Managing Risk: IDENTIFY – Is it holistic?
Identification of risk should capture all risks faced by Treasury, which means market, economic and operational risks are managed in a holistic, integrated framework.
- High percentage of Sales or Purchases in foreign exchange not being managed
- Supplier or customer contracts misaligned to risk management objectives
- Uncertainty of the sources or extent of natural hedging offsets and diversification
- Uncertainty of risk sources in relation to a global balance sheet and multiple subsidiaries
- Unclear implications of floating rate debt
- ‘Pre-transactional’ risks not identified
- Treasury risk reviews
- Identification of risk across foreign exchange, interest rates, commodities, and operations
- Identifying sources of any existing natural hedges
- Opportunities to align supplier or customer contracts to the business’ risk profile
- Centralised oversight
The critical element in designing a risk identification process is in assessing risk at an aggregate business level, rather than only isolating individual sources. This means not only identifying potential natural hedges in financial market risks within the business, but also understanding and strategically accounting for where risk sits within supply and sales contracts linked to foreign exchange and potentially commodity prices. It is not a matter of ‘what risks are we facing?’, but rather, ‘what is the overall risk profile of the business?’. Derivative hedging should be the last line of defence in hedging market risk, only after exhausting contract bargaining power and optimising intercompany foreign exchange payments.
Developing a means to identify risks is not a continuous process. Rather, an initial deep dive workshop should map risk sources, and critically, their interaction both vertically within the organisation structure and horizontally as individual risks interact with each other. Once achieved, their measurement, management and monitoring can occur thereafter, with stakeholders remaining cognisant of how the risk profile is developing over time. Scheduled periodic risk and policy workshop reviews are a fantastic way to consolidate ideas on changing risk profiles and pivot the management process as required. Adjusting to an emerging risk in an abrupt manner, without achieving stakeholder alignment on the management approach risks creating a culture of putting out spot fires as opposed to strategically implementing holistic preventative operations.
Implementation of risk identification firmly resides within the Treasury policy. All risks the business seeks to actively manage should be acknowledged and defined, with focus given specifically to the potential adverse effect of the risk to business. Implementation should also be visible in any system and process design, notably in how the data related to the risk is captured and fed through calculations that produce clear calls to action linked to the policy that give clear recommendations on whether and what remedial actions are required.
If Design, Development and Implementation are successfully achieved, then operational time spent specifically on ongoing identification of risk should be nearly minimal. All the identification work was done during design, and a single implementation piece ensures that risks remain identified on an ongoing basis. This leaves individuals most free to Manage and Monitor risk in confidence that they are doing so at a holistic and appropriate business level.
Why the challenge was proving difficult to solve:
- The most effective currency for debt denomination was unclear given diverse forecasted cash flows
- A lack of multi-asset portfolio risk evaluation processes prevented assessment of adverse risk implications across various scenarios
- An accurate confident bid submission was hindered by lack of clarity on a preferred ongoing risk profile
Rochford actions to address and correct the problems:
- We designed an agreed flow chart of funds, from operations through to fund investors, isolating points of foreign exchange risk under various funding scenarios
- We then applied foreign currency operating cash flow forecasts and ran a Cash Flow at Risk analysis using a Rochford-developed model
- Rochford could then confidently present identified risks and their measured impact, with a clear recommendation of funding structure and the holistic risk profile it would entail
- The fund submitted a revised bid in increased confidence while setting a clear expectation to global investors
- Our approach to framing the problem provided upskilling to fund managers that was deployable on future investment opportunities