Sizing your reserves: a risk-based approach.

• Author: Kavanagh, Shayne
• Position: Cover story

City officials in Colorado Springs, Colorado, had been holding an on going conversation about the right level of reserves. The city's primary revenue source, at more than half of general fund revenues, is the sales tax, while the property tax constitutes less than 10 percent of revenues. This means that the city's revenue is subject to a greater degree of volatility than would perhaps befall a municipality with greater reliance on the property tax. Further, legislative tax and expenditure limits prevent the city from freely making changes to tax rates in response to changing financial conditions. On top of these fiscal limitations, the city is at risk for different types of natural disasters (wild fires, floods, blizzards), any of which would require a quick and decisive public safety response from the city government. Finally, the city has an aging capital infrastructure, particularly its bridges and storm sewers, and a significant failure in any of these assets could place an unexpected and large burden on the city's finances. These risks called for a financial hedging strategy--in other words, a deliberate and strategic amount of general fund financial reserves.

To help local governments determine the optimal level of reserves, the Government Finance Officers Association has been developing a risk-based approach to sizing reserves. A number of local governments have used the general framework (which has been described in the GFOA publication, Financial Policies) to make a determination as to the optimal reserve size for their circumstances. (1) In summer 2012, the GFOA was able to work with the City of Colorado Springsto apply the risk-based model. This article describes that process, including background on the project, the "triple-A" framework for analyzing risks, the application of the triple-A approach to Colorado Springs' risk factors, and, finally, what happened in Colorado Springs as a result of the analysis.

ANALYZING UNCERTAINTY: THE TRIPLE-A APPROACH

Municipal governments are subject to a number of risks, often of highly uncertain probability and magnitude, that require them to maintain reserves. Since these risks are impossible to predict, the best that anyone can do is to be prepared. The accomplished forecasting scientist, Spyros Makridakis, has suggested a "triple-A" approach for dealing with this kind of uncertainty. (2)

1. Accept. We have to accept that we are subject to uncertainty, including events that we haven't even imagined. For example, Colorado Springs experienced a severe downturn in sales tax revenues as a result of the 2001 dot-com bust and the 2007 Great Recession. Sales taxes are subject to severe downturns due to rare and unpredictable events. Further, because it is relatively easy to imagine scenarios that could cause the economy to suffer (e.g., European financial crisis, federal debt crisis, etc.), the economy is subject to other potentially dangerous unknowns that we cannot imagine.

2. Assess. Next, we must assess the potential impact of the uncertainty. History can provide a baseline reference. Looking at the sales tax declines Colorado Springs experienced after the dot-com bust and Great Recession, we see that a downward trend has persisted for as long as 25 months, and the greatest severity has been a 0.53 percent average monthly decline over the life of the downturn (during the Great Recession that started in December 2007).

3. Augment. The range of uncertainty that we really face is almost always going to be greater than we assess it to be, so we should augment that range. Many economists believe that the effects of the Great Recession--the baseline for Colorado Springs' worst-case monthly decline--would have been much worse without the interventions of the federal government (although the long-term impact of those actions is, of course, still unknown). What if continued gridlock in the federal political system (or other, unimagined, circumstances) were to prevent an effective mitigating response to the next crisis? As a rule of thumb, Makridakis suggests doubling your range of uncertainty if you have little historical data to rely on, or multiplying it by 1.5 if you have more.

The GFOA used the triple-A approach to analyze each of Colorado Springs' major risk factors--sales tax volatility, bridges and storm sewers, and natural disasters--and suggested reserve amounts based on that analysis. The city was subject to other risks, as well, but these were deemed to be of secondary importance and were therefore...