Risk Management. This edition looks at how risk management has evolved, the problems facing UK FDs today and what can be done to manage them.

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1 Wholesale Banking & Markets FD INSIGHTS Risk Management This is the third in the series of Lloyds Bank and Financial Director magazine s FD Insights which focus on the most pressing issues facing finance directors. This edition looks at how risk management has evolved, the problems facing UK FDs today and what can be done to manage them.

2 INTRODUCTION Financial directors in the UK are operating in incredibly challenging conditions. While austerity measures continue to impact the economy at home, so volatility on our doorstep continues to evolve in the shape of the Eurozone crisis. Against this backdrop, strong corporate risk management processes are vital, not only to shield organisations from global economic turbulence, but also for FDs to gain competitive advantage and position their companies for growth. Matt Lawrence Managing Director, Mid and Commercial Markets, Lloyds Bank The new research from Financial Director and Lloyds Bank highlights that risk management has evolved from being a simple issue of compliance. Identifying, assessing and mitigating risk is now a key element in the life of a FD. Some 40% of the FDs we spoke to reported that risk takes up more of their time than it did last year. Risk presents itself in different guises. Some risks have been high on the agenda of FDs for a number of years. Regulatory risks following the global financial crisis and the ongoing Eurozone trauma are clear for all to see. Organisations have had a certain amount of time to develop risk management strategies to mitigate and manage these to their best ability. Black Swan risks are more problematic. These emanate from an unseen event that could not have been reasonably expected to be part of a general risk management process. In today s globalised economy, the possibility of these risks is enhanced, and so they need to be addressed. We collaborate with a variety of experts to give our clients the best view of the unforeseen risks they may face, creating a holistic view of risk. Only by addressing all sources of risk can an organisation negotiate the challenges and position their company for growth. This highlights the importance of economic forecasting. One factor that all risks have in common is that forecasting is critical to effectively managing any potential scenario. The FDs that we spoke to emphasised this point, by selecting business forecasting as the most important part of a risk management process. In a similar vein, it is important for FDs to ensure they understand the impact that ongoing regulatory changes will have on their business. Speaking with Financial Director and Lloyds Bank, 59% of FDs say they only somewhat understand the impact of regulatory change. Keeping up to date with, and understanding the implications of, every new regulatory initiative can be time consuming. As risk management takes up a far greater amount of the FD s time, it follows that it will require additional resources and expertise. This can appear to create a problem, particularly in the current economic climate, and 23% of the FDs that we spoke with stated that the lack of internal expertise and resources was a major issue for them. It is important to be aware of all of the resources and expertise that are available to help corporates with their risk management strategies. Not everything has to come from the internal organisation. Relationships with organisations such as Lloyds Bank can assist FDs in identifying specific company risks and formulating the processes in which to mitigate and manage the challenges ahead. Matthew Lawrence Managing Director, Mid and Commercial Markets, Lloyds Bank Lloyds Roundtable: Risk When the governor of the Bank of England asserts that the economy is not yet halfway through the deepest depression for a generation, then it s fair to say times are tough. The economic environment continuing volatility abroad, sluggish domestic growth and further government austerity is possibly the most challenging in living memory. It was in this context that Financial Director and Lloyds Bank sought the views of the UK s FDs on the risks they face, what help they need to manage them, and where they see the opportunities developing in the short to medium term. The findings of the research presented in this white paper also formed the basis of a discussion held at the Renaissance St Pancras in London. Ten finance directors participated in a breakfast roundtable. Despite the challenging state of the economy, business activity continues, and for many companies opportunities are beginning to emerge. And while growth is the Holy Grail, responsible investment strategies have to take priority. As a consequence, for many finance directors the focus is beginning to fall more on the issue of risk. According to research carried out by Financial Director in association with Lloyds Bank, the importance of risk management the strategies, approaches and techniques that govern how businesses accept and mitigate risk is clearly growing into something beyond the traditional compliance-led approach. Clearly, the finance director s role is critical to any business recovery. Constructing an optimal risk management strategy within which the business can go forward cannot be underestimated. The FD will never be far from the centre of the action as the economy continues to challenge businesses. The question of where the key risks lie, and what finance directors can do to identify and mitigate these risks was the driving force behind the research project undertaken by Financial Director and Lloyds Bank. The findings provide a barometer of the current state of play for the UK s finance directors and go some way to illustrating where the pressure points lie. 2 LLoyds Bank Financial Director White paper May 2012 White paper May 2012 LLoyds Bank Financial Director 3

3 RISK ITSELF IS NOW CLIMBING THE AGENDA 40% report risk as taking up more of their time than a year ago, which says a great deal about the continued pressure facing the business community. But where is the uncertainty most being felt? Unsurprisingly, the impact of Eurozone instability regulatory risk s close confederate - and other, perhaps less dramatic changes to the regulatory landscape were cited as the most pressing concern for FDs over the coming year. Graph 1: Compared with last year, how big a role is risk management playing in strategic business planning? 2% % REPLIES They include the possible breakup of the Eurozone, a scenario that would have been dismissed as fantasy just 12 months ago. The fallout of a breakup would be felt across all sections of the economy. The derivatives market would be thrown into turmoil, a credit crunch similar to that of 2008 would undoubtedly occur, and investment strategies would need to be renewed. With that as a backdrop, one of the big emerging risk themes is how to gather a competitive advantage through clever risk management. Ultimately, it s not just about managing risk it s about achieving something better than your peers, and being optimal in the way you manage that risk. I think the trick for the UK is to try and rebalance the economy more to producing and doing things without necessarily immediately destroying the one bit of the economy. But what constitutes risk management? Many FDs would simply assert that managing risk is the very essence of their job, whether that involves determining the asset mix of the company, the capital structure of the business or managing the varying liabilities the business carries. A more significant role 40% 123 The same role 58% 179 A less significant role 2% 5 Total respondents % 40% REGULATORY RISK TOPS FDS CONCERNS Table 1: Looking ahead to the next 12 months, how concerned are you (on a scale of 1-5) with the following in regards to your business? From macro economic decisions taken at international level think banking rules and stimulus debates - to more prosaic elements such as VAT, finance directors across the UK are watching the newswires with trepidation to see what comes next. Preparing for the latest event to affect not just their industry but the economy as a whole is becoming core competency for FDs. The concept of the Black Swan has recently passed into common parlance thanks to the work of Franco-American economist Nicholas Talleb. In Talleb s view, the Black Swan event is that which arrives out of nowhere, that couldn t have reasonably been predicted. The Japanese tsunami and subsequent Fukushima meltdown is a perfect recent example. For FDs in the current economic environment, the importance of understanding the concept and risk of Black Swan events cannot be ignored. Lloyds Bank has worked with a range of experts to provide its clients with the clearest possible view of the unforeseen risks currently facing businesses. 1 not at all very REPLIES Regulatory risk Eurozone instability Political uncertainty Inflation Interest rate rises Counterparty risk Foreign exchange movements Credit/refinancing Commodity prices RATING The continued atmosphere of uncertainty has done very little to assuage the growing concern over the impact of regulatory risk. Finance directors clearly feel the ongoing economic slump will lead to more, not less, government and regulatory intervention. I think the trick for the UK is to try and rebalance the economy more to producing and doing things without necessarily immediately destroying the one bit of the economy, said one respondent FD. Because the City is one of the few areas that attracts external, global capital into the UK, and a certain amount of it sticks in that pipeline and comes into the UK economy. These profound changes to the landscape make it even more important than ever for finance directors to call upon all the resources at their disposal to make sure they understand and can mitigate the worst of the risks that face them. But it s not just changes to the rules. FDs also identified inflationary pressures as significant risks to their business. One FD at the Renaissance certainly thought so. It s a real problem. Inflation is eating into people s income, and I fear that we re not going to be able to control inflation, and probably governments will at the end, allow inflation to go out of control, as a way of repaying the debt. The impact of some key changes in the area or regulation are already being felt. As one FD said, We are seeing the implications in the global banking markets of Basel III starting to bite already. In his view, it is becoming increasingly apparent that, particularly for longer term lending, the banks margins will be so high that it is going to squeeze businesses to get a rating and go to the bond market. Given that, he believes, The sooner companies actually start preparing for the future the better. Johann Kruger, IFRS & financial risk management specialist at Lloyds Bank agrees that wrestling with the immediate implications of regulatory change must stay front of mind for FDs, Regulations that affect capital adequacy and minimum liquidity levels for banks drive up the cost of lending, he said. 4 LLoyds Bank Financial Director White paper May 2012 White paper May 2012 LLoyds Bank Financial Director 5

4 They may make banks safer, but that does not mean the cost of capital comes down proportionately. The cost of borrowing will migrate higher for corporates, so liquidity will be more expensive for both short-term cash and long-term borrowing. Basel III means banks have to hold more and better quality capital against the same business and have liquid assets to cover a 30-day stress period, which causes a cash drag. Little reported, but just as important, are the new liquidity rules that fall under the banner of ILAS, or Individual Liquidity Adequacy Standards. It can at first glance appear esoteric, but in essence, this set of rules fundamentally changes the way in which money is priced. In my view, we shouldn t be thinking about internal expertise. Rather, we should be thinking about the expertise at our disposal, wherever it is. While there are complexities in the new rules, some simple rules do apply, says Robert Hare, Director, Specialist Sales and Liabilities at Lloyds Bank. Firstly, the FSA and Bank of England will in future expect banks and others to have liquidity available even though it is settled back to zero every day, just in case. Previously this did not apply, as the assumption was that firms banks and other FSA-regulated businesses - would have the time to reorganise their balance sheets to meet any liquidity need. Now, the banks will have to agree with the FSA what the outflow risk is. The FSA will consult with banks to arrive at a point where they can agree the necessary liquidity buffer, which means that at any point in time the bank will have to have that money available for its customers, explains Hare. The natural consequence of having that liquidity available is that it will cost the bank money. As a result, banks will not continue to pay the same level of return for those short term deposits. FORECASTING REMAINS CENTRAL Table 2: When considering your risk management strategy, please rank (on a scale of 1-5) the importance INTERNAL EXPERTISE A CONCERN Graph 2. What are the obstacles that may prevent you from actively managing your risk? % REPLIES None, I manage risk effectively 44% 137 Lack of internal expertise/resource 23% 71 Cost (too expensive) 20% 63 Lack knowledge on how to protect 8% 24 against risk Other 5% 14 Total respondents 309 Of course, having identified the risks that the business runs, the onus is on the FD to design the right tools and strategies in order to mitigate away the worst of the effects. For many FDs, however, the question is where to focus resources, and at what level. And while 44% of respondents reported they were happy with their risk management strategies, a significant 23% said a lack of internal resources and expertise was a serious issue. Effective risk management will necessarily require the combined efforts of a number of different functions within the business, and so finance directors are faced with the challenge of leading on risk management often with little resource back-up % 23% 20% 8% 5% But despite being constrained by this, believes another FD, the answer may lie beyond the boundaries of the organisation In my view, we shouldn t be thinking about internal expertise. Rather, we should be thinking about the expertise at our disposal, wherever it is, he said. And the key is identifying that you need support and help from partners and so on, rather than expecting it all to be internally generated. I don t know many organisations that absolutely everything they do, they do themselves. This is not the way the world works. 1 unimportant The importance of economic forecasting has never been so high. The reactions we see to real life economic shocks the Eurozone crisis, Japanese earthquake or the collapse of Lehman Brothers illustrate that no matter how hard a finance director tries, predicting the outcome to 100% certainty is impossible. Indeed, finance directors report that business forecasting is the most important element in general risk management strategies. That is followed, unsurprisingly, by ensuring adequate liquidity for the business. Finance directors are using a range of tools to improve and develop their forecasting capability. The leading source of intelligence, according to the research, is still general market data, but a growing number are also using more detailed risk analytics. Encouragingly, they are also accessing the advice on offer from accountancy firms and banks important REPLIES Business forecasting Providing adequate liquidity Reducing impact of regulatory changes RATING Maximising shareholder value Ability to participate in favourable market movements Meeting bank covenants Interestingly, once again regulatory risk, and assessing the impact of regulatory change comes high on the list of elements making up finance directors plans. And this issue is clearly pre-occupying FDs, given that 59% say they only somewhat understand the impact of regulatory change. Ultimately, all FDs understand unless they can demonstrate a sound grasp of the risks facing the business, then they are doomed to never truly realise the potential value it could create. Assessing and managing risk offers FDs the opportunity not only to drive the business forward on a sustainable basis, but also to underline their own importance to that process. 6 LLoyds Bank Financial Director White paper May 2012 White paper May 2012 LLoyds Bank Financial Director 7

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