Risk Management

Risk Management

LGFA recognises that an effective risk management framework is a critical part of its business structure. LGFA is exposed to both business and treasury related risks because of its normal business activities that relate to raising and on-lending funds to local councils.

LGFA adopts the three lines of defence model to ensure that essential risk management functions are completed using a systematic approach that reflects industry best practice:

  • The first line of defence establishes risk ownership within the business and is represented by the operational risk and control processes within the business. Business managers are responsible for identifying controls, maintaining effective controls and mitigating risks.
  • The second line of defence establishes risk control within the organisation by ensuring that risks are actively and appropriately managed by processes such as the regular review of risk reports and compliance monitoring against the risk management framework.
  • The third line of defence establishes independent assurance on the risk governance framework provided by both the internal and external audit functions which review and highlight control weaknesses and inefficiencies to management and the Board.

The Audit and Risk Committee assists the Board by considering, reviewing and monitoring LGFA’s risk management framework and processes, and the internal control environment and mechanisms.

LGFA continually reviews its core business risks. This review process includes the identification and assessment of core business risks which are ranked using predetermined criteria for both the likelihood and potential impact of each risk. LGFA maintains a company-wide risk register which records all identified risks, potential impacts and the controls and mitigation strategies used to manage the risks.

LGFA has treasury exposures arising from its normal business activities that principally relate to the raising and on-lending of funds. A detailed description of LGFA’s risk management processes for treasury exposures is detailed in the Treasury Risk Management section of this report.

Internal audit

LGFA has established an internal audit function to provide assurance that LGFA’s risk management, governance and internal controls are operating effectively.

The Audit and Risk Committee has responsibility for oversight of the internal audit function, including:

  • Reviewing the Internal Audit Charter, the operations of the internal audit and organisational structure of the internal audit function;
  • Reviewing and approving the annual audit plan;
  • Reviewing the effectiveness of the internal audit function; and
  • Meeting separately with the internal auditor to discuss any matters that the Audit and Risk Committee or Internal Audit believes should be discussed privately.

Health and safety

LGFA is committed to a safe and healthy work environment and has formally adopted a LGFA Health and Safety Policy that clearly sets out the duty of directors, LGFA and staff under the Health and Safety at Work Act 2015. A staff health and safety committee has been established with responsibility to continuously review health and safety issues and ongoing compliance with the Act, with reporting to the Board on health and safety issues at each Board meeting.

Treasury Risk Management

LGFA funds itself through domestic and international wholesale and retail debt capital markets, with the funds raised on-lent to participating New Zealand Local Authority borrowers. LGFA activities are governed by the Local Government Borrowing Act 2011, the Local Government Act 2002, and the Companies Act 1993. In addition, the company is required to comply with ‘Foundation Policies’ outlined in the Shareholders Agreement. Any change to the Foundation Policies require shareholders’ consent.

LGFA has treasury exposures arising from its normal business activities that principally relate to the raising and on-lending of funds. LGFA manages treasury exposures under a Board-approved Treasury Policy. The objectives for the Treasury Policy are to:

  • Effectively manage balance sheet and interest rate risk within the interest rate risk control limits to protect LGFA’s capital position and Net Interest Margin over time.
  • Fund participating local authorities in the most cost-effective manner and in accordance with the operating principles, values and objectives of the LGFA.
  • Protect LGFA’s assets and prevent unauthorised transactions.
  • Promote professional expertise of financial and management control to all external parties.
  • Minimise operational risk by maintaining adequate internal controls, systems and staffing competencies.
  • Provide timely reporting to the LGFA Board with meaningful and accurate reporting of interest rate exposures, liquidity, asset and liability maturity, funding, counterparty credit, performance and Policy compliance.

Specific treasury exposures relate to liquidityinterest rate/market riskforeign exchangecounterparty creditoperational and lending risks.

LIQUIDITY RISK

Liquidity risk refers to the potential inability of LGFA to meet its financial obligations when they become due, under normal or abnormal/stressed operating conditions.

Liquidity risk is managed using a forecasted cashflow approach measured over 30-day, 90-day and one-year periods. LGFA is required to maintain sufficient liquidity (comprising a government standby facility and holdings of cash and liquid investments) to support 12 months operating and funding commitments.

INTEREST RATE RISK/MARKET RISK

Interest rate risk is the risk that financial assets may re-price/mature at a different time and/or by a different amount than financial liabilities.

Market risk is managed using Value at Risk (VaR) and Partial Differential Hedge (PDH) limits to mitigate the potential change in value of the balance sheet due to changes in interest rates.

  • Value at Risk calculates the potential amount LGFA’s portfolio could be expected to lose 5% of the time over a given time period. It is calculated using historical changes in underlying risk variables and applying those changes to the current portfolio.

LGFA measures VaR over a daily time horizon with a 95% confidence interval. A daily 95% VaR exposure of $1,000,000 means that there is a 5% chance that the portfolio could potentially lose more than $1,000,000 over the next business day.

  • Partial Differential Hedge measures the sensitivity of a portfolio to a one basis point change in underlying interest rates. For example, a PDH of NZD$40,000 means that the portfolio value will increase by NZD $40,000 for a one basis point fall in interest rates.

COUNTERPARTY CREDIT RISK

Counterparty credit risk is the risk of financial loss to LGFA (realised or unrealised) arising from a counterparty defaulting on an investment, security and/or financial instrument where LGFA is a holder or party.

Counterparty credit risk is managed through:

  • Counterparty limits for investments. These are determined as a function of the term of investment, liquidity and credit quality of the counterparty (as measured by credit rating).
  • Counterparty risk on derivative contracts is mitigated by utilising the NZDM as the counterparty to derivative contracts.

Investment is restricted to approved financial investments listed in the LGFA Treasury Policy.

FOREIGN CURRENCY RISK

Exposure to foreign exchange could exist if LGFA accesses foreign capital markets for funding purposes.

Foreign exchange risk is managed through a requirement for LGFA to fully hedge back to floating rate NZD the full amount and term of all foreign currency funding and cash flows.

OPERATIONAL RISK

Operational risk, with respect to treasury management, is the risk of financial and/or reputation loss because of human error (or fraud), negligent behaviour, system failures and inadequate procedures and controls.

Operational risk is managed using internal controls and procedures across LGFA’s operational functions. Segregation of duties between staff members who have the authority to enter transactions with external counterparties and the staff who control, check and confirm such transactions is a cornerstone internal control principle, that is always complied with.

Financial instruments are not entered into if the systems, operations and internal controls do not satisfactorily support the measurement, management and reporting of the risks.

LENDING RISK

LGFA provides debt funding solely to New Zealand Local Government entities such as Councils, Council Controlled Organisations (CCO’s) and Council Controlled Trading Organisations (CCTO’s).

The LGFA Board will have ultimate discretion on approving term lending to Councils and CCO’s and CCTO’s.

All Councils that borrow from LGFA will:

  • Provide debenture security in relation to their borrowing from LGFA and related obligations, and (if relevant), equity commitment liabilities to LGFA and (if relevant) guarantee liabilities to a security trustee approved for LGFA’s creditors.
  • If the principal amount of a Councils borrowings is at any time equal to, or greater than, NZD 20 million, then it is required to become a party to a deed of guarantee and an equity commitment deed.
  • Issue securities (bonds/floating rate notes/commercial paper) to LGFA and cannot enter into facility arrangements.
  • Comply with their own internal borrowing policies.
  • Comply with the financial covenants outlined in the following tables

Table 1: LGFA Financial Covenants

Financial covenant

Lending policy covenants

Foundation policy covenants

Net Debt / Total Revenue

<175%

<280%

Net Interest / Total Revenue

<20%

<20%

Net Interest / Annual Rates Income

<25%

<30%

Liquidity 

>110%

>110%

 

Table 2: LGFA Alternative Net Debt to Total Revenue Foundation Policy Covenant for the financial years ending June 2020 to 2025

Alternative Net Debt / Total Revenue Covenant

Financial Year ending

Net Debt / Total Revenue

30 June 2020

          <250%

30 June 2021

          <300%

30 June 2022

<300%

30 June 2023

<295%

30 June 2024

<290%

30 June 2025

<285%

 

For covenant calculation purposes

  • Total Revenue is defined as cash earnings from rates, grants and subsidies, user charges, interest, dividends, financial and other revenue and excludes non-government capital contributions (e.g. developer contributions and vested assets).
  • Net debt is defined as total debt less liquid financial assets and investments.
  • Liquidity is defined as external debt plus committed loan facilities plus liquid investments divided by external debt.
  • Net Interest is defined as the amount equal to all interest and financing costs less interest income for the relevant period. 
  • Annual Rates Income is defined as the amount equal to the total revenue from any funding mechanism authorised by the Local Government (Rating) Act 2002 together with any revenue received from other local authorities for services provided (and for which the other local authorities rate).
  • Financial covenants are measured on Council only basis and not consolidated group basis, unless requested by a Local Authority and approved by the LGFA Board.

Unrated Local Authorities or Local Authorities with a long-term credit rating lower than ‘A’ equivalent can have bespoke financial covenants that exceed the:

  • Lending policy covenants outlined in the above table only with the approval of the Board.
  • Foundation policy covenants outlined in the above table only with the approval of an Ordinary Resolution of shareholders.

Local Authorities with a long-term credit rating of ‘A’ equivalent or higher will not be required to comply with the Lending policy covenants in the above table and can have bespoke financial covenants that exceed the Foundation policy covenants outlined in the following table only with the approval of an Ordinary Resolution of shareholders.

Any Board or Ordinary Resolution approval of bespoke financial covenants will only be provided after a robust credit analysis and any approval must also include bespoke reporting and monitoring arrangements.

Non-compliance with the financial covenants will either preclude a council from borrowing from LGFA or in the case of existing council borrowers trigger an event of review. An event of default will occur if (among other things) a council fails to meet an interest or principal payment (subject to grace periods). An event of default will enable LGFA to accelerate all loans to the defaulting council.

Financial covenants are measured on Council only, not consolidated group.

To minimise concentration risk, LGFA requires that no more than the greater of NZD 100 million or 33% of a Council’s borrowings from LGFA will mature in any 12-month period.

Auckland Council will be limited to a maximum of 40% of LGFA’s total Local Government assets.

CCO’s and CCTO’s can borrow from LGFA provided that:

  • If a CCO, then its obligations are guaranteed by its council parent.
  • If a CCTO, then it is supported by uncalled capital within the CCTO.
  • All parent council shareholders of the CCO or CCTO must be guarantors of LGFA.
  • Any CCO or CCTO borrower must be wholly owned, directly or indirectly, by one or more councils and Central Government (if applicable).
  • Council shareholder(s) must agree to their CCO or CCTO joining LGFA.
  • A CCO or CCTO will hold the Borrower Notes, but prior to conversion the Borrower Notes are transferred to the relevant council shareholder(s).
  • LGFA Board to approve each CCO or CCTO to join. 
  • Bespoke financial covenants (if any) are to be negotiated between LGFA and each CCO or CCTO.
  • Annual testing of the CCO or CCTO compliance with bespoke financial covenants (if relevant) and reporting as per council membership.
  • Credit analysis of the council shareholders and ongoing compliance with LGFA covenants will be undertaken on a parent basis and reported on a parent and consolidated group basis.
  • Lending to CCO or CCTO by LGFA is expected to be on the same (or better) security terms than their existing banking security.
  • Redemption of LGFA loans to CCO or CCTO if the CCO or CCTO ceases to be a CCO.

 

LGFA will report to its shareholders on a quarterly basis the breakdown of CCO and CCTO lending.