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Risk management: Leading practices part 7

This is the seventh topic and eighth article in a series on leading practices in corporate treasury.

Risk management is at the heart of treasury management, and identifying, assessing, managing, mitigating and monitoring expected and unexpected risks is a crucial responsibility of the corporate treasurer.

Today’s treasurer is expected to have a thorough understanding of a variety of risks – currency, interest rate, liquidity, credit, enterprise, counterparty, country/political, commodity or markets – and how these individual risk components can affect the organization’s strategy, cash flow, reputation, branding, growth and value.

New risks and demands have also come to the fore, including the COVID-19 pandemic, the Russia-Ukraine war, the global supply chain snarls, cyberattacks on supplier networks, environmental, social and governance (ESG) pressures, and the growing threat of a global food crisis.

Treasury will have to raise its game to overcome the risk management challenges they are facing right now and will face in the future. There is work to be done to fulfil their companies’ strategic objectives amid ongoing volatility and uncertainty.

Here are our recommendations on how to apply leading practices for prudent risk management. We are aware that these may vary or differ depending upon the location, size and complexity of a business’s operations. Nonetheless, there are some themes that stand out: know your risk capacity; differentiate between risk appetite and risk tolerance; risk perceptions are different; risk management and hedging are purpose-driven; and interconnectedness of corporations, suppliers, competitors, customers and risks.

Know your risk capacity:

Successful corporations were built by taking on risk in one form or another. The key to creating a sustainable and successful corporate treasury is to fully understand and analyse the set of risks and different risk scenarios to which the business is exposed and to decide what the maximum level of risk is that the business is able to accept, withstand or support (risk capacity) in the context of its financial position and without endangering its future.

“The risk capacity of a company is basically how much risk it can endure in pursuit of its strategic objectives and before a potential financial crisis such as going bankrupt (a liquidity or credit capacity constraint), tripping debt covenants, or violating potential regulatory capital levels or cash flow volatility restrictions,” said Craig Jeffery, managing partner at Strategic Treasurer, a leading treasury consulting firm.*

It is vital for corporate treasurers to define and quantify their risk capacity. This considers the cash flow and liquidity position (buffer sizes), the maximum level of loss, excessive volatility, production decline and reduced earnings that can be absorbed without compromising key business objectives. Quantifying the risk capacity sets the upper bound for losses that cannot be breached under any circumstances. Risk capacity should also take into consideration the performance track record in managing risks.

Depending upon the nature of the business and its strategic objectives, risk capacity may vary. The commonality in calculating risk capacity is that it represents the absolute maximum loss a corporation is able (not willing) to take on. If we were to compare two companies with similar capital levels and risk profiles, the organization with superior risk management would invariably have higher risk capacity.

Differentiate between risk appetite and risk tolerance:

To determine how best to deal with the risk an organization faces, the treasurer needs to understand the risk appetite, which is how much risk the organization or its stakeholders (investors, creditors, the board and employees) are willing to accept in the pursuit of their strategic objectives or business returns. Should the risk appetite limit be breached, immediate corrective action must be taken to decrease the quantum of risk within the appetite.

One of the most important aspects of prudent risk management is to ensure that a company not only does well during normal market conditions, but also achieves its strategic objectives during adverse periods. It is recommended that risk appetite and limits should be tested under stress scenarios (stress testing).

A useful technique is to perform reverse stress testing. This will provide useful information about the vulnerabilities in an organization’s business model and strategy, and insights into what events could sink the corporation or make it unviable.

A robust risk appetite framework should be developed and supported by independent oversight and good governance. It is also advocated that a regular review of the risk appetite framework is undertaken to ensure that new risks are identified, including those that might be difficult to quantify. Treasury can then move down to the policy document and write down the specifics.

Often used as a synonym for risk appetite, risk tolerance in practice is different and does not always match. Risk tolerance is considered a lower level of risk than risk appetite and is defined as the aggregate levels of risk or levels of loss or volatility that treasurers will accept with some degree of comfort. Alternatively stated, it is the point at which treasurers can get uncomfortable even though risk levels haven’t reached their stated risk appetite.

Whereas risk appetite is a strategic determination based on long-term objectives, risk tolerance can be seen as a tactical readiness to bear a specific or individual risk within a company, business unit or function in order to achieve its risk appetite.

=It is critical to establish quantified risk tolerance thresholds at which hedge levels may be set and/or other action steps taken. These thresholds, individually and on aggregate, provide the basis for the firm’s critical risk management objectives, and can be defined by earnings, cash flow, or other financial measures. In addition, statistical analysis and model-driven assessment (economic capital, scenario analysis and stress testing) are useful approaches to establishment of risk tolerance levels.

Risk perceptions are different:

Know that not everyone looks at risk the same way. Also, every risk or exposure is not the same. A US$100 million exposure to the largest bank is not proportionally the same as a $100 million exposure to a regional bank.

“Risk is in the eye of the beholder. It is a relative, rather than an absolute, term. One treasurer’s acceptance of an exposure to a particular level of volatility and impact is likely different than another’s. The commodity hedge fund, for example, has a much different view of risk than does the retirement portfolio manager,” observed Jeffery.

Usually, the perception of risks varies. The upper echelons in the finance and treasury leadership chain tend to focus on longer-term strategic risks, while those in the lower to mid-levels focus on more tactical and operational risks. Similarly, individuals in different functional areas will frequently view risks and risk levels differently. This does not mean that one is right and the other wrong. Rather, it highlights the necessity and usefulness of considering multiple factors in identifying and mitigating significant risks.

It is imperative to remember that risk management is not a time-defined event that is over or finished and then forgotten about, but a dynamic process that is constantly changing and volatile.

A dynamic risk management process identifies, analyses, measures, evaluates, mitigates and monitors risk in real-time. Formalizing the risk management process assists the organization in becoming more resilient and adaptable in the face of change, helps them include contingencies they didn’t consider, reduces business liability, manages risks better and ensures more informed decisioning based on a complete picture of the company’s operating environment.

Risk management and hedging are purpose-driven:

Treasurers must be cognizant of the purpose of risk management and hedging.

The purpose of risk management is bringing or reconciling a company’s risk exposures in line with its risk appetite – that is, decreasing exposures into the realm of what the company is capable of accepting as a loss.

Similarly, the purpose of hedging is the mitigation of risk by bringing it within an organization’s risk tolerance, not necessarily eliminating the risk completely. This process of mitigating the risk is done by offsetting losses (by taking equal but opposite positions in the cash and futures market). In doing so, treasurers prevent losses from exceeding a certain level in response to variance, volatility or downward price movement.

When adeptly executed and purpose-driven, the financial, strategic and operational benefits of hedging can go beyond merely avoiding financial distress to preserve and create shareholder value and to help improve consistency and the perception of stability. To do this, the treasurer must develop a thorough understanding of the organization’s risk appetite, its strategic and business objectives, and three interacting parts – economics, controls and accounting.

“The economics of hedging defines the value in risk management. Controls ensure that the objectives of risk management are being met, and accounting can aid in making an educated decision during the time when it is a choice of accounting risk (the risk of earnings volatility due to lack of favourable hedge accounting treatment) versus economic risk (the volatility of cash flow or market value due to an unhedged exposure),” explained Jeffery.

Next, it is recommended that treasurers “Don’t cheer for their hedges.” In Chapter 10 of his book The Strategic Treasurer: A Partnership for Corporate Growth, Jeffery mentioned, “Clear objectives from the outset and effective communications are the Treasurer’s best allies. As a Strategic Treasurer, you are just doing your job; no cheers from the executive grandstands coming your way.”

Jeffery discusses this further in an episode of the Treasury Update Podcast: “You would prefer your underlying exposure does better and that your hedge would lose money. You don’t want your hedge to make money by itself because your underlying exposure would lose more money. So if you want to do some cheering, it should be for your underlying exposure, but you shouldn’t be doing any cheering because the reason you have your hedge is because you’re trying to bring your exposure in line with your risk appetite, and you’re perfectly fine if it’s accomplishing that objective.”

Remember, as a treasurer, you have to ask yourself, “What puts your corporation in a better position?” If you protect the risk and exposures from greater volatility, it will help with the company’s underlying assets, cash flow, income and more. It’s primarily about bringing your exposures in line with your risk appetite.

“It is the volatility you are trying to protect against; that is your hedge objective, not necessarily trying to buy or sell at the best price,” affirmed Jeffery.

Interconnectedness of corporations, suppliers, competitors, customers and risks:

Corporations, customers, counterparties and suppliers are increasingly interdependent and interconnected along the entire value chain, and so are their risks and vulnerabilities (different types and categories of risks are not independent of each other). That means that a local risk can turn into a global one, and a disruption in one location or region can spread out quickly to many more regions, as we have witnessed during the pandemic and the Russian invasion of Ukraine.

The treasurer’s concern is not just with his or her own corporation’s risks or a credit rating change, but also the impact of these interlinked risks on competitors, customers, counterparties (affecting their ability to pay) and even suppliers (impacting their ability to perform or deliver).

As corporations expand globally, value chains have grown in length and complexity. Companies have successfully implemented a lean, global model of manufacturing achieved through improvements in inventory levels, on-time-in-full deliveries and shorter lead times. However, these operating model choices sometimes led to unintended consequences, unintentionally creating more problems than they solved, because they were not calibrated to risk exposure. Intricate production and supplier networks were designed for efficiency, cost and proximity to markets, but not necessarily for resilience or transparency. Now they are operating in a world where disruptions and uncertainties are regular occurrences.

Treasurers should be aware of the potential for unintended consequences and prevent or redress problems as far as possible. For instance, if a company is well placed to help a supplier reduce its price risks, it can demand some concessions in return. Alternatively, it can change its pattern of demand by consolidating its purchase orders, decreasing purchase volumes from a powerful supplier by switching to a substitute, or creating a new supplier.

Furthermore, treasurers must comprehend the dynamics of the industry and also develop a complete understanding of the underlying vulnerabilities the corporation is exposed to, including the value chain as a whole. It is equally important to focus on risks that can have a major impact on the company (disruptive risks) and its value chain.

To excel in managing disruptive risks, corporations have to be flexible, agile and responsive, develop good and trustworthy relationships with their suppliers (treat them like business partners) and customers. They must improve information flow metrics, empower their employees and facilitate open communications, internally and externally. This will serve the company well when a disaster hits and will make it more resilient to disruptive and non-disruptive risks.

Risk management efforts should also be understood in light of what your competitors are doing. That translates into having a clearer perception of risk than your competitors have, managing risks better than competition and believing the notion that risk management can spawn competitive advantage.

To do so, it is judicious to gather risk intelligence and use game theory to analyse the competitive landscape, gain market share from poorly prepared competitors when a risk strikes and also become better at unearthing the unexpected.

It is also recommended that treasurers calibrate their risk exposures across value chains and pay attention to the calibration methods they are using to ascertain which are the bigger issues. Analysing data, sentiments and actions is necessary, but also look at what your informal network is doing. Talk to your peers, consultants or bankers. If you see a lot of people getting concerned about a particular counterparty in times of trouble, they may be giving or getting signals to move out. That doesn’t mean you need to move out too, but be attentive to the noise of the herd.

Finally, be ready to respond to rapid changes. Ask the important questions – What slows you from being able to respond rapidly? What will make you nimbler? What will allow you to detect things more readily, and what are some of your plans that you have ready in case there are problems? Answers to these queries can save you time when time truly matters the most.

Conclusion

These are challenging times for treasurers. The unfortunate and unexpected events of the last two years have increased uncertainties and risks and have exposed corporations to growing vulnerabilities, threats and potential losses that can adversely affect their capital, earnings, value, reputation and branding.

There is never a right or better time than now to invigorate a risk culture and continually and proactively identify, manage, mitigate and monitor expected and unexpected risks.

The only thing certain in business is uncertainty. Fortunately, these leading practices will help corporate treasurers strengthen the risk management function and do so effectively under uncertainty.

⃰⃰ Disclosure: Strategic Treasurer owns CTMfile.

 

Read more from this series:

Part 1: Bank account management

Part 2: Bank relationship management

Part 3: Cash concentration

Part 4: Liquidity structure

Part 5: Treasury owns cash

Part 6A: Staff development

Part 6B: Staff development

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