Reserve Bank of Australia Annual Report – 2005 Risk Management

Objectives and Governance Structure

The Reserve Bank encounters a range of risks in fulfilling its responsibilities. The largest of these, in financial terms, flow from its market operations and the holding of assets needed to underpin those operations. There are also various operational risks that affect all parts of the organisation to differing degrees; these vary from personnel and information-management issues, which may be specific to individual areas, to events such as the loss of access to Head Office, which would affect the whole organisation.

The Reserve Bank cannot eliminate all the risks it faces. Rather, it manages these risks with a view to containing them to levels that are consistent with the satisfactory fulfilment of its public policy responsibilities. Underlying this approach is the principle that risk management is an integral part of the management function in the organisation. As such, the prime responsibility for controlling and mitigating risk on a day-to-day basis rests with line management of the respective functional areas.

These arrangements for risk management are overseen by a Risk Management Committee, which comprises the Deputy Governor, who is Chairman; the Assistant Governors of Financial Markets, Business Services and Corporate Services; the Heads of Audit and Risk Management; and the Bank's General Counsel and Deputy Secretary. The Committee is mainly responsible for ensuring that the full spectrum of non-policy risks – particularly those that extend over more than one functional area – are managed properly across the organisation. The Committee meets at least quarterly and keeps the Audit Committee apprised of its activities; it makes a formal report to the Reserve Bank Board annually.

Assisting the Risk Management Committee in its work is a small Risk Management Unit. Besides this role, the main tasks of the Unit are to facilitate, co-ordinate and advise on the risk-management process, to help Groups and Departments manage their risk environment in a manner that is broadly consistent across the organisation. Although the Unit remains separate from Audit Department, risk-management work in the two areas is closely co-ordinated. More generally, the internal-audit process supports the overall risk management strategy by providing independent assurance on the Reserve Bank's risk management and control systems. Audit Department reports directly to the Audit Committee, which meets quarterly (see the chapter on ‘The Reserve Bank Board and Governance’).

The sections below describe the various risks, and the associated management practices, in more detail.

Balance Sheet Risks

The Reserve Bank is exposed to three main risks related to its balance sheet, namely credit risk, interest rate risk and exchange rate risk. The primary responsibility for managing these risks lies with Financial Markets Group. A comprehensive framework of controls is in place to ensure that these risks are managed in accordance with the objectives and guidelines approved by the Governor and the Board. This framework includes a clearly defined and documented delegation structure, detailed procedures manuals, a well-defined benchmark for the foreign reserves portfolio, and limits on open positions and counterparty exposures. Compliance with the control framework is reported daily to senior management, including to the Assistant Governor (Financial Markets) and Head of the Risk Management Unit.

Credit Risk

Credit risk is the potential for financial loss arising from the default of a debtor or issuer. For the Reserve Bank, credit risk arises from exposure to the issuers of securities held as assets, the banks with which funds have been deposited and the counterparties with which transactions have been undertaken. By confining its dealings to highly creditworthy counterparties and by holding only highly rated securities, the Reserve Bank's overall credit exposure is low in comparison with that of a typical private financial institution. Details of credit exposures are given in Note 18 to the Financial Statements.

In the case of the Reserve Bank's foreign currency portfolio, credit risk is limited by investing primarily in securities issued by the US, German, French and Japanese governments. These securities have Aaa credit ratings, apart from those issued by the Japanese government, which are rated Aa2. The credit risk on foreign currency deposits is managed by placing deposits only with banks with a high credit rating (a short-term rating of P-1 and a long-term rating of Aa3 or above) and by imposing limits on the amount that can be deposited with each bank.

As noted in the chapter on ‘International Financial Co-operation’, during 2004/05 the Reserve Bank invested in the second phase of the Asian Bond Fund initiative (ABF2), following its earlier investment in ABF1. While the ABF2 portfolio includes securities of lower credit rating than those otherwise held as foreign reserves, the average credit rating of the investment is still relatively high, at A2. Also, the ABF investments represent only a small portion of foreign currency reserves.

Within the domestic portfolio, as noted in the chapter on ‘Operations in Financial Markets’, the ongoing consolidation of the market for CGS has seen the Reserve Bank broaden its holdings of other securities. The range of securities eligible for domestic repurchase agreement transactions was widened to include bank bills and CDs in March 2004; holdings of these securities grew to $4.7 billion as at June 2005, from $4.1 billion a year earlier. Holdings under repo of State government paper have also increased, while holdings of CGS under repo are little changed.

In addition to the broadening of repo collateral, the range of securities held outright now includes securities of State and Territory central borrowing authorities. The Reserve Bank currently holds about $1.3 billion of semi-government securities on an outright basis, all of which are rated Aa1 or higher. Outright holdings of CGS have continued to decline.

The Reserve Bank may deal with a counterparty across a variety of financial products and the exposure to a given counterparty is measured so as to capture all transactions with that party. For the foreign currency portfolio, a single limit on the absolute exposure to each counterparty is imposed, in accordance with the institution's financial strength, credit rating and the size of its capital base. Counterparty limits are reviewed on a regular basis and adjusted immediately following changes to credit ratings.

The Reserve Bank also has some credit exposure arising from its repurchase operations in both the domestic and foreign portfolios. A loss would arise if a counterparty failed to repurchase securities it had sold to the Reserve Bank and the market value of these securities had fallen to less than the value of the cash consideration. This risk is managed by requiring that the initial position be over-collateralised, the collateral be revalued daily and that counterparties supply additional securities once the market value of the collateral falls below the required amount. Credit exposure on foreign repurchase agreements is further controlled by imposing limits on individual counterparty exposures.

Delivery-versus-payment for domestic and foreign securities transactions eliminates intraday settlement risk for outright transactions and repurchase agreements. However, settlement risk on foreign exchange transactions still arises because the two legs of the foreign exchange transaction are settled in different time zones, requiring the Reserve Bank to pay out funds well before it receives any funds in return. This risk is controlled by restricting foreign exchange transactions to certain counterparties and by imposing a limit on the total value of foreign currency transactions allowed to settle on a given day with those counterparties.

Interest Rate Risk

The Reserve Bank's assets are mainly financial assets, such as domestic and foreign fixed-income securities. The value of these assets is subject to movements in domestic and foreign market yields. Since the income stream from these securities is fixed, a rise in market yields results in a fall in the value of these securities. Securities that have a longer maturity (or duration) contain a greater degree of interest rate risk, as cashflows further in the future are more sensitive to discounting than are near-term cashflows.

Around one-quarter of the Reserve Bank's assets are invested in domestic securities. Of these, a large portion is invested in relatively short-term repurchase agreements, with the result that interest rate risk on domestic assets is quite small. Furthermore, the overall exposure to a change in domestic interest rates is reduced by the presence of liabilities that also pay a domestic short-term interest rate, as these provide an offset. During the past year, the purchase of longer-term holdings of semi-government securities saw some rise in the interest rate risk on the domestic portfolio, but this risk nonetheless remains low by historical standards.

The overall level of interest-rate risk on foreign assets, measured by the duration of the foreign currency portfolio, has been set at 30 months, a level that meets the Reserve Bank's long-term risk and return preferences.

Across the balance sheet, including domestic and foreign assets, the Reserve Bank would suffer a capital loss of about $800 million if interest rates in Australia and abroad were to rise uniformly by 1 percentage point.

Exchange Rate Risk

As the holder of Australia's reserve assets, the Reserve Bank is required to maintain a portfolio of foreign currency assets. These are exposed to exchange rate risk as their value, when measured in Australian dollars, varies with movements in the exchange rate between the currency in which the assets are denominated and the Australian dollar.

Holdings of foreign currency are largely determined by intervention operations and cannot be separately managed. If carried out effectively, however, intervention operations themselves serve to mitigate the level of exchange rate risk (even though that is not their main purpose). This is because they involve selling foreign exchange when the Australian dollar is undervalued, so foreign exchange risk on the balance sheet tends to be lowest when the exchange rate is relatively low and therefore most likely to appreciate.

The risks in holding foreign currency are also reduced by diversifying holdings across three currencies. Forty-five per cent of foreign exchange is held in the US dollar, 45 per cent is held in the euro and 10 per cent is held in the Japanese yen. The benefit, in terms of risk reduction, from this diversification is illustrated by the fact that over the past four years the US dollar has depreciated by 34 per cent against the Australian dollar, whereas the basket of currencies held in the portfolio depreciated by only 20 per cent against the Australian dollar.

A portion of foreign assets is held under foreign exchange swap agreements. These do not expose the Reserve Bank to exchange rate risk because, at the time the foreign exchange is acquired, an exchange rate for the reversal on a future date is agreed.

As noted, the level of foreign currency risk varies over time. Currently, the level of risk is above average as reserve holdings are in the upper end of their historical range. A 10 per cent rise in the Australian dollar (on a weighted average basis against the three currencies in the portfolio) would at present result in valuation losses of a little over $2 billion.

Operational Risk

While all parts of the Reserve Bank are exposed to operational risks of varying degrees, the most significant are those associated with carrying out the market operations and supplying banking and settlement services to clients and to the market as a whole. Significant operational risks can also arise from the mishandling of sensitive information, as this can cause financial loss or damage to the organisation's reputation.

Operational risk in Financial Markets Group arises from the large volume of transactions undertaken in markets each day. Around 51,000 transactions were undertaken in 2004/05, with average daily settlement flows of around $22 billion. These risks are managed by having systems and processes that are efficient and robust. A new financial markets trading and settlement system is currently being installed to replace a number of existing systems and put all dealing functionality and risk controls onto an integrated platform. Foreign exchange operations were shifted onto the new platform during the past year and domestic operations will migrate in the coming year.

A significant risk facing any financial institution is that staff may undertake unauthorised transactions and expose it to financial loss or reputational damage. This risk tends to be smaller for the Reserve Bank than other financial institutions because of the specialised and relatively narrow nature of its operations, and because staff incentive structures do not encourage the undertaking of these risks. Nonetheless, the Reserve Bank has put in place a number of measures to control these risks, including a clear decision-making hierarchy, with all staff involved in financial dealing having limits to their authority to take on risk; controls in the computer systems to prevent unauthorised dealing; separation between those who initiate transactions and those who settle them; an independent middle office to monitor compliance; and a strong internal-audit function.

Operational risks involved in providing services to clients or market participants are especially significant for the Reserve Bank because a failure could have widespread consequences. The Reserve Bank is the main banker for a number of government agencies, and processes on average about 270 million transactions a year, including all Australian Taxation Office, Health Insurance Commission and Centrelink payments. It also provides real-time interbank payment and settlement services through RITS, which typically involve processing about 23,500 payment instructions per day, for an average daily value of $140 billion. It is important that these functions be carried out not only efficiently but also with complete reliability. Back-up capacity and plans for business resumption in the event of a loss of access to premises or IT systems are therefore vital, and a major program is under way to strengthen these capacities. As part of this, the Reserve Bank plans to build a new self-contained back-up site in Sydney, housing computer systems and able to accommodate all staff necessary for maintaining core services. This will require substantial investment over the next couple of years.