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Managing risk

General elements of good risk management

A good risk management framework will operate within clear lines of agency accountability and responsibility with overall central coordination. These should be based on who has the necessary skills, knowledge and expertise to manage risks as efficiently and effectively as possible. Risk tolerance needs to be clearly specified at an aggregate level, as this will impact how agencies manage risk. See Figure 6.2 for an overview of the risk management cycle.

Mitigating risk

Mitigating risk involves taking actions to reduce the potential impacts of risks before they are realised. This can include taking regulatory measures, buying insurance, public information and communication exercises, cost sharing or risk pooling arrangements and hedging actions.

Risk management also involves building resilience. Resilience refers to the ability to withstand the effects of an event or shock.

Risk management is rarely free of cost. Accordingly, its desirability will depend on the overall costs and benefits to the Crown and wider economy. These need to be continually assessed to ensure efficiency and effectiveness.

Figure 6.2 - Comprehensive risk management
Figure 6.2 - Comprehensive risk management   .
Source:  The Treasury

The Crown's current framework for balance sheet risk management

The basic elements of a comprehensive approach to systematic risk management are present in the Crown's current framework for risk management.

Agency risk

Each individual entity is responsible for identifying and managing any risks they are exposed to on the basis that they have the best information and incentives to do so. This generally involves managing individual operational, insurance, financial, asset management, and reputational risks.

However, risk management may be subject to overarching guidance. For example, Treasury Instructions stipulate that departments must undertake a systematic financial risk management process covering:

  • identification of the risks faced, or likely to be faced
  • quantification of the type and size of the risk (including consideration of possible losses and probability of loss)
  • determination of a risk appetite (ie, the amount of risk the department is prepared to accept), and
  • how the risks are to be managed or controlled, including whether to purchase insurance cover.[51]

Taking this into account, there are strong expectations that each agency considers and manages risks that are relevant to their responsibilities.

Macro and national security risks

In the case of macro and national security risks that affect New Zealand (such as financial and economic risks, biosecurity and natural disaster risks), risk is managed more centrally. The Officials' Domestic and External Security Committee, led by the Department of the Prime Minister and Cabinet, provide an overarching risk management framework for risk of national significance that spans the responsibilities of several agencies. This involves assessing overall national preparedness, providing guidance and policy advice, planning, and co-ordinating risk management roles across agencies.

In some instances, purpose-designed agencies have been established to manage these risks, such as the EQC. The Treasury has responsibility for providing advice around the overall fiscal and economic implications of nationally important events.

Implicit risks and contingent liabilities

The Crown plays a key role in managing risks on behalf of others. Events in other countries through the GFC have shown the material effect implicit risks can have on governments' finances. In New Zealand this led to the Retail Deposit Guarantee Scheme, which transferred risk from the private to the public sector.

This highlights why efficient and effective management of these off-balance sheet risks and issues is critical. Where the Crown is best placed to address these risks on behalf of others this can be a valuable function. However, there can be unintended consequences particularly where the Crown takes on costs that would be more appropriately carried by the private sector.

Implicit risks and contingent liabilities need to be well understood to allow for careful management to ensure there are no unintended negative fiscal consequences and that economic and social outcomes are protected.[52] These types of risks, including the effects of natural disasters and perceptions about implicit support of the banking sector, represent some of the largest risks the Crown faces.

Resilience

Ultimately the Crown and taxpayers bear any residual risk of an event through potential loss of service provision, increased costs, or both.

New Zealand's approach to resilience has been to run a strong and disciplined fiscal position with low net core Crown debt levels. This allows the cost of an event to be absorbed without unduly affecting the continuation of core public services or the wider economy. For example, many of the costs of the Canterbury rebuild were funded through an increase in debt issuance. This allowed the response to the earthquake to be swift, without putting undue pressure on Crown finances or current taxpayers. This approach is discussed in more depth in the next chapter regarding fiscal buffers.

Assessment

The devolved model for Crown risk management, with some centralisation of nationally significant risks, generally has worked well. The way that risk management responsibilities are assigned has created generally appropriate management accountabilities.

That does not mean there is not scope to seek opportunities to find efficiency gains in risk management practices. This may involve, for example, finding ways for agencies to take advantage of offsetting risks or diversification benefits available elsewhere in the Crown's overall balance sheet.

In addition, taxpayers through the Crown may bear some of the residual impacts of risk that agencies are responsible for managing. There may be room to improve the alignment of incentives for managing risk in agencies and the wider Crown.

As the Crown balance sheet grows and its composition changes the magnitude of risks the Crown faces will increase and their sources will likely change. Therefore, managing risk will become more important over time. In particular, the projected growth of financial assets the Crown owns will likely lead to increased operating and balance sheet volatility. This will require astute management and a greater understanding of the implications of interventions.

These issues will require a greater understanding of the total risk implications of agency interventions, and on and off-balance sheet risks. Accordingly, there could be further improvements to the existing Crown risk management framework to capture some of these benefits while maintaining the benefits of the status quo.

Notes

  • [51]http://www.treasury.govt.nz/publications/guidance/instructions
  • [52]The EQC scheme is an example of this approach. In the event of a disaster, it can be difficult for governments to withstand the pressure to meet the costs of uninsured homeowners. Knowing this, homeowners may choose to underinsure. The EQC scheme is a way of limiting this moral hazard by levying homeowners in return for financial support following an earthquake.
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