5 Further development of the framework and supervision
5.1 Introduction
The management of the Government Pension Fund – Global is governed by Act No. 123 of 21 December 2005, Regulations No. 1725 of 22 December 2005, guidelines with supplementary provisions, and a management agreement between the Ministry of Finance and Norges Bank. Norges Bank shall, pursuant to Section 7 of the Regulations, ensure the existence of satisfactory risk management systems and control procedures for the instruments used in the management of the Fund. The framework requires that the management, measurement and control of risk shall be in accordance with best practise and internationally recognised methods. In 2006/2007, the Ministry drew on external resources to survey “best market practise” and “recognised international standards” for, inter alia , the handling of different types of risk within asset management. This survey is a step towards the operationalisation of the changes to the framework that were discussed in the National Budget for 2006, cf. Sub-chapter 5.2.
The management of the Government Pension Fund – Norway is governed by the Regulations of 15 December 2006 No. 1419. The Regulations govern both administrative matters on the part of Folketrygdfondet (also known as the National Insurance Scheme Fund) and the guidelines for the investments of the Government Pension Fund – Norway. When the Regulations entered into effect on 1 January 2007, they replaced a set of rules laid down by the Storting. This resulted in a more uniform system for determining the guidelines for the two parts of the Government Pension Fund.
Upon the establishment of Folketrygdfondet in 1967, no clear distinction was made between Folketrygdfondet as the name of a fund (asset pool) and Folketrygdfondet as the name of the organisation that managed such an asset pool. Concurrently with the present Report, the Government is submitting a proposal for an Act relating to Folketrygdfondet, cf. Proposition No. 49 (2006-2007) to the Odelsting. The Proposition brings the formal framework for the management of the Government Pension Fund – Norway in line with the developed practise, with Folketrygdfondet acquiring, through a separate Act, the status of an independent legal entity, cf. more detailed discussion in Sub-chapter 5.3.
5.2 Risk based supervision of Norges Bank’s management of the Government Pension Fund – Global
The capital of the Government Pension Fund is growing rapidly. At the same time, the investment strategy of the Fund is undergoing continuous development. This is taking place alongside major changes to the supervision of risk management in financial institutions as a result of new rules both in Europe (EU Directive) and globally (Basel II). 1 The Ministry deems it important to ensure that the framework for the management of the Government Pension Fund is adapted to these developments on an ongoing basis.
The risk/return-profile (ex ante) of the Pension Fund is largely determined by the Ministry’s investment guidelines. The risk assumed in active management has only to a limited degree increased the actual market risk of the Fund beyond the level that is implied by the benchmark portfolio, cf. the more detailed discussion in Chapter 2. The Ministry’s risk budget for active management has been stipulated in the form of an upper limit on tracking error at total fund level. No further limits on active risk have been stipulated at lower levels, like for example individual asset classes. The optimal allocation of the risk budget between the individual strategies and mandates is a key value driver in Norges Bank’s active management.
The Ministry of Finance expanded the investment universe of the Government Pension Fund – Global with effect from 1 January 2006, cf. the discussion in the National Budget for 2006. Based on advice from Norges Bank, as set out in its letter of 11 March 2005, the minimum rating criteria for bonds and the interval for the duration of the fixed-income portfolio were abolished. The provision to the effect that a maximum of 5 pct. of the equity portfolio shall be invested in emerging markets was also abolished. Furthermore, general authority was granted to make use of instruments that are inherently associated with permitted assets, hereunder fund units and commodity derivatives. In a letter of 11 January 2007 to Norges Bank, the Ministry of Finance has clarified that the authority to make use of fund units also encompasses funds whose underlying portfolios fall fully or partly outside the investment universe of the Government Pension Fund – Global, provided that the fund units are listed in a recognised market place inside such universe.
The expansion of the investment universe adds more degrees of freedom for active management. This was supplemented by additional requirements pertaining to risk management, valuation, performance measurement and reporting. In order to exploit the new degrees of freedom in its management, Norges Bank has to be able to document that these qualitative requirements of the guidelines have been met. It is stated in the supplementary guidelines to Section 7 of the Regulations that:
“Valuation, performance measurement and the management, measurement and control of risk shall adhere to internationally recognised standards and methods. The Fund shall not invest in markets, asset classes or instruments unless these requirements can be complied with.”
Furthermore, it follows from the guidelines that Norges Bank shall adopt best market practise in its management, measurement and control of market and counterparty risk.
The Ministry announced, in connection with the expansion of the investment universe, that it would introduce risk based monitoring of Norges Bank’s investment management. In the National Budget for 2006 it is stated, inter alia , that:
“Norges Bank operates a specialised asset management regime. By imposing reporting requirements, the ministry will be better placed to identify areas where, with the help of external expertise, it can evaluate Norges Bank’s compliance with instructions set out in the regulatory framework. The ministry plans regular due diligences of the fund, and particularly the bank’s risk management, in collaboration with consultants possessing suitable expertise.”
The first due diligence project on the basis of the new requirements in the framework was initiated in the autumn of 2006. Following prior competitive tendering, the Ministry of Finance chose an international team from Ernst &Young LLP (London/Zurich/New York) to review the risk management and control procedures of Norges Bank. The project comprises the following milestones:
Propose a reference framework for best market practice and internationally accepted standards within relevant areas such as, inter alia , operational risk and the modelling of market, credit and counterparty risk.
Design a questionnaire to be used by Norges Bank for self assessment of the risk management and control procedures within its asset management operation.
Perform a third-party evaluation of Norges Bank’s systems for handling risk in its asset management operation, based on Norges Bank’s self assessment and further follow-up work.
Prepare a final report, with recommendations and a list of areas that the Ministry should prioritise in its further follow-up of the asset management.
The Ministry aims to conclude the external review of risk management in relation to the asset management activities of Norges Bank in the spring of 2007. One aims to discuss the final report in the National Budget for 2008. One may, based on experience from this review, wish to re-examine certain aspects of the framework, e.g. the reporting requirements in relation to various types of risk.
5.3 The management framework of the Government Pension Fund – Norway
Folketrygdfondet was created as a government fund in 1967. Upon its establishment, no clear distinction was made between Folketrygdfondet as the name of the fund (asset pool) and Folketrygdfondet as the name of the organisation that managed such asset pool. At present, Folketrygdfondet is a government asset manager, and its activities are governed by, and pursuant to, the Act relating to the Government Pension Fund.
Concurrently with the present Report, the Ministry of Finance is submitting a proposition containing a proposal for a new Act relating to Folketrygdfondet, cf. Proposition No. 49 (2006–2007) to the Odelsting. The Proposition brings the formal framework for the management of the Government Pension Fund – Norway in line with the developed practise, with Folketrygdfondet acquiring, through a separate Act, the status of an independent legal entity. The main principles in the present organisation of Folketrygdfondet are continued in the proposed Act relating to Folketrygdfondet. No changes are intended in the activities of Folketrygdfondet or in the management of the Government Pension Fund – Norway. The new framework represents a tidying-up of the regulatory framework, which will also render visible the distinction between the asset pool designated as the Government Pension Fund – Norway and Folketrygdfondet as the entity managing this asset pool.
In its preparation of the Proposition, the Ministry has emphasised the distinction between organisational matters on the part of the manager and the guidelines for investing the capital of the Government Pension Fund – Norway. The Regulations relating to the management of the Government Pension Fund – Norway will therefore have to be amended to concentrate purely on the investment guidelines, after the administrative provisions relating to the management of Folketrygdfondet are set out in a separate act as outlined in the said Proposition. The Ministry will in this context be considering certain technical adaptations in the Regulations, e.g. whether the investment limits should be specified in percentage of market value instead of acquisition cost. The Ministry is also considering whether to specify the investment limits of the Government Pension Fund – Norway in more detail through a benchmark portfolio with a limit on permitted deviations fixed by the Ministry, as is currently the case with the Government Pension Fund – Global. At present, the Ministry specifies the investment strategy of the Government Pension Fund – Norway in the form of general investment limits, whilst the more detailed benchmark portfolio for the measurement of return and risk is determined by the Executive Board of Folketrygdfondet. A changeover would result in a clearer distinction between the outcome of the decisions that are the responsibility of the Ministry and the outcome generated by Folketrygdfondet through its management of the Government Pension Fund – Norway. Such a changeover may also be appropriate in view of the planned formation of a management agreement with Folketrygdfondet, which will govern, inter alia , the compensation principles pertaining to the management of the Government Pension Fund – Norway. The Ministry will revert with an assessment hereof in connection with the National Budget for 2008.
Footnotes
This development is described, inter alia , in Chapter 12, “Risk-based supervision – development of new tools”, in the anniversary publication “Experiences and Challenges – 20 Years as an Integrated Supervisory Authority” of Kredittilsynet (the Financial Supervisory Authority of Norway).