Ask where treasury lies in the spectrum of risk and many a businessman will say somewhere between hang-gliding and pot-holing. Suggest that it can be a value-creating activity and he may well give you an odd look.
It is true that adding value is currently playing second fiddle to risk reduction as chief executives get cold feet after reading about another misuse of derivatives. This natural reaction has prompted boards of directors to ask questions about the financial risks their companies are running and what can be done by the finance director and treasurer to reduce them.
Not before time.
The first question has to be answered by the board itself. What is the company’s appetite for risk? The answer cannot be expressed numerically because it is a cultural issue: the degree of risk-averseness will depend on the industry, the firm’s profit record and prospective cash flow, the behaviour of its competitors, and, not least, the skills and energy of the finance director and treasurer. Whatever the answer, the company should be clear where it stands – as should its shareholders – because all its treasury activities must be carried out against a clear mandate from the board. No surprises please, the chairman pleads!
Beyond this general mandate, the board will want to give the treasurer its approval to a more detailed set of policies and procedures. For this, the treasurer must carry out a rigorous risk analysis exercise – perhaps in the form of a risk map – across the whole business, identifying, for example, where foreign exchange and interest rate exposures arise; the sensitivity to commodity price movements; and the availability of funds.
Straightforward stuff for a competent treasurer but the really good operator will see how these risks relate to the business and are affected by its vicissitudes. If this is done, the risk management policies will track the underlying business exposures closely – a key factor for their success.
If they do not, the danger is that the policies will increase the company’s risks, not reduce them. In this way treasury can inadvertently become a risk-creating activity, the opposite of what most non-financial companies want.
It will be apparent by now that risk analysis should start at a high level in the organisation and be strategic in its approach; in that sense it forms part of the strategic planning process for the business as a whole. It does not do to be too prescriptive about analysis or process: firms rightly choose approaches which suit their peculiar structures and styles. However, as today’s flatter organisations facilitate management by process or business stream, this also seems the logical way to manage risk. The treasurer who stays close to the business will fit easily into this new world and add value for his or her company.
A sense of proportion is important. There will be some risks which because of their size or nature should be ignored. Sensitivity analysis is helpful to see the possible impact of market changes on the earnings or balance sheet. More sophisticated tools like the value at risk (VaR) models used by banks may soon be imported by companies. Shareholders should be told via the operating and financial review, and as part of investor relations, what is being done so they can decide how much hedging is left for them to do by spreading their portfolios. Operational hedges should be examined.
For example, care in analysing customer and supplier contracts will pay off; is it clear who is bearing the currency risks? If manufacturing and selling take place in different countries (and currencies), are there overriding reasons for this or could a natural hedge be arranged? Can more information about risk exposures and policies of competitors be got and action taken?
There is much misunderstanding about a firm’s attitude to managing these risks: “we never speculate”; “we hedge all our exposures”. Sadly, such chairman-like statements, while well-intentioned, mean little without a good deal more explanation – one company’s hedge can be another’s speculation.
Even FDs and treasurers can fall into the trap: “our treasury is a cost centre, not a profit centre”; perhaps with an aside: “but of course it does add value”. These labels are less important than a clear definition of what is permitted within board-approved treasury policies. They should relate to the business expressed in terms of risk to cash flows or profits, and dispel the myth that if a treasury profit centre means one that measures performance against a benchmark, all companies should have one!
Does all this risk management activity have to involve the use of derivatives?
For all but the smallest firms, the answer is often “yes”, simply because they offer an increasing range of solutions, tailored to a firm’s needs.
However, they should never be used until the treasurer is satisfied that all the opportunities for operational hedging have been exhausted. Once they are introduced into the treasurer’s toolkit, the board must recognise that they represent an additional source of risk: they normally exist to reduce or eliminate risk but can also be used, knowingly or unknowingly, to create it. Regular reporting and review of the derivatives’ portfolio and the exposures it is hedging, using market values, is essential information for the directors who will then focus on the accuracy of the correlation between the two. Because derivatives are “derived” from market instruments, their value moves with the markets; they must therefore be actively managed even if the intention is to hold them until the underlying exposures mature.
This is because the correlation between the two, which should be a negative one, may break down.
The board should have a treasury committee or the equivalent, with at least two directors not involved in the company’s treasury department, to monitor the operation of board policy. Last year, the Association of Corporate Treasurers published Derivatives for Directors which described the sort of controls needed.
Finally, a good treasury policy should set out responsibilities and the organisation structure for carrying them out. It should start with the board and the audit committee, and work through the company structure so as to include the treasury department and the operating divisions.
Dealing limits, risk limits, approved counterparties – all should be covered.
Internal and external audit have an important role to play but it has to be said that both have had difficulty keeping pace with treasury developments.
Auditors and boards should thoroughly review treasury policies at least once each year.
Jeremy Wagener is director general of the Association of Corporate Treasurers.