Perspectives from Asia: Corporate Risk Management

by Ben Higgin, Director, PricewaterhouseCoopers, Hong Kong

During the current period of global economic turmoil, corporates in Asia have not been immune to the crisis. High profile losses towards the end of 2008 suggest that some companies’ hedging strategies have not worked. Consequently, many firms in Asia, as in other parts of the world, have started to review their hedging activities and in some cases simplified their approach. However, while we recommend that companies seek continual improvement in their internal processes and controls, technology and risk management strategy, the current market volatility means that corporate treasurers should still be looking carefully at how the use of derivatives can protect the business from risk.

Back to Basics: Risk Appetite

Companies in Asia, including those acting as regional treasury centres for North American or European multinational corporations, are increasingly taking a “back to basics” approach to their hedging strategy. This involves going back to the fundamentals of the business, identifying the risks to which they are exposed, reviewing the financial products they are using to mitigate these risks, and assessing any additional risks that these products create. This review process is something that often needs to take place at Board level. There will generally be a range of risks to which the Board is prepared to be exposed, and degrees of magnitude of financial risk deemed acceptable, which will differ across companies depending on the industry and interests of shareholders. Whatever the risk appetite of a business, a clear definition of risk appetite is essential in order to compose an appropriate risk management policy.

Simplifying Hedging Strategy

Media coverage of derivatives as “weapons of mass financial destruction”, according to one commentator, has resulted in many firms embarking on a flight to simplicity by reducing their use of derivatives for hedging. However, reducing companies’ risk protection can, in some cases, expose the company to far greater risks than the hedging instruments themselves would do. So long as derivatives are well-understood and used appropriately, they are important means of hedging risk. Some firms have even stopped hedging altogether. Although this approach eliminates derivative risks, these companies are obviously entirely exposed to financial and market risks.

Focus on Staffing and Systems

In addition to reviewing, and potentially revising the company’s risk management strategy, many treasurers are also assessing the staffing and systems that they have in place. For example, treasury needs to have the skills and technical capability in place commensurate with the complexity of their risk management approach. If a company is using FX options, for example, treasury needs the staffing and systems to understand, value and explain the use of these instruments. Many companies in Asia have a 31 December financial year end, and many treasurers, and their auditors, found the audit process more difficult this year. With financial risks often greater than in previous years, with far higher levels of volatility and more complex derivatives in the market, the need for companies to have the right staffing and systems in place will be vital to a smooth audit.

So long as hedging products are well understood, recorded, managed and valued correctly, they are a valuable tool in the treasurer's armoury.

Technology to manage valuation and accounting for derivatives has not been marketed widely in Asia, and many firms use spreadsheets for this purpose. The problems with using spreadsheets for financial management are widely documented, but include a lack of auditability, a high frequency of errors and in the case of hedge accounting, issues with calculation methods and designation of hedges. For example, looking at designation, there are a range of subtleties which need to be taken into account. It needs to be clear what exposures a derivative transaction is intending to hedge, and whether credit risk is included or excluded from the calculation of hedge effectiveness. In addition, however, an element of flexibility is required, such as when hedging forecast cash flows where the exact timing or amount may not be known in advance. Our experience has shown that unless hedging activity is straightforward, treasurers should have IT systems in place that support their financial risk management strategy, whether as part of a treasury management system (TMS) or as a standalone capability. [[[PAGE]]]

Control Procedures

Another important area of internal control relates to the processes and procedures present within the treasury function. There are often enhancements that treasurers can make, particularly when the treasury centre has grown in significance to the organisation (in terms of size or volume of transactions) without a corresponding strengthening of controls. Some of the areas where we see the potential for improvement commonly include:

• Segregation of duties. This can often be difficult, particularly in smaller treasury departments and/or where predominantly manual processes are in place.

• Ongoing monitoring. Treasuries of all sizes often lack ongoing monitoring to ensure that management is alerted if a valuation or exposure reaches a certain level, or if a hedge is at risk of becoming ineffective.

• Communication. Communication between the treasury and accounting department is vital. For example, there need to be procedures setting out what financial products will be used in practice and how. All relevant personnel need to be fully appraised of these procedures. In addition, back office staff should have a sufficient understanding of financial instruments to recognise when a transaction involves a plain vanilla instrument, and when it is more complex, for example instruments containing embedded written options.

• Bank facilities. Treasurers should monitor bank facilities closely, including renewal terms, covenants, required approvals and the purposes for which they can be used.
• Clear, detailed and up to date documentation of strategy, policy and procedures. This extends from treasury and finance into the wider business. For example, it should cover issues such as how pricing is set of the underlying risk (sales, purchases, etc.) and how information, including changes to forecast data, is communicated to treasury.

Some treasuries have responded to the increased focus on risk management by employing additional staff; in reality, however, many of the control issues which we identify in corporate treasuries could be addressed more effectively through the use of a system.

Specific Challenges

Clearly, every company is experiencing its own unique challenges relating to risk management according to its industry, organisational structure, geographic focus, risk appetite and approach to managing risk. We are seeing many large corporations seeking help in their hedging policy and processes, but smaller firms are similarly exposed and the relative impact of financial loss though inadequate or inappropriate hedging could be greater.

Firms of all sizes, whether regional treasury centres of North American or European multinationals, or companies domiciled in Asia, will frequently benefit from a “back to basics” approach to ensure that the risk management strategy and its implementation are appropriate. However, the recent scandals relating to derivatives activity should not deter treasurers from using derivatives altogether. With significant market volatility across interest rates, FX and commodities, companies that do not hedge their underlying exposures and create certainty in their business run significant risk. So long as hedging products are well understood, recorded, managed and valued correctly, they are a valuable tool in the treasurer’s armoury.