Risk Management

The Local Government Funding Agency (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 a professional image 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 liquidity, interest rate/market risk, foreign exchange, counterparty credit, operational 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 liquidity periods.  LGFA is required to maintain sufficent 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 through the use of 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.

  • PDH risk 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 fall by NZD 40,000 for a one basis point fall in interest rates.
  • Value at Risk is used to measure market risk. The VaR model calculates the amount LGFA’s portfolio could be expected to lose 5% of time over a given time period. It is calculated using historical changes in underlying risk variables and applying those changes to the current portfolio.

VaR measures expected loss for a given period with a given confidence. For example, 95% confidence, daily VaR of NZD 250,000 means that it is expected that the portfolio will lose NZD 250,000 on 5% of days i.e. 1 day in 20 the portfolio value will decrease by NZD 250,000.

 

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 NZDMO as the counterparty to derivative contracts
  • Investment is restricted to approved financial investments listed in the Treasury Policy

 

FOREIGN CURRENCY RISK

 

Exposure to foreign exchange will exist as a result of accessing 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 as a result of human error (or fraud), negligent behaviour, system failures and inadequate procedures and controls.

Operational risk is managed through the use of 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 complied with at all times.

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

 

The LGFA sole purpose will be to provide debt funding to New Zealand Local Government (i.e. the Local Government borrowing counterparty will be the Council itself and will not be any Council Controlled Organisation, Council Controlled Trading Organisation, Council joint venture or partially owned entity).

The LGFA Board will have ultimate discretion on approving term funding to Council.

All Local Authorities that borrow from the Company will:

  • Provide debenture security in relation to their borrowing from the Company and related obligations, and (if relevant), equity commitment liabilities to the Company and (if relevant) guarantee liabilities to a security trustee approved for the Company's creditors.
  • If the principal amount of a Local Authority's 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 / FRNs / CP) to the Company (i.e. not enter into facility arrangements).
  • Comply with their own internal borrowing policies.
  • Comply with the financial covenants outlined in the following table, provided that:
  • 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 following table only with the approval of the Board;
  • Foundation policy covenants outlined in the following 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 following 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.

 

          Financial covenant                Lending policy covenants     Foundation policy covenants

          Net debt / total revenue                                 <175%                                     <250%

          Net interest / total revenue                            <20%                                       <20%

          Net interest / Annual rates income               <25%                                      <30%

          Liquidity                                                           >110%                                    >110%

 

  • Non-compliance with the financial covenants will either preclude a Council from borrowing from the 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 the LGFA to accelerate all loans to the defaulting Council.
  • Total Revenue is defined as cash earnings from rates, government 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 consolidated 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 LGs for services provided and for which the other LGs rate.

Financial covenants are measured on Council only not consolidated group.

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

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