A Structured Approach towards a Best in Class Financial Risk Management Framework
The increased volatility in the commodity and foreign exchange markets, augmented counterparty risk and the low interest rate environment have led to an increased focus on financial risk management (FRM) for multinational corporations (MNCs).
Many surveys confirm that further strengthening of the FRM function is in the top 3 of the CFO’s agenda. Zanders observes an increasing desire by corporations to transform their current FRM practices and pursue, amongst other activities, increased and company-wide risk visibility, enhanced risk quantification and eventually a more holistic and integrated FRM approach with the overall objective to enhance shareholder value. Based on years of risk management experience, Zanders has developed a structured FRM Transformation Approach that provides MNCs a solid and proven methodology to reach these objectives, which we will explain in this article.
Financial risks as a collateral effect
First of all it is important to define financial risk management in a corporate context. FRM focuses on measurable and manageable financial risks, such as market risk (e.g. FX, interest and commodity risk), liquidity risk and credit risk. These financial risks can be seen as a collateral effect for corporations as a result of business risks. Business risks arise from the specific business activities including international trade, investments in working capital, capital expenditures and the design of the supply chain. Considering that shareholders invest in companies primary to seek exposure to (and compensation for) the specific business risks of a corporation, financial risks are likely to be perceived by shareholders as a negative side effect.
Therefore, it is vital to ensure that a company’s FRM practices are aligned with shareholders’ expectations. As a consequence, it is paramount for every company to have a solid FRM framework in place in which it is clearly stated how the company manages its financial risks. As explained in the introduction, volatility in financial markets is currently a primary driver behind FRM projects. Other internal and external factors which may trigger a company to revisit their FRM framework include:
- MADS events (Mergers, Acquisitions, Divestures, Spin-offs)
- Organic growth of the organization (especially into Emerging Markets)
- Changes in the regulatory environment
- Desire to be innovative and best-in-class
Holistic versus Integrated Financial Risk Management
Zanders increasingly observes a shift in the MNC’s FRM approach from a ‘silo-based’ FRM approach towards a more holistic FRM approach. In such an FRM approach the various relevant market risks as well as the link to liquidity risk and the company’s credit profile are analyzed in a holistic manner. A quantitative approach to measure the potential impact of financial risks on key financial parameters – such as earnings, net income and financial covenants via ‘at-risk’ quantification measures (e.g. earnings–at-risk) – is becoming the new standard in the treasurer’s toolbox.
Next to the move towards a holistic FRM approach, Zanders notes a trend towards more business integration. Integration between treasury and the broader business organization is a prerequisite for an effective FRM approach. Business integrated treasury organizations can add value through early identification of financial exposures and by being able to anticipate financial risk consequences of business decisions at the exposure origination stage. Concepts such as Risk Adjusted Return On Sales (RAROS) are a key example of this. With RAROS, FRM is part of a company’s commercial process. Financial risks of specific transactions are quantified in order to determine the true economic value add of a specific transaction.
A Structured and Proven FRM Transformation Approach
While multiple triggers may require the revision of a company’s FRM framework, it is essential to define a solid approach in order to achieve objectives. Based on years of risk management experience, Zanders has developed a structured FRM Transformation Approach. Transformation in this context refers to the comprehensive definition and implementation of the future state of FRM, taking into account all relevant aspects including the strategy & organization, exposure identification and quantification, risk modelling, processes, systems, compliance, (hedge) accounting and valuations. We will highlight some key aspects of each of the project phases in the following sections.
Figure 1: Zanders’ FRM Transformation Approach
Review and Assessment
In the Review and Assessment phase an in-depth understanding of the company’s financial risk profile is established and the current FRM practices are reviewed in detail.
In order to establish the company’s financial risk profile, first all relevant exposures need to be identified by researching, amongst other, the following aspects:
- Company profile and international footprint
- Analyzing the cash flow forecast
- Identifying the main business activities generating financial risks
- Analyzing contractual terms and conditions (e.g. pricing and invoicing currencies, price adjustment clauses, etc.)
This will ensure that the origination of financial risks is fully understood.
Subsequently, exposure quantification (measurement) will take place by assessing the likelihood and potential impact of actual financial exposures on key financial parameters. Based on the outcome of this impact analysis the most important financial exposures can be identified and prioritized.
During the Review and Assessment, Zanders often observes a misalignment of the client’s corporate strategy, the risk appetite and risk bearing capacity and its financial objectives. For example, a corporate may choose not to hedge its FX translation risk, which stems from the geographical footprint of the company or issued debt in the non-functional currency, despite its financial objectives to protect the covenant ratios (e.g. leverage ratio) and to minimize P&L volatility due to changes in the FX rates.
Aside from this strategic misalignment, Zanders often detects system limitations to properly identify and quantify different financial risks. As a consequence it becomes extremely challenging to properly manage the financial risks of the company.
The main objective of this phase in the FRM Transformation Approach is to establish a Solution Design for the future state of the company’s FRM.
Using the Review & Assessment as a starting point, Zanders highlights its findings and advises on how a revised FRM framework can be implemented based on best market practices. A key aspect in the Solution Design is to determine the company’s financial objectives and shareholder expectations, its risk appetite in relation to its risk bearing capacity, as well as the key financial parameters to steer on e.g. earnings, cash flows, financial covenants and/or net asset value.
Overall, after this step the company will have a complete design of the future FRM framework, integrating the various elements as shown in figure 2.
Figure 2: FRM Framework
Roadmap & Execution
Based on the Solution Design, several sub-projects are formulated, each with a different priority. It is important for the overall success of the FRM transformation that the sub-projects are sequenced in a logical order, incorporating all interdependencies. In the Roadmap phase, the sub-projects are organized and prioritized. The Roadmap portrays the timeframe to fully complete the FRM transformation. Zanders always strives to support its clients in developing ‘best in class’ ideas and solutions but is also committed to implement these solutions. As a result the company will have a fully operational, best in class FRM framework after the implementation of the Solution Design in the Execution phase.
Given the current volatile financial market environment, FRM is firmly in the spotlight. For every company, it is vital to establish a future proof FRM framework to protect key financial parameters, increase visibility and remain compliant to the increasing regulatory burden. In addition, an improved FRM framework enables a company to enhance its communication to debt and equity investors (and other stakeholders) on financial risks. It has also been shown that when a company is better in control of financial risk this is positively valued by credit rating agencies, potentially resulting in a better credit rating and as result improved access to liquidity at better conditions.
To ensure a complete and successful redesign of all key areas in FRM, a solid and proven project approach is required. Zanders’ FRM Transformation Approach provides such an approach, by working from a detailed “as-is” analysis, to the implementation of the sub-projects to come and the envisaged future proof FRM framework.
- Comprehensive, integrated and strategic approach focusing on managing financial risk in order to enhance shareholder value.
- Extensive proprietary benchmarking and advanced risk modelling tools
- Access to the subject matter expertise and experience of over 130 treasury and risk professionals covering the full spectrum of FRM.
- Excellent references and client testimonials demonstrate our deep knowledge base and track record on Financial Risk Management.
- Unique combination of strategic knowledge on treasury & risk best market practices and ability to implement these.