3.3  The Crown’s risk budget

We begin by presenting a notional risk budget for the Crown. Risk budgeting is the practice of systematically allocating a level of risk exposure across asset classes or business units (Mina, 2005). It is used by financial firms to allocate capital to achieve risk-management objectives. For example, an investment management firm may wish to allocate its market risk exposure equally among its investment managers. This is not the same as allocating an equal amount of investment capital to each manager because the risk exposure will depend on the riskiness of each manager's market position. While the government does not use risk budgeting, we apply the technique to get a rough understanding of the importance of various sources of risk.

To construct the notional risk budget, we measure the risk of each asset and liability class as its annual standard deviation.[13] If returns are normally distributed, each asset and liability class will experience a loss at least as large as this with annual probability of around 16%, or about every six years.

The model implies first that the Crown's comprehensive net worth has annual volatility of $30 billion. Offsetting a loss of that amount would require a permanent increase in taxes of 3.2%.

We can also present an approximate indication of where that risk comes from (Table 5 and Figure 1). The measures are only indicative because the contribution of an asset to the Crown's total exposure to risk depends on correlations: to the extent that the correlations are less than 1, each entity's contribution to the Crown's total risk will be less than the amount reported. The total effect of imperfect correlations is the benefit of diversification.[14] With that proviso, we can note that about half of the total risk comes from the primary balance and about a quarter from social assets (Figure 1). If social assets are excluded from comprehensive net worth, annual volatility is reduced to $26 billion, equivalent to a 2.7% permanent change in taxes and the relative importance of the other items increases (Table 6 and Figure 2).

It is not surprising that the primary balance dominates the risk budget. The present value of primary revenues, for example, is more than 20 times as great as the asset value of all state-owned enterprises. Nonetheless, other assets and liabilities also matter: the analysis shows that they may contribute up to a quarter or a third of the Crown's financial risk depending on whether social assets are excluded from the analysis.

Figure 1 - Sources of risk on comprehensive balance sheet

Source: Authors' calculations

Figure 2 - Sources of risk on the comprehensive balance sheet excluding social assetssheet

Source: Authors' calculations