Managing Financial Risk during Market Turbulence
An Interview with Wayne Read, Partner, Financial Risk Management, KPMG
What risk management and hedge accounting issues do you see CFOs and treasurers facing in the current climate?
In Australia, as in many other parts of the world, one of the most challenging issues for CFOs and treasurers is coming to terms with the implications of ineffectiveness in hedge relationships, when IAS 39’s fair value measurement rules are contributing to income statement volatility.
Many long term commodity, foreign exchange and interest rate hedges were designated for accounting purposes when financial market conditions were benign. Invariably, hedge designation practices were designed with administrative convenience in mind due to system constraints. These hedges are now being impacted, with the effects of market illiquidity, basis and counterparty credit risks compromising hedge effectiveness, sometimes with dire consequences.
The recent market turmoil has provided a salient reminder to CFOs of the importance of understanding the economics of hedging relationships, the fair value measurement process and designing effectiveness tests that accommodate a variety of adverse market conditions.
In assisting companies to document their hedge relationships, we focus on the “what if” scenarios, including the impact of market changes on the valuation of the instrument, basis risks and cash flow modelling assumptions. IAS 39 is a prescriptive standard, but it does provide mechanisms to accommodate less than perfect hedge
relationships. The key is to appreciate that credit, basis, liquidity and other sources of ineffectiveness are magnified in a fair value measurement world. With the benefit of hindsight, many CFOs would prefer to have documented their hedge relationships differently than deal with income statement volatility or re-designate ineffective hedges into new hedge relationships.
How do you see treasurers going about addressing these challenges?
The focus on risk management objectives in structuring transactions and hedging strategies is now being complemented by greater awareness of the accounting requirements of IAS 39 generally, and an understanding of the fair value measurement process in particular.
Accounting for derivatives is no longer an afterthought. This applies equally to structuring commercial arrangements where pricing features have derivative-like features. Finance is now an integral part of the transaction approval process.
We are also seeing continued investment in building treasury management capability, in terms of both quantitative and valuation skill sets, but more importantly in terms of the upgrading of systems to support quantitative risk management and derivative accounting functions.
How well prepared are directors to assess the accounting implications of their company’s risk management strategy?
Directors are acutely aware of the accounting complexity associated with derivative and related hedging activities, particularly in the current environment. Strong finance experience often features prominently in deciding the composition of the Board, particularly where derivatives are used extensively to manage balance sheet, earnings and cash flow exposures.
Other responses made by directors in order to manage accounting complexity include appointing an accounting advisor to support the CFO function and facilitate regular sessions with directors on derivative-related risk and accounting matters.
These responses complement initiatives by management to improve transparency in reporting the impact of treasury activities and highlighting contentious accounting issues at an early stage.
How are treasurers ensuring that their risk management and hedge accounting processes stand up to scrutiny?
When IAS 39 was first adopted in many countries, we expected treasury departments to take the opportunity to invest in their system capability as an important element of their implementation strategy. In many cases this investment did not occur, with many companies relying on manual or spreadsheet-based solutions.
Today, this investment is occurring. Streamlining cumbersome hedge accounting processes; reducing operational risk and building internal capability to more effectively analyse transaction pricing and effectiveness, hedging structures are important factors underpinning the business case.