No treasury management activity is without risk, and therefore defining the level of acceptable risk is essential. Fundamentally, a treasury policy is a governance mechanism by which the board, or risk management committee, can delegate financial decisions in a controlled manner to the treasurer, or those responsible in respective departments.
Key practicalities
- Integral process of treasury management with regards to the efficient management of liquidity and financial risks in a business; and
- Provide a clearly defined risk management framework for those responsible for treasury operations to frame the organisation’s risk appetite and setting a coherent road map to identify, control, manage and report the subsequent risk responses.
The treasury policy is the company’s response to a financial risk such as FX, interest rate, commodity, counterparty, liquidity or funding risk. The risk response, set out in a treasury policy statement, outlines details on the cause and potential impact of the risk, risk appetite for that risk, the response, the controls to manage the risk and the system of risk reporting.
Policy Objectives
The objective should clearly define what treasury is expected to achieve. For example, in a surplus cash investment policy, the policy objective will detail:
- Which risks should be managed, for example, the risk of default by a bank or other counterparty where funds have been deposited; and
- The extent to which risk may be taken, reflecting the company’s own attitude to risk, for example, the maximum amount and tenor of any deposit with a particular counterparty.
Corporate governance and risk management process
- Risk identification: definition, identification and classification of treasury risk exposures and sources;
- Risk assessment: assessment of the likelihood of each risk occurring and its potential impact;
- Risk evaluation: comparison of risk exposures against organisation risk appetite;
- Risk response: planning and implementation of responses, including the design of treasury policies;
- Risk aggregation: risks should be evaluated cumulatively so that any connection between the risks, if they exist, can be evaluated effectively. For example, the response to a risk may have to be adjusted if it is negatively correlated to another risk faced by the organisation;
- Risk reporting: ensure risks are managed as stipulated in the investment policy statement; and
- Feedback reporting: continual review of risk management outcomes is a vital part of risk management to ensure the process evolves, keeping at pace with both business and market developments.
Corporate strategy
Understanding the corporate strategy of the organisation is important when establishing the treasury policy for the following reasons:
- Current and future risk exposures will flow from the strategy adopted by the organisation. Where, for example, a company is looking to expand overseas, foreign currency exposures will arise, which need managing. Examining the current and future profile of the company will help to identify the risk exposures that need to be managed and whether local currency balances should be held locally or in local currency, remitted centrally or converted into the functional currency; and
- The board’s attitude to risk is key to formulating corporate strategy and hence an important factor in producing risk policies, for example, through the articulation of risk appetite statements.
Treasury objectives should be aligned with the overall organisation strategy and these subsequently determine the scope of the risk exposures that are to be managed by the treasury function. For example, some treasury functions are responsible for managing equity investments, and this area of risk needs to be included in the investment policy.
The expected contribution of the treasury function to the profits of the organisation need to be clearly set out, as this will determine the attitude to the treasury risk exposures. There are three common approaches:
1. A cost centre is a treasury that acts as a centre of excellence managing operational risks – at a cost. A cost-centre treasury can add value by using techniques such as cash-balance aggregation to reduce costs or improve interest income, while not adding to risks.
2. Treasury value-added centres are a more risk-tolerant variant of a pure cost centre. A value-added centre is a treasury that – like a cost-centre treasury – acts primarily as a service function/centre of excellence, but is allowed a degree of discretion about what actions can be taken and when with a view to adding value to the organisation by reducing net costs. Hence, a value-added treasury can add value in a way that is beyond the authority of a cost-centre treasury. However, value-added treasury centres are not allowed to take speculative positions in the financial markets.
3. Profit-centre treasury may actively create market positions with a view to earning profits, as well as hedging. Profit-centre treasuries require sophisticated treasury operations and systems with very strong internal controls and management reporting.
The board must fully understand and decide which approach fulfils the objective of aligning the treasury’s risk management policy with the wider strategic objectives and risk propensity of the organisation. Risk appetite will be reflected in the detailed policies covering how the treasury will react to identified financial exposures and mitigate those exposures. The importance of performance measurement applies to all approaches equally.
Order of importance for investments
Security of principal, and maturity
The overriding priority for the treasurer in managing the company’s short-term funds is the security of the principal. The original sum committed to the purchase of assets must be retained when the investment matures.
There are two main risks to investment security:
1. Counterparty risk: the risk that the counterparty will not meet its obligation to repay the principal and interest in full, when due.
2. Market risk: the risk that on any realisation prior to their maturity, investments may be worth less than expected. This may be caused by interest-rate changes for fixed-rate investments, changes in credit ratings or by alternative views adopted by the market.
As a general rule:
- Short-dated instruments carry lower risk than long-dated instruments and;
- For fixed-rate instruments, market risk (due to interest-rate fluctuation) can be avoided by holding the investments to maturity. However, interest-rate fluctuations and inflation will still affect the real value of fixed-rate instruments held to maturity.
Liquidity and accessibility
Treasurers are required to execute their liquidity management strategy against a backdrop of increasing market, compliance and regulatory complexities. Nowhere is this more evident than in the management of a company’s liquidity.
Liquidity is essentially the ease of converting an instrument or portfolio into cash at any time, without materially affecting its value. The amount of liquidity considered appropriate is a component of the risk appetite and forms part of the investment policy. Ensuring sufficient liquidity is a key responsibility for most treasurers and getting it right can be the difference between the success or failure of a business.
The investment policy should indicate how liquidity is to be achieved, by setting a maturity profile or specifying the proportion of cash that must be invested in liquid instruments. This profile or proportion will vary according to:
- Level of certainty regarding future cash requirements;
- Overall accuracy of cash-flow forecasting;
- Size of the maximum daily cash outflows that might need to be met unexpectedly; and
- Amount of funds available for investment.
Yield
Availability, diversification, flexibility, accessibility, tax and accounting
- Availability: whether a particular instrument is both permitted and freely available in a particular country or market;
- Diversification: risk can be reduced by diversifying across a range of types of organisation and instrument;
- Flexibility: of amounts, maturities and currencies required to meet the needs of the investor accessibility – ease of access to the market; and
- Tax and accounting treatments
Liquidity risk
Liquidity risk revolves around fluctuations in the ability to access the cash when and where it is needed. There is no universally accepted definition, but it is commonly accepted that liquidity risk appears as:
- Funding liquidity risk: defined as an organisation’s inability to obtain funds to meet cash-flow obligations due to its own issues; and
- Market liquidity risk: refers to the risk that market transactions will become impossible due to market disruptions or inadequate market depth.
Importantly, treasurers must be able to recognise that funding and market liquidity risk can overlap. For example, if commercial paper or bond markets dry up, that is market risk, which will immediately become a funding risk if the borrower has insufficient committed banks. The occurrence of these risks can have a considerable impact on a liquidity risk profile of an organisation. Treasurers are thereby most concerned with the systemic implications of liquidity risk.
Liquidity risk arises if we have insufficient liquid resources to pay invoices when they fall due. That is, if the liquidity obtained from either the asset (for example, lower than expected receivables) or the liability side (for example, lower external funding than planned) of the balance sheet is less than expected, income is not converted to cash, or the liquidity needs are more than anticipated. This suggests that liquidity risk may result from any or all of the other categories of risk. All risks could eventually result in liquidity risk, and risks must be brought together for their management, rather than being managed in silos.
Credit risk
Credit risk arises from the failure of a counterparty to abide by the terms and conditions of the financial contract, resulting in the loss of (some of) the invested principal.
Credit ratings can help to manage credit risk, as they provide a measure of the likelihood of default on financial obligations. Where credit exposures have a rating from an external rating agency, one can obtain a probability measure using rating agency data on default statistics. The three main global credit rating agencies, Standard & Poor’s, Moody’s and Fitch Ratings, annually publish the levels of default by rating (ie AAA, AA, A, etc) over specific time periods, from which the probability of default could be derived.
Where credit exposures are not publicly rated, companies have the following options:
- Seek advice from an external adviser or ratings provider (for example, Dun & Bradstreet); or
- Form a view on the probability of default using both quantitative (financial ratios) and qualitative (strategy, experience of management) analysis. Deriving an exact risk probability could be difficult. Opting instead for a range of probabilities may therefore be more realistic. In any case, the objective is to rank the key risks so that the response can be prioritised.
Defining risk appetite
Risk appetite is defined as the willingness to bear financial risk. The board determines the company’s appetite for risk, and this will be reflected in the investment policy as the acceptable level of loss of principal. Companies need to define their appetite for risk by setting levels of maximum acceptable losses or tolerance levels – only then can the board decide and execute applicable investment and hedging strategies. Ultimately, the degree to which a business participates in risk management is determined by the tolerance for risk and earnings volatility.
Within the universe of potential risks the company faces, the risk capacity provides the level of risk the company is able to accept without endangering its future. The risk tolerance then further limits the maximum level of risk the company is willing to assume. The risk appetite ultimately defines this range, taking into account the preferred policy in terms of risk versus reward.
Risk appetite variables
Risk appetite statements should be at the core of the corporate treasury policy, providing the basic principles underlying risk management approach.
Variability of business cash generation can affect risk appetite. Three key periods of sharp decline in risk appetite have been recorded: the 2008 financial crisis, the euro area sovereign debt crisis (2010–11) and the COVID-19 pandemic. During the pandemic, reduced risk appetite of corporates was primarily based on the uncertainty regarding assessing sufficient liquidity levels to support the business.
Loan covenants can represent important drivers in determining an organisation’s risk capacity. Companies that operate close to their covenants will have a relatively lower capacity for risk, especially if the covenants incorporate cash (for example, via net debt calculations) or net interest cover.
Other drivers can include:
- Boardroom prudence. Companies with relatively ‘conservative’ boards may be naturally more prudent reflecting in cautious risk appetite statements.
- Stakeholder views. Shareholders and bondholders may have a preference, reflecting on the overall level of appetite for risk.
- Financial profile of the organisation. Lower risk appetite for treasury risks may be appropriate for a highly leveraged organisation.
- Volatility of business operations. High volatility of cash flows may necessitate a lower risk appetite to ensure overall volatility doesn’t endanger the organisation.
Where does risk arise?
The challenge for treasury when investing corporate cash is to understand how risk arises so that it can be managed effectively to ensure the investment objectives are met. For example, treasury may be permitted to assume more risk when investing longer-term strategic cash than operational cash.
Counterparty risk is the risk that arises from the failure of a counterparty, resulting in the loss of some or all of the invested principal. To manage, limits are set in notional terms with total exposures per counterparty, based on their credit rating. Care must be taken where it concerns an unrated subsidiary, as the only option then is based on the reputation of the rated parent company and ability to support the subsidiary in question. Where local subsidiaries have the authority to invest, limits must be set to ensure that total global limits are not exceeded.
Either as a percentage or in nominal terms, limits may be set on portfolio diversification set by type of investment activity, distinguishing between bank deposits, repos, commercial paper and money market funds.
Investment maturity limits may be set either in nominal terms or percentages. During periods of high liquidity in the business cycle (for example, retail stores stockpiling ahead of holiday seasons), this may be managed on a more cyclical basis, with more investments being held for the short term at specific times of the year.
Limits could be set on the nominal or percentage held in different currencies. This may be based on the level of activity, and whether or not the currency flows are two way (for example, business with EUR as its functional currency, having sales and purchases in USD) or one way (for example, sales are in USD but costs are in EUR).
Country risk refers to the uncertainty associated with investing in a particular country, and the degree to which that uncertainty could lead to loss of principal. Traditionally, companies measure their country risk by physical locations, and nominal/percentage limits could be set on the total exposure arising from where the counterparty banks are domiciled.
Allowing for flexibility
Policies set rigid frameworks, providing absolute clarity over company risk appetite and what activities are acceptable within this. However, there are occasions when rigidly applying a policy may actually result in breaches, and it may therefore be prudent to carve out when breaches are ‘acceptable’. Depending on the nature of the business and the culture of the organisation, the following situations may need to be planned for:
- Building a war chest in anticipation of an acquisition, which may result in counterparty limits being breached;
- Delays in settling an acquisition, which may result in a breach of policy;
- Late receipt of funds may result in a breach of policy if the funds cannot be invested;
- The downgrade of a financial counterparty may result in a breach that cannot be remedied until the investment matures; and
- Lack of strong credit rating available in a certain jurisdiction.