Treasury Risk Management - Expect the Backlash
Author:
John Finn
[Full text] Treasury management is a strange area. Many people are not sure what it is about and so choose to ignore it as best they can rather than take the time to understand it. Depending on who and where you are, such a strategy may be costly as recent events have shown.
To paraphrase a saying I once heard: "the one thing that we have learned from history is that we have learned nothing from history".
Itâ??s a maxim we could apply to derivatives or off-balance sheet accounting or â?¦ the list goes on.
The result of these recent events will be to change the attitude of many parties to assessment and management of risk. Expected reactions are as follows:
Corporates may find their ability to deal in derivatives (and I refer to forward contracts as much as sophisticated options structures) will be curtailed as banks insist on the establishment of dealing mandates and ISDA agreements.
Result: Positive. Mandates can protect corporates as much as banks but are nearly always seen as low priority by the former.
Bank lending could tighten as banks require capital in order to lend. The coming months may make it difficult for financial institutions in general to raise extra capital.
Result: Negative. If capital gets scarce, pricing could go up and/or terms get tighter and/or banks re-assess their loan portfolios with a view to reducing their exposure to certain companies or sectors.
Derivatives will come under scrutiny again with a resultant decrease in their use by corporates.
Result: Negative. Don't throw out the baby with the bathwater! Use of derivatives is not the problem - it is their abuse that is the issue. Doing nothing can be a riskier strategy than using derivatives unless the "do nothing" scenario has been evaluated against other strategies and deemed to be acceptable in that context.
We will see a drive to put everything on-balance sheet including mark-to-market losses on derivative contracts regardless of their size, maturity, or purpose.
Result: 50:50! The need to police this area better is a given as users of accounts including shareholders and employees deserve to be put in the picture regarding potential hidden liabilities. Yet, I have a feeling that like financial markets, the reaction to sudden sharp shocks is always overdone. It is likely that moves to standardize international accounting practice in this area will be accelerated or will meet less resistance. Whilst it has certain appealing qualities I still have grave reservations about the "one size fits all" approach. Banks already try to include mark-to-market losses on interest rate swaps used to hedge borrowings in their definition of debt for covenant calculations despite hedges being put in place at their behest!
Non-executive directors will find their role becoming more important and more significant.
Result: Positive but ...! There should be increased use of non-executive directors especially in areas where the Board is short of expertise, or indeed, dominated by a single individual. Institutions will have an important role in this regard in the future if they choose to take this route. Private companies tend to use non-executive directors less frequently than plcs but their value to private companies is of equal importance. My qualification to the positive assessment above is due to the "apparent shortage" of good non-executives. A trawl through the Boards of plcs seems to throw up a lot of the same names. I am not trying to suggest that these people are anything other than capable of undertaking these roles but I am asking if the pool of appropriate candidates is really that small? God forbid that anyone under 40 and female be considered!
The demise of the defined benefit pension scheme in Ireland has been accelerated due to the fall-off in Irish equity values.
Result: Positive / Negative (for corporates / individuals respectively). The move to defined contribution schemes will ease the burden for corporates as it will give certainty to their contribution levels. The losers are pension scheme members on to whom the burden of risk has been shifted. They will now be forced to live with the uncertainty of not knowing final pension levels until close to retirement age.
Economic recovery may be delayed by the effect of events on stock markets in general and the Irish stock market in particular.
Result: Negative. The concern is twofold: poorer returns had already placed additional pressure on corporate contribution levels to pensions in 2001. This trend could continue in 2002 resulting in cost reductions in other areas to fund the shortfalls. The other risk is one of consumer spending - if employees start to worry about final pensions, their only choice is to increase their saving levels now. An increase in the savings ratio reduces disposable income which has a negative effect on consumer spending and economic growth.
Auditors will come under increased pressure amd their role will be subject to further scrutiny.
Result: Probably negative. Auditors can often be scapegoats for the deficiencies of controls and / or management so I have some sympathy for them. If employees can devise methods to escape internal controls, internal audit functions and experienced management, it is probably unlikely that external auditors will uncover such schemes given the scope and nature of their work. However, their role in situations where they are aware of issues but have an opposite view to management will be telling.
Expect annual audits to be focused on treasury risk management and to be uncompromising in approach.
Treasury risk and controls will benefit from increased awareness.
Result: Positive. There would appear to be unease and lack of understanding about the topic particularly among personnel up to and including Board level resulting in an unwillingness to devote time to rectifying the situation. This has to change as if the risks exist they must be addressed by the Board under corporate governance regulations.
Whistleblowers may find some clarification of their position.
Result: Positive. According to the media
there is no protection in law afforded to
"whistle-blowers". This has to be re-examined as, apart from the moral obligation, there can be other conflicts. For example, even if no legal protection is afforded, chartered accountants have an ethical obligation as members of the Institute to behave in an appropriate manner. This could be a "lose/lose" situation as failure to report breaches Institute requirements but reporting offers no legal protection.
While some of the effects outlined above are obvious, others are less so and all are worth contemplating. The one thing that has struck me about the whole area of risk management over the recent past has been the lack of time devoted to it from either operational or strategic perspectives. It is the latter that is surprising given the importance attached to strategic planning, at least in theory, by progressive firms. Equally surprising from my experience, is that it is not a forgone conclusion that public companies are more likely to be any more sophisticated in this area.
The pressure of six monthly reporting can increase the onus to deal with impending rather than strategically important issues.
The bottom line in all of this is that the impact of the AIB, Enron and Elan media coverage will have an effect on attitudes to risk management in a wide sense for 2002 and beyond. Be proactive or be caught in the backlash!
Accountancy Ireland Vol 34 No 2 April 2002