What Matters Today
#1: Risk Management
by David J Aldred, Managing Director, Regional Corporate Sales Executive, EMEA Treasury Services, J.P. Morgan and Jeremy Shaw, Managing Director, Regional Trade Executive, and EMEA Emerging Markets Corporate Sales Executive, Treasury Services EMEA, J.P. Morgan
In this first article in a series by J.P. Morgan, we look at some of the key issues affecting treasurers today and offer insights into ways of addressing them. In this edition, we look at risk management, which has become an integral element of every decision made in treasury. While treasury has always been tasked with managing risk, the profile of the risk management function has been elevated over the past two years, with the board now seeking a closer involvement in risk identification and mitigation. This is leading to heightened visibility of the activities that treasury undertakes, and increased recognition of its value to the enterprise.
Payment and counterparty risk
As with other forms of risk managed in treasury, counterparty and payment risks are not new, but over the past year or so, treasurers have needed to evaluate contingency risk more fully, e.g., how the company would deal with a potential bank failure. There are various issues associated with this. For example, although the risk that a bank will discontinue its business is far lower than a few months ago, companies need to have confidence that their banking partners have the balance sheet and business strategy that will stand it in a good stead over the long term. This is particularly the case in emerging markets, such as in Russia, where economic issues continue to threaten the stability of the banks, leading treasurers to seek alternative solutions of making payments should it ever prove necessary. Treasurers are re-evaluating the location in which they clear currency payments as well, particularly currencies which are traditionally considered problematic, such as the Russian ruble; for example, they may prefer to settle these currencies in London rather than in Moscow.
Banks and corporates alike have recognised that risk extends beyond the organisation itself.
However, while the risk of a complete bank failure may seem generally less likely to treasurers, contingency plans are required to deal with more subtle but damaging eventualities. For example, the burden of compliance with regulatory requirements, technology investment etc. is becoming ever higher, and not every banking institution today will be able to justify this ongoing investment. Furthermore, with a number of banks now supported by their home governments, there is increasing pressure on these banks to focus on their home markets as opposed to investing in their international network. Corporate treasurers therefore need to look at reducing their reliance on individual banking partners so that they are not exposed in the event that their banks refocus their business. Providing payment services creates a major liquidity overhead for banks as capital is required to support the daily movement of liquidity, such as through CLS. Treasurers are increasingly seeking greater transparency over their banks’ ability to support daily settlement requirements.
One of the outcomes of treasurers’ renewed focus on counterparty and payment risk is a greater ‘bank agnosticism’, i.e., the ability to conduct payments and cash management without relying on an individual bank. In this regard, initiatives such as SWIFT Corporate Access have been instrumental by enabling companies to adopt a bank communications infrastructure that is non-proprietary and allows access to all of a company’s banking partners. A related issue is SEPA (Single Euro Payments Area), although take-up of SEPA payment products has so far been relatively slow. SEPA payments are based on ISO 20022 standards, which enable consistent formats to be used across banks, as well as the potential for using SWIFT as a single communication channel. Furthermore, the combination of SEPA and the Payment Services Directive (PSD) enables companies to streamline their cash management across Europe and benefit from legal harmonisation, including simplifying cash management structures and reducing the number of banking relationships to a few trusted partners.
Another trend relating to both counterparty and liquidity risk is the increased use of escrow. While escrow arrangements were historically used for activities such as M&A, for holding cash pending settlement, escrow is now in use for trade and project finance purposes.
Financial supply chain risk
Increasingly, banks and corporates alike have recognised that risk extends beyond the organisation itself. Rather, when evaluating a company’s risk, a bank will also look at its major suppliers and customers to identify potential risks. Treasurers are focusing increasingly on mitigating the risks in their value chain, reviewing payment terms with both suppliers and customers to improve working capital whilst increasing the resilience of the financial supply chain. We are finding treasurers coming to us with a variety of ideas in this area including receivables financing. Furthermore, as the recognition of supply chain dependency increases, such as on key suppliers and distributors, supplier and distributor financing can be useful vehicles in supporting these organisations. Although supply chain financing has been available for some time, there has been increasing interest in the solution over the last six months or so. In today’s market, when companies raise cash, they are doing so for a particular purpose, and supply chain financing is very specifically directed towards supporting the supply chain.
Until recently, there was a perception that the supply chain risk involved a company in western Europe or North America typically selling into emerging markets. Today, however, the reverse is often the case, with suppliers based in emerging markets concerned about the stability of their customers in other parts of the world. All types of company, wherever they are headquartered, are increasingly focusing on trade instruments for facilitating international trade, such as letters of credit, with treasurers seeking the help of banks offering trade finance products to help increase the robustness and flexibility of their financial supply chain. There are various elements to trade risk, including the length of time between documentation and payment, and the frequent inaccuracies that exist in trade documentation. One of the related risks is compliance risk, with goods held at ports with insufficient documentation, creating delays that can affect the whole supply chain and consequently a company’s profitability. Therefore, ensuring the efficiency of trade processes is vital in reducing risk in the supply chain.
With consolidation amongst some banks, the number of banks providing trade finance services has declined, and we expect to see further consolidation over the next two years or so. However, although trade services are still provided by most commercial banks, it may not necessarily be a core product compared with other transaction banking services, which is an issue that treasurers should consider when selecting or evaluating their trade banks.