Corporate Treasury Risk Management and Technology
Virtually any kind of risk management conducted in a treasury department requires technology support, because of the volume, complexity and time criticality of the necessary data processing. It therefore follows that the delivery of sophisticated risk management solutions has progressed hand in hand with the availability of the necessary network, server and processor power. In this article, I will briefly review the key technological advances that have facilitated the delivery of advanced risk management solutions to corporate treasuries, to give the current situation some context. I will also review some of the different0 risk management techniques that have emerged (and sometimes subsequently vanished) at various times over the last 10 years or so. And I will look at current market trends in risk management, and will outline some of the differences encountered in different parts of the world.
Sophisticated risk management was the preserve of banks until the mid 1990s, when their relatively massive IT budgets enabled them to deploy the mainframe computers, which offered the necessary storage capacity and processing power. As most corporate treasurers are aware, their own IT budgets are comparatively modest – despite the volume of money which they process, and the various types of risk that this implies. The advent of networked minicomputers in the early 1990s was the first key advance, as it enabled low-cost PCs to share information to complete such processes as the aggregation of different kinds of treasury deal; this potentially provided much of the raw data needed for risk analysis in a timely and convenient way.
The early networked PCs were significantly constrained by disk capacity, network speed, processor power and memory capacity. As the demand for treasury systems grew, programmers cheerfully met this demand by producing more and more complex risk solutions – whose success was inhibited by the slowness of the technology on which they had to operate. These constraints have been eliminated by the exponential improvement in capacity and performance, coupled with the seemingly inevitable downward pressure on prices. Contemporary treasurers now have the technological means to perform sophisticated risk analysis, using fast, high capacity storage systems, usually interconnected globally via the web to assure the supply of up-to-date information that is critical for accurate risk management.
If you put together a panel of corporate treasurers, and ask them for their definition of risk management, you will get a range of answers. These will not only reflect individual preferences and prejudices; they may also vary with each treasurer’s geographic location, and with the patterns and nature of the company’s underlying business.
Perhaps the most universal type of risk management seen today continues to be counterparty risk control. In simple summary, this is done by assigning dealing limits to counterparty banks, and then monitoring actual utilisation against these limits. For a single treasury with few operations, such risk management in isolation may not need much technological support. But there are many factors underlying this seemingly simple (and nowadays essential) form of risk management which stimulate demand for technology. For example, if limits are managed on a global basis, this will make significant demands on communications and data transfer, perhaps on a 24×7 basis. This supporting technology is essential in order to realise the practical benefits means of identifying and managing this kind of risk.
Treasurers who use option hedging have traditionally fallen into two groups with respect to technology: those who are happy for the banks to perform pricing for them; and those who are prepared to invest in technology so that they can generate their own independent and objective valuations. The potential value of the latter approach was graphically illustrated a few years ago by a company that had option hedged some fairly exotic currency risks on a projected business expansion. When the business plan was abandoned, the option portfolio of course became an exposure, which had to be unwound. Anyone who has tried to perform such functions without independent pricing will understand the analogy with flying blind. The company in question saved ‘more than the cost of the system’, through checking and ‘correcting’ banks’ quotations. A risk management tool that might have been dismissed by some as an expensive luxury in fact provided a million dollar saving.
Value at Risk was a topic that much occupied treasurers in the late 1990s. VaR was seen as a risk management tool that would alert executives to the kind of abuses that brought down Barings Bank. VaR required quite heavy computational power, especially for portfolios including options, which required at least a Delta/Gamma solution to allow for the underlying asymmetry. At the present time, the increase in cheaply available computing power means that full valuation accuracy is now available in VaR derivation; but that is of little value globally, as VaR is not now a hot topic (or any kind of topic) with most corporate treasurers. It is seen as a control tool that is useful in financial institutions, but which does not work well in corporations where commercial flows of various kinds and certainties comprise the majority of the risk.
Exceptionally, ‘German’ treasury (Germany, Austria, German-speaking Switzerland) still favours VaR analysis for financial portfolios; and there is in fact demand in this sector for ‘Cash Flow at Risk’ derivation; in which the effect of the volatility of future cash flows is measured, projecting into a time horizon as opposed to the market valuation approach of VaR. Cash Flow at Risk uses underlying techniques such as Monte Carlo simulation, which are computationally very demanding. At this time, it is not clear whether Cash Flow at Risk will be adopted as a valuable risk management technique by the broader marketplace.
The concept of the CFO’s nightmare originated in United States. The CFO bursts, wild-eyed, into the treasury department at the start of the working day. “I had a terrible nightmare last night! The Dollar declined 10% against the Euro. I’m sure this is going to happen! What would be the impact on our bottom line if we keep our current risk profile?” The nightmare is then of course transferred to the Treasurer – who would like to evaluate this scenario at the push of a button, and get his crazy boss off his hands. Scenario analysis is, in my opinion, an extremely valuable tool of global applicability. For scenario analysis to be viable (and instantly available) in most corporate environments, it requires real-time visibility of global cash flows, coupled with sufficient computing power to perform the necessary revaluations. As we have seen, current technology now offers the necessary power at an acceptable cost. The former is the Holy Grail of cash and risk management – and is just coming into focus as a practical goal for more and more treasuries.
Globally, the demand for risk management solutions became muted after the advent of the Euro. Cash management became the primary driver especially in Europe. This tendency has now changed, as a consequence of two factors, both of American origin: hedge accounting and the Sarbanes Oxley Act.
Hedge Accounting (both FAS133 and IAS39) places some interesting demands on treasuries and their technology. This is because this discipline uniquely combines accounting, which essentially looks at a past/present time frame, with risk management, looking into the future through the Prospective Test vehicle. Hedge accounting has forced many treasurers to think in new ways, and, arguably, these relate more to the measurement and mitigation of risk than to the generation of accounting reports.
Most of the application of Sarbanes Oxley to treasury is prosaic. Transparent, secure auditable processes clearly reduce risk – and self-evidently demonstrate this. This is scarcely sexy risk management – but it does represent a direct effort to reduce real risk for shareholders. Perhaps more interestingly, Sarbanes Oxley requires aberrant events to be detected and managed, and it is in this field that more creative risk management solutions can be employed. There is increasing evidence of interest in adopting Sarbanes Oxley processes as treasury best practice outside North America, to demonstrate high standards of corporate governance to potential investors and clients, and this is stimulating the development of compliance tools of global applicability.
If we consider the history of treasury risk management over the last ten years, we see a rather erratic series of loosely related techniques and processes which have waxed (and frequently waned) in popularity. It does seem that, if there is any discernable trend, it is towards demonstrably practical solutions and functions, as opposed to the more speculative and theoretical. The availability of real-time global cash visibility is likely to be the catalyst for the evolution of new techniques for forecasting and optimising the management of cash and working capital – though some would describe this opinion as rather speculative!