Part 4: Challenges in managing and governing financial assets
4.1
In this Part, we review the challenges that individual public entities and the whole of government face in managing and governing financial assets. We also provide some guidance for public entities that hold, or are looking to hold, financial assets.
Challenges and risks for public entities
4.2
Although there are clear opportunities for using financial assets, the global financial crisis in 2008 highlighted how financial assets can also create sizeable risks when their use is not transparent, or they are not understood, or they are not adequately managed or monitored.
4.3
Figure 19 summarises the main risks for public entities in holding financial assets.
Figure 19
Key risks in holding financial assets
Source: Adapted from Chief Investment Officers and the Association of Public Pension Fund Auditors (2000), Public Pension Systems: Statements of Key Risks and Common Practices to Address Those Risks, Columbus, Ohio.
4.4
Figure 19 covers the spectrum of risks involved in holding a diversified pool of financial assets for the purposes of meeting some future liability (such as pension obligations). Many of the risks would also apply to a single financial instrument used for a single policy objective (such as using derivatives to mitigate interest-rate risk).
Taking on additional external risks might be necessary
4.5
External risks are particularly important in an investment context. They affect not only how financial assets are managed and governed, but also the potential return expected on those assets.
4.6
Any financial asset will have some market risk. Where higher returns are sought to fulfil a particular objective, taking on additional market risks may be necessary.
4.7
How much additional market risk an entity is willing to take on (its risk tolerance) depends on many factors, including the purpose for which the assets are being held, the investment horizon, the financial strength of the entity, and the expectations of stakeholders.
4.8
Understanding the investment context is important in determining what market risks are important, how they are measured, and how they are evaluated. Specialist advice might be needed.
Nine guiding principles for managing internal and external risks
4.9
The following principles should be helpful for public entities managing the various internal and external risks highlighted in Figure 19.
Clear and relevant objectives
4.10
Be clear about the reasons for holding financial assets. Financial assets can be held for several reasons, including funding future liabilities, managing risks, and motivating commercial behaviours. Ensuring that these objectives are clear, justified and remain relevant to the entity is fundamental to ensuring that the financial assets do what they are supposed to do. For example, a portfolio with a long-term investment objective should be designed around long-term investment strategies with long-term performance measures.
Get the design of the management and governance processes right
4.11
Designing the portfolio's management and governance correctly means matching the entity's objectives, legislation, and tolerance for risk with the right set of financial assets and the skills necessary to manage and govern them. The right processes ensure that stakeholders, governors, and managers have common, clear investment expectations and are appropriately resourced and organised. Depending on the size and complexity of the entity's objectives, independent specialist advice might also be needed.
Clearly assign responsibilities
4.12
As a principle of good governance, responsibility for different tasks should be clearly assigned to the party or parties best placed to carry them out. For example, usually, internal accounting and finance staff members should not choose which shares to invest in.
Use delegations appropriately
4.13
Delegation can be an effective way to bridge expertise and capacity gaps. It can also reduce costs and improve efficiency. For example, it would be unusual for a board to delegate strategic asset allocation responsibilities, but understandable for day-to-day portfolio management to be delegated to external professional fund managers. However, with delegation comes the need to monitor effectively.
Clearly separate duties
4.14
The risks of fraud or falsifying information increases when complementary functions are not kept separate. For example, an investment management firm should not be made accountable for assessing its own performance. A clear separation of duties is the first line of defence against risks of fraud.
Have effective, well-aligned incentives
4.15
Staff-related risks and operational risks can be reduced by ensuring that effective incentives are in place. For example, governors should be aware of creating "free options" within performance fee structures, because they can encourage investment managers to take on risk with impunity. Similarly, those tasked with assessing performance should not have incentives to show that the performance has been favourable, nor be punished for finding that it has been unfavourable.
Have a clear process
4.16
"Prudence is process" is a simple and easily remembered principle in financial management. Although it is possible to suffer failures or losses with the best laid plans, such failures are more likely to be tolerated and understood if good processes were in place. Processes must be recorded clearly.
Monitor effectively
4.17
Monitoring is an integral part of a healthy process. Continual reviews can help to create a culture of continual improvement and refining of processes over time. They should also be effective in identifying why outcomes are favourable or unfavourable. Continual reviews also inform the planning for corrections or policy changes, when necessary, or reinforce the current approach.
Communicate clearly
4.18
Clarity and transparency about the design, management, and governance of financial assets is important to all stakeholders during the lifetime of a portfolio of such assets. The reasons the portfolio was set up and whether the financial assets are meeting the entity's objectives can be complicated to explain. However, if these matters are not well understood by all stakeholders, it can lead to misunderstandings, relationship problems and, at worst, financial assets that become detached from the operational objectives of the entity.
| Recommendation 2 |
We recommend that public entities with significant financial assets regularly assess how well they are managing and governing their financial portfolios and reporting to stakeholders using the following questions:
|
Challenges at a whole-of-government level
4.19
As the value and use of financial assets continue to grow, challenges will emerge at a whole-of-government level. We discuss some of these potential challenges in paragraphs 4.20-4.35.
Governance and agency relationships
4.20
In 1998 and 2001, Treasury working papers24 raised various matters about the relationships between taxpayers, the government, and financial asset investment managers. The matters included the potential for:
- the Government to directly or indirectly affect the performance of the financial asset, such as through unexpected withdrawals or enforcing excessive prudence, "short-termism", or other government perspectives on investment decisions;
- adverse effects on private sector behaviour through the Government exercising its ownership rights in a way that conflicts with private sector goals; or
- insufficient stewardship, particularly where governors are not independent enough from fund managers.
4.21
The governance structure of the NZSF was designed to address these matters. The NZSF is "double arms-length" away from the Government. The Government does not decide on the pool of candidates for appointment to the board that governs the NZSF. The board and management make investment policies and decisions.
Effects on financial stability and sustainability
4.22
As financial assets become a larger part of the Crown's balance sheet, investment decisions will affect not only the public entity holding the assets but also the financial position of the Government and, possibly, the whole economy. Collectively, these assets could materially affect the Government's financial risk exposure through:
- the way in which the value of the financial assets change relative to the value of key industries or the economy − financial asset portfolios can be designed to exploit or mitigate the effects of such movements;
- the potential for increasing cross-holdings of financial assets by public entities, which create financial interdependencies25 that could affect how financial risks flow through the public sector − the FSG show that, in 2014, about 14% of the financial assets held by three segments in central government26 were securities issued by other central government entities, up from 11% in 2008; or
- the potential exposure to global systemic risks − for example, the more foreign-owned and/or foreign-denominated financial assets, the more the Government is exposed to movements in global financial markets.
4.23
Changing returns on financial assets affect important government indicators, such as the operating balance, net debt, and/or net assets. For example, the 2015 FSG show that core Crown net debt (excluding the NZSF) changed little during the past year because the increase in sovereign debt (about $4.6 billion) was offset by a similar increase in the value of financial assets.
4.24
Figure 20 shows how central government financial asset gains and losses, and interest earned, has affected the Crown's operating balance from 2008 to 2014.
Figure 20
Effect of financial asset gains, losses (including derivatives), and interest on the Crown's operating balance, 2008-14
Source: Financial Statements of the Government.
4.25
Figure 20 shows the historical variability in the value of financial asset gains and losses and their effect on the Crown's operating balance. Without the large and positive returns in 2013 and 2014, the operating balance would have been negative.
4.26
Indicators such as the operating balance focus mainly on the short-term financial stability of the Government. However, many of the Government's reasons for holding financial assets relate to longer-term responsibilities. Measures are also needed that reflect how financial assets affect the longer-term financial sustainability of the Government.
Effects on the tolerance for risk
4.27
As with individual entities, understanding the whole-of-government's willingness for taking on financial risk is a fundamental part of planning, managing, and governing a portfolio of entities that holds many financial assets.
4.28
For example, the NZSF does not insure the fund from a catastrophic or global financial crisis because it believes the opportunity cost (in lost returns) outweighs the benefit of lower risk. This is consistent with the NZSF's long-term investment approach, higher risk tolerance and return expectations.
4.29
However, this might also be inconsistent from a whole-of-government perspective, where such a crisis could mean widespread challenges for government entities, potentially leading to increased debt (and other obligations) at a time when financial asset values are also declining. In this situation, important financial indicators such as net worth and net debt could take a short-term to medium-term double hit − as debt needs to increase while the value of financial assets decline.
4.30
Appreciating the relationship between higher (lower) returns and higher (lower) risk is fundamental to understanding how much risk is acceptable at all levels of government. Preparing a formal Risk Appetite Framework that includes policies, processes, controls, and systems through which risk appetite is established, communicated, and monitored, is one way to gain a whole-of-government perspective on the level of tolerance for risk with financial assets.27
Effects on effectiveness and efficiency
4.31
Although the CFIs are co-operating and sharing information, the issues identified in the Government's 2013 ICT Strategy and Action Plan about the use of different technology platforms by entities might become more relevant (such as duplication and fragmentation, and a lack of co-ordinated investment creating cost inefficiencies).
4.32
In our review of the 14 public entities, we found little commonality in the technology platforms and systems used to manage and track financial assets.
Effects on domestic capital markets
4.33
In its 2015 annual report, ACC noted that it "… is one of the largest investors in New Zealand companies, owning about 3% of the market capitalisation of the New Zealand share market".28 As well as this significant share ownership,
ACC owns 40% of the inflation-indexed bonds that have been issued by the New Zealand Government, and 6% of the regular (not inflation indexed) New Zealand Government bonds.29
4.34
In total, the NZSF, the Government Superannuation Fund, and ACC own close to 5% of all New Zealand Stock Exchange-listed securities. As the value and use of government-owned financial assets increase, this could have implications for domestic markets. Although greater public sector participation in financial markets can have benefits, such as improving liquidity and encouraging a greater range of investments, it can also:
- "crowd out" private investors;
- limit private shareholder power;
- influence company behaviour; and
- cause instability through political changes and time frames.
4.35
Independent governance frameworks and clear objectives can manage most of these concerns at the entity level. However, at a whole-of-government level, these issues could remain.
Planning for future opportunities and challenges in managing public sector financial assets
4.36
The increasing, complexity, and materiality of public sector financial assets will offer new opportunities and challenges for public sector entities, New Zealand's capital markets, and the economy. Careful thought about how best to manage these changes is now needed at a whole-of-government level.
4.37
In a recent report on how best to manage the numerous financial institutions that the Government of the United Kingdom has ownership interests in, the National Audit Office concluded:
We consider that government should adopt a portfolio management approach alongside the traditional departmental oversight model to provide heightened assurance over the portfolio.30
4.38
The Treasury already has a strategic plan for physical assets. The National Infrastructure Plan provides a long-term framework with a vision that "New Zealand's infrastructure will be resilient and co-ordinated, and contribute to a strong economy and high living standards".
4.39
The Treasury has also recently released a consultation document about a proposed framework to "increase the Treasury's ability to advise the Government on risk in the Crown's balance sheet".31 An important part of this work will be ensuring that there are enough financial assets to provide resilience against major risks, such as another global financial crisis. Related to this are questions about clearly defining and measuring risk across short-term and long-term investment horizons.
4.40
Preparing such a strategic vision (and plan) for financial assets could help:
- show the future direction and profile of financial assets;
- provide more alignment between entities and sectors;
- increase public awareness of the role that financial assets play in public sector service delivery and the challenges that emerge; and
- complement and reinforce the Treasury's National Infrastructure Plan, Debt Management Strategy, and current work on managing the Crown's balance sheet risk.
4.41
All these strands of work are interrelated. Brought together, they provide the foundation for an integrated asset strategy for the Government.
| Recommendation 3 |
| We recommend that the Treasury prepare a strategic perspective on and vision for holding financial assets in the public sector. |
24: Much of this discussion is based on Grimes, A. (2001) Crown Financial Asset Management: Objectives and Practice and Davis, N. (1998) Governance of Crown Financial Assets.
25: Where one entity's financial performance depends, to some extent, on another entity.
26: The three segments in the FSG are the core Crown, Crown entities, and State-owned enterprises.
27: For example, see the Financial Stability Board (2013), Principles for An Effective Risk Appetite Framework.
28: ACC's Annual Report 2015, page 35.
29: ACC's Annual Report 2015, page 35.
30: National Audit Office (2015), Financial institutions landscape, page 13.
31: See the Treasury's 5 October 2015 consultation document, Crown Asset and Liability Management, pages 2 and 4.