The Treasurer's Triangle
A treasurer and his team constantly walk the tightrope and a delicate balancing act is essential to measure and manage asset liability management process - invest in creditworthy assets, maintain sufficient liquidity and maximise returns. This triangular relationship between credit, liquidity and returns is of course not static. The elements constantly flex around - for example, in a stable market, precedence is given to returns, creditworthiness is usually easily determined as results seem to be broadly predictable within the usual credit models, and liquidity is not an issue as the environment is free of major shocks. However, in a disturbed or chaotic market, the order is often reversed, the immediate worry is liquidity, this is of course closely tied to credit (which is typically deteriorating and perhaps in sudden and unexpected ways) and returns become almost an afterthought (though of course maintaining profitability is still a requirement but not always achievable in such circumstances).
In the past twenty years more and more credit decisions have been effectively "out sourced" by lending institutions to credit rating agencies. While this worked well during the long benign credit period prior to the collapse of sub-prime and the subsequent global banking crisis, the limitations of credit scoring and VaR based analysis were amply shown during the credit crunch. It is likely that we will see much more use of scenario planning and more sophisticated use of stress tests; not to substitute existing techniques, but to enhance and develop them further.
The risks in liquidity, on the other hand, usually come in two forms; market liquidity risk that arises when one cannot execute a large amount transaction at the expected market rate, and funding liquidity risk when it becomes impossible to borrow funds to cover cash flow requirements. Both are serious from a Treasurer's perspective, but examples like Northern Rock, Bear Stearns and Lehman Brothers demonstrate clearly that the latter can be fatal for banks and other financial institutions. Paradoxically investment benchmarks, index tracking, credit ratings and fixings may well be adding to liquidity risk issues, as risk averse investors seek to trade at known ratings and prices, and within certain agency defined asset groups. This can have the effect of bunching up supply and demand and may well be adding to market inefficiencies rather than mitigating them. This means conventional economic thinking regarding market bubbles and liquidity crises will not be sufficient.
Finally the subject of return should be straightforward - but whilst trying to maximise it there is the potential for failed credits and poor or even non-existent liquidity. In the past institutions have tried a mixture of hard rules and experience to judge adequate returns. Unfortunately returns are a function of macro-economic forces as well as individual lending or investment decisions. Typically in a credit boom lending margins are heavily squeezed and banks are faced with greater and greater competition; this is leading regulators to consider so called macro prudential rules to dampen such effects. Of course, experience and market knowledge will still be a vital human input into the risk assessment process.
At the end, there is no perfect answer to the Treasurer's Triangle (in fact if we over fit for perfection we actually increase the chances of future problems) but here is my checklist of the issues and challenges that I feel could be coming into view in the coming years:
• New risk techniques will be imported from other industries - scenario planning, complex stress tests and modelling the cascading of risk through different asset classes, markets and instruments
• Further work will be done on measures to counter pro-cyclicality in regulatory rules i.e. the tendency for banking risk models to all signal red at the same time - which can cause unforeseen correlations and market dislocations
• Banking clients are going to demand higher standards of flexibility in their risk systems. Financial IT companies will respond and address this through more modular and scalable products
• Increased and more complex regulation will put a greater burden on banks, and further investment in processes and people to meet these demands will be a constant feature in the next few years
• Bubbles and crashes cannot be entirely eliminated in free markets - but treasurers will be armed with more tools to create buffers and fire breaks that can contain their potential risks
I am writing a 4 paper series which will present an in depth view on a Treasurers' challenges. Click here to access Part 1 - The Treasurers' Triangle
