Published: February 01, 2009
“A ship in port is safe, but that’s not what ships are built for.”
Grace Murray Hopper, American military leader, mathematician and educator (1906 - 1992)
Nothing we do in life is free of risk, and if it were, it would not be much of a life at all. Business success is created by knowing when to take risks and to what degree. As we navigate our way through the current economic downturn, fear of the unknown has encouraged many of us to ‘batten down the hatches’ and seek refuge in safe havens until the storm has passed. With every treasurer far more conscious of risk than twelve or eighteen months ago, how should we be approaching financial risk today, and how have attitudes towards risk changed? In this article, we are delighted to introduce Jonathan Chesebrough, Head of Risk Advisory at RBS Global Banking and Markets, and Nicholas Blake, Sales Executive, J. P. Morgan Treasury Services, Corporate and Public Sector, who give their insights into how treasurers should be addressing risk in the current climate.
Treasurers approach risk in different ways. In some cases, it is something to be feared and therefore eliminated as far as possible. In others, it has been less of a priority, compared with other issues, simply due to the benign economic climate. In others again, risk management falls into the category of “too hard”, particularly for smaller treasuries where people often feel intimidated by the world of complex risk analytic models which require highly specialist skills to decipher. Jonathan Chesebrough, RBS explains,
“Risk management is now “en vogue,” but it has received relatively little attention in recent years. During a long benign period, the view that “what can go wrong?” has prevailed. Now, companies are reassessing their risk management objectives and policies. Previously, these were simpler and managed in silos - FX risk, liquidity risk etc. In many cases, companies did not check to see that these policies were aligned with each other or with their overall business objectives.”
Another issue is resourcing. As Nicholas Blake, JP Morgan explains,
“The treasurer’s role in many companies has been expanding over the past two or three years, but treasury departments remain small, covering a wide range of risks. An effective and pragmatic approach to managing risk is not simply about policy, but allowing automated processes to be maintained to ensure consistency and avoid the risk of error and fraud.”
Risk brings opportunity as well as danger, and a company, which adequately and realistically assesses and manages their risk appropriately, can create competitive advantage. In practice, this could mean hedging commodity costs or financing suppliers to create security in the supply chain, avoiding the need to pass on price increases to customers, which competitors may be forced to do. This active and competitive approach to risk management will differentiate between great companies and simply good companies in the coming months. There is not sufficient space in a single article to cover comprehensively all the different types of risk for which treasury is responsible; rather, in this article we will consider: traditional risks, the relationship between risks, and the 2009 risk agenda, touching on financing, supply chain and operational risks. [[[PAGE]]]
Jonathan Chesebrough, RBS, provides an excellent summary of risk as follows:
“A significant element of risk management, from a corporate perspective, is about stripping out non-core risk - such as interest rate and FX risk - provided it can be done at an acceptable cost. Companies need to be clear about their risk management objectives, and make sure they are aligned with the strategic objectives of the company. For example, if a company’s goal is to achieve a certain level of growth, earnings per share, or return on equity targets, risk management policies should be aligned with these targets. In many cases we have seen corporate risk management policies based on objectives that are unrelated or even in opposition to the high level strategic objectives, and therefore requiring an overhaul of policy.”
Nicholas Blake, JPM concurs, saying:
“The more traditional risks managed in treasury - FX, interest rate risk etc - remain topical whatever the market conditions, but increased volatility has meant that the risks are even more pronounced. We are seeing companies going ‘back to basics’ in their risk management approach. For example, many treasurers are nervous about using derivatives. Instead, they are seeking more transparent means of hedging, such as intercompany netting.”
One of the observations I have made through working with corporate treasuries is that people are moving away from the opaque, statistical risk models which they may have acquired or built up over a number of years - or which treasurers without these tools fear. Nicholas Blake, JP Morgan explains,
“As well as simplifying their hedging strategy, treasurers are reviewing the use of highly complex risk analytic tools. These can be useful when the market is functioning as it should be. Today, these models frequently may not reflect reality, and consequently, common sense is now the order of the day. If using risk models, treasurers need to understand clearly what they are telling them, and apply judgement, so that decisions are based on the true situation in which they find themselves.”
This view is supported by Jonathan Chesebrough, RBS, saying,
“Treasurers are starting to reassess how they use risk models. There is a welcome return of common sense in the realisation that a model can be a useful tool in managing risk, but it is absolutely not the “end all be all.” Also we are seeing a simplification in some cases in measuring risk. For example, while statistical techniques such as Value at Risk may be in use, more pragmatic modelling such as stress testing is now becoming prevalent. These techniques also have the advantage that the results are more intuitive to non-financial experts.”
Risk brings opportunity as well as danger, and a company which adequately and realistically assesses and manages their risk appropriately, can create competitive advantage.
The final point, which Jonathan makes, is particularly important. Risk management has always been a topic clouded by jargon and impenetrable numbers. The Board, which is far more attuned to the need for an appropriate risk management strategy than in the past, is likely to understand and be able to make decisions more easily based on a stress tested risk number rather than a complex value at risk calculation.
“The winds and waves are always on the side of the ablest navigators"
The relationship between risks is a vital consideration when devising or implementing a risk management policy. Risks are inextricably related and impact on each other. Harnessed correctly, they can also be an opportunity. Jonathan Chesebrough, RBS illustrates,
“Treasurers have become more proactive in their risk management approach in a variety of ways. Firstly, there is an overriding objective to maintain financial flexibility. In the past, this was limited perhaps to matching maturity of assets and liabilities, ensuring access to different forms of financing, or having unutilised facilities “Just in case.” Now, the importance of other factors such as the currency mix of debt has been highlighted. For example, the recent substantial currency movements, such as the fall of GBP against the USD and EUR, has wreaked havoc on the Net Debt/EBITDA covenants and rating agency credit metrics for some UK corporates where the currency of debt was not tranched in similar currency proportions as underlying cash flows. In many cases, financing was arranged in the currency that was cheapest at the time, so the currency of debt may not now be aligned with the company’s cashflow. Consequently, while looking at the cheapest form of debt, or hedging net assets may have been a priority in the past, the focus is now to secure the future needs of the business through protecting financial flexibility.”
The result of this is not necessarily to try and eliminate risk. After all, without the wind and waves, a ship would go nowhere. Jonathan continues,
Secondly, treasurers are looking deeply at the trade off between risk and reward when seeking to reduce volatility in key metrics such as earnings per share, cashflow and return on equity. While many firms are seeking as much protection from the markets as they can, it is important to ensure that an approach is not only cautious, but also proportionate and cost-effective.”
Risk management is not simply looking at ‘what if’ and the use of derivatives. It is also about capital structure, such as the currency of debt and whether there is a sufficient equity and liquidity cushion to withstand a downturn. Derivatives offer a temporary transfer of risk but they can only protect a company for so long - therefore, firms need to ensure an appropriate capital structure to support it during prolonged periods of weakness.”
Looking too at transactional risk, in the past a company may have hedged only with FX forwards 6 or 12 months out, where the choice of product and tenor was often driven primarily by the desire to achieve hedge accounting treatment and limit P&L volatility, or to protect a budget over a financial period. While accounting and financial planning are still important, we are now seeing a better balance with long-term economics. For example, we are now working with clients to implement hedging programmes over a longer period, where the tenor of hedging programmes are ideally long enough in the event of an adverse market movement for companies to make compensating changes to their operational model. Also, treasurers are now more willing to consider purchasing options which despite the cost of the premium, are more attractive as hedging tools as they provide a greater ability to match or surpass competitors in absorbing increased costs, and therefore preserving or increasing market share.”
[[[PAGE]]]
While FX, interest rate and in some cases commodity risk has dominated the risk agenda in the past, treasurers’ risk priorities have changed substantially since the credit crisis first arose. In particular, counterparty and financing risk have come to the fore.
The relationship bewteen risks is a vital consideration when devising or implementing a risk management policy.
While diversification is a mantra of any risk management textbook, many smaller treasuries in particular find it difficult to divide surplus cash across multiple counterparties or multiple asset types, either because the value of cash may not seem to warrant it, or they do not have the resources to do so. Relatively speaking, however, cash for investment may still be of material value to the company, and the financial and reputational damage of capital loss could be substantial. One or two commentators (who, it should be said, are not those who have any cash to invest themselves) argue that corporate treasurers should not worry about counterparty risk, as the government would not allow a bank to fail, or the bank in question would be acquired by a stronger credit. While this advice may be appropriate for your aunt saving for her holiday, it would seem irresponsible for a corporate investor.
As Nicholas Blake, JP Morgan outlines,
“Counterparty risk has become particularly important to corporates, particularly for financial counterparties. A number of our corporate clients are asking for advice on where their excess cash sits, and where it should sit. They want to achieve greater transparency over their investments, and assess their banks and asset managers etc more closely. Diversification and capital preservation are now the priorities.”
Jonathan Chesebrough, RBS agrees,
“While in the past, banks were scrutinising corporate credit, now the tables have turned, and treasurers are scrutinising the banks and focusing on where their money is and how secure it is. Credit risk management is now therefore an increased priority.”
There are various ways of spreading counterparty risk and achieving diversification, without adding substantially to a treasury’s workload. One alternative is to use AAA-rated, constant NAV money market funds. We will not discuss these in detail in this article, but articles providing more information on these instruments, and the opportunities they present, can be found at www.treasury-management.com. As Nicholas Blake, JP Morgan, outlines,
“We are helping our clients to consolidate their cash investments through a single conduit, but then invest across multiple counterparties and assets. This investment approach allows corporate treasuries to maintain an automated and consistent process whilst managing counterparty risk.”
According to the Treasurers’ Benchmark, the peer benchmarking service for corporate treasurers, (and which includes predominantly large corporates with the greatest risk to banks) many corporates have paid lip service to credit risk in the past. Today, few corporates are likely to be complacent about credit risk; however, many firms’ credit risk policy, and how this is reflected in practice, could be considered insufficient. For example, risk to financial counterparties includes more than simply exposure limits. The Treasurers’ Benchmark illustrates, that while the majority of corporates have some mechanism for measuring and limiting the exposure to individual banks, this does not take into account the full set of risks (fig 1)
While in the past, banks were scrutinising corporate credit, now the tables have turned and treasurers are scrutinising the banks...
For example (and purely hypothetically) what would happen to payments made through a bank which had not yet reached their destination at the point that a bank failed (and for this reason, CLS is becoming more important)?. What would happen to collections which had not yet reached you? What about cash held in bank accounts, as well as those held in deposits and other instruments? These elements are rarely included in companies’ calculation of counterparty risk. Furthermore, how seriously are exposure calculations taken into account in a company’s financial decision-making? Again, according to the Treasurers’ Benchmark, only 55% of companies with an annual turnover above $4bn actually produced limit reporting, even though they have the policies and systems in place. If a limit is breached, in most cases, this is not remedied, but the breach may be alerted to management for approval or picked up in exception reporting. In very few cases (less than 5%) is a limit breach a disciplinary matter.
Perhaps treasurers have taken the view in the past that the risk of bank failure is too small to justify substantial resources in managing it. However, this cannot now be a matter for complacency. The issue is rarely one of technology - most of the major treasury management systems provide better bank risk management tools than their users are taking advantage of. [[[PAGE]]]
With credit less widely available and expensive, many companies have been looking to negotiate or extend financing terms to provide greater financial flexibility. In addition to securing external financing, intercompany financing creates opportunities for some companies, as Nicholas Blake, JP Morgan explains,
“Financing risk remains a priority for many corporates, both long term funding and supporting everyday financing needs. To reduce their reliance on external providers, many treasurers are looking more closely at intercompany financing opportunities, and focusing more on working capital efficiencies. While working capital optimisation has been on the agenda for a few years, the value of this approach has increased considerably
... most of the major treasury management systems provide better bank risk management tools than their users are taking advantage of.
The working capital issue, which Nicholas raises, is significant. While working capital optimisation has been a mantra of the financial media for some time, not all treasuries have given the issue sufficient focus, and internal sources of finance and cash flow optimisation have remained untapped. Financial supply chain optimisation creates even greater opportunities, by using different steps of the financial supply chain, such as purchase order, invoice or receivable as financing collateral, as well as enhancing efficiencies in the process to accelerate the cash flow cycle. Nicholas Blake, JP Morgan explains,
“Supply chain risk has traditionally been outside the treasurer’s remit, but treasurers are now more often taking an oversight role in this area. Although there has been a trend in recent years towards open account, we are seeing a return to more traditional trade finance instruments, such as letters of credit, to allow corporates to manage their counterparty and supply chain risk more effectively.”
In addition, increasing the robustness of the supply chain is vital in order that the company can deliver goods and services, as well as ensuring cash flow stability. Techniques such as supplier or distributor financing can be valuable ways of managing supply chain risk.
Many treasuries have become very effective in automating their financial processes and achieving visibility and control over their cash flow. One of the ways in which they have done this is through centralisation and consolidation of their banking partners, such as for cash management purposes. In theory, there could be an argument for returning to a larger panel of cash management banks to mitigate consolidation risk. However, there would potentially be a substantial loss of efficiency, visibility over cash flow, ability to net credit and debit balances, and potential for economies of scale. Consequently, it would seem undesirable to fragment cash management structures already in place. In reality, few companies operating across regions have a single banking relationship for cash management so the issue of sole cash management concentration risk is rarely an issue in reality. What is important is to avoid excessive dependency on a single bank. One of the ways of doing this is maintaining bank independence from a technology point of view to ensure that the cash management business could be transferred to another bank if necessary. Nicholas Blake, JP Morgan, emphasises the potential advantage of SWIFT Corporate Access in this respect,
“In recent years, there has been a trend towards centralisation for transactional processing, so corporate treasurers now have a significant exposure to a small number of financial counterparties. We are looking at ways of enabling treasurers to enjoy high levels of automation, whilst ensuring greater diversification of risk. One example of this is SWIFT Corporate Access, which also facilitates greater control and visibility over transaction processing and cash balances. This has been an important evolution in their use of providers, which enables them to take advantage of automation while not being too exposed to a single counterparty.”
Operational RiskOne of the additional advantages of SWIFT Corporate Access is its potential to allow greater visibility and control over cash flow. Operational risk is an area in which many treasurers have significant experience, particularly due to the constant need to do more with less and the potentially devastating financial impact of error or fraud. Attempts at fraud increase during difficult times, so companies need to continue to be rigorous in their processes and systems.
Operational risk does not only include risk of error or fraud, however. Other areas in which treasurers need to be vigilant include technology and personnel. For example, in the event of non-availability of business-critical systems, what disaster recovery plans are in place? In addition, with smaller companies experiencing greater constraints in their access to credit, what plans are in place should your technology supplier be forced into liquidation, or how have you mitigated this risk?
In difficult times, small departments in particular become even more reliant on key individuals. What skills and information transfer arrangements are in place to ensure that expertise is not lost in case of staff members being unavailable to work? [[[PAGE]]]
“When rats leave a sinking ship, where exactly do they think they’re going?”
An economic climate with volatility across the major treasury risks and with new, or exacerbated risks developing, particularly in financing and counterparty risk, it is neither a time for panic, or complacency. Great companies will ride the storm and come out stronger, good companies will survive it. Treasury is in a unique position to contribute to a good company being a great one, by taking a pragmatic and realistic view of risk, and constantly ensuring that risk policy and process is aligned with corporate objectives, rather than becoming a separate or unrelated discipline. Furthermore, while risk management has often been seen as a specialist activity, it has come to the fore with the Board and other stakeholders in the business to assess the company’s health and its ability to come through the storm intact. Good risk management requires excellence in financial processes and systems, which treasuries of all sizes need to ensure, but complex risk management models, which few can understand, will not prove a panacea. Rather, common sense and a firm grasp of what the business requires will place the company in a strong position to ride the storm and create competitive advantage.
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