Notes on risk management

Structural interest rate risk on the balance sheet

The liquidity created via purchase programmes and refinancing operations is reflected on the liabilities side of the Bank of Finland’s balance sheet as central bank deposits.

The Eurosystem sets, on monetary policy grounds, the interest rate payable on the central bank deposits made by commercial banks. The interest rate decision has an immediate effect on the Bank of Finland’s interest expenses. Monetary policy assets, however, mainly carry a fixed interest rate. Thus, an increase in the deposit rate weakens the Bank’s net interest income. This difference in the interest rates applied to assets and liabilities on the Bank of Finland’s balance sheet poses a structural interest rate risk for the balance sheet.

For a long time, the Bank of Finland’s purchases of fixed-rate bonds in connection with monetary policy implementation were made at a low yield level. In the second half of 2022, the Eurosystem’s policy interest rates were raised, and the rate increases continued during 2023. This meant that the interest rate on central bank deposits also rose, which had a significant negative impact on net interest income.

As a consequence of this financing cost, the Bank of Finland’s operating profit remained negative in 2024. Based on the interest rate expectations prevailing at the end of 2024, interest rates are on a downward trend. Nevertheless, the Bank’s operating profit is expected to remain negative in 2025. As the interest rates fall, it will gradually improve.

The structural interest rate risk position will decrease as the fixed-rate bonds acquired for monetary policy purposes mature.

Risk management and control of risks related to investment of financial assets

Investment activities are exposed to risks, which risk management seeks to identify, measure and limit. In managing these risks, the Bank of Finland uses widely employed risk management methods, market and credit risk models as well as sensitivity analyses.

Risk management of investment activities by the Bank of Finland has been entrusted jointly to the Administration Department’s Risk Control and Financial Accounting Division and to the Market Operations Department. Risk control of investment activities and reporting on risks and returns are the responsibility of the Administration Department’s Risk Control and Financial Accounting Division.

Risks to investment activities are reported daily to the persons involved in operational investment activities and monthly to the Board of the Bank of Finland. Investment returns are reported monthly to the persons involved in investment activities and to the Board member responsible for investment activities. The Markets Committee, chaired by the same Board member, discusses investment returns every quarter. The Board discusses risks and returns twice a year. Cases of non-compliance with the limits imposed are reported immediately. A report on total financial risks is submitted to the Board at quarterly intervals.

Decision-making framework for investment of financial assets and for risk management, and various risk committees

Decisions on investment of financial assets and related risk management are taken by the Bank of Finland Board, the Markets Committee and, in the case of operational matters, also by the Investment Group and the Risk Group.

The Board is responsible for decisions on the objectives of investment activities and on investment policy, as well as on the principles for risk management and for responsible investment. Such decisions relate, among other things, to the volume of the Bank’s own financial assets and foreign reserves, the currency composition of foreign reserves, long-term investment activity, the strategic allocation of fixed-income investments in the foreign reserves portfolio by investment class, the investment class-specific variation limits permitted in fixed-income investments, and the level of interest rate and credit risks. The Board also determines the maximum credit risk limits.

Within the limits imposed by the Board, the Markets Committee decides on the details of the investment of the Bank’s financial assets and risk management. Such decisions include the criteria for counterparties and issuers, and more specific credit risk limits. The chair of the Markets Committee, who is also responsible for decision-making on the Committee, is the Board member responsible for the Bank of Finland’s own investments.

The emphasis of work in the Investment Group and the Risk Group is on the preparation of matters to be considered by decision-making bodies. In addition, the Investment Group acts as an internal decision-maker within the Market Operations Department and as coordinator of matters common to the investment and risk control functions. Decisions on new trading counterparties are taken mainly by the Investment Group or in exceptional cases by the Markets Committee. The Head of Market Operations chairs the Investment Group and makes decisions therein. The Head of the Administration Department’s Risk Control and Financial Accounting Division chairs the Risk Group and makes decisions therein.

In addition to the decision-making bodies specified above, the Bank of Finland has also set up an internal working group on responsible investment. The working group makes decisions on the companies to be excluded from or brought back within the scope of the Bank’s investment activities. These decisions are taken based on the principles for responsible investment and using analyses of an external service provider.

The Bank of Finland’s Financial Risks Committee is, independently of the management of financial assets, tasked with supporting the Board by monitoring and assessing financial risks that may affect the Bank’s balance sheet. The committee is not a decision-making body but instead gives recommendations and may submit matters to the Board for information or decision, as necessary. The Financial Risks Committee is chaired by the Board member responsible for risk control.

In addition to the Financial Risk Committee, the Bank of Finland has also set up a Committee on Operational and Cyber Security Risks. The task of the committee is to evaluate the level of the Bank’s operational and cyber security risks and the related risk management and to give instructions and make recommendations on the development of risk management procedures. Similarly to the Financial Risks Committee, the Committee on Operational and Cyber Security Risks is not a decision-making body but instead gives recommendations and submits matters to the Board for information or decision, as necessary. The committee is chaired by the Board member responsible for risk control.

Risk measures and breakdowns

Bonds and deposits in the Bank of Finland’s financial assets by credit rating¹

Bonds and deposits in the Bank of Finland’s financial assets by home country of issuer/counterparty (according to market value)

Sensitivity of the Bank of Finland’s financial assets to market changes

Allocation of the Bank of Finland’s fixed-income investments in the foreign reserves portfolio at end-2024

Definitions and concepts

• Market risk means the risk that the net value of assets will decline due to changes in market prices. Market price changes refer to variation in, for example, interest rates, exchange rates, the price of gold or stock prices, which are referred to as interest rate risk, exchange rate risk, gold price risk and equity risk, respectively.
• Credit risk means the risk of financial losses arising from changes in the creditworthiness of a counterparty to a financial transaction or a securities issuer, or from default by a counterparty or issuer.
• Liquidity risk means the risk that assets cannot be made available when the need arises or their conversion into cash causes additional costs.
• Operational risk refers to the risk of extra costs or losses resulting from inadequate or failed internal processes, personnel, systems or external events.
• Foreign reserves comprise unhedged direct and indirect fixed-income investments denominated in foreign currencies and net receivables from the International Monetary Fund (IMF).
• Modified duration is a measure of interest rate risk, indicating how much the value of a fixed-income investment or investments changes in response to a small change in the level of interest rates. For example, if the modified duration is 2 and interest rates rise by 1%, the value of fixed-income investments falls by 2%.
• Value-at-risk (VaR) at a certain confidence level means a loss in excess of which a loss occurs with a probability corresponding to that confidence level, over a given time horizon. For example, if VaR on a one-day horizon and a confidence level of 99% is EUR 3 million, there is a 1% probability that the current day’s outcome will be a loss of more than EUR 3 million (and a 99% probability that the loss is less than EUR 3 million).
• Expected shortfall (ES) at a certain confidence level indicates the amount of expected loss in case that the loss exceeds the VaR calculated at the corresponding confidence level. For example, an ES at a confidence level of 99% gives the average loss in the worst 1% of cases.