Effective market operations in a modern central bank

Oliver Wyman’s Paul Fisher and Oliver Wünsch explain how central banks can successfully organise and manage their market operations departments (MODs) with a public sector workforce, and when their objectives are not dictated by financial returns.

Central bank mandates can specify a wide range of roles and objectives, ranging from setting monetary policy through to maintaining systemic payment systems and prudential regulation. In different jurisdictions, some of these roles – such as that of prudential regulation – are allocated to other institutions according to local preferences. But, if one focuses on the things that only a central bank can do, then it really comes down to just one – the central bank is the monopoly supplier of the domestic currency. If one wanted to define what a central bank is, that would have to be it.

The domestic currency base is the main component of a central bank’s liabilities, and it is the ability to increase or reduce the supply of money at will that gives the central bank its operational powers to intervene in financial markets to set interest rates, act as a lender of last resort and influence the external value of the currency through management and utilisation of foreign exchange reserves.

These market interventions are implemented via the central bank’s MOD. Many commercial firms – banks, asset managers, hedge funds and even large non-financial corporates – have dealing rooms focused on narrow financial objectives. Such entities can afford to buy in, train and keep experienced staff. In this article, we address the question of how a central bank can organise and manage a successful MOD in a policy institution where objectives are not dictated by financial returns and in which the staff are public servants.

Context

In a commercial setting, the objective of a trading desk is usually to make financial returns by actively seeking risk. The personal financial rewards for staff may be correlated with the outcome and hence highly variable. The level of risk-taking also varies – some firms will be relatively passive whereas hedge fund traders, for example, may be given substantial discretion, subject to a set of risk limits and controls that are likely to be binding. There may exist the temptation for commercial traders to ‘cheat’ – on counterparty peers, clients or even their own employers and colleagues – so compliance rules need to be set and actively monitored, with significant penalties for transgression.

A central bank dealing room is a completely different environment. The objective of financial transactions in a central bank is to implement public policy, not maximise returns. Individuals will not be remunerated on the basis of financial outcomes. The central bank risk appetite is among the lowest – often zero – partly for reputational reasons as significant losses could damage policy credibility. The staff of a central bank are not civil servants exactly, but many are motivated by a similar public service ethos, and the salary levels in the MOD will be comparable to others in the institution – which could range from economists working on policy matters to banking supervisors. So fixed pay will be (much) lower than in the commercial sector, and variable pay will be (much) lower on average and much less variable.

Policy objectives and dealing-room organisation

The primary objectives of the central bank MOD are to implement and inform policy. This has multiple layers, including the design of the operations needed to intervene in the market, the execution of transactions and acting as the central bank’s eyes and ears in financial markets to feed back to policy analysis. The MOD may even play a role in outward messaging of policy.

There are three distinct ‘front office’ operational ‘desks’ likely to be present in a central bank MOD:

1. Domestic monetary policy implementation is usually characterised by a set of non-discretionary operations and facilities designed to set interest rates and provide routine liquidity, or to set the monetary base, including through programmes of asset purchases. These operations and facilities will usually take the form of auctions or facilities with limited discretion that ensure equal access to all potential counterparties.
2. FX dealing varies. In some countries – those with fixed or managed exchange rate regimes – monetary policy is actively implemented by buying or selling FX. Domestic operations would still be required to implement the required policy interest rate and manage liquidity, but those settings may be determined by exchange rate management. In countries with a free float, the FX desk will be less active but still required to manage the central bank’s own currency needs, or those of the government, including in relation to portfolio management. These desks also need to be ready to intervene should policy demand it.
3. Portfolio management for FX reserves. Depending on the origin of these reserves and the policy objective, such portfolios do not always sit on the central bank balance sheet – in some countries they belong to the finance ministry, and larger FX reserves may sit in a sovereign wealth fund. But the central bank is nearly always the manager of some part of the reserves as it has an active MOD and most governments do not. Reserves normally comprise high-quality sovereign bonds or gold, providing appropriate liquidity and security for a policy portfolio – but they may include some other elements ranging from equities to art treasures. Portfolio management normally involves some level of trading discretion for at least part of the portfolio – if only to avoid routinely losing money. But the degree of risk-taking does vary considerably across central banks. In an intervention scenario, the portfolio managers will likely need to raise or absorb FX liquidity.

The skill sets required to operate across these three markets will be different, as well as the level of discretion and the consequent risk framework and controls. There will also be supporting activities in risk reporting, IT and other operational matters and, in terms of personnel numbers, there are likely to be more staff in supporting roles than acting as front-office dealers.

Information flow

Effective operation of an MOD requires full information flows, from other central bank policy departments such as the macroeconomic and financial stability functions, and including middle and back offices, press offices and legal departments. All operations need to be consistent with policy decisions made elsewhere, with a particular need to avoid any unintended signals about future monetary policy.

Furthermore, a strong understanding of the (local and global) financial market environment is required to design effective operations. That should then underpin a robust market intelligence framework that can generate important information for both monetary policy and financial stability (including prudential supervision). Given the contacts between MOD staff and market counterparties – at different levels of seniority – market intelligence need not be limited to the markets in which operations are undertaken, and it includes routine liaison with MODs in other central banks.

Recent trends

Over the past 10–15 years, central bank operations have changed as their balance sheets have been enlarged through unprecedented policy innovations and greater attention to financial stability risks. Today, information flow and co-ordination across the aforementioned layers needs to be swift, agile and comprehensive. Several central banks have instituted organisational changes to address challenges: inter alia, the organisational rigidities of traditionally very hierarchical institutions; a substantial increase in complexity of market operations, requiring diligent design and execution but also timely monitoring of effectiveness in dynamic financial markets; and an ever-increasing volume of information that needs to be evaluated.

The evolving environment has implications for how the central bank organises itself. Across all trading desks, the skill sets required for policy analysis and trading are different, so it can be difficult for staff to switch between functions, market segments or non-dealing activities without detailed management attention. For example, FX and reserve management operations are usually more judgemental and discretionary, and involve risk-taking, and any active positions require continual attention. For many individuals – whatever the context – short-term priorities can dominate longer-term objectives, such as research, and time for the latter needs to be carved out and protected.

Tools to strengthen organisational agility

Successful approaches to increase agility are not (predominantly) based on changing the organisational structure but on the way staff and organisations collaborate, especially across hierarchy paths. The right ‘tone at the top’ provides the best basis for an agile and collaborative culture within an organisation, regardless of context, requiring a clearly stated objective and expectations of the top-level board.

This needs to be accompanied by concrete actions to influence and incentivise staff behaviour. In many organisations, middle management is a key impediment to organisational agility. The main reason for this is that middle managers are acting under (often severely) binding resource constraints and have limited flexibility regarding their objectives and agendas. In such circumstances, middle managers usually focus themselves and their staff on the primary tasks for which they will be held to account. Everything that is not directly related to that primary role or conflicts with short-term needs will be deprioritised and never actioned. To this end, formal role descriptions and appraisals need to give adequate weight to lateral responsibilities.

Central banks also face a dilemma – many of their staff are technical experts, yet management positions are favoured, in part because they offer control over resources. The result is that many management positions are occupied by poor managers, and technical expertise may be developed but then ignored. This could be addressed by establishing the possibility to switch between management and expert roles for those people qualified to best match supply and demand on a continuous basis. This prevents the perception of one career track being superior and ensures the changing demands of the organisation can be met without negatively impacting career prospects and motivation. It also helps staff improve their skills in all dimensions.

The establishment of cross-functional working groups, on a standing and ad hoc basis, is a good way of encouraging collaboration across the organisation, as well as facilitating the flow of information and the creation of insights and ideas, and senior experts can be useful ‘wild cards’ to chair such groups. These can also be successful if co-chaired harmoniously by leaders from different areas. Such groups provide members with insights into the wider policy agenda, create awareness of the workings and needs of other parts of the organisation and contribute to job diversification. For example, mixed groups can be tasked with obtaining and interpreting intelligence from particular market segments (for example, eurozone debt markets, environmental, social and governance criteria) and consist of staff that work in a trading capacity, as financial market analysts, and financial stability and economic policy specialists. Cross-functional groups could also be established to cover operational fields (often IT-related) as well as emerging and innovative fields such as data science and algorithmic trading.

These considerations amount to active, strategic career management for senior staff. In the past, certain central banks and international financial institutions have placed a lot of emphasis on job rotation, including on a mandatory basis. But the idea of a central banking generalist does not fit into today’s reality. At the same time, staying in one specialist line will probably be career-limiting. In fact, many roles benefit from having leaders with a high analytical capability or the ability to communicate in familiar language with their peers in other functions. Such career placements only work if one accepts that people need to grow into a role.

Finally, we note that the staffing of an MOD room can depend on the competing markets. Central banks in large financial centres find staff being regularly poached by commercial firms. Appropriate human resources policies are then needed to deal with the issue of ‘revolving doors’. Given salary constraints, central banks cannot always hire experience in the market – they must train up younger staff, knowing they will lose many of them to outside opportunities. But recognising this and managing it can mean that the MOD is an attractive place to begin one’s career, and leavers can provide a useful network in the wider market. In central banks in smaller financial centres, the problem can be the other way around – with limited opportunities to move externally, a lack of turnover can block career progression opportunities for junior staff. To this end, education, training and secondments – within as well as outside of the institution, alongside a tough but fair policy of ‘managing out’ – are also vital. The best way to keep staff motivated and loyal is to give them intellectually satisfying work.

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