Published: October 01, 2010
The economic turmoil over the past two years stemming from the global financial crisis and the European sovereign debt crisis should cause companies to reassess their exposures and risk comprehensively over the long and short term. The assessment should include not only their interest rate, foreign exchange and commodity exposures, but also new exposures caused by changes to their global value chain. But for many multinationals, development of a sound risk management programme continues to be an elusive goal.
According to PricewaterhouseCoopers’ 2010 Global CEO Survey, 80% of senior executives say they expect to change the way they manage risk; however, only 37% say that their companies link key risk indicators with key performance indicators, and of those, only half say they employ risk-adjusted performance metrics. Where companies have closely linked material exposures with risk mitigation on a risk-adjusted basis, a disconnect in performance is less likely to occur. During periods of abnormal market fluctuations the natural tendency is to focus unduly on the market prices rather than on changes in underlying exposures, resulting in unrealistic performance measures. The challenge is, then, to maintain the risk and control elements of a comprehensive risk mitigation strategy while markets are highly volatile and discourage poorly designed rapid responses that might not result in an acceptable long-term result.
The CEO and CFO must provide the leadership and the resources to ensure that a comprehensive exposure assessment is performed across the entire company.
Let’s examine the core elements of a structured risk mitigation programme that would protect multinational companies during periods of significant market volatility. The successful development of such a programme rests on strong commitment and involvement of the corporate leadership team, broad management involvement across the value chain — from product design through sales — disciplined hedging practices and transparent reporting of performance results.
The process starts with a complete reassessment of risk exposure. This is necessary because business performance, sales and product sourcing, are also dynamically changing due to both broad economic fluctuations and micro factors, principally foreign exchange rates and commodity prices. This risk exposure assessment cannot be done in a treasury vacuum and certainly cannot be done independently within other business silos – procurement and marketing. The CEO and CFO must provide the leadership and the resources to ensure that a comprehensive exposure assessment is performed across the entire company. That leadership includes support for the design and development of an integrated structured reporting and assessment technology that goes beyond infrequent and potentially incomplete collection of data through spreadsheets or other disparate systems. [[[PAGE]]]
In most companies, the treasurer has the responsibility for assessing the exposure, determining the financial risk over multiple time horizons and executing the risk mitigation practices. The complexity of 21st century business should encourage the treasurer to avoid sole responsibility for the entire corporate risk mitigation programme. To enhance transparency and accountability across the enterprise, a risk committee is the preferred vehicle.
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The formation of a risk committee, preferably under the direction of the CEO or CFO, creates broad engagement across the enterprise. The membership of the committee should represent the operations of the company with participation from procurement, sales and marketing, treasury, accounting and other operational functions that have exposure to financial risk. (For some companies, product development should also be represented.) Clearly, the committee make-up will depend on the nature of the company.
While there are many dimensions to the organisation and operation of the risk committee, three bear mentioning. First, is the need to have regularly scheduled meetings to keep the members engaged. Too often, risk committees are organised to deal with a crisis or issue, only to disband eventually because the information content and decision-making become less significant. To avoid this trap, there needs to be clear understanding of the underlying enterprise-wide risk mitigation strategy and practices and of supporting content that is meaningful and relevant.
Second, the scope of the risk committee should be broader than financial risk. The totality of risk to the enterprise goes well beyond financial risk, and certain operational risks greatly exceed foreign exchange and interest rate risk both notionally and on a risk-adjusted basis. While the scope of the committee needs to be broad, all risks should be captured and evaluated using a consistent methodology. That methodology will, most likely, be based on core financial risk management principles.
To enhance transparency and accountabiliy across the enterprise, a risk committee is the preferred vehicle.
Third, involve all participants. Meeting presentations should be made by committee representatives or other company representatives to describe how enterprise risks influence their activities and fundamental changes to the company’s operations, products and services. It is also important to understand what the company’s vendors and competitors are doing. Invite outside experts – financial market specialists, economists, risk management specialists – to keep the committee current on economic trends, market conditions, hedging alternatives and risk management best practices. While many feel that any committee structure dilutes responsibility, a properly organised and managed risk committee can improve transparency and accountability for management, shareholders and other stakeholders.
While there is still uncertainty around the impact of financial legislation in the US and globally, the use of derivative hedging instruments will still be necessary. It is expected that these instruments, even for corporations, will incur a capital cost that is greater than current practice. Nevertheless, these derivative instruments are valuable hedging tools. Corporations have only run into trouble using derivatives when the sophistication and complexity of the instruments was greater than the underlying exposure and the company’s ability to understand and price the instruments. Some companies seek to minimise the cost of their hedging programmes through complex option strategies, and while the changes that new financial regulation will bring are not yet known, they should be careful not to be overly aggressive in seeking to minimise the capital cost through complex structures, if that alternative becomes available (It should be noted here that the structure and discipline of the hedging execution should be the same for all risk mitigation needs regardless of the technique.)[[[PAGE]]]
The adoption of risk-adjusted reporting should evolve over time and not seek to adopt complex modeling approaches that are difficult to understand. At initiation, the company should recognise that risk is not limited to the hedging instruments; there is risk and a distribution of expected values in the underlying exposure - both variability and uncertainty of the notional exposure forecast and in the realised value of the forecasted exposures. At its core, risk-adjusted reporting should capture the distribution of operating exposure forecasts and the underlying economic value combined with the value distribution of the hedges. The techniques to measure these risk-adjusted results can be based on simple stress testing or simulation. Sophisticated modelling is not necessary.
Many companies do pay close attention to the organisation and operation of their risk management programmes, having adopted many of the recommendations found in this article. Where many of these organisations fall short is in the development of a rigorous reporting framework. The reporting framework needs to combine the use of robust data, internal and external, with visual presentation of results and projections.
Risk identification and management can often seem a daunting task. The state of the art has certainly matured over the past years with a sound body of knowledge, skilled practitioners and tailored systems. As with any business practice, strategy and programmes need to be regularly evaluated and modified. Those changes need to fully assess the urgency of current economic and market conditions while resisting the tendency to make quick decisions. As long as the risk management programme rests on the foundation of strong governance and controls, broad corporate engagement, comprehensive data collection (company specific and market), well designed and documented strategies and robust risk-adjusted reporting, the results will meet or exceed the expectations of all stakeholders.
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