Assessing and managing risk
The assessment and underwriting of risk is central to EFIC's financial management framework. All transactions underwritten by EFIC are reviewed by the Board or by management in accordance with delegated authorities from the Board.
Country risk is assessed by the Chief Economist. Large or complex transactions are reviewed by a Credit Committee.
Contingent liability and loan ceilings
EFIC operates within a strong regulatory environment. The controls imposed on EFIC include:
EFIC’s treasury activities are carried out within a control framework approved by the Board and complying with the EFIC Act, the Commonwealth Authorities and Companies Act 1997 (Cth) ("CAC Act") and approvals of the Australian Government. Within this framework, we aim to minimise the cost of funding the loan assets of EFIC on both the Commercial Account and National Interest Account and to maximise the return on its investments, including funds representing EFIC’s equity, reserves and working capital. Our treasury unit confines risk to highly-rated counterparties and does not trade speculatively.
EFIC's functions and obligations are set out in the EFIC Act, including the framework for EFIC's funding activities by Treasury. Section 61 of the EFIC Act states that "EFIC must not borrow or raise money except under section 58 or 59". Section 58 allows the Finance Minister to lend money to EFIC and section 59 allows EFIC to borrow or raise money, subject to written approval of the Finance Minister. To date, EFIC has funded its activities under section 59 approvals.
EFIC borrows in the international market to fund its lending operations. The core function of EFIC's Treasury is to obtain competitive rates and to manage the reserves that represent EFIC's capital base. Treasury uses derivative products to minimise currency and interest rate risks involved in EFIC's business. EFIC's power to enter into derivatives transactions derives from its general powers in section 11 of the EFIC Act.
EFIC's management reports regularly to the Board the results of its Treasury operations.
Foreign exchange and interest rate management
EFIC funds its assets in matched currencies, either by borrowing in the appropriate currency or, more usually, by borrowing in another currency and using cross-currency swaps or foreign exchange markets to remove the foreign exchange exposure.
Similarly, we use interest rate swaps and futures to match the interest rate profiles of our liabilities with those of our loans.
Under the EFIC Act, the Commonwealth guarantees all of EFIC’s liabilities, including our borrowings from third parties. Section 59 of the EFIC Act allows us to borrow or raise money, subject to written approval of the Finance Minister. The main borrowing instruments currently used are medium-term notes issued in the capital markets and euro-commercial paper.
The main reason we borrow money is to fund loans made to exporters on either the Commercial Account or the National Interest Account. Funding may also be necessary when contingent liabilities, such as export finance guarantees provided to banks to support the financing of Australian export trade, are called and EFIC pays out the bank. For this reason, we are required to have additional funding lines available to cover the possibility of borrower defaults and subsequent calls by lending banks on EFIC’s guarantees.
We are also authorised to raise funds from our approved commercial paper borrowing facilities in advance of loan funding needs. This facility was introduced in 1990 to maintain a minimum market presence and therefore enhance the effectiveness of EFIC’s funding ahead of permanent funding requirements.
Investments and liquidity
EFIC’s treasury investments, which are treated from an accounting perspective as ‘available-for-sale’, are required to be ‘marked to market’ and gains or losses are to be reflected through equity, not profit and loss. While our policy is to hold our investments to maturity, they can be sold if necessary. Assuming no credit defaults, any ‘unrealised’ gains or losses caused by revaluations will not be realised.
The investment approval issued by the Finance Minister under the CAC Act requires our treasury investments to be in entities rated AA– or better or ADIs rated BBB– or better.
Capital adequacy guidelines
Under section 56(i) of the EFIC Act, the Board is required "to ensure, according to sound commercial principles. that the capital and reserves of EFIC at any time are sufficient". This requirement relates only to our Commercial Account activities. APRA requires banks in Australia to have minimum capital requirements consistent with the Basel II framework. Although EFIC does not have to comply with APRA guidelines, the Board has adopted Basel II principles in line with best practice for measuring capital adequacy within EFIC until Basel III guidelines are released and finalised by APRA.
When making this assessment, the Board is required to include as capital the $200 million of callable capital that is available from the Commonwealth in accordance with the provisions of section 54 of the EFIC Act.
EFIC’s lending business is essentially similar to a wholesale corporate banking business, although the risk profile is different from that of a typical bank. We have a more concentrated portfolio of generally longer-dated and higher-risk exposures, consistent with our role of working beyond the limits of the commercial market.
We have therefore based our assessments of capital adequacy upon the prudential standards and calculations used for regulating banks. The Board has endorsed a model that takes into account the Australian Prudential Regulation Authority (APRA) guidelines and the Basel framework issued by the Basel Committee on Banking Supervision. The model covers credit risk, operational risk, market risk and credit concentration risk. We assign probability of default statistics and loss given default ratios to each of our facilities and calculate an amount of capital accordingly, with the riskier, longer-dated facilities requiring more capital than the less risky, shorter-dated facilities. We have used probability of default statistics published by the major ratings agencies and Berne Union statistics to assist in constructing the model.
EFIC holds no capital against the National Interest Account business on the basis that the risks are borne by the Commonwealth.
Large exposure guidelines
EFIC has adopted APRA guidelines in relation to large exposures. Australian banks are required to consult with APRA prior to committing to any aggregate exposures to non-government, non-bank counterparties exceeding 10% of their capital base. APRA has also indicated a maximum exposure per non-bank counterparty (or related group of counterparties) of 25% of capital but have emphasised that this is an upper limit. Only better rated risks would be contemplated for these levels of exposures.
The Board has endorsed this limit of 25% of capital and reserves (including callable capital) to apply to exposures graded ERS 1 (AAA/AA– or Aaa/Aa3) or 2 (A+/A– or A1/A3), but a 15% target would apply for risks graded ERS 3 (BBB) or worse within the general guideline of 25%. Exceptions in excess of the 15% target would require consideration by the Board in light of such issues as the creditworthiness of the relevant counterparty or group of related counterparties, the tenor of the exposure and the level of Australian content and Australian interest in the particular transaction. In any event, under current delegations, the Board must approve all transactions that involve commitments in excess of $50 million.
As an exception to this policy, the Board has approved increases in exposure limits to single counterparties under risk transfer arrangements from a maximum 25% to 37.5% for risk transfer partners rated ERS 1 or 2; and from a maximum of 25% to 50% for risk transfer partners rated ERS 1 from government-backed export credit agencies.
For bank counterparties, APRA has indicated a maximum exposure of 50% of capital. The Board has endorsed the application of this limit of 50% of capital to all treasury activities with bank counterparties (defined by EFIC as Approved Deposit-taking Institutions (ADIs) under the Banking Act 1959 and rated BBB– and above, and other financial entities rated AA– and above), provided any exposure in excess of 25% of EFIC’s capital has a maturity of six months or less.
For large exposure purposes, the Board includes as eligible capital the $200 million of callable capital that is available from the Commonwealth in accordance with the provisions of section 56 of the EFIC Act.
EFIC publishes its financial statements each year in its Annual Report, which is tabled in Parliament. The financial statements are audited by the Australian National Audit Office.
The EFIC Act requires the Board to make a recommendation to the Minister for Trade and Competitiveness on the payment of a dividend to the Commonwealth.
The Minister by written notice to EFIC either “approves” the recommendation from the Board or “directs” the payment of a different specified dividend.