Today’s Risk Management Challenges for Corporate Treasury

What comprises best practice risk management in today’s corporate treasury? And how are the industry and its suppliers rising to new challenges for policy, process and technology?
This article analyses a range of risk classes that are generally managed in today’s corporate treasury operations, and examines how a demanding set of evolving challenges is being met in practice.
There are two essential requirements for effective treasury risk management: having a documented treasury policy that clearly defines which risks are to be managed, and how they are to be managed; and having access to technology of sufficient power and flexibility to apply and monitor the policy in daily operations.
RiskMarket risk
The management of different kinds of market risk has been the primary concern for corporate treasuries ever since treasury departments were first organised as a distinct section of the finance operation of the largest multinational corporations. And since the financial crisis first struck in 2008, more and more companies have determined that a necessary part of protecting working capital, profits, earnings and financial asset values involves investing in deeper and more powerful resources to manage the market risks relating to liquidity, foreign exchange and interest rate risk exposures.
Technology is central to market risk management, supporting the databases, information imports, calculations and reporting that are needed for effective market risk management. Treasuries today are seeking flexible solutions that address risks according to policy requirements, company structure and specific business patterns.
•Liquidity risk is based upon achieving complete and accurate cash visibility, which depends on utilising effective and timely bank communications to obtain current balance and transaction statements from domestic and international cash management banks, including intra-day updates. Modern treasury technology combines the bank positions with the future committed cash flows of open treasury FX and interest rate deals, and with payable and receivable flows that can be extracted from ERP and accounting systems to provide an accurate projection of multi-currency cash positions out to several weeks or even months. Such reporting means that treasury is no longer flying blind with respect to future liquidity needs, and is therefore much better placed to anticipate and manage future funding requirements. The most sophisticated treasuries look further ahead, by importing operating subsidiaries current forecasts of future income and expenditure, to build a more precise view of future liquidity. Treasuries that effectively manage liquidity risk are better placed to minimise external borrowings by funding shortfalls in one place with any available surpluses in others, through inter-company lending operations. They improve the organisation’s performance through efficient funding, and can minimise the expense of external funding. Effective liquidity risk management helps to protects companies’ abilities to maintain the required level of commercial activity when credit and profitability are squeezed.
•FX risk management is a familiar activity for all South African companies with significant overseas exposures, and especially for those dependent on the profitability of export operations. The volatility of the FX market seems to be a standard fact of life, and treasurers and finance departments continue to invest in technology to support FX exposure capture and analysis, and the related hedging operations. More and more companies are looking to support their core business expertise by seeking expert outsourcing services for FX risk analysis, hedging strategy design, and for optimal market execution.
•Interest rate risk management is important for leveraged companies, and for cash rich organisations looking to maximise interest income from financial investments. Forthcoming risk exposures, and maturities of existing borrowings and investments, are areas of interest rate risk that need effective technology to generate the necessary reporting, and for the execution and administration of the resultant market operations.
FX and interest rate risk management share common ground through periodic mark-to-market revaluations, where applicable. Best practice now requires the use of independent market rates, often automatically sourced from specialist suppliers to ensure objectivity. Risk management and accounting effectively converge with the calculation and posting of unrealised FX gains and losses.
Additionally, IFRS 13 compliance now requires the application of CVA (‘credit valuation adjustment’) in the calculation of derivative valuations. Effectively, this means that derivatives must be priced taking into account the counterparty’s probability of default – which links naturally into discussion of counterparty risk management which follows.
Counterparty risk
The risk of a counterparty defaulting has been explicitly managed by financial institutions for many years, and is now becoming more and more common in treasury and finance operations, as they seek to understand and navigate market turbulence. Those few corporate treasuries which had market-sensitive counterparty risk management facilities in place in 2008 enjoyed advance warning of the evolving problems at Lehman brothers, and were therefore able to adjust their counterparty exposures before the bank collapsed.
The standard corporate approach today is to set and apply counterparty limits, dealing limits to cap the size of deposits and FX and other hedges that can be placed with a given bank. Corporate treasurers may not feel qualified to define realistic dealing limits, and this is an area where the help of relationship banks or of consultants may be usefully sought. The supporting technology enables treasury dealers to check limit headroom in advance of dealing, and it will notify nominated managers in the event of actual limit violations. A complete counterparty risk exposure analysis should extend beyond FX hedges and time deposits to include bank account balances, derivative positions and bond and equity investments.
It is primarily the risk of different bank counterparties that are measured and managed in treasury, but treasuries should also monitor the creditworthiness of the organisation’s commercial counterparties – both suppliers and customers. Such risk management proactivity can give early warning of emerging problems, providing the opportunity to initiate discussions, and to take remedial action if necessary.
Modern treasury technology enables treasurers to monitor changes in the market’s perception of each counterparty’s creditworthiness, by tracking and alerting changes in an organisation’s credit agency rating, CDS (credit default swap) spread, bond, equity or other related market-sensitive indicator. CDS spreads are required inputs for CVA calculation, which is outlined above.
South Africa’s recent sovereign grade downgrade has had a knock-on effect on the local banks’ credit status. The impact of this on the cost of corporate debt will become apparent over time – but arguably the most important risk management function in this area at present is to monitor counterparties to try to gain advance warning of any further downgrade – which would surely have a dramatic negative effect on the cost and availability of bank and capital markets borrowing, and on the value of the rand.
Corporations and companies should also track their own creditworthiness as a prospective counterparty for future borrowing operations, such as loan syndications and capital markets issuances. The results are likely to help treasurers and finance directors with the planning of refinancings and new debt raising operations. The application of this kind of treasury risk management analysis can make a critical contribution to securing a sufficient degree of corporate liquidity in turbulent times, to assure the continuity of commercial operations.
Operational risk
Treasury departments today are more and more frequently explicitly mandated by policy to manage a broad spectrum of the organisation’s financial risks, essentially protecting asset values, profits and earnings through prudent hedging operations, and effective counterparty exposure management.
As a front-line financial function, treasury should be supported by suitably powerful and robust systems and processes, reflecting an investment proportionate with the level of financial risk being carried. The cost of securing treasury operations against errors and failures needs to be evaluated against the costs of a catastrophic processing and reporting failure. The risk management features include disaster management facilities, planning and documentation, so that treasury operations can be effectively and accurately restored and resumed at another site should that be necessary. It is necessary to test contingency plans, to verify that they work as intended, and therefore give real protection against extreme operational risk.
Robust and transparent treasury technology is critical to operational risk protection. Treasury management systems (TMSs) are purpose-built to support treasury in a controlled and effective way which cannot be approximated by spreadsheet solutions – which almost always lack validation through rigorous testing, documentation and release control.
Modern treasury technology provides a controlled environment for securing treasury operations, according to the specifics of client treasury policy. The use of access control, workflow lock-down, segregation of duties and data encryption are all TMS features that combine to minimise operational risk.
Security risk
Effective security risk management is an additional benefit of using a modern TMS, which follows naturally from robust operational risk management. Customised workflows, including automated data validation and import scheduling, and effective exception reporting, maximise error detection rates, and help to reduce the frequency of errors, and the scale of their impacts. Broader TMS security around system access and data integrity restrict system access rights to properly authorised individuals; and these controls are combined with automated processes to detect illegal system access attempts, and alerting of nominated individuals who can take prompt remedial action. Investment in strong TMS functionality provides treasurers with the means to put in place effective protection against errors, fraud and crime.
Today, security risk management extends to the emerging disciplines of KYC (know your customer) and AML (anti money laundering) regulation. Effective KYC and AML solutions are technology based, using automated workflows to perform the necessary checking and validation, and to report on all situations that lie outside the KYC and AML framework defined in treasury policy.
Advanced financial risk
The largest multinational corporations – and those exposed to the highest levels of financial risk – will typically deploy additional (and, accordingly, more expensive) technology to provide more advanced levels of financial risk management. The risk tools deployed include scenario analysis, in which users can model the impact of a possible future FX and/or interest rate scenario on the value of their positions and exposures; Monte Carlo simulation, to evaluate the potential outcomes of a range of different market situations; VaR (Value at Risk)derivation, which calculates the maximum loss for a given event probability and time horizon; and CFaR (Cash Flow at Risk) derivation, which models variable interest rate exposure over a future time frame. Considered advanced today, it is likely that at least some of these techniques will be accepted as standard treasury best practice as the supporting technology becomes affordable to larger numbers of corporates.
The application of technology in treasury risk management
We have seen how the use of a contemporary treasury management system is essential for the effective management of all kinds of treasury risk. Treasurers will naturally need to perform a rigorous cost benefit analysis to determine a realistic technology investment level for their organisation. Some treasury technology projects justify themselves on the basis of tangible costs savings, such as optimising interest income/expense and optimising bank communications. Others are simply evaluated on the basis of objectively enhanced treasury risk management: if treasury is managing significant levels of liquidity, cash and interest rate risk – or some combination of these – the cost of deploying robust technology may be justified as, effectively, an insurance premium that buys protection against catastrophic treasury operations failure.
Today’s treasurers enjoy a range of technology solution choice, so that the investment decision can be based on the relative level of risk being carried versus budgetary constraints.
Some companies will opt for outsourced solutions, in which the risk management expertise of the outsourcing partner is supported by a robust TMS.
In-house treasuries in smaller organisations may opt for solutions in which the technology is hosted and managed by an expert third party; this includes SaaS (‘software as a service’) offerings in which functionality and services are scaled to specific client requirements. The act of outsourcing to an expert partner may be seen itself as a form of risk management, potentially covering multiple forms of risk in setting up and operating systems.
The largest corporations’ IT policy often requires that systems should be installed and managed in-house, and the higher end TMS systems accommodate this preference, in which the corporation itself directly assumes all aspects of treasury risk management.
The current marketplace therefore presents a full range of offerings for prospective buyers, and so offers effective solutions for meeting the demands of risk management imposed on today’s corporate treasuries.
The norms of treasury risk management are becoming more complex and demanding – and the industry, combined with its supporting technology and service providers is rising to this significant challenge.
Source: Treasury-management.com

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