Financial Risks and Investment Management of Trust...

Financial Risks and Investment Management of Trust Funds

Michael KochDirector,

Financial Management (CFPFM)

Overview

2

Financial Risks in Trust Fund Programs1

Area of Focus: Currency Risk2

Investment Management of Trust Fund Liquid Assets3

Introduction

3

The World Bank - as trustee – manages funds from donors until disbursed to recipients

Trust Fund financial risks are managed by the World Bank within a value chain that includes monitoring, reporting, systems and controls

CFP carries out regular, comprehensive risk assessments for Trust Funds

For Q4 of fiscal year 2011, a new Trust Fund financial risk section will be added to the Board’s Quarterly Risk Report

Significant investment in Trust Fund information systems and security

A recent internal audit of Trust Fund Financial Risk Management was rated “Satisfactory”

The auditors suggested that Management raise the issue of Currency Risk with Trust Fund donors

Management is also updating the Investment Strategy for Trust Funds

Four Primary Financial Risks in Trust Fund Programs

4

II. Investment

Risk

• Donor contributions

have outpaced grant

disbursements

• The WB invests these

resources in the capital

markets until funds are

disbursed

• Investment risk arises

from changes in market

interest rates and credit

spreads, causing

changes in bond prices

and yields

• Risk mitigation:

Conservative risk

limits, combined with

tailored investment

horizons

I. Liquidity

Risk

• On aggregate, Trust

Funds administered

by the WB hold some

$24.9 billion in liquidity

• Liquidity covers more

than 2 years of Trust

Fund disbursements

• Liquidity risk is

considered low, even

though liquidity held

by individual funds is

not fungible across

other funds


Daily cash flow

monitoring, aided by

timely donor

contributions

III. Donor

Funding Risk

• Some donors provide

funding over time

• If funding is delayed,

or reduced, grant

recipients may receive

less resources than

expected

• Donor funding risk

arises if the WB

approves grants

before donor

contributions have

been paid in


Best practice is to limit

grant commitments to

funds already received

from donors

IV. Currency

Risk

• Most donors provide

funding in currencies

other than US dollars

• Most recipient grants

are committed in USD.

This results in a

currency mis-match.

• Currency exposure

arises if the WB

approves grants

before donor

contributions have

been paid & converted


Limiting grants to 85%

of future donor

contributions, until

funds are paid in

Overview

5




Nature of Currency Risks in Trust Funds

6

More than 200 donors to Trust Funds, from 77 countries, providing funding in 30 different currencies

Risks inherently result from the structural currency mis-match between donor contributions and grant commitments for a Trust Fund

Actual currency exposure arises if the World Bank approves grants before donor contributions have been paid in & converted into the required currency for a Trust Fund

This is an exposure of grant recipients, not of donors nor the World Bank

If the donor currency loses value against the Trust Fund’s commitment currency, before contributions have been paid in by the donor, then grant recipients may receive less funding than expected

Currencies of Donor Contributions and Grant Commitments

7

EUR

32%

GBP

33%

Donor Contributions: 10% in USD

GBP

33%

EUR

32%

USD

10%

JPY

8%

NOK

8%

AUD

4%

SEK

2%

CAD

1% Other

2%

USD

95%

EUR

4%

Other

1%

Grant Commitments: 95% in USD

USD

95%

Note: Data as of March 31, 2011. Shown are aggregate portfolio amounts; individual Trust Fund contribution/ disbursement profiles may differ.

A Structural Currency Mis-match

Managing Currency Risk

8

What the World Bank Does: Temporarily Limiting Grant Commitments Until Donor Funds are Paid in

Extending grants against unpaid donor funds?

No currency exposure (WB best practice)

Does donor

currency differ from

grant currency?

No

Yes

No currency exposure (currency

match)No

Yes Currency exposure

for recipients

$85 available for grants

$15 currency

buffer

$100 available

for grants

Before donor funds are paid in

Afterdonor funds are paid in

Example: $100

of donor

contributions

Managing Currency Risk (contd.)

9

What the World Bank Does: Current Practice vs. Alternate Approach


$15 currency

buffer

$100 available

for grants

Before donor funds are paid in

Afterdonor funds are paid in

• Uniform 85% Commitment Limit• Effectiveness confirmed by historical

testing of currency volatility• Easy to implement and communicate

Current Practice


$5 buffer

$100 available

for grants

• Commitment Limit depends on each donor• Strengthens currency risk management• Could result in high currency buffers• Complex to implement and communicate

Alternate Approach


$25 buffer $100

available for

grants

Donor currency with highvolatility

Donor currency with lowvolatility

Managing Currency Risk (contd.)

10

What Donors Can Do: Contributing in the Required Currency for Grant Commitments

Extending grants against unpaid donor funds?

No currency exposure (WB best practice)

Does donor

currency differ from

grant currency?

No

Yes

No currency exposure (currency

match)No

Yes Currency exposure

for recipients

Donors pledge in

Euros

Grants are inEuros

Trust Fund B

Donors pledge in

US Dollars

Grants are in

US Dollars

Trust Fund A

=

=

• Eliminates currency risk• No Currency Buffer necessary• Donors could buy own FX hedge• IBRD could intermediate FX hedge

Overview

11




Review of the Investment Strategy for Trust Funds

12

Last Update of the Trust Fund Investment Strategy in November 2004

Stable investment performance between 2005 and 2010 - The current strategy has served donors well

Avg. investment return of 3.9% per year over FY05-10, while minimizing risks

USD 534 million of incremental investment income since February 2005

Motivation for new review at this time

Substantial growth of the Trust Fund liquid asset portfolio

Emergence of FIFs with large liquidity balances, reliance on investment income

Challenging market environment after the global financial crisis

Updated Trust Fund Investment Strategy is scheduled for review by the World Bank Audit Committee on June 22, 2011

Investment Objectives and Risk Limits

13

Objective: Optimize investment returns subject to conservative risk tolerances and liquidity requirements

Preservation of capital of Trust Funds seen as the dominant objective

Reflects perceived donor sensitivity to principal losses

Individual funds have different horizons and risk tolerances, captured in the tranche structure of the Trust Fund investment pool:

Tranche 0: Cash

Tranche 1: 1-year investment horizon

Tranche 2: 3-year investment horizon

Tranche 3: IFFIm investments

Tranches 1 & 2 are managed on a constant risk basis: Limiting the risk of reporting a negative return to 1% over the respective investment horizon (i.e. reporting a positive return 99 times out of 100)

Growth of Trust Fund Investments

14

By Type of Trust Fund (in USD equiv.

million, past decade)

0

5,000

10,000

15,000

20,000

25,000

FY00 FY01 FY02 FY03 FY04 FY05 FY06 FY07 FY08 FY09 FY10

GEF

GFATM

IFFIm

Other FIFs

Trust Funds

By Trust Fund Tranche

(in USD equiv. million,

since updatedTF investment

strategy)

Investment Performance

15

Rolling 12-month and 36-month returns vs. UST 2-year yields

0

1

2

3

4

5

6

7

0

1

2

3

4

5

6

7

8

Jan

-05

Ma

y-0

5

Se

p-0

5

Jan

-06

Ma

y-0

6

Se

p-0

6

Jan

-07

Ma

y-0

7

Se

p-0

7

Jan

-08

Ma

y-0

8

Se

p-0

8

Jan

-09

Ma

y-0

9

Se

p-0

9

Jan

-10

Ma

y-1

0

Se

p-1

0

Jan

-11

US

T 2

ye

ar

yie

ld (

%)

Ro

llin

g

retu

rns

an

nu

ali

zed

(%)

Tranche 1 USD

Tranche 2 USD 36 month rollingUST 2 year yields

100

105

110

115

120

125

130

135

Jan

-05

Ma

y-0

5

Se

p-0

5

Jan

-06

Ma

y-0

6

Se

p-0

6

Jan

-07

Ma

y-0

7

Se

p-0

7

Jan

-08

Ma

y-0

8

Se

p-0

8

Jan

-09

Ma

y-0

9

Se

p-0

9

Jan

-10

Ma

y-1

0

Se

p-1

0

Jan

-11

Va

lue

of

$1

00

inv

est

ed

LIBOR

UST1-3

TF hist

T1

T2

Cumulative returns vs. Libor and UST 1-3 year index

Performance follows market yields; Tranche 2 (3-year horizon) has added further value

Market Environment

16

The current low-yield environment leads to a higher likelihood of rising market yields

This increases the risk of mark-downs of fixed income securities, and of incurring low or negative returns

-4%

-2%

0%

2%

4%

6%

8%

10%

12%

19

95

19

96

19

97

19

98

19

99

20

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20

01

20

02

20

03

20

04

20

05

20

06

20

07

20

08

20

09

20

10

20

11

*

An

nu

al r

etu

rns

Coupon return

Price return

Total return

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

4.5%

De

c-9

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n-9

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Jun

-97

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(to

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set

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up

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US Treasury 1-3 Year Index – Risk and Returns, 1995 to 2011

Summary of Investment Strategy Recommendations

17

Area Review of Current Approach Proposed Revisions

Investment Objectives, Risk Constraints, Governance

Governance and ongoing oversight should be further strengthened, given the continued growth of the Trust Fund investment portfolio.

• Maintain current investment objectives and risk constraints

• Create a new Trust Fund Investment Committee composed Bank unit directors, reporting to Bank Group CFO

Tranche StructureFor some of the largest funds and programs, their high and rising liquidity levels suggest a longer investment horizon than currently offered.

• Establish a new 5-year investment tranche, managed to a 1% risk of reporting a negative return over the investment horizon

Asset Mix

The Trust Fund portfolio is exposed to possible mark-downs in fixed-income instruments, as market interest rates are expected to rise from historically low levels.

Large funds will benefit from more investment options and further diversification of asset classes.

• Add a low percentage of equities in the new 5-year tranche, with well-defined eligibility constraints for participating funds

Financial Risks and Investment Management of Trust...

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