Facilitating the Flow of Money - Case Study Example

Treasury and Risk Management: Facilitating the Flow of Money Through the Economy Introduction Financialinstitutions as intermediaries of capital and debt in financial markets are responsible for transferring funds from investors to companies needing capital to create more wealth. Since financial institutions facilitate the flow of monies through the economy, their presence and profitable operation are critical to economic health. For this reason, the Treasury departments in many countries have been pushed to centerstage to manage the rising levels of risk that financial institutions contend with because of uncertainties brought about by intensified competitive pressure, enhanced compliance requirements and rapid globalization. The Treasury has always been involved in risk management but its previous responsibilities were limited to identifying and hedging financial exposures related to foreign exchange and interest rates. It simply laid down the best-practice policies for financial risk management and tracked the compliance of financial institutions. In today’s increasingly complex and volatile environment, the Treasury is tasked with managing a broader range of financial and operational risks that confronts the economy as well as companies that have their eyes set on domestic and global expansion. This paper discusses the increased responsibilities of the Treasury in financial risk management even as it illumines the workings of the financial market, functions of financial institutions, characteristics of financial products, purposes of commoditization, and the past and future trends of financial markets. Risk Management The Treasury is the appointed guardian of a country’s cash flows, which gives it a vested interest in managing financial risks (Conrad & Glenzer, 2006). Its long-held domain includes the management of liquidity and risk exposures in foreign exchange and interest rates and it is only natural that, when the environment posed an increased amount of risks, the Treasury was called upon to manage a broader range of financial and operational risks. This gives Treasury a more strategic role, in which it takes more initiatives that drive business performance. The function is also expanding outward by leading or playing key roles in other functions such as long-term capital responsibilities and risk management. In a 2008 report, JP Morgan Chase reports that it saw first-hand how dramatically has the role of Treasury changed not only in the sense of broadening but also accelerating its functions in managing all risks that seriously threaten cash flows. In the US, the expanded concerns of the Treasury now include liquidity maintenance, counter-party risk, operational risk, country risk, credit risk, market risk, energy risk and the organization of the overall risk management program. In Africa, the African Development Bank reports that the Treasury as risk manager plays a central role in the continuous monitoring of financial exposures and reporting for periodic realignment purposes. These activities are designed to ensure compliance with risk management policies in terms of exposure limits, concentration and volatility limits. To a lesser degree, Treasury also works with other parts of the regulatory network to address commodity and non-financial risks such as strategic and operational risks. The Treasury is one of the few specialized agencies that can combine process expertise, long-standing business unit relationships and detailed knowledge of businesses that is required in a cohesive organization-wide risk management program. While the movement toward increased Treasury involvement in risk management is clear, the responsibilities assigned to Treasury vary by industry and company. Moreover, a clear consensus has yet to emerge on the role that treasury should play in risk management or the ways in which the treasury skill set can add value to risk management processes. Risk management deals in various financial instruments and involves a multitude of counter-parties and securities organizations. The end-goal is to meet the needs of borrowers and manage the exposure against fluctuations in market interest rates and currency exchange rates. In these transactions, there is the ever-present risk that the counter-parties may not be able to meet their obligations. To ensure that these obligations are met, the Treasury usually maintains a stringent set of criteria for counter-party credit rating and size, subject to a maximum 10 percent of the total risk capital. Financial Markets Financial markets are where people buy and sell financial securities, commodities and other fungible items of value at low transaction costs and at prices reflecting the efficient market hypothesis. Securities may be stocks and bonds while commodities consist of precious metals and agricultural goods. An item is fungible if it can be replaced by another item of the same type. As for the efficient market hypothesis, it states that prices on traded assets such as stocks, bonds and property reflect all the information that needs to be known, such that it is impossible to outperform the market (Elton, et al., 2003). For the returns, the dynamics are governed by the fractal market hypothesis, which suggests that yields are influenced by investor attitudes and represent the result of the interaction between traders who often exhibit different investment styles. The main influences in returns dynamics are liquidity and type of admissible orders (Mattarocci, 2006). Without the financial markets, borrowers could not find lenders elsewhere. Thus, financial markets facilitate the raising of capital through capital markets, transfer of risk through derivatives markets, and international trade through currency markets. In the capital market, the money of those who have it is matched with those who need it. Once a match is made, the borrower issues a receipt to the lender promising to pay back the capital at the agreed-upon interest and date. These receipts are securities that may be bought or sold and the interest is a form of dividend that the lender exacts from the borrower as compensation. All these transactions may be done in a physical location like New York Stock Exchange and Hong Kong Stock Exchange or an electronic system like NASDAQ or NISHEI. Whatever the form and type of a financial market, the primary concern is to maintain and improve liquidity such that financial markets are constantly innovating to attain a liquid position. For this purpose, banks and other financial institutions help by serving as intermediaries, taking money from those who have money to save, which is in turn lent to borrowers at the financial markets. From the macroeconomic perspective, the primary purpose of financial markets is precisely to allocate available savings for the most productive use. If the economy does not channel savings to their most productive, this is expected to stunt economic growth (Polanyi, 2004). In the 2007 Global Financial Centers Index, London is regarded as the financial hub of the world followed by New York, Hong Kong and Singapore in that order. Of the 46 major financial centers around the world, London and New York were selected as the only truly global financial centers that provide a broad range of services for global trade. The selection was based on human resources, business environment, market access, infrastructure and competitiveness. Based on these criteria, Hong Kong emerged as the most important financial center in the Asian region with the strictest regulatory system and most experienced personnel. Tokyo is ranked 9th while Shanghai in China is 24th, both of which lagged behind Hong Kong and Singapore because of shortages in human resources, inadequate market controls and problems in the enterprise environment. In all these financial markets, the driver for competitiveness used to be human resource and technology. Now, they are most interested in policy controls and the tax environment. Institutions & Intermediaries In financial economics, a financial institution acts as an agent that provides financial services for its clients or members. Financial institutions generally fall under financial regulation from a government authority. Financial institutions consist of banks, stock brokerage firms, non-bank financial institutions, building societies, asset management firms, credit unions and insurance companies that various types of financial services and whose activities are controlled or supervised by government regulatory agencies. Many of these financial institutions also function as mediators or intermediaries in stock and debt security markets, where their principal role is to collect funds from investors and rechannel the funds to different financial providers that need the money. As such, they are responsible for transferring funds from investors to companies in need of those funds. In effect, the presence of financial institutions facilitate the flow of monies through the economy. This is the primary means for depository institutions to develop revenue. Should the yield curve become inverse, firms in this arena will offer additional fee-generating services including securities underwriting, and prime brokerage (Mattarocci, 2006). Financial institutions deal with bonds, debentures, stocks, loans, risk diversification, insurance, hedging, retirement planning, investment and portfolio management. In thus transferring money or funds to various tiers of the economy, they play a role in the domestic and international economy. Because of globalization, activities of financial institutions have achieved global implications, no matter if they are private or publicly owned. A financial intermediary is an institution, firm or individual that performs intermediation between two or more parties in a financial context. Typically the first party is a provider of a product or service and the second party is a consumer or customer. In the US, a financial intermediary is typically an institution that facilitates the channelling of funds between lenders and borrowers indirectly. That is, savers (lenders) give funds to an intermediary institution (such as a bank), and that institution gives those funds to spenders (borrowers). This may be in the form of loans or mortgages. Alternatively, they may lend the money directly via the financial markets, which is known as financial disintermediation. For all these financial institutions, governance is a critical issue as they operate in a substantially regulated environment. In the US, the key governing bodies include the FFIEC, FDIC and NCUA, even as State governments often regulate and charter their own financial institutions. Asset management firms are among the world’s largest financial institutions, such that the collapse of one reverberates around the world. In 2008, the largest asset managers in terms of the amounts of money handled are UBS AG of Switzerland, Barclays of UK, State Street Global of the US, AXA Group of France, Allianz Group of Germany and Fidelity Investment of the US. Also in the top 15 are Deutsche Bank, Credit Suisse, JP Morgan Chase and Mellor Financial. Products & Services Financial products range from equities, convertible bonds, high-yield bonds, equity derivatives, fund derivatives, structured credit, asset management, derivatives, securities and hedge funds. Equities – these represent the ownership interest of a common stock share in a corporation. Convertible Bonds – these are types of bonds that can be converted into shares of stock in the issuing firm. High-yield Bonds – bonds issued by an organization, which is often a foreign company or government, that do not qualify for an investment-grade rating made by credit rating agencies. Equity Derivatives – a class of financial instruments whose value is partly derived from one or more underlying equity securities. Fund Derivatives – these are structured financial products related to a fund that normally use the underlying fund to determine the payoff. Structured Credit – this refers to a wide range of credit-derived products that financial institutions buy and sell. Asset Management – the management of collective investments for individuals or groups. Derivatives – these may be commodity futures or financial options on shares, bonds or currencies that are available in specialized derivatives exchanges. Securities – any certificate of stocks, bonds or notes. Hedge Funds – forms of financial derivatives representing an obligation whose value derives from an asset and reference, index and interest rates, or they could be the result of a specific event. Hedge funds include futures, credit swaps and forwards. (Jackson, 2006) Of these financial products, trade in hedge funds is the least popular because of perceptions that these funds are fraught with risks. In fact, China closed its derivatives exchange for hedge funds in 2005 when trade in credit derivatives brought losses to hedge fund holders, after an expected default corrections in the corporate credit markets failed to materialize. As a derivatives instrument, the hedge fund is a financial obligation whose value is derived from an underlying asset, reference and index rates or interest rates, the result of a specific event or the price of an underlying asset such as debt equity or commodities. Apart from commodities, the other kinds of hedge funds are futures, swaps and forwards. Futures are exchange-traded agreements to buy or sell an asset at a definite time and price, while forwards are instruments in which the assets are sold at current prices for delivery at a later specified period. The fastest growing of the three funds is the credit default swap, which currently trades worldwide at nearly $20 trillion. This is a form of a credit derivatives contract in which a party called the “protection buyer” pays a periodic fee to another party called “protection seller” in return for a certain compensation for default by a reference entity. For example, a financial institution may buy protection from another institution that sells it in exchange for a loan portfolio to protect it from possible default. The entity that buys such protection may also sell one to another entity. Jeffrey Tuckes, founding partner of Fairfield Greenwich Group, a leading hedge funds developer-investor in the US, believes it is a misconception that hedge funds are always highly leveraged such that they contribute to market volatility. In fact, only 2 percent of hedge funds use leverage. Overall, hedge funds are the most attractive, highest yielding financial instrument if management is done in an efficient and technology-based manner. How an investor could make a killing in hedge funds trade is disarmingly simple. Let us say the hedge fund investment is in commodity futures involving wheat production in Poland. At a derivatives exchange in London, the investor through his fund manager buys 1,000 tons of wheat today for delivery two years hence, paying at the current price of $2,000 per ton. Thus, he pays a total of $200,000 for the whole order. If the market price for wheat doubles to $4,000 per ton when the order is to be delivered two years later, the investor doubles his $200,000 investment, too. Of course, the money goes down the drain if the market price of wheat deteriorates after two years. To eliminate this kind of risk, the hedge fund manager must be able to read market trends related to wheat production, taking into account such smallest details as the climate or the discovery of disease-resistant strains of wheat crops. It even pays if the fund manager has the capability to predict what kind of weather disturbances will Poland experience in the next two years. The reason is that if wheat production in Poland suffers in two years because of extreme weather, this means trouble for the hedge fund investor in London. Commoditization Commoditization in general refers to the expansion of market trade to previously non-market areas and the treatment of things as if they were tradable commodities. Specifically, commoditization is the transformation of goods or services into a commodity for the purpose of giving liquidity to an illiquid financial contract related to the product. Polanyi (2004) describes commoditization as the process by which goods with an economic value that is distinguishable in terms of uniqueness, brand and similar attributes end up becoming simple commodities in the eyes of consumers and the market. In effect, a product becomes a commodity when it becomes indistinguishable from others like it and consumers buy on the basis of price alone. The prices decrease when the market for a unique branded product is transformed into a market based on undifferentiated products since competition for the commoditized product increases. In this case, the consumers benefit since perfect competition usually leads to lower prices, but the brand producer suffers since the value of the brand weakens. In the financial market, for example, the commoditization of such financial products as index funds and online brokerage services has steadily driven costs down although it improved product quality (Jackson, 2006). Meanwhile, the fees for less commoditized products such as managed accounts and mutual funds have actually risen, for which reason commoditization is more appealing to the more moneyed investors. An increasing number of financial analysts, however, find commoditization undesirable for both buyers and sellers. Weber (2005) surveyed 467 affluent consumers in 2005, which consisted mostly of baby boomers planning their retirement, and found that majority would not include banks, insurance and securities firms in their decision-making about the use of their retirement funds because of dissatisfaction about the continued commoditization of financial products. Over half of the affluent baby boomers surveyed said financial institutions are their last choice as source of information about their financial decisions. Long-term care insurance is a big purchase and in researching products or considering the purchase, many of the interviewees expressed satisfaction with the information obtained online than from that obtained offline from insurance or securities firms. Of the baby boomers surveyed, social security was the main source of retirement funds for 45 percent, investments for 24 percent and insurance for 7 percent. According to Weber (2005), this places consumers at risk of making poor choices. In some industries, the main complaint against commoditization is that it prevents consumers from comparing or discovering prices while it enables sellers to charge higher prices for higher profit margins. For example, there used to be no standards for grading diamonds such that dishonest retailers called their diamonds “perfect” or “blue-white” to fetch higher prices. Honest retailers who admitted their goods were less than perfect lost their customers to the dishonest ones. Thus, big liars built big businesses for themselves while small honest retailers went out of business (Rapaport, 2007). Eventually, the Federal Trade Commission outlawed the use of perfect or blue-white to describe diamonds and grading standards were established. This only showed that unique products cannot be effectively priced through commoditization because they cannot be compared to similar products. Rapaport (2007) observes that because of heightened competition, commoditization of products continue unabated, from sophisticated telecommunications equipment to chemical. As a result, firms compete only on the basis of prices and they continue to extract even greater concessions from retailers. Mark-to-Market Schemes Market forces play a dual role in the financial market. They serve as signal of underlying fundamentals and actions taken by market participants and also serve a certification role in influencing these actions. When these actions affect prices, and the prices in turn affect the actions, the loop created can generate amplified responses in both creating bubble-like booms in asset prices and in magnifying distress episodes in downturn situations (Plantin, et al., 2005). These are the effects of mark-to-market accounting, which can adversely affect financial stability because of its tendency to amplify financial cycles. This view holds that the disclosure regime brought by mark-to-market accounting would confuse investors because of the constant marking up of portfolios and then marking them down on a regular basis. However, Mason (2008) equates the marking of assets with openness and transparency, which are essential in financial regulation. In this contrary view, marking assets to market must be done on a regular basis for the investment and regulatory community to know what is going on. The opponents of the disclosure policy related to asset marking argue that financial markets are so volatile that such marking would serve no purpose. To this contention, Mason (2008) ripostes: “If the assets are so volatile, why invest in them at all?” This refers to long-term and high-yield assets that are usually risky, such that most financial institutions have charters that avoid trading in them. If financial institutions trade in this high-risk instruments, then Mason (2008) said it is all the more necessary for transparency through regular marking to preclude cover-up. In addition, assets not traded or infrequently trade on the financial markets should be marked on a regular basis to determine their value. According to Jackson (2006), commoditization in the financial services industry is not going to go away, with investment management to be increasingly commoditized in the next five years as competition goes stiffer than ever. This means a sustained movements in market prices over time. Works Cited 1) Conrad, K. & Glenzer, J. 2006. Treasury’s Growing Role in Risk Management. Risk! Newsletter, Association for Financial Professionals. Webpage design available at: http://www.afponline.org 2) Elton, E.J., Gruber, M.J., Brown, S.J. & Goetzmann, N.N. 2003. Modern Portfolio Theory and Investment Analysis. New York: John Wiley & Sons. 3) Jackson, D. 2006. Brokers, Financial Advisors and Investing for the Wealthy. ETF Investing Guide. Webpage design available at: http:/seekingalpha.com/article/98619 4) Mason, J. 2008. Openness and Transparency: The Basics of Financial Regulation. Mase: Economics and Finance. 5) Mattarocci, G. (2006). Market Characteristics and Chaos Dynamics in Stock Markets: An International Comparison. University of Rome. 6) Plantin, G., Sapra, H. & Shin, H.S. 2005. Marking to Market, Liquidity and Financial Stability. Department of Economics, University of Connecticut. 7) Polanyi, K. 2004. The Self-Regulating Market. 2d ed., Economics as a Social Science. 8) Rapaport, M. 2007. Commoditization: Diamond Industry to Establish Fair, Open and Competitive Markets. Webpage design available at: http://www.diamonds.net/news/NewsItem.aspx?Article ID=18283 9) Weber, C. 2005. Emerging Affluent Baby Boomers, Financial Services and the Web. Boston MA: Celent Report. Read More