The world often turns to economists when ‘the finances’ aren’t going too well. But sometimes it seems that the professional requirement for this breed of expert is to predict what will happen and then to explain why it didn’t happen the way they predicted it would.
In fairness, risk ‘prediction’, and thus risk management, can be a very difficult task to undertake, even for trained experts. Financial risk management can be qualitative or quantitative but either way it is about identifying, assessing and addressing sources of risk. For treasurers without access to a lifetime’s accumulated knowledge and endless resources, the need is to shift the focus and response away from the ‘big picture’ of uncertainty towards market risks that are potentially damaging to their own organisations.
Part one: watching the numbers
In doing so there is still a need to find the balance between breadth and depth but trying to remove all uncertainty is not necessarily the right approach, claims Yuri Polyakov, Head of Financial Risk Advisory, Lloyds Banking Group. He believes that businesses must establish an “appropriate degree of risk tolerance” and then focus on the major adverse scenarios rather than getting too caught up in mitigating the risk of all rare market moves.
Of the tools that are available, Polyakov says the focus tends to be on hedging strategy and accounting rather than risk evaluation. If a business wants to understand how much its cash flows will be impacted by FX risk, commodity risk, interest rate risk or inflation risk, for example, he states that there is no perfect tool yet available that can achieve that.
There is evidence to this effect. Procter & Gamble talked at the EuroFinance conference in Barcelona last year about this problem. Its spokesman, Director of Global Treasury, John Byma, took delegates through the process of building its own risk toolset, driven by the absence of anything on the market to help. But P&G is a company with assets of $139.26 billion (2013) and has the resources to undertake such a project. At the same conference, Jennifer Ramsey-Armorer, Director of Treasury for Canadian communications firm, BlackBerry, talked about how FX volatility represented a huge risk to its operations and that because no solution existed to predict this risk it had to call upon a neighbouring University for help. It ended up with an Excel spreadsheet macro that could handle the calculations.
Methodologies
For better or worse, the solution for most treasurers without access to a risk department or huge resources still lies in the hands of their banks. As long as both bank and client agree on the methodology and, more importantly, the assumptions that drive the process, the results can be entirely credible, says Polyakov. For him, the methodologies are pretty simple anyway, “even though people can spend ten years or more talking about modelling the markets”.
He divides the process into three different steps. Step one is to model market uncertainty. “There are plenty of tools, methodologies and accepted algorithms that allow you to model FX rates, interest rates, commodity risk and so on – it’s not rocket science; there is nothing proprietary here.”
The key is not to try to predict specifically where the market will go, but to try to broadly understand where the market could go. The need is thus to uncover trends around each risk element (FX, interest rate, commodity price and so on) and the relationships between the different risk forces that act upon these elements, whether by studying current market implications or historical data.
Having made an assumption and modelled market behaviour around it, the next step is to consider the company’s business plan in the context of this model. If market uncertainty has been simulated and the company knows, for example, exactly when cash is coming in and in which currencies, and what its debt payments will be, it then becomes a simple spreadsheet exercise to generate an answer with a plus/minus range of acceptability, says Polyakov. “But if you change your assumptions, the results may change. This is where step three – stress-testing – is very important.”
By repeating the process with different assumptions it will be seen that some of those assumptions will have very little impact on results and some will have a huge impact. Those that do not have much impact are not a problem. “But if you realise that certain trends in a particular FX market, for example, have a big impact on your results, then that is where you should spend your time.”
Finding the areas of most impact will inform the treasurer’s operational activities in terms of hedging, for example. “But before you run off to hedge something, you should ask yourself if you can operationally change something to create the same level of risk mitigation,” he advises. It might be, for instance, more provident to reconsider the contract currency in which your buyers are operating. From a shareholders perspective at least, it is always better to optimise the business model before hedging.
Black swans
In all risk analyses there are external factors that cannot be predicted but which can significantly impact the markets. Major terrorist attacks, the outbreak of war or civil unrest, financial meltdown, geographic catastrophe: all are seemingly impossible to factor into the equation but all could happen. Can a business realistically be prepared?
So-called ‘black swan’ events – those that deviate significantly from the norm and which are very difficult to predict – were first introduced as a concept by Nassim Taleb in his 2001 book ‘Fooled by Randomness’. Taleb has since progressed his theory and now argues that as we have seen so many different black swan events in recent times it is possible to imagine and draw up a list of almost every possible significant incident. We have no idea whether any of these events will happen or not, nor when, just that they could; this is Taleb’s concept of the ‘grey swan’.
“People are much more aware of the breadth of scenarios that need to be evaluated, but they need to be very clear that whatever the level of confidence in a prediction, it is not the worst case scenario; things that are worse can and will eventually happen,” says Polyakov. The only sensible response to this, he says, is for a business to have enough liquidity on its balance sheet to survive unknown and major disruption. This begs the question for how long would the business need to be completely disrupted before it became unviable, the answer to which can be found in the business model.
In all risk analyses there are external factors that cannot be predicted but which can significantly impact the markets. Major terrorist attacks, the outbreak of war or civil unrest, financial meltdown, geographic catastrophe: all are seemingly impossible to factor into the equation but all could happen. Can a business realistically be prepared?
Ultimately, a large liquidity buffer is the only thing that will help if things become really disruptive. “You can manage risk all you want, but at the end of the day it is that unknown element, which can happen, that will hurt most,” warns Polyakov. The size of liquidity buffer depends on the business. Moody’s says Microsoft has $77 billion in cash; its arch-rival Apple is believed to be sitting on $147 billion. These are extremes, but all companies should take a holistic view of where their cash is and know that when calculating how much it needs the answer should be “a straightforward function of how long it wants to survive”.
Part two: watching the banks
There is no return without risk. And yet, as far as the banking system is concerned, the regulators seem to believe that their objective is to remove risk. They do things like applying higher levels of taxation and demanding ever more capital and liquidity against failure so that the risk shifts to another part of the industry. Then the regulators inspect the new source of risk and find ways of regulating that, forcing it somewhere else in the system. And so it goes on. “The logical extension of this risk management strategy is that we push risk to where we can no longer see it, because if we can’t see it we can’t do anything about it. That will not make the world a safer place.”
These are the words of Avinash Persaud, Emeritus Professor at Gresham College, a former Governor of the London School of Economics and Chairman of investment analysis firm, Intelligence Capital and London investment bank, Elara Capital. With years of experience in the field, Persaud knows that almost any activity can generate risk; it cannot be removed entirely and so the real question, he says, is how well it is managed and how easily its effects are absorbed. Banks may be regulated but they can still fail.
As such, when selecting a bank, as part of the due diligence process, a treasury should be aware of a number of indicators that could show that its prospective partner is heading in the wrong direction. The interesting factor is that none of these indicators require detailed numerical analysis.
Certainly for a treasurer seeking shelter from the ravages of recession, Persaud highlights three key areas of financial risk that must be known about any banking partner: its level of diversification (“concentration of lending in any one sector is a sure sign of risk”); leverage (“the less leverage a financial institution has, the safer it is”); and liquidity (“the shorter a bank’s funding, the more vulnerable it is”). But beyond the purely financial there are a number of risk factors that he believes treasurers can use as a measure of a bank’s susceptibility to failure. The first of these relates to the behavioural element of banking.
Remuneration
With politicians talking volubly about bankers’ remuneration packages, many may feel a little uncomfortable about governments getting involved in private sector pay. In this instance, perhaps this view is misguided. “Everything that happened in the financial crash was incentivised to happen,” comments Persaud. The lack of a requirement to provide capital adequacy against certain contracts meant banks were not discouraged from putting them off balance-sheet, he explains. Bankers were thus effectively encouraged to swap credit risk, for which they had a capital adequacy requirement, and take in liquidity risk, for which they didn’t. “The danger of having stratospheric levels of pay in banking is that it creates a tendency for lottery-style risk-taking.”
Why does anyone enter a lottery when most people know they have a low chance of winning? The answer, says Persaud, is because there is an opportunity, however small, of “life-changing” results. Before the crash (and some may argue after it too) banks would pay many of its staff life-changing levels of bonus. Where such opportunities for individuals exist it creates a risk-taking culture that steps well beyond the norm. Understanding a bank’s remuneration structure can give clues as to its risk-taking culture.
In a competitive environment a certain degree of risk-taking seems inevitable but the regulators have talked a lot about increasing competition in the financial sector, notes Persaud. “The problem is that competition seems to have a trade-off with stability.” The banks that fail, he observes, are often the “challenger banks”. For example, before it imploded, BBCI was offering much higher rates than other banks. The Icelandic banks expanding into Europe similarly went too far too soon, as did the UK’s Northern Rock – all failed spectacularly by trying to break into new markets. “Aggressive competitive behaviour is often a sign of a bank that is going to run into trouble,” he believes.
Aggressive or not, all banks like to talk about how customer-focused they are. A bank that has a deep customer franchise that exists because of long-term client relationships will encourage a broad connection across the organisation, says Persaud. “How often does your bank introduce you to other parts of the business? The more your bankers try to broaden the relationship, the more it is a sign that they are investing in that client franchise – not the individual banker’s franchise.”
Relationships
Internal and external relationships play a key role in Persaud’s proposal. “There was a time when it was thought by some that there were too many bankers and insiders on the Boards of banks, that they were too cosy,” he notes. The thought that people with no preconceptions about banking could steer a safer passage rose to prominence on the back of a belief that these people would question every move. When the crash happened it was discovered that there were many such individuals on Boards, he says. This suggests they weren’t as inquisitive as they should have been. The recent case in the UK of the Co-operative Bank which was steered gracelessly into a wall by its CEO who was, it transpired, untouched by banking experience, serves to highlight the need for knowledgeable guidance.
But some banks are better survivors than others and another indicator of robustness is how risk is treated at the highest level. “There was a tendency for banks in the run up to the crisis to amalgamate their risk committees with their audit committees,” notes Persaud. The problem is that the audit function is very different to risk management: audit is more of a box-ticking exercise (albeit a complex and demanding one) whereas risk management is not. “The more you merge audit and risk, the more risk becomes a box-ticking exercise,” he states, adding that this is a dangerous state of affairs.
If internal relationships with Boards and clients are very important for a bank, the relationship it has with its regulators is vital. Pre-crash, many banks were “openly disdainful” of their regulators, says Persaud. Post-crash it was the regulators, alongside the tax-payer, that saved some of these banks. “You can still sense the disdain, but regulators are human beings too; they don’t like being insulted.”
When the regulatory authorities were considering whether to save Bear Stearns and Lehman Brothers – two institutions that had “well-articulated disdain” for government regulators – he suggests that “there was no love lost” when they were allowed to fail. “There were other institutions arguably in similar positions that were rescued by regulators because they had a better relationship with their regulators,” he adds, further commenting that some of the huge fines meted out to banks today may have more than a passing connection with the state of their relationships. For a bank, attacking the regulator in public is seemingly ill-advised because if ever that bank is at the mercy of its regulators, the strength of the relationship counts more than it would like it to.
The key message to take from all these points is that a treasurer can manage risk using quantitative and qualitative approaches, and that although clearly the numbers have a lot to say if crunched intelligently, when assessing counterparty risk there are many other factors worth considering that can tell so much more. By studying all these elements and understanding the relationships between the different risk forces it is possible to make more informed judgements about future events – and that is as much as anyone is able to do.
