Mitigating Risk Through a Centralised Treasury
Corporate management is becoming increasingly concerned with liability, due to news headlines regarding employee fraud, interest risks and computer breakdowns. Obviously, companies cannot fully cover all their risks – this is usually neither possible nor financially viable. A company needs to be fully aware of the impact of certain risks if they do occur.
But how do risks relate to your organisational structure? Risks in a decentralised treasury set-up are very different from risks in a more centralised environment.
In a typical decentralised environment, a company allows its subsidiaries to manage their own payables and payments processes. Each location uses its own staff and infrastructure to support the operation. While this offers flexibility, it can also result in poor visibility of cash and additional interest rate risks because of a lack of pooling mechanisms and a fragmented view of cash.
A lack of standardisation in treasury systems across different subsidiaries and a lack of automation can lead to risks in transactions that are not processed straight-through (i.e. incorrect payments and data redundancy). As segregation of functions is more complex within small(er) group companies, combined with a limited central audit/control, the possibilities of fraud increase.
In a decentralised treasury, the subsidiaries remain responsible for their own foreign exchange (FX) and risk management. Proximity and knowledge of the local markets could be an advantage and help to select appropriate hedging instruments. Such a structure, however, might also trigger unwanted exposure for the group as a whole.
By centralising its payments processes, a company can achieve the maximum benefits of liquidity management. Whether operating from a centralised or regional shared service centre, companies will be able to gain control and visibility over their cash out-flows (payments processing) and cash in-flows (receivables management) which, in turn, offer treasurers greater control over their operational risks. As a result of centralised control of the groups’ currency position, the FX risk and overall group exposure therefore decreases.
A centralised treasury will involve substantially higher values and volumes of its cash flows, centralised transaction processing and often single platform IT infrastructures and thus results in different kind of risks, such as system failures.
By using a payment factory, a company can consolidate standard accounts payable files from the operating units and prepare the respective payment instructions in one process, enabling a single payment transmission to banks.
By utilising software to connect in-house systems (such as ERP, TMS) to banks, the payment factory can act as a centralised operating centre for multiple locations (using a payment hub). The payment factory maintains full control over payments, cash flows and operational issues through embedded workflow and approval procedures.
As a result, a centralised treasury organisation along with a payment factory enables companies to improve liquidity and risk management and introduce control around security, thanks to the greater transparency.
The most important operational risk factor in the payment factory concept is that the in-house systems are directly connected to the bank. This involves issues around authentication, access and delivery of files to the banks. To fully protect itself against fraud, corporations need to implement end-to-end controls to guarantee integrity of payment files.
The in-house bank (IHB) is a powerful tool to centralise a treasury’s financial activities and risks. It frees up local operating management from daily cash management and FX activities, reduces interest-rate risks and bank fees for the entire group and minimises idle cash. With the IHB concept, subsidiaries buy and sell in their own currency from the central treasury or in-house bank and FX risk is transferred to the in-house bank. As a result, foreign currency exposure management is fully centralised.
The IHB ideally operates as a separate legal entity, controlled by the treasury. The main benefit of the IHB is that it enables the company to centralise Sarbanes-Oxley (SOX) processes, accounting, reporting and the control of tax compliant inter-company transactions. By doing this, an IHB enables interest-rate and FX risk mitigation.
Irrespective of the different cash management concepts and whether your primary concern is operational risk, technology risk, interest-rate risk or FX risk, corporates should decide which risks are acceptable and which are not. They must choose to either accept the risk or take measures, including prevention, hedging or insurance, in order to mitigate the risk banking instruments. When dealing with risk, companies have to find a balance between the cost of covering every risk and the cost of paying for the risk (should the event occur).
In terms of the ‘risk appetite’ of an organisation, a bank can help by carrying out a risk assessment. An enterprise risk management (ERM) scan can identify the range of risks the corporate may be facing – from standard financial and insurance risks to less obvious risks, such as operational risks, counterparty risks, interest rate and FX risks.
By taking preventative measures internally, an organisation can reduce its risks. The best deterrent for fraud is to create a controlled environment and company culture where the chance of detection is high. In a centralised set-up, this is even easier to implement and control because of a central audit/control staff. Measures to be considered include:
Various banking instruments can be used to hedge against risk. These include forwards, options, trade products and cash concentration instruments (such as cash pools), which mitigate interest-rate risk; treasury instruments that mitigate FX risks; and trade instruments, such as letters of credit or documentary credits, to deal with political risks or non-payment by customers.
Insurance against loss or damage is another way of safeguarding against risk. One way of doing this is to start up a special purpose vehicle (SPV) syndicated to an insurance company.
In a fragmented, decentralised organisation, there are more risks to mitigate than in a centralised environment. When choosing to move from a decentralised to a centralised treasury, corporates need to be fully aware of the impact of certain risks during the different phases in moving towards centralisation.
In order to meet today’s complex compliance requirements, a centralised treasury is quickly becoming best practice for corporates to mitigate risk. Quite simply, centralisation helps corporates to improve risk management, provide a better view on short-term assets and liabilities and also enables an instant dashboard of cash positions across the businesses.