Portfolio diversification is more important than ever despite its failure to offer protection against market moves during the financial crisis, says the deputy governor of Malaysia's central bank.

Speaking at AsianInvestor's Southeast Asian Institutional Investment Forum in Kuala Lumpur yesterday, Bank Negara Malaysia's Muhammad Bin Ibrahim highlighted the potential importance of moving into new asset classes. This is not something one might typically expect from a central banker, particularly one from a so-called emerging market.

The benefits of portfolio diversification have not been overstated, he says, despite the relatively low idiosyncratic risk as against systemic risk in times of high volatility and the correlation breakdowns between asset classes, especially at the height of the financial crisis.

In fact, the accelerated pace of reserves accumulation in the past decade, a low-yield environment in the G7 economies and changing trends in trade patterns and currency regimes necessitate a “rethinking on how reserves should be invested”, adds Muhammad.

Indeed, he says, the fast pace of reserves accumulation and low yields on G7 assets were the most compelling reasons for diversification in the quest for better risk-adjusted returns in asset classes such as emerging market debt, commodities and equities.

Bin Ibrahim also points to the raising of limits on foreign investment by institutional investors. Certainly, bodies such as Malaysia's Employee Provident Fund are boosting their overseas exposure.

Moreover, as institutions increasingly move into new asset classes, says Muhammad, they would increasingly need to enhance analytical capabilities, resources and risk controls.

One result of this realisation is the gradual move by many central banks and institutional investors away from over-reliance on credit-rating agencies towards an internally-based credit-rating assessment practice in portfolio management.

“In the wake of the US financial crisis and recent European sovereign issue,” he says, “one would question the credibility of credit-rating agencies in flagging the risks built up in banks and sovereigns ahead of the crisis.”

Most rating agencies also tend to apply ordinal ranking of credit, rather than specific risk metrics that can be mapped to default probabilities or expected losses, adds Muhammad.

“In my view, one of the major weaknesses of credit-rating agencies is their objective to establish rating stability by applying smoothing methodology that can potentially delay minor downgrades, but trigger cliff-like and abrupt downgrades in the event of sharp credit deterioration,” he says. “The abrupt regrading of credits tends to spook markets and is certainly not good for investors with a heart condition.”

He argues that central banks and major institutional investors in Asia were aware of such limitations, and suggested that the best way forward was to complement “ratings-embedded investment guidelines” with a more robust and rigorous internal credit risk evaluation framework.

Muhammad went on to discuss the growing focus on and support for Islamic finance in Malaysia. The most recent significant development, he says, has been the establishment of the International Islamic Liquidity Management Corporation in Kuala Lumpur.

The corporation will act as a conduit to issue highly rated short-term Islamic instruments to enhance cross-border liquidity management and provide Islamic financial institutions with an additional avenue to manage their short-term liquidity.

In addition, Bank Negara Malaysia has allocated a small portion of funds to be disbursed to prospective and existing Islamic fund management firms to invest primarily in foreign-currency sukuk.

This would, he says, provide a platform for fledgling fund managers to build track records and spur their growth of assets under management, besides broadening the sukuk market in Malaysia.