Trade & Supply Chain

Treasury’s companion

Published: Apr 2016
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A treasury policy allows the treasury team to conduct activities with the level of flexibility needed, defined by accepted parameters. At least, that is what’s meant to happen. In this article, we look at the importance of exception handling and regular reviews to ensure harmonisation with market and business developments, amongst other priorities, to explore the fundamentals of what a good treasury policy should cover.

No treasury department should be without a treasury policy. The document is typically divided into a body (including the overall approach to treasury management in terms of scope, objectives, roles and responsibilities, the management of transactions, balance sheet and liquidity, and risk) and annexes detailing specific execution minutiae.

Having a well-defined treasury policy ensures treasury staff have written guidelines on their responsibilities and, more importantly, how to fulfil these. It will also detail their boundaries and how the department’s performance will be measured, minimising the risk of internal fraudulent activity due to the failure of suitable policy. “The most important part of the policy is the fact it needs to be adhered to at all times,” says Aashish Pitale, Group Treasurer, Essar Services India.

Making the right call

The processes treasury carries out are not areas in which to be vague; the value of a policy is largely dependent on the extent to which detail is provided. It is insufficient, for example, for a policy to simply state ‘forwards should be used to manage FX risk’. Rather, it is important that the treasury policy sets out what strategy should be used, and why, relevant to the particular business. The eventuality to avoid, according to Dana Laidhold, Treasurer of The Carlyle Group, is a “policy for the sake of policy mentality without a clear link back to the business”.

A Chinese manufacturer will have different priorities to the electronics company in Europe that buys parts from them, for instance. As a hypothetical example, in regards to currency transaction exposure, the latter’s policy might state something such as: ‘We import electric components from China (priced in US dollars), to sell in France (priced in euro). We pay the Chinese manufacturer 30 days after invoice date. We typically get paid within 14 days of shipment. From the point at which the obligation to make a payment from the Chinese company arises to the point at which the supplier is paid for those goods (in US dollars), the euro equivalent of the payment will fluctuate in accordance with movements in the USD/EUR exchange rate. Treasury’s aim is to hedge this risk to ensure the products can be sold at the profit margin forecast when the goods were purchased.’

The acceptable hedging instruments, exposure limits, approval process and use of any natural hedge will then be set out, based on this initial justification. It should have a fair amount of flexibility. As Pitale says: “When decisions are made by the treasury’s risk management committee on how to execute the policy, they respond to market conditions – but crucially within the framework of their policy. The policy document itself is not meant to change habitually in response to market conditions.”

Key considerations when establishing a good treasury policy are, therefore, to focus on the document’s compliance with local and international regulations as well as conforming to the objectives of the organisation. Taking a reactive approach, or deviating from policy because of volatility, Pitale says, can lead to treasurers “burning their fingers badly”. He highlights the current oil price volatility as one area which has caught out some international treasuries in this regard. It is worth emphasising that treasury is there to achieve its objectives, not to ‘win’ (or ‘lose’) on a particular hedge. Therefore, Pitale advises: “Stick to your policy during all times of market volatility.”

Risks to address:

  • Market risks: interest rate risk, FX risk, commodity price risk.
  • Credit risks: counterparty and settlement risk.
  • Liquidity risks: cash flow risk, market liquidity and funding risk.
  • Operations risks: human resources risk, fraud risk, business continuity risk.
  • Legal risks: covenant risk and other legal risks in the mandates a company has with banks and other financial suppliers.
  • Systems risks.
  • Appetite for risk should also be addressed.

The first (and ongoing) steps

For this to be possible – and to avoid the occurrence of poor market-based decisions – policies should be tailored to the individual company’s business model. The starting points are largely the same, however, and the creation of a treasury policy can be split into three key stages:

  1. The identification of all the activities which routinely take place in the treasury – and all of the risks which the company faces from a treasury perspective (see box above). This is an aspect where the finance director and the other departments which regularly work with the treasury (eg tax, accounting, and internal audit) should be involved.
  2. Developing the set of procedures and strategies for managing the risks identified in the first step. This analysis and decision-making should be the responsibility of the treasurer and finance director.
  3. Approval from the board. This approval process will vary from company to company, of course, depending on who was responsible for drafting the policy. Ideally, this approval should take the form of a formal vote of confidence at a full board meeting.

As Laidhold says: “What’s most important is to balance risk management with effective business operations. Policies should be underpinned with effective and executable processes.” To ensure this, her treasury team alongside writing the policy also drafts the operating procedures in narrative form and often use visio charts to ensure they will be efficient and “to plug any gaps”.

After which comes approval – but by no means is this the last step. “Every business is organic,” says Laidhold. Periodic reviews are a necessary part of ensuring a treasury policy matches developments within the business and in the industry – and therefore guarantees the department can operate in the relevant manner, without the constraint of an outdated policy. Reviews are typically annual but “to the extent that something material happens in the market or business, we may look at them more frequently than that”, Laidhold explains.

Factors that should be addressed in any policy review include: changes to regulations, changes in key personnel, and changes in the company’s business due to mergers and acquisitions, divestments, any relocation of operations, adding new business lines or products and major changes in the operating/reporting currency(s).

What if… policy isn’t adhered to?

The policy should outline sufficient checks along the way “so something damaging can’t reach a point of material impact late in the game”, says Laidhold. Proper segregation of duties, levels of review and checklists, therefore, are essential “so that you minimise the risk a policy won’t be adhered to because you have a lot of cooks in the kitchen managing that process”.

She continues to say that to the extent which a treasury department writes a policy, implements it but doesn’t provide “training, ability for input or guidance for all affected stakeholders,” problems are bound to be encountered.

There are also external factors to consider, which are equally as driving. Laidhold provides the current example of changing factors in the short-term investment landscape – Basel III, Fed moves, prime Securities Exchange Commission (SEC) money market reform, for instance. “That influences treasurers to go back, look at their policies and make sure the department is equipped to effectively operate in that new environment.”

Having an up-to-date policy is not only vital for control, consistency and the assessment of new risks, but also the assessment of new opportunities. Reviews can ensure the department is utilising current best practice. This is particularly relevant to technology enhancements, says Laidhold. “It is important to stay abreast of technological developments, as new tools can make your operations more efficient and/or add controls.”

Do note, however, that not every area of a policy changes year-on-year. “It doesn’t have to be a monumental exercise and you don’t need to reinvent the wheel,” advises Laidhold.

Beyond the basics

Most departments will have these basics covered, but there are areas worth emphasising. Exceptions to the procedures set out in the policy, for instance, are bound to occur and therefore warrant inclusion. A comprehensive policy will contain guidance on exception handling with resolution methodology – but from the start, it clearly cannot contain every exception. With each new exception, new knowledge can be included in the policy to ensure resolution can be achieved quicker should it happen again.

Whilst being an overarching document then, a balance needs to be struck between a policy containing necessary and comprehensive restrictions and one that is practical enough for the day-to-day operations of an individual treasury department. “This too shouldn’t be seen as daunting, however,” says Laidhold. It’s about bringing together stakeholders from within and outside of the treasury department that will be impacted by policy and the supporting operating procedures. “By doing so upfront, you get that buy-in and make sure you are striking the right balance between governance and risk management, and allowing procedures to remain efficient in impacted operations,” she says. “Turn over every rock together.”

A focus on risk

As the need to manage liquidity and risk has become more pressing during recent times, the importance of clearly defined conditions for some operations should not be overlooked – limits for market-related transactions, for instance. Again, this is an aspect which will not achieve equilibrium from the outset, emphasising for another time the importance of regular reviews. Limits set maximum and minimum levels of exposure for market factors. Examples include: no more than $8m of crude oil exposure to remain unhedged, no more than 1% of spare cash to be retained in RMB and no less than €5m of investment in money market funds.

When review time comes around, cause for change on limits could be, for instance, extremely large unutilised limits or regular limit breaches (from the perspective of operational and/or trader discipline and the adequacy of the limits in that market factor). Scandals in recent years reveal that it is these basic controls which are typically breached.

In addition to complying with limits, some of these (larger) transactions may require approval from senior members of the company. These people, however, are frequently travelling for meetings and conferences and are unlikely to be immediately available in all instances – consequently requiring the policy to cover the procedure in these cases (markets cannot wait for CFOs to return to address pending transactions). For most companies it will be pertinent to have pre-approved ranges so, should those people be out of the office, transactions can still go through on a case-by-case basis.

A matter of detail

Treasury policies need to reflect the risk appetite of the company. But, as alluded to, it is a fine line to tread when trying to establish a policy with sufficient detail to be a document relevant for serious use, but one without an overbearing amount of different elements to fulfil. For example, a statement such as “our objective is to maximise our return on liquid investments at minimum risk” is of little value as a policy on the treatment of cash deposits. At the other extreme, however, a treasury policy which lists the names of appropriate counterparties for cash deposits provides too much detail. Whilst the policy should specify the criteria for an appropriate counterparty, this would be too inflexible.

The key concept to bear in mind is parameters. If a policy doesn’t provide clarity of the acceptable margins in which to respond to such questions as ‘what conditions on borrowings is the company prepared to accept?’, ‘how is data held and stored on the systems and for how long?’, ‘what is the ideal maturity profile of the company’s borrowings?’ and ‘how will the company measure exposure to interest rate risk?’, then it’s time to revisit.

It is worth noting that the aspects covered here – such as appetite for risk, frequency of review, market limits – will be influenced by company-specific factors such as corporate philosophy, extent of natural hedges, volatility in cash flows, volatility of the business sector, what competitors are doing and what advisors say, for instance. That is why it’s important when answering questions like those above to not rely on a one-size-fits-all approach, but to focus on your specific operating model. What’s more, individual treasurers will bring their own beliefs, standards and expertise to the table.

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