IN AN EXTRACT FROM A RECENT ASSOCIATION OF CORPORATE TREASURERS BRIEFING NOTE, GURDIP DHAMI SETS OUT AN APPROACH TO IDENTIFYING AND CLASSIFYING TREASURY RISK
The first step in risk management is to identify the key risks that an organisation faces. It is also important to capture emerging risks – potential risks that the organisation does not yet face but may materialise in the future. There are various definitions of risk and they usually include some reference to the impact of uncertainty. Examples of uncertainty include potential changes in market rates, regulation or credit quality of counterparties.
METHODS TO IDENTIFY TREASURY RISKS
The identification of risks should be a continuous process so that new risks are identified on a timely basis. Depending on the company profile and the prevailing economic environment, the frequency could be monthly, quarterly or semi-annually. Common methods used to identify key risks include:
1. Review of the financial statements and management accounts
Regular reviews will show those items, such as revenue, costs, assets and liabilities, whose values are directly susceptible to uncertainties such as FX rates, interest rates, commodity prices and funding costs. The range and size of uncertainties will vary from one organisation to another. For example, if a UK company purchases goods from overseas priced in a non-sterling currency, then the profit and cash flow of the company will be impacted by changes in the non-sterling currency relative to sterling. At each period end (for example, monthly), the management accounts of an organisation should be examined to see whether there are any unexpected variances caused by uncertainties that have not previously been identified. Although it is a useful starting point, a review of the financial statements will not detect indirect exposures. For example, if a company pays an overseas supplier in sterling, the supplier may over time adjust their prices quoted in sterling to take into account changes in the FX rate.
2. Risk assessment workshops
Workshops can identify risks faced by the organisation by pulling together the knowledge, expertise and experience of people in relevant departments. This is particularly useful in identifying indirect exposures (ie those not readily identifiable in the financial statements) and emerging risks. The workshops could also be a useful forum to discuss the response to risks, setting the appropriate parameters for scenario testing, identifying potential contingency plans for stress events and for identifying emerging risks. Some organisations ensure that their risk process incorporates regular workshoplike discussions at all levels of the organisation including the board, regional teams, etc – to ensure risk is at the forefront of people’s thinking and is not seen as a box-ticking exercise.
3. Review of competitor annual reports
It is often useful to review the annual reports of competitors for two main reasons:
- Identification of risks – general. The annual reports may set out the key risks of the competitor, both current and emerging, which could assist in identifying relevant risks in one’s own organisation.
- Identification of risks caused by the actions of competitors. The way in which a competitor manages its risks may lead to risks in one’s own organisation
4. Discussion with stakeholder
The organisation’s management should consider feedback provided by stakeholders, such as shareholders, bond holders, loan providers, rating agencies and regulators, on the key risks of the organisation and its competitors.
Risk register - Once the key treasury risks have been identified, they can be set out in a risk register along with other risks identified by the organisation’s management, such as strategic, compliance, health and safety and so on. An organisation template can be used if one exists. The risk register should describe the risk, including the cause of the risk, and impact on the organisational objectives (for example, on cash flow, profits or shareholders’ funds). An owner should be assigned to each key risk so that it is clear who is responsible for managing that risk.
Enterprise risk management - Splitting risks into categories can lead to a ‘silo’ approach so that the effects of interaction between risks are missed. Correlations between risks may reduce the overall risk exposures (ie natural hedges may exist), or indeed increase them. Therefore, it is important that all treasury risks and nontreasury risks are reviewed together on a regular basis in order to assess whether there are any linkages between them – this is an enterprise risk management approach.
It should be noted that the analysis of risk relationships can be a difficult exercise for management and the board of some organisations, given the technical expertise that is required. It would be unusual however nowadays for an organisation of any scale not to have in-house specialist risk management expertise.
Author: Gurdip Dhami, Treasury consultant & author
Source: The Treasurer magazine