Challenges Treasurers Faced in 2008 and What to Expect in 2009
Peter Reynolds, vice president of Reval EMEA (Host):How is the credit crunch affecting corporate treasuries?
Dan Ferguson, treasury manager at Royal Sun Alliance: The cost of borrowing has shot up and some corporate treasurers have been slow to realise the full impact of what has happened. Around this time last year, many people looked at the cost of borrowing, thought that it was expensive and that they could hold on until next year or the year after. Our view is that it is not getting any easier and borrowing is not going to get any cheaper in the near term.
Another point is on the liquidity side. In managing the cash portfolio for Royal Sun Alliance, we just provide liquidity for short-term cash investments. A good indicator of the impact of the credit crunch is the amount we would normally invest in certificates of deposits, purely for their negotiability, but that secondary market has pretty much dried up for most of this year. Usually we would rely on being able to access that market if we needed liquidity. The types of instruments that are available to us to manage liquidity have reduced considerably.
François Masquelier, president of the Association of Corporate Treasurers of Luxemburg (ACTL): Presently, we are in a relatively comfortable situation because we face lender issues rather than borrower issues. But it is difficult for us to ensure repayment of the principle with interest from our short-term placements. I have noticed that clearly there is already an increase in the credit spreads – we noticed this even before 15 September – and this is increasing for small and mid-cap companies.
Committed facility is never a guarantee. We are getting the impression that some banks could be tempted to transfer their risk to other banks, to welcome new banks into the syndicates or to try to find other legal ways to escape from tending. The market is quite tough. Some banks are more selective in terms of the borrowers’ quality, not just the credit rating of the company but also the potential return they can get from their customers. Increasingly, the banking relationship is an issue and one that needs to be managed carefully.
Mike Lloyd, partner at Deloitte: I am not surprised that most people are affected by the credit crunch and it is not over yet – we are probably just at the start of it. The cost of borrowing and the availability of credit have been addressed by others, but there is another fundamental issue that might impact corporate treasury operations and individuals – companies preparing their annual statutory accounts will increasingly be challenged on producing cash flow information and looking at the funding requirements to make sure that they have evidence that they can pay their debts when and if they fall due. They are likely to get that line of questioning from senior management, from boards and external auditors. If the banking crisis tells us one thing it is that you can have enough capital and be profitable but you can still go bust. I think that more will be asked of the corporate treasury operations to give information on why you think you can renew your borrowing for the next 12 months.
Ferguson (Royal Sun Alliance): We have started to see a few more questions from the analysts via our investor relations teams – nothing too intensive or in-depth, but they are starting to look at cash flow and debt maturity profile, for example, more than in the past. Particularly, a few of the buzz words around investments, such as asset backed securities, have come into common parlance over the past year and a half. For example, we will get questions on what we have got invested in retail mortgage backed securities, which we wouldn’t necessarily have got in the past.
Reynolds (Reval): How should companies review their capital structure in light of the credit crunch?
Lloyd (Deloitte): It is difficult to know where the world is going to be in six weeks time, let alone six months. But if you go back over that last few years and look at what has happened to the banking model, three or four years ago a banking model that relied on wholesale funding was quite sensible. In the last year or 18 months that has been completely destroyed and that model doesn’t work anymore. Equally the investment banking model, where the whole of the balance sheet is mark to market, seems to be completely destroyed. Following that trend, gearing is a bit of a dirty word at the moment and if a company is in the fortunate position of having cash, then I am sure that it will have a lot more strategic opportunities than one that hasn’t. If a firm is in a position where it is highly geared, then I think life is going to become more difficult and it will be reliant on funding sources and hopefully its relationship bank. This is a time when the term ‘relationship bank’ gets tested to see whether it has any value or not.
Reynolds (Reval):How should you monitor counterparty exposure in the light of Lehman’s, etc?
Masquelier (ACTL): This is a brand new situation for us, although we have a strict policy in terms of what we can invest in with regards to short-term cash investments. We changed our policies to make it tougher and more transparent to management. We had a direct line to top management so that they know exactly what risk we were running for short-term deposits with some banks. We were quite stressed because even the solid banks were under pressure.
Are money market funds (MMFs) the solution to short-term placement with banks? Possibly. What we have tried to do so far with short sell is to go with MMFs rated AAA. So far it has been quite good because we have been strict on the quality of the counterparty. We wanted the diversification which an MMF gives. We also tried to diversify the number of counterparties and funds we invested in. We may have increased the risk of losing some money but we have decreased the risk of losing everything.
Ferguson (Royal Sun Alliance): We have seen a lot more focus on counterparty analysis. ‘Return of capital’, rather than ‘return on capital’, has been the focus over the past three months. It is always a difficult balance between the income generated from a cash portfolio, for instance, compared to the inherent risk in having exposures to various banks. Despite the credit rating agencies, a treasurer has to take a pro-active approach to counterparty analysis. Look for banks at the moment that are too big to fail or ones where there are systemic risks to the local economy – that’s where banks have been saved.
During a treasury conference in February, a large multinational said it had switched its entire cash portfolio – billions of euros – into treasury bills. It was quite happy to take a short-term income hit knowing that it was going to be protected. That may be an extreme action but in some ways we have to remember what we are here for in the corporate treasury – to provide liquidity for the company.
Lloyd (Deloitte): It is an interesting debate – if you have a lot of cash, do you spread it as far and wide as possible, recognising that if one goes down then you have lost a manageable amount, or do you stick it with the banks that are too big to fail, where no one is ever going to criticise you? If at the end of the day, banks are not willing to lend to each other for more than seven days, then why should corporates lend to banks for six months? At times like these, the important thing is to be transparent and open within your own organisation to keep senior management and boards informed of what you are doing. If it does go wrong, at least it is a shared decision rather than being your fault.
Reynolds (Reval): What are the key issues with hedge accounting at the moment?
Ferguson (Royal Sun Alliance): We are lucky because we are at the vanilla end of the market so the vast majority of any foreign exchange (FX) transactions that we enter into are forward contracts, so it is sad to say that it has taken us a couple years to really get up to speed with just forward contracts. I almost dread to think what it would be like if we had to do more complicated options strategies. We are not looking to take on board anything more structured at the moment.
Masquelier (ACTL): Fair valuation is clearly an issue – in the US and Europe, the need is better information in order to fair value products particularly in inactive markets. On the positive side of this current crisis, we should rely on good products and suppliers to get proper evaluation and have a method in place. If you enter into more structured product, you have to choose the support to properly valuate your assets and defend your evaluation of your assets.
In terms of the recent discussion paper issued by the International Accounting Standards Board (IASB), the EACT’s proposal is to re-simplify accounting. We think it is better to keep IAS 39 like it is with simplifications rather than move to a full fair value model. These proposals were not satisfactory for all actors, i.e. investment banks or insurance companies or some corporates. Commodity hedging is very difficult because of volatility of markets.
Reynolds (Reval):How can you include credit risk in your evaluation?
Lloyd (Deloitte): Credit risk is nothing new and banks and financial institutions have been making evaluation adjustments for credit risk since they were fair valuing derivatives. The reason it has become more topical is because credit spreads are widening and having a greater impact on evaluations. But fundamentally from an accounting point of view, whether you are a corporate or a bank, you are aiming to come up with a value for your derivatives that is an exit value. It has also become more complex because do you take credit risk into account in respect to your derivative liability? There seems to be a divergence between US businesses and the rest of the world, where US businesses do take it into account while very few others seem to – it’s not transparent but I think that is a fair summary.
Reynolds (Reval):What is happening with rules-based standards such as IAS 7?
Lloyd (Deloitte): First IAS 7 is not as much of a rules-based type standard as it is principled-based. And the principle is that we are not going to set out guidelines for what you should disclose. You tell us what is important for reasonable accounts to understand and that probably means that you are reporting things externally that you report internally – that is the thrust of IAS 7. The trouble is that we are all uncomfortable about disclosing too much information. Ultimately, you will be judged against your peers and over time there will be a move by all users of accounts, particularly analysts, to ask for more and more disclosures so they can compare entities in the same industry. There is clearly a risk if you don’t disclose as much information as your main competitor because that might be interpreted by the analyst community as having something to hide.
Reynolds (Reval):What is going on in commodity hedging?
Gianluca Alviti, head of financial risk at Telecom Italia: It is important for surviving the credit crunch. It reflects the higher price volatility of crude oil, which was traded in the range of US$45-145 per barrel. The crude oil prices behaved as any other commodity with price swings in time of shortage or oversupply. Last year the new emerging markets China and India economies expanded, which boosted the global demand of oil. Furthermore, European countries saw a great opportunity in the weakness of the US dollar against the euro. The combination of these effects has led to an increasing level of historical price volatility, which doesn’t look like it will subside in the future.
From now on Europe will be a starting point for corporates to increase their hedging strategies facing the potential impact that could affect our balances. It could be expected that corporates aim to avoid the impact on core business cash flows derived from the fluctuations of commodities market and we should achieve protection through using derivatives. It is estimated among the European derivatives market ranking, commodity risk will be the first hedged risk size by volume after foreign exchange and interest rates. Under this scenario it will become more crucial for large corporates to access and deal with the hedge/energy market derivatives, which is distinguished by complexity and low transparency and over-the-counter (OTC) transactions. What we expected is a growing number of derivatives are going to be priced, dealt and test to be effective reachable for hedge accounting purposes.
Reynolds (Reval):What are your experiences with FX forwards ans options evaluation?
Ferguson (Royal Sun Alliance): In the treasury team, we are more comfortable using options, but it is more of an internal education process whereby going out and buying options, paying premiums, etc, is not fully understood. The best way to look at options is paying an insurance premium, which for an insurance company is an easy analogy to put to senior management. But there is still some reluctance internally – the perception that options, even vanilla options, are a kind of structured product and something that we shouldn’t be getting into. I think that it is changing slowly.
Lloyd (Deloitte): We have quite a few clients that have option strategies and are trying to build them into a hedging relationship. I think Dan’s point on simplicity is important, and given the problems with the credit crunch, people will likely move away from hedge accounting through options, to be honest. If you look at it from the banking side, there has been a huge increase in the volume of vanilla products and the complex products are a bit harder to sell in this type of environment. So in the short term we could see a move to vanilla products.
Reynolds (Reval):How about embedded derivatives?
Lloyd (Deloitte): Embedded derivatives have always been perceived as being a complex subject. Unfortunately we can’t avoid it and must deal with the consequences of embedded derivatives. There is clearly is a concern, particularly in Europe, that this is far too complex and we need to go to a simpler model that François was talking about earlier. That will be a driving force, from Europe to the IASB when they do eventually get around to amending IAS 39, to try and make it simpler and in that process change the rules and make embedded derivatives simpler. That is some way in the distance – not in the short term.
Reynolds (Reval):Do you think there is a good understanding of risk mitigation at the Board level?
Ferguson (Royal Sun Alliance): The focus has been there over the past two years – we have seen some spectacular bank failures and corporate failures are now coming into the picture with Woolworths, etc. If you were on the board of any company at the moment, you would make it your business to understand what was happening. There is always a lot of focus in our company on preparing senior management for analyst presentations or delivering results so they are the best prepared to answer the questions, and the sort of questions that will be coming up will be along the topics that we have been speaking about today. These topics are a lot higher up in their thoughts than they have been in the past perhaps.
Masquelier (ACTL): Once a year we have IAS and IFRS training – I think this is quite important to inform management and your subsidiary affiliates about the rules, the evolution of the rules and the impact for the companies – what they are doing and why. The affiliate levels are suffering by not having a full picture of the group. At management level, we want them to understand the reason why we are doing things. We, as corporate treasurers, should improve our communication skills to make sure all communications, whether to the board, external auditors, investors, or ratings agencies, are as clear and transparent as possible.
Lloyd (Deloitte): I agree. The onus is on the treasurers, the finance staff, to ensure that senior management, audit committees and boards understand rather than expecting them to understand, because if something goes wrong, it when it can impact you personally. The worst thing you can possibly have is complete divorce between the risk appetite of the board and the non-executives and what you are actually doing in the business.