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 authorities and council-controlled organisations.
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.
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.
Treasury Risk Management
LGFA funds itself through domestic and international wholesale and retail debt capital markets, with the funds raised on-lent to participating borrowers, being New Zealand local authorities and council-controlled organisations. LGFA's 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 and council-controlled organisations 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.
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 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 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.
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, 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.
LGFA provides debt funding solely to New Zealand Local authorities, council-controlled organisations (CCOs) and council-controlled trading organisations (CCTOs).
The LGFA Board will have ultimate discretion on approving term lending to local authorities, CCOs and CCTOs.
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 council's borrowings, or LGFA's commitment under a facility agreement with a council, is at any greater than NZD 20 million, be required to become a party to a deed of guarantee and an equity commitment deed (in each case, in a form set by LGFA).
- Issue securities (bonds/floating rate notes/commercial paper) to LGFA and/or enter into facility arrangements with LGFA.
- Comply with their own internal borrowing policies.
- Comply with the financial covenants outlined in the following tables:
|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%|
|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 Table 1 above only with the approval of the Board.
- Foundation policy covenants outlined in Table 1 above only with the approval of an ordinary resolution of LGFA's 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 Table 1 above and can have bespoke financial covenants that exceed the foundation policy covenants outlined in Table 1 above only with the approval of an ordinary resolution of LGFA's shareholders; and, in any event, will not be required to comply with the Net Debt Total Revenue foundation policy covenant outlined in Table 1 above until the financial year ending 30 June 2026. Until that date, each local authority must comply with the Alternative Net Debt/Total Revenue covenant set out in Table 2 above.
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 borrowings 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.
Auckland Council will be limited to a maximum of 40% of LGFA’s total local authority (including CCO) assets.
CCOs and CCTOs can borrow from LGFA provided that:
- In the case of a CCO, then its obligations are guaranteed by its council parent.
- In the case of a CCTO, then it is supported by uncalled capital within the CCTO.
- All parent council shareholders must be guarantors of LGFA.
- The CCO/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 will be transferred to the relevant council shareholder(s).
- The LGFA Board has approved the relevant CCO or CCTO joining.
- 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.
- If the CCO/CCTO ceases to be a CCO, LGFA's loans will be redeemed.
LGFA will report to its shareholders on a quarterly basis the breakdown of CCO and CCTO lending.