The Age of Risk (and Fewer Returns)

by Karen M. Kroll
Source: Business Finance Magazine

The implosion of much of America’s financial services sector has prompted discussion regarding the role of risk management — or, perhaps more accurately, the lack of risk management — at the country’s largest financial institutions. While most nonfinancial firms haven’t been body-slammed to the same degree that their Wall Street counterparts have, many CFOs and treasurers are reviewing their own approaches to risk management. “Risk management is rising on the radar screen,” says Mike Gallanis, partner with Chicago-based consulting firm Treasury Strategies, Inc.

One clear sign of corporate America’s current aversion to risk was the December sale of 1- and 3-month Treasury bills at yields of zero percent, says John Snyder, director of business development with Chesapeake System Solutions, Owings Mills, Md. He adds that some financial executives now describe their investment strategies as “not losing money.” Tellingly, there’s no mention of return.

Moreover, while companies’ compliance efforts used to focus primarily on ensuring that executives didn’t run afoul of any laws, risk management now is seen as critical to keeping firms solvent, Snyder adds. “Before, it was an academic and legal exercise,” he says. “Now, the concern is whether the company will take a big hit.”

At the same time, the current economic crisis “has highlighted the breadth of the question of risk management,” says Michael Gannon, vice president and treasurer with Owens-Illinois, Inc., an $8 billion manufacturer of glass containers. It’s brought to the forefront the interplay between all areas of risk management, including cash forecasting, minimizing counterparty risk, and navigating a volatile economy. He adds that “doing these things well is more important than ever for Owens-Illinois.” This is true even though the company’s sales and earning per share rose 10 and 40 percent, respectively, and total debt dropped by nearly a tenth in the nine months ending in September 2008.

To take one example, counterparty risk, or the likelihood that the other party to a transaction may fail to hold up its end of the deal, was something that few companies properly monitored even just a few years ago, says Gallanis.

Not anymore. “What’s really been a focus over the past 6 months has been counterparty risk,” says Ather Williams III, managing director and global segment executive with JPMorgan Treasury and Securities Services. In a switch from the historical banker/client relationship, corporate clients have inundated their account managers with phone calls, seeking information on the bank’s performance and details about the quality of the holdings in their investment funds. They’ll ask, for example, whose commercial paper the bank is holding. “We’re seeing requests for a level of due diligence that we haven’t seen in the past,” he says.

Another topic of concern is the bank’s view of the firms, Williams notes. Clients want some assurance that their funding will remain in place — not surprising, given that in the October 2008 “Senior Loan Officer Survey on Bank Lending Practices” conducted by the Federal Reserve, 85 percent of domestic banks indicated that they had tightened lending standards. This was up from 60 percent in July.

In fact, Treasury Strategies now is counseling clients away from minimizing the number of their banking relationships, Gallanis notes. “Even if it’s more costly, having backup relationships and spreading exposures is now the best approach.”

Gannon says that this is the approach that Owens-Illinois is taking. “We like the idea of dealing with fewer players, but in the world we’re in, banks are much less willing to commit $100 or $200 million at a time,” he says. And, maintaining a group of banking partners helps the company to mitigate counterparty risk.

Many companies also are more closely reviewing their insurance policies and carriers. “If your risk mitigation tool is insurance, you need to look at the contract and the viability of the insurance partner,” says Judith Graham, the London-based chief operating officer with Optial Corporation, a provider of risk management solutions. Given the systemic problems in the financial sector, it’s “foolish to make assumptions about any counterparties,” she notes.

Chief financial officers and treasurers are paying closer attention to their cash investments. This is a shift from the recent past, when it was assumed that following corporate policies regarding, for instance, the types of money market funds in which they could invest would keep their firms safe. Now, they’re questioning the composition of the funds and rethinking instruments like enhanced funds, which entail more risk than traditional prime money market funds. “They’re taking more stringent steps,” to identify safe, suitable investments, Gallanis says.

While Gannon isn’t planning any major changes to the cash investment practices of Owens-Illinois, he is viewing potential investments with “even more of a bias to safety of principal.” For example, he’s shortened the average maturity of the money market funds in which Owens-Illinois invests. “The reality is, we care about 10 basis points; it’s real money,” he says. But in this environment, cash safely in hand trumps potential return.

At the same time, Gannon and his colleagues are combing through the Owens-Illinois pension portfolio, “looking for hidden time bombs.” Despite the fact that the pension is overfunded, they want to verify that the company doesn’t have any unintended exposures. And, over the longer term, they’ll likely shift investments to include a greater portion of bonds, rather than equity, to correlate more closely with the company’s pension liabilities.

Effectively hedging commodity prices is another area of risk management that’s raised its profile. Driving this are the dramatic price swings recently: The EDC Commodity Price Index soared from about 160 in December 2006 to 300 in June 2008, before plummeting to 120 in December.

Also rising on treasurers’ To-Do lists: mitigating credit risk. “Credit risk will be swiftly elevated on the list of issues that risk managers and CFOs think about,” says Robert Hartwig, Ph.D., president of the Insurance Information Institute in New York.

Bemis Company, a $3.9 billion supplier of packaging, primarily to the consumer packaged goods industry, has earned an A rating by Standard & Poor’s, says Treasurer Melanie E.R. Miller. In contrast, most of its competitors fall below investment-grade. These days, some are struggling to fill orders or get financing. As a result, Miller and her colleagues are closely watching orders from companies that haven’t typically done business with Bemis before. They don’t want to get so busy filling orders from newer, less stable customers that they’re not able to meet their regular customers’ needs.

Bemis also doesn’t want to end up in the position of “loaning its balance sheet indirectly to customers” who extend terms beyond what’s been negotiated. So far, this doesn’t appear to have happened, but under today’s circumstances, it warrants monitoring.

Technology has a role to play in managing credit risk, Williams notes. He’s seeing greater demand for products that help companies to speed up invoicing, which should cut the time it takes to get payment.

Financial execs also are looking to technology to help them to reduce the risks associated with imprecise cash flow forecasts. “We’ve seen an active market in the treasury technology arena develop in the past 6 to 8 months,” Gallanis says. This is true even as most companies tighten their overall IT belts, wary of slowing sales.

After all, as bank funding becomes more iffy, treasurers and CFOs need to make sure that they’re fully accounting for all of the funds lying around the company. Gannon at Owens-Illinois says that he is redoubling efforts to accurately forecast how much cash the company will have and how much they’ll need. Where he and his team are unable to predict exactly how cash flows will play out, they’re turning to “what if” analysis, such as estimating best and worst cases for sales in different markets.

At this point, what’s not clear is how the use of financial modeling — say, to predict the potential returns of an investment — might change. Until recently, some companies relied too heavily on quantitative models, says Carol A. Fox, chair of the ERM Development Committee at the Risk and Insurance Management Society (RIMS) and senior director of risk management at Convergys Corporation, a $2.8 billion provider of customer relationship management solutions. What’s more, they overlooked the “tails” on the models. These are events that are highly unlikely to occur but are catastrophic when they do.

This has changed more recently, as a few of the worst-case scenarios — such as the ratings downgrade of the debt of insurer AIG — have come true. As a result, financial execs increasingly are setting aside buffers to help cover potentially deadly hits.

Because existing models have been less than useful, a return to common sense and a more qualitative approach appears likely, says Graham of Optial. “This is not to say that going down the quantitative route is pointless, but you need to take the models with a pinch of salt.”

One tool that companies seem to be avoiding, at least so far, is drawing down their lines of credit before they actually need the money. Gannon notes that it’s an expensive safeguard, as the company ends up investing at a lower rate than it can borrow. Instead of doing that, he’s reaffirmed with Owens-Illinois’s banks that the company’s lines of credit are available.

While tapping into a line of credit even when a company has other cash may be helpful in a few extreme cases, if the practice becomes widespread, the overall effect is harmful, Gallanis notes: “It’s the corporate equivalent of a run on the banks.” Instead, most companies are better off enhancing their cash forecasting capabilities, he advises.

Among the other areas that merit attention are these:

• Communication: While it may not seem as sophisticated as, say, regression analysis, one effective risk management tool is old-fashioned communication, says Jim Tuite, chief financial officer with the Christian Children’s Fund, a nonprofit group that aids vulnerable, at-risk children in 32 countries. “It can’t be underestimated,” he says. Employees have been calling donors to thank them for their support and let them know that the organization is taking cost-cutting measures, such as reducing travel. The more knowledge that donors have about the steps the organization is taking to manage in this economy, the more likely they are to continue supporting it. Tuite acknowledges that it is hard to measure the impact, but says that they are getting fewer visits from worried employees and fewer calls from concerned sponsors. “Communication has been the number one thing that we’ve done with donors, sponsors, and employees.”

• Centralization: The current crisis has reinforced the importance of a centralized treasury as one way of controlling risk, Gannon notes. Because of the need for both specialized skills and tight control over functions like hedging, a centralized treasury structure makes sense.
• Compensation: Many companies need to rethink their compensation plans, says Hartwig. In the past, risk controls often were watered down or ignored in order to boost sales. Of course, this often boosted executives’ compensation, as well. Given the current troubles in the economy, it’s clear that risk management needs to figure into compensation plans.
• Culture: In the end, an effective risk management approach comes down to culture, says Arnold Garcia, manager of risk management with Charlotte-based Piedmont Natural Gas Company, Inc. No program can compensate for executives who choose to look the other way when employees take on excessive risk in an effort to boost performance. “It all depends on culture,” he says.

The Age of ERM?

Given the focus on risk at many firms, it’s not surprising that the concept of “enterprise risk management” is capturing greater interest. In the past, most financial executives could zero-in on their companies’ exposure to financial risks and not be as concerned with operational risk, says Carol A. Fox, chair of the ERM Development Committee at the Risk and Insurance Management Society (RIMS). Now, they have to be aware of potential surprises on the operational side, as well. “Risk management can’t be siloed and be effective,” she says.

David Spence, senior consultant and head of strategic risk management with Boston-based Spring Consulting Group, LLC, notes that few American companies have taken ERM seriously in the past. The challenge has been in demonstrating its benefits. “If you put resources in place and nothing happens, how do you measure its value?” he asks. Today, however, the turmoil ensuing from such unlikely events as the demise of financial titans like Lehman Brothers and Bear Stearns has hammered home the benefit of understanding the range of potential risks.

Similarly, executives are paying closer attention to external risks that they may have dismissed before, notes Robert Hartwig, Ph.D., president of the Insurance Information Institute. For instance, retailers now are examining how consumers’ debt loads may affect purchasing decisions, which obviously will impact merchants’ sales.

Enterprise risk management stems from the concept that risk is a variation from expectations, whether positive or negative, says John Phelps, director of business risk solutions with Blue Cross Blue Shield Florida. His firm has had an ERM program in place for nearly a decade and classifies risk into two broad categories: strategic and operational. As the term indicates, strategic risks are longer-term — say, 3 to 5 years out — and involve the direction of the company. An example would be the emergence of new competitors in the market. Operational risks cover events within the next 18 months and are more tactical in nature. One example is the risk of the inadvertent release of clients’ private health information.

Even with the program in place, Phelps has made some enhancements in light of the business environment. He and his colleagues are starting to better analyze emerging risks, such as the growing use of nanotechnology in medicine. While this holds tremendous opportunity, its costs are largely unknown. By definition, emerging risks lack the historical perspective needed to perform mathematical risk analysis. As a result, he is turning to scenario analysis. While not precise, it will give some idea of the possible impact.

More important, the company avoids the trap of assuming that some risks are unquantifiable and just a cost of doing business. Even when their analysis is imprecise, Phelps and his team still gain a greater understanding of the potential impact of a risk. When it comes to understanding the uncertain, they aren’t looking for precision, he says. “We don’t need home runs every time. We can win the game with a series of triples.”