A Time to Get Back to Basics
by Sarah Jones, Managing Director, JPMorgan Liquidity and Investment Products
If there’s a silver lining to the current liquidity squeeze, it’s that today’s market turmoil gives companies an opportunity to get back to basics and reexamine, strengthen and improve their investment processes.
Among the issues that are top of mind for corporate treasurers as they manage and invest excess liquidity in a volatile market are investment guidelines, risk management processes and operating practices.
Spurred by market conditions and regulations, such as Sarbanes-Oxley, CFOs, CEOs, boards of directors and corporate audit committees are demanding an in-depth look at investment policy. Senior officers, responsible for overseeing and monitoring internal controls, want clearly articulated investment guidelines. Clear, published guidelines provide a common basis for understanding investment practices and explicit parameters for allowable investments, duration and investment processes.
When revisiting investment guidelines, companies must carefully review objectives, portfolio characteristics, risk tolerance, credit quality and limits, performance and analytics—all within the framework of industry standards and peer group comparisons. The ultimate goal: aligning investment strategies and guidelines with corporate strategies.
Today’s market turbulence highlights the necessity for proactive scrutiny. While there are as many kinds of risk as there are investment instruments, there are four areas treasurers should re-evaluate.
First, investment benchmarks. Are they appropriate in all market conditions? For instance, in the volatile markets of fourth quarter 2007, managing to a 30-day benchmark would have driven an investor to take incremental risk in light of the lack of inventory of 30-day duration securities. An overnight benchmark would be more reflective of the market reality and drive smarter investing behavior.
Traditional investment benchmarks may not work given the extremes of current market conditions. Ask questions about your current benchmarks: Are they viable right now? Have they impacted investment practices in the last six months? How aggressive are they? If you’re consistently beating the benchmark, are you taking undue risks?
Second, investment structure. Not all Structured Investment Vehicles (SIVs), money market mutual funds or Collateralized Debt Obligations (CDOs) are created equal. Sophisticated investors demand greater transparency in underlying investment structures. At a minimum, ask, what are the structures? What are the underlying investments? How deep is the secondary market? Who are the other investors? Who rates the structure? Do the ratings make sense? A rule of thumb for gaining transparency: If you can’t get answers to these questions or if the answers are contradictory, think twice.
Third, duration. When aligning investment duration with realistic liquidity needs, there’s more to it than when the cash is needed. Can you optimize returns without constraining liquidity? What is the cost to break the terms of the investment? When you’re ready to sell, will there be a buyer? The auction rate securities market has proven that this could be a challenge.
Fourth, counterparty risk. Examine counterparty practices, history and management processes. Also assess the strength of sponsoring institutions. For banks, look at the strength of their balance sheets. For money market mutual funds, evaluate the credit processes, sponsorship, fund size and investor base.
In times of market turmoil, it makes more sense than ever to review operating practices. Two questions should drive this review—what are your processes and who is overseeing them? Use the age-old principle of dual control: The person initiating a transaction must not be the person approving the transaction.
Assess your oversight and compliance processes for cash management and investments, or if there is a custodial arrangement, for securities trading, accounting and reconciliation. Daily, real-time information reporting provided by banks gives treasurers an efficient way to track activity and provide transparency for cash and securities flows.
For global operations—especially in countries such as China, India or Venezuela—regulations can trap cash. Headquarters’ visibility into local activities is critical. It is important not only to monitor yields and cash flows, but also to track the controls that ensure local compliance with company-wide cash or investment management policies and guidelines.
Sustaining the flow of liquidity and preserving investment principal—not primary concerns in the recent past—have come to the forefront. Faced with continued market uncertainty, companies are strengthening their investment processes with the goal of achieving solid, risk-adjusted returns even in the worst of times.