Rocket scientists, with a bank’s computers to play with, are brilliant at inventing ever more complex products to offer the FDs of their corporate clients. They tend to be less expert at explaining the implications and risks of their creations. So, when faced with the latest whiz-bang derivative from the company’s banker, finance directors often feel it is best to be guided by the old adage: “If you don’t understand how it works, don’t do it.” With new products, FDs and treasurers have to devote much time and effort to achieve a sufficient level of understanding that they feel comfortable with the transaction. Accountants find their systems cannot cope with the complexity and worry about control. And financial reporting standards require frequent market valuations of financial instruments; some products from banks pose real problems in this respect. Even sophisticated organisations have had difficulties in this area. Proctor and Gamble claimed during a recent lawsuit against Bankers Trust that it had been misled when the bank sold it derivatives. Allied Lyons incurred losses of £147m as a result of foreign exchange trading, and there was no independent control function when an individual took on larger positions to recoup the losses. Metallgesellschaft lost £300m in the oil markets hedging a long-term position in forward contracts with short-term futures, producing cash flow problems on roll over of the short-term contracts when the futures soared. One banking product that has claimed numerous victims is the structured note. Behind the facade of a straightforward interest rate swap, there can be an option based upon a multiple of the principal sum. If the option element comes into play, losses can significantly exceed the principal amount. The new generation of treasury products bring a variety of risks. There are market risks, where the use of derivatives may exaggerate market movements; counterparty risks, where an understanding of the exposures of each counterparty is vital; inherent risks, associated with the design of the product; and control risks, where the task of monitoring exposures is too complicated to be encoded in the normal accounting systems. But these risks can be managed, and often losses are not due to a failure of internal risk management systems, but rather to more fundamental failings. For example: – insufficient understanding of the products and the operation of controls – too much responsibility concentrated in the hands of dominant individuals – poor definition of the mandates and the internal authorities – insufficient segregation of duties – failure to revalue positions frequently – poor quality management reporting. As a result, finance directors are now beginning to think the unthinkable and are considering outsourcing treasury management as a way of overcoming these difficulties, and are seeking efficiencies, cost savings, risk reduction and enhanced information from specialists. Corporate cultures are receptive to the notion that specialisation brings efficiency. FDs have traditionally outsourced such activities as accounting transactions, payroll processing, pension administration and taxation compliance, but outsourcing treasury management is new. Many are reluctant to even consider the idea, since they regard treasury management as a core activity of the company, the source of competitive advantage, best done internally and an activity not to be trusted to others. Some may fear their boardroom colleagues will think less of them if they need to contract out activities for which they are seen internally as the expert. Too frequently, the consequences of poor treasury management are not identified in the financial reporting of the company and so, rather than tackle this challenging area, the FD elects to leave well alone. But others, especially FDs in organisations where they assume the full range of responsibilities and do not have a specialist treasurer, accept that their training may prepare them inadequately for the complexities of modern treasury management and therefore embrace the idea of outsourcing. They want the advantages that complex banking products can give them and they want to sleep at night. But how does outsourcing work? The service envisaged here is similar to that provided by fund managers to the company’s pension fund. FDs are comfortable outsourcing this activity and should be equally comfortable with a similar service managing the company’s, rather than the pension fund’s, cash resources. A specialist provider can not only deliver technical knowledge, identified earlier as a key requirement for success, but also benefits from the economics of specialisation and should out-perform in-house execution of treasury transactions, at lower cost. Importantly, control can be enhanced because the provider can justify investment in complex dealing software and technology. Dealing is undertaken from screens showing the current market rates, telephone conversations are recorded, deals are automatically confirmed to the correspondent bank and written to the in-house system by an individual remote from the transaction. Reporting of real-time positions and valuations is provided so that management is kept informed. The lines of communication between the FD and his outsourced treasury have to be based on a detailed Service Level Agreement. The provider will be required to deliver a measurable service at demonstrably lower cost than the in-house alternative. Policy, objectives and authorities for discretionary action must be clear. The company’s cash needs will be set out flexibly. If there is a significant chance of the company needing short-term cash, then the hedging and cash management policy will build in this contingency. Meetings between the FD and the service provider will be regular and ensure outside events can be dealt with on the basis of up-to-date information. The risk of the rogue trader will always remain, whether the treasury is outsourced or not. However, the process of creating a Service Level Agreement will be a catalyst in creating clear treasury policies and authorities for action, which may not always be present with in-house treasuries, but which are essential before outsourcing can occur. Moreover, service providers have more staff and can ensure complete segregation of duties, unlike all but the largest corporate treasuries. The costs of outsourcing are likely to include one or more of: – a base fee, related to the permanent resources required by the provider – a variable fee, that will be linked to transaction volumes – a performance fee, linked to benchmark service standards or margins – a consultancy fee, when the provider is acting as a consultant. Windsor-based Record Treasury Management provides a good example of outsourcing services. Chairman Neil Record says: “We believe the benefits of outsourcing treasury management vary between organisations. For small organisations, benefits arise from identification of risks and subsequent hedging strategies. For large companies they arise from effective execution, reporting and control. For the largest organisations it may be the requirement for enhanced control and frequent valuation of instruments that is key.” Brian Birkenhead, a consultant, university teacher, and director of three companies, is a former chairman of the Hundred Group of Finance Directors.
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