8  Provision of risk management services

Economic objective

The economic objective is to achieve citizens’ desired wealth portfolio, particularly meeting their desired risk tolerance.

The motivation for this objective rests on the view that citizens may be in a weak position to manage their risk exposures, including their exposure to the Crown. It is useful to think of potential barriers to efficient risk management in terms of information, incentives and capability:

• Information: Citizens may lack information about the risk/return properties of their exposure to the Crown (and exposures to other risks). The transactions cost of gathering appropriate information may be too high or the information simply may not be available to citizens irrespective of willingness to pay.
• Incentives: In general, citizens may be expected to have strong incentives to identify and manage risk exposures consistent with maximising their own welfare. However, public choice issues in a democratic political system may lead to moral hazard and therefore distorted incentives. For example, citizens might assume rationally that the government of the day will provide retirement income, leading to reduced incentive for private savings. Another example is that taxation of return on capital also distorts incentives, possibly causing citizens to exacerbate their risk exposures (Coleman, 1997b).
• Capability: Citizens may lack capability to manage their risk exposures, for two reasons:
  • citizens may not possess the capacity to make fully rational decisions consistent with their objectives. Such “bounded rationality” may result in myopic decisions as individuals seek to simplify their decision problem through, for example, the use of finite planning horizons and ignoring readily available information; and
  • capability to manage risks may be constrained by imperfect capital markets, such as liquidity constraints, short-selling restrictions, and trading margins. Missing markets or lack of access to market instruments may also present barriers to efficient risk management.

Faced with these barriers, citizens have an incentive to delegate decisions to agents with better information, incentives and capability. Private sector financial intermediaries such as banks, insurance companies, and mutual funds arise to provide risk management services of various forms.

The motivation for this section is that in some circumstances the Crown may have a comparative advantage over the private sector in the provision of particular risk management services.

Key insights for policy

For the purposes of discussion, the following ignores the conceptual and practical difficulties relating to interpersonal welfare analysis. These are discussed in Section 11.

The general nature of optimal policy may be conjectured without analysing in detail each potential barrier.[27] All that is required is recognition that some barriers may result in citizens being exposed to risks that desirably should be hedged, while other barriers may prevent citizens from achieving welfare-enhancing exposures. For example, bounded rationality and missing markets (or lack of access to markets) could result in citizens taking unwarranted risk exposures, while liquidity constraints may prevent citizens from creating appropriate risk exposures (e.g. by borrowing to invest in risky assets).[28] Short-selling restrictions could work either way: they may prevent citizens from creating risk exposures and equally they may prevent citizens from unwinding risk exposures in situations where the Crown holds too much of an asset.

Thus the first step to achieve the economic objective would involve identifying two sets of risk exposures: those exposures that should be mitigated and those exposures that should be created or increased. Crown financial policy would aim to structure the Crown portfolio to have negative correlation with exposures to be mitigated and positive correlation with exposures to be created or increased.

The analysis does not imply that the Crown portfolio should lie on the CML. Rather, the objective requires only that citizens’ total wealth portfolios be positioned appropriately on the CML. The location of the Crown portfolio in risk/return space would be determined by the asset and liability holdings required to ensure citizens’ total wealth portfolio achieved the optimal risk/return target. In contrast to Davis (2001) and Grimes (2001a), it is unlikely that this would translate into a generic risk/return specification for the Crown portfolio.

Summary for risk management services

Economic objective

Achieve citizens’ desired risk/return trade-off on their total wealth portfolio

CFP objectives

Portfolio policy

Crown portfolio has perfect negative correlation with all risks exposures that should be hedged and positive correlation with exposures that should be increased

Targets

Specified risk exposures for the Crown portfolio (set to mitigate/create identified risks to citizens)

Instruments

Portfolio weights