Why Transparency is Crucial to Managing Global Treasury Operations

Recent volatile times have highlighted the need for
comprehensive and forward-looking measures of risk that allow a business to
avoid and, if need be, respond to any aberrations in a timely and effective
manner. This has placed additional demands on the treasurer to ensure that
policies and procedures are optimised and that all enterprise-related risks are
well-managed.

If the past few years have taught us anything, it’s that by
optimising processes and taking a best practice approach to risk management
while focusing on technology to increase data accuracy and the speed of
information, the treasurer can ensure that the institution has a transparent
view of risk and an appropriate policy for managing that risk.

A treasury’s
core responsibility is one of stewardship: to safeguard the assets of a company
and manage liquidity to support the operations of the company’s principal
business.

This is why market turmoil influences minute-to-minute decisions
and why it is among the most critical and challenging roles in an organisation
today.

Furthermore, the treasurer is often one of the few individuals in an
organisation who has a thorough understanding of enterprise risk, and how the
individual risk components – be they movements in foreign exchange (FX) rates or
corporate credit ratings – affect the risk profile, liquidity, and ultimately
the value of the institution. There are numerous unforeseen risks that must be
managed. On top of that, the larger the organisation, the greater the challenge
for the treasurer on a daily basis. The financial crisis, as well as the rapid
pace at which global market conditions continue to change, means that many of
these challenges have the potential to significantly impact on a corporation.

Data Accuracy and Transparency

Reliable financial data that is
accurate, consistent and accessible should be the bedrock of day-to-day treasury
operations. When data is inadequate or incorrect, the consequences can be felt
throughout the organisation.

In an increasingly competitive global
marketplace, institutions need dependable data to help improve productivity,
reduce risk and exposure, and ease the compliance burden.

These
institutions are often challenged by inadequate information, making it difficult
to capture the data needed to make sound business decisions. For instance, it is
not unusual for a number of days to pass after period close before all foreign
exchange (FX) exposures are quantified. It can often take time to consolidate
and drill down into the data, especially when it is held in disparate systems
across a global company.

In 2009 the business press reported that Google had announced a US$300m hit to revenues in its third quarter accounts
as a result of currency fluctuations. Having
embarked on an ‘intense currency hedging programme’ backed up by the
implementation of FX currency management software, Google’s treasurer, Brent
Callinicos, said that “the difference between having the system and not having
it is material.”

According to the source, in 2009 Google “recognised
US$316.6m in hedging gains to revenue in the first nine months of the year.”
More complete and timely information can help give companies like Google the
confidence to do more hedging to reduce risk.

Speed is also vital,
especially when one considers one-week versus one-day volatilities, and a firm
can further reduce its exposure to risk with fast hedging decisions. This is
impossible without an efficient method of consolidating and reporting
exposures.

The key to making the correct hedging decisions is transparency
to the underlying risk data – and exposures can often seem hidden. Operating in
a global economy makes FX exposure unavoidable. Exposures in overseas
investments can often be rolled up and reported in the balance sheet of a
foreign branch. Attaining complete data and making timely decisions depends upon
a company’s ability to achieve greater visibility to the exposure data within
their business systems.

Effective use of technology is the only way a
treasurer who manages global exposures can consolidate and analyse information
quickly and accurately. Automating the exposure management process eliminates
errors, creating opportunities for optimal cost savings and risk reduction. By
interacting with enterprise resource planning (ERP) and accounting systems and
other exposure data sources, treasurers and risk managers are able to accurately
identify, quantify and manage exposures based on complete data, with minimal
dependence on IT or finance.

Counterparty Risk

Transparency of
data is required to understand risk exposure. For example, in order to
understand concentration risk in the portfolio, one needs to be able to avoid
over-exposure to a particular industry or geography. Limits can be adjusted, or
investments taken off quickly, if the exposure is transparent.

Faulty data
can result in breaches of limits, while out-of-date prices can lead to incorrect
revaluation of portfolios and poor decision-making.

Treasurers have often
set counterparty limits according to credit ratings. While this is a valid
criterion, recent events have shown that institutions with good ratings can very
quickly develop issues with liquidity and have problems in repaying debt. The
events of late 2008 led to previously well-rated Icelandic banks freezing the
assets of overseas depositors in the wake of the country’s economic woes. It was
quickly revealed that UK local authorities had invested almost £1bn in
short-term deposits with Icelandic banks in order to take advantage of
attractive interest rates.

In addition to credit ratings, limit management
should at a minimum take into account country and industry risk, as well as
understanding the group structure and ownership of counterparties, to avoid
doubling up on exposure.

When reporting risk, one should aim for the
ability to review information in different ways and in real-time. Using
derivatives to manage risk will introduce more complexity when it comes to
measuring the exposure to those counterparties. While using a simple percentage
of the nominal amount is valid as long as the limit is set appropriately and
reviewed regularly, the ability to measure the market value of derivatives is
vital. This requires the availability of up-to-date market data and appropriate
systems that can value positions.

Also important is the ability to apply
different limits to exposures depending on time to maturity, and to
automatically adjust these limits as the maturity date approaches and the level
of risk changes. Up-to-date market information enables accurate pre-trade limit
checking and alerts of potential limit breaches prior to trade.

Risk
Management: A Holistic Approach

Recent turbulent market conditions
have revealed the limitation of opaque risk models that rely heavily on one
measure without properly stress-testing the results. Treasurers are increasingly
employing a ‘back-to-basics’ approach in setting risk management policy that
provides a holistic view. Treasurers also need to react quickly to changes in
market conditions and adjust policy if the approach becomes ineffective.

Enterprise risk management and a holistic view over asset classes (credit,
interest rate, FX, commodity and equity) as well as across different types of
risk (market, credit, operational and liquidity) needs to become an accepted
best practice.

Let us now consider the best practices elements of this
holistic approach:

• Consolidate risk positions: The first stage of
  understanding risk is to ensure that all positions are consolidated and reported
  in one instance. Any data that is maintained separately and not included in
  analysis may cause incorrect decisions to be made, and can lead to unnecessary
  cost and risk.
• Mark-to-market the portfolio: Once the risk is
  quantified, the treasurer needs to be able to value and mark the exposure to
  market. When considering counterparty risk, this means adopting systems that can
  value the underlying risk as well as the instruments used to hedge these
  exposures.
• Understand profit and loss: If a treasurer can explain his
  profit and loss (P&L), he/she can take measures to ensure that the firm has
  formulated the optimal hedging strategy. The ability to ‘slice and dice’ data in
  real time gives a deeper understanding of how the exposure is made up.
• Scenarios: Up-to-date market values are crucial, but to fully understand how
  risk and the exposure are affected by market movements, a forward-looking
  approach is required. This means running various ‘what if’ scenarios that shift
  or tweak market rates and report how this affects the value of any open position
  and the P&L. For those using derivatives it is important to understand the
  convexity risk of options and how this is affected by movements in both spot
  exchange rates and volatilities.
• Value-at-Risk: To date,
  value-at-risk (VaR) methodologies have played a large role in producing risk
  numbers and were the main measure that many institutions used to calculate their
  liquidity buffer requirement. However, VaR models, whether using Monte Carlo or
  historical simulation, are not always useful at predicting catastrophes. VaR
  tends to provide metrics on ‘business as usual’ and is perhaps not the best
  measure to show the magnitude of potential downturn. Nonetheless, VaR is
  probably the best single measure of risk in that it is enterprise-wide and
  covers all asset classes, and it remains a vital component of risk management
  reporting as part of a holistic approach. These limitations do not imply that
  risk models are completely inadequate in identifying risks. Treasurers need to
  be aware that there were certain risks that these models did not identify, and
  as a result should therefore employ additional tests accordingly.
• Stress
  testing: The VaR approach that identifies the 1% worst case scenario to a
  firm’s risk does not account for events when historical correlation patterns
  break down. The only way to address such issues is to conduct stress tests.
  First, shift forward curves arbitrarily and see the resulting change in the net
  asset value (NAV). Second, simulate price movements to mimic a historical event
  such as a hurricane or a stock market crash. Conducting stress tests identifies
  the potential impact of a catastrophic event to the portfolio. This should be
  done with a view to identify a company’s liquidity needs in such a scenario.
  These scenarios should not be limited to what are considered ‘normal’ events.
• Formulate policy – benchmark and review: Policies need to be
  reviewed and updated constantly in response to events. Performance benchmarking
  against a ‘do-nothing’ or budget rate benchmark allows the treasurer to
  effectively manage risk and monitor the performance of the company’s hedging
  policy.

The need for effective technology in treasury management is
evident, especially in light of the increasingly strategic remit of the
treasurer in recent years. Recent events triggering volatility have exacerbated
this and the spotlight has focused on treasurers, even though markets have
generally been more settled today than at the height of the crisis.