Risk management is one of the key principles of treasury management and requires organisations to evaluate the types of risk that are likely to be encountered in the course of operations, what their impact will be, and how best to manage these risks. Balancing expected impact, expected returns, and expected costs.
Risk management doesn’t necessarily always equate to risk avoidance. Organisations often have to take some level of risk in order to realise a potential opportunity; so only pursuing risk avoidance can lead to a competitive disadvantage for a business. However, some risks - especially certain types of risk – only have downsides and must be mitigated in order to avoid taking unnecessary costs.
For example, a business that undertakes an ambitious capital investment programme such as acquiring a new subsidiary or investing in new technologies is taking a risk as there would usually be considerable uncertainty associated with the cashflows of such an investment. If these decisions are within the organisation’s strategic plan and the necessary due diligence on possible costs and benefits reveal potential value, then such a risk can create additional value.
On the other hand, some risks provide no positive elements and while it may be costly to manage these risks, they have to be mitigated as best as possible. Operational risks such as systems failures, fires, or theft are clear examples of risks that have no potential benefits and need to be planned for and mitigated.
The majority of risks lie somewhere in between these two scenarios and include concerns such as interest rate risk or foreign exchange risk. These can be fatal to an organisation if not properly managed but do not need to (and often cannot) be avoided entirely. But the extent to which these risks are accepted or reduced and transferred is the key question that is answered by stakeholder risk appetite and policy direction.
Some level of risk taking is usually acceptable in the course of business operations. Where this is the case you should ensure that this is done as part of a wider corporate strategy and sits within the specified risk appetite of the organisation. There should be regular monitoring of any risks, through a variety of measurement techniques and comparison against pre-determined Key Performance Indicators (KPIs).
When setting KPIs, the risk management objective needs to be linked to a specified risk measure and ultimately to the KPI you are measuring against. For example, if the risk you are managing is that of a covenant breach and your covenants are measured on EBITDA/net interest, then an example KPI could be to ensure a minimum EBITDA/net interest cover ratio of 3.0x over a specific forecast period. Ensuring KPIs are measurable and within control of the treasury function will allow for better monitoring and risk management policy development.
The level and type of response to each risk depends on your risk appetite. For risks to which you are particularly averse, there would likely need to be a transfer of risk to another counterparty through an external hedging arrangement. Other risks you may choose to manage internally through internal hedging or stricter procedures and reporting.
It is worth remembering that risks can almost never be completely eliminated. Even if you undertake a diligent hedging programme to manage your organisation’s interest rate risk through derivatives, you are only transferring your interest rate risk into counterparty risk on the bank providing the derivatives. This may of course be the preferred strategy and is potentially easier to manage but will depend on the skillset of the treasury function.
Financial risks such as interest rate or commodity risk will often interact with other risks such as commercial concerns, or failure to manage one risk adequately can lead to the occurrence of other issues such as liquidity risk. This is why risk management must be considered holistically, in light of the organisation’s wider risk appetite and policy approach, taking into account the main factors facing the organisation together.
For assistance in drafting treasury management policy and information on risk management strategies, please contact treasury@arlingclose.com.
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