Treasury Today Country Profiles in association with Citi

A matter of policy

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If a treasury investment policy has not changed to reflect the ‘new normal’ of regulatory reform, market volatility and struggling interest rates, then something is very wrong. Treasury Today looks at the processes involved in establishing an investment policy that is fit for purpose.

With regulatory reforms in the money market fund (MMF) space and the far-reaching implications of Basel III making their mark on the financial community, corporate investments are facing the kind of pressures now that warrant very close attention. This attention must inevitably extend to investment policy as treasurers struggle with an unprecedented period of low interest rates across the major currencies that shows little sign of lifting anytime soon.

“It’s clearly an extremely challenging environment,” says Roger Merritt, Managing Director, Fitch Ratings. “I cannot think of a time, certainly in the past 25 years, that treasurers have faced so many different challenges at the same time with regards to how they can effectively manage their liquidity.”

Back in April 2015, Fitch Ratings published a report suggesting that if treasurers are not already looking at a policy review in this context, then they really should be. The report said that it is high time for “a proactive, strategic update of investment guidelines” and that corporate investors should give particular thought to future changes in cash management products and ratings coverage. “If the world of cash management is changing and the products that you are used to investing in are not available any more – or perhaps not available to the same degree – then flexibility with regard to the type of products that fit with your investment guidelines is important,” Merritt explains.

The balance of yield versus liquidity versus the inevitable cost of carry that holding cash incurs is an unenviable task. It is thus the role of an appropriate investment policy, in the words of the Association of Corporate Treasurers (ACT) Handbook, to “encapsulate how a company’s risk appetite translates into practical objectives and rules”. This appetite will be determined by a number of factors including the nature of the industry within which it operates, the strategic direction of the company itself and the resources available to manage risk (both in terms of skill and experience of its personnel, and its ability to absorb any losses).

Think again

There are three areas treasurers may wish to focus on when revising policy, says Hugo Parry-Wingfield, EMEA Head of Liquidity Product at HSBC Global Asset Management. First, as ratings agencies continue to review and in some cases downgrade banks, corporates should be thinking about whether polices do indeed remain ‘fit for purpose’. “Companies should not simply adjust their criteria downward in response,” says Parry-Wingfield, “rather there should be a deep analysis to decide whether they have the right – and sufficient – counterparties.”

The second area for consideration is the investment products referenced in an investment policy. If the ability to place some short-term deposits with banks is becoming limited, then perhaps treasury needs to explore if other instruments are needed, such as MMFs or direct securities (see the section ‘Try something new’, opposite).

Finally, in light of Basel III and the introduction of the LCR, corporates should also be thinking about how their investment policies define their liquidity profile. “The treasurer should now be reviewing what liquidity they really need to run the business. There is always an opportunity cost to holding too much liquidity but we believe that is going to be accentuated in the months to come,” adds Parry-Wingfield.

As part of its Treasury Leadership series of videos, J.P. Morgan’s ‘Is Your Investment Policy Holding You Back?’ provided viewers with some thoughts on structuring an appropriate investment policy. Jose Franco, J.P. Morgan Liquidity Solutions, EMEA Regional Executive, considered the realities of investing in the current environment, commenting that the negative rates seen in some European countries means treasurers “could be breaching the company’s investment policy as negative yield erodes capital”.

The J.P. Morgan take on this situation is that treasurers can either adopt the view that, in time, interest rates will rise above zero (whilst realising that their current investment policy is not adequately structured to deal with a negative rate scenario) or alternatively, they can help re-write the investment policy to address the risks associated with these unusual market conditions. In the latter, the suggestion is to consider reducing reliance on overnight balances by extending the yield curve. This strategy, it advises (in concurrence with HSBC’s Parry-Wingfield), must be balanced against liquidity requirements and risk appetite, since some businesses may feel that sacrificing liquidity will not compensate for a longer-term investment’s potential returns.

The changing face of policy

The purpose of an investment policy has necessarily changed in recent times, notes Steve Baseby, Associate Policy and Technical Director, ACT. The emphasis since 2008 has been more about return of capital than return on capital, and counterparty exposure management has risen to the fore. With the availability of funding now in question for some borrowers, he feels that policy will also tend to lean towards depositing surplus cash with relationship banks, “as a reward for offering credit facilities”, although the demands of Basel III are making short-term cash deposits less attractive for banks.

And when it comes to steering policy in the right direction, Baseby notes a current tendency to be far more reactive. “Prior to the 2008 banking crisis, a treasury policy might have remained almost static for years on end; now there is usually a requirement to change it in the period between regular reviews.” Often there will be provision for ‘emergency changes’ to be effected. With improved communication and awareness within business, counterparty exposure for cash holdings is something that he sees as “high on the list of things most executives and non-executives will monitor”.

Aside from changes in the risk of target counterparties, bringing policy into line with current needs requires that a number of other key elements be considered when establishing or re-visiting an investment policy.

Treasurers are still thinking in terms of what can be done if they need to access their money quickly. Investment policy must dovetail into the liquidity requirements of the business and the evidence seems to be that most are sticking with simple deposits because they can build in fixed maturity dates, Baseby notes. In fact, in a very high turnover cash business, it is likely that most or all maturity dates will be short term, but for other business models, forecast accuracy is increasingly important as a means of determining investment strategy – there is after all a boardroom requirement to know that, should some event beyond treasury’s control suddenly impact the business, it will not run out of money. “Forecasting used to be something that companies did on an approximate basis, on a weekly cycle, over the next quarter. Now it is done in much more detail.”

For this reason, there is today more active oversight of where funds are, and why they are there. But how often should policy be inspected to keep investments relevant? “Investment policies are not supposed to be something that change every six months,” says Jim Fuell, Head of Global Liquidity, EMEA at J.P. Morgan Asset Management. “They are broadly written, but with a level of constraint. Having said that, though, I think it is also important to build in some level of flexibility that allows you to navigate through some of the impending changes without necessarily having to go back to the board for further approval.”

A general rule of thumb is that it should be revisited annually at least, but more often during times of market stress. Certainly a policy that never changes should be a thing of the past, but conversely there should be a wariness of over-analysis. One means of avoiding so-called analysis paralysis is to make accurate and timely data easily available in a format that avoids confusion.

Sitting on the dashboard: case study

Harvesting and presenting information to fulfil the high level needs of the board and the broad practical requirements of treasury is a function of advanced technology. The confluence of IT and investment policy is an approach taken by Dow Corning, a global leader in silicon-based technology and innovation. Its specific focus was counterparty risk management which had, by the company’s own admission, historically fallen short of industry standards. The process had involved a considerable amount of manual monitoring, was primarily reactive versus proactive and was limited in scope: “Treasury realised that this approach was not acceptable,” says John Coon, Global Treasury Manager, Dow Corning.

With thoughts of protecting its $2bn-plus in cash and investments from counterparty default to the fore, in 2014 Dow Corning created a Global Cash and Investments Committee. It consisted of a cross-functional team with members from Customer Financial Services (CFS) and Treasury. The team adopted a mission statement to “ensure that the risks associated with the company’s global cash and investments are monitored and are made transparent, leading to best in class practices supporting our investment objectives as defined in the Dow Corning Corporation Investment Policy”.

With this in mind, it set itself a number of practical goals including the implementation of a counterparty risk limit model, and the creation of a monitoring system in which risks could be quickly identified and remedied. The result – a Treasury Today Adam Smith Award 2015 Winner – was an internally developed risk limit model capable of aiding and checking the implementation of investment policy. This uses multiple independent sources of counterparty and default risk metrics including balance sheet health at bank-parent and subsidiary levels, as well as regulatory data such as Basel III risk ratios. Aggregated data is presented via a centralised “fully-automated one-stop-shop” dashboard for treasury. It enables easy daily monitoring of financial counterparties and provides a clearly defined escalation process when credit events occur. Functionality includes limit usage by financial institution (delivering real-time monitoring with alert notifications for breaches) and breakdowns of limit usage by cash type (for example bank accounts or time deposits). In addition, it provides background credit ratings information and credit default swap (CDS) activity for all counterparties.

“Investment policies are not supposed to be something that change every six months.”

Jim Fuell, Head of Global Liquidity, EMEA, J.P. Morgan Asset Management

Counterparty risk management solutions tend to use one or two sources of data to monitor risk. Dow Corning has developed a comprehensive limit model using in-house quantitative measures and credit risk metrics with real-time updates to a dashboard that incorporates supplementary sources including Bloomberg and Credit Risk Monitor. Coon explains that the overall process includes a “forward-looking, scalable model” to assess counterparty risk. It gives a 40% weighting for in-house quantitative measures using bank financial statements. Short and long-term credit ratings from multiple rating agencies are given a 25% weighting. Probability of default, calculated using a third-party tool with real-time market data, has a 25% weighting. The final 10% is made up of the Dow Corning Intangible index, incorporating a scale of bank service offerings and other relationship criteria.

“Like any risk management solution, it is difficult to place a figure on an event that you avoided by having the necessary safeguards in place,” says Coon of the system’s value to the company. “What we can say is that our ability to rest easier at night knowing our assets are allocated appropriately is worth a lot to us.”

Trying something new

Whilst treasury should always adhere to policy, the generally changeable state of the market requires having the flexibility to respond in a timely manner to any cash or investment issue. It is therefore Baseby’s view that companies should have an “escape valve” to use when investment for some justifiable reason cannot remain within those conditions. A treasurer may be granted power to step beyond policy in certain circumstances but usually an exception would be executed through the Finance Director, CFO or, if a major breach of policy is required, then by referral to either an internal committee of senior executives or the board.

Regardless of the difficulties that investing may present, dealing with lower-rated institutions and products is not inevitable in today’s low/zero return environment. “Treasurers are beginning to find other ways of achieving security,” notes Baseby. The repo (repurchase agreement) market is developing to enable short-term (usually three to six months) investors to mitigate counterparty risk by taking baskets of high quality securities (such as bonds or equities) in exchange for cash.

Repos are often perceived as difficult to administer by the inexperienced user: this is almost certainly criticism levelled at bi-lateral deals where a corporate must find a custodian, manage a complex contract and have valuation, settlement and variation margin capabilities. But as an antidote to such difficulties, tri-party repos are gaining ground. Here, an appointed collateral agent does most of the background work so that beyond fine-tuning the standard contract (the Global Master Repurchase Agreement or GMRA), establishing any policy restrictions and preferences, and issuing instructions to go to market, the operational involvement of the treasurer is minimised.

Indeed, Baseby’s observation is that this route into the repo market appears to be the favoured one for the corporate investor although, he adds that the agent may seek to manage a number of counterparties on behalf of its corporate client to make it worthwhile. In policy terms, this may be desirable anyway, as not only will treasurers feel more comfortable lending more to counterparties with covered cash than without, it also means they can lend against the quality of collateral, not the borrowing institution, and this in itself may generate more scope for deals.

This may even open up safe non-bank financial institutions as viable deposit counterparties – insurance companies and pension funds sitting on high quality securities from time to time need short-term cash and at least one London broker has software enabling these transactions. This could be a market to watch as a means of diversifying investments without degenerating credit quality. As long as there is full understanding of what is being done, and that it does not conflict with policy, then arguably any collateral is better than no collateral in risk management terms.

With treasurers in ever-closer engagement with the wider corporate finance function, it has placed them in the driving seat as far as preparing and acting on investment policy is concerned. An effective investment policy need not prevent a progressive approach to cash and liquidity so that it is entirely possible to reflect the dynamic landscape of regulatory reform, market volatility, and low, zero or even negative interest rates whilst providing sufficient headroom to add yet more value.

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