Treasury Today Country Profiles in association with Citi

Euro break-up: stress test your treasury

Baseball smashing through a window

Treasurers are increasingly using stress testing and contingency planning techniques to protect their businesses from a euro break-up. But what is involved and can it really help?

The words ‘stress testing’ might bring to mind the controversial stress test exercises carried out by the European Banking Authority (EBA) in 2010 and 2011 in order to determine whether banks are prepared for another financial crisis. They might also evoke the rigorous stress testing that banks are undertaking on their organisations in the current volatile market conditions. But stress testing is not just a bank concern: with the threat of a euro break-up still very prominent – Citi’s chief economist recently put the likelihood of Greece leaving the euro within 18 months at 90% – a growing number of treasurers are making use of stress testing techniques in order to understand the impact of such an event on their own businesses.

“Stress testing is a term that we typically associate with banks, but today this is something that is happening at a corporate level too, particularly around the Eurozone crisis,” says Suzanne Barry, Head of Liquidity and Investments, GTS EMEA, Bank of America Merrill Lynch. “It is an important part of the management process to identify, analyse and manage risks in the company that are, in this case, presented by the external environment.”

Stress testing is a risk management tool that can be used to gauge the impact of certain events on the business. In order to understand the impact of market changes, a company might look at a particular scenario, such as an increase in the price of oil or exchange rates reaching a certain level, and ask what the impact would be on the company’s revenue or operating margin.

Most, or all, treasurers will be asking these questions to a certain extent but some companies are tackling this exercise more enthusiastically than others. “Not everyone is doing this proactively, although in our opinion, stress testing should be part of the job description,” says John Clark, Principal Treasury Consultant and Product Manager at IT2 Treasury Solutions. “Some may be doing tests without realising. If they are asking what would happen if rates shift – this could well be an ad hoc calculation in a spread sheet, rather than a daily process. Across the broader professional community we meet, probably less than half are making substantial use of the automated functionalities available within treasury management systems, such as scenario analysis or Value-at-Risk.”

Anatomy of a stress test

So why is stress testing important? “Whether you’re a bank or a corporate, there’s a very broad understanding that the market impacts the performance of the business and the strength of the balance sheet,” explains Yuri Polyakov, Head of Financial Risk Advisory, Lloyds Bank. “How do you know how much market movement you can withstand? In order to determine this you look at the balance sheet, the business plan and the income projections and you try to understand which market variables you need to be concerned about.”

While a lot of companies focus on specific variables, Polyakov says that the benefit of such an exercise is limited. “Unfortunately a lot of people just look at what the balance sheet does, if cable goes to two, or if LIBOR goes from 1% to 7%,” he says. “It’s an exercise that a lot of people do, but it’s not an exercise that would withstand much scrutiny. Typically if LIBOR went from 1% to 7%, FX rates would change hugely – you can’t just look at the impact of one variable and ignore the impact of others.”

Polyakov says that instead of testing two or three scenarios, companies should take a more comprehensive approach. “You should really change the task frequently and test in the region of 10,000 scenarios, bearing in mind that stress testing on a single variable basis – ie only FX, or only commodities, or only interest rates – doesn’t really give the full picture because these variables are interdependent. After generating a number of different economic scenarios, Polyakov says that companies should push the business plan through those scenarios and calculate the performance metrics that are important to them. “From there, they can find the metrics in which they are underperforming and which market factors impact on them. They should then consider whether those scenarios are realistic or not.”

The majority of companies may balk at attempting such an exercise in-house yet banks may be able to assist with a stress testing exercise of this scale. Treasury technology may also have a part to play if companies are undertaking stress testing at a more sophisticated level. “It comes down to the speed and frequency of the testing and the analysis that’s being done,” says IT2’s Clark. “For example, one of our clients is running ten scenario tests every day, based on their investment portfolio. They wouldn’t be able to do that without the support of technology. If companies are just looking at a shift in interest rates or FX rates, this can be done using spread sheets – although resources are still required to do that.”

Euro break-up

In the current climate, it should come as no surprise that the scenario companies are predominantly focusing on is a break-up of the euro, the impact of which could be enormous for companies around the world. Jeff Wallace, Managing Partner at Greenwich Treasury Advisors, says that the prospect of a euro break-up presents three key types of risk: “The first, and smallest, component is the redenomination risk of their cash into a weaker currency. The second risk, which could be quite significant, is their financial counterparty risk with the European banks. However, the biggest risk companies face is their commercial credit risk – the risk associated with their suppliers and customers.”

“If you’ve got a Spanish supplier with euro debt to a bank in London, and Spain redenominates to the peseta, you’ve basically bankrupted that company, which means that your supplier is gone. How will your Spanish customers be able to pay you their euro balances when the peseta just devalued 50% against the euro? And post-break-up, will you be willing to sell to them in either euros or pesetas?”

Polyakov says that when considering the impact of a euro break-up, companies usually look at several different scenarios. “The first is that the break-up never happens,” he says. “The second is that the weaker players – namely Greece, Portugal and Ireland – exit the euro and everyone else strengthens up. The third scenario is a disorderly break-up in which someone as big as Spain or Italy falls out and there is a full disintegration of the euro. When running a stress test, people assign different future FX rates, interest rates and inflation scenarios to every one of those outcomes. They try to understand how their business will perform under each of those scenarios.”

A break-up of the euro might be the scenario that most companies are focusing on – but it is worth noting that it is not the only one. “Aside from the impact on the Eurozone, people are looking at the impact on emerging markets and the US dollar,” says Polyakov. “Will a European break-up strengthen or weaken the dollar? Another thing they are looking at is Asia and what would happen if the RMB was free floating. Latin America and the FX dynamics in that region are also of interest.”

Stress testing in practice

The prospect of a euro break-up was the key focus of a quantitative stress test undertaken by SAP last year. “We looked at the worst case that could happen – that’s not only Greece or three or four other countries leaving the Eurozone, but a total break-up,” says Steffen Diel, SAP’s Head of Treasury Finance. “We did some historical analysis first, which means that we took a look at the development of the European currencies against the deutschmark in the 12 years before the euro was actually introduced. That was quite interesting, because when you look at the Greek drachma, for example, or the Spanish peseta, they devalued quite considerably during that time.”

“One scenario we looked at was the possibility that the same historical devaluation could happen in the case of a euro break-up. The rationale behind that scenario is that the historical devaluation of the European currencies against the deutschmark was subdued to some degree by the single currency constellation. This pent-up devaluation could then be released in one shot following a break-up. So we came up with figures of up to 75% for Greece and 30%-40% for Italy and Spain, and that was our ‘base case scenario’ when we looked at how our revenue and operating profit in those countries would be impacted if we saw such devaluation against the new deutschmark.”

On the qualitative side, SAP also looked at the impact on existing bank accounts in those countries in the event of a euro break-up. “We asked whether we would have to change anything; what would be the impact on our existing euro cash pool; would there be any financing need for our subsidiaries in those countries?” Diel explains. “We considered whether we would see a situation where customers, such as those in southern European countries, would increasingly ask for guarantees by banks or by SAP AG given the uncertain environment. We also asked ourselves what would be the impact on the capital markets and our funding sources. In our case, we have a revolving credit facility with our core bank group and in the case of a euro break-up I would assume that the banking environment would get even more difficult and more volatile. So the question is whether you should focus on an early extension of such credit facilities.”

Diel points out that another consideration is the need to begin hedging the new currencies. “You have to make sure that the additional volume of FX hedges can be handled by the organisation. You also have to look closely at interest rate developments and potentially also consider inflation-linked investments,” he adds.

Contingency plan

Determining the impact of particular scenarios on the business is an important exercise for companies looking to manage Eurozone risks – but just as important is developing a contingency plan to prepare the business for specific outcomes. “Companies should clearly be doing liquidity contingency planning for a euro break-up, for example assuming the cash flow implications of a 25% decline in their European sales,” observes Wallace.

For many companies, the first course of action has been to sweep excess cash out of Europe or out of the countries perceived to be most at risk. Furthermore, a growing number of businesses are developing more detailed plans to cover actions that the company needs to take in the event of a euro break-up. Carlo Nazareno, Global Head of Managed Treasury and Liquidity Services Product, Bank of America Merrill Lynch, says that companies are increasingly engaging in peer-to-peer discussions in order to understand the challenges and get feedback on what other companies are doing to mitigate the risks.

Jack Spitzer, Starwood Hotels’ Assistant Treasurer, agrees that his company has spent a lot of time planning for a break-up of the euro, particularly in the last three months. “We’ve been minimising balances in Greece and all across Europe and putting them into dollar accounts in Australia or Canada,” he explains. “From an operations perspective, we’ve spent most of our time on Greece, developing a contingency plan that can be 90% applied to any other country in the EU. That template covers how we deal with anything from employees to vendors to customers, and how we deal with a change of currency from a systems perspective. Of course, all of the contingency planning is based on pure speculation as to what may or may not occur, but the exercise in itself is still valuable.”

AstraZeneca has recently set up a company-wide Eurozone task force in order to identify and understand the risks the company would be exposed to in the event of a Eurozone break-up. The task force meets on a weekly basis to monitor the situation. “It’s a piece of work that’s been underway since last September,” says Patricia Greenfield, the pharmaceutical company’s Head of Treasury Operations. “We’ve presented many papers to our Board and we’ve engaged with J.P. Morgan, HSBC and Citi to ask them what their mitigations are in the event of a collapse. We feel comfortable that they are well placed to provide an alternative banking service for any new currencies introduced.

“We have looked at things like days sales outstanding for our business. Most of the cost bases sit within the UK and Sweden and we’re controlling those quite well, but around a third of our sales are in the Eurozone, so there is some risk of customer default. But again we know where this is and we are monitoring it.”

In order to prepare for a possible euro break-up, the company has set up reserve accounts with J.P. Morgan and HSBC. “In the event of a euro break-up we would contact the head of the Eurozone task force and agree on the next steps,” Greenfield says. “Our banks have already guaranteed us new bank accounts for the legacy currencies of any countries exiting the euro – we’ve asked them to reserve account numbers for our businesses in Italy, Spain, Portugal and Ireland, so there are account numbers in existence, should that be needed.”

In the meantime, AstraZeneca operates a daily zero balancing structure which sweeps cash out of the Eurozone and into London. The only Eurozone country not included in the structure is Greece, for domestic and fiscal reasons. “What we have done is open up a bank account in London for our Greek operations, so that when they do get surplus cash, they put it into that account and that’s treated as a pre-payment for their inter-company netting,” Greenfield explains.

The euro may have survived thus far, but it is clear that companies are taking no chances. As Jack Spitzer concludes, “We’re doing everything we can to make sure that if something does happen, we’re as prepared for it as possible.”

Stress testing in three steps

Polyakov suggests that companies should focus on three steps when looking to undertake stress testing:

  1. Answer the simple question: do you understand how much uncertainty the financial market brings to your business, operating model and cash balances? Have you done a proper risk assessment exercise? If not, make it the highest priority.

  2. Examine how comprehensive that exercise has been and how imaginative you are in the market scenarios you are assessing. Stress testing is not adequate unless the scenarios under consideration are really stress scenarios.

  3. Don’t be afraid to talk to peers, banks or consultants in order to draw upon their collective expertise – this is not something that you should do on your own.