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|Liquidity management risk|
|Source: Standard Chartered|
Corporate treasury is rapidly evolving from a task-based department into the financial ‘nerve’ centre of the organization. At the same time, treasurers at corporates and banks are becoming more and more aligned in terms of risk management practices, as both need to be fully aware of the impact of liquidity risks on their business activities.
The collapses of Northern Rock and Bear Stearns prove that profitability and capital are no defence against liquidity risk. Both made profits in the quarter before they defaulted and both were well-capitalized businesses. And yet, as a result of their failure to deal with their liquidity risk issues, they vanished. The fact is, no one talked much about liquidity risk and as a result, liquidity was largely an invisible risk for many firms.
Corporate treasurers and their bank counterparts are starting to employ similar strategies in dealing with liquidity risk. Both have learned valuable lessons over the past few years, and now it’s time to put them to good use. We see that ‘best in class’ treasury organizations are outpacing their peers by addressing the following items in a structured manner:
1. Cash management fundamentals
- Cash visibility;
- Cash management;
- Liquidity management tools;
- Cash deployment.
2. Liquidity risk analytics
- Cash forecasting;
- Liquidity stress-testing.
3. Liquidity risk management
- Benchmarking your liquidity risk;
- Execution to limit liquidity risk.
Cash management fundamentals
Effective cash management has been a key priority for the corporate treasury over the past few years and this obviously starts with full visibility on the organization’s worldwide cash positions. This requires access to a system that provides you with timely and accurate information on all your cash positions, preferably on a real-time basis. It includes insights into balance levels, transactions within the clearing cycle and capital trapped in your supply chain. If you can see it you, can manage it.
This is basically about gaining full control over your cash flows. The payments and collection processes are like the arteries through which the blood (liquidity) of the company flows, so ensuring ‘best of class’ practices are used in each country is critical. Full control to move funds (internally and externally) also requires a clear access authorization process – without it you might have visibility but you are still unable to manage the cash effectively. With this control in place the organization is able to take a well-founded short-term funding or investment decisions.
Liquidity management tools
A key part of the fundamentals are the various tools that help free up internal liquidity. Besides the basic ‘leading and lagging’ of their collections and payments there are also others tools such as;
- Supply chain finance solutions – such as receivable services, bill discounting, vendor pre-payment services and an efficient collateral management service – will free up internal liquidity that would otherwise be stuck in a company’s supply chain.
- Physical sweeping and notional pooling are tools that allow a company to automatically concentrate and utilize operating cash positions across different entities and locations. This can be either in a domestic or cross-border structure within a single currency or in multiple currencies.
Treasuries that have complete global visibility of their cash positions, effective control mechanisms in place and utilize the right liquidity tools are in a better position to deploy their cash where and when it’s needed. Intercompany lending provided to operating companies, either directly or indirectly via multi-entity physical sweeping structures, limits the need for external funding.
Based on the lessons learned in the financial crisis, cash will be even more valuable in the future. These changes also bring opportunities for corporate treasurers. With upcoming regulatory changes around Basel III, balances linked to operating business may provide a valuable alternative to other short-term investments as banks will start to provide more incentives in order to hold on to operating account balances.
Liquidity risk analytics
Over the past year many banks have been reviewing their liquidity policy statements and contingency funding plans and are challenging the assumptions made that underpin their behavioural modelling and funding mismatch guidelines. These items should also be a vital part of any corporate liquidity risk analytics toolkit and could be linked to the company’s cash flow forecasting and liquidity stress testing.
Industry-leading treasuries have all the cash management fundamentals in place and are currently focusing on improving their cash forecasting methodologies and systems. The quality rather than quantity of data is the critical factor. Industry leaders tend to use the following framework:
- Senior management support – top management needs to acknowledge the strategic importance of cash flow forecasting and give incentives to encourage the right behaviour.
- Decide what data will be used – it is critical that an organization identifies the most relevant data that will provide the needed information. The data is usually captured from multiple sources.
- Automatically link the above data sources to the forecasting tool – most organizations spend more time on bringing all the information together than they spend on validating, analyzing and acting on the information.
- Performance testing – understand how accurate your forecast is and find out what the critical drivers are. You need to understand the difference between the forecast and the actual results. Optimizing the model could take up 80% of your time spent on cash flow forecasting and this is usually underestimated.
This is where most corporate treasuries stop, but taking the next step is just as important. To be able to understand the impact of changes in the underlying drivers you need to perform a scenario analysis or stress test.
All treasurers are struggling to better understand and monitor the interrelationships between market, credit and liquidity risk. A practical way of dealing with scenario testing is to follow a three-step approach:
- Identify liquidity risk drivers such as: Decreasing sales margins and increased costs of goods; Evaporating funding; Decline in value of liquid assets.
- Design scenarios and assign probabilities: External scenarios such as a market shock in your line of business, market risk (rates, FX or commodities); Internal scenarios such as operational risks resulting in claims, rating downgrade impacting your loan covenants; Ad-hoc scenarios covering industry or country specific events.
- Model the scenarios: Step 1: Quantify the liquidity outflows in all scenarios for each of the defined risk drivers; Step 2: Identify the potential cash inflows to mitigate the liquidity shortfalls identified; Step 3: Determine what your net liquidity position is under each scenario.
Liquidity risk management
Even with having the cash management fundamentals in place and being able to forecast your cash positions, plus what the impact of different scenarios on those positions will be, you are only half way there. The next step is to determine what the acceptable risk levels are and, more importantly, what is not an acceptable risk level any more. This requires benchmarks that are clearly communicated within the organization.
Benchmarking your liquidity risk
The benchmark for liquidity management tools should be the most efficient method of freeing up internal cash. Depending on the company’s operating model, solutions such as supply chain financing and physical sweeping and notional pooling structures should be optimized.
In the current environment companies should consider a careful review of their investment objectives, portfolio characteristics, risk tolerance, investment credit quality, limits and performance.
Clear investment guidelines and benchmarks will provide a common basis for understanding the investment practices within your company.
Execution to limit liquidity risk
Liquidity risk management is entering a new and much more demanding era whereby speed of execution is of the utmost importance. This requires the support of a bank that understands your business model and the specific markets you are in, and that is able to provide you the latest technology and advice to grow your business.
Too often the systems capturing information on operational/business risks, counterparty/credit risks and market risks are separated. It’s time to combine these, remove the silos created by banks and corporates alike and have a more holistic view on how to manage liquidity risks.
In the end it’s all about an effective risk governance structure – what is your risk appetite, what are your limits, what are your strategies to limit these risks and how effective is your oversight?
Due to the changed market circumstances some corporates and most banks are changing their risk policies. They are all changing the way they work today. Most companies have a management committee made up of the top senior managers and the treasurer, and their main responsibility is the formulation of risk management policies for the company. Treasurers are mostly charged with the implementation of such policies, with the committee having oversight responsibility. Besides efficient systems and processes there is a need to weave this new risk awareness attitude into the social fibre of the organization, to create a real liquidity risk management culture.
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