Understanding What Corporates Want From Derivative Dealers
Since the global financial crisis, there have been numerous studies
, reports and articles written about the relationship between banks and corporates. These pieces examine issues primarily around counterparty risk, cash management and liquidity management. Less seen across the spectrum of treasury-related analysis, however, is quantifiable data on what corporates are saying they want from their banks to support their use of derivatives to hedge financial risks. In the third quarter of 2012, Reval surveyed half of the FTSE 100 and 25 large cap corporations across Europe to capture the sentiment of major corporations about derivative-related services from banks. This paper reports the results and discusses how financial institutions can understand their clients risks or risk the client relationships.
Over the past few years, market volatility and substantive changes in rules governing derivatives have left corporations struggling with their hedging strategies, ongoing risk management, accounting and reporting. Increasingly, companies have been turning to their financial institutions for guidance and support, but many financial institutions have come short in offering effective solutions because they lack any combination of vision, expertise or technology. However, as banks take a step back and re-examine their own business models in the face of industry regulations and global business dynamics, they can consider the latest thinking among the corporate treasury community to find opportunity where there is currently restraint.
Revals research highlights a unique opportunity for banks to step in as strategic advisor to their corporate clients, providing the guidance they need for strategic decision-making and management throughout the lifetime of their derivatives. Overall, these findings point to a broader trend of companies needing and wanting to become more strategic in their approach to risk management. Outlined within this paper are data points and commentary on hedge accounting concerns, products by asset class, valuation, and documentation.
Hedge Accounting Considerations
In their quest to hedge risk, companies first must determine if they should economically hedge at all, and then decide whether to apply hedge accounting and hence deal with the robust and sometimes complex hedge accounting rules. However, uncertainty in accounting for derivatives and diverging standards still exist. This is exacerbated in that some multinationals may have to report under as much as three separate accounting standards, US GAAP, IFRS and local GAAP. It is no surprise, then, that 81 percent of companies said that it is imperative that their banks understand the implications of IFRS 9
1 and this new standards impact on their use of derivatives and their application of hedge accounting. Still, corporations must comply with hedge accounting requirements already in place, and they must do so while abiding by their companys risk management policies. This poses a problem for corporations as 77 percent confirm that adherence to their companys accounting policy is very important when deciding which type of derivative they should use. Interestingly, while respondents say that one third of the banks they deal with do not understand hedge accounting rules as well as they should, market feedback indicates that these same corporations say they are keen to explore more complicated hedging strategies. These findings illuminate the opportunity waiting for banks to step in as dynamic strategic advisor.
Products Across Asset Classes
Reval delved deeper into the kinds of derivative instruments companies were looking to use, and aside from interest rate and foreign exchange products, the following key commodity asset classes were identified as preferred among corporates surveyed:
1.Energy products led mainly by fuel volatility and the need for airlines to comply with the EU emissions Trading Scheme;
2.Agricultural products as a result of extreme and unusual weather conditions (shifts in temperature, natural disasters such as hurricanes, earthquakes) affecting crops globally and simultaneously.
3.Metal products due to sensitivities to the global business cycle, many beverage companies need to hedge metal exposures.
Interestingly, the timescale for derivatives used by corporates has changed from five years ago, when Reval research
revealed that corporates needed to be able to look up to a year out. This survey, however, indicates that 56 percent of
respondents want to look at potential profit and loss impact from between one and five years, and they are turning to
banks to provide suitable instruments to assist them with applying hedge accounting and managing sensitivity analysis.
Option Structured Products
Revals survey also examines corporate interest in option/structured products. Fifty percent of respondents would be
interested in looking at using these more complex instruments if only more advanced reporting accompanied them. In
the current economic environment, the extreme volatility in the underlying markets and the capital charges relating to
option products, and hence the reduction in costs applicable for corporates, has allowed option products to become
more favourable. Four major points were raised:
Do we fully understand the risk profile?
What are the economic benefits of hedging with such an instrument?
What are the accounting implications?
What can we look at now and on an ongoing basis:
Sensitivity analysis
Cash Flow at Risk
P&L Impact
In the recent past, the barrier to using these products has been primarily that treasury departments around the world have needed to convince management teams that anything with the terms structured or option in it is not, in the words of billionaire investor Warren Buffet, a "financial weapon of mass destruction." What treasuries have needed is information, information and more information, and they have needed banks to help them.
As a result of the stigma attached to such instruments, corporates want to feel assured that they are fully informed. They want to be able to see the risk analytics that explain the risk profile of the instrument, how it can be designated in an effective hedge, and what volatility they could expect based on various scenarios and impacts on cash flows.
Valuations
Treasury teams also need assistance with derivative valuations. Over 77 percent of respondents indicate they require additional support in looking at how potential economic scenarios could affect derivative valuations going forward. This is not surprising, given the volatility in the markets from financial crises, which have continued to make conditions unstable. While 62 percent of companies are still looking for simple stress testing from their banks, others are looking at Value-at-Risk-based approaches, with Cash Flow at Risk being the favoured approach. Over 10 percent of respondents had asked their banks to help produce their sensitivity analysis disclosures as required by IFRS 7
Touching on the technical side of valuations, over 80 percent of respondents noted that IFRS 13
3 and, in particular, credit valuation adjustments are now major challenges with which they need help. These standards require an entity to consider the impact of credit risk on the derivative valuation. This is the risk of default of the counterparty bank as well as risk of default on the entitys own credit rating. In other words, if the position is in an asset, it should be adjusting the derivative valuation using, for example, credit default swap spreads of the counterparty and if the position is in a liability then using credit default swap spreads of the entity. Two complications arise for corporates, one being the model to apply to compute these valuations and the lack of available technical resources or compliant valuation systems, and secondly, the availability of appropriate market data to be used. Many corporates are not listed, never mind having credit default swaps being traded on their names. Commonly corporates will then look to use industry CDS for comparable rated companies. This has become more and more urgent given the introduction of IFRS 134 and that the majority of banks have been downgraded. Past conversations with auditors that had deemed these adjustments as immaterial are starting to come apart. What is the biggest concern in relation to this? Audit pressure is mentioned every time as the driving force. First place they would turn? The banks themselves!
Documentation
Operational support is another area in which corporates are saying they need support. Half of the corporations that responded to the recent survey saw banks providing hedge documentation, prospective and retrospective effectiveness testing as a competitive edge over banks that did not provide this service. Indeed, 27 percent viewed hedge compliant documentation as a value-added service when looking at two deals from competitive banks.
Despite the obvious compliance and audit points related to hedge accounting documentation, 82 percent of companies said they were required to review their risk management policies over the past three years to ensure that hedging programs being deployed were in line with the hedging guidelines outlined in the corporate strategy. This has led to more detailed analysis being carried out on a deal-by-deal basis, with ongoing support becoming increasingly important. Rather than corporates seeing derivative services as a transactional business, they want to receive ongoing support that considers their dynamic risk profile, monitors the performance of current hedges and identifies areas for improvement.
Comments from a Corporate Treasurer
My impression is that the track record of banks providing long term support has not been good from the corporates perspective - with one notable exception of Lloyds. Generally at the moment if you buy something you cant value on your own system expect to be left in the dark on your own. Since the objective of hedging, in particular, is ultimately to provide P&L or balance sheet stability resulting from an economic hedge, then the prime objective of entering into the instrument can be compromised in some cases seriously if the treasury involved cant value and test the product. And seriously is how the rest of the organisation will take P&L volatility.
Banks may start off with sincere, good intentions from the sales force. But after some time (often years) has elapsed someone else at the bank will question the on-going cash spend on providing in-life support (youll need both prospective testing at the start and retrospective during the life of the derivative). They will also point to the fact that the spend is not, apparently, generating any (new) revenue. This is then compounded by the fear of liability they naturally have of providing any accounting and tax advice especially years later when it may get more complicated by changing circumstances at the corporate, change in audit requirement, the accounting standards themselves and of course market conditions. (e.g. the auditor may stop accepting a valuation from the bank counter party especially if it becomes a Level 3 derivative i.e. valued in a model with "unobservable" market inputs - as happened to securitised US mortgage investments when the market evaporated during the financial crisis).
So the upshot is, in my opinion, that unless the bank can demonstrate a serious commitment to providing life-time valuation services, then its unlikely that corporates are going to buy anything that they dont have the tools already they are confident will value, revalue and test in future.
- Jeremy Johnson, Group Treasurer, Hitachi Capital (UK) PLC
Conclusion
The companies that have participated in this survey speak clearly to the challenges faced by most corporates hedging against risk in a dynamic global business environment. Increasingly, they are turning to their banks for support and advice, but as treasury departments become more strategic, so too must the financial institutions they deal with. While much is still left to be explored among the relationships between banks and corporates, what is certain today is that there is long-term growth potential for banks who can deliver more sophisticated and robust capabilities to address these complex needs.
by: Reval
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