Managing Your Company’s Risk Through Measurements and Policy

Announcer 00:04

Welcome to the Treasury Update Podcast presented by Strategic Treasurer, your source for interesting treasury news, analysis, and insights in your car, at the gym, or wherever you decide to tune in.

Jonathan Jeffery  00:20

Welcome back to another episode of the Treasury Update Podcast. Today’s discussion, we’re going to be talking about some more of the content found in The Guide to Excellence in Treasury. We are discussing the final chapter. That’s titled “Basics of Risk Management.” I’m Jonathan, media production specialist here at Strategic Treasure. And I’m joined today again by Craig Jeffery. Welcome back to the show.

Craig Jeffery  00:42

It’s good to talk about this. Jon, I’ve, I look forward to discussing this book and this chapter in particular.

Jonathan Jeffery  00:48

Yeah, just start us off. Could you tell us a little bit about The Guide to Excellence in Treasury?

Craig Jeffery  00:53

Yes. So this is a book that we provided and other materials are following. It’s a way to fulfill one of our goals and missions is to inform the broader industry at large and excellence in treasury means doing certain things, understanding certain issues, and having a mindset that builds on your practices for how you help your organization. And so this is a way of sharing and setting standards out there for people to read and study in an easy to consume manner. So we have it in digital form that’s free to download and, and we have it in podcasts like this.

Jonathan Jeffery  01:28

Yeah. And it’s not just good in treasury, or good enough in treasury, its excellence in treasury.

Craig Jeffery  01:34

So awesome. That’s so that’s good, the superlative.

Jonathan Jeffery  01:38

So you can find in the shownotes, a link to download the whole ebook where there’s it goes into much more than just basics of risk management. Before we get into the meat of today’s podcast, risk management. Could you talk a little bit about risk identification techniques? We don’t go into this in the chapter but I wanted to set the foundation with how do you identify what you need to manage?

Craig Jeffery  02:01

Any person has a risk manager mentality looks and thinks about what could go wrong. And you know, people that see physical things like oh, there’s a ladder on the slope, there spilled water in the aisle, at the supermarket or at home, whatever those issues are, these are, these are items where things can go wrong, just like when it gets wet outside, you hopefully adjust your speed when you’re going around the corner. So you don’t break free from the road and fly off into the woods into a tree. So risk identification is identifying what are those risks that matter? There’s risk for getting up, there’s risk for not getting up? How do you make those decisions? So to my way of thinking is risk identified as scanning the environment? What are the potential risks, and then identifying those that are major or moderate things that would concern you enough? And, you know, identifying those and calibrating those or ranking those for what matters? And then there’s other activities? Do you accept those risks? Do you alter those risks? Do you avoid those risks? There’s all kinds of things you can apply that to your individual life, your personal life at home, traveling, etc? It’s what are the things that you need to be concerned about?

Jonathan Jeffery  03:17

What should the process of scanning for those risks look like?

Craig Jeffery  03:21

The idea of here are the standard risks that we look at, you know, interest rate, interest rate risk and foreign exchange, currency pair volatility, what are exposures? They’re commodity price risk counterparty risk, across the the enterprise liquidity risk, what if we’re not paid? Or things don’t come due on time? How do we build in additional flexibility to manage those? Those are all risks that I think everyone thinks about fairly regularly? How do you keep track of other risks and see what comes on, you know, in the broader market, geopolitical risks that have a reverberation on the supply chain, and which has a an impact on the finance of the organization? So all of this, how do you scan and so there’s, there’s different risks that you look at in terms of staying current with what’s being discussed, as people are looking and say, This could be an issue, you can listen to people that might seem a little extreme in their views about what’s happening, or what could happen. But, you know, even it’s extremely low probability, you know, hearing those items and evaluating those is usually a worthwhile endeavor, to a certain extent, staying current on what people are talking about, where there’s volatility, that regions of the world, or where you’re operating. There’s a there’s a whole range of that, John, and, you know, this, this idea of we’re continually scanning for what we see we’re scanning what people are talking about. We’re gaining information from peers, from bankers from consultants. That’s a good way to look at it.

Jonathan Jeffery  04:53

That makes sense. As we move into the conversation on risk management, do you want to give a broad overview of what it is?

Craig Jeffery  05:00

If I were, if I were to give a definition, it would probably differ depending on the time of day or the time of week. But it’s risk management is the process of identifying and managing risks in a way that you, your goal is to bring your exposures or your risk in line with your, your risk appetite, or risk tolerance. So you make sure that you’re operating with risks that are acceptable to you, or that are acceptable to your company. So it’s, you know, identifying those and making sure you’re bringing in light. And that’s, there’s a lot to unpack there. It’s not a default, everything’s fine. Or I’m ignorant of it, but it’s I understand the environment, I’ve identified those items, and I’m managing them in a way that I’ve either accepted the risks, I’ve altered the risk, I’ve avoided the risk, not acceptable is I, you know, ignored the risk.

Jonathan Jeffery  05:54

Okay, so in The Guide to Excellence in Treasury, if you download the PDF version, there’s this nice little chart in here that’s got blue, white and red different circles growing in scale, with categories of risk management. You want to walk us through those?

Craig Jeffery  06:09

The included circles in like a Euler style diagram has the largest circles capacity within that as appetite and then within that as tolerance. So the largest is what’s your risk capacity. So anytime you look at the categories of risk, how you measure risk, the your capacity to handle risk is the largest circle, anything more than that you become insolvent, or your business stops, or you you get shut down whatever those risks, whatever risk you’re looking at, that’s the maximum that you can stand the appetite. And not everyone uses the terms risk appetite, or risk tolerance. Sometimes they use those interchangeably to mean the same thing. But we look at appetite as the next level down what the organization states that they’re willing to do. And you can think about this on a, at a corporate level people are, they say they’re comfortable with a certain level of risk. But if you hit that risks are pretty upset. And they, they didn’t like that same thing on the individual side, again, I’m gonna ride the putting stuff into the S&P 500. From my investment portfolio, if there’s a, you know, bear market, they’re like, pulling out, it’s like, I lost so much money, and they pull it out. And even though that might have been with, well, within their stated appetite to bear risk for the yield, it really wasn’t because they, they got nervous when it got close to their level, or even if it was far away from their level. So that’s when we think of tolerance, what you’re really tolerant of what the company is really tolerant to bear, you know, movements that go in a negative way for, you know, commodity prices, or, you know, for the currency pair shifts that that happen, capacity, appetite and tolerance. You want to know what your capacity is. And it’s, it’s good to really know what the actual tolerance of the company is for losses. Because you can get in trouble if you just think why it was stated on the appetite, the risk appetite level is truly sufficient for the organization, you need to know the warning track, which would be the risk tolerance that you have.

Jonathan Jeffery  08:15

Yeah, I could see that happening. Someone says we’re willing to lose this amount, and then you lose it. You say, I thought that was fine.

Craig Jeffery  08:23

It’s exactly what is in. And it’s an it’s not just that it’s there’s a I know, you’ve got other questions, too. But one of the things that happens is, you know, if you if you put in controls in place, you put financial instruments in place that will provide some financial benefit if your underlying asset or your underlying exposure moves negatively, right? You You ended up making money on your hedge, but you lost on your underlying exposure. Right, interest rates went up, and now I have to pay more interest. But I had a hedge, I swapped that out through a hedge. So I hedge made money, but my underlying asset or exposure loss, and sometimes people were like, Oh, that’s great. We, we made money on the hedge. And that’s not what the purpose was at all. The purpose was to bring your risks and exposures in line with your risk tolerance and your risk appetite, to make sure that you’re not going to experience something beyond that, when your underlying asset does. Great. And you’re hedges and out of the money. Sometimes there’s this negative view of we would have done better if we didn’t hedge it all. There was this was a waste of money. Why did we do this? What was the purpose of it? You use this as a way of insurance of eliminating a certain negative event. Just because the negative event didn’t happen doesn’t mean you shouldn’t have done it. It’s like yeah, we wasted all that money on life insurance. I didn’t die this year. I bought car insurance while you’re trying to avoid a you know, a catastrophic financial loss. Sir impact due to certain situations. And so not everybody, labor finance people, many, many finance people, probably most finance people don’t understand that about risks. And so there’s all kinds of examples of treasures, getting in trouble for doing and protecting the company. And someone is saying, you know, we would have done better without the, without the hedge, we would have done better without this activity.

Jonathan Jeffery  10:25

I would have done better with a HELOC, and put my home equity into bitcoin eight years ago.

Craig Jeffery  10:32

Yeah, the answer to that would be no. For in most cases, unless, unless you’re like, hey, my risk levels high, I want to maximize my potential I don’t care about you know, huge loss, right. And it’s like, oh, you know, I had a fixed level on my home equity line, I dumped it into something that was extremely speculative. Well, that’s the that might be your risk appetite tolerance, and you have a way of covering it, you know, okay. I said no, because that wouldn’t make sense to me. But but there’s, you know, and the difference between the difference between, let’s say, a hedge fund, and a corporate or public institution is you are not trying to take a position on the market, you’re trying to bring your risks in line with your, your risk tolerance, your risk appetite, you’re not taking a position on the market? Well, I think interest rates are gonna go up, or these currency pairs are going to move this way. Or I know those things are therefore I’m doing this activity or not. That’s not what a corporate treasurer should be doing. That’s, that becomes now it’s a it’s a speculative position, you’re taking a position? How do you know that? You don’t, you don’t know that, you know, if you’re, if you’re a hedge fund, your business is taking positions and speculating on what’s going to occur, you’re providing great service to the market, because you’re gonna be on the other side of transactions for people who want to reduce their exposure, you’re taking exposure, because you want what that brings to you, you want that amplified activity. But that is very different from what a corporate treasurer needs to do.

Jonathan Jeffery  12:07

Gotcha. What have you seen happen in your career, whether it’s economics or an event that chip most changed people’s those categories of tolerance.

Craig Jeffery  12:20

Capacity really tends to be a fairly static measure in terms of what what an organization compared their, their can bear their their financial position may shift. So the capacity gets larger as they get larger, or they have, you know, other situations. But the difference between appetite and tolerance is usually, that difference is exacerbated or made very clear. When a significant event happens, you know, you can think of all the years where we go back to like, 1988, you go to all these different years, where significant things happen 2008 2009, the beginning of COVID, when these when these very extreme situations happen, there’s a massive amount of movement, everyone gets extremely concerned, you know, when you should have something that’s more consistent, everyone pays attention. When those events are happening, you know, they can happen to the time but there tends to be fairly long periods of stability in terms of it’s not days, it’s you know, it’s weeks, it’s months, it’s years, where there’s stability, and then there’s turmoil, turmoil can come from different places and different ways.

Jonathan Jeffery  13:29

In The Guide to Excellence in Treasury, you have a breakout of different principles of risk management. You want to run us through those.

Craig Jeffery  13:37

Yeah, I’d love to talk about those. I mean, some of those people are gonna be very familiar with I mean, the number one that we would talk about and that people are familiar with is, is diversification. Don’t put all your eggs in one basket. I know, some people say, you can put all your eggs in one basket and watch that basket really carefully. Well, okay, well, that’s maybe good for eggs. But diversification, you know, in terms of credit in terms of how much exposure you have to any one individual party, who you’re exposing your investments to like a particular industry, or particular types of banks, whatever those elements are, whatever those diversification tends to protect us tends to protect as well. So diversifying is a foundational method of risk management. You know, some of these other principles are framework, the policy, you know, everyone says, We need a policy on risk management, a policy on bank account management, a policy on investment management, well, we always think we’d like to think and we want people to think about what’s our framework for understanding risks? And then how does that flow down to policy so your risk framework should help identify what’s our capacity, appetite and tolerance? How are we going to handle those? What will we do with accepting How will we accept certain types of risks or exposures? How will we make decisions to avoid them? Alter exposure we want to Take on the exposure, but not all of it. So we alter it, or we ignore it, and how do we alter it? Do we use financial instruments? Do we use some type of natural hedge? Do we figure out, you know, just some way of keeping all these areas in line with our, our risk tolerance and our risk appetite. In other areas expect the unexpected. And people say all the time, well, this can’t happen again, because there’s some regulation or the environment slightly different. And there’s a point where that’s true. It’s like whatever particular event happened, won’t happen exactly the same way. Because the world is different, right? It’s like that, the quote, he can’t step in the river twice, because it’s not the same river and you’re not the same person, right? feet still get wet, lay still still wet, you could still stumble and get your foot stuck under a rock or whatever those those particular areas are, but they expect the unexpected, as always be ready for, something’s gonna happen, you don’t know what it is just like, you know, in your house, like, there’s always gonna be a five or $10,000 issue that you have to deal with your house, at least every 18 months, something’s gonna come up, you don’t know what it is, you know, the gutters gonna fall off, something’s gonna come through your, your wall, or some, you know, there was a leak slowly, if you didn’t see, there’s gonna be something you don’t know what it is, it’s probably gonna be in that that neighborhood of five to 10 grand. And you’re like, Oh, I didn’t expect that to happen. You knew something was gonna happen in a certain period of time, you didn’t know exactly when or exactly how much it was. But there was gonna be something and so you reserve money for a based on the value of your home for repairs and upkeep. Because it will average out to that you just don’t know when it’s going to occur, but expect the unexpected. And I’ll give you one example. It was in a remote area of Florida. And I was driving out to let someone in through a gate through a place we were camping. And we’re driving on a dirt road. And I had my young daughter on my lap, driving the van. It was a dirt road. And it was there was a gate. So there’s nobody else there. So I was like, Oh, let her drive as we’re driving down the dirt road and are going about 40 miles an hour with this long van. Right. And one side is a little bit of a field. The other side is a swamp as we’re driving down the dirt road about 40. So we’re humming, right? What can go wrong. She’s sitting there staring. And I’m driving, I’m right there. Well, she whips the steering wheel wheel in a direction. And so we’re all of a sudden we broken free from the it’s not even gravel, it was like dirt. And so now we’re fishtailing down the road, and there was an instant sensation that I was gonna die. And, you know, adjusting the steering wheel was like, okay, glad I drove in the snow because this was like driving in the snow. Because with that little adjustment, it was like the the vehicles like 45 degrees angled facing Legos gonna launch into the swamp was able to correct it. And, you know, after I calmed down, I was like, what were you thinking I was I just wanted to see what would happen if I yanked the steering wheel away? Well, I hadn’t incorporated that type of thinking, into my mindset to expect that to occur. And so it’s not that I just never trust my kids or whatever. But it’s the idea that you don’t know what can happen, and so be careful.

Jonathan Jeffery  18:16

Don’t put a intern in charge of CFO.

Craig Jeffery  18:23

There’s all kinds of things. You know, the, there’s, there’s quite a few things in here. I won’t go through all of those there. But I will mention one is davidstow, who used to work with us a number of years, we he and I had many, many conversations about risk. And one of the one of the phrases was he coined this phrase to describe the situation is like, do you really want your hedges to do well, and the phrase was Don’t cheer for your hedges. So and then that idea is you have a underlying asset. Let’s say I have a floating interest rate. Okay. And I have a hedge why I fixed those, like, maybe a fixed percentage of it or you hedge a certain percentage of FX activity? Do you want your head just to make money? If you’re like, yes, I want my head just to make money. Why would you cheer for them? Because usually, you’re only hedging a portion of your exposure. If they if your hedge moves in the opposite direction. Let’s say let’s say you hedge 75%. Let’s say you lost $10 million on your exposure. But you made seven and a half million dollars on your hedge. Why are you cheering for your hedge? You’re not wanting to lose the extra two and a half million dollars as if they had stayed stable. And so this idea is what are you trying to do? That’s an insurance policy that moves in the other direction. Now you may you may cheer for your hedge in a situation where you’ve hedged, you know, you’re let’s say you’re an airline and you hedge, you know, 75% of your fuel prices on fuel prices went in a bad direction and you’re hurting but everybody else in this industry hedged zero to 25%. So it’s killing them. And it’s just uncomfortable for you, maybe, maybe you’re cheering for that, because you’re like, hey, this, this really hurts them a lot more than me puts them in a bad position. But generally you don’t want to, you don’t want your hedges to do well, you want them just as a backstop, and it’s only a portion. So that’s another aspect. And that’s the that’s the thing that most finance people don’t get. It’s not just most senior management, it’s most finance, people don’t understand that. That’s a risk management mentality that has to be understood by treasury. That’s not understood by every every area of finance. And you can run into problems, because they’re like, Oh, we lost money on the hedges. This was terrible. Your underlying exposure was fine. You were trying to protect it. And so that’s, that’s the mentality where it’s like, are you looking at things properly? What are we trying to do here that correlates with you know, your company and what their appetite is. And it’s also you have to make sure that you don’t treat risk management and how you communicate what you’re doing in the company as a single event? You teach them what it means you have a session, you explain what why are we hedging? Why are we putting these risk management techniques in place? Here’s what it is great, great presentation, nice PowerPoint. If you leave that alone, they won’t even be a full year, it certainly won’t be a couple of years. Before, if you have a problem, they’re going to forget what you told them. And they’re going to be upset. And so you need to continue to share the risk management mentality and purpose in front of them. Here’s what happened, hey, our hedges made money. That’s not great. You know, I mean, it was nice, because it protected us because we lost more money on our underlying exposures on buying assets or whatever, or liabilities, whatever those things happened to be, that have moved in the direction or we lost money on our hedge. But, you know, our underlying asset moves in the direction we’re in, we’re in good shape. Those are a couple the couple of those principles and, and concepts and Maxim’s that I think, help Treasury people and risk management people to understand that.

Jonathan Jeffery  22:07

Yeah, and I know this is a whole environment you’re looking at, but how do you prioritize? Where to spend your time?

Craig Jeffery  22:15

Yeah, so if you’ve done if you’ve done your assessment, your scan, and you’re continuing to scan to look for new areas, and you’ve calibrated those potential exposures, potential losses, and you said, these are all the ones that I have to mitigate, these are the ones that I’m watching. Because they might become big enough that I need to do something. If you’ve calibrated those, and you figured out how you’re going to handle those, the processes is just to continue to do that and make sure it’s, it’s working smoothly. So how do you prioritize? What’s the biggest issue? Right, as one of our Marines who, who worked here like to say was that, you know, what’s the alligator closest to the boat? You know, you worry about that one, well, especially if it’s facing you and heading towards you, that’s a bigger concern, then then a large one heading away, or a small one heading away, or a small one heading towards you. So it’s a way of saying what are the biggest risks? Which ones are concerned? So knowing what is something you have to be concerned about matters the most?

Jonathan Jeffery  23:17

Do you have any other stories from experience either good or bad on on risk management, something that your team or someone that you’ve worked with, avoided or fell into?

Craig Jeffery  23:29

Sure I’ll give some examples, I’ll I won’t do the some of the famous ones. So I won’t be giving some of the names. But I’ll give this example. This has happened to multiple, multiple companies. And now Now people are doing a better job. But one was company had had hedged certain exposures. One example would be a company had a interest rate swap on their debt. And then when the company was sold to the other entity, they retired the debt, but they were supposed to retire the swap. And so now that piece of debt was gone. But the swap was out there meant to offset you know, if one moved in the wrong direction, if the if the debt moved in the wrong direction, and went negative, the there’d be a positive on the on the swap side. And vice versa. While there was those were meant to move in opposite directions, it was a it was a nice risk management technique. Well, now the underlying asset was gone tonight, you just had a swap, which becomes speculative, which means there’s nothing that’s moving in the opposite direction. And so of course, what do you think happened? Well, there were it’s now a mismatch. There’s a you know, there’s a swap that’s just floating around, of course, it moved in the negative direction, created all kinds of of challenges.

Jonathan Jeffery  24:41

This was an oversight when the company was bought.

Craig Jeffery  24:45

Yeah, yeah, we’d be missing it. And so when you acquire things, it’s like oh, we’re gonna require that I’m sure someone said a quote will retire the debt will end the end the swap Well, the debt was retired, but the swapped in and of course, it moved in the wrong turn. Correction, I’ve seen that even on investment portfolios where there’s a, you know, underlying asset and then a swap or a hedge placed on the other side of it. And then someone sells the underlying asset sells, it sells as part of a portfolio swap, and that the link wasn’t, you know, didn’t give them an alert that says, hey, get rid of this swap, as they had some swaps are sitting out there. And of course, it moves in the wrong direction. I remember one very vividly where it was in the it was in the six digits. But because whenever you find these things is never, oh, we made a lot of money, we shouldn’t have, oh, that’s terrible. It’s always you find it when it’s negative, and you got to pay. So those are a couple of examples of where risk management failed. And I’ll just mention another category, not for today’s discussion. But, you know, Excel, the use of Excel causing restatements on financial records, right. It’s that’s an operational risks. You can you can look and query and see how many people are like, Oh, we had a problem, because there was a problem with a spreadsheet that we use to feed into our financial statements. successful. I think you asked about successful risk management stories. Yeah. In your notes, you said it could be from companies or personal situations, you know, on the mortgage side, from my mindset, I know, I can mentally show that it’s better to buy to get your mortgage, a variable rate mortgage, it’s, it’s almost you know, how long people hold homes, what the rates are, what those things do, it’s almost always better. But I can’t make myself do a variable rate mortgage, get a variable rate mortgage, whenever I’ve financed or refinance, I never felt comfortable doing it. And that was my emotions or feelings. Overruled my mind, because I didn’t want that overhead, that issue hanging over my head. So I was like I went fix, those rates aren’t going to change anything to worry about is how taxes keep going up. That’s part of the mindset of understanding your risk and your your risk tolerance. My appetite was strong enough, but didn’t like that. The other thing was successful risk management process work that a client of ours was was growing substantially, moving into more countries needed to diversify that everything concentrated in a single bank. And we work with them and help add some additional banks. And they closed almost all their activity with their initial bank. And that initial bank ran into significant problems earlier in 2023. And it was nice because they diversified away and so operationally, there was almost no exposure. And as we know, most of those banks, nobody suffered a loss at the time. But that was more than their primary bank was more than 90% of their activity and imbalance as well over 9% their balances 18 months earlier. And as we helped them diversify, select banks would meet their operational needs, and also provide them growth for the future, it helped diversify and greatly reduce their exposure. And they breathed a pretty big sigh of relief. When that occurred, you can’t move all that in a day, when there’s bad news usually happens very quickly, and things fall apart. And so this was a, this was part of that diversification principle that helped them certainly feel a lot more comfortable that during that weekend, when everyone was trying to figure out how are they gonna meet payroll? Are they gonna build getting funds out of the particular bank?

Jonathan Jeffery  28:32

Well, thanks for sharing. Any final thoughts on risk management?

Craig Jeffery  28:35

Yeah, I would emphasize one of the points that recognize that people don’t understand risk management, they don’t understand hedges. And you have to think about it as a process, not an event. A process to keep people informed about what you’re doing and why. You have to do this continually. It doesn’t matter that you told them, that you can refer to a memo, that you can even you know, have a picture of you shaking their hand agreeing to it. But you have to keep reminding them. Here’s what we’re trying to, here’s what we’re doing. Here’s why it’s working even when you’ll say your hedge moves in the wrong direction. Here’s why it’s working. This is what we’re accomplishing. Here’s how effective it was, according to what we’re trying to do. If you do that, you will have a much better career, and much better feelings about other people in the organization.

Announcer  29:26

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