STRESS TESTING: Your Reserves with Advanced Analytical Techniques.

• Author: Kavanagh, Shayne

Financial reserves, or "rainy day" funds, safeguard local governments against budget-straining risks like recessions or extreme events that demand a quick and decisive public safety response. The perennial question local governments have about reserves is how much is enough. Too little and you may be underprepared for the risks you face, but too much may mean you're overtaxing the public or failing to make investments in needed infrastructure or services.

GFOA recommends maintaining general fund reserves equal to two months of operating revenue--or, put another way, equal to 16.7 percent of annual revenue. However, this is just a rule of thumb, and each local government needs to decide the right amount for itself. For example, a smaller local government that relies on sales taxes (which are often vulnerable to economic downturns) and is at risk for experiencing a number of potential natural disasters would need relatively more reserves than a larger government that is reliant on property taxes (which are usually fairly stable, despite economic downturns) and is subject to fewer natural disasters.

TRYING TO UNDERSTAND RISK

The way to decide the appropriate amount for your local government is to better understand your risks. Risk can be defined as the probability and magnitude of a loss, disaster, or other undesirable event. (1) To understand risks, you need to quantify them. Peter Bernstein, author of Against the Gods: The Remarkable Story of Risk, makes a good case for why we need to quantify risk:

"Without numbers, there are no odds and no probabilities; without odds and probabilities, the only way to deal with risk is to appeal to the gods and the fates. Without numbers, risk is wholly a matter of gut. "

Most human beings are terrible judges of odds and probabilities, making gut feelings a terrible way to judge risk. For example, researchers have found that people are generally overconfident in their ability to predict the future. This leads us to underestimate the range of possibilities we face. In fact, research has shown that human judgment generates a 50 percent smaller range of possibilities, compared to the range a statistical formula produces. GFOA recently had the chance to test this with a local government that was at risk for wildfires. The association asked the local fire department to estimate the magnitude of potential fires, and we compared its estimate to data on actual fires that had occurred in the region. The range from the fire department was almost exactly 50 percent smaller than the range suggested by the data we had gathered.

Another persistent flaw in people's reasoning about risk is tending to over-rely on recent experiences because they are able to more easily recall them. The classic example is flood insurance, which people buy after a flood occurs--but after a few years, many of those people will have let their insurance lapse, even though the underlying risk of a flood has not...