Business

Friday August 21, 2009

The role of boards in managing risks of firms

Whose Business Is It Anyway - By John Zinkin


It’s essential to understand the nature of financial exposure to external events

FINANCIAL risk can be both externally caused and the result of poor internal controls.

For the purposes of today’s article, I am only concerned with the financial risk that comes from outside. I will deal with the internal financial risks in the next article.

There are three external factors that create serious financial risk: a change in the cost of money; a change in exchange rates and a general collapse in liquidity. Any one of these, singly or in combination, will affect the risk inherent in the funding structure of the company.

When deciding on how to finance a company, it is not enough to just think about the cost of capital and relate it to the discounted net present value of cash streams.

The board also has to think carefully about the risk dynamic that any given financing strategy brings with it, which in turn can change the risks presented by a given debt to equity profile.

Changing the cost of money

The cost of money is reflected in the interest rate. As interest rates change, so do the cost of money and the viability of projects, because the interest rate affects the hurdle rate of return.

But that is not all; a rise in interest rate affects the amount of interest that has to be paid. And so any change in it may lead directly to a downgrade in the company’s rating even though it did not affect the debt/equity ratio or the margins in the profit and loss statement.

That downgrade, in turn, will increase the cost of money for the company as banks will charge a higher spread as a result. We have only to remember what happened to AIG when the rating agencies downgraded the company’s rating, leading to the biggest collapse of all time.

Boards, therefore, must pay careful attention to what central bankers are doing. They may raise interest rates to choke off excessive demand, curb the growth of asset bubbles or protect the exchange rate.

These actions will hurt the company in three ways: first by slowing down growth; second by raising the cost of finance, making marginal investment projects uneconomic; and third, simultaneously making it harder for the company to cover its existing interest costs.

Obviously the reverse is also true. Lowering interest rates to stimulate the economy or weaken the exchange rate will help the company in the short term, though the inflationary effect of these actions in the long term may have unintended consequences.

Exchange rates

Exchange rates are volatile since most countries no longer have fixed exchange rates. The demand for currencies is now less about financing trade than about carry trades.

The desperate need at the end of 2008 to repatriate dollars to the United States was purely to cope with the unprecedented deleveraging in the second half of 2008.

Investors had to get out of commodities, equities and emerging markets all at the same time as a result of the credit crunch, driving down the prices of all asset classes, except for gold.

This had the perverse effect of pushing up the price of the dollar when the US economy was at it weakest in decades.

As people realised what was happening, the demand for dollars turned into a flight to quality as countries dependent on exports saw their markets collapse.

Boards, therefore, need to understand what is driving exchange rates – is it the balance of payments; differential interest rates causing a carry trade or a flight to quality because the long-term impact will differ in each case.

Liquidity

Perhaps the most important external factor to consider is what is happening to liquidity. Each time the credit markets seize up, the resulting recessions are longer, deeper and more painful than if they were just part of the normal business cycle.

What is perhaps more serious is that boards must remember that we seem never to learn from the mistakes of the past, and Wall Street does not seem to be learning from its recent “near-death experience”, to quote Paul Krugman.

Credit crises are always caused by excessive availability of credit leading to speculation; bubbles followed by debt repudiation bringing down the whole house of cards, or in the words of Larry Summers: “Money borrowed in excess and used badly.”

What we have been experiencing in 2008/2009 is not very different from the Long Term Capital Management Crisis in 1998.

In both cases, the mathematical models were found to be wanting and the financial engineers were shown to be just that – people who created no sustainable long-term value and whose arrogance led them to ignore “Black Swans” which were assumed incorrectly to be impossibly rare.

As we can see, external financial risk can easily become systemic risk. It is therefore essential that boards understand the nature of their financial exposure to external events.

l The writer is CEO of Securities Industry Development Corp, the training and development arm of the Securities Commission. Readers’ feedback is welcome. Please email starbiz@thestar.com.my

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