By Garreth Rule
In order to achieve their monetary policy goals central banks must interact with wider financial markets through money market operations. Operations where the central bank provides reserves to the market through the means of a loan potentially leaves the central bank exposed to the risk of loss should the counterparty be unable to repay. As losses can lead to the central bank's reputation and independence being compromised, it is important that central banks undertake steps to protect themselves. Risk management in central bank operations is therefore crucial to the central bank's ability to effectively implement its policy goals.
In this handbook we outline how a central bank can limit its exposure to the risk of loss when conducting money market operations. We review the need for operations, discuss the form of such operations and distinguish the contrasting challenges facing countries with surpluses or shortages of liquidity. We then discuss the channels through which the central bank is exposed to the risk of loss and look at the role of capital on a central bank's balance sheet. We introduce the concept of collateralised lending and detail the means through which a central bank chooses the types of collateral it is willing to accept. Subsequently we examine how the central bank manages the collateral it has accepted in its operations, introducing the concepts of valuation, haircuts and margin calls. The recent financial market crisis has let central banks to consider whether or not they should change their collateral policies in the face of market stress, we look at both the advantages and risks of such a move.