CIPFA’s new Prudential Code will include proportionality as a key objective for the first time. But for treasury managers, proportionality has always been a key principle for their roles. They live in a world of controls and limits, and within these frameworks make judgement calls on decisions involving staggering sums of money that can have long term ramifications for their organisations. These controls are often set with proportionality in mind, although not everyone may think of it in this way.
It helps to consider what risk is in treasury management terms. Risk is not a nebulous concept, but is a value that represents the uncertainty around our future expectations, primarily in terms of the effect on our organisation’s finances. Risks come in different forms; treasury risks are normally grouped into credit, liquidity, and market risks, but this is not a comprehensive list, and other risks will take centre stage at certain times. Almost every treasury decision involves risk, and the risk of every decision needs to be identified, measured, managed, and monitored. The avoidance of one risk normally involves the acceptance of another. Risk appetite is the amount of a type of risk we are willing to take and risk capacity is the amount of risk we can take.
The latter distinction is important. Controls and limits are set to mitigate the impact of losses from various activities on the organisation’s finances. This normally means referring to a level of reserves, specifically those reserves that can absorb losses: non-school General Fund revenue reserves. The overall level of such reserves is therefore the capacity for risk, although these reserves are required for many different reasons and for many different risks, so, in general, we need a more measured view. Whatever the size of an organisation’s capacity, any limits placed on treasury management decision-making in relation to that is incorporating proportionality into the framework.
At Arlingclose, we often refer to reserves when advising on setting limits for treasury risks. Credit risk is the prime example and the risk capacity of the organisation will be most apparent in setting individual counterparty limits. While credit losses are rarely 100%, a cautious stance requires consideration of the capacity of the organisation to accept the complete loss of a deposit. A sensible counterparty limit will equate to a manageable level of reserves available to absorb losses – counterparty limits are therefore proportionate to reserves and that proportion represents both risk capacity and risk appetite.
A similar, but more complex exercise, is carried out for other risks, i.e. a movement in interest rates or financial asset values. For a given adverse movement in market variables, what is the financial impact on the organisation and can we bear it? If not, we need to consider a different strategy.
The more volatile an investment is, or perhaps we should say, the higher the probability an investment will move in ways we do not want, the greater the capacity we need. The risk of a 1% movement in short term interest rates over one year might be judged to be relatively low, but a 10% change in equity values over the same period is generally more likely. The capacity for the latter will therefore need to be greater, which should prompt a lower invested amount.
These limits therefore represent the application of proportionality to the organisation’s reserves for a range of treasury decisions. In the draft Codes currently under consultation, CIPFA rightly flags the importance of proportionality. While the focus on “commercial investments” is narrower, it is a simple reminder that such a process should have been carried out for all risk exposures.
It’s worth mentioning here that the focus of risk management on the financial impact means that proportionality should focus on the capacity to absorb that financial impact rather than simply the size of investment balances. An authority with significant levels of capital receipts, unallocated capital grants, HRA balances or historic over-borrowing bolstering investment balances may find this a tricky proposition, as none of these balances share in the losses from treasury decisions.
The key issue around proportionality is that outcomes rarely follow expectations, so activity should be tempered as necessary to remain within an organisation’s capacity. Risk appetite can then play a greater role in treasury decision making.