Risk management has become increasingly critical for corporate treasurers in todays era of economic uncertainty, Robin Arnfield writes. But where are the biggest risks coming from, and what are the implications those providing corporate payments services?
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Treasurers face three areas of risk in their role as guardians of a corporations cash and working capital.
Firstly, there is the risk of exposure to volatile foreign exchange (FX) rates, interest rates, and commodity prices, as well as default by counterparties, political upheaval, and natural disasters.
Secondly, there is the risk of corporate payment fraud, and thirdly the risk of failure to comply with increasingly onerous financial regulations. Each of these risks can potentially hit a corporations balance sheet and profitability.
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By GlobalData"The treasurers role is to remove fluctuations and volatility," says Paul Bramwell, senior vice-president, treasury solutions, at US software firm SunGards AvantGard corporations business.
"Typically, treasurers put their corporations cash to work by investing it in money market funds [MMFs], which consist of commercial paper and other short-term debt instruments issued by governments and banks."
2008 crisis
According to PricewaterhouseCoopers (PwC) 2010 Global Treasury Survey of 600 treasurers, the 2008 financial crisis raised the profile of treasury within the corporation.
"Nearly 80% of survey participants believe the crisis won them greater boardroom attention," PwC says.
"Treasurers are keen to stay on top of their exposures, with risk management topping the list of participants priorities for the future."
"There is a big difference between pre-2008 and post-2008 in terms of risk strategies," says Jeff Jellison, North America CEO of institutional MMF portal operator International Cash Distributors (ICD).
"Prior to the crash, treasurers were very trusting of the credit ratings agencies [Standard & Poors, Moodys, etc], and, if they said an MMF was AAA-rated, then treasurers bought into it. But treasurers lacked visibility into where these funds were investing their cash."
In September 2008, Lehman Brothers collapsed following the US governments refusal to rescue the investment bank.
"A lot of MMFs were heavily exposed to troubled firms like Lehman, so this meant treasurers investments in these funds became illiquid," says Jellison.
"The trend in the last three years has been for companies to focus on the credit risk of borrowers and the counterparty risk of the banks that they deal with," says Yann Umbricht, a partner in PwCs treasury group.
"The problem with using credit rating agencies to get a view of credit risk is that their ratings dont change very often.
"So what people look at now is credit default swaps [CDS], a form of insurance for firms lending capital to other companies. [Unlike traditional credit insurance, anyone, not just the lender, can purchase a CDS. Speculators may buy a CDS hoping that the lender will fail, and they will then receive a payout].
"The markets view of the riskiness of a company seeking credit, will determine the price of its CDS."
The PwC Global Treasury Survey says that nearly three times more participants are monitoring CDS rates than before the 2008 crisis.
SunGards Bramwell says that banks pose two kinds of risk for corporates.
"Firstly, theres the credit risk that a bank will fail, and the corporate wont recover the full amount of the cash deposited with that institution," he says.
"Secondly, there is settlement risk. If Bank A is waiting for $500m from corporation B, it may not be able to pay the full amount of the $500m it owes to corporation C in a timely fashion."
"Five years ago, firms were trying to consolidate all the disparate bank accounts they had with different institutions into just a few bank accounts and bank relationships," says Justin Brimfield, senior vice-president for corporate development at Reval, a US firm whose web-based software enables treasurers to monitor their interest rate, FX, credit, and commodity risks.
"But now we realise there is no such thing in the banking industry as too big to fail. Its better not to have all a firms cash with just a few banks."
Technology
When the 2008 crisis happened, ICD had to create manual spreadsheets for its treasury clients, as they didnt know what they owned and what the risks were, Jellison says.
Consequently, ICD developed Transparency Plus, a web-based analytics system which enables treasurers to drill down into the underlying debt securities that MMFs are invested in.
As they can see whether they are over-exposed to any one company or country, they are able to recalibrate their portfolio, and also run what if scenarios before making specific investments.
"Prior to using Transparency Plus, one of our largest clients was spending 85 hours a week analysing his companys exposure to short-term credit investments," Jellison says.
"He had to look at each underlying investment in an MMF, and aggregate his total risk exposure. By using Transparency Plus, he has cut down this work to 10 hours a week."
Transparency Plus also helps manage geopolitical risk. "In the immediate aftermath of the 11 March 2011 Japanese earthquake, our clients were using Transparency Plus very heavily to reduce their exposure to Japan," says Jellison.
"Being able to tell where your investments are actually held in an MMF is very important," says PwCs Umbricht. "Not many treasurers have this insight yet, however."
Technology is the solution for gaining visibility into exposure, says Revals Brimfield.
"Leverage technology, as this not only minimises human error, but also frees up staff to analyse findings, and stay in-tune with the market," he advises.
Brimfield advocates using an outsourced platform such as Reval (also the name for Revals software), where the application is hosted on the vendors own server.
"Reval automatically updates its platform in response to market changes," he says. "In a market thats changing daily, the treasurers software needs to be equally dynamic."
SunGard offers the AvantGard Treasury Workstation that consolidates all data across an organisation to give a true impression of the risks a firm faces, Bramwell says.
"This enables the treasurer to make decisions, such as whether to fix interest rates," he adds.
"Also, you can use AvantGard to stress-test your system."
Brimfield adds: "Reval has seen a big uptick recently in clients stress-testing their risk management systems."
Hedging
Forward contracts that commit the purchaser to buying at a fixed price give them cost-certainty. However, treasurers can also purchase options, which give them the right, but not the obligation, to purchase at a fixed price.
Umbricht says that a treasurers use of hedging depends on their companys ability to absorb short-term market rate fluctuations.
"If a company has low profit margins and a lot of international currency flows, it risks suffering significantly from foreign currency movements, so it needs to use hedging," he says.
"Also, if a firm is highly geared, it needs to protect itself from FX changes that may impact its borrowing covenants or other financial ratios.
"But a company with higher margins, where exposure to financial risks is less significant, may think that hedging is expensive and decide not to hedge."
Brendan McGrath, senior market analyst at FX specialist at Western Union Business Solutions, says options are very popular with his firms clients because of their flexibility.
"In the past, a lot of firms hedged on a regular basis, and, if the FX market changed dramatically, this impacted their bottom line and their competitiveness," McGrath says.
"If they hedged too soon, and the currency rate improved, they couldnt lower their pricing, but competitors who werent locked into a particular FX rate, could offer their customers lower prices."
Treasurers are increasingly focusing on hedging their firms exposure to commodities, says Paul Higdon, chief technology officer of UK-based IT2 Treasury Solutions.
"IT2s recent experience is that fuel and electricity are priorities, reflecting the present volatility in these important commodity classes," Higdon says.
Fraud
Preventing corporate payment fraud is an important part of the treasurers role. The Association for Financial Professionals 2011 AFP Payments Fraud and Control Survey, which was underwritten by JP Morgan, found that 71% of US organisations surveyed experienced attempted or actual payments fraud in 2010.
Cheques were the payment format most frequently targeted by fraudsters, with 93% of organisations affected by fraud saying their cheques were targeted.
Other payments formats targeted were ACH debits (25% of participants affected by fraud ACH debits involve funds being withdrawn from an account by a third-party, similar to UK direct debits); consumer payment cards used for business (23%); corporate/commercial cards (15%); ACH credits (4% a credit transfer initiated by a payer); and wire transfers (4%).
Corporate account takeover fraud, where a fraudster hijacks a corporate online bank account, has emerged as a significant threat. The AFP survey found that 14% of respondents experienced this type of fraud in 2010, with 2% suffering a loss.
Michele Edwards, fraud analytics practice leader at US-based advisory firm PRGX Global, told the International Accounts Payable Professionals May conference in Orlando, Florida, that back-office fraud is robbing corporate treasuries of billions of dollars a year.
"Most companies are weak in the area of back-office fraud, which poses a significant threat to them," Reuters quotes Edwards as saying.
Part of the recent rise in US corporate fraud losses may be due to more efforts by firms to detect fraud in the last two years. This focus is in response to US regulators taking a harder stand against firms which werent doing enough to prevent fraud that caused shareholder losses, Reuters reports Edwards as saying.
JP Morgan Treasury Services executive director Stephen Markwell says the fraud prevention strategies treasurers need to deploy include installing internal controls to prevent account-hijacking.
"All electronic transfers need to have a second layer of approval," Markwell says. "Even if a fraudster does penetrate your payment system, he will be thwarted by this.
"Segregate duties to prevent internal fraud, so that a different person is involved at each stage of the payment cycle. Thirdly, segregate your bank accounts, so that each has a specific purpose, for example one account for cheque payments, and one for ACH.
"Keeping accounts for separate, narrowly-defined purposes makes it much easier to spot exceptions that may be fraudulent."
Regulatory risk
James Allen, head of capital market policy at the Chartered Financial Analyst Institute, says uncertainty over the future direction of financial regulations is a big risk factor for treasurers.
"Where will regulations go in the future?" Allen asks.
"In the US, we have the Dodd- Frank Wall Street Reform and Consumer Protection Act in place, but for how long? Will Congress rewrite part of Dodd Frank? It is a big challenge for treasurers, as regulators keep changing regulations."
Separately, the International Accounting Standards Board is drafting rules that will create new standards governing how firms account for their hedges in their financial statements.
Signed into law by President Obama in July 2010, Dodd-Frank aims to prevent a re-occurrence of the near-collapse of the banking system in 2008.
Its impact on treasurers is that it is expected to regulate their activities in the OTC (over-the-counter) derivatives market, such as forward contracts, options, and interest-rate swaps.
Because the OTC derivatives market involves trades between banks and end users that are not cleared through an exchange, it has been largely unregulated and has lacked transparency, one of Dodd-Franks key tenets.
John Jay, a senior analyst at Aite Group, says Dodd-Frank will likely increase the cost to treasurers of participating in the OTC derivatives market.
"FX derivatives will be exempted from the Act but treasurers will be required to provide greater collateral for other kinds of OTC derivatives," Jay says.
"US regulators are trying to eliminate systemic risk in the banking industry, and corporates have got caught up in this."
According to Reval, Dodd-Frank aims to push as many OTC derivative trades as possible onto regulated exchanges, which will put up the cost of the trades.
For complex swaps that cannot be cleared on exchanges, banks will be required to ask for more collateral funding from end users, so as to limit the banks exposure, it says in a White Paper.
