By Paul Bramwell,
SVP Treasury Solutions,
As we gradually emerge from the financial crisis, strong risk management measures are being hailed as the solution to previous failures that caused the credit bubble to burst. But for corporate treasurers, what does risk management mean, and how can the right risk management techniques help them prevent their company from running into difficulties in a tight credit market?
One of the treasurer’s key responsibilities is to ensure a company has access to sufficient liquidity to meet its financial obligations, as well as ensuring that access to this liquidity is managed efficiently and cost effectively. Sound treasury management means that the cash a company generates should be invested wisely and used efficiently to minimize reliance on third party providers of finance. Risk management plays a crucial part in this; budgets are set on assumptions around market rates and changes in these rates can have a profound effect on the performance of a business. Without the proper risk management techniques in place, even the most profitable company can fall into difficulty. A significant change in market rates could have huge implications for the business if, for example, it affects covenants on debt agreements or margins on borrowing facilities.
Risk management tools and techniques have evolved over time, and risk measurement has become more complex and often difficult to fully understand for those outside of the treasury department. Value-at-Risk (VaR) was introduced in the 1990s as an enterprise-wide single measurement of risk. Many financial institutions and corporates embraced it as the best single measure of risk across all asset classes. However, an over-reliance on VaR has been cited by many as a principal cause of the failure of banks’ risk systems to predict the rapid deterioration of global financial markets. The theory is that the problem was not with the measure itself, but the way it was applied. VaR was the measure adopted by global regulators, notably the Basel Committee and while this is not to suggest that this choice of measure was incorrect, the move led some banks to push VaR out to the remote confines of regulatory capital rather than the inner sanctum of internal risk management.
Several factors impacted risk analysis and contributed to the current crisis:
• VaR gave bank management teams a single maximum loss figure within a certain confidence level for a certain time period, for example 95-99 per cent. However, the potential loss that could have occurred one to five per cent of the time due to a large unexpected swing in the market was missing.
• Risk management was often seen as a compliance tool rather than something at the heart of the trading floor.This risked disconnection between traders and those responsible for measuring that risk.
• Trading volumes and instrument complexity increased, making detailed and timely analysis more challenging.
• Reporting timelines increased the likelihood of scenarios being calculated using shorter histories and not complemented with the necessary stress tests.
It is possible to structure trades that raise the risk profile of the bank without necessarily materially affecting the VaR number. In short, risk managers need the correct data to empower them to add value to a business. As we know, when the big market shock came, some banks were left without sufficient reserves of capital. The lesson for banks and corporate treasurers alike is to adopt a holistic view of risk management. Reliance on one measure, particularly static measures, and historic data are not sufficient in today’s environment. VaR is an excellent risk measure, but treasurers should use it in conjunction with the underlying scenario analysis. As such, risk reporting should evolve into risk modeling and analytics to become more forward-looking, rather than taking a static view.
For the treasurer, common risks include interest rate, foreign exchange (FX), credit and liquidity. Hedging these risks and investing surplus cash open up another exposure – counterparty risk. As we have seen previously, well-rated companies have run into problems. Treasurers are now increasingly drilling down into their counterparty exposures to avoid risk concentration in a particular industry or country.
Knowing Your Exposure
The first step in effective risk management is to know your exposure. This sounds simple, but a long-standing issue for treasurers has been the difficulty in consolidating up-to-date information relating to risk. The key is an efficient system for reporting and reviewing information and ensuring that this data is up-to-date. One example is to ensure that all bank account balances are reported and reconciled at least daily. This is particularly important when the accounts are in disparate locations. If a corporate treasurer does not have all the right information in one place, the probability of risks going un-managed increases and the quality of decisions made based on this information may be compromised.
Once a treasurer has centralized all the information, the next step is to set policies on how to keep it updated, measure it and report exposures. A mixture of static and forward-looking measures will give the most complete view of risk and how changes in market rates might affect this risk and subsequently the bottom line and value of the enterprise. After the positions have been consolidated and reconciled, any un-hedged exposures should be marked to market at current market rates. These rates should be updated as often as is practical. A best-in-breed risk management system will allow for regular updates of live rates – most important when markets are in turmoil and changing rapidly.
Scenario or ‘what if’ analysis should run across a portfolio. This will allow the treasurer to see how likely changes in market rates affect potential gains or losses and aid decision-making around hedging strategy. As discussed earlier, it is important to stress test the numbers to see how these change due to a one-off shock to the markets. Testing needs to be comprehensive and should not be limited to what would be considered ‘normal’ events. Combining these measures with VaR puts the treasurer in the best position to report on and manage underlying business risks.
After measuring the risks, treasurers should set risk policy. Rather than implementing these on an annual or even six-monthly basis, risk management limits should be constantly reviewed. While we could not have foreseen the banking crisis, having an active review on these limits and reducing concentration risk reduces the likelihood of loss, plus the treasurer is able to react quicker and make more informed decisions. Corporate treasurers cannot see into the future, but by being diligent and as forward-looking as possible, they can minimize the impact from unforeseen events with the ideal outcome being one where little impact is felt when the markets move dramatically.
Risk Management Tools
So what kinds of tools can help companies better manage treasury risk? Derivatives have been demonized recently given their role in the recent crisis, but they remain a very useful weapon in a treasurer’s arsenal. If you are selling goods in a foreign country, then currency risk is often unavoidable. The risk-averse approach may be to hedge these risks fully as soon as they arise. However, few companies have the luxury of being price-makers and if their competitors have adopted a different strategy enabling them to take advantage of favorable market movements in setting more competitive pricing, a more dynamic strategy may be required. Buying a currency option hedges the exposure at a fixed cost, while still allowing the possibility of upside from a favorable market movement if this arises. Treasurers need to strike a balance between risk and reward. The key to using any financial instrument is to ensure transparency in reporting and fair value calculations, and that the risks surrounding such instruments are fully understood by all on the treasury/risk management group.
Clearly, technology has been a great enabler when it comes to managing treasury risk. The right technology can consolidate the information a treasurer needs, keep it updated, consolidated and centralized with relative ease. This gives the treasurer improved visibility of treasury processes and risk management and means they are much better able to manage the company’s financial obligations better. Treasury management systems can help treasurers to actively manage their risks, provide real-time data and consolidate information. Integrating this technology with other systems, such as accounting or dealing systems, further helps to reduce operational risk and provides transparency across the treasury function.
Ultimately, a robust, scalable, dynamic treasury system reduces the risk of unreported cash balances sitting idle/at risk in different parts of the business and affecting the bottom line. In addition, flexible delivery options now mean that treasurers don’t necessarily need to install large pieces of hardware to manage the complex processes within their treasury. Instead, a hosted or web-based application allows them to access all the information they need, with the hardware managed elsewhere.
Clearly, no corporate treasurer can avoid risk in their day to day business – it is naturally present. But a good treasurer, equipped with the knowledge of how risk can be measured and managed and with the right technology to assist will be able to manage risks to the business effectively.