Managing Eurozone risk outcomes

14 December 2011

The ongoing financial and banking crisis means that the identification and controlling risk continues to be critical to successful Treasury management. High impact risks have the potential to threaten the survival of a business or erode its financial strength. Whilst it is becoming easier to see the impact of these high impact risks, the ability of a treasurer to predict and perhaps control those risks within the remit of Treasury is getting ever more difficult. Events such as the Eurozone crisis may have been unforeseen but are not unforeseeable, although its ultimate outcome —such as what will happen to the Euro — are virtually impossible to predict.

Treasurers need to be more fully and flexibly prepared for a range of unpredictable outcomes. One way to think about this is to focus on potential risk consequences—in this instance an undefined event that causes a break up of the Euro with a combination of the following illustrative risk consequences and to use these perspectives to create contingency plans:

  • a liquidity crunch;
  • a prolonged failure of or access to Treasury or banking systems in a country or countries;
  • a sudden and unexpected significant foreign currency exposure/s;
  • a withdrawal of credit line/s;
  • legal uncertainty;
  • imposition of capital controls.

Why is it important to think about this even if it might be a low probability risk?

Managing risk in this way is not a new concept, however, two things have changed in recent years that have made it difficult to have an approach that only worries about the risks as they crystallise and only puts in place just in time contingencies:

  • Speed of global communications have changed time frames. The moment something happens everyone knows about it.
  • Complexity of business and the interlinking of political, social and environmental risks have made it harder to manage issues.

The challenge and opportunity is one of looking forward rather than backward and Treasury has an important role to help ensure that the potential risk consequences associated with a low probability event, such as the break-up of the Euro, are anticipated and appropriate plans and resources allocated to identify and mitigate their effect. It is far better, and sometimes easier, to have a set of plans available which set out the immediate actions to respond to a critical incident and provide considered approach to manage any resultant crises and return to normal.

What should Treasurers be doing to respond to this challenge:

1. Have up to date and relevant contingency plans.

Most treasuries that take risk seriously will have a risk matrix that sets out a list of possible risks and their approach to mitigating these risks. They may also have an associated procedures manual, oversight mechanisms and detailed contingency plans.

Recently we have noted that leading edge treasuries are focussed on ensuring that their contingency plans are up to date and have considered within these the potential combination of risk consequences that might be associated with an event such as the break up of the Eurozone. By making these risk consequences visible, as part of the organisation’s governance and risk management arrangements, it is possible for the organisation to have a more complete view of the risk it faces and ensure that it plans accordingly. In doing so the organisation may be able to weather the resulting crisis and economic downturn by acting quickly and decisively, and making the hard decisions early on. In preparing this contingency plan management should consider:

  • Do you have the right plans?
  • Is the board adequately involved to ensure priorities are appropriately set?
  • Have responsibilities been allocated?
  • Have the plans been rehearsed?
  • Are sensible investment choices being made?

The consequences of a Eurozone breakup go beyond those organisations directly exposed to countries that may exit the euro. The risk of contagion and fear of exposures that financial institutions have to these countries remain and may lead to reduced liquidity and other consequences. Furthermore some of these actions remain good practice - even if there are no crises.

2. Make effective use of scenario analysis and stress testing to determine Treasury’s ability to respond to identified risk scenarios and the organisation’s ability to withstand various stresses.

Proactive and robust downturn scenario and stress testing can allow plans to be formulated to deal with a range of outcomes and allow the organisation to be ahead of the game in terms of strategy and implementation. Such scenario analysis and stress testing can also help an organisation understand those risks that require additional investment or attention and ensure that the plans have been rehearsed effectively and regularly.

3. Make effective use of early warning indicators to prevent or limit the consequences of high impact risks.

Indicators can help illustrate the emergence of risk and enable a timely and planned response, even if those risks cannot be prevented. A simple example is regular monitoring of bank and non-bank counterparty, sector and sovereign risks using a variety of sources to help Treasury ensure that its exposures are diversified away from lower-rated counterparties or counterparties with particular exposures to at risk counterparties, sectors or sovereigns.

More advanced Treasuries have a suite of indicators that monitor the emergence of risk. These are sometimes focused on those operational areas of Treasury that could cause loss due to inadequacies or failure of: people, process or systems. Increasingly there is a view that this should also include external events. An example of this might be to consider cashflows, earnings or capital at risk in the event of a currency redenomination across a range of Euro breakup scenarios and contractual exposures.

I would be interested to hear your thoughts on this.

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