Global visons on corporate risks
There is much to gain from seeing things from a different point of view, especially in the current market conditions. In this double interview, Paul Nailand, founding director of Visual Risk in Australia, and Judith van Paassen, partner at Zanders, share their visions from opposite sides of the world on risk management.
What do you see as the most innovative trend in the area of corporate risk management in the Asia-Pacific/European market?
PN: “I think the growing interest in using cash flow at risk (CFaR) methodologies is very interesting. The global financial crisis resulted in companies developing a razor-sharp focus on liquidity management. As we know, cash has become king, so consequently market risk measures that tie in more closely to cash flow rather than valuation are attracting far more attention than ever before. The converse trend has been a decline in the use of VaR (value at risk). CFaR can free the corporate treasurer from making specific guesses about the direction of financial prices and get a better feel of potential impact on the bottom line for many outcomes. Moreover, CFaR measures allow a corporate to understand their exposure to market rates over an extended time period.”
JvP: “The challenging and constantly changing markets companies have been facing in recent years have provided a need for innovation in corporate risk management. A ground-breaking trend is that European corporates are starting to realize the valuecreation potential of risk management. They actively seek to transform the traditional risk management activities, mainly focused on regulatory compliance, into a strategic function that aims to enable the realization of business targets. One example is the increasing popularity of enterprise risk management (ERM). The concept looks at risks throughout the organization in an integrated manner. Although adoption in the European market is still slow, the interest shows that mindsets are changing. Companies are also widening the scope of their risk management by managing new risk classes, such as commodities, pensions and insurance risks. Managing additional risk classes potentially signals a move towards strategic risk management.”
What steps can companies take to update their risk management in order to better respond to the current market environment?
PN: “I would suggest it’s not so much a case of updating but rather of ensuring that the company has or maintains a disciplined approach to risk management. Too often companies start hedging after a severe market move and by then it can be too late. The global financial crisis was an earthquake and there will continue to be major aftershocks. Australia has been the ‘lucky country’ faring better than most during and after the crisis. Commodity prices rose considerably, interest rates were low and the currency largely stable. Now commodity prices are faltering, the currency is weakening sharply and the interest rate environment is more uncertain. Those companies who are not identifying their exposures, quantifying their risk and taking steps to manage it could suffer extensively on an absolute cash flow basis and relative to their better prepared competitors. Best practice treasuries should consider leveraging specialist technology available today which can help efficiently manage this process and ensure risks are clearly reported to senior management for optimal assessment and decision making.”
JvP: “Successful risk management depends heavily on the quality and availability of information. With companies strongly relying on systems and information technology to run operations smoothly and gather management information, the way data is organized is instrumental to business success and, by extension, to corporate risk management. By implementing and maintaining a solid data warehousing structure, companies can certainly gain a strategic and competitive edge in their risk management approach. Here the risk manager welcomes the Big Data technology trend! It is also important that all risk management activities have a foundation in an end-to-end risk management framework. Zanders has a proprietary framework that comprises five steps, covering the whole range of risk management activities: identification, quantification, policy, process and execution. Organizations should also treat risk management as an ongoing process, with proper reporting and assessment to evaluate the success of the risk management strategy providing the necessary feedback.”
More companies are choosing to incorporate different risk categories into one holistic risk management framework. This presents a great challenge but will, if executed properly, largely increase the understanding of risks within a company. How do you view these developments in your market?
PN: “I agree that a full company model incorporating all risks, if executed well, can be very useful for understanding the potential performance of a company. My first technology role was in developing systems for equity research so I have a strong interest in helping companies use technology to incorporate financial risk management as a core part of their overall financial modeling. From our customer base of over a hundred organizations I only see a few attempting modeling of this nature. These are typically much larger companies or those whose financial risk is also their business risk such as commodity producers or consumers. For instance, one of our customers uses our software to model the overall impact of various commodity inputs, such as wheat and oils as well as currency correlation, in producing bread. They can better measure and understand their risk to adverse soft commodity prices or exchange rate movements on their profit margin give the inelasticity of the price of bread. Of course, too sophisticated a model means that trying to understand the impacts of the variables is going to be very difficult, so there needs to be a balance. Just going through the process of setting up these kinds of models can be a valuable exercise in itself.”
JvP: “Again, European companies are only slowly taking integrated risk management on board. I do expect a pick up in speed in this area but there are indeed great challenges in the implementation. The biggest challenge in the application of the concept is development of an integrated quantification of the various risk classes. This requires sufficient data and advanced skills to obtain the correct risk figures. The second challenge arises from the risk culture of an organization. Managing risks in an integrated approach requires excellent coordination of the various risk management activities and cooperation between business groups and functional teams within an organization. Management of the individual and company-wide results should be carefully taken into account. I definitely see a role for treasurers here, as they possess the knowledge and skills to support risk-based decision making and thus are well positioned to bring risk owners together.”
There seems to be a trend towards increasingly sophisticated methods such as VaR and CFaR to measure interest rate, currency and commodity risk. How well integrated are these methods already in your market and how do you expect this trend to develop in future?
PN: “Yes, as I identified earlier, this is a growing trend. Australian treasurers have always had to be adept risk managers due to their need to borrow offshore, having a highly traded, volatile currency, and producing and consuming a very broad range of commodities. Consequently they have been early adopters of risk management techniques combining more than one asset class. Historically only the largest companies, or those with diverse financial risks that have a significant influence on their bottom line, have tended to implement full CFaR type models. In recent times we’ve seen a growing trend from smaller organizations seeking to employ more sophisticated techniques and tools to enhance their risk management. Since we started delivering advanced risk management functionality over 12 years ago there has been an increased uptake and appreciation of the role these kinds of techniques can play. Hedge accounting for a long time dominated the thinking of many corporates when considering hedging but the bedding down of processes surrounding this and changes coming with IFRS 9 have allowed economic risk management to be re-invigorated. And just in time for corporates to cope with an era of increased volatility!”
JvP: “European corporates never fully accepted and applied at-risk analyses in their risk management approach to the same degree that, for instance, companies in the United States have. Few companies calculate at-risk measures – but then it is not used in management decisions. I think this is partly due to the fact that the adaption of this method to one that is easily understood and applied in a corporate environment is a hurdle for many corporate treasuries. Nonetheless, there is a trend among treasurers to look for alternative quantification methods, such as a risk-adjusted return on sales, for instance. This is mainly triggered by the realization that existing methods are insufficient. I expect more companies will implement at-risk calculations but the main development in this area will be the availability of better data and more sophisticated scenario and sensitivity analysis to complement existing measurement techniques.”