Capital receipts and payments of the Petroleum Fund

Petroleum Fund of Timor-Leste Notes to the financial statements for the year ended 31 December 2013 12 Financial risk and management objectives and policiescontinued a Operational risk Operational risk is the risk of direct or indirect loss arising from a wide variety of causes associated with the processes, technology and infrastructure supporting the Petroleum Fund’s activities with financial instruments either internally within the entities that manage the Petroleum Fund or externally with the Petroleum Fund’s service providers, and from external factors other than credit, market and liquidity risks, such as those arising from legal and regulatory requirements and generally accepted standards of investment management behaviour. The Banco Central de Timor-Leste, as the operational manager of the Petroleum Fund, manages the operational risks associated with the operations of the Petroleum Fund. Operational risk management includes policies that describe the standard of conduct required of staff, and specific internal control systems designed around the particular characteristics of the Petroleum Fund. Operational risk management is built into the policies and procedures of the Petroleum Fund Management Department, including periodically identifying and monitoring operational risks at the Banco Central de Timor-Leste, the external managers, the global custodian and other key service providers. The overall standards for the management of operational risk include the following: • Requirements for appropriate segregation of duties between various functions, roles and responsibilities. • Requirements for the monitoring of transactions • Compliance with regulatory and other legal requirements • Documentation of controls and procedures • Requirements for the periodic assessment of operational risk faced • Ethical and business standards The Banco Central de Timor-Leste’s assessment over the adequacy of the controls and processes in place at the external managers and other service providers with respect to operational risk is carried out via ad hoc discussions with service providers and a review of the service providers’ ISAE16 reports on internal controls, if available. Compliance with policies and departmental internal control systems is managed by an internal audit function, and there is specific provision in the daily management reports prepared by the Risk Management Division for the reporting of all issues that arise in connection with operational matters. The purpose of this section of the reports is to notify senior management promptly of unexpected operational issues, and provide senior management with the opportunity to provide advice or take remedial action. J.P. Morgan was appointed custodian of the Petroleum Fund in June 2008. As part of the custodial agreement their responsibilities include holding the Petroleum Funds assets. Substantially all the assets of the Petroleum Fund are held by J.P. Morgan. Bankruptcy or insolvency of the Petroleum Fund’s custodian may cause the Fund’s rights with respect to the securities held by the custodian to be delayed or limited. Banco Central de Timor-Leste monitors the credit ratings and capital adequacy of its custodian and reviews custodial performance against the measures in a service level agreement on a quarterly basis. Specific due diligence on operational risk is also undertaken as part of the external manager appointment process, and ISAE16 reports are obtained from external managers that evidence the ongoing effectiveness of their internal control systems. - 22 - Petroleum Fund of Timor-Leste Notes to the financial statements for the year ended 31 December 2013

12. Financial risk and management objectives and policies continued

b Credit risk Credit risk is the risk that a counterparty to a financial instrument will fail to discharge an obligation or commitment that it has entered into with the Petroleum Fund, resulting in a loss to the Fund. It arises principally from debt securities held, and also from derivative financial instruments, cash and cash equivalents, balances due from brokers and receivables from reverse repurchase agreements. For risk management reporting purposes the Fund considers and consolidates all elements of credit risk exposure, reflecting the fact that the main concentration to which the Fund is exposed arises from the Fund’s investments in debt securities. i Credit risk management Articles 14 and 15 of the Petroleum Fund law provide broad constraints on the extent of credit risk that can be taken by the Petroleum Fund. The law specifies that not less than 50 of the Petroleum Fund may be invested in investment grade fixed income investments while not more than 50 of the Petroleum Fund may be invested in listed equities. Up to 5 of the Fund may be invested in other types of securities. The Investment Advisory Board advised the Minister of Finance in June 2012 that in view of the long-term investment horizon of the Fund, the strategic asset allocation to listed equities should be 40 while the allocation to investment grade fixed interest securities should be 60. The Board recommended implementing this strategic asset allocation by gradually increasing the public equity exposure by 0.83 a month from the then 20 exposure to equities over a period of two years to 30 June 2014. This strategy was in the process of being implemented during the reporting period. The mandate in the Operational Management Agreement prescribes that the performance of the Petroleum Fund shall be measured against benchmark indexes for a series of mandates, restricts the permissible investment universe to highly rated financial instruments, and establishes tracking error limits restricting the permissible deviation of the portfolio investments from the benchmark for each mandate. The maximum loss that the Petroleum Fund would suffer from the default of a single issuer is the amount disclosed below with respect to investments in Treasury Notes issued by the United States Government and Equity Securities traded on developed market exchanges. ii Concentration of credit exposure Concentrations of credit risk arise when a number of financial instruments or contracts are entered into with the same counterparty, or when a number of counterparties are engaged in similar business activities, or activities in the same geographical region, or have similar economic features that would cause their ability to meet contractual obligations to be similarly affected by changes in economic, political or other conditions. In order to avoid excessive concentrations of risk, the Petroleum Fund’s policy is to develop over time a well diversified portfolio within limits set by the Petroleum Fund law. The Petroleum Fund’s significant end-of-year concentrations of credit exposure by the industry or country of the issuer were as follows: As at 31122013 As at 31122012 USD USD Fixed interest securities and money market securities Sovereign issuers: United States Government 8,112,364,538 8,676,319,344 Australia Government 145,008,543 - Japan Government 136,010,191 - United Kingdom Government 146,555,355 - European Governments 444,651,310 - Governments of other countries 586,562,474 - 9,571,152,411 8,676,319,344 - 23 -