2  Need for central risk management

The Crown's exposure to financial risk matters. The cost to New Zealand of the Crown's getting into financial distress would be very high; witness recent crises in Argentina, Iceland, and Ireland. So it is useful to assess the extent of that risk and to try to keep it very low. There is also a widely accepted case for reducing the variability of tax rates and government spending, which also requires monitoring and when necessary adjusting the Crown's exposure to risk.[1]

2.1  Crown’s exposure to risk can be managed only centrally

If the government is to manage the Crown's aggregate exposure to risk, it must do so centrally. We define risk management as the measurement and monitoring of risk, as well as the setting of policy to achieve an acceptable level of risk. The riskiness of the Crown’s portfolio depends on the riskiness (variance) of each part of the portfolio and on the correlations among the parts. The higher the correlations among assets and among liabilities, the greater the risk, and the higher the correlation between assets and liabilities, the lower the risk. Only by considering the correlations can the risk of the Crown's portfolio be understood. The managers of one part of the Crown's portfolio (for example, debt or a set of financial assets) may know how risky their assets or liabilities are considered by themselves, but they cannot be expected to know the correlations between the value of their assets and liabilities and the value of the rest of the Crown's portfolio. So the managers cannot be expected to know how their choices affect the Crown's exposure to risk. The management of the Crown's assets and liabilities can be decentralised, and individual managers can manage the risks to which their portfolios are exposed. But the Crown's aggregate exposure to risk is either managed centrally or largely left unmanaged.[2]

The nature of risk also means that the management of the Crown's exposure to risk needs to take account of all the Crown's main assets and liabilities (all its main sources of future cash inflows and outflows). This requires the analysis of a ‘comprehensive' balance sheet, which includes a notional ‘tax asset' and ‘spending liability' as well as those assets and liabilities reported in accordance with generally accepted accounting practice (GAAP). For some purposes, it is of course useful to look at the GAAP balance sheet because it excludes policy commitments whose costs the government can influence, and focuses on debt and other liabilities that represent binding obligations. But even assessing the risk to which the GAAP balance sheet is exposed over any time period requires consideration of the correlation between GAAP assets and liabilities and spending and tax receipts over that time period.

2.2  Management does not imply micromanagement

Central management of risk does not, however, imply micromanagement of the comprehensive balance sheet. No central risk manager should try to measure the Crown's exposure to every kind of risk or to fine-tune all those exposures. Risks should be managed by the people with the information, incentives, and capability to manage them. For most of the risks to which the Crown is exposed, those people are the managers of particular business units. The risk associated with the value of the Crown's electricity assets, for example, depends on the quality of decisions to invest in and operate power stations and transmission networks. Those risks need to be managed by the people who understand the demand for electricity and the costs of supply and who (because of competition, regulation, or governance) have incentives to make good decisions. Anyrealistic central management of risk involves much delegation. The particular risks that are candidates for being managed centrally are those that affect many different parts of the Crown's portfolio, such as risks associated with interest and exchange rates, the price of oil, the strength of the economy, and the creditworthiness of the Crown's major counterparties.

Central management of a risk need not involve more than central measurement and monitoring of risk and certain high-level instructions to the managers of parts of the Crown's portfolio. It might, for example, involve instructions to some agencies to limit certain kinds of risks (for example, preventing certain agencies from borrowing) or instructions to other agencies to match their financial assets with certain liabilities—as, for example, the Debt Management Office matches financial assets to some of the debt the Crown has issued. If the matching is perfect—if the values of the matched assets and liabilities are perfectly correlated—the combination of the assets and liabilities is essentially risk-free.

Lastly, although the management of the Crown's exposure to risk must take account of the Crown's comprehensivebalance sheet, not all risk-management decisions must refer to an analysis of the comprehensive balance sheet. An analysis of the comprehensive balance sheet might suggest that a certain category of risk was concentrated in a certain part of the GAAP balance sheet. If so, day-to-day management of the risk could be made by reference only to that part of the GAAP balance sheet.