Audiovisual activity

Listen to the audio, Risk mapping and risk management, a discussion between:

• two treasurers of major companies – Paul Outridge of De La Rue and Neil Henfrey of Boots, now a brand for the international pharmacist Alliance Boots
• a banking risk management specialist – Hor Chan
• Head of the Department for Accounting and Finance at the Open University Business School – Martin Upton.

It examines the financial risks that organisations are exposed to and how they are addressed by management.

The audio contains some technical matters and terms that will probably be new to you. Do not worry about this, though. It is intended to give you a flavour of risk management in action and what risks organisations are concerned about.

You may be surprised, as I was to a degree, to see pension fund risk referred to in the audio as being a financial risk. Personally, I would see pension fund risk – the risk that organisational pension schemes fall into deficit – as arising from increasing longevity and the fall in returns on financial assets seen in recent decades. The former increases a pension fund’s liabilities due to the resultant need to pay out pensions for longer periods. The latter reduces a fund’s assets by reducing the returns on investments, which, in turn, may be re-invested.

However, increasing longevity is not a financial phenomenon and falling returns on assets are a result of adverse interest rate risk and equity price risk, both forms of market risk. So pension fund risk is really a form of market risk mixed with growing longevity. What do you think?

Download this audio clip.Audio player: Risk mapping and risk management

Show transcript|Hide transcript

Transcript: Risk mapping and risk management

Music – 00:16

Martin Upton:

Hello, and welcome to this audio programme on financial risk management. To help me explore these issues and, in particular to show how financial risks are managed in the business world, I’m delighted to be joined by Neil Henfry, the Group Treasurer of Boots, the United Kingdom’s leading health and beauty retailer and Paul Outridge, the Head of Treasury at De La Rue, the world’s largest commercial security printer and paper maker. Managing company risks involves an active relationship with the banking sector... and here to represent that sector I'm pleased to have Hor Chan. First, can I turn to you Neil – what are the financial risks that arise in the business at Boots?

Neil Henfry:

Thank you, Martin. We would say there are six main financial risks. First of all there would be liquidity risk. Secondly, there would be counter-party credit risk. This would be particularly with bank counter-parties, and also when we’ve got substantial amounts of funds to deposit. Thirdly, the currency risk; relatively small at Boots but it would be primarily around purchasing goods for Christmas from the Far East, which might be dollar related, and also sales in our Republic of Ireland stores, which would be euro related. Fourthly, interest rate risk; this arises from the debt we’ve got on the balance sheet – about £600 million – and also, at the current time, cash we’ve got on the balance sheet – about £700 million – and making sure there’s no interest rate mismatches between the two of them. Fifthly, like any corporate treasurer, there’d be operational treasury risk arising from having a small team and needing to ensure there’s segregation of duties, such that fraud can’t take place. And finally, a large risk for an organisation like Boots would be pensions risk.

Martin Upton:

Paul, is it the same at De La Rue?

Paul Outridge:

Martin yes that’s right. Certainly I’d agree with Neil on that the principal areas of financial risk that we also face at De La Rue, although I think the emphasis for us is slightly different. As a major UK exporter, foreign exchange risk is certainly the most significant risk that we face, and managing that is a key part of our treasury operational management. Following on from foreign exchange risk, simply would add that liquidity risk and counter-party and credit risk are also similarly important. Liquidity risk, ensuring that there’s sufficient cash available in the right currency at the right time and in the right place, is a key area for all treasuries. With regard to credit risk and counter-party risk, again we have a surplus of cash on the balance sheet – it’s in making sure that the institutions with which we deposit our cash have sufficient credit ratings to ensure they will be there tomorrow when we want to receive the cash back.

Martin Upton:

Well Hor, if I can turn to you – risk is the nature of banks’ business, so I suspect that your list will contain every financial risk in the financial dictionary.

Hor Chan:

Yes, Martin, I imagine that’s right. Our biggest risk, of course, as a bank is credit risk. If you look at the assets of any bank, the biggest category there is really the loan portfolio. So, when we lend money to people, of course, we have to be reasonably sure that they will be paying us back, and that’s where the credit risk comes in.

I think the second category which overlaps partly with Paul and Neil’s is market risk, what we would call market risk, but perhaps they’ve separated it out slightly into foreign exchange and interest rate, which of course it includes, but then we would also put in equity risk or commodity risk from our trading books, and so on.

The third category is operational risk, which is increasingly important nowadays with the new regulations coming in, Basel II and with the ratings agency focus on this nowadays. There’s much more emphasis on that.

Perhaps the fourth one I’ll mention is one again that overlaps with Paul and Neil, which is liquidity risk, and about being able to fund ourselves and have enough cash to meet our obligations.

And just to wrap up on a few other risks which we face, these would be legal risk, reputation risk and business risk.

We approach risk in a very different way to corporates. We’re really looking at risk as an opportunity, an opportunity which, as long as it generates the return which is adequate for the capital we’re using on this risk, then we probably should be taking it, provided of course it doesn’t impact our reputation. So yes, we are in the business of taking on risk, rather than necessarily getting rid of all the risk. And sometimes, indeed, we would even take on risk deliberately when we have a particular view of the markets, because we feel that’s an opportunity to speculate, if you like, and make a bit of extra money. Of course, it’s so difficult nowadays for banks to make money in the traditional lending business. We have to supplement it by taking, in a sense, a few more risks in different areas to try to increase our returns.

Neil Henfry:

I think there’s one other thing that Hor brought up there about banks take views of markets. It probably would be true to say, I think, in the corporate world these days that most corporates do not take any views on markets and therefore, you know, you don’t get into speculation. Speculation could be that you don’t hedge something, even though you’ve got the exposure. But we tend not to take views on markets and you tend to just hedge irrespective of whether you might personally think dollar/sterling is going to move in one direction. Personal feelings don’t come into it these days.

Martin Upton:

I guess, if you’re on the Board of Boots, you might find it understandable if you’ve taken a business decision to launch a product which ends up failing and losing money, but if you lose money on foreign exchange speculation, I think the Board members might find that inexplicable.

Neil Henfry:

That would be absolutely right, which is why most corporates don’t do it these days.

Martin Upton:

Thank you. I want to drill down now to what actually happens when you want to manage those risks. It’s one thing to say, “OK, I’ve got foreign exchange risk, I don’t like it, I want to get rid of it. I’ve got interest rate mismatch risk, I’m borrowing floating, I’m lending fixed. What do I do about it? What transactions do I do? And how might I use derivatives?” Neil, can I turn to you.

Neil Henfry:

I think the first one, on the funding liquidity is, what we do is make sure we’ve got access to a variety of funding mechanisms, so we have a Euro-MTN Shelf Program, to be able to issue public bonds off. We’ve got a credit rating from Standard and Poor’s, and Moody’s, again an investment grade credit rating, to be able to issue public bonds. But more importantly in many ways, is committed financing, so that’s having undrawn committed facilities from banks, so that you’ve got the ability at any time to be able to draw down funds on the same day basis in case something happens. And the key thing there, really, is to make sure you fund before you need the money, so that you’re not kind of held ransom to the markets. And, there’s quite an important example recently on that, where Philip Green made his phantom bid for Marks & Spencer’s – all of a sudden, not just Marks & Spencer’s, but many of the retailers in the UK had a lot of trouble accessing capital markets because of rumours about – could it happen to them as well? So, if you’d been wanting to go to market at those few months you wouldn’t have been able to. And so that’s why you always need your committed financing and things like that to stand behind it.

You asked me about derivatives. We do use them for currency so, when we are hedging our US dollar imports for Christmas trading, we use straightforward FX forwards and spot deals to hedge those, we’ve got some interest rate swaps to be able to convert the fixed rate bonds into effectively floating rates, which then the interest rate risk matches off against, with the cash that we’ve got.

Martin Upton:

Paul, what’s your experience?

Paul Outridge:

Our exposures and our risks are much more concentrated on the foreign exchange side, and our policy is fairly straightforward for those. We again use plain vanilla forward contracts to hedge our foreign exchange exposures. We do, within the treasury department, have the ability to use currency options, for example, should we choose. But, in practice, it’s something that we have not used in the last three or four years. So, they are there as an instrument that is available to the treasury department, if it so chooses, but in practice, straightforward forward contracts provide the level of cover that we need for the vast majority of our exposures.

Martin Upton:

Paul, I wanted to explore another matter with you, managing foreign exchange exposure. Before you need to use derivatives like foreign exchange swaps to manage that exposure, you should look at alternative, what we call internal techniques, to manage your currency risk. Now, does this go on in the real world? What’s the experience at De La Rue?

Paul Outridge:

Yes, most certainly it does. Natural hedging, as we call it, essentially matching currencies of payables and receivables, is a key first line in managing currency exposures because that can be done at no cost. It reduces your net exposure and, therefore, reduces the volatility that you need to manage as part of that risk.

Another key feature, because foreign exchange forward contracts are very much a short-term option for smoothing the flow in terms of volatility, what is also key is looking longer term in terms of more strategic ways of managing risk. And for us, particularly for currency risk, is, for example, where do we situate our manufacturing plants? A key area for us, and which is one in which we’ve recently implemented, is to move some of our manufacturing sites away from Europe into low-cost, dollar-denominated regions in the Far East. Now, not only does that help to reduce our cost base, it also helps to reduce our currency exposures as well, because many of our key markets for some of our machines are in the US, and we are, therefore, managing naturally to hedge our dollar exposures by sourcing products in a dollar-denominated region and selling, obviously, in North America. So, that provides a natural hedge to us, which reduces our net exposure, and therefore reduces the actual number of forward contracts and derivatives that we need to use.

Martin Upton:

Hor, it’s again slightly different from the banking perspective, isn’t it? Because companies like Boots and De La Rue, they could be your customers when it comes to hedging transactions, when it comes to the use of derivatives. How would you describe the relationship you would have at ABN with those types of customers, and how would you be using derivatives to manage your own risks?

Hor Chan:

Well, I think from the point of view of dealing with customers like Neil and with Paul, of course, we are suppliers of the financial hedging instruments and market makers in those, so of course if they wanted to use a swap or a forward they could call us and we would tell them at what price or at what rate we could provide that hedging instrument. And the point is that we are there to provide liquidity in the market, we provide both a bid price and an offer price, if they wanted to unwind their hedge as well.

But for us as a bank, I think the real change for us in terms of using derivatives in the last few years has really been the advent of credit derivatives, and that’s really helped us to manage our credit portfolio in a much more active way than we ever did, even five years ago. And, as I mentioned earlier, that really is the biggest credit risk that we have.

Paul Outridge:

Can I come in at this point? Because if I wasn’t happy with the credit worthiness of an issuer, I wouldn’t buy the bond in the first place. So why do I need to access the credit derivatives market to manage credit exposure, which perhaps I didn’t want in the first place?

Hor Chan:

I think that there are different ways of acquiring the assets in the first place. Sometimes we’re given the risk, in a sense, by a client who asks us for a price and then sells to us, of course, on the bid side hopefully some asset which has credit risk which we aren’t really happy with, so we may want to hedge that. But, more often, I think, where credit risk arises is where we deliberately take on the exposure. We would deliberately lend money to a client, or we may think that their bond which they’ve issued is a good investment. But, of course, circumstances change. The markets move, credit worthiness alters with business cycles and so on. So, something may happen which would mean that we’re less happy, perhaps, with the credit risk which we have, and we want to hedge that. And, of course, on occasion it’s very difficult, especially when you’ve given a loan. It’s very difficult to go back to the client and say – we’d like to pull your loan now; we’d like our money back please – because I’m sure Neil and Paul would not be very happy if I tried to do that. So, what we would do instead, of course, is merely hedge it using a credit derivative, and that’s the way we can get around having to go back to the borrower and saying, you know, we’re not so happy with you nowadays.

Martin Upton:

And the most common deriviatives in use are credit default swaps – is that the case?

Hor Chan:

That’s right.

Neil Henfry:

Can I come in, because corporates are not necessarily that thrilled about the development of the credit default swap market. It gives a very visible price on your bonds and your funding. So, if you’ve issued a five-year bond, you’ve now got a very visible price that’s very volatile. In the old days you used to issue bonds to investors and they used to sit on them and there was hardly any trading went on in them. Now there’s a credit default swap market, it’s a very visible traded market. It’s often got hedge funds acting in it, and so you can get some very volatile pricing in that market. And, of course, if you then try and issue new bonds into it the reference market is the credit default swap market, not how your bond is trading in the kind of real world. So to go back to that example of Philip Green with Marks and Spencer’s, all the retail of bonds, credit default swap markets went, may be up a hundred basis points or whatever within a day. And so it can make things very difficult.

Martin Upton:

Neil, can I ask you to talk about the problems which you think exist with pension funds and how they pose a significant additional risk for companies like yourselves?

Neil Henfry:

Yes, Martin. Boots, like many companies in the UK has got a defined benefit scheme. It’s fairly closed to new members but, nevertheless, it’s got liabilities of three and a half billion at the last count, which is broadly the same as the market capital of the company, and, therefore, it’s a very substantial size of liability there. Now, obviously there’s assets matching those liabilities to the extent they can, and Boots is in the very fortunate position of having broadly a fully-funded scheme. So, it’s got about three and a half billion of assets as well.

So, you might say, so what’s the problem? Well, the problem is that the size of the liabilities depends on things like long term discount rates, inflation rate, prospective salary increases and, probably most important of all, actuarial assessment of longevity, mortality of the people in the fund. And so, the size of those liabilities moves up and down with the markets, as discount rate moves, and every time actuaries decide that people live an extra five years it adds more to the liabilities.

Now, the assets themselves, of course, depending on what they are, might act in a very different way. Boots itself has got 85 per cent of its funds in bonds and 15 per cent of its funds in equities and properties. Now, obviously, they don’t necessarily move in the same way as the liabilities do, so what you find is that, when you measure both the assets and the liabilities on a market base, which is what you’re required to do for accounting purposes these days, you can quote very substantial volatility in the difference between the two. And, let’s imagine that you’ve got a deficit of two hundred million, how are you going to make that up, and how quickly are you going to make that up? And so you can find that all of a sudden that you’ve got a very quick demand from the trustees to make substantial additional contributions to the fund that you weren’t expecting. So, it eventually flows through to a funding liquidity issue.

However, even despite that, during the whole process of this – because it’s a market valuation, it’s now on balance sheet, banks look at the deficit, investors look at the deficit, rating agencies look at the deficit and treat the deficit as being debt-like; and so it can impact you quite substantially in your credit rating, your share price and your relationships with banks, if you’ve got substantial deficits, which many companies do have.

Paul Outridge:

Adding to what Neil said, I think, one important area that is now coming through is how treasury departments can help the trustees to manage that deficit and in terms of derivatives, which we’re talking about. The problem is the mismatch in the funding gaps. For example, the assets may well be in bonds, but the maturity of the bonds won’t necessarily match the profile of the maturity for the pensioners or prospective pensioners in the scheme. And this is one area in which, for example, interest rate swaps are certainly being talked about as one mechanism in which you can help to smooth the difference the exposure between the assets and liabilities.

Martin Upton:

We know that with the introduction of international financial reporting standards, IFRS, the position in respect of pension fund liabilities has to be reported, but also I understand, Paul, that IFRS, as we know it, has had an impact on other areas of your risk management business.

Paul Outridge:

Certainly for us at De La Rue, yes, that’s right. IS32 and 39, for example, which deal with financial derivatives and financial instruments have a significant effect on us in term of not necessarily the way in which we manage our exposures, but certainly the way in which we’re required to report them and also to the level of documentation that we have to provide. The key element of IS39 simply relates to how you can match your forward contracts or your financial derivatives that you’ve taken out to hedge your underlying currency exposure. Traditionally, providing the level of forward contacts you had in place matched your level of exposure, then that was sufficient within the accounting rules in order to effectively to be able to combine the two and simply effectively, when the forward contracts matured, you would then be able to match those off against your sales or your purchases within the profit and loss account.

What has happened now is that, in order to achieve the same treatment under IFRS, there’s a whole new regime called ‘Hedge Accounting’ that has become now part of this exposure document. And, as result of that, to achieve Hedge Accounting there are very strict rules that you have to manage in order to be able to achieve the same result, and effectively put all your forward contract revaluations which now have to be marked to market on a monthly basis, to your reserves rather than taking them to P & L every month. The level of documentation required is quite onerous and, certainly for major international groups, it’s a key decision in terms of managing your exposure, whether you want to manage that volatility to your P & L or not. For De La Rue the decision was made that we do need to manage that, because the potential volatility exposure, sudden changes in exchange rates, is such that it could produce a significant effect in our reported results which, not as a result of our actual economic hedging that we’ve undertaken, but simply as a result of an accounting standard, has created this volatility. And that, to us, was unacceptable.

Martin Upton:

So, in effect, you’re saying that changes to accounting standards are, in a sense, leading to certain business inefficiencies when it comes to your hedging and business activities in treasury?

Paul Outridge:

Um… certainly in the sense that we have, as a policy, decided we did not want to change the business rationale for hedging. We still have underlying exposures in currencies, we still wanted to maintain that level of hedging on an economic basis. What it has impinged on, certainly, is the level of administration that now goes into maintaining the level of exposure management that we do currently. And that has put a considerable onus, not just on treasury departments, but also on the subsidiaries throughout the group in order to comply with these, the new accounting standards.

Martin Upton:

What impact have all these high-profile, treasury-related disasters had on the way in which large banks undertake business?

Hor Chan:

I think it’s, for the bank itself, I think it’s made us improve our own control systems and made us focus much more on operational risk than perhaps we had previously. When you think that the Allfirst debacle, for example, was really about loss of controls, about a single person who managed to run up large positions which seemed to be undetected for some time. But within the bank, what it’s really meant is that we’ve undertaken a huge exercise really to identify all our operational risks and also try to construct a database, really, of where we’ve had operational risks in the past within the bank itself. But, in fact, not just the actual losses, but we also need, of course, to try to capture the near misses also, which has been more difficult because people don’t’ really like to admit that they almost made a loss.

So, that’s one area, certainly it’s made us focus much more on operational risks I think, and that’s been a great impact. The impact of Enron, for example, one of the impacts certainly is Sarbanes-Oxley, which has actually created a lot more work for us. Paul’s mentioned the onerous tasks that have to be undertaken for IS39, well Sarbanes-Oxley is also hugely onerous on our control systems, on our auditing, on the reports we have to produce internally to make sure we’re complying with it. So I think what’s really happened, in a sense, with these disasters is much more regulation and essentially much more work for us on keeping records and showing that we’re doing the right thing.

Martin Upton:

Paul and Neil, has that been the experience in the corporate world?

Neil Henfry:

At Boots we’ve been very lucky that we’ve not had to deal with Sarbanes-Oxley because we’re not US listed. However, even in the UK the introduction of the Operational Financial Review and forward-looking risk statements in the annual report and prospectus and things like that means that we’ve had to introduce a far more formal risk management process across, not just treasury, but the whole of the business operations. And that’s been introduced over the last couple of years. So, there’s a much more rigorous, holistic risk of process nowadays of which treasury is actually a very small part, because many of our risks are quite mitigated away, whereas your core business risks you can’t mitigate away, and they’re the ones that you actually need to understand on the Board more than many of the treasury risks which we’ve got rid of.

Paul Outridge:

That’s right, and I think, certainly now, part of the annual accounts require formal statements on policy in terms of how you address the risk, as we’ve said, Neil’s said, not just financial risk but also insurance risk, etc, business operational risk; and certainly the whole corporate governance has moved. Even De La Rue does not have to, I’m pleased to say, report under Sarbanes-Oxley either. But the whole level of reporting under corporate governance is now filling quite a few pages now of everybody’s annual reports. And it’s an area that, as Hor said, I think more and more, there will be additional requirements in which we need to comply in future, as we go forward, as more accounting standards and, potentially, more disasters happen, in which everybody, if you like, needs to make sure and demonstrate that they have the systems in place to mitigate those risks.

Martin Upton:

But this is also setting a serious educational challenge for executive and non-executive directors who don’t necessarily come from a financial background. How are companies dealing with this?

Paul Outridge:

Well, certainly from our side, and we do have formal training courses for directors when they’re appointed. They now actually have a series of lectures and informal discussions, so they are actually made fully aware of just what the risk of being a company director for a public quoted company is. Because in circumstances they are liable along with the company, and therefore it is a personal liability as well as a corporate liability.

Neil Henfry:

We would have a similar kind of thing at Boots.

Hor Chan:

Well, I think one of the things I can say from the difficulties perhaps that some of the corporates are facing is actually this is a good opportunity for banks, of course. It’s a chance for us to move in, perhaps, and help advise on some of the regulations that are required, or to advise on how to manage your hedging systems, so it’s more efficient and you comply with IS39 or, indeed as Neil mentioned, on the pensions funding side, of course, we are suppliers of the financial instruments that he mentioned, inflation links, swaps and assets for investment and so on, of course.

Martin Upton:

I’d like to finish by focussing on one curious but particular foreign exchange-related risk which I was discussing with Paul just before the making of this programme. Now De La Rue prints banknotes and recently we’ve seen the emergence of the euro and the eurozone in recent years, and who knows, in the future many more countries may be joining the eurozone. And, as a printer of banknotes, I just wondered whether this development in the forex market was good business news or bad business news.

Paul Outridge:

Well, in the sense of certainly the spread of the euro market, to a certain extent it is, from a treasury perspective, it is actually quite good because obviously it helps to mitigate the risks in the foreign exchange market. From a business perspective there are both opportunities and, perhaps, disadvantages. With regard to principal western European countries, most countries print their own banknotes. As the largest private printer of banknotes we have about approximately 50 per cent of the private market, but 90 per cent of the banknote market is actually printed by state governments. So, therefore, particularly for the eurozone, most countries will actually print their own notes, and, therefore, there isn’t an opportunity in that particular area necessarily for us. Although, together with the change, obviously, in the changeover in currency, it means that there needs to be new machines both for handling and counting notes, and that is an area of opportunity for us in which, obviously, we make sure we’re well placed.

Martin Upton:

And would you be well placed when Britain goes into the euro?

Paul Outridge:

Yes, I think there’s sufficient lead time on that to allow everybody, I think to be able to manage that transition.

Martin Upton:

I suspect there’s a very long lead time on that. OK, and with that, can I thank Hor Chan, Neil Henfry and Paul Outridge for the insights they have provided into the realities of risk mapping and risk management in the business world. Financial risks are pervasive but at least we know that there are means of managing them effectively.

Music – dur: 00:05

End transcript: Risk mapping and risk management

Download

Risk mapping and risk management

The audio was recorded in 2006, but its contents are still very relevant for our understanding of contemporary risk management issues.