Reserve Bank of Australia Annual Report – 1994 Reserve Bank Earnings and Operations

Earnings

Profit maximisation is secondary to the Bank's monetary and banking policy objectives. The Bank does, however, earn substantial, but variable, profits in most years; these have amounted to more than $21 billion over the past decade. Increases in yields on domestic and foreign bonds resulted in below-average profits in 1993/94.

The Bank's profits comprise an “underlying” earnings component, and another component which reflects capital gains and losses on its holdings of securities and foreign exchange. Underlying earnings essentially reflect the margin between the interest received on assets and interest paid on liabilities, less operating expenses. The Bank's assets consist almost entirely of Commonwealth Government securities (CGS) and gold and foreign exchange (GFE), the foreign exchange component of which is mainly fixed-interest securities of foreign governments denominated in foreign currencies. The Bank's liabilities include the large volume of currency notes on issue, on which no interest is paid. Underlying earnings, therefore, depend mainly on the level of interest rates in Australia and abroad, and on the size of the Bank's balance sheet. These earnings, which are subject to relatively small fluctuations from one year to the next, amounted to $1,556 million in 1993/94.

Sources of Reserve Bank earnings

($ million)

	Underlying earnings	Realised gains & losses*	Net operating earnings
1984/85	1,122	819	1,941
1985/86	1,292	1,371	2,663
1986/87	1,412	2,035	3,447
1987/88	1,508	18	1,526
1988/89	971	−554	417
1989/90	1,248	−153	1,095
1990/91	1,322	391	1,713
1991/92	1,516	1,038	2,554
1992/93	1,760	2,803	4,563
1993/94	1,556	−48	1,508
Average	1,371	772	2,143
* Charges to earnings in 1993/94 (and to provisions in the three years to 1989/90), when market values of investments and/or foreign exchange holdings fell below cost, are recorded here as capital losses

The other component of profits is subject to wide fluctuations, being dependent on movements in interest rates and exchange rates. Gains (and losses) can arise in one of two ways. First, the capital values of domestic and foreign securities in the Bank's portfolio will change as interest rates change. When interest rates fall, for example, the value of securities in the Bank's portfolio rises, and vice versa. The recent sharp rise in bond yields in Australia and abroad resulted in substantial capital losses on the bond portfolio in 1993/94, mainly in respect of domestic bonds. Losses on domestic bonds are difficult to avoid for the Bank, as it is obliged to give primacy in its market operations to its monetary policy objectives. Moreover, any attempt by the Bank to make large shifts in its portfolio to reduce potential losses would be very disruptive to markets, given the size of its portfolio.

In line with normal accounting practice, capital gains and losses are reflected, in the first instance, in the appropriate asset revaluation reserve but, as securities are sold, the gains or losses are realised. Realised losses for the year on the bond portfolio totalled $29 million. In addition, unrealised losses were such as to push the asset revaluation reserve into deficit; this was extinguished by a charge against 1993/94 earnings of $676 million (representing the write-down of investments to a market value below cost). Although sizeable, the losses incurred by the Bank on its bond portfolio over the past year were much less in absolute terms than the gains of $1,564 million which were realised in the preceding two years when yields fell.

The second way in which realised gains and losses can occur is through changes in the Australian-dollar value of foreign-currency denominated securities held in official reserve assets, as a consequence of exchange rate changes. If, for example, the Australian dollar falls against the currency in which securities are denominated, the value of those holdings in Australian dollars rises. Exchange rate gains and losses are realised when official reserve assets are sold. In 1993/94, realised foreign exchange gains totalled $657 million – still substantial, but well down on the record gains of $1,985 million in the previous year. This change mainly reflected the fact that, against the background of a generally stronger and steadier Australian dollar, the Bank sold smaller amounts of foreign exchange during the past year.

Taken together, the capital losses on the bond portfolio and the realised foreign exchange gains produced a net capital loss for the year of $48 million. This brought the Bank's total net operating earnings for 1993/94 to $1,508 million, well down on the exceptional result of $4,563 million achieved in the previous year.

The Bank's profits are paid to the Commonwealth Government, as its owner. In line with international practice, profits are paid as a revenue item to the Commonwealth Budget, after any transfers that might be made to various reserve funds which the Bank maintains to deal with certain contingencies. In the event, these reserves were built up in recent years to the point where, with the transfers made from the exceptional earnings in 1992/93, they have remained at the target levels established by the Board and no further transfers from 1993/94 earnings were required for that purpose. The amount of the interim payment to be made to the Government out of the Bank's current year earnings is a matter for determination during the course of 1994/95.

Reserve Bank profits and payments to Government
($million)

The Bank has little control over the external factors which can influence its earnings but it does have direct managerial control over some of its revenues and costs, including through:

• the way it manages its portfolio of financial assets;
• the terms on which it provides services to its customers; and
• the controls it exercises over its operating costs.

Management of financial assets

(a) General considerations The Bank has a portfolio of financial assets of some $29 billion, in which it transacts to implement monetary policy. It has, for the reasons mentioned earlier, only limited discretion over the composition and duration of its holdings of domestic securities. In overseas markets, while the Bank is careful not to be disruptive, it is essentially one of many investors and has greater discretion in managing its holdings of assets. This consideration is relevant in determining the split of the overall portfolio between domestic and foreign assets. In a climate of rising bond yields, for example, losses on a portfolio weighted to foreign assets, on which there is scope to shorten duration, will be more controllable than those on a portfolio weighted to domestic securities.

The distribution of the portfolio between domestic and foreign assets is influenced by the market operations the Bank undertakes in pursuit of its monetary policy objectives. It has some scope, however, to adjust the composition of its portfolio, independently of the effect of those market operations, through the use of foreign exchange swaps. The Bank has made greater use of swaps in recent years to sterilise its foreign exchange intervention. Rather than deliver immediately the foreign exchange it had sold through foreign exchange intervention, the Bank has chosen to fund some of that intervention by acquiring foreign exchange through the swap market. This has had benefits for both portfolio management (since it allowed the Bank to maintain a more balanced portfolio between CGS and foreign exchange) and the efficient management of domestic liquidity conditions (as the depth of the swap market sometimes makes it a more efficient means of influencing liquidity).

At 30 June 1993, the Bank had net swaps outstanding as a result of previous intervention – under which it was committed to deliver foreign exchange – of about $8.5 billion. The bulk of these swaps was rolled forward during 1993/94 as they matured. The more limited intervention undertaken during 1993/94 was also funded through the swap market. Additionally, the Bank undertook about $1 billion of foreign currency swaps in connection with domestic liquidity management, unrelated to foreign exchange intervention. As a result, net swaps outstanding at 30 June 1994 amounted to $10.8 billion. Swaps do not entail any foreign exchange risk as the exchange rate is set at the time the transaction is entered into.

These swap transactions allowed the Bank to avoid a further reduction in its holdings of foreign exchange and a corresponding increase in its holdings of CGS. At the end of the year, the Bank held $15.7 billion of foreign exchange assets and $13.1 billion of CGS. By avoiding a shift from foreign currency assets to CGS, the capital losses associated with rises in bond yields in Australia (which were larger than rises in overseas bond yields) were lower than they would otherwise have been.

In 1993/94, the Bank achieved returns (on a marked-to-market basis) of 4 per cent on its foreign portfolio and 0.5 per cent on the domestic portfolio (where the substantial capital losses resulting from rising bond yields offset much of the interest income received on the bonds). During the first half of the year, when bond yields were falling, the Bank acted to reduce the exposure of the domestic portfolio to a rise in domestic bond yields. These actions helped to reduce losses in the second half of the year.

(b) Management of international reserves In its management of international reserves, the Bank invests only in liquid assets issued by borrowers of the highest credit standing. At the same time, it has managed this portfolio more actively in recent years with the aim of enhancing returns. This more active management involves:

• changes in the currency composition of assets, to take advantage of expected exchange rate movements;
• changes in asset allocation, to take advantage of differences in expected rates of return among the major markets (the use of foreign currency swaps and forward transactions makes possible the separation of decisions about currency composition and asset allocation);
• managing the duration of individual portfolios to take advantage of, or hedge against, expected movements in the yield curve; and
• trading to take advantage of anomalies in the yield curve.

The Bank holds assets in US dollars, yen and European currencies, mainly the German mark but also small holdings of sterling and guilder. In the past year, the Bank began trading in interest rate futures contracts on offshore exchanges to augment its hedging activities. The benefit of futures is that they can be a more efficient and low-cost way of hedging against exposures than is available in cash markets.

Returns on foreign reserves are measured against a set of benchmarks designed to reflect the investment objectives of the Bank, which emphasise a high degree of liquidity and security in holdings of foreign assets. The benchmarks include the full range of assets which the Bank has deemed as eligible investments, so that returns relative to the benchmark could not be enhanced by, say, acquiring assets of a lower credit standard than those specified. Performance against the benchmark essentially measures the extent to which the Bank takes positions which correctly anticipate movements in yields and exchange rates. To outperform the benchmark, the Bank must deviate from the benchmark portfolios through, for example, acquiring assets of longer or shorter duration than specified. This, of course, also opens up the possibility of underperforming the benchmark. To limit that risk, the extent to which the Bank deviates from the benchmarks is limited to certain bands, which apply both to the duration of individual portfolios and the currency and asset composition of the overall portfolio.

The bands for duration were widened on the lower side during the past year, to allow greater scope to hedge the portfolio by shortening duration. The lower limit, which used to be six months below the benchmark, was reduced to zero duration for all three currency portfolios. The upper limit remains six months above the benchmark for each portfolio. The risk parameters of the benchmark portfolios are summarised in the table below.

Benchmark parameters

During the year, the Bank commissioned an external review of its benchmarks, with the aim of ensuring that the Bank's approach conforms with best practice; this review is expected to be completed early in 1994/95.

The Bank assesses investment performance on foreign reserves in Special Drawing Rights (SDRs), a unit of account which reflects average values of major currencies. During 1993/94, the return on holdings of foreign currency assets, measured in SDRs, was 4.0 per cent, a little above the return on the benchmark portfolio of 3.8 per cent. The difference, which represents the contribution from active management, was equivalent to $31 million and came mainly from the management of assets, with currency management making only a small contribution.

Early in the year, the Bank was long relative to the benchmark on duration of all portfolios. It also had an overweight position in German securities. This proved profitable as yields fell in all countries, but particularly in Germany. The Bank moved short of benchmark duration in US assets when US bond yields started to rise in October, and overweight in its exposure to the US dollar relative to the currency benchmark. These positions also proved profitable. In the March quarter, however, the Bank underestimated the rise in bond yields, especially in Germany, and did not foresee the fall of the US dollar against other major currencies; this resulted in losses which offset some of the earlier gains. The Bank moved short of the benchmark duration in all three portfolios during the June quarter, in line with the common view that hedging of interest rate risk was prudent in the light of recent volatility in bond markets. It also moved back to benchmark weightings for currency and asset composition, given the uncertain climate in financial markets. Late in the quarter, following a further rise in German yields and some fall in Japanese yields, the Bank increased its position in German securities and reduced its exposure to Japanese securities.

The past year was more difficult from an investment point of view than other recent years, given the sharp changes in exchange rates among the three major currencies and the rise in bond yields in all countries in the second half of the year. Consequently, while the return during 1993/94 was above benchmark, the excess was less than in the previous two years.

Amount by which actual returns exceeded benchmark

($A million)

	Asset management (including duration and trading)	Currency management	Total
1991/92*	165	n.a	165
1992/93	264	156	420
1993/94	27	4	31
* In 1991/92, the Bank did not have benchmarks for currency composition or asset allocation.

(c) Gold The Bank holds approximately 250 tonnes of gold as part of Australia's official reserve assets, with a value of around $4.2 billion at 30 June 1994. The Bank continued to expand its gold lending activities in 1993/94, increasing the volume of gold on loan (fully secured) to 48.8 tonnes at the end of the year, and the number of counterparties to ten. Earnings from these loans amounted to $5.2 million in 1993/94, a fall of $0.4 million from the previous year which reflected lower market interest rates on gold lending.

Customer services

The Bank provides banking, registry and settlement, note issue and cash distribution services through its network of capital-city branches. It seeks to cover the costs of providing banking, registry and some specialised cash distribution services through fees and charges. It does not charge for note issue which, by its nature, generates substantial profit to the Bank; nor does it charge for cash processing and wholesale note distribution, which are regarded as public goods.

In response to technological changes and competitive pressures, the Bank has devoted considerable effort to improving the quality of its customer services. It has invested heavily in electronic data processing, implemented best practice work methods and introduced a program of benchmarking with comparable organisations to assess performance. These initiatives have allowed the Bank to realise significant cost savings and to handle growing business volumes with diminishing staff numbers.

(a) Banking services Specialised banking services are provided to the Commonwealth Government, several State Governments and government instrumentalities, and a number of overseas official institutions. The principal customer is the Commonwealth Government and its departments; the Reserve Bank Act provides that the Bank shall, in so far as the Commonwealth requires it to do so, act as its banker and financial agent. In addition to operating their bank accounts, the Bank works closely with its major clients to improve their cash management, particularly their payment and revenue collection systems. It is continuing to develop and install electronic banking services designed to increase the efficiency and cost-effectiveness of payments by the Commonwealth. Despite a further rise in volumes of transactions processed in 1993/94, the Bank was able to reduce its charges for banking services provided to the Commonwealth by around 11 per cent.

In common with the general trend, the Bank's processing continues to move from paper-based to electronic transactions. During 1993/94, it processed some 52 million paper-based transactions, compared with 57 million in 1992/93. Electronic banking transactions, on the other hand, expanded. The Bank's Government Direct Entry System (GDES), which gathers data from various government agencies and sorts and electronically distributes payments to a wide range of financial institutions, processed 187 million transactions during 1993/94, compared with 174 million in 1992/93. The Bank's electronic processing systems were streamlined by merging the existing direct entry system with GDES, and by giving GDES the capacity to handle debit transactions. In 1993/94, the Bank processed approximately 50 per cent of all bulk electronic credit payments exchanged among financial institutions in Australia.

A total of 71 customers now uses the Bank's PC-based desk-top banking package, ReserveLink, compared with 40 in 1992/93. ReserveLink is designed to meet the specialised needs of the Bank's customers and allows them to perform a range of banking- related tasks from their own offices.

During 1993/94, the Bank was appointed “Banker to Issue” for the public sale of CSL Limited, formerly the Commonwealth Serum Laboratories. In this role, it provided a range of banking facilities, including the clearance of payments through the banking system for credit to the Commonwealth Public Account. The Bank's Financial EDI (electronic data interchange) pilot project was implemented during the year, allowing some Commonwealth departments to settle commercial transactions with customers of the Commonwealth Bank of Australia. The Department of Finance also uses the system to facilitate Commonwealth inter-agency payments and disbursements from the Commonwealth to the States.

(b) Registry and settlement services The Bank's branches provide registry services for the Commonwealth Government, borrowing authorities of the Governments of New South Wales, South Australia and Western Australia and a number of other local and foreign official organisations. These services include the issue of securities, payment of interest, maintenance of ownership records and redemption of securities at maturity.

Further steps were taken during 1993/94 to streamline registry processing, including the centralisation of more activities in Sydney. These steps followed the introduction of electronic settlement services for Commonwealth Government securities (CGS), technological change more generally in registries, and the winding-down of the remaining series of Australian Savings Bonds. The changes helped to boost efficiency and reduce costs. The cost of conducting registry services for the Commonwealth Government, for example, fell by more than 10 per cent in 1993/94. Membership of the Reserve Bank Information and Transfer System (RITS) has grown steadily since it was introduced in August 1991 and 150 organisations are using this system to settle electronically their transactions in CGS. Securities to the value of $68 billion are now lodged in the system, which handles around 95 per cent of turnover in the professional market.

RITS provides a number of other services to members. It automatically pays interest and maturity proceeds associated with securities held in the system; it allows members to make high-value loans secured by mortgage over securities in RITS; and it enables those members with accounts at the Bank to make high-value payments unrelated to transactions in CGS. In 1993/94, RITS handled over 100,000 high-value loans/payments. In October, a facility was added to RITS to permit members to lodge bids at tenders for CGS, rather than deposit them by hand into tender boxes at the Bank. This facility allows both members to lodge bids closer to the tender cut-off time and the Bank to process the bids and announce the result more quickly. Almost all bids are now lodged electronically on RITS; members use the system to take delivery electronically of securities won at tender. Work has commenced on incorporating Treasury Capital Indexed Bonds into RITS.

(c) Note issue and cash distribution In 1993/94 the value of notes on issue grew by 7.4 per cent, a little less than in the preceding year; the trend towards increased use of higher denomination notes continued.

Value of notes on issue
($ million)

The Bank has developed performance benchmarks as targets for more efficient work practices in its currency operations. Its goal is to achieve international best practice in such areas, and data suggest that, in high-speed note processing, the Bank's productivity is close to that of central banks using comparable equipment. Cash services have been improved by substantially reducing lead times for ordering currency notes, and by more flexible procedures.

New note series

The new $10 note was issued in November 1993, the second in the series of polymer notes. The move from paper to polymer notes has a number of benefits, particularly greater security against counterfeiting, which is on the increase (albeit from a low base). Polymer notes also last at least three times as long as their paper counterparts, which is a source of significant cost savings.

The Bank has been liaising with various community, business and special interest groups on experiences following the change to polymer. Feedback generally suggests that while some people still do not like polymer notes, the $10 note was seen as an improvement on the $5 note issued in 1992. The improved texture of the $10 note has assisted cash-handlers, and this change has been carried over to newly issued $5 notes. The Bank is continuing its efforts to develop a polymer substrate which folds and unfolds more readily. It is also looking to modify the colouration of the $5 note to help those who have experienced difficulties in differentiating it from the $10 note.

A new $20 polymer note is planned for release later in 1994. It will have the same basic red colouring as the paper $20 and will feature Mary Reibey, a successful Australian businesswoman of the last century, and John Flynn, the founder of the Royal Flying Doctor Service.

The Bank's administration and budget

(a) Staffing Staff structures and numbers have continued to adapt to the Bank's changing responsibilities and its pursuit of improved productivity. In particular, a new group under the Assistant Governor (Corporate Services) was established to draw together the Bank's various “corporate” (or internal support) services, such as accounting, property management, information technology and other administrative services. At the same time, the provision of banking and other services to external customers has been brought together under the retitled Assistant Governor (Business Services). In the process, Personnel Policy and Secretary's Departments have been freed of many of the support functions they have provided in the past. The new Personnel Policy Department will concentrate on strategic and policy issues, and the new Secretary's Department on servicing the Bank's Board, and providing information and legal services.

Staff numbers (excluding Note Printing Australia) fell a further 7 per cent in 1993/94, continuing the trend evident over the past decade. About half of the decline last year was achieved through natural attrition, which was supplemented by a program of voluntary redundancy offers (VROs); about 100 staff left during the year under this program and a similar number is expected to depart in the first half of 1994/95.

Staff numbers

End June	Head Office	Branches	Total excl. NPA	NPA
1970	997	1,647	2,644	838
1980	1,154	1,865	3,019	629
1983	1,243	1,931	3,174	653
1984	1,183	1,900	3,083	625
1985	1,175	1,839	3,014	585
1986	1,225	1,828	3,053	565
1987	1,152	1,726	2,878	552
1988	1,083	1,573	2,656	516
1989	1,015	1,286	2,301	487
1990	1,043	1,255	2,298	278
1991	1,012	1,197	2,209	283
1992	943	1,033	1,976	273
1993	913	935	1,848	273
1994	913	800	1,713	272

Part of the near halving of staff numbers over the past decade reflects the abolition or winding-down of some earlier Bank functions. Of more importance, however, have been the productivity gains flowing from greater use of technology (large-scale computer applications such as GDES and RITS, in particular, have produced significant savings in clerical and processing areas), and active husbandry of staff resources in a climate of greater public accountability and increased competition for certain banking services. The same pressures continue to put a premium on upgrading the skills of staff and in 1993/94 the Bank spent the equivalent of 5 per cent of its salary bill on staff training (Training Guarantee Levy basis). Productivity bargaining and performance pay arrangements are also contributing to improved work practices, which now include more flexible working arrangements.

(b) Operating costs The Bank's “underlying” operating costs (which exclude the lumpy expenditures on VROs) have increased by a total of 6 per cent over the five years since 1988/89. This represents a sharp reduction in real terms.

Operating costs
($ million)

The “output” of bodies like central banks is inherently difficult to quantify, but such indicators as can be constructed for certain parts of the Bank suggest some strong productivity gains over the past five years. The accompanying table presents some rough measures of output in the banking and registry areas, and in market transactions; the latter measures, of course, say nothing about the effectiveness of such dealing. The largest gain is shown in respect of banking transactions, where the introduction of direct-entry processing through GDES has been the main factor.

Indicators of output

(Percentage change from 1988/89 to 1993/94)

Banking and registries
Banking transactions (incl. GDES)	220
Bank accounts maintained	60
Registry transactions (incl. RITS)	60
Transactions in domestic and foreign markets
Foreign exchange transactions	30
Transactions in foreign government securities	130
Domestic market operations	70

Cost containment has been a key priority in the provision of customer services, particularly where the Bank competes with private-sector suppliers. The principles on which public sector entities should engage in such competition were articulated in the Report of the Independent Committee of Enquiry on National Competition Policy (the Hilmer Report), and were endorsed by the Council of Australian Governments in February 1994. To avoid any competitive advantage by virtue of their ownership, the Report recommends, inter alia, that public sector entities should price their services to ensure full cost recovery. The Bank has been working towards that objective in its business areas for some time; pricing of most services now meets the test and in the remaining areas substantial progress has been made towards full cost recovery. As part of this process, the Bank has refined its costing methodology to ensure that all relevant costs are taken into account. Fees and charges for banking, registry and specialised cash services are reviewed regularly and are adjusted as necessary.

In its internal corporate services, the Bank is also developing appropriate benchmarks that will encourage best practice. One area where this process is well under way is property management. The Bank owns premises in each State and Territory capital and, as a result of continued decreases in staff numbers, a significant volume of spare office space is now let, or available for letting, to commercial tenants. The Bank's property management was the subject of a “project audit” by the Auditor-General in 1993/94 and, in line with the recommendations in that report, the Bank has taken steps to improve its professionalism and accountability in this area, including through the development of a strategic property plan, better budgeting and management accounting systems and benchmarking.