ERM - The Role of the Corporate Treasurer
Managing risk on a comprehensive, firm-wide basis requires an emphasis on measuring the full range of risks in ways that can be used to support executive decision-making in setting strategy, budgeting and allocating capital. But where can a company find the skills required by this more rigorous, quantitative approach to risk? One obvious place to look is the treasury.
Treasurers, after all, are deeply familiar with financial risks and their quantification, and many are already taking on responsibility for a variety of risks outside their traditional remit. Besides their traditional roles in corporate finance, foreign exchange, interest rate and cash management, corporate treasurers are being assigned responsibility for new areas that hard-pressed chief financial officers (CFOs) cannot address. These new responsibilities include a range of financial risks such as pensions, insurance and commodities. This expanded role allows them to offer valuable input to the enterprise risk management (ERM) programme – if not, in some cases, even to manage it directly. With CFOs increasingly challenged to deliver against their own expanding responsibilities and few other qualified candidates available, enterprise risk seems a good fit for treasurers’ skill sets, and it is also the answer to a clear business need.
The vast majority of the treasurers we have spoken to confirm that they see enhancing ERM capabilities as a major opportunity to add value to their companies. As such, many treasurers are attempting to become engaged in shaping ERM frameworks in their organisations. In a few instances, treasurers have taken on ‘chief risk officer’ roles, while others have taken on wide-ranging responsibility for financial risks. However, many treasurers still lack an active role in managing enterprise risk. Why is this the case?
Far too often, ERM approaches have been defined in response to the raft of new regulation introduced after the governance scandals earlier this decade. Compliance, audit and other control functions have taken the reins, and ERM has devolved into an exercise in ‘box-ticking’ albeit one that now commands the attention of senior management. A compliance exercise disguised as ERM might offer senior executives and board members comfort when it comes to signing off accounts and regulatory filings, but it does not add value to the running of the business or executive decision-making. A true ERM programme is a holistic initiative that puts the organisation’s decisions and activities on a sound and actionable quantitative footing.
Firms that have fully embraced ERM have demonstrated its potential to create substantial value. Today’s incoming board members are far more risk-aware than their predecessors were, and many have been appointed precisely to ensure that the right questions are being asked about the balance of risk and reward in the company’s activities, and to ensure that risk is being properly integrated into the decision-making process. These directors will be stakeholders who will look to the treasurer for increased leadership in the area of risk management.
Treasurers clearly realise that the time has come for action on enterprise risk management. But what should treasurers do? Rising to the challenge of ERM requires treasurers to educate themselves in new technical skills, best practices, non-financial risks and business strategy. On an organisational level, the urgency of enhanced risk management will vary from firm to firm. Some organisations have made significant progress and the changes have fundamentally enhanced their core decision-making processes.
The figure below describes the evolution of ERM from a compliance exercise to a risk-return optimisation perspective.
Most companies have some version of an ERM programme in place but often they involve only the first three stages of development such as: qualitative assessments of probability and impact (high, medium or low) instead of quantitative; addressing risks individually rather than in aggregate; failure to incorporate risk into decision-making; and dealing in one-off ‘point’ estimates rather than dynamic ranges of outcomes.
At leading practitioners, the objective of the ERM programme is typically to enhance corporate decision-making with tools developed to support actions ranging from analysis of overseas expansion plans, business mix, capital allocation or optimisation of the insurance programme. Such programmes systematically identify and quantify volatility in earnings, cash flow or other defined metrics, taking care to produce results that can be used as meaningful inputs to decision-making.
Capital allocation and budgeting is an area of increased focus for most corporates. In principle, treasurers are well positioned to adjudicate on the best ways to allocate and manage capital – leading treasurers are involved in capital budgeting and in calculating differentiated costs of capital for their businesses based on the inherent risks faced. Undertaken effectively, this enables an improved ability to evaluate which funding alternatives offer the best risk/return potential or the appropriate balance between on- and off-balance sheet funding, including the optimal use of insurance or other sources of contingent capital.
There is evidence of a growing trend towards an integrated, quantitative approach that supports decision-making, and external circumstances will make quantitative ERM a priority. When this crystallises more widely, treasurers will be called upon to step up to the challenge. One thing is certain – all treasurers should be prepared. What are the characteristics that organisations should be emulating as they move along the ERM evolutionary track?
Companies with a fully-implemented ERM framework, which is integrated with their strategic decision-making processes, generally exhibit a number of key characteristics: comprehensive risk measurement capabilities, a firm-wide defined risk appetite, leading-edge balance sheet management capabilities, performance measurement tools, a risk-oriented culture, and information transparency.
These companies have quantified their risk profile over the entire spectrum of risks. They can isolate the impact of individual risks, and also produce an integrated view of risk taking at any meaningful level of the organisational hierarchy. In addition, they can assess the effect of risk mitigation (insurance, hedging, etc.) on their risk profile.
The firm’s risk appetite is expressed in measurable terms and is communicated throughout the organisation. ‘Off-strategy’ risks are strictly managed through a formal limit structure, while ‘on-strategy’ risks are entered into as a conscious part of the firm’s business strategy and are aligned with the firm’s return targets.
In terms of balance sheet management, the firm’s gearing ratio is set consistently with its risk appetite and with the capacity of its assets to generate cash flow. The firm takes a portfolio view of its assets and allocates its own capital in order to optimise the group-level risk-return positioning.
The firm has defined its performance targets using risk-adjusted metrics that reduce the impact of risk-taking on business unit results, and then link them to individual performance assessment.
Leading organisations are characterised by an awareness of risk-taking that permeates the culture down to the lowest levels. They usually have a high tolerance for losses resulting from known risk-taking and a low tolerance of surprises. Along with this culture there is a clear flow of risk management information up and down the corporate hierarchy. Senior management needs to receive timely and accurate risk reports, and there needs to be clear communication of both the authority to take risk (delineated by product area, geography and customer segmentation) and the limits on that risk-taking.
Additionally, the experience of organisations that have implemented value-creating ERM suggests the need for a senior executive who sits on decision-making bodies and ensures that an improved understanding of risk is leveraged effectively. This individual should also be responsible for risk management strategy, processes, infrastructure, people and culture. Such individuals – whether they bear the title of ‘chief risk officer’, ‘director of treasury and risk’ or another moniker – face a number of challenges including understanding the business drivers, identifying the right tools and techniques to quantify the risks, and capturing all sources of earnings or cash flow volatility in the ERM process.
Regardless of the firm’s state of ERM development, we recommend corporate treasurers implement an action plan for their involvement in ERM. Such a plan might simply be outlined as follows:
A clear opportunity exists for the corporate treasurer to take an active role in enterprise risk management. The skill sets required to transform a compliance-driven project into a value-added initiative are demonstrated regularly within the existing and expanding role of the treasurer. As corporate CFOs continue to struggle, due to the myriad demands placed upon them, along with new external pressures, there are benefits to accessing the resources of the treasurer. Separately, these same pressures dictate that value be extracted from any risk management programme. However, the only true way to realise that value is through a systematic upgrade of a firm’s ERM framework to incorporate quantitative methods that allow for incorporation of risk-based strategic decision-making.