The role of the treasurer has been constantly evolving. The original responsibilities of the treasurer were more operational, focused on transaction execution and nostro management. During the period from the 1980s to the mid-1990s, treasurers were required to be more analytical and proactive with responsibilities for forecasting and managing liquidity and financial risk. Today's treasurer has a strategic role with board level accountability and the responsibility to manage enterprisewide 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. The treasurer is often one of the few individuals in an organization who has a thorough understanding of enterprise risk, and how the individual risk components - be they movements in exchange rates or corporate credit ratings - affect the risk profile, liquidity and ultimately the value of the company. There are numerous unforeseen risks that must be managed. On top of that, the larger the organization, 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 have a significant impact.
How can a treasurer manage this situation? Preparation for an event can help, but the unknown presents a major impediment. In these increasingly volatile market conditions, focusing on areas of key treasury management best practices and using technology to optimize processes will help to achieve greater transparency and improved decision making.
Cash and Liquidity
As the traditional sources of liquidity have become less reliable, maximizing the use of available cash is now critical to the survival of some businesses. Organizations today are challenged by manual processes, disparate systems and lack of workflow automation. By leveraging automation, workflow and connectivity that spans treasury, risk and cash management, the quality and timeliness of information available to the treasurer on which to base investment and hedging decisions has increased.
Having control of cash and implementing effective cash management strategies has long been considered a best practice, but in light of the current environment, it has become mandatory. The goal is to achieve real-time visibility into cash balances locally, regionally and globally.
The ability to capture all relevant transactions impacting cash today and in the future is vital to an effective cash flow forecasting methodology. The impact of up-to-date and complete information can be considerable: freed-up cash, lower costs of funding and higher investment returns.
Data Accuracy and Transparency
Reliable financial data that is accurate, consistent and accessible should be the bedrock of day-to-day treasury operations. So, when data is inadequate or incorrect, the consequences are felt throughout the organization. In an increasingly competitive global marketplace, organizations need dependable data to help improve productivity, reduce risk and exposure, and ease the compliance burden. Companies are often challenged by inadequate information, making it difficult to capture the data needed to make sound business decisions. It is not unusual for a number of days to have passed after period close before all foreign exchange exposures are quantified, for instance. 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.
For example, according to an article on CFO.com in December 2009, Google reported a $300 million dollar hit to revenues in its third quarter accounts as a result of currency fluctuations. "The company's foreign-exchange-related costs increased by a net $126 million in the first nine months of the year, according to its latest 10-Q." Having embarked on an "intense currency hedging program" backed up by the implementation of foreign exchange currency management software, Brent Callinicos, the treasurer at Google said that, "the difference between having the system and not having it is material." This is coming from a company that "recognized $316.6 million in hedging gains to revenue in the first nine months of the year." More complete and timely information gives Google's treasurer and his team the confidence to do more hedging to reduce risk.
Speed is vital as well, especially when we consider one-week versus one-day volatilities. An organization can reduce its exposure to risk by as much as 90% 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. Operating in a global economy makes foreign exchange 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 analyze 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.
The consequences of poor and incomplete data can be serious. Faulty data can result in breaches of limits, and 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 repaying debt. We saw in late 2008 that previously well-rated Icelandic banks froze the assets of overseas depositors in the wake of the country's economic woes. It was quickly revealed that local authorities in the UK had invested almost £1 billion 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 to obtain the ability to look at 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, particularly in these volatile times, 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. Once again, up-to-date market information enables accurate pre-trade limit checking and alerts of potential limit breaches prior to trade.
A Holistic View of Risk Management
Recent turbulent market conditions have revealed the limitation of opaque risk models that rely heavily on one measure without proper stress-testing of the results. Treasurers are increasingly employing a "back-to-basics" approach in setting risk management policy that provides complete transparency of the risks and the interdependence of the parts - a holistic view. Treasurers also need to react quickly to changes in market conditions and adjust policy if it becomes ineffective.
Enterprise risk management and a holistic view over asset classes (credit, interest rate, foreign exchange, 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 elements of this holistic approach:
Consolidate risk positions. The first stage in 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 your 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 the profit and loss (P&L). If you can explain your P&L, you can take measures to ensure that you have formulated the optimal hedging strategy. A basic understanding is key in formulating the right risk management policy. 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 (VaR). To date, VaR methodologies have played a large role in producing risk numbers and were the main measure that many banks used to calculate their liquidity buffer requirement. However, VaR models, whether using Monte Carlo or historical simulation, are not useful at predicting catastrophes. David Einhorn, founder of prominent hedge fund Greenlight Capital wrote recently that VaR was, "like an air bag that works all the time, except when you have a car accident." VaR also tends to provide metrics on "business as usual" and cannot show the magnitude of potential downturn. Nonetheless, VaR is probably the best single measure of risk in that it is enterprisewide 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. One way to do so is stress testing.
Stress testing. The VaR approach that identifies the 1% worst-case scenario to an organization'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 like 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. When 10 of the largest U.S. banks failed stress testing in May 2009, revealing a $74.6 billion funding requirements, some analysts argued that the "doomsday" scenario that the banks' books had been subjected to was actually no worse than the economic situation existing at that time.
The question is: how extreme is extreme? In a 2009 New York Times article, David Viniar of Goldman Sachs said, "Things that we would have thought were so extreme have happened. We used to say, what will happen if every equity market in the world goes down by 30% at the same time? We used to think of that as an extreme event - except that now it has happened. Nothing ever happens until it happens for the first time."
Formulate, Benchmark and Review
In today's volatile world, policy needs 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 responsibilities of the treasurer in recent years. The one thing that we can be certain of is continuing change and volatility in the future, requiring vigilance in management and agility in policy and response which will remain of paramount importance. Organizations are asking for more from their treasurers and, in turn, treasurers must ask for more from the resources they use.