Risk Management for Corporate Treasurers
One of the key responsibilities of a corporate treasurer is to ensure that the company has access to sufficient liquidity to meet its financial obligations, as well as ensuring that this liquidity is managed efficiently. Sound treasury management means that the cash that the company generates is invested wisely and is used efficiently to minimise 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.
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 measure 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. Currently, the theory is that the problem wasn’t with the measure itself, but the way it was applied. VaR was the measure adopted by global regulators, notably the Basel Committee. This is not to suggest that this was the wrong choice of measure, but 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:
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 the 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 measure of risk, but treasurers need to complement and augment it, and analyse the underlying scenarios. As such, risk reporting should evolve into risk modelling and analytics to become more forward-looking, rather than taking a static view.
For treasurers, common risks include interest rate, foreign exchange (FX), credit and liquidity. Hedging these risks and investing cash open up exposures to counterparties. As we have seen previously, well-rated companies have run into problems. Treasurers are now drilling down into their counterparty exposures to avoid risk concentration in one particular industry or country, for example.
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 doesn’t 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 centralised 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 update of live rates.
Scenario or ‘what if’ analysis should be run across the 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. While I am not advocating running the thousands of scenarios that banks may run, testing does need 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 and manage 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 couldn’t 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 can’t see into the future, but by being diligent and as forward-looking as possible, they can minimise the impact from unforeseen events.
So what kinds of tools can help companies better manage treasury risk? Derivatives have been pilloried recently given their role in the current 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, if the market is price-sensitive and competitors have adopted a different strategy enabling them to take advantage of favourable market movements and potentially set 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 benefitting from a favourable 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 around using such instruments are fully understood.
Clearly, technology has been a great enabler when it comes to getting a handle on managing treasury risk. The right technology can bring together all the information a treasurer needs, keep it updated, consolidated and centralised. Giving treasurers visibility of treasury processes and risk management means that they can 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.
For example, Coloplast, a Danish medical device manufacturer, recently implemented a new treasury system (SunGard’s AvantGard) to support its treasury, risk and cash management activities. The system provides the company with a single, centralised treasury database, helping the company improve control and visibility of its cash and risk positions. Coloplast had plans for global expansion, and this, coupled with the increased requirements for controls and compliance, meant it needed a treasury management system that could cover all areas within of the treasury function, manage risks and support straight-through processing (STP).
Ultimately, a robust, scalable, dynamic treasury system reduces the risk of disparate money sitting in different parts of the business and affecting the bottom line. In addition, application service provider (ASP) solutions now mean that treasurers don’t need to install large pieces of hardware to manage processes across the treasury. Instead a web application allows them to access all the information they need, with the hardware hosted elsewhere.
Clearly, no corporate treasurer can avoid risk in the business – risk is naturally present in any business. But a good treasurer, equipped with the knowledge of how risk can be measured and managed and the right technology to assist with this, will be able to manage risks to the business effectively.
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