Published: October 01, 2010
The importance of understanding and managing risk has escalated over the past two years, prompted by the global financial crisis. For companies headquartered in Asia Pacific – or with significant standalone financial operations there – this has created the dual challenges firstly of establishing an appropriate way of measuring and managing risk, and secondly of accounting for hedge transactions in accordance with the relevant accounting standard, particularly the hedge accounting requirements of IFRS, US GAAP or other local equivalents.
While in many respects, these issues are reflected globally, treasury functions in Asia Pacific have typically had fewer resources available, in terms of specialist treasury management systems, compared with those in Europe and the US, with the possible exception of Australia. The use of spreadsheets rather than specialist treasury management systems or modules of ERP systems is commonplace within the region, even amongst large corporates, and there is a heavy reliance on banks for valuation of financial instruments. This article looks at how the issue of identifying, monitoring and accounting for risk has developed in Asia Pacific and how this could change in the future.
Asia Pacific cannot be considered as a cohesive region in any respect, with significant variations in financial culture and complexity. The same applies to treasury and accounting practices. For example, many of our corporate clients are only now introducing IFRS and the related hedge accounting requirements of IAS 39 – for instance, those in countries such as India (which is adopting IFRS from April 2011) and Malaysia (which adopted the standards in 2010). Companies in these countries typically need support throughout this statutory reporting transition process, from risk identification through to hedging and accounting for hedges. At the other end of the spectrum are more accounting-savvy clients in countries such as Australia. These companies are generally looking for advice on the best way to structure and execute a transaction to minimise accounting risk and maintain hedge effectiveness, or need help in identifying, quantifying and minimising the residual risks.
Whatever our clients’ level of financial sophistication, our starting point is to understand their business fundamentals, risk appetite and exposures. We are then in a position to help them to understand how market movements could affect their earnings. Depending on market conditions, we highlight certain risks that clients should be looking to hedge, or opportunities that they may look to take advantage of. Based on this, we can then recommend specific hedging products or assist them in restructuring or unwinding existing hedge transactions. Particular attention is paid to the fine-tuning of hedging proposals and execution strategies, as small differences can have a significant impact on the accounting treatment.
As in any region, our corporate clients are very interested in their competitors’ approaches to hedging risk, as well as those of companies outside of their immediate peer group, which may face similar market risks to them. One of the advantages of working with a bank with the global reach and diverse client base of HSBC is our ability to share a wide range of experiences and identify trends in terms of approaches to risk and use of financial instruments, not only by sector or by country, but at a global level.
Given the volume of import and export activity in the region, FX risk has historically been a top priority for corporates across Asia Pacific, and treasurers have historically been prepared to take stronger views on market direction than their counterparts in Europe and North America. This often resulted in the use of more sophisticated financial instruments, including structured options.However, the financial crisis, a number of high profile derivative losses, and the resulting greater scrutiny of statutory accounting results have all contributed to a change of approach. Companies have extended their focus from pure market risk in terms of specific exposures towards holistic balance sheet analysis (i.e., analysing the overall risk of the company and taking a high level, strategic approach rather than a product-specific one), following similar approaches taken by their peers in Europe and the US.
This shift in focus has resulted in a growing need amongst corporates to identify and outline their accounting objectives as they increasingly consider factors that would not previously have featured as highly in hedge decisions. For example, many companies are now interested in the impact of hedge ineffectiveness, or how the use of certain structures might be more ‘risky’ from an accounting perspective. More than ever, corporates are aiming to quantify differences or to rank alternatives relative to each other based not only on economic objectives, but on less tangible parameters such as accounting volatility. To support our clients in achieving this, we have implemented Reval®, which has become instrumental in assisting in their pre-hedge analysis. The system provides a wide variety of independent historical data, valuations and ‘what if’ features, which allow us to model how an instrument would have performed over a period of time and to compare different structures on an equivalent basis. Significantly, Reval provides this information not only from a pure mark-to-market standpoint, but it also performs the necessary accounting adjustments to provide statutory P&L output. Different hedging strategies can therefore be compared and contrasted quickly and efficiently, with the analysis recognised by the auditing profession as being generated by a reliable independent provider. [[[PAGE]]]
To give an example, we are currently considering a range of different rate structuring propositions for our clients that are seeking to manage their interest rate risk. Rather than considering only vanilla interest rate swaps, we are also proposing structured alternatives which would alter the client’s cash flow profile to better meet its overall risk/reward objectives more precisely. Structuring transactions in this way inevitably leads to potential issues with hedge accounting, and in particular ineffectiveness, so we use Reval to compare and contrast how different alternatives behave in terms of hedge effectiveness, and potential P&L volatility. The ability to present this additional quantitative information is vital to our clients’ decision making process, as typically without it they are often unable to justify a structured solution, even when it more closely meets their economic objectives. In the current conservative environment, the existence of a potential accounting issue would frequently drive clients towards a vanilla solution as the impact, in terms of earnings, of that specific accounting issue could not be quantified and therefore its relative importance assessed.
While accounting issues have made steady and positive progress up the corporate treasury agenda in Asia Pacific, there are some major challenges on the horizon. The ongoing development of a replacement for IAS 39 remains a significant disincentive for many corporates to become fully conversant with the current regime, particularly in jurisdictions which have only recently adopted, or are soon to adopt, IFRS. This reticence is often compounded by a general reluctance among corporates to act in a way that is different from their peer group.
Of more widespread concern, perhaps, is the impact on corporate end-users of the proposed changes to banking regulations, specifically the treatment of over-the-counter (OTC) derivatives. Many of our clients have expressed concerns about the potential impact of enforcing the use of exchanges for transacting OTC derivatives, which they argue are both inflexible and incompatible with the way they currently manage both their risk and cash positions. Corporates manage their cash according to the needs of the business; therefore, if their hedge transactions begin to effect their cash positions, the impact on the business could be substantial, and the cost of maintaining standby lines to fund potential margin calls (where these are feasible) would be prohibitive.
More positively, the global financial crisis has encouraged a change in approach towards credit risk management. Whereas in the past, corporates have prioritised other forms of risk, such as FX and interest rate, there is now a greater focus on credit risk to their counterparty banks. Clients have become more selective about which banks they deal with, particularly for longer-dated products where the credit risk is more substantial. Apart from the direct concern of increased credit risk, the need to credit-adjust derivative valuations also leads to potential hedge accounting issues as these adjustments will create ineffectiveness and therefore earnings volatility.
The regulatory landscape is currently characterised by uncertainty and speculation, and we are likely to see considerable change in the future. Corporate treasurers across Asia Pacific and beyond will need to remain close to developments as they unfold in order to determine the impact on the way that they manage their financial risks. Working with a trusted advisor can be instrumental in helping clients to identify and leverage new opportunities and manage their financial risks effectively.
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