PCSMA INVESTMENT SCHEME INVESTMENT POLICY RISK MANAGEMENT POLICY LIABILITY MANAGEMENT & DEPOSIT SCHEME POLICY. Draft Version: 27 th April 2010

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1 Proserpine Co-operative Sugar Milling Association Limited PCSMA INVESTMENT SCHEME INVESTMENT POLICY RISK MANAGEMENT POLICY LIABILITY MANAGEMENT & DEPOSIT SCHEME POLICY Draft Version: 27 th April 2010 Information Disclaimer: The information set out in this document has been prepared by Dr Robert Bianchi based upon information available to Dr Robert Bianchi and/or made available to Dr Robert Bianchi and/or from information available in the public domain. No independent verification has been made of such information or sources. This document is for information purposes only. Dr Robert Bianchi does not guarantee the accuracy or correctness of the information provided in this document or that any forecasts or projections made in this report will be realised. Dr Robert Bianchi does not accept any responsibility for any errors whether caused by negligence or otherwise or for any loss or damage incurred by anyone in reliance on anything that is included in this document. The recipient shall solely be responsible for losses, damages, costs and other consequences resulting directly or indirectly from using any information made available in this document. This document is only for internal use by Proserprine Co-operative Sugar Milling Association Limited and not for external distribution without expressed written permission of Dr Robert Bianchi. 1

2 PCSMA INVESTMENT POLICY PREAMBLE AND SCOPE OF THIS POLICY DOCUMENT This document reflects PCSMA s investment philosophy and guidelines for the management of its at-call deposits scheme (hereafter referred to as the Investment Scheme ). The deposits made in the Investment Scheme are employed by PCSMA as a source of working capital to finance its day to day operations. Deposits in the Investment Scheme that are surplus to daily working capital requirements are invested until required. PCSMA will adopt the Investment Policy as the guidelines for the investment process under the Investment Scheme. PCSMA will adopt the Risk Management Policy as the set of guidelines in the management of the various types of investment risk in the Investment Scheme. Finally, the Procedures Policy will detail the necessary procedures to administer the PCSMA Deposit scheme. The approval of the Investment Policy, Risk Management Policy and Procedures Policy documents require formal ratification by the PCSMA Board. The approval of the Investment Policy, Risk Management Policy and Procedures Policy will supersede previous Investment Policy guidelines and binds PCSMA, its officers, employees, contactors, consultants and other PCSMA third party representatives in regards to the adoption of these investment practices and guidelines in respect to the PCSMA Investment Scheme. GOVERNING LAWS OF THE INVESTMENT SCHEME Under the advice provided to PCSMA from McCullough Robertson lawyers dated 18 th May 2009, the PCSMA does not require an Australian Financial Services Licence (AFSL) and is bound by the Queensland Co-operatives Act 1997 and not the Corporations Act 2001 in regards to the Investment Scheme. 2

3 DEFINITIONS Asset Allocation The strategy employed in selecting the various kinds of possible asset classes in the investment portfolio. Investment Objectives Explains how each type of asset in the investment portfolio contributes to the specific goals detailed in the Investment Objectives. Investment Policy Statement A statement between an investment manager and their client (ie. the investor) which outlines how the investment funds are to be managed. Investment Strategy A set of procedures designed to guide an investor s selection of an investment portfolio. Segregation of Duties A principle based on separating certain areas of responsibility and duties in an effort to reduce fraud and unintentional mistakes. RESPONSIBILITY FOR INVESTMENT POLICY The Chief Executive Officer of PCSMA and the Board are charged with the ratification and approval of the Investment Policy. All aspects of the PCSMA Investment Policy may be delegated to the PCSMA Treasury Risk Management Committee and/or Chief Financial Officer as the Chief Executive Officer sees fits, however, it is good investment governance that PCSMA adopt the guidelines in relation to segregation of duties which are outlined in the PCSMA Risk Management Policy document. 3

4 INVESTMENT POLICY STATEMENT PCSMA s investment policy is designed to optimally deploy the surplus cash from the PCSMA Investment Scheme in a manner that is consistent with the necessary liquidity requirements, investment objectives and appetite for risk that suits the conservative, risk averse attitude of PCSMA s Board. The PCSMA Investment Policy is determined by the following factors: PCSMA s core business is the processing of its members cane and the production of raw sugar and related products. The PCSMA Investment Scheme deposits are employed for working capital requirements. The Investment Scheme funds that are surplus to PCSMA s working capital requirements are invested in a manner that reflects the conservative, risk averse attitude of the PCSMA Board. The surplus cash invested under the Investment Scheme is generally required by PCSMA for working capital requirements (ie. current assets minus current liabilities) which by strict accounting definitional terms reflect an expected time horizon of up to 365 days. The short-term time horizon of this surplus cash means that the PCSMA Investment Scheme must invest these funds in a conservative manner with very low probabilities of investment losses within the 365 day time horizon. PCSMA does not employ credit risk financial analysts, and as a result, the Investment Scheme s management of credit risk is reliant on the assessment of external 4

5 professional credit rating agencies such as Standard and Poors, Moodys Investor Services and/or Fitch. INVESTMENT OBJECTIVES The PCSMA Investment Scheme aims to deliver a competitive interest rate to its depositors whilst maintaining superior security and safety of surplus funds through a conservative investment process. The PCSMA Investment Scheme will achieve these investment objectives through a diversified portfolio of high quality short-term money market based assets. The performance of the Investment Scheme is benchmarked against the UBS Australian Bank Bill Index over the medium term. INVESTMENT STRATEGY The PCSMA Investment Scheme aims to deliver a competitive rate of return to PCSMA whilst maintaining capital stability through limited exposure to interest rate movements and prudent credit management. The Investment Scheme will invest in a combination of either government, bank-backed and/or corporate money market assets to deliver a rate of return which will be benchmarked against the UBS Australia Bank Bill Index. The comparison between the Investment Scheme and the UBS Australia Bank Bill Index return allows the monitoring of investment for performance and benchmark purposes. ASSET ALLOCATION The asset allocation of the Investment Scheme reflects the return/risk profile required to deliver the Investment Objectives of the PCSMA Investment Scheme. The asset allocation is also consistent with the conservative, risk averse attitude of PCSMA s Board. The Investment Scheme will hold a portfolio of money market securities. The Investment Scheme may also invest in other managed investment schemes that have the same investment criteria as PCSMA. 5

6 AUTHORISED INVESTMENTS The authorised investments of the PCSMA Investment Scheme must reflect the conservative and risk adverse approach of the PCSMA Board. The PCSMA Investment Scheme wishes to be exposed to investments that are some of the highest rankings of investment recoverability in the event of a government or corporate default. To achieve this, the PCSMA Investment Scheme will implement the following: The PCSMA Investment Scheme shall invest in debt securities only. The PCSMA Investment Scheme shall invest in securities denominated in Australian dollars only. The PCSMA Investment Scheme shall invest in securities whose entities are domiciled and regulated by Australian federal, state or local legal jurisdictions. The PCSMA Investment Scheme will not invest in equity securities or hybrid securities that exhibit both debt and equity characteristics. Structured products are unauthorised securities or instruments. Derivatives are unauthorised securities or instruments. 6

7 DELEGATION OF AUTHORITY The PCSMA Investment Scheme requires a strong governance framework to control the various aspects of risk. The PCSMA Board serves to approve and delegate the management and operational functions of the PCSMA Investment Policy, Risk Management Policy and Procedures Policy. From the perspective of investment management, the delegation of authority under these policies must be carefully structured to ensure that the segregation of duties principle is adhered to within PCSMA and its Investment Scheme. It is recommended that the PCSMA Treasury Risk Management Committee implement the Investment Policy process. 7

8 PCSMA RISK MANAGEMENT POLICY DEFINITIONS Credit risk The risk of loss due to the borrower s failure to meet their debt obligations. Interest rate risk The risk or variability in asset value due to the variability of interest rates. Liquidity risk- The risk that a given security or asset cannot be traded quickly enough in the market to prevent a loss. Transaction Risk The risk to the value of the investment portfolio arising from fraud, error, and the inability to deliver investment products or services to your clients. RESPONSIBILITY FOR RISK MANAGEMENT The Chief Executive Officer of PCSMA is charged with implementing the appropriate risk management systems for the PCSMA Investment Scheme. Aspects of the investment and risk management process may be delegated to the Treasury Risk Management Committee and/or Chief Financial Officer. The Board of Directors ultimately has responsibility for internal compliance and control. Under the segregation of duties principle, it is recommended that the PCSMA Treasury Risk Management Committee implement the Risk Management Policy and the PCSMA Chief Financial Officer measure, monitor and report on the Risk Management Policy. 8

9 DEFINING RISK AND INVESTMENT RISK The following definitions originate from the Standards Australia risk management standard, AS/NZS 4360:1999 Risk Management. The original definitions employed in the former PCSMA Investment Scheme Risk Management Policy & Procedures are as follows: Risk the chance of something happening that will have an impact on the achievement of the Business s objectives. Risk is measured in terms of consequences and likelihood. Risk Assessment the overall process of risk analysis and evaluation. Risk Management the culture, processes and structures that are directed towards the effective management of potential opportunities and adverse effects within the PCSMA environment. Investment Consultant the term refers to any person or Company appointed by PCSMA to advise the Board on this Policy. Whilst the abovementioned definitions of risk relate to general business practices, they do not clearly articulate the risks associated with investments and the appropriate risk management guidelines required when making investment decisions. As a result, we refine our definitions to specific types of investment risks and the associated risk management designed to minimise the impact of these investment risks on the aggregate portfolio of investment assets. All investments involve some level of risk. If the value of an investment is expected to change (go up and down) significantly from time to time, this is considered a volatile or more risky investment. Investments that offer the highest return tend to carry the highest levels of risk over time. 9

10 To compare various investment and investment products requires an understanding of the risks being taken for the return/interest rate achieved. In order to make a meaningful assessment of an investment, it is important to define and understand the sources of investment risk. We can define investment risk as the risk of not earning a required return over a given period of time. It can also be viewed as the potential range of realised returns for an investment over a given period. The four main sources of risk that PCSMA need to manage are the nature of authorised investments, interest rate risk, liquidity risk, credit risk and transaction/operational risk. Finally, the world of investments involves an unpredictable element which is known as uncertainty. The concept originates from Frank Knight who defines uncertainty as an adverse event or loss whereby the expected loss or its likelihood cannot be calculated with any degree of accuracy. Examples of uncertainty include events such as: the global financial crisis, the attacks on 11 th September 2001, the collapse of the Icelandic financial system, an earthquake in New York and London. The following Risk Management Policy is designed to minimise risk, investment risk and uncertainty, however, it is impossible to mitigate all risks and uncertainties that are confronted in the investment world in the future. MANAGEMENT OF CREDIT RISK Credit Risk is the risk of an entity defaulting on its repayment obligations (both principal and interest) possibly resulting in loss of all or part of its capital, or delays in receiving its funds. Investors are normally compensated with a higher return for an investment that has a higher level of credit risk. The credit rating agencies rate the credit worthiness of investments and companies by assessing the ability to repay their debt over short-term and long-term time horizons. The three largest credit ratings agencies in the investment industry are Standard and Poor s, Moody s Investor Services and Fitch. The credit rating agencies apply long-term credit rating to investments and companies from AAA (Standard & Poor s) and Aaa (Moody s) - indicating a very low risk of loss to BB 10

11 (Standard & Poor s) or Ba2 (Moody s) indicating a high risk of loss or worse. Generally, it is recommended that you should only invest with a counterparty rated BBB- (Standard & Poor s) or Baa2 (Moody s) or above which are lowest ratings that are referred to as investment grade. It is important to acknowledge that a AAA rated investment is not a guarantee that the borrower will not default, but rather, in the opinion of Standard & Poor s, it is less likely to default in comparison to lower rated (ie. AA or BB) borrowers. The credit rating does not indicate the investment merits of an investment, but rather, reflects the credit quality and expected recovery of funds in the event of a default. For the purposes of the PCSMA Investment Scheme, the credit ratings assessment of Standard and Poors (S&P) will be employed. The S&P long-term ratings express opinions about the creditworthiness of an issuer or the credit quality of a debt issues over the longterm. The S&P short-term ratings express opinions about the creditworthiness of an issuer or the credit quality of a debt issuer in the near future. The following table provides a summary of the Standard and Poors (S&P) credit ratings system. The events of the 2008 Global Financial Crisis (GFC) demonstrated that AAA rated securities suffer from large levels of risk due to the underpricing of risk evident in securitised investment vehicles by the ratings agencies. Given the very high level of investment sophistication required to analyse and understand these structures, the PCSMA Investment Scheme has a restricted investment universe to pure debt instruments in the forms of Government issued securities or bank securities (such as bank accepted bills) and deposits. Furthermore, the Risk Management Policy will limit the investment exposure of a single debt issuer by ensuring diversification. 11

12 S&P Long-Term Ratings Summary of S&P Credit Ratings System S&P Short-Term Ratings Short Description AAA A-1+ The AAA rating represents an extremely strong capacity to meet financial commitments. This is the highest rating. AA+ A-1+ The AA rating represents a very strong capacity to meet financial commitments. AA A-1+ AA- A-1+ A+ A-1 The A rating represents a strong capacity to meet financial commitments, but somewhat susceptible to adverse economic conditions and changes in circumstances. A A-1 BBB+ BBB BBB- BB+ BB BB- B+ B B- CCC CC C D Source: Standard and Poor s The BBB rating represents an adequate capacity to meet financial commitments, but more subject to adverse economic conditions. The BBB- rating is considered as the lowest investment grade credit rating by market participants before non-investment grade. Payment default on financial commitments. N.B. According to S&P, a short term credit rating of A-1+ is equivalent to a long-tem credit rating of AA- or better. A short term credit rating of A-1 is equivalent to a long-tem credit rating of A or A+. 12

13 The PCSMA Investment Scheme will manage its exposure to credit risk by: Invest only in Australian federal or state government issued debt securities or investment grade bank securities with a Standard & Poors short term credit rating of A1 or A1+ or a long-term rating of A or better. At any point in time, the Investment Scheme shall not invest more than 25% of all assets in A1 rated bank securities and deposits. At any point in time, the Investment Scheme shall not invest more than 33% of all assets in A1+ rated bank securities and deposits. The Investment Scheme may hold no more than 33% in any one nongovernment counterparty. This investment policy constraint will limit the exposure to any single issuer to ensure adequate investment diversification. The weighted average term to maturity (ie. duration) of the investment portfolio must not exceed 70 days. 13

14 MANAGEMENT OF LIQUIDITY RISK Liquidity Risk comes in two forms. First is the risk of a cost or penalty in trying to sell an investment, when the number of transactions has decreased significantly or because of lack of depth in a market. You should expect a higher return if you are exposed to a higher level of liquidity risk. In this regard, more complex investments (ie. collateralized debt obligations (CDOs) and Asset Backed Securities), because they are highly structured, generally have less flexibility (higher levels of liquidity risk) than simple transactions such as bonds or bank bills. Therefore, you should be compensated, in the form of a higher return, for this additional risk. The second form of liquidity risk refers to a situation where your cash reserves may fall quickly because of some unexpected cash flow obligation and/or possible difficulty in raising cash through borrowings over a short period of time. This form of liquidity risk is related to the capacity to borrow and, therefore, has no impact on your investments. The PCSMA Investment Scheme will manage its liquidity risk by: Restricting the exposure to illiquid assets (such as term deposits which are not marketable securities) to 25% of the total value of the investment portfolio. Restricting the term to maturity of all assets to 365 days or less. 10% of the Investment Scheme must mature with seven (7) days; 50% of the assets must be held in government and/or bank securities. The weighted average term to maturity of the total assets in the Investment Scheme must not exceed 70 days. 14

15 MANAGEMENT OF INTEREST RATE RISK Interest Rate Risk is the risk that a change in interest rates leads to a fall in the value of an investment. Longer term investments usually have a higher level of interest rate risk as changes in market interest rates will have a greater impact of the market value of the investment over a shorter period of time. Certainty of interest rates can be important if you have budgeted for a level of interest income. The higher the level of interest rate risk, the lower the level of interest rate certainty you will have. The PCSMA Investment Scheme will manage its interest rate risk by: PCSMA will measure and monitor the weighted average term to maturity of the aggregate position of all assets in the Investment Scheme on a daily basis. PCSMA will measure and monitor the weighted average yield earned on the aggregate position of all assets in the Investment Scheme on a daily basis. The PCSMA Investment Scheme will employ the UBS Australia Bank Bill Index as their benchmark to measure and monitor their interest rate risk and investment performance. The UBS Australia Bank Bill Index has a weighted average term to maturity (known as duration) of days. The UBS Bank Bill index methodology is detailed in Appendix A. When the PCSMA Treasury Risk Management Committee strongly feels that Overnight Cash to 90 day interest rates are expected to rise in the next 3 months then the Investment Scheme s assets should generally exhibit a weighted average term to maturity (or duration) that is shorter than the UBS Australia Bank Bill Index benchmark of days. 15

16 When the PCSMA Treasury Risk Management Committee strongly feels that Overnight Cash to 90 day interest rates are expected to fall in the next 3 months then the Investment Scheme s assets should generally exhibit a weighted average term to maturity (or duration) that is longer than the UBS Australia Bank Bill Index benchmark of days, but no longer than 70 days. When the PCSMA Treasury Risk Management Committee has no strong view on the direction of 1-90 day interest rates, then the Investment Scheme will maintain a weighted average term to maturity (or duration) that is days which is identical to the UBS Australia Bank Bill Index benchmark. MANAGEMENT OF TRANSACTION AND OPERATIONAL RISK Transaction and Operational Risk is the risk of direct or indirect loss resulting from inadequate or failed internal processes, technology, people, systems and changes in the legal/regulatory environment. An effective method of minimising the probability of losses from transaction risk is the implementation of the segregation of duties principle. This means separating the transaction by appointing different individuals and authorities responsible for various duties throughout the life of the transaction. This provides various individuals to identify potential risks and loopholes within the transaction. An example of the segregation of duties principle is to ensure that the individual (usually the Treasurer) who makes the investment decisions (including the purchases/sales of securities) must be a different individual who settles the transaction (generally the Financial Controller) and reports on risks and performance of the Investment Scheme. Furthermore, it is good investment practice that both individuals report to different lines of management. 16

17 Another key issue with transaction risk is the capacity for an organisation to understand the transaction, including the risks of the transaction and the ability to administer the transaction. Complex products such as Collateralised Debt Obligations are difficult to understand and record, and require significant administration over the life of the investment product, as compared to more simple investment products such as fixed rate deposits. As a result, the PCSMA Investment Scheme will manage its transaction and operational risk by implementing the following: The PCSMA Investment Scheme will not invest in any form of structured debt product regardless of its credit rating. The PCSMA Investment Scheme will not invest in any form of debt product that contains a direct or indirect position in options (ie. derivatives with nonlinear payoffs.) PCSMA will implement the segregation of duties principle in the prudential management of funds by ensuring different individuals perform the various functions of the front office and back office. The individual(s) who implement the Investment Scheme will operate within the internal operational organisation of the entity but are required to operate in a framework which is consistent to the segregation of duties principle. ETHICAL CONSIDERATIONS PCSMA does not necessarily consider social, ethical or environmental considerations or the labour standards of any company when selecting, realising or retaining investments that the Investment Scheme may invest in from time to time. 17

18 DELEGATION OF RESPONSIBILITIES AND DUTIES The responsibilities and duties of the PCSMA Risk Management Policy must be executed based on the segregation of duties principle. It is standard investment governance that the Treasury Risk Management Committee performs the functions of the front office whereby all investment decisions are made. It is good investment governance that the Chief Financial Officer executes the role of back office of settling the transaction and provides the necessary reporting to the front office. The following provides an example of a typical risk management report required by the PCSMA Board. Parameters Criteria Guidelines Met Credit Risk: A or better Yes A1 or A1+ Yes Max. of 25% in A1 securities Yes Maximum of 33% in non-govt counterparty Yes Duration =<70 days Yes Liquidity Risk: Illiquid securities <=25% of Portfolio Yes Maturity of all assets is equal to or less 1yr. Yes 10% of investments with maturity 7 days or less Yes 50% of portfolio in govt and bank securities Yes Duration =<70 days Yes Interest Rate Risk: Portfolio Weighted Average Term to Maturity Benchmark Weighted Average Term to Maturity Net Duration 50 days 48 days +2 days Portfolio Weighted Average Yield 5.52% Benchmark Weighted Average Yield 5.40% Excess Portfolio Yield 0.12% Exceptions/Breach Report: Breaches during the month Yes Each breach/exception should be detailed and reported to the Board. Each breach report should provide the date that the Breach, why the breach occurred and the immediate action to rectify the breach. 18

19 Exception/Breach Reporting: When the Investment Scheme operates outside the risk parameters set in the Investment Policy or Risk Management Policy, the Board must be notified of this breach. Every breach (or exception) must be detailed and reported at the next PCSMA Board meeting. Each breach report must disclose the following information: Date of the breach. Date that the breach was identified. The Investment or Risk parameter that was breached. The details of the breach. What immediate action was taken by PCSMA person(s) to rectify the breach in order to position the PCSMA Investment Scheme back to the parameters set by the Investment Policy or Risk Management Policy. Person(s) responsible for the Breach. Person(s) who identified the Breach. Proposed action or change in PCSMA policy to ensure that the Breach is not repeated in the future. RISK MANAGEMENT REPORTING The management staff of PCSMA will provide regular monthly reporting to the Board summarising the risk management criteria in these Policies to verify that the Investment Scheme operated within its risk management guidelines. The PCSMA Treasury Risk Management Committee will detail any Investment Policy or Risk Management Policy breaches that took place and what relevant action was taken to remedy the breach. An example of a typical report is detailed on the above page. 19

20 INVESTMENT POLICY AND RISK MANAGEMENT LIMITATIONS The execution of this Investment Scheme inherently assumes that PCSMA has the internal capability to adequately employ a direct management approach in the management of their surplus cash. This means that the PCSMA Board wishes to directly manage the various risks associated with the deployment of their surplus cash in the Australian debt markets. In the event that the PCSMA Board determines that the entity is unable to appropriately execute the Investment Scheme due to a lack of resources, skilled staff or inadequate organisational structure, there exists an alternative solution. Instead of direct management of the funds, an alternative solution is to deposit the surplus funds in a wholesale or retail based Cash Management Trust which generally provide access to funds with 24 hours notice. Typical examples include: UBS Cash Fund AXA Wholesale Cash Management Trust Fund Queensland Investment Corporation (QIC) Cash Enhanced Fund Prior to outsourcing the PCSMA Investment Policy via an external Cash Management Trust, the PCSMA Treasury Risk Management Committee must assess the nature and appropriateness of these funds and compare their fee structures to the costs and benefits that are achieved through an in-house PCSMA investment management operation. The size of PCSMA funds warrants the negotiation of fees between PCSMA and their prospective Investment Manager. 20

21 APPENDIX A UBS AUSTRALIA BANK BILL INDEX METHODOLOGY The UBS Australia Bank Bill index is an Australian performance benchmark that represents the performance of a passively managed short-term money market portfolio. The UBS Australia Bank Bill Index (formerly known as the Warburg Dillon Reed Bank Bill Index and the Swiss Banking Corporation (SBC) Bank Bill Index) commenced in March 1987 with an initial index value of The UBS Australia Bank Bill index has an average term to maturity of approximately 45 days which is commensurate with the average term to maturity of assets of many Australian short-term money market funds and cash management trusts. Over time, this index has become the primary benchmark for performance for Australian investments that exhibit a term to maturity of less than one year. The construction of the UBS Australia Bank Bill Index comprises of 13 Bank bills of equal face value each with a maturity of seven days apart. The shortest bank bill has a maturity of 7 days and the longest exhibits a maturity of 91 days. On each day, the term to maturity of each bank bill (hence the entire index) reduces by 1 day until the shortest bank bill matures. The face value of the bank bill is then reinvested in a new 91 day bank bill (hence the index to maturity lengthens by approximately 7 days). The UBS Australia Bank Bill index is an accumulation index as the total face value received on the maturity of each bank bill is reinvested in the discounted value of the new 91 day bank bill. The UBS Australia Bank Bill Index is the sum of the market value of each bank bill. The price of each bank bill is calculated using yields interpolated from the following rates: 24 hour cash rate rate (that is, r1) 30 day bank bill rate (that is, r2) 90 day bank bill rate (that is, r3) 21

22 Thirteen interpolated rates are calculated and applied to each of the thirteen bank bills as follows: Days to Maturity Interpolated Rate 1-7 r /3r1 + 1/3r /3r1 + 2/3r r /9r2 + 1/9r /8r2 + 2/9r /8r2 + 3/9r /8r2 + 4/9r /8r2 + 5/9r /8r2 + 6/9r /8r2 + 7/9r /8r2 + 8/9r r3 The above interpolated rates are incorporated into the normal bank bill pricing formula whereby: Bank Bill Market Price = Face Value / [1 + (Days to Maturity /365 x Yield/100)] 22

23 Historical Annual Returns of the UBS Australia Bank Bill Index 1980s Return 1990s Return 2000s Return % % % % % % % % % % % % % % % % % % % % % % % Please note: The historical performance of the UBS Australia Bank Bill Index is not representative or indicative of future performance. 23

24 PCSMA LIABILITY MANAGEMENT & DEPOSIT SCHEME POLICY LIABILITY MANAGEMENT POLICY The objective of the PCSMA liability management policy is to formalise the management of the company s debt finance. Borrowed funds may be employed to manage cash flows and liquidity levels within PCSMA to meet known and reasonably unforeseen funding requirements and asset purchases. PCSMA will employ a prudential financial management approach to debt finance to ensure that the company s borrowings are constrained to within the limits of PCSMA s adequate capacity for debt repayment. PCSMA acknowledges that it must utilise both (i) short-term and (ii) long-term borrowing facilities in order to achieve an effective borrowing mix which balances the two tradeoffs and requirements of: (i) certainty of finance, and; (ii) an effective cost of borrowing. In general, entities gain easy access to sources of short-term funding rather than long-term borrowings. Short-term debt is generally issued at lower credit margins because investors expect to receive their capital back from the borrower within a short-term time horizon (ie. usually less than 180 days). From PCSMA s perspective, the risks associated with short-term funding are that this source of borrowing may evaporate during stressful market conditions when liquidity disappears and capital is rationed. 24

25 Alternately, long-term borrowing facilities provide debt at more expensive credit margins because the maturity profile is long and investors need to wait for a longer period of time before their capital is returned. Although long-term debt is more expensive form of borrowing than short-term finance, it reduces the probability of refinancing risk, thereby providing companies with financing certainty and is more advantageous in the event of stressful market conditions. As a general principle, permanent working capital can be financed with long-term or shortterm borrowings, however, temporary working capital needs should be supported with short-term funding only. Temporary working capital supports the seasonal peaks in the business. In the event of asset purchases, PCSMA shall follow the maturity matching principle which is outlined in subsequent section of this policy document. Given the advantages and shortcomings of both short-term and long-term financing, the objective of the PCSMA Liability Management Policy is to cater for these market considerations and to manage the risks associated with the financing of the company. PCSMA acknowledges that this document serves to minimise and manage these risks, however, these risks can never be completely eliminated. 25

26 DEFINITIONS Diversification of funding sources the practice of developing multiple sources of finance so that PCSMA is not reliant on a single funding source. Liquidity risk describes the risk where a profitable company has a large proportion of its total liabilities maturing over the short-term (ie. less than 180 days). At times, the immediate liability outflows of cash are greater than the immediate cash inflows arriving in the balance sheet. As a result, a company expects to finance the difference through the issuance of new debt. When this new debt cannot be issued, the profitable company is unable to continue its business and may result in a corporate default. Long-term borrowing or debt Debt finance with a maturity date longer than 180 days. Maturity Matching Principle The concept whereby the term of financing (ie. debt) matches the duration or maturity profile of the item or asset supported. Refinancing risk The risk that a borrower cannot gain access to new debt finance to repay an existing debt that will mature in the near future. Short-term borrowing or debt Debt finance with a maturity date within 180 days. 26

27 MATURITY MATCHING PRINCIPLE Many companies finance the assets on their balance sheet via the maturity matching principle. The maturity matching concept means that the maturity date of its liabilities should be roughly matched to the duration of the asset or project being financed. In other words, a loan taken out to finance a project or asset should be repayable at approximately the time of the project s or asset s completion. The maturity matching principle ensures that the asset and liability combination are a self-liquidating proposition which takes a prudential approach to the financing of a company s assets. The maturity matching principle reduces a number of risks, including, (i) raising unnecessary finance that is not required by the organisation, resulting in the overfinancing of an asset or project, (ii) being exposed to refinancing risk and (iii) being exposed to liquidity risk. Generally, very long-term assets should be financed with equity, which has an indefinite duration or with long-term debt lasting 20 to 40 years. PCSMA acknowledges that the maturity matching principle can reduce the probability of financing problems, however, it can never eliminate the risk. PCSMA will adopt the maturity matching principle by implementing the following: PCSMA will develop the maturity matching principle in the financing of the majority of the assets on the company s balance sheet. 27

28 DIVERSIFICATION OF FUNDING SOURCES An important liability management strategy is the diversification of liability sources in order to reduce reliance on any one market, geographic area, type of funding instrument, maturity term, investor base or pricing benchmark. In the case of PCSMA, some of these diversification benefits (such as funding from various geographic area and investor base) cannot be achieved or met due to the restricted eligibility of PCSMA scheme investors. It is important to note that attaining a diversified set of funding sources comes at a cost but provides longer term funding stability for PCSMA as an organisation. A company should never be reliant on a single source of finance. For example, at the time of writing, the PCSMA s two primary funding sources are in the form of (i) the 90 day borrowing facility from its banker and (ii) the On-Call deposit scheme. To reduce the risks from the concentration of funding sources, PCSMA will implement the following: PCSMA will develop multiple funding sources so that it is not reliant on a single concentrated source of debt financing. PCSMA will always maintain at least two sources of debt finance facilities that are open and operational. PCSMA will develop multiple source of finance from multiple financiers. PCSMA will ensure that a single debt finance facility represents no more than 50% of all liabilities. 28

29 MANAGEMENT OF REFINANCING RISK Entities that rely on a single source of debt finance exhibit a higher probability of corporate failure. A single source of debt finance is not a serious problem for a company until this funding source is interrupted by an unexpected event or by stressful market conditions. When this source of finance is disrupted, the company becomes a riskier proposition due to the uncertain continuation of the operations of the business. Refinance risk occurs when new debt finance cannot be found to repay an impending maturing debt, which results in a corporate default. An entity can develop risk management practices to reduce the probability of refinancing risk, however, PCSMA acknowledges that refinancing risk can never be eliminated. PCSMA will manage its refinancing risk by implementing the following: PCSMA will develop multiple sources of debt finance. PCSMA will implement multiple sources of short-term money market funding (ie. debt finance that matures within 180 days) PCSMA will implement multiple sources of long-term finance (ie. finance with maturities that are longer than 180 days) with multiple financiers. PCSMA will ensure that a financing facility must not equate more than 50% of the entity s total liabilities. Debt maturities are to be spread over a time horizon to ensure that no more than 40% of total borrowing is subject to refinancing in any financial year. PCSMA will seek a standby financing facility that it will ensure access to emergency funds for a term to maturity of more than 90 days. 29

30 MANAGEMENT OF LIQUIDITY RISK Liquidity risk arises when a large proportion of the company s liabilities consists of shortterm debt. There are times when this short-term debt matures and lenders are unwilling to refinance the maturity amount. Furthermore, the cash flows arriving from the firm s assets or investments are not large enough to fully repay the short-term debt maturing at that point in time. As a result, the company defaults on its debt. PCSMA acknowledges and understands that a company that exhibits a high proportion of outstanding short-term debt is exposed to higher probability of liquidity risk than a company that holds a large proportion of its debt in the form of long-term borrowings. PCSMA will seek to ensure that its liabilities mature across a variety of dates so that any liquidity risks are minimised to a small amount of maturing debt. PCSMA acknowledges that it will implement policies to minimise liquidity risk, however, this risk can never be eliminated. To manage liquidity risk, PCSMA will implement the following: PCSMA shall maintain its borrowing facility with the longest maturity profile as its primary source of borrowing to finance the entity s long-term projects and assets. PCSMA shall seek to minimise its liquidity risk by avoiding the concentration of debt maturity on similar dates. PCSMA will manage its liquidity risk by accessing multiple sources of finance that exhibit the longest liability maturity profile. PCSMA will maintain a minimum of 60% of its liabilities at its longest possible maturity profile as long as it is consistent with the maturity matching principle of asset/liability management. 30

31 OTHER LIABILITY RISK MANAGEMENT POLICIES PCSMA acknowledges the dynamic nature of markets and how sudden changes in market sentiment may adversely affect the organisation s ability to seek finance. These sudden shifts in market dynamics can cause companies (eg. RAMS Home Loans, Bear Stearns, Lehman Brothers and Allco Finance) to default due to the sudden and unexpected evaporation of funding sources. PCSMA recognises that it is also exposed to these market dynamics. Whilst PCSMA can implement policy to minimise this risk, it is also acknowledges that this risk can never be eliminated. To manage these risks, PCSMA will implement the following: PCSMA will issue debt denominated in Australian dollars only. PCSMA will not issue debt with associated derivatives or structured transactions. PCSMA will continuously monitor any erosion of the value of its long-term and short-term assets that may act as collateral or security for any PCSMA debt financing facility. PCSMA will continuously monitor its daily levels of outstanding liabilities across its funding sources. Sudden changes in its liability mix may indicate as an early warning signal of financial markets under distress. The sudden change of any source of finance will trigger the immediate convening of the Treasury Risk Management Committee (TRMC) meeting. The TRMC meeting will (i) quantify the level of liquidity outflow, (ii) identify alternate sources of finance to implement cash flows to mitigate liquidity shortfalls, and; (iii) determine the net liquidity position of PCSMA under this current market scenario. 31

32 PCSMA will continuously assess the viability of new and alternative sources of finance. PCSMA DEPOSIT SCHEME At the time of writing, the PCSMA s primary source of debt finance is the 90 day BBSY plus margin borrowing facility with its primary banker. This source of short-term financing provides PCSMA with funding certainty for up to 90 days only. As an alternative source of finance, the PCSMA currently operates an On-Call Deposit Scheme for certified investors. The On-Call Deposit Scheme provides an alternative source of finance, however, it brings less stability in the funding mix due to the depositors capacity to withdraw this funding within 24 hours. As another source of finance, the PCSMA shall consider the development of a Fixed-Term Deposit Scheme. The Fixed-Term Deposit Scheme shall operate in the same way as the On- Call Deposit Scheme, however, the maturity profile of this short-term debt will have a duration that is longer than 24 hours. This will provide debt finance without the tendency to exhibit the same levels of refinancing and liquidity risks that are associated with 24 hour funding such as the On-Call Deposit Scheme. To manage the risks associated with the On- Call and Fixed-Term Deposit Scheme, PCSMA will implement the following: PCSMA will reduce any concentration of debt financing by supplementing its prime source of finance with contingent sources of debt finance. PCSMA will seek to maintain its contingent source of finance via On-Call Deposits to represent no more than 20% of PCSMA Total Liabilities. PCSMA will seek to maintain its contingent source of finance via Fixed-Term Deposits to represent no more than 25% of PCSMA Total Liabilities. 32

33 SETTING OF INTEREST RATES FOR PCSMA INVESTMENT SCHEME The PCSMA Treasury Risk Management Committee (TRMC) comprising the CEO, Company Secretary, Commodity Pricing Manager and Chief Financial Officer shall meet monthly or as required by market movements to consider the interest rate paid on the On- Call and Fixed-Term deposits of the PCSMA Investment Scheme. The Committee will consider: The current level of investment in the Scheme. The optimum level of investment in the Scheme required to meet the cash flow requirement of PCSMA. The importance of diversification of funding sources required by PCSMA. Any changes since the last meeting to the Reserve Bank of Australia s Official Overnight Cash Interest Rate. The comparative cost of funding and associated risks between: o PCSMA s borrowing facility priced at 90 day BBSY plus the current margin, versus o Current overnight (ie.1 day) interest rates. The interest rates being offered by competitors to the Scheme including Banks and Building Societies. The market forces of demand and supply in the debt markets. In arriving at the optimum level of investment in the Scheme, which can be influenced by the level of interest rate paid, it will be necessary to take a conservative view of the borrowing requirements projected in the long and short-term cash flow forecasts of PCSMA. This should also include a conservative allowance for unplanned working capital peaks that may be caused by timing issues or other unforeseen circumstances. 33

34 To effectively implement, operate and manage the PCSMA Investment Scheme, it is assumed that the Board will place the necessary organisational resources towards the management of its liabilities in the form of training, staff and technology. 34