A WHOLE NEW BALL GAME
Businesses need to develop a new range of tools if they want to achieve truly holistic risk management.
By Denise Bedell
The world of risk management has changed drastically as a result of the economic and credit crises. Banks and businesses are changing the way they look at what risks they evaluate, and many companies are reviewing all risk-related policies—including bank selection, asset management policies and hedging policies—to ensure they are well-prepared for future risk events.
Counterparty risk has changed dramatically, as have both credit and liquidity risk. One of the biggest risks faced by companies and banks alike right now is counterparty risk. At the height of the crisis the big question was, who would survive and who would be lost in the fray, and many companies and banks were unsure from day to day who would be next to file for Chapter 11 bankruptcy protection.
“Counterparty risk is critical for corporates right now,” says Mike Cummins, head of large corporate sales for J.P. Morgan. “They want to understand the risk associated with their banking partners, the investments they are making and how those investments will affect the viability and financial standing of their bank in the future.” Some companies have also increased their total number of banking partners to act as a buffer should anything happen to one of them, which is still a real risk in some markets.
Credit risk is also a big concern for both corporates and their banking partners. This is a threefold risk as corporates deal with the rising cost of credit, fears that their banking partners may reduce or eliminate participation in credit facilities, and risks over the long-term strength of their banking partners. They must pay attention to the terms and conditions of credit facilities and the costs when they mature.
At the same time, liquidity risk management has become a much more important part of the job of a treasurer. “We, as corporates, now realize it is important at any time to remain liquid,” says one treasurer. “This is definitely a lesson we have learned over the past year.”
Companies are now using more quantitative tools to better assess the sensitivity of their portfolios to credit risk and taking more sophisticated approaches to quantifying mark-to-market value. “We measure the credit risk of each fund and also the aggregation of exposures in our portfolio to ensure we don’t face too much risk,” adds the treasurer.
In addition, risk management hedging policies are changing as companies deal with massive market fluctuations and the impact that has had on their derivatives products. Says the treasurer: “Also we have to think about internal controls. We had policies and procedures in place, but we must review all of them now.”
Using Available Technology
There is a greater corporate focus on enterprise risk management, and many corporates are now taking a much closer look at how their ERP systems, treasury workstations (TWS) and other systems can provide data and tools to help in creating a global, enterprise-wide risk picture. Particularly with the focus that Standard & Poor’s has placed on enterprise risk management in corporate ratings, companies increasingly have a focus on operational risk and how to manage it on a global basis.
Enrico Camerinelli, senior analyst for Europe at consultant Celent, says that corporate dependence on Excel spreadsheets makes holistic risk management impossible. Holistic management requires new tools and better data integration. “Treasurers are seen much more as the channel that provides information on a day-to-day basis on cash positions, FX risks and so on,” says Camerinelli. “They are under pressure to provide all of this information, but they don’t have the means to because often their basic underlying systems are not sufficiently integrated to pull out that data.”
The ERP may have the necessary data, but moving it from the ERP into a spreadsheet is unwieldy and inefficient. Sophisticated risk assessment tools may already be available to treasurers, as treasury management systems—such as SunGard, Wall Street Systems, FXpress and Misys—all come equipped with a risk management module.
But in order for these solutions to properly work they must be fully integrated with the ERP, TWS and IT management systems so needed data can be pulled out for analysis, otherwise, that analysis cannot happen. This is a big challenge for many corporates going forward: moving beyond Excel spreadsheets to more sophisticated risk tools and analyses.
As part of that holistic operational risk approach, treasurers must also have a more in-depth understanding of the processes that make up that risk, says Camerinelli. “The treasurer should become more aware of the business processes that pertain to the physical supply chain of the company—knowing the needs of the purchasing manager, sales manager, supply chain manager, logistics manager and so on—in order to understand the different inputs and business imperatives of the working capital chain. Treasurers must make this jump from looking at the trees to looking at the forest. A company is not just made of financial transactions, and that perspective is missing right now,” he says.
Next Stage in Bank Evolution
It’s not just corporations that are changing how they measure risk. Banks are also changing the way they look at risk. Anders Kvist, head of treasury at Swedish banking giant SEB, says: “The whole concept of liquidity risk has a lot more focus than ever before, and banks are managing liquidity in several dimensions: the marketability of securities held, liquidity in funding the balance sheet of the group, and accessing short- and long-term funding from different funding sources.”
This is critical not just from a practical financial institution perspective but also as an agenda-topper for regulators. The question that everyone is dealing with is how to curtail liquidity risk at systemically important banking institutions. This is not a simple question.
“The way I see it is that banks have always been good at measuring, evaluating and managing credit risk,” Kvist says. “Then, about 25 years back, they started improving the way they manage market risk. And now we come to a third risk category of liquidity risk, which arguably has been neglected in the recent past.” He says that one interpretation is that mismanagement of liquidity risk created the crisis and that now, as banks relearn how to manage liquidity, it is the next stage in the risk management development of financial institutions.
In order to better manage liquidity risk, banks are reducing their dependence on wholesale funding by deleveraging their balance sheets so overall funding requirements go down, and they are working to improve the balance between fixed assets and their deposit base. In addition, banks are more willing to extend the duration of their wholesale funding, even though that comes at a cost.
“This increasing cost would have a devastating effect on banks’ net interest income if they didn’t charge a higher cost of liquidity back to their borrowing customers,” Kvist notes. As such, corporates are now paying not just for their own credit risk but also the transfer pricing for the cost of liquidity and liquidity risk that the banks face.
Liquidity is being managed more carefully, but corporate credit customers are feeling the impact of that. It is a changed world for both banks and their customers, as both sides of the market work to improve their own risk management and deal with the outcomes.