History Repeating: Treasury Best Practice Lessons Learned from 2008
As 2012 begins, critical threats loom for the global economy, e.g. the creaking eurozone, high debt level in the US and early signs of China’s deflating housing bubble. It is possible that we could return to the extreme financial conditions sparked by the 2008 crisis this year. Should this happen, what lessons can treasurers learn from the banking crisis of 2008 to chart a successful course for their organisations through troubled waters in 2012?
There are two types of lessons that treasurers can take from the 2008 crisis and apply to the situation in 2012. First, there are obvious lessons around risk management and access to liquidity. Second, but no less critical, is the need for a greater level of rigor and a stronger data, analytical and communication infrastructure, accompanied by a new appreciation for – and recognition of – the critical role of treasury within the organisation. Key is to ensure adequate access to liquidity – the lifeblood of any organisation.
Liquidity can be accessed from external and internal sources. The main external source is bank credit. When the 2008 crisis hit, many corporates found that they were unable to renew their existing credit lines, or could only do so at the cost of very prohibitive additional charges. Following a scramble for credit, the lesson that many corporates learned was the need to diversify accesses to credit, both by seeking alternative sources as well as by distributing bank business among a number of institutions.
Corporates want to deploy an integrated banking network, while maximising access to credit. While the immediate trend for corporates was to rapidly increase, rather than consolidate, their banking group (or hold steady if already well banked), this did not take long to change, particularly for larger corporates. For example, the group treasurer of a large German multinational corporate (MNC) we recently spoke with said that their company has already reduced the banks that they deal with. On top of specific banks in their domestic markets, they are focused on working with a few banks globally that have trans-regional capabilities. Other MNC clients have chosen to select a single primary bank for each region, or, as a recent client has done, select a bank globally for each key currency (e.g. pound, euro, US dollar, yen, etc).
Another source of external liquidity that has grown rapidly in popularity as a result of the 2008 crisis is supply chain financing (SCF). Before 2008, the perception was that SCF was primarily a source of financing for smaller corporates; however, the crisis prompted many larger corporates to explore the benefits of unlocking liquidity that SCF offers. SCF is also being deployed to help critical suppliers ensure access liquidity – thus not just ensuring the liquidity of the firm, but importantly its end-to-end supply chain. With these benefits, SCF will likely remain attractive to corporates of all sizes in 2012.
Of course, corporates can also access liquidity from internal sources. Following the 2008 crisis, companies renewed with a vengeance their focus on optimising working capital and maximising access to internal liquidity. There are two main ways that corporates can go about achieving this. The first way is to centralise payments within the organisation, usually by setting up payments factories. The migration of manual and paper-based activities to automated and electronic media often accompany this.
A payment factory is a single platform that runs a corporate’s many payments structures around the world. By replacing the previous non-streamlined payments infrastructure with a payments factory, corporate treasurers can gain real-time visibility over the organisation’s entire payment transactions, which boosts their ability to manage and access liquidity, as well as providing a clearer view over the company’s cash position and exposures. This visibility will be critical in 2012, and we expect to see more corporates setting up payments factories this year.
Another way to exploit internal liquidity is to establish cross-departmental working capital groups within the organisation and conducting an end-to-end working capital optimisation initiative. By bringing other business partners within the organisation, such as from sales and/or procurement, corporate treasurers can drive the best practice working capital message across the organisation and identify trapped cash – which often resides within handoffs or lack of co-ordination across departments. The financial crisis of 2008 had the effect of elevating the role of the treasurer within the organisation, and treasurers now have the mandate to lead the quest for working capital efficiency. By demonstrating the benefits of working capital visibility, for example of timely and accurate data reporting, to the other business units, treasury can gain a clearer view of their cash position. In turn, getting closer to the business can provide the treasurer with an insight into the challenges and sometimes conflicting pressures that exist in different areas of the company.
Companies have clearly acted on liquidity lessons learned from the 2008 crisis as evidenced by recent Treasury Strategies’ Quarterly Cash Surveys. Drawing from surveys of corporate treasurers globally, as well as corporate cash levels reported quarterly by the Office of National Statistics (UK), the European Central Bank (ECB) and the Federal Reserve, the following two charts demonstrate dramatic increases in corporate cash levels as well as the key sources of that cash. Figure 1 shows indexed growth rates of cash with the UK exhibiting the fastest growth. Figure 2 shows that the focus on working capital is beginning to run its course (how much lower can inventories go?) and companies are looking to core cash flow and credit sources.
The need for diligent risk management was the second key lesson learned in the 2008 financial crisis, and the need for that diligence is just as relevant to corporates in the current environment. When the 2008 crisis hit, some corporates found to their financial loss that the risk management strategies they had in place were not sufficient to cope with the sudden liquidity freeze and heightened exposures to counterparties. Board members became interested in knowing the specific funds or institutions to which their company was exposed, and for many treasurers at the time this information could be difficult to uncover at such short notice.
Counterparty risk became a major issue. Large corporates needed to carry out extensive counterparty risk analysis on the suppliers in their supply chain, and many found that to maintain the chain they had to step in and play the role of a bank in order to prevent their small – but essential – suppliers from collapsing. In some cases, well-rated large corporates used their rating to access credit for their suppliers that would otherwise have been prohibitively expensive to them. While this supply chain support was an additional risk for the larger corporate, for many it proved far more palatable than any potential break in the supply chain. In the current environment, many corporates are again looking to stay close to their supply chain partners.
Another area of counterparty risk came to light as a result of the 2008 crisis. Following the collapse of a number of financial institutions, with Lehman Brothers being the most high profile, corporates found that counterparty analysis had to be conducted with greater risk due to embedded exposures, settlement risk, etc, not to mention that financial firms can have material changes in financial health very quickly, necessitating more dynamic monitoring. Those that relied solely on the credit ratings agencies for their banking counterparty analysis learned an expensive lesson that they could be unreliable at times. Other sources of information were sought, and one of the most popular was to analyse the credit default swap (CDS) spreads as a more dynamic means of determining the credit quality of an institution.
In response to the heightened risk, corporates also began to monitor their risk exposures more frequently. This is still the case today, and with more regular monitoring providing greater visibility across the threats that exist, corporate treasurers are well placed to manage and mitigate rising risk when it appears. For example, looking at bank counterparty risk, a 2011 gtnews Treasury Risk Management Survey found that almost 60% of corporate respondents review their banking partners’ credit standing at least every six months, while 22% review it quarterly and 27% review it even more regularly. This regular analysis will continue to be a trend through 2012.
Now, more companies are exchanging collateral to mitigate the counterparty risk they encounter in their derivatives portfolio. Recent International Swap Dealers Association (ISDA) agreements mandate exchange of collateral based on mark-to-market valuations of derivatives covered by the ISDA. This is typically a very manual effort, but one that is critical for managing counterparty risk.
Adequate access to liquidity and more meaningful risk management were the immediate key takeaways from the 2008 crisis, and remain ever more relevant in today’s uncertain and volatile environment. But beyond these there are other, equally critical lessons that have come to light. Two of the most important of these are:
Pre-crisis, corporates had a number of imbedded assumptions about liquidity and risk they were not critically thinking about. One example of this is the underlying clearing of instruments. In 2008, many corporates were not actively thinking about what had to hold true for liquidity to be available to them. Even pre-September 2008, many companies in the US were caught holding auction rate securities which they had classified on their balance sheets as cash equivalents, but which quickly became long-term assets.
Another example is the blind faith in and singular dependence on the accuracy of the ratings agencies – how many corporates in the pre-2008 environment were comparing the analysis of the ratings agencies with other credit indicators? A final example of the assumptions that failed some corporates is found when looking at true counterparty exposures – how many treasurers told their executive management they had no exposure to Lehman’s, only to discover that in fact they did?
The 2008 crisis rocked many assumptions such as those just mentioned and exposed the weaknesses in the processes and analytics around liquidity and risk. It is vital that treasurers continue to think critically across all of their liquidity and risk assumptions and employ rigor in their processes and analytics. Treasurers are now looking at the end-to-end liquidity of every pound/euro/US dollar – assessing credit and liquidity risk across each stage of settlement and clearing, as well as any direct or indirect changes that could affect price levels
Perhaps the most important overarching and transforming lesson of 2008 is the clear recognition of treasury’s role as the financial nerve centre of the firm; its importance in assessing and ensuring the financial viability of the firm. Whereas executive management may not previously have prioritised treasury initiatives, the crisis moved the goalposts and suddenly executive management and the board were turning to treasury (on a daily basis), demanding to know the financial exposures that the organisation faced. Given the more complex, dynamic world with more complex risks and a need to ensure liquidity across the entire supply chain, corporations are enabling their financial nerve centre with technology, data architecture, tools, people, and other initiatives to support the successful execution of treasury’s role.
Treasury can no longer afford to play its former, largely operational role. It must be able to immediately respond to crises – to access accurate and timely information, conduct analyses, quickly assess the impact of internal and external events and provide reports and recommendations to executive management and the board.
Treasury Strategies believes the treasury of the future will be an analytic and technology hub that provides end-to-end business intelligence and strategic advice to the company’s board, business units, creditors, customers, suppliers, shareholders, rating agencies and regulators. It will become increasingly critical for corporate treasuries ??(along with their providers) to adopt the approach and tools required to fully and successfully execute the role of the financial nerve centre.
It is important not to waste a good crisis and, coming out of 2008, corporate treasurers today are in a stronger position to lead their organisations through the turbulent times ahead.