The financial crisis has brought risk management to the forefront of treasury operations. For some companies this has meant increased technology budgets to buy products which help to analyse and avert a wide variety of risks. We examine the role of risk software in today’s treasury and ask whether ‘state of the art’ software is really a must-have for companies today.
Software vendors say that demand for tools to calculate corporate risk is increasing in the wake of the financial crisis, but whether corporate treasurers are reaping the benefits of these products is unclear. Is risk software finally starting to be seen as a key investment to help corporate treasury to track and mitigate risk? Or is it simply a luxury if a company already has sound risk management policies in place?
There are a number of different risk software packages on the market. The most popular vendor-bought solutions either bundle a solution together with a treasury management system or sell separate modules to deal with these types of risk.
Typically the treasury has two choices when it comes to risk software implementation. The first is integration within an existing TMS system. Examples are Wall Street Systems’ Wall Street Suite and IT2’s Treasury Workstation. This solution provides integrated VaR and historical market risk simulations, credit risk software, liquidity risk and operation risk software together with the TMS system. The system can manage and report on figures from subsidiary positions, centralised treasury, bank balance and future forecast, in real time. Similarly Ecofinance, a German technology vendor, offers VaR and CaR software within its ITS Treasury system. SunGard’s AvantGard Quantum treasury management system has a number of tools to manage debt and investment risk, as well as interest rate and FX movements. SunGard also produces a credit risk management application.
The second option is specific risk software. Algorithmics, for instance, offers individual products to deal with liquidity risk, credit risk, market risk and operational risk. These products are sold separately, which allows the treasury to select risk software specific to its own needs. Some vendors specialise in products for specific risk areas: Fireapps produce an application that monitors FX risk and exposures. SunGard also offers some individual risk modules alongside an integrated solution. Many of the individual module merchants are in partnership with large-scale TMS vendors, for examples Numerix’s counterparty risk software can be embedded within the Wall Street Suite and Wall Street FX applications to provide better counterparty risk management. Fireapps, too, can be found within the SunGard offering.
In broad terms, the cost of vendor-bought risk software starts in the region of €200,000 for a licence. For many small treasury departments, Excel is therefore a more cost-effective option. Yet as ASP solutions become more popular, the large vendors are offering more choice and costs are likely to reduce.
Protecting the key financial risks
The majority of this type of risk software works on the principle of a Monte Carlo simulation. Complex systems work on a Value at Risk (VaR) basis and calculate risks derived from a number of market factors. The software can calculate the VaR position for all financial transactions, from FX and interest rates to derivatives and commodity deals. This enables the treasury to map all of the risks of their financial positions in one place. However VaR has been criticised for not predicting the large deviations that can and do occur every few years in the financial markets. Jiro Okochi, CEO, Reval, a risk solutions vendor, says, “I think it is hard for many companies to take the first step to measure the actual market exposures they have as obtaining the exposure data can be manually intensive (eg spreadsheets from subsidiaries) or unreliable (eg conservative sales forecasts). The second step is to net out any natural offsets which many companies also fail to do before blindly entering into a hedge against each exposure. Risk software can help companies properly identify, measure and hedge these risks.”
Credit and counterparty risk
Perhaps one of the most useful tools for treasury is the new wave of software that can track counterparties, the single most challenging risk to come to light with the financial crisis. Sophisticated systems can track this risk by monitoring counterparty credit ratings and can report on counterparties that are approaching limits or have defaulted on payments. For example, Numerix, a vendor of counterparty risk software, measures current exposure, potential future exposure, and has credit valuation adjustments built in. This allows a corporate to accurately limit counterparty exposures across all business units.
Cash flow at risk (CaR) examines the risks associated with internal company cash flows. By determining cash in and out of the company over a period of time the software can work out the cash position of an organisation to liquidity planning in the longer term. This can prevent companies being forced into unnecessary short-term financing, at unfavourable rates, due to a lack of visibility over future cash positions.
Home grown vs shop bought
The vast majority of risk software implemented by corporates will be off-the-shelf solutions, and will have to be adapted to individual needs from a one-size-fits-all model. However some large companies have built their own risk software. Microsoft, as you would expect from a technology giant, is one such company. Microsoft’s 360 Degree Exposure Report enables the company to see its exposures to counterparties, its collateral positions, and derivatives across the company and displays the results graphically. This is proprietary software developed for Microsoft’s treasury and not for resale. But for companies that believe good risk management is critical, yet don’t have the resources to design their own solution, will vendor-bought solutions improve their risk management?
The value add or not
Many corporates are sceptical as to whether expensive risk software adds real value. Torbjörn Sandblom, Risk Manager, AB Stena Finans, the financial arm of the shipping giant Stena, says, “In terms of risk, the technology that we use is based on our treasury management system. It is basically used as a database to make sure that we have the correct reporting on all of our positions. It is actually more of a data collection tool, rather than a risk measurement system. However it provides a solid basis for making sure that the input data for any risk measurement calculations is correct going forward.”
Dr Karlheinz Sclögl, Managing Director of Ecofinance, a European technology vendor based in Germany, agrees that software cannot be solely responsible for the outcome of any calculations performed and says, “A manager’s decision can be based on qualitative or quantitative factors. In complex surroundings risk software is a tool used to aggregate data and support managers’ decisions on a quantitative basis. The challenge is to interpret the results provided by the system.”
The argument for many is that risk software cannot add true value because it failed to pick up the early signs of the banking crisis. However some believe this was because the instruments were looking at the shorter end of the market and not at long-term risks. Reval’s Okochi says, “Many statistical models, like Value at Risk, failed to work during the crisis and some corporates are discarding this practice as a result. Although statistical models are less reliable when you have large standard deviation moves, as was observed during the height of the crisis, the real error was that companies were not combining their statistical models with sound stress tests that would have captured some of the unexpected moves. For example, during the crisis, oil prices moved rapidly up to $140 and then quickly down to $40 and then back to $70, which no statistical model had predicted.”
There is no doubt that if a treasury has the resources to implement sophisticated risk software, it can be a help with day-to-day risk management. The use of longer-term stress tests should also be a useful tool for preparing early for off-the-scale events such as the financial crisis. So, as longer term positions are incorporated into risk software, it has the potential to become a more useful weapon in the armoury of every treasury department. That said, the importance of treasury staff being able to comprehend what the software brings to risk management should not be underestimated. Okochi says, “You can have the best system in the world but if your staff don’t know how to formulate a good risk policy, and for example execute hedges, then it will not work. However it is always good to have the best tools for the best team to maximise the results and minimise the chance of worst case scenario.”