The Importance of Sound Risk Management

12 December 2000

Peter McCray
Deputy Chief Executive
Australian Office of Financial Management

The Importance of Sound Risk Management

The Importance of Sound Risk Management

  • a better integrated, more cohesive management framework
    • obliges a clear articulation of govt’s risk preferences and its willingness to trade off cost and risk
    • establishes a coherent basis for better long-term cost performance

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The Importance of Sound Risk Management

  • enhanced transparency, clear lines of accountability
    • well-defined objectives
    • cost and risk concepts, risk policies and procedures well defined and documented
    • motives for operations clearer to all stakeholders
  • sound basis for measuring and reporting performance

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Marketing Risk Management Reform

  • not necessarily a straightforward task
  • a considerable departure from the ‘traditional’ approach
    • political/budget management pressure to minimise current period debt service costs
    • standard budget management framework focus on identifiable up-front savings as a pre-condition for new program spending

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Marketing Risk Management Reform

  • traditional approach often grounded in a short-term transactional focus
    • consistent with a focus on the marginal implication of alternative transactions for debt service costs
    • usually inadequate attention to government’s risk preferences and risk trade-offs
    • cost and risk concepts may not be well specified
    • generally inadequate attention to risks to longer-term cost performance

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Marketing Risk Management Reform

  • better defining the traditional approach
  • debt management task viewed as a series of discrete functions undertaken within only loosely-related ‘silos’
    • managing day-to-day liquidity needs
    • achieving budget funding task
  • operating objective might typically be pitched at minimising the budgetary cost of these discrete functions, perhaps even on a ‘silo by silo’ basis

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Deficiencies of the Traditional Approach

  • this functional view can be helpful in describing what a debt manager does
    • but provides little insight into why particular strategies adopted / decisions taken / activities prioritised
  • and seriously deficient as a management framework

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Deficiencies of the Traditional Approach

  • functional focus encourages an overly narrow notion of ‘cost’ and ‘performance’
    • e.g. cash management focus on minimising ‘idle balances’
    • e.g. issuing offshore in pursuit of short-term cost savings at the expense of developing domestic market liquidity
    • e.g. building liquidity across the curve without proper consideration for portfolio interest rate risk

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A Risk Management Framework

  • a key insight is that similar or equivalent risks can arise in the conduct of a variety of financial functions
  • provides a framework for ‘looking through’ the operations of seemingly quite loosely-related debt management functions to identify common risks
    • Basle standards – the overall prudential standing of a financial entity can best be assessed in terms of its exposure to different risks and the effectiveness with which those different risks are treated or managed

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A Risk Management Framework

  • true of any economic entity with financial exposures in its balance sheet – including a sovereign debt manager
    • risk focus provides a management framework for moving away from seeking to manage cost outcomes on a transaction by transaction basis
    • towards addressing all relevant risks bearing on cost performance within a more transparent and coherent management framework

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A Risk Management Framework

  • a risk-based management framework requires identification of all relevant risks to cost performance
    • market risk, funding risk, liquidity risk, credit risk, operational risk
    • makes it clear in what areas the gov’t is exposed in terms of inadequate capacity to manage these risks
    • and, unlike traditional approach, makes it clearer that risks are not independent

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A Risk Management Framework

  • obliges conscious decisions as to the balance to struck between different risks, the govt’s risk tolerance and it’s preferred cost-risk trade-off
    • clear that a ‘do nothing’ strategy is as much a deliberate choice about risk and risk preference as a decision to manage the existing risk profile

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A Risk Management Framework

  • does not eliminate risk nor provide for 20:20 foresight
  • but provides a coherent framework for making choices about risk
    • for selecting efficiently from among different risks so as to minimise risk overall in line with the govt’s risk preferences
  • makes it clearer to external stakeholders why it is that the debt manager may be prioritising certain activities

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A Risk Management Framework

  • a risk-based management framework is better geared to a more robust measure of debt management cost performance than the traditional functional approach
    • obliges a focus on the full term implications of all risks to cost outcomes
    • with all risks identified, extent of exposures will be clearer, as well as how effectively those exposures are being managed
    • provides a sound basis for resource deployment and prioritisation

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Conclusion

  • a risk-based focus provides for a discipline and a rigour absent from more traditional approaches to sovereign debt management
    • a more coherent management framework, greater clarity in objectives and risk policies, enhanced accountability
    • and, ultimately, a much sounder basis for achieving better longer-term cost performance

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Last updated: 7 November 2013