Reserve Bank of Australia Annual Report – 2012 Financial Statements Note 15 – Financial Instruments and Risk

As the central bank of Australia, the RBA is responsible for implementing monetary policy and managing Australia's foreign reserve assets. As a consequence, the RBA holds a range of financial assets, including Australian dollar securities, foreign government securities, repurchase agreements, deposits with the BIS and other central banks, interest rate futures contracts, foreign currency swaps, gold loans, cash and cash equivalents. The RBA also holds a shareholding in the BIS. As to financial liabilities, the RBA issues Australia's banknotes and offers deposit facilities to its customers, mainly the Australian Government, and eligible financial institutions. Accordingly, the main financial claims on the RBA are banknotes on issue as well as deposit liabilities. The RBA also provides banking services to its customers, and operates Australia's high-value payments and interbank settlement systems. These payments and settlements occur through accounts held on the RBA's balance sheet.

AASB 7 – Financial Instruments: Disclosures requires disclosure of information relating to financial instruments; their significance and performance; terms and conditions; fair values; risk exposures and risk management.

Financial Risk

The RBA is exposed to a range of financial risks reflecting its policy and operational responsibilities. These risks include market risk, credit risk and liquidity risk. The chapters in the Annual Report on the Reserve Bank's ‘Operations in Financial Markets’ and ‘Risk Management’ provide additional information on the RBA's management of these financial risks.

Market risk

Market risk is the risk that the fair value or future cash flows of a financial instrument will fluctuate because of changes in market prices. Market risk comprises: foreign exchange risk; interest rate risk; and other price risk.

Foreign exchange risk

Foreign exchange risk is the risk that the fair value or cash flows of foreign currency assets and liabilities will fluctuate because of movements in exchange rates. Foreign exchange risk arises from the RBA's foreign currency assets, which are held to support its operations in the foreign exchange market. The value of these assets, measured in Australian dollars, varies with movements in the value of the Australian dollar exchange rate against the currencies in which the assets are invested. An appreciation in the exchange rate results in valuation losses, while a depreciation leads to valuation gains. The overall level of foreign currency exposure is determined by policy considerations and the Bank does not seek to reduce foreign exchange risk. The RBA's net foreign currency exposure as at 30 June 2012 was $35.9 billion ($35.8 billion as at 30 June 2011). Within the overall exposure and to a limited extent, foreign currency risk can be mitigated by holding assets across a diversified portfolio of currencies. The RBA holds foreign reserves in four currencies – the US dollar, the euro, the Canadian dollar and the yen – because the markets for these currencies are typically liquid and suitable for investing foreign exchange reserves.

The RBA also undertakes foreign currency swaps to assist its daily domestic market operations. These instruments carry no foreign exchange risk since the exchange rates at which both legs of the transaction are settled are agreed at the time the swap is undertaken.

Concentration of foreign exchange

The RBA's net holdings of foreign exchange (excluding its holding of Special Drawing Rights) were distributed as follows as at 30 June:

Per cent of foreign exchange
2012 2011
US dollar 45 45
Euro 45 45
Canadian dollars 5 5
Japanese yen 5 5
Total foreign exchange 100 100

Sensitivity to foreign exchange risk

The sensitivity of the RBA's profit and equity to a movement of +/−10 per cent in the value of the Australian dollar exchange rate as at 30 June is shown below. These figures are generally reflective of the RBA's exposure over the financial year.

2012 $M 2011 $M
Change in profit/equity due to a 10 per cent appreciation
in the reserves-weighted value of the A$		 −3,267 −3,258
Change in profit/equity due to a 10 per cent depreciation
in the reserves-weighted value of the A$		 3,993 3,982

Interest rate risk

Interest rate risk is the risk that the fair value or cash flows of financial instruments will fluctuate because of movements in market interest rates. The RBA's balance sheet is exposed to interest rate risk because most of its assets are financial assets, such as domestic and foreign securities, which have a fixed income stream. The price of such securities increases when market interest rates decline, while the price of a security will fall if market rates rise. Interest rate risk increases with the maturity of a security because the associated income stream is fixed for a longer period. Interest rate risk on foreign assets is managed through limits on the duration, or interest rate sensitivity, of the portfolio. Interest rate risk on domestic assets is small as the bulk of the portfolio is held under short term repurchase agreements.

Sensitivity to interest rate risk

The figures below show the effect on the RBA's profit and equity of a movement of +/−1 percentage point in interest rates, given the level, composition and modified duration of the RBA's foreign currency and Australian dollar securities as at 30 June. The valuation effects shown are generally reflective of the RBA's exposure over the financial year.

2012 $M 2011 $M
Change in profit/equity due to movements of
+/−1 percentage point across yield curves:		    
Foreign currency securities −/+467 −/+456
Australian dollar securities −/+171 −/+169

A rise in interest rates would be associated with a valuation loss; a fall in interest rates would be associated with a valuation gain.

Other price risk

The RBA holds shares as a member of the BIS. This membership is mainly to maintain and develop strong relationships with other central banks which are to Australia's advantage. Shares in the BIS are owned exclusively by its member central banks and monetary authorities. For accounting purposes, the RBA treats the BIS shares as ‘available for sale’ and the fair value of these shares is estimated on the basis of the BIS' net asset value, less a discount of 30 per cent. Accordingly, these shares are revalued to reflect movements in the net asset value of the BIS and in the Australian dollar. The price risk faced on the BIS shares is incidental to the policy reasons for holding them and is immaterial compared with other market risks faced by the RBA. For this reason, this exposure is not included as part of the RBA's net foreign currency exposure outlined above.

Credit risk

Credit risk is the potential for financial loss arising from an issuer or counterparty defaulting on its obligations to: repay principal; make interest payments due on an asset; or settle a transaction. For the RBA, credit risk arises from exposure to: the issuers of securities that it holds; and counterparties which are yet to settle transactions. The RBA's credit exposure is low compared with that of most commercial financial institutions, as it manages such risks within a highly risk-averse framework. In particular, credit risk is managed by: holding securities issued by a limited number of highly rated governments, government-guaranteed agencies and supranational organisations; and holding collateral only of low credit risk against buy repurchase agreements and gold loans.

Cash invested under repurchase agreements in overseas markets is secured by collateral in the form of government securities or securities issued by US agencies; the RBA takes and maintains collateral to the value of 102 per cent of the cash invested. Cash invested under domestic buy repurchase agreements is secured by securities issued by Australian governments, banks and various corporate and asset-backed securities (see Note 1(b)). The RBA holds collateral to a value of between 101 and 123 per cent of the amount invested according to the risk profile of the collateral held. If the current value of collateral offered by a counterparty to a repurchase transaction falls by more than a predetermined amount, the counterparty is required to provide additional collateral to restore this margin; the thresholds are specified in the legal agreements which govern these transactions.

The RBA does not sell or re-pledge securities held as collateral under buy repurchase agreements.

The RBA's maximum exposure to credit risk in relation to each class of recognised financial assets, other than derivatives, is the carrying amount of those assets as indicated in the balance sheet.

The RBA's maximum credit risk exposure in relation to derivative financial instruments is:

  1. Foreign exchange swaps – As at 30 June 2012, the RBA was under contract to purchase $4.4 billion of foreign currency ($0.2 billion at 30 June 2011) and sell $9.5 billion of foreign currency ($0.3 billion at 30 June 2011). As of that date there was a net unrealised gain of $110 million on these swap positions included in net profit ($4 million unrealised gain at 30 June 2011). The exposure of these contracts to credit risk is the cost of re-establishing the contract in the market if a counterparty fails to fulfill its obligations.
  2. Interest rate futures – As at 30 June 2012, the amount of credit risk on interest rate futures contracts was approximately $0.7 million ($1.4 million at 30 June 2011). As at 30 June 2012 there was an unrealised loss brought to account on those contracts of $0.03 million ($0.6 million unrealised loss at 30 June 2011).

Concentration of credit risk

As noted, the RBA operates to minimise its credit risk exposure through comprehensive risk management policy guidelines. The table over the page indicates the concentration of credit risk in the RBA's investment portfolio.

The RBA held no past due or impaired assets at 30 June 2012 or 30 June 2011.

Risk rating of
security/issuer(a)		 Risk rating of
counterparties(a)		 Per cent of investments
2012 2011
Australian dollar securities
Holdings – Commonwealth Government Securities AAA na 1.9 0.6
Holdings – semi-government securities AAA na 4.0 4.3
AA na 4.0 5.9
Securities sold under repurchase agreements AAA AA – 0.2
AAA A 0.1 0.2
AA AA – 0.1
Securities held under repurchase agreements AAA AA 9.1 11.9
AAA A 8.6 7.4
AAA BBB 0.1 0.1
AAA Other(b) 0.7 0.3
AA AA 7.1 6.1
AA A 2.6 2.6
AA BBB 0.1 –
AA Other(b) 0.2 0.1
A AA 0.5 1.8
A A 1.3 0.5
A BBB – 0.1
Foreign investments
Holdings of securities AAA na 17.2 29.9
AA na 18.1 1.5
A na 0.5 0.5
Securities sold under repurchase agreements AAA AA – 0.9
AAA A – 0.8
AA A 1.8 –
Securities held under repurchase agreements AAA AAA – 0.4
AAA AA 0.5 8.3
AAA A 1.2 5.5
AA AA 1.8 –
AA A 11.9 0.5
AA BBB 0.2 –
Deposits na AAA – 1.7
Other na AA 0.1 –
na A 0.1 –
Gold loans na AAA 0.1 0.1
Other     6.2 7.7
    100.0 100.0
(a) Standard & Poor's or equivalent rating.
(b) This category includes counterparties which are not rated.

Liquidity risk

Liquidity risk is the risk that the RBA will not have the resources required at a particular time to meet its obligations to settle its financial liabilities. As the ultimate source of liquidity in Australian dollars, the RBA has the powers and operational wherewithal to create liquidity in unlimited amounts in Australian dollars at any time. A small component of the RBA's liabilities is in foreign currencies, namely foreign sale repurchase agreements.

Liquidity risk is also associated with financial assets to the extent that the RBA may in extraordinary circumstances be forced to sell a financial asset at a price which is less than its fair value. The RBA manages this risk by holding a diversified portfolio of highly liquid domestic and foreign assets.

The maturity analysis table (over page) is based on the RBA's contracted portfolio as reported in the RBA's balance sheet. All financial instruments are shown at their remaining term to maturity, which is equivalent to the repricing period. Other liabilities include amounts outstanding under sale repurchase agreements. Foreign currency swaps reflect the gross settlement amount of the RBA's outstanding foreign currency swap positions.

Maturity Analysis – as at 30 June 2012

Balance sheet
total $M		 Contracted maturity $M No specified maturity $M Weighted average coupon rate % Weighted average effective
rate %
On
demand		 0 to 3 months 3 to 12 months 1 to 5 years Over 5 years
Assets
Cash and cash equivalents 164 – 135 – – – 29 3.25 3.25
Australian dollar securities
Securities sold under repurchase agreements 17 – – – 17 – – 5.50 2.47
Securities purchased under repurchase agreements 24,484 – 23,983 501 – – – 3.57 3.57
Other securities 8,028 – 2,269 2,225 2,007 1,527 – 5.09 3.39
Accrued interest 119 – 117 2 – – – na na
32,648  
Foreign exchange
Balances with central banks 572 10 562 – – – – 0.15 0.15
Securities sold under repurchase agreements 1,155 – 245 – 330 580 – 1.01 1.01
Securities purchased under repurchase agreements 12,129 – 12,129 – – – – 0.14 0.14
Other securities 29,344 – 7,413 6,850 8,707 1,595 4,779 0.95 0.37
Deposits with BIS 5 3 1 – – – 1 0.01 0.01
Accrued interest 91 – 91 – – – – na na
43,296  
Gold
Gold loans 48 – – 48 – – – 0.40 0.40
Gold holdings 3,979 – – – – – 3,979 na na
4,027  
Property, plant
& equipment		 448 – – – – – 448 na na
Loans and advances 5 – – – – 5 – 3.40 3.40
Other assets 491 – 33 – – – 458 na na
Total assets 81,079 13 46,978 9,626 11,061 3,707 9,694 1.97 1.59
Liabilities
Deposits 18,000 3,500 14,500 – – – – 3.45 3.45
Distribution payable to Australian Government 500 – 500 – – – – na na
Other liabilities 2,615 – 2,447 – – – 168 0.19 0.19
Australian notes on issue 53,595 – – – – – 53,595 0.19 0.19
Total liabilities 74,710 3,500 17,447 – – – 53,763 0.98 0.98
Capital and reserves 6,369  
Total balance sheet 81,079  
Local Currency
Swaps    
Contractual outflow (83) – (83) – – – – na na
Contractual inflow 5,191 – 5,191 – – – – na na
5,108 – 5,108 – – – –  
Foreign Currency
Swaps    
Contractual outflow (9,539) – (9,539) – – – – na na
Contractual inflow 4,431 – 4,431 – – – – na na
(5,108) – (5,108) – – – –  

Maturity Analysis – as at 30 June 2011

Balance sheet
total $M		 Contracted maturity $M No specified maturity $M Weighted average coupon rate % Weighted average effective
rate %
On
demand		 0 to 3 months 3 to 12 months 1 to 5 years Over 5 years
Assets
Cash and cash equivalents 1,209 – 1,187 – – – 22 4.50 4.50
Australian dollar securities
Securities sold under repurchase agreements 404 – 41 – 156 207 – 6.55 5.29
Securities purchased under repurchase agreements 23,203 – 23,078 125 – – – 4.82 4.82
Other securities 8,111 – 3,247 1,721 1,961 1,182 – 5.47 4.99
Accrued interest 116 – 78 38 – – – na na
31,834  
Foreign exchange
Balances with central banks 305 7 298 – – – – 0.12 0.12
Securities sold under repurchase agreements 1,234 – – 186 467 581 – 2.14 2.14
Securities purchased under repurchase agreements 10,797 – 10,797 – – – – 0.45 0.45
Other securities 24,011 – 3,275 7,653 5,275 2,824 4,984 1.60 1.22
Deposit with BIS 1,261 2 1,258 – – – 1 0.06 0.06
Accrued interest 119 – 67 50 2 – – na na
37,727  
Gold
Gold loans 46 – – 46 – – – 0.30 0.30
Gold holdings 3,553 – – – – – 3,553 na na
3,599  
Property, plant & equipment 454 – – – – – 454 na na
Loans and advances 6 – – – – 6 – 3.91 3.91
Other assets 484 – 33 – – – 451 na na
Total assets 75,313 9 43,359 9,819 7,861 4,800 9,465 2.79 2.61
Liabilities
Deposits 17,504 6,854 10,650 – – – – 4.53 4.53
Distribution payable to Australian Government – – – – – – – na na
Other liabilities 2,411 – 2,273 – – – 138 1.12 1.12
Australian notes on issue 50,059 – – – – – 50,059 0.23 0.23
Total liabilities 69,974 6,854 12,923 – – – 50,197 1.34 1.34
Capital and reserves 5,339  
Total balance sheet 75,313  
Local Currency
Swaps
Contractual outflow (7) – (7) – – – – na na
Contractual inflow 163 – 163 – – – – na na
156 – 156 – – – –  
Foreign Currency
Swaps
Contractual outflow (340) – (340) – – – – na na
Contractual inflow 184 – 184 – – – – na na
(156) – (156) – – – –  

Fair Value of Financial Instruments

Fair value is the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm's length transaction, and is usually determined by the quoted market price. The RBA's Australian dollar securities, foreign government securities, interest rate futures, foreign currency swap contracts and its shareholding in the BIS are carried in the balance sheet (and shown in this note) at fair value. The RBA's repurchase agreements, the BIS deposits, cash and cash equivalents, notes on issue and deposit liabilities are carried in the balance sheet (and shown in this note) at face value, which is equivalent to their amortised cost using the effective interest method; this approximates fair value.

AASB 7 requires that the fair value of financial assets and liabilities be disclosed according to their accounting classification under AASB 139.

2012 $M 2011 $M
Assets accounted for under AASB 139
At fair value through Profit or Loss 38,283 33,366
Loans and receivables 37,912 37,487
Available for sale 325 302
Assets accounted for under other standards 4,559 4,158
Total assets as at 30 June 81,079 75,313
Liabilities accounted for under AASB 139    
At fair value through Profit or Loss 15 1
Not at fair value through Profit or Loss 74,020 69,842
Liabilities accounted for under other standards 175 131
Total liabilities as at 30 June 74,210 69,974

AASB 7 also requires that financial assets and liabilities measured at fair value be disclosed according to their position in the fair value hierarchy. This hierarchy has three levels for financial instruments valued at fair value: Level 1 is based on quoted prices in active markets for identical assets; Level 2 is based on quoted prices or other observable market data not included in Level 1; while Level 3 valuations are based on inputs other than observable market data.

Level 1 $M Level 2 $M Level 3 $M Total $M
As at 30 June 2012
Assets at fair value through Profit or Loss
Domestic government securities 5,364 2,720 – 8,084
Foreign government securities 28,389 1,684 – 30,073
Foreign currency swap gains 8 118 – 126
Available for sale
Shares in international and other institutions – – 325 325
33,761 4,522 325 38,608
Liabilities at fair value through Profit or Loss        
Foreign currency swap losses – 15 – 15
– 15 – 15
As at 30 June 2011
Assets at fair value through Profit or Loss
Domestic government securities 4,927 3,587 – 8,514
Foreign government securities 22,370 2,477 – 24,847
Foreign currency swap gains – 5 – 5
Available for sale
Shares in international and other institutions – – 302 302
27,297 6,069 302 33,668
Liabilities at fair value through Profit or Loss        
Foreign currency swap losses – 1 – 1
– 1 – 1