A Treasurer’s Perspective: Trends in Risk Management: Part I
James Lockyer | September 19, 2016 |
The management of risk and reward is central to successful delivery of the treasury’s core function of sourcing and delivering money to finance a business, while avoiding making material mistakes.
Treasury is typically responsible for financial risk, related to, for example, foreign exchange, commodity price, interest rate, and liquidity risk. To manage financial risk effectively, treasury and the business should work in close partnership to ensure that treasury’s activity in financial markets properly supports the business’ aims. Consequently, treasury often has a key interaction with the professional accountants in their organization.
Because of this important interaction and cross-reliance, it is useful to share some of the key priorities and issues the Association of Corporate Treasurers (ACT) is seeing in the financial risk space:
- Global fragmentation of bank services as Basel III and other financial regulation take effect. These measures are completely changing the risk and return landscape, both for funding and for successful operation of the business itself.
- Advances in technology, which may help the business (e.g. artificial intelligence, big data, blockchain), or hinder (e.g. cyber threats or changes in the competitive environment from disruptive new competitors).
- Political risk, particularly extraterritorial, that can create additional barriers, including financial.
- Threats to forego good business opportunities in an increasingly risk-averse world.
These four key issues are illustrated below.
- Increased liquidity risk and a lack of access for businesses to finance generally
- Basel III implementation has driven a wholesale retrenchment by the classic banks. For instance, there is almost no meaningful European or American banking presence in Sub-Saharan Africa. In the UK, numerous corporate customers are being forced to move or close bank accounts at short or zero notice, materially disrupting their business.
- The retrenchment by the classic banks from many markets has been compensated for by the emergence of new banks, such as from the Middle East, South East Asia, and China. Many of these banks are excellent institutions, well run and properly capitalized. However, companies still need to build relationships and assess banks’ capability and culture prior to transacting. A number of companies are struggling to build trusted relationships in time to meet their business needs.
- Similarly, we are seeing the rapid emergence of financial technology companies (FinTechs) and so-called “parallel” banks, offering services similar to or more attractive than banks, but in a less regulated environment and often in an original format. Again, companies need to perform rigorous assessment of the capabilities, management, and financial strength of such potential providers before transacting. In the absence of a suitable regulatory framework this can be a challenge, and arguably some novel, workable solutions are not being taken up owing to due diligence concerns rather than flaws in the offering itself.
- Basel III and associated reporting/compliance requirements may materially increase organizations’ cost to hedge the classic financial risks of foreign exchange, commodity, and interest rates. Besides adding in cost of compliance, a reduction in the ability to manage financial risk effectively means that more risk has to be contained within the business—making it riskier overall, and hence increasing investors’ required returns and/or decreasing the value of the business.
- The Know Your Customer (KYC) regulations are a substantial compliance burden with potentially severe penalties for non-compliance by banks. Bank fragmentation means that the KYC burden increases even further as customers are forced to use more banks. Conversely, in the post-crisis environment, corporate customers need to keep their Know Your Bank (KYB) information up to date, so they know exactly what is at risk in the event that the bank or part of it fails.
- Organizations are having to respond to a global, industrially scaled and resourced cyber risk threat. The ACT’s 2016 Contemporary Treasurer survey emphasized the vulnerability of technology and signaled an overall trend to increase technology solutions in treasury activity, and that as businesses become more digitized, they inevitably become more at risk from cybercrime.
- Risks to the brand, such as from crowd-based campaigns on social media or ill-advised email or social network posting by staff, may affect the company’s competitiveness and/or financial reputation. With so much information in the public domain, corporate communications need to be properly coordinated across the board, and the organization’s actions must always be consistent with its statements.
Artificial intelligence (AI), big data, and blockchain: As in core accounting and business reporting, a great deal of treasury’s work is potentially automatable. For instance, combining big data and AI theoretically enables hedging to be executed exactly in line with policy. In fact, the combination could arguably be used to write the policy in the first place. Blockchain can provide the complete audit trail for every transaction, and could simultaneously meet any external reporting requirements. Daily cash could be managed seamlessly and in real time, and funding and deposits organized to meet the cash flow forecast—again prepared using big data and AI. And so on. These areas offer significant potential for business but also include new sources of risk.
Political risk is important because it is random, very hard to determine using probability, and largely unhedgeable, uninsurable, and unavoidable.
Major political risk issues include:
- Taxes: It seems that some governments want businesses to pay the maximum tax possible. The G-20 Base Erosion and Profit Shifting (BEPS) Project seems set to fundamentally affect investment decisions and is likely to depress investment as it decreases free cash flow to investors. Future developments in taxation will undoubtedly further impact investment decisions.
- Sanctions and fines: sanctions increasingly affect all businesses, particularly banks. These are a key driver of risk aversion, depressing investment, and growth.
- Regulation and compliance: as complements to sanctions and fines, regulations and compliance also increasingly lead to a ‘compliance mentality’, which hampers effective risk management. Moreover, the key risk perceived by many organizations is regulatory or compliance failure, and this often frustrates sound business decision making.
- Extraterritorial application of domestic legislation: this new trend includes the US Foreign Account Tax Compliance Act (FACTA) and Volker Rule, the EU’s Financial Transaction Tax (FTT), and G-20’s BEPS.
- War and conflict: affect international trade, customer demand, and increasing uncertainty overall.
- Political future: The political future of nations, regions, and politico-economic unions like the EU, is a significant uncertainty, highlighted by the recent Brexit vote in the UK, the ongoing US presidential election, and China’s One Belt One Road initiative, which relies heavily on international cooperation for success (cooperation that is still in the early stages). These types of factors depress investment in developed economies, but the reduction in banking provision also raises significant barriers to expanding into developing economies and/or participating in growth strategies.
- Quantitative easing (QE) and negative interest rates: these represent artificial distortion of investment and borrowing decisions. While remaining competitive in the current environment, organizations need to also maintain a plan for operating in a future world without QE and with more “normal” interest rates.
Foregoing good business opportunities
A major issue in the current, risk adverse environment is that organizations have become irrationally cautious. We also wonder whether managers sufficiently understand the concept of sustainable value creation—whether for shareholders or the wider stakeholder community. Some particular concerns include:
- A heavy, sometimes exclusive focus on income statement performance, with the starter and sometimes only question being “what is the effect on earnings per share?” Balance sheets and cash generation/absorption may only be addressed as part of the annual financial reporting process and going concern review, by which time it is often far too late.
- A lack of investment because too much risk is factored in, resulting in too high a cost of capital.
- A tendency to focus on a single answer rather than a range of outcomes, which can lead to a correspondingly narrow view on managing threats and opportunities. After all, not every slip on a banana peel is lethal…
Now we have identified some of the most pressing concerns of the participants in our latest Contemporary Treasurer survey, my next article will address responses, and what the ACT is doing to support treasurers and their organizations.