Reserve Bank of Australia Annual Report – 2008 Risk Management

Objectives and Governance Structure

In carrying out its responsibilities, the Reserve Bank faces a range of risks, the most significant of which, in terms of potential financial impact, flow directly from its operations in financial markets and the assets it must hold to support these operations. The Bank also faces significant operational risks, as it provides high-volume banking and settlement services to its customers and the financial system. In addition, security risks, both IT and physical, arise because of the sensitive nature of information with which the Bank deals, the fact that communications with the financial system, businesses and the community is of strategic importance to the Bank, and because of the valuable physical assets it holds. Operating risks vary from the potential loss of key infrastructure, either temporarily or for an extended period, to the possibility of fraud or other unethical behaviour on the part of employees.

The Reserve Bank works to contain the risks it faces to levels that are consistent with meeting its policy and operational objectives, while maintaining the confidence of its customers, counterparties, the Government and the community more generally that it is equipped to carry out its responsibilities to the high standard expected. The framework the Bank has established for managing risk at the strategic level involves assessing risks and monitoring and reviewing controls to ensure that threats are contained to acceptable levels. Underpinning this approach is the principle that risk management remains an integral part of the job of line managers themselves. As such, the prime responsibility for controlling and mitigating risks on a day-to-day basis rests with managers of the various business areas within the organisation. More generally, management also promotes a culture that emphasises the careful analysis and control of risk throughout the Bank.

Arrangements for risk management in the Reserve Bank are overseen by the Risk Management Committee (RMC), which is chaired by the Deputy Governor and comprises the Assistant Governors for Banking & Payments, Corporate Services, Currency and Financial Markets; the Chief Financial Officer; the Heads of Audit and Risk Management; and the General Counsel and Deputy Secretary. Reflecting changes to the organisational structure, membership of the RMC was expanded during 2007/08 to include the Assistant Governor of the Banking & Payments Group and the Chief Financial Officer. The RMC is responsible for ensuring that the full spectrum of non-policy risks is properly assessed and managed across the Bank. It meets as needed, but at least once every three months, and keeps the Audit Committee of the Reserve Bank Board advised of its activities.

The RMC is assisted in carrying out its responsibilities by the Risk Management Unit (RMU), whose main role is to help different areas of the Reserve Bank manage their risk environment within a broadly consistent framework across the Bank. The Audit Department complements and co-ordinates closely with – but remains separate from – the RMU. In addition to providing assurance that the Bank's risk management policies are effective, the Audit Department also has a separate, independent brief to test the adequacy of procedures and controls at all levels of the Bank.

Since it was established in 2003, the RMU has operated as a stand-alone unit with a direct reporting line to the RMC. The role and structure of the RMU was reviewed over the course of 2007/08 to determine the extent to which it was meeting the expectations and needs of business areas of the Reserve Bank. Several changes were made as a result. Principal among them was an expansion of the responsibilities of the RMU to include the middle office function associated with the Bank's operations in financial markets. This function had previously been located in the Financial Markets Group. The purpose of the relocation was to lift the point at which the front and middle office reporting lines come together to the level of the RMC. At the same time, the RMU was aligned with the Reserve Bank's broader financial control function to ensure that the risks affecting the Bank's financial position are fully monitored.

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

Operational Risk

All parts of the Reserve Bank are exposed to operational risks of varying degrees. The most significant are those associated with carrying out market operations and supplying banking and settlement services to the Bank's clients and the market as a whole. There would also be potential for significant financial loss or damage to the Bank's reputation if sensitive information was mishandled.

A significant risk common to almost all financial institutions is the threat of loss or damage to reputation from unauthorised transactions by staff. The Reserve Bank controls this risk in a number of ways, including by having a clear decision-making hierarchy; controls over access to computer systems; and separation of staff who initiate transactions from those who settle them. Independence of the middle office, to monitor compliance with trading and investment guidelines and provide reports on risk exposures, is a further key control. This was strengthened during the year by the relocation of the middle office to the RMU.

Operational risk in the Financial Markets Group arises from the large volume of transactions undertaken in markets each day. Around 80,000 transactions were undertaken in 2007/08, with daily settlement flows averaging around $43 billion. These risks are managed by ensuring that systems and processes are efficient and robust. Consistent with this, in 2007/08 the Reserve Bank commissioned an external review of the processes and controls underpinning its financial markets trading system. The purpose of the review was to identify any shortcomings that could give rise to fraud-related trading losses similar to those that emerged in several high-profile financial institutions in recent years. The review, which was undertaken in October 2007, found no major weakness in the system, indicating that the controls were consistent with broad industry practice.

A significant part of the Reserve Bank's operations is also involved in providing services to clients or the market as a whole. The Reserve Bank is the main banker for a number of government agencies, and processes around 280 million transactions a year on their behalf. It also provides real-time interbank payment and settlement services through RITS, which typically involves processing about 31,000 payment instructions per day, for an average daily value of $194 billion.

It is important that these functions be carried out efficiently and reliably. The Reserve Bank has extensive plans and back-up capacity for business continuity in the event that access to Head Office facilities or IT systems is lost. These were enhanced in July 2007 when the Bank commissioned its self-contained business resumption site. Several of the Reserve Bank's operational areas have staff based permanently at the site to ensure that critical functions can be maintained if access to Head Office is lost. Other business areas in the Reserve Bank regularly test their back-up arrangements at the site.

Portfolio Risks

The Reserve Bank's balance sheet is subject to a number of risks, including exchange rate risk, interest rate risk and credit risk. The Portfolio Risk and Compliance Section, as part of the RMU, has primary responsibility for monitoring these risks within the parameters defined by the Governor. The framework used in the day-to-day control and mitigation of these risks includes position and counterparty limits, formal delegations and market benchmarks. Compliance with the control framework is reported daily to both the Assistant Governor (Financial Markets) and Head of Risk Management. Performance and risk on the Reserve Bank's financial assets are also reported daily to senior management.

Exchange Rate Risk

Foreign currency assets are held by the Reserve Bank to support intervention operations in the Australian dollar market. As a result, the level of foreign currency exposure is determined on policy grounds and the resulting exchange rate risk cannot be separately hedged. The value of foreign currency assets (when measured in Australian dollars) varies with changes in the Australian dollar exchange rate against the currencies in which the assets are denominated. An appreciation of the Australian dollar relative to these currencies will result in a decline in the Australian dollar value of the foreign currency assets. The larger the size of foreign exchange assets, the greater the potential loss from an exchange rate appreciation.

Diversification of foreign currency assets across three currencies mitigates exchange rate risk somewhat. The exchange rate risk on a portfolio invested across a basket of currencies is lower than the risk on a portfolio of the same size invested in only one currency. For example, over the past five years the Australian dollar has appreciated by 45 per cent against the US dollar, but by only 5 per cent against the euro and 30 per cent against the yen. Against a basket of currencies in the Reserve Bank's foreign portfolio, which includes 45 per cent in the US dollar, 45 per cent in euro and 10 per cent in yen, the Australian dollar has risen by 25 per cent.

The timing of intervention and reserves replenishment also has some mitigating effect on exchange rate risk. Intervention tends to reduce the level of foreign currency holdings when the Australian dollar is low, which reduces the level of risk when the Australian dollar is most likely to appreciate. In turn, the Reserve Bank will tend to hold more foreign currency and be more exposed to exchange rate risk when the Australian dollar is high and so not likely to appreciate much further. Foreign currency assets acquired through swap operations do not entail foreign exchange risk, as the forward rate embedded in the swap hedges the risk.

Exchange rate risk on the balance sheet has increased in recent years. This has occurred as the Reserve Bank has rebuilt foreign currency reserves following a period of intervention at the turn of the decade. At current levels of reserves holdings, the potential valuation loss from a 10 per cent depreciation of the Australian dollar would be around $3 billion.

Interest Rate Risk

The value of the Reserve Bank's balance sheet tends to fluctuate with changes in market interest rates. Increases in market interest rates reduce the value of securities that earn a fixed rate of interest, which make up most of the securities held by the Bank. In contrast, when market interest rates fall, the value of these securities rises, as investors are willing to pay a premium for the higher fixed-income stream. Securities with a longer maturity (or duration) will have an income stream fixed for a longer period and so will be exposed to a greater degree of interest rate risk.

Over the past year, the interest rate risk faced by the Reserve Bank has declined marginally. A reduction in the holdings and average maturity of Australian government securities has been partly offset by a rise in foreign security holdings. In addition, an overall reduction in the size of the balance sheet has had little impact on interest rate risk; this has reflected the withdrawal of government deposits that were invested in relatively short maturities to broadly match the maturity of these deposits (i.e. effectively hedging the risk on the deposits).

Across the domestic and foreign portfolios, the Reserve Bank would suffer a valuation loss of about $900 million if interest rates in Australia and abroad rose by 1 percentage point across the yield curve. This is consistent with the level of valuation risk observed over much of the past five years. As shorter-term investments are reinvested at higher interest rates, such a loss would be partially offset over time.

Credit Risk

Credit risk is the possibility of financial loss owing to default by an issuer or counterparty. This risk can arise for the Reserve Bank through default by the issuers of securities held outright, default by banks with which funds have been deposited or default by counterparties with which transactions have been carried out. Unlike the financial risks discussed above, there is no policy imperative for having a given level of credit risk. As a result, this risk can be set at low levels.

The Reserve Bank mostly holds highly rated securities to minimise exposure to credit risk. For the domestic portfolio, the securities held outright include those issued by the Australian Government or State and Territory government borrowing authorities. A large proportion of the domestic portfolio also consists of repos, the largest component being repos in bank bills. Repos carry limited credit risk because they are a collateralised loan – i.e. both the counterpart to the repo and the issuer of the collateral would have to default simultaneously for the Reserve Bank to experience a loss. To reduce credit risk on repos further, the Bank requires excess collateral (referred to as over-cover) and imposes margin calls when this falls below a set level.

Over the past year, the Reserve Bank has expanded the range of collateral it is willing to accept under repo for open market operations to include bank bonds, a greater range of bank bills, residential mortgage-backed securities (RMBS) and asset-backed commercial paper (ABCP). In order to maintain a low level of credit exposure, the Bank sets strict eligibility criteria upon all collateral, ensuring that only high-quality securities are received. These criteria include high credit ratings and, in the case of RMBS and ABCP, mortgage insurance and a limit on funds provided against low-doc loans. The Reserve Bank also requires a higher level of over-cover for bank bonds, RMBS and ABCP.

For the foreign portfolio, the main investments are securities issued by the US, German, French and Japanese governments as well as certain highly rated supranational institutions. In addition, deposits are held with the BIS and some commercial banks. A small amount of the foreign portfolio is invested in the Asian Bond Funds, which have an average credit rating well within the range of investment grade paper.

Defaults by institutions with which the Reserve Bank has deposited funds and by counterparts to transactions represent the major source of credit risk faced. Foreign currency deposits are placed only with commercial banks that have a short-term rating of P-1 and long-term rating of Aa3 or above. Foreign exchange transactions are limited to counterparties rated P-1 and at least A3, while foreign repos and gold lending transactions, which are secured with high-quality assets, are limited to counterparties rated P-2 and Baa1 or better. In addition, limits are placed on exposures to those institutions that are eligible as counterparties. Other measures to control risk include requiring repos and gold loans to be over-collateralised, and requiring securities provided as collateral to be revalued daily and for counterparties to supply additional securities if the value of the securities falls below a specified amount.

The Reserve Bank has closely monitored developments in counterparty credit risk throughout the recent period of turmoil in global financial markets. In particular, the appropriateness of counterparty limits has been closely scrutinised on an ongoing basis.

No minimum credit rating or exposure limits are explicitly assigned to counterparties for domestic operations, as these are conducted for policy purposes. However, dealings are restricted to members of RITS.

Settlement risk can arise when a counterparty may not be able to complete a deal. This risk has been eliminated for securities transactions through the use of delivery-versus-payment systems, which involve the simultaneous exchange of securities for cash. However, settlement risk can be significant for foreign exchange transactions, as the two currencies of the foreign exchange transaction are settled in different time zones. This may require the Reserve Bank to pay out funds before any are received in return. This risk is controlled by dealing only with highly rated counterparties and limiting the total value of foreign currency transactions settling with an individual counterparty.

Legal Risk

In common with other organisations, the Reserve Bank acquires a broad range of goods and services in carrying out its work. In most instances, these are provided under detailed written contracts, the content of which has been agreed in advance between the Reserve Bank and the vendor. In circumstances where services are required over a long period, the contracts are regularly reviewed and, where applicable, re-negotiated to ensure that the services provided to the Bank are at a high level in terms of quality, reliability and value for money.

Many of the Reserve Bank's financial market activities are also executed under written contract. For example, repo transactions entered into by the Bank in domestic and foreign currency denominated securities are carried out under internationally recognised legal agreements, which specify the nature of the transactions and the rights of the parties involved, including the actions to be taken if either party fails to meet its obligations under the agreement. At the time of preparing this annual report, the Bank was finalising work on signing similar internationally recognised agreements with counterparties underpinning all of its foreign exchange transactions.

Reputational Risk

Reputational risk arises as an adjunct to all the risks outlined above: the Reserve Bank would suffer reputational loss were any of these risks not well managed. Likewise, reputational risk is contained to the extent that the other risks are adequately controlled. Reputational risks are further contained through, among other things, protocols on access to and handling sensitive information, careful controls governing dealings with the media, and clear guidelines for the conduct of management and staff in carrying out their duties. Making strenuous efforts to maintain a strong and cohesive organisational culture is key to maintaining a reputation for competence, integrity and impartiality. The Bank invests considerable resources in training its staff to develop both technical competence and also an awareness of the need for ethical behaviour and the requirement to put aside personal interests in carrying out official duties. The Code of Conduct for staff is an important vehicle for achieving this goal.