even
with established, marketable, traded portfolios,
wrongly-constructed benchmarks can result in
perverse incentives and rewarding performance
that does not necessarily help to achieve the
goal; hence the title of a presentation at a
conference on benchmarks, Lies, Damn Lies
and Benchmarks.
Each country should establish its own risk
tolerances, goal statement and hierarchy
of constraints because the achievement of
macroeconomic objectives produces long-range
benets to the economy not accounted for in
the standard short-term cost/risk formulations
that benchmark commercial portfolio
performance. For example, domestic sovereign
debt is a macroeconomic tool that can affect
the functioning of domestic money and capital
markets. Also, a sovereigns foreign currency
debt can have implications for the exposure of
the economy to international market conditions.
Macroeconomic objectives such as these become
constraints in the framework for the sovereign
debt manager.
Especially where there is a transition
implied in market development, performance
measurement is more likely to be consistent
with the complex interaction of constraints
if a single benchmark portfolio concept is
avoided. Each sovereign would have its unique
hierarchy of constraints depending upon its
own starting position and time path for market
development. Well-constructed performance
measures can provide positive incentives and
a helpful framework for making choices that
are most consistent, all things considered,
with the sovereigns objectives. Given this
complexity, and the possibility that at times a
1-16
set of constraints might contain some internal

conicts, performance measures that are
structured more like optimizing statements
than typical commercial portfolio benchmarks
are likely to be most useful. An example of the
overall statement is provided in the top section
of Table 1. This statement would likely be
unchanged for many years and is amenable to
being made public.
The sovereigns funding operation risk
tolerances and management guidelines are
likely to be quite specic, on the other hand,
and would evolve as needed or desired. The
specic tolerance ranges need not be publicly
stated, nor would they be expected to be as
stable as the overall policy statement. Perhaps
risk appetites or risk-bearing capacity might
change, for example, and that change would be
reected in the specic tolerances. The specic
macroeconomic considerations also would be
detailed, focused on achieving a near term goal
or satisfying near term constraints. Examples
of specic risk tolerance and macroeconomic
policy guideline topics are in Table 1. The
statements would be specic enough to provide
an operating framework for issuing debt and
evaluating the cost/risk tradeoff of alternative
funding choices. The statements likely would be
formulated by the risk management and policy
functions and endorsed by senior management.
These statements are the basis to measure
performance.
A tool for establishing these specic tolerances
is the dynamic simulation model, as described
in the following section and more fully in
Chapter 2. Extreme situations can be tested
and measured so that the potential risk
exposure linked to a cost reduction can be
evaluated. An example is the additional interest
risk exposure and funding risk exposure
associated with reducing cost, in a typical yield
curve environment, by issuing all short-term
debt.
The work underpinning the statement of specic
tolerances also can be helped by a thought
exercise. What is the case with no exposure to
funding and market risks? Each sovereign will
have its own answers to establish its own no
risk hypothetical position. That starting point

helps in evaluating how much true value comes
from the acceptance of additional risk in return
for reduced cost, viewed in light of the countrys
own capacity to cope with risk exposure. The
context is the ability to honor each debt service
obligation, in full and on time.
Funds Available to Service Debt. How
sensitive is the net scal decit, excluding
interest payments, to economic conditions?
How tightly are interest payments on
outstanding sovereign debt linked to current
market conditions?
Funding Risk Exposure. What is the size of
the current and projected scal decit, and
the need for net new funding? How evenly
are principal payments due on outstanding
debt spread throughout the next ten years
and what is their size relative to the typical
volume of debt issued in that countrys
capital markets?
Market Risk Exposure. What is the currency
composition of the countrys source of funds
available to service debt? How much does
that vary under different market conditions?
What is the currency composition of the
countrys debt servicing obligations? What
is the net difference between the sources
and uses of funds in each currency, and
how does each net amount respond to
changing economic and market conditions?4
Similar questions are asked about the net
responsiveness of the funds available to
service debt and debt servicing with respect
to market interest rate changes
Credit Risk. Are there counterparties in
swaps or related transactions? Are there
contingent obligations outstanding but
not yet exercised? Are there on-lending
contracts?
This measure of risk, the currency-by-currency net difference between sources available to service debt and debt service
payments owed, is illustrated by the denition of a sovereign debt crisis: when the sovereign has insufcient funds to
supply or to purchase the currency needed for a debt service payment.
1-17
Table 1
Sovereign Goal and Policy Guidelines
Example of Public Statement of Goal for Sovereign Debt Management:
To provide the required funding volume in a scal year, in an orderly way that does not
compromise the ability to do that again in the coming year, and at lowest cost consistent with
guidelines and policies.
(1) Funding operations would be conducted within risk tolerances as dened by policy
guidelines. (Guidelines would be specied.)
(2) Funding operations would be subject to macro-economic considerations established by
policies with regard to cyclical stability and domestic market development. (Policies would
be specied.)
Example of Internal Guidelines for Risk Tolerances:
Subject to remaining within [specific tolerance range] of policy/risk management limits for:
(a) the currency composition of future debt servicing requirements over the medium term
horizon
(b) the interest rate resetting pattern over the coming [ve] years
(c) the overall annual debt amortization prole over the coming [ve] years; and
Other [specied in detail] considerations, as established by risk tolerances and other
macroeconomic objectives, such as:
(a) using instrument designs and marketing procedures that enhance liquidity and
marketability
(b) limiting credit risk exposure [with respect both to volume and minimum credit rating],
especially with regard to external entities
(c) using settlement and internal operating procedures that limit exposure to operational
risks.
Example of Policies for Macroeconomic Considerations:
Subject to [specied approaches] to funding so that it is consistent with offering debt regularly
and predictably in order to:
(a) enhance primary and secondary markets
(b) maintain market liquidity
(c) maintain the risk free status of sovereign obligations
1-18
1.7
Procedures for Managing Market

Risks and Returns
Using the tools and conceptual framework

described above, asset-liability managers are
able to establish processes and incentives to
help achieve their portfolio goal within their
constraints. They are able to measure the
performance of portfolio managers in that
framework, having been able to inform the
managers ahead of time what that framework
is i.e., with clear denition of the goal and
limits. They can measure performance returns
adjusted for risk, and ultimately can judge how
close their managers are to the efcient frontier
in their market risk class.
Thinking about sovereign debt management as
having some features that are macroeconomic
in nature but others that are shared by
managers of any nancial portfolio helps
to identify sources of value added from
providing technical assistance to sovereign
debt managers. The aspect of sovereign
debt management that carries all the same
hallmarks as any generic portfolio management
can benet from best practices and tools that
have been most reliable during the recent
general upgrading in quantitative nancial risk
management.
There is a strong case for relying on those
existing systems to the extent feasible.
They have a proven track record. Moreover,
introducing sovereign debt managers to best
practices, and helping them to use these tools
in an appropriate way, is in the end a very
efcient form of technical assistance. The tools
and approaches may involve a considerable
5
initial investment, both in money and technical

effort, however. Accordingly, some of the
technical assistance to sovereign debt managers
would likely take the form of helping them plan
the steps in the transition to a fully quantitative
risk management and measurement system.
The market risk measurement system has
several components. Two components are the
structure of the data architecture and the use
of hardware and software appropriate for the
risk management and accounting/transactions
needs. The tools for making projections and
risk evaluations are a third component, and
the optimizing tool for measuring tradeoffs is
another. These are discussed below.
Projections for planning purposes, for
evaluating the risk/cost attributes of alternative
strategies, and for stress testing all can be
accomplished through a simulation model.
This procedure is becoming standard for
nancial risk management.5 The simulation
model is fed from the Analytical Database and
uses exogenous variables to depict market
conditions such as for interest and currency
exchange rates, and to depict other exposures
such as funding, liquidity and credit risks. The
simulation model is the tool for measuring the
value at risk, the extremes of risk exposures,
and the dynamic testing of risk-bearing
capacity. Chapter 2, Dynamic Simulation
Model for Sovereign Debt Risk Measurement,
describes this procedure. A simulation model
can be designed as a generic tool for sovereign
debt risk measurement. However, any such
model and its use can be complicated, and the
best technical support would come from helping
Optimal Bank Supervision in a Changing World by Alan Greenspan, The Declining? Role of Banking May 1994,
Thirtieth Annual Conference on Bank Structure and Competition, Chicago Federal Reserve Bank.
A Survey of Stress Tests and Current Practice at Major Financial Institutions: report by a Task Force established by
the Committee on the Global Financial System of the Central Banks of the Group of Ten Countries, April 2001. Bank
for International Settlements. available at www.bis.org. Forum for Central Banks, Committee on the Global Financial
System.)
Stress Testing by Large Financial Institutions: Current Practice and Aggregation Issues, April 2000, Committee on the
Global Financial System, Bank for International Settlements, Basel, Switzerland (available on www.bis.org. Forum for
Central Banks, Committee on the Global Financial System.)
Standard of Practice on Dynamic Solvency Testing for Life Insurance Companies, Canadian Institute of Actuaries, June
1991. available at www.actuaires.ca.
Bank for International Settlements release, May 21,1996, Basel Committee/IOSCO Ensuring that Banks Have Adequate
Capital. www.bis.org.
A Universal Approach to Credit Analysis. Moodys Investors Services at www.moodys.com.
1-19
the country team to ultimately own its model.

This would be accomplished by providing a
generic set of equations, a fairly standard set
of exogenous variables, and perhaps even a
standard set of output tables and charts. But
these are best provided in a way that helps
assure that the country team does its own
programming and tailoring of the generic to suit
its own needs and learn from the ground up
how the model works.
A fully quantied risk measurement system
will have a structure for evaluating choices
and for trading off among alternative cost/risk
portfolio positions. This structure for evaluating
choices could be achieved by an explicit model
that measures these tradeoffs and that solves
for an optimal portfolio taking into account
the goal, constraints and available choices.
Such a model is complicated to build and
maintain, however. It moreover requires a fairly
high technical prociency among decisionmakers. And most importantly, an explicit
optimizing model is of no practical use if the
sovereigns own debt data, and the sovereigns
own strategic objective, are not available to be
incorporated. This point highlights the notion
that there is a critical path in developing good
measures for portfolio management.
Even if there is no explicit model to solve for
the optimal portfolio, it is possible to structure
the approach to making choices within this
risk management framework. Articulation of
the goal and constraints, and the desired time
path to achieve a certain goal, as described in
Section 2 of this chapter, are the rst step in
any case. The sovereigns own debt data must
be available in a sufciently detailed form for
risks and opportunities to be measurable. The
current choices available from the market
in other words, the interest costs for each
maturity class, for each type of instrument,
in each currency also are needed in any
case. Successive simulations, while not
directly solving for the optimal portfolio, can

show the dynamic time proles of costs and
risks under many alternative future market
conditions. These results can then be used to
make choices within the tolerance ranges of the
existing framework; they also can be used to
inform further development of policies and risk
tolerances.
1.8
A Structured Approach to
Organization and Information
Architecture
There is a methodology with a well-proven track

record used to analyze the data and information
technology needs of an organization that
also provides an analysis of the organization
structure for conducting business. Experience
has shown that this business process can be
applied to all institutions in the public sector
and all industries in the private sector because
the requirements for developing information
systems are similar regardless of the business
served or the products and services provided.6
This information architecture methodology
starts from the premise that information
technology objectives should support an entitys
business objectives. For any given business
objective, the business process and data
requirements are relatively stable.
The structured approach discussed here
identies objectives, needs and priorities
largely through interviews with managers at
all levels. Results of these interviews are used
to establish a framework of the processes
and data requirements, and ultimately the
information resources, needed to serve the
business objective. Many organizations
have found that this structured approach to
information strategy planning also has yielded
valuable insights into business organizational
improvements. This process yields results
needed for both quantitative market risk
management and for operational risk
management.
From Information Systems Planning Guide, which offers assistance to teams conducting a Business Systems Planning
study, copyright International Business Machines Corporation (IBM), Third Edition, July 1981. This approach was used
initially in the 1960s for internal corporate business planning at IBM. It has been rened and used successfully among
a wide group of entities. By now, many professional practitioners in strategic information planning and information
engineering use procedures emanating from this original approach and an extensive literature is available.
1-20
The interviews determine each managers

opinions on the following:
1.
The key responsibility of each manager;

the most important objective in the
key areas he/she manages relating to
output of the organizational unit and
management processes.
2.
How personal success is measured and

dened.
3.
Critical success factors and the

information needed to enable success.
4.
Major obstacles or problems inhibiting

achievement of the objective, and his or
her suggested remedies.
5.
Specic items of information needed

to support each business process in
which the manager is involved; where
the information originates; adequacy
of information; and an opinion of the
benets of gaining access to available
information not already received.
6.
Likely future changes in the objective,

business process, organizational structure
and outputs in the managers area of
responsibility.
The compilation of the results of these openended interviews produces output including:
1.
Mission statement.
2.
Detailed list of functions performed and

the associated processes. For example,
borrow money is a function and the
associated processes could be develop
borrowing needs, issue debt, manage
outstanding debt portfolio, pay debt
service, etc.
3.
List of business process denitions. For

example, report nancial condition
could be dened as prepare mandated
and routine information and reports on
nancial condition and performance
for external and internal uses such
as audited nancial statements and
prospectuses.
4.
Data entity type denitions. For example,

borrowing instrument could be
business agreement by which funds are
raised and which results in a liability.
5.
Business area identication and

denitions. For example, risk
management is a business area that
could be dened as the processes and
data used to manage nancial risk
exposures.
6.
Data collection denitions or subdatabases. For example, common

data might be dened as a data set
commonly used by many functional areas,
processes and application systems, such
as exchange rates, information about
counterparts, and macroeconomic data.
7.
Inventory of application systems. For

example, those that compute daily market
values for debt obligations, using daily
market prices.
8. Matrix of business processes and the

application system each uses.
9. Matrix showing each business process and
the organizational unit involved and its
degree of responsibility.
10.
Matrix showing each business process,

the data associated with the business
process and whether the data involvement
is to create the data or only to use it.
The matrix referred to in (10) above can be

thought of as a map showing where the data
are generated and where the data are used.
This map is essential in building an integrated
data/information system that will support
quantitative risk management as well as the
requirements for the General Ledger and
transactions processing.
These structured interviews bring to light areas
of responsibility for a subject or process and the
linkages of that organizational unit with other
parts of the organization that have subsidiary
responsibilities or dependencies. This output,
the matrix in (9) above, also can be thought of
1-21
as a map. In this case, the map yields valuable

insights into the nature of operational risks and
any gaps or redundancies in the organizational
structure that would need to be corrected to
minimize operational risk. This lends itself to
an action plan with appropriate assignments.
In particular, the process of producing these
maps through interviews with all managers
helps to generate their feeling of ownership
of the action plan and their support for its
successful conclusion.
This methodology can be especially valuable
in a setting in which such a structured
approach has not yet been applied. Many
countries now working on improved methods
for measuring and managing their sovereign
debt are examples. Typically, they are starting
from a position of fragmented institutional
responsibility for issuing sovereign obligations;
in many cases multilateral debt, guarantees,
foreign currency private market debt and
domestic currency obligations are all handled
by different units of government. Those
divergent responsibilities often are associated
with incompatibilities in data structures and
data handling standards across organizational
units, and with difculties in data sharing at
many levels.
1.9
Organization Structure
The debt management system of any country is

complex. Many functions are interdependent
and performed by a number of government
agencies. Effective debt management requires
a clear allocation of responsibility and tasks
among agencies and smoothly functioning
relationships between the units involved.
Fortunately, however, many of the
considerations that are most signicant in
designing an appropriate organization structure
are common to any nancial management
function. Accordingly there are well-dened
best practices and a broad base of regulatory,
nance and academic literature on which
to draw. For example, an entirely different
approach to risk management comes into play
in managing exposure to the legal, regulatory,
underwriting and control risks of issuing debt.
A robust organization structure helps limit
exposure to some of these risks, as described
below. Well-designed accounting, cash
management and transaction databases and
procedures also help. Experienced legal advice
is necessary, as is advice on individual markets
and managing market presence.
The potential to use this methodology for

providing technical assistance to countries
in their sovereign debt management can be
summarized as follows. Each country will
have its own unique starting position in terms
of data quality and data processing tools, its
own unique data map and its own unique
organizational arrangements. The same tool
this structured, interview-based approach
would be applied to each country, but the
specic information derived for each country
will be a unique guide to the requirements
of the debt management organization in that
country. The data map will show where data
items originate, the unit responsible for them,
and other units that rely on that data for
their own work. Additional information on
this structured approach to information and
organizational architecture is provided in Part 2.
1-22
1.9.1
Organizational Structures to
Limit Portfolio Operational Risk
Some types of organizational structures have

proven to be effective at providing appropriate
incentives and other approaches to limit
operational risk. For example, the risk
management unit needs to report to the apex
of the management team, independently of the
managers directly involved with the portfolio
decisions. The risk management unit needs
some staff with strong quantitative analytical
skills and some with experience in markets and
transactions. The performance measurement
function should reside in a separate
management stream from the personnel
responsible for transactions. Accounting and
transactions processing should be segregated
from the personnel responsible for generating
transactions. The internal audit function
should report directly to top management
and should be appropriately staffed with
experienced, qualied individuals. Policy and
risk management should be independent
from the transactions group, and authority
should be commensurate with responsibility
throughout the organization. A number of
classic red ags that indicate a awed
organization structure are described in Table
2. Further examples relate to organizational
checks and balances in data entry and
validation. Yet others refer to the incentives
and controls structure for the traders. Many
of the largest external auditing rms as well
as the commercial bank regulators provide
information on best practices in this broad
area.7 Table 3 lists principles for sound
operational risk management that are drawn
from recommendations for banks 8
For example, see documents available from the U.S. Board of Governors of the Federal Reserve System at
www.federalreserve.gov. Supervision Manuals (1) Bank Holding Company, (2) Commercial Bank Examination Manual,
and (3) Trading and Capital-Market Activities. Another source is the Bank for International Settlements in Basel, whose
web site www.bis.org lists many publications, especially those from the Committee on Bank Supervision and Regulation.
Basel Committee on Banking Supervision, Sound Practices for the Management and Supervision of Operational Risk,
February, 2003. Bank for International Settlements, Basle, Switzerland.
1-23
Table 2
Red Flags that Indicate Lack of

Organizational Controls
Stacked One-on-One Reporting Relationships.
This concerns relationships among managers,
supervisors and workers. Assume a Manager
has an Assistant Manager as a sole report who in
turn has an Assistant Deputy Manager as a sole
report. The Assistant Deputy Manager supervises
three rst-line supervisors, each of whom has
responsibility for several actual workers. In
the example, the Manager must deal with three
additional layers of supervision before reaching
anyone who does the real work.
Negotiated Report Results. Reports should

reect data gathered from the real world, analyzed
by objective professionals. When reports are
tailored to t preconceived notions from within
the organization, there is a problem. A grant of
independence to the analysis unit is a cure.
Static Organization. No organization structure is
perfect for all times and all circumstances. Things
change. Markets evolve. Needs arise, then go
away. New ways of doing things become possible
through technology. And so on. The organization
must change in response to these stimuli. When
such stimuli exist, an organization that has not
changed is the problem, not the proposal for
change.
Information Cubby Holes. The problem here is

that while information is created by or provided
to the organization, it is not transmitted to the
user. A bureaucrat who retains it in a poweraggrandizement scheme, or who simply fails to
pass it along, may have captured the information.
Responsibility Without Authority. This is the

classic trap of the dysfunctional bureaucracy; a
worker is held accountable for performance of a
task without being given the authority to complete
it. The usual cause is someones desire to avoid
responsibility.
Circuitous Information Pathways. This

often results from repeated reorganizations.
The information ows were not considered
when people were moved, with the result that
information ows are not direct. This often results
in slow transmission of decision-critical data or
lack of focus in the data. Late data have the same
value as no data. Obscure data may escape the
attention of the decision-maker.
Excess Staff. This is not just an efciency

problem. It has effectiveness aspects. The old
saying among managers If you need something
done, give it to a busy person is applicable.
Underutilized people are demoralized and
dissatised. Most people would prefer to be
challenged than to be told, in effect, We dont
expect very much from you, so we are paying you
eight hours to accomplish four hours of work.
Delivery of Time-Critical Data to the Wrong

Address. Here, the information is clear and timely
but does not reach the user. The effect is the same
as if the data were never created or observed.
Lack of Career Progression. A healthy

organization is self-regenerating. People have the
opportunity to enter, gain skills and experience,
and progress in responsibility and compensation.
People should also have the opportunity to
move on to other organizations. Dead-end jobs
attract deadhead people. Debt management is
too important to be entrusted to the intellectually
dead.
Crisis Management as the Norm. When everyday

operations require the intervention of senior
ofcials, as in a true crisis, the organization has
failed. Crisis management should be the rare
exception and be invoked as the result of an
external event.
Forced Coordination. Complex tasks require
complex organizations. The various organizations
must communicate, share data, and accept
one anothers roles for both effectiveness and
efciencys sake. Failures to communicate or
support one another in routine operations that
require the intervention of a senior manager
indicate an organizational failure.
Internal Bartering. Complex tasks often require
input from more than one ofce. Sometimes,
ofces are reluctant to carry their end of the load.
Evidence of this phenomenon is a statement by a
person in another ofce in response to a normal
request to the effect that Ill do it, but it will cost
you! instead of When can I have that done for
you?
1-24
Risk Management Unit With No Authority.

The risk management unit should be considered
an integral function, reporting directly to senior
management and with authority commensurate
with responsibility. Red ags include risk
managers reporting through transactions
personnel; risk managers with responsibility but
only nominal authority; tension between risk
managers and transactions personnel allowed to
fester by senior management.
Independent Department Limited to One
Type of Transaction. This is a classic reason
a portfolio becomes too concentrated in one type
of instrument or one foreign currency. A red
ag is lack of coordination, at a relatively low
organizational level, across the units charged with
transacting the various instruments available to
the portfolio so that the relative volume of each
instrument meets an overall portfolio goal.
Table 3
Principles for Sound Practices for Managing and Supervising Operational Risk
1.
The Senior Ministers should:
Approve and periodically review the operational risk management framework. It should have a
wide denition of operational risk and lay down the principles of how operational risk is to be
identied, assessed, monitored, and controlled/mitigated.
Ensure that the operational risk management framework is subject to effective and
comprehensive internal audit by operationally independent, appropriately trained and
competent staff. The internal audit function should not be directly responsible for operational
risk management.
2.
Senior management should:
Be responsible for implementing the operational risk management framework consistently

throughout the Ministry.
Identify operational risk in all material activities, processes and systems.
Be responsible for developing policies, processes and procedures for managing operational risk
in all material activities, processes and systems to control and/or mitigate operational risks..
Implement a process to regularly monitor operational risk proles and material exposures to
losses and report pertinent information to senior Ministry ofcials.
Establish adequate operational risk assessment procedures before new activities, processes
and systems are introduced or undertaken.
3. Ministry management and staff should:

Periodically review their risk limitation and control strategies and adjust their operational
risk prole accordingly using appropriate strategies, in light of their overall risk appetite and
prole.
Have in place contingency and business continuity plans to ensure their ability to operate on
an ongoing basis and limit losses in the event of severe business disruption.
Make sufcient public disclosure to allow market participants to assess their approach to
operational risk management.
1-25
Structured Approach to Business

Functions and Processes
Establish frequency, volumes and

instruments of issuance
The main participants and their roles, and the

stakeholders and their goals and constraints,
are either known or emerge through the
structured approach to organization
architecture described in this chapter. The
functions and business processes associated
with sovereign debt management are likely to
include the items listed below, among others.
Each country will organize its own linkages of
functions and processes for debt management.
Best practices can be implemented in an
organizational structure that will accommodate
the particular existing setting, skill base,
cultural sensitivities, budget status, and
other realities in a particular country. That
is, one way or another all the functions and
processes listed below will be performed but
not necessarily with the same organizational
structure in each country.
Implement portfolio limits
Borrow: bring transactions to market via

auction, syndicate, or private placement
Select and manage primary dealers
Manage day-to-day relationships with

external nancial institutions
Report compliance with portfolio guidelines

to policy/risk management
Monitor performance
Provide timely information on amount and

timing of funds availability
Monitor government securities markets and

advise on market preferences
Follow macroeconomic forecasts and trends

for their impact on debt management
Maintain relationships with rating agencies
Monitor and receive data on budget revenue

and performance versus plan
Analyze and report debt data for risk/

performance management purposes
Maintain Analytical Database
1.9.2
Functions
Policymaking
Planning and Program Management
Transacting Borrowings
Cash Management
Risk Management
Analysis
Legal
Operations and Controls
Accounting
Budgeting
Auditing
Business Processes
State management objectives and risk

tolerances
Develop policies
Authorize nancing instruments
Approve funding program
Plan currency mix
Develop nancing plan
1-26
Implement counterparty risk limits

Advise on policy and risk management levels
Design new instruments
Establish and maintain relationships with
investors and underwriters
Manage funded debt outstanding

Manage day-to-day relationships with
domestic nancial institutions
Manage market risks

Maintain ofcial deal documentation
Manage cash ows: Pay and collect
Control currency ows
Monitor cash ows
Project short-term cash balances and
requirements
Prepare prospectuses and other similar debt

issuance materials
Develop and maintain portfolio model

Build assumptions
Run portfolio model for medium

term projections, stress testing and
benchmarking
Ensure compliance with domestic law
Prepare contracts and agreements
Hire external counsel where needed
Ensure compliance with laws in other

countries where debt is issued
may be more culturally sensitive, and therefore

country-specic, than the standards for
the preceding set of functions and business
processes.
Sovereign-Related Functions
Market Development
Manage delivery of securities or

maintenance of book-entry registry
Market Regulation
Monitor arrangements for DVP delivery of

securities against full payment of funds due
Sovereign-Related Business Processes
Conduct debt administration
Maintain General Ledger and its databases
Advise policymakers on all aspects of debt

management and their impact on the
budget, macroeconomic stabilization, crisis
exposure and readiness
Build political consensus
Avoid crises to the extent possible
Review organization structure periodically
Manage indirect issuers as to timing,

volume and nature of issuance
Manage exposure and public benets from

indirect and contingent obligations
Provide material and timely information to

the public, the legislature, the media, and
other stakeholders in the public debt
Assure transparency and fairness in the

markets
Develop markets for efcient capital

allocation in the economy
Develop legal and regulatory environment

supporting market efciency
Approve disclosure and other similar

nancing documents
Maintain relationships: scal agents,

registrar, paying and transfer agents
Maintain ofcial records
Manage input to Analytical Database
Manage information staff and systems
Audit
Train staff
Manage for appropriate professional work
environment
In addition to the best practices, incentives,

controls, and other organizational issues
that face any debt management function,
there are several other aspects unique to
debt management undertaken on behalf of
the sovereign. For one thing, the portfolio is
managed on behalf of public trust, so that
serious losses have signicantly more far
reaching consequences than those associated
with a private portfolio. For another, sovereign
debt is a very important macroeconomic tool,
with consequences ranging from development
and maintenance of efcient markets, to the
conduct of monetary policy, to crisis avoidance
and crisis management. These attributes of
sovereign debt management add to the list
of functions and business processes, with
the following items likely to be among those
included. The standards for best practices
Central Banking
Legislation
Managing Indirect and Contingent
Obligations
Monitor government securities markets and

advise on market preferences
Manage crises to minimize their damage
Monitor auction results and arrangements
for pricing efciency
1-27
1.10 Information Architecture Using

Separate but Integrated Databases
in systems and quantitative support for the

sovereign debt management team.
It is not possible to manage a portfolio efciently

if risks and compensation for risk exposure are
not properly measured. A good quantitative
foundation is very helpful.
The structured interviews on data creation,

use, sharing and disposal will show that data
needs fall into two broad categories. One
requires continually updated information for
recording, accounting, cash management
and active liability management. The other
requires data snapshots taken at the close of
the books for time series and other analysis.
The descriptions of data uses also will show
that these two categories are associated with
different requirements for processing and data
handling tools.
A valuable starting point is a review of the

existing informational and organizational
structure of the national debt management and
supporting Information Technology functions,
with a plan for restructuring if needed. The
preceding section describes a comprehensive
approach to this process in which the results
for each country would be unique. This process
can be time consuming at the front end,
and requires skilled leadership, but it is an
important component of producing high quality
results.
Best practices for the organizational structure
consistent with healthy incentives and effective
institutional risk management/controls
structure have been promulgated by, among
others, commercial bank regulators in the U.S.
and other countries, the Bank for International
Settlements and by the major external
auditing rms. These best practices provide a
helpful comparison to the map of the existing
organizational structure in each country that
would be an outcome of the information and
organizational mapping process described
here. This comparison will help to guide any
institutional changes that might be warranted
for improving controls and incentives toward
achieving the sovereigns goal.
The other outcome of this process is the map of
information ows. This would be the bedrock
of the design of the data system to support
risk measurement. To the extent feasible, it is
also desirable to use best practices to design
the information strategy and to use tools with
proven track records. The advantages are:
(1) high quality of data as to its completeness
and its accuracy; (2) improved chance for
success in systems design and reliability; and
(3) transfer of technical capacity at a very
high level. The drawbacks are likely to be: (1)
potential large initial investment for licensing;
and (2) potentially intense technical training
1-28
With these differences, the most efcient

information structure to manage either a single
nancial portfolio, such as sovereign debt, or
a set of portfolios such as in the asset-liability
management of a nancial institution, is to
use two separate databases. One is the ledger
record of all transactions, essential for paying
bills and for conducting all accounting and
control functions as well as active liability
management. It is referred to here as the
Ledger Database. The other, supporting
quantitative risk management, is referred to
here as the Analytical Database.
While the two would be distinct, they are
integrated in that they draw from the same core
data source the data input to the ledger by
the authority responsible for the data create
function. This structure is one in which each
data item, or set of data items, is associated
with a business process that has the authority
and responsibility for creating it. For example,
an accounting function supporting the funding
transactions might be responsible for entering
into the system all of the data attributes for
each new debt issue. Other organizational
units might use that data item, even if they
are not responsible for entering it (and hence
not responsible for its validity). To continue
the example, there may be a central accounting
unit that is responsible for reporting the debt
balances to the public, even though it is not
responsible for having entered or validated the
data in the rst place. The unit responsible for
entering the data item also must be viewed as
the authority for the accuracy and completeness
of the data entered, and as such it takes

responsibility for its achieving the highest
feasible quality level.
This approach obviously enhances the efciency
of data management. For one thing, it assures
that there is no duplication of effort: each
data item is entered once and only once. For
another, it helps to assure that the validation
procedures for the Analytical Database can
rely on tables produced from the transactions
or accounting systems, which often are the
source for published and audited information.
Furthermore, this linkage of responsibility and
authority can be important if, for example,
the terms of a particular debt issue or swap
transaction are unusual and subject to
misinterpretation or perhaps miscalculation of
market value or market yield.
This data structure and information ow
usually transcends organizational units. A
senior-level information management function
is needed for effectiveness.
Described briey here, with a more complete
description in Part 2, is an information
architecture that consists of a core data system
that is modular, that supports a transactional/
accounting database and a relational/analytical
database. This approach has long been used in
businesses, and accordingly there are existing
generic database tools that operate in this way.
Choices can be made among these database
management systems, considering their
robustness in meeting dened needs, efciency
of upgrades and ultimate cost-effectiveness
as well as their initial cost. The standards by
which to judge ledger systems, whether building
one using a generic tool or purchasing one
specically designed for debt management,
would depend upon clear technical
specications to meet users needs. Similarly,
the design for the analytical/relational database
likely can draw on existing databases that have
good track records and that contain many of the
same types of instruments, including contingent
obligations and derivatives that would be
found in a sovereign debt portfolio. In addition,
these existing databases can provide useful
guides to data table structures, data dictionary
contents, validation procedures, and other data
management issues. The table structures and
data dictionary for the Sovereign Debt Analytical

Database described in Part 2 provide a sound
basis for ensuring that all data elements are
captured in the information architecture.
The data handling tools for assembling data
on existing portfolio into tables, charts and
other transactions/accounting and analytical
formats are another key component of the
quantitative portfolio management. Application
of these tools is relatively straightforward if the
databases have been structured properly. First,
a simple query language for straightforward fact
nding and a robust analytical language for
more complicated analyses should be available.
The Analytical Database is structured to be
compatible with these query and analytical
tools.
Many analytical and risk management uses
are supported by the integrated data structure.
One category of these uses is statistical analysis
such as time series analysis or cross section
analysis. For example, time series analysis
might be used to answer the question of the
payments performance record for groups of
borrowers within the country (e.g., farmers)
receiving loans on-lent from the proceeds of a
sovereign borrowing. Or cross section analysis
might be used to measure exposures and
portfolio concentration, such as the relative
volume across currencies of debt principal
payments contractually scheduled in selected
future time periods.
The Analytical Database also is the primary
source of information on the existing debt
portfolio used with a model that projects
future cash ows and portfolios, such as for
medium-term planning purposes and for risk
measurement. A simulation model that allows
projections of many different scenarios also
expands use of the quantitative base. This
allows stress testing of the portfolio(s) and is
described in Chapter 2.
1-29
1-30

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Sovereign Debt Risk Management

Part 1 Risk Management

Chapter 1 Risk Management for Sovereign Debt

Sovereign Debt Risk Management

Chapter 1 Risk Management for Sovereign Debt

Part 1 Risk Management

Sovereign Debt Risk Management

Part 1 Risk Management

Setting the Goal and Establishing Constraints ...................................................1-5

Classes of Risk ..................................................................................................1-7

Risk As a Macroeconomic Problem .....................................................................1-9

Risk Management of Contingent Obligations ....................................................1-10

Risk Tolerance and Performance Measurement ................................................1-15

Procedures for Managing Market Risks and Returns ........................................1-19

A Structured Approach to Organization and Information Architecture..............1-20

Information Architecture Using Separate but Integrated Databases ................ 1-28

Chapter 1 Risk Management for Sovereign Debt

Sovereign Debt Risk Management

Chapter 1 Risk Management for Sovereign Debt

Part 1 Risk Management

Sovereign Debt Risk Management

Part 1 Risk Management

This document provides a framework to help

Chapter 1 Risk Management for Sovereign Debt

Two of the principal risks facing all debt

Setting the Goal and Establishing

Sovereign debt is an explicit contractual

Sovereign Debt Risk Management

obligation might be indirect, meaning that a

1.2.1 Risk as an Asset-Liability

Part 1 Risk Management

usefulness of the asset-liability management

The Strategic Objective and the

Any asset-liability management structure

Chapter 1 Risk Management for Sovereign Debt

Sovereign Debt Risk Management

The classic denition of risk refers to exposure

Part 1 Risk Management

to measurement or management. They are

Chapter 1 Risk Management for Sovereign Debt

Sovereign Debt Risk Management

In summary, market risk is best managed

Part 1 Risk Management

These broad categories of risks are

Chapter 1 Risk Management for Sovereign Debt

Sovereign Debt Risk Management

such as a borrower, will not pay the full

Risk As a Macroeconomic Problem

There are three principal additional

Chapter 1 Risk Management for Sovereign Debt

Part 1 Risk Management

management as practiced in a nancial

Sources of Funds Available to

Sovereign Debt Risk Management

The Role of Sovereign Debt in

Sovereign Debt as a Policy

Part 1 Risk Management

setting and performance monitoring. The stage

Risk Management of Contingent

Contingent obligations are a good example

Chapter 1 Risk Management for Sovereign Debt

Sovereign Debt Risk Management

1.5.1 Sovereign Guarantees