Treasury is a place where entire cash of the Company sits, this can be compared with a fresh lake of water serving the needs of the villagers for all water needs. Any contamination, shortage, irresponsible use may bring the lives of the villagers in jeopardy. The same is true with any Company if cash is not managed well. Treasury is required to maintain sufficient liquidity including cash management for daily and emerging future needs; invest the cash in such a way that it fetches good return; the instrument in which cash is invested should have high creditworthiness else there could be a risk of not realizing full value of money; if the Company is doing overseas business is to manage the fluctuation in the exchange rate else there could be loss due to fall in local currency; up and down movements in the interest rate may impact meeting long- term liabilities, if any. The timing of “cash in” and “cash out” is very important that may otherwise have an adverse impact on the overall return of the Company. In this write-up, the details of these risks are discussed and how they can be managed.
The fundamental management of cash has a great linkage with the cash-outgoes because the Company is to manage all the payouts and earn a decent return. These payouts depend on the type of liabilities arising in the future. Liabilities here are defined as all the payments that are due to be paid. For example, the liabilities of the banks and insurance companies are very different in the financial sector. Life insurance liabilities (Death, Maturities, and Surrenders) are long-term in nature while the liabilities of the banks (Savings, Fixed Deposits etc.) are short-term in nature. Both bank and insurance companies require different treatment of cash. The different treatment of cash means investing in assets with a mix of tenure and types of currency so that it can be redeemed when required without any losses. Manufacturing industry, on the other hand, may not require cash-outgoes for liabilities pay-outs, but it may require for the purchase of raw materials, vendor’s payment etc. so cash management here have could be in short to medium term in nature.
The key risk with the cash management is that the Company may not have enough liquid money to make all pay-outs as it emerges in future. This due to lack of liquid cash, the Company may have to force sell long-term assets that are earning a better return than short-term assets resulting into loss due to lower market price than the purchase price.
On a business as usual situation, such risks can be managed using the cash flow matching based on likely income stream in future and likely outflow stream. This will enable the Company choosing the right tenure of assets matching with out-goes. In such investment, the Company can find a right mix if short, medium and long-term assets to optimize the return for the Company.
The cash management situation is relatively easy to handle in business as usual situation as the future events may turn out to be more on the predictable lines and return on the assets can be optimized.
The situation of cash management could be challenging when the future events turn out to be worse than expected, such as steep fall in the equity market, sustained fluctuation in the exchange rate, volatility in the interest rate and inflation, big international events affecting national market etc. Similarly, on the demographic front, there could be a higher number of deaths or sickness due to either natural calamities, the emergence of new diseases, an outbreak of existing disease impacting large population etc.
These changes in the economic and demographic front induce changes in the behaviour of customers. This may results into either in terms of higher withdrawal from the financial institution putting pressure on treasury or customer reduces the cash inflow into the financial institution reducing the inflow of income to the treasury. Both the situations either individually or collectively adversely affect the ability of cash management of the Company putting pressure on liquidation of long-term assets.
Such situations are often described as “Stress Conditions” because situation warrants more attention than business as usual.
Such risks of liquid cash management are performed by doing the Stress and Scenario Testing (SST) at the time of planning for cash management exercise. In the stress testing based on the industry, different parameters are stressed such as in insurance companies, for instance, 50% of the higher number of deaths are assumed, 50% of higher lapses and surrenders of policies are assumed to look at the demographic impact. Similarly, the impact of fall and rise in the equity market, up and down movement in the interest rate are tested for the likely cash required to pay if such situation arises. The Company is to make available this cash required under the stressed conditions at all the time.
This would mean, some loss of return on assets due to keeping more than extra cash required to meet business as a usual situation but liquidity position will be managed. This is required because lack of liquidity may damage the reputation of the Company as well as trust in the financial institutions. No government would like its people losing trust in the financial system of the Country. The 2008 economic crisis is a great example where liquidity risk was the highest risk compared to any other risk. The demonetization is another example of the liquidity crunch faced by the Country.
In the very extreme situation, the shareholders may have to inject the capital to manage the liquidity/cash management risk; this is a very similar situation of US government funding AIA insurance Company in the US during 2008 economic crisis.
A similar Stress and Scenario testing may be performed in different institutions in the financial sector such as Banks, Mutual Funds etc. The Manufacturing sector may require different stresses for cash management as this can impact both incomes to the Company and outgo. For example, due to economic turmoil, the cash pending to be received from distributors getting delayed impacting the income of the Company and this mismatch may have an adverse impact on its ability to make pay-out to its vendors.
SST is turning out to be a strong tool in risk management of the Companies because it allows pre-empting the scenarios that may bring greater challenges if those events occur in reality. The key success for the application of SST is identification of scenarios are plausible to allow for extra buffer.
Credit risk is a risk of default when the borrower of the money may fail to make payment in full or in part when it became due. Such credit risk may arise either from the bank, government, corporate borrower, vendors, reinsurance companies etc. When the Central Government borrow money from the market, they are generally considered as risk-free but there have been examples in the world where the Central Governments have failed to pay when due.
When the treasury is recommending to invest its money in different assets instruments, they have to take care of the creditworthiness of the borrower. Such creditworthiness is often recognized by the credit rating of the borrowers. Such ratings are given by rating agencies that invest time and money on research about the Company and the Management. However, these ratings to be used with care and not just blindly following the ratings given by the rating agencies. It may be known that the Companies pay for their own rating. Again 2008 economic crisis is a great example where AAA rated companies failed. So one of the key jobs of the treasury is to analyze the ratings of the companies on a regular interval, use own judgment, keep abreast to the market development and invest with a mix of assets to diversify the risk of loss due to default.
The investment in different instruments have bearing on the return on the assets, as lowly rated assets give higher return; so it’s a judicious judgment how to mix the assets to manage the liquidity, creditworthiness and return on assets.
Assets and Liability Management
As mentioned above the availability of cash is required when the liability becomes due; that is, the available cash should be matched with both the amount and timing of the liabilities arising.
What is the risk, if this is not performed?
If the available assets are not liquid when liability is due, the Company is to force sell its long-term assets that may result in a loss. This is due to interest rate risk. This is because if the interest rate does not change forever, then the Company may sell long- term assets realizing the same value when it was purchased or purchase assets any time in future will have the same value. However, when interest rate fluctuates, there will be a difference in the value of assets when purchased and when sold, the difference is gain or loss. So it is important that the assets should be purchased in such a way that immunizes the interest rate risk. This is often performed by matching the duration of assets and liabilities.
The treasury is also to manage currency risk when either the payment to be received from the foreign client or to pay to the foreign client. The fluctuation in the exchange rate may bring risk of loss. The currency risk need not be managed for domestic players doing business within the country. One of the ways to manage the exchange rate risk by purchasing derivative contract.
When the Company invests its money in the equity market, due to the market price movement, there is a higher risk that the Company may require money when the market has tanked. Such risks are even higher if the Company is investing in short-term because it does not allow time for the market to recover when it nose dive. Equity investment may also depend on the investment policy of the Company which Board is aware of. However, a judicious use of long-term equity investment along with investment in the blue-chip Company may bring profit. The proportion of investment in the equity market is also a key determinant in the overall scheme of the thing. From a liquidity point of view, equity may be considered as highly liquid, the key risk is due to its current lower value compared to when purchased.
The key financial risks from treasury point of view are cash management/liquidity, credit risk, interest rate risk and exchange rate risk. These risks have a very strong bearing on the long-term sustainability of the Company. Also, many of these risks are correlated, where triggering of one risk can have an adverse impact on the other risk. For example, fall in the interest rate have an impact on the amount of money investment in the equity market. When the interest rate is low, there will be more investment in the equity market and vice versa. A fall in the credit rating may have an adverse impact on the liquidity position as all the investors may try to withdraw money from the Company rated lower. So the treasury is not only to manage the individual risks but also to monitor the correlation between the risks.