Financial Regulation Is The Answer

In the 1970-ties before deregulation of the capital markets there were book keepers in every bank and corporation managing the effects of government administratively changing exchange and interest rates. There was no need to manage risk, no derivatives, no financial volatility (well apart from occasional devaluations and rate hikes). However with time this paradise came to an end with sky rocketing inflation and too little access to capital. It made it hard to build companies to create the jobs and prosperity we all expect from them. We were lucky having the now so celebrated Mr. Volcker keeping Fed rates so high it created such a deep recession, which later gave us good growth in the coming decades. Meanwhile our great leaders were spending much of their valuable time to figure out how we would get the economy going again. They came to the conclusion we needed many more loans. They launched a new buzz word: “Credit Expansion”. They explained to us, the common men and women, that we must deregulate the financial markets. Prices on financial assets and debt should be set in open market auctions organized through exchanges or on a bilateral basis. This would make the world strive and everyone being very happy creating easy credit flow to everyone wanting money.

Then there was a wake up call for all banks and corporations in the 1980-ties. Now suddenly the inherent positions from cash flows and balance positions could be marked to market in real-time. We were so happy and even so more when we also were blessed with the computer enabling us to expand on market information coverage and how to define and calculate financial risk. Meanwhile the always so clever leaders were worried since they felt we could loose control over the financial development. A special worry was what would happen with the financial system if a bank defaulted. “Oh no”, they so intellectually stated; “We cannot allow for any bank to go belly up.” So they created the Basel Framework in detail stipulating how the banks would measure and report risk. In this way they succeeded creating a solution to avoid the financial system to collapse for any reason. We felt safe and proud. The first crash happened not until the beginning of the 1990-ties when Sweden went through a PIIGS crisis and basically all but one bank got bust. But Sweden was so small and no one really cared (except the Swedes of course). Eventually they developed a very nice solution with even higher taxes and an expanded public sector hiring more bureaucrats than doctors and nurses. This was very clever since it created well paid employment with very low demand of output for our distinguished leadership.

In the 1990-ties we were blessed with sophisticated treasury systems, value-at-risk, and separation of duties. Now the field lay open for anyone to trade, regardless of underlying commercial position. Sometimes it popped up scandals with some sorry guy who had taken too big positions, doubling and doubling, even hiding trade tickets in the drawers. But that was all forgotten when he came out of jail and wrote a book. Some even earned more on books than trading. It was a wonderful time. We all continued to trade and sometimes we also hedged. We built portfolios of our financial positions; Trading, Strategic and Tragic were their names. Some positions even had so long duration that the traders were long gone when they expired. This did upset the auditors for the right reasons. They felt they had no control, which shall never happen. They therefore eagerly and faithfully started to lobby for new legislations for accounting. The most famous was Hedge Accounting. (Fair Value Accounting is also another valuable milestone in their careers, but unfortunately it came way later). One thing is clear; if you want to solve a simple problem ask an auditor and you will have plenty of valuable spend and bureaucracy to fill your time for at least a decade. We owe a lot to them.

The 2000-ties started a bit sour. We had a big crash. Who could have guessed that all those solid companies with p/e ratios in the millions would crash? It struck like lightning on a clear day. Anyway we had a great comfort in eagerly implementing Hedge Accounting in our spare time. A special treat was that if we had the assistance from a consultant to implement it, we surely would hear from our auditors they would not approve it creating ample opportunities for interesting and high energy creating discussions. And we were happy, hedge accounting created immense value for society and it was reaching our target of creating annual accounts leaving no question marks on the financial position whatsoever. In parallel we excelled the skills of defining policies that would eventually eradicate all financial risk for ever. The policies and hedge accounting combined was so successful that we would develop so robust procedures that we would be able to even control our future. Anyway that was what we believed. However something happened in 2008. Two very old brothers in the US (heard they were more than 150 years old) – the Lehmann Brothers – did something to interrupt the whole scheme of things. Somehow they managed to eradicate the water proof protection to financial volatility that hedge accounting and treasury policies and credit expansion so wisely had provided. The brothers even made banks go bankrupt. Poor central bankers having worked so hard for so long time to build up the perfect remedy for financial domino effects (the Basel framework). But the Lehmann brothers got what they deserved, I have even heard they are dead now – for real! And being America, they probably had it coming in the good, old fashioned way from a tree.

But now everything is back on the road again to full control and final eradication of financial risk. Our clever leaders have come to the divine conclusion that we must regulate again. I feel so much comfort in their common sense, high spirits and smart actions. I’m so grateful they borrow very much to ensure we can have our good standard of living forever. They have recently informed us that the good thing with government loans, regardless how many or how big, is the fact they create absolutely no financial risk what so ever. Only derivatives on loans do. This has made me understand the connection so clearly. I cannot understand why I have not realized this long ago. Probably that is why I’m not a bureaucrat.

Now it makes complete sense that our distinguished leaders want to regulate and even ban financial derivatives. That must be the very best way to eradicate financial risk once and for all so we can continue being safe and sound.

Hey, hey for a job well done.

Benchmarking on Asian Cash Pools

The European Treasurers’ Peer Group has conducted a benchmarking survey on set-up of Asian Cash Pools. Of special interest was to map if and how such a cash pool could be managed from another time zone, typically North America or Europe.

Please contact ETPG if you are interested in receiving a copy. This offer is only open to corporate treasuries.

Holistic Risk Management

I have several times on this blog discussed the purpose of financial risk management. Why do we perform it? Is it primarily an accounting issue with the purpose of reducing volatility in the income statement? Or is it an activity we perform to actively manage and choose the risks to fit into our business activities? In short: is financial risk a business risk or an accounting risk?

For the past 10 years we have been very focused on managing risk so it complies with hedge accounting principles. But after the crisis everyone could see that financial risk actually is a business risk and hedging only postpones the effect and hedge accounting is mainly window dressing. The underlying task of choosing the strategic financial risk position is the issue. The financial risk has been delegated to treasury to manage through policies. We learnt from the crisis it is not that easy to escape the effects of financial market volatility. Instead the financial risk position has to be one parameter affecting the overall strategy of the company, for instance when deciding of locations for operations. This in turn requires an analysis leading to what the management expects of future financial developments and how to balance all business risks, including financial, into a combined risk profile.

The European Treasurers’ Peer Group is discussing this issue and the hedge accounting perspective is loosing its grip on risk management. There is a difference between being effective and being efficient.

Treasury Leading Group Consolidation

Generally in cases of group centralizations the treasury is one of the key functions taking a leading role. By getting control of the group’s cash processes treasury is a catalyst for the rest of the centralizing initiative. Most of the strategic treasury initiatives are implemented through technology. Treasury process improvements are therefore putting a focus on the TMS and other treasury applications and how well they are integrated in the group’s operations. Modern treasury solutions provide huge opportunities for optimizing processes, centralizing cash and control, and for reducing working capital and costs. They therefore become very able tools for leading the consolidation of group operations.

Conclusions of this reasoning are firstly that the ability for technical integration of the treasury applications and the scalability of the IT infrastructure is crucial to achieve results. This is also the reason why the Oracle and SAP treasury and cash management modules are gaining attention and increasing the installed base. Secondly group consolidations is an ample opportunity for the treasury to prove value add for the core business organization. The level of decentralization your company has is part of its DNA and consolidations are therefore usually hard to perform. But getting control of the group’s cash is the tool treasury can use. When treasury gains that control the group management has the means of controlling the group. The guy with the wallet decides.

Increase Transparency of Banks – Best Regulation

One can question if the root causes of the crisis were lack of regulation and that the OTC derivatives markets were not properly monitored. Surely the explosion of OTC derivative contracts was an effect of the credit expansion started in the early 80-ties rather than the other way round. The main cause behind the large swings is too much debt. We need to keep that in the back of our mind.

I have studied the work by the EU commission on regulation of OTC derivatives. What strikes me is that regulating separate areas independently seems to be easier than putting the new regulatory framework into context. I am particularly struck by the limited perspective of the discussion. It mainly revolves around banks and other financial institutions when it actually affects the whole society. The corporates are only involved in the periphery of the regulatory discussions.

The key, I believe, for sound financial regulation is to increase the transparency of the banks’ financial accounts. For many years the accounts have been impossible to decipher because the regulators have been keen on not forcing banks to disclose information to the market with regards to competition. But the fact is that banks do not compete in the general sense of the word.

Competition means having the risk of going bankrupt because your competitors take your market. No bank risks that. The banks go bankrupt when they take too much risk, have insufficient controls and bad management. I feel compelled to question if the regulators and bank supervisors know what competition really is.

Compare the transparency of corporate accounts with that of financial institutions. Why can corporates have transparent accounts when the banks can’t? Because the banks are more exposed to competition than corporates?

A more holistic perspective on regulation would be to force the banks to become transparent and enable us to understand what risk their business model and balance sheet entails. Force the banks to become as transparent as the corporates so we all can make our analysis. Now the only parties having sufficient information to evaluate a bank’s risk position are the supervisors. And what can they do about a bank taking too much risk? What can they do about systemic risk? Basically nothing.

However if everyone would have sufficient information of each bank’s positions everyone would price the bank’s shares and choose to transact with the bank based on their own judgment. This is how we usually organize society and free markets. Why shall we not do the same in the financial markets?

Forecasts Does Not Come Easy

Pre-crisis corporates produced forecasts and ran the business based on relatively stabile conditions. Markets were expected to follow a trend, many times growth rates of the economy. This is no longer true. The trend is not your friend instead you need to be prepared for the unexpected.

The Corporate Plans for 2010 survey, performed by the European Treasurers’ Peer Group and sponsored by NFS Group, clearly indicated that forecasts do not any longer come easy. This force mitigation through making the cost base and capex programs much more flexible and it raises the question how we shall hedge without reliable forecasts. Anyway hedging of forecasts only postpones the effect of market rate changes. An alternative is to increase the price elasticity transferring the FX effects to the customers and vendors earlier. This would be an effective hedge but require that we adjust our business model. Alternatives are to seize hedging other than for confirmed transactions or hedge unreliable forecasts. But these options raise more questions than answers.

But there is seldom something bad that does not give birth to something good. The crisis has forced corporates being much more agile, fast moving and flexible, not only relying on the trend. This is a very good improvement and it also forces the corporate management to treat financial risks as business risks and adjust the business model to cater for them.

Factoring May Improve Rating

Factoring might be a way to improve the rating for sub investment grade corporates. Lately there has been a gradual shift by banks to change how they view factoring, or invoice discounting. Previously they regarded the factor to take control over some of the collateral decreasing the security for the other financiers but lately there has been a shift towards regarding the cash generated through factoring as early payments from the customers. This perspective means that the cash flow is improved and therefore the default risk is reduced. Through the grape vine I hear the CRA (Credit Rating Agencies) might even improve the rating dependent on the terms of the factoring program of course. One critical issue is obviously recourse.

Implemented on a broader scale this would mean that factoring companies could substantially increase the amount of available funding for corporates. This does not happen every day and could be a counter action to manage the negative effects of Basel II.