Treasury and Risk Management Top Financial Risks and Tools to Manage Them

February 2013

Ankita Tyagi

This document is the result of primary research performed by Aberdeen Group. Aberdeen Group's methodologies provide for objective fact-based research and represent the best analysis available at the time of publication. Unless otherwise noted, the entire contents of this publication are copyrighted by Aberdeen Group, Inc. and may not be reproduced, distributed, archived, or transmitted in any form or by any means without prior written consent by Aberdeen Group, Inc.

February 2013

Treasury and Risk Management: Top Financial Risks and Tools to Manage Them

In February 2012, Aberdeen conducted a study on Treasury and Payments, Putting Your Cash to Work: Reducing Risk and Maximizing Returns with Treasury and Payments Management, which shed light on the impact of treasury and payment strategies in financial operations. That study focused, primarily, on Accounts Payables (AP) and Accounts Receivables (AR). This study, on the other hand, explores the classic corporate treasury and risk management function and its role in financing business operations as well as in shaping company strategy. Aberdeen reached out to C-Level executives, Treasurers, and other business leaders across different financial functions, from November 2012 through January 2013, to identify top market pressures as well as gain an insight into the critical market risks and responding companies' level of exposure to those risks. This study uncovers those market drivers, strategies, and capabilities which companies have in place to manage financial risk. It concludes with a discussion of top technologies which are in play today and offers recommendations for building a robust treasury and risk management function.

Key Market Drivers: Risks at Large and Exposure Level The last few years have seen a spike in regulatory reforms, with the majority directed at financial functions, particularly towards reporting and risk management. Further, the 2008 housing crisis, and the ensuing euro crisis, have led to a new normal where organizations and financial institutions operate in a highly constrained (particularly in terms of liquidity) economic environment. Evidently, 50% of respondents to Aberdeen's recent survey cite this greater regulatory and compliance oversight as one of the key market drivers for undertaking treasury and risk management initiatives (Figure 1).

Analyst Insight

Aberdeen’s Insights provide the analyst's perspective on the research as drawn from an aggregated view of research surveys, interviews, and data analysis

"[Information from] balance sheets, credit assessment from ratings partners, and close monitoring of amount of exposure due to customer supply chain risks [are some of tools used by our organization for risk management].

~ Manager, Procurement, Financial Services

Treasury and Risk Management: Top Financial Risks and Tools to Manage Them Page 2

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Figure 1: Top Market Drivers

Source: Aberdeen Group, January 2013

Other key attributes which set 2008 and beyond apart from the prior years include an economic environment marred by heightened financial risks, low interest rates, precarious global financial conditions, and fluctuating commodity prices (case in point: crude oil). This has led to an overall low liquidity environment, making it difficult for companies to steer their business through these economic buoys. Despite these substantial challenges, there are no concessions for companies today. If anything, the crisis in 2008 only exposed hollow lines of credit and shook up stakeholders' trust. In fact, stakeholders are now demanding greater financial transparency and prudent investment practices, particularly responsible risk management. So it is no surprise that the biggest market pressure, as cited by 58.8% of the respondents, is the increase in financial risks (Figure 1). Financial risk, however, is a broad term, inclusive of several types of risks. As such, for the purposes of this study, financial risk includes the following seven types of risks:

• Commodity risk

• Counterparty risk

• Credit risk / liquidity risk: Credit and liquidity risks are two distinct types of risks. But, many times, companies use these two terms interchangeably and for the purpose of this study, we do not distinguish between them.

• Foreign exchange risk

• Interest rate risk

• Sovereign risk

• Reputational risk

• Other risks

14.7%

20.6%

26.5%

50.0%

58.8%

0.0% 13.0% 26.0% 39.0% 52.0% 65.0%

Inability to keep upwith market volatility

Low interest rate - difficult to find areas to invest

Inability to accuratelyforecast cash flows

Greater regulatory and compliance oversight

Increased financial risk

Percentage of Respondents, n = 36

All Respondents

Regulatory Oversight - Recent Directives

Some of the directives particularly issued for financial services and / or financial operations, in recent years are as follows:

√ eXtensible Business Reporting Language (XBRL)

√ The Basel Accord

√ Dodd-Frank Reform with a complimentary Volcker Rule

√ Generally Accepted Accounting Principles (GAAP) to International Financial Reporting Standards (IFRS)

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According to the survey, respondents cite a 0.47% increase in exposure to total financial risk over the past year. While a sub 1% figure may appear insignificant at first glance, it can be quite impactful when one takes into account millions and billions of dollars that a company may invest and which may now be at risk. The following section — Risky Business — explores risk prioritization, visibility, and the exposure level of these seven different types of risks.

Risky Business: Relevance, Visibility, and Exposure We asked respondents to prioritize different financial risks, on a scale of 1 to 5, with one (1) being least important and five (5) being most important, based on the risk's potential impact on business operations and continuity. The findings are summarized in Table 1.

Table 1: Risk Priority, Tracking, and Exposure Level

Risk Type

Priority 1- Least

Important 5- Most

Important

Visibility 1 - No

Visibility 5- Excellent

Visibility

Change in risk exposure over the past year

(%) '+' indicates an

increase '-' indicates a

decrease

Interest rate risk 3.64 3.10

+1.22%

Counterparty risk 3.61 3.03

-1.97%

Sovereign risk 3.35 2.63

+1.83%

Credit risk / Liquidity risk 3.19 3.69

+5.23%

Commodity risk 3.19 2.83

-5.03%

Foreign-exchange risk 3.00 2.77

+1.26%

Reputational risk 3.00 3.30

-1.48%

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Risk Type

Priority 1- Least

Important 5- Most

Important

Visibility 1 - No

Visibility 5- Excellent

Visibility

Change in risk exposure over the past year

(%) '+' indicates an

increase '-' indicates a

decrease

Other 0.74 1.89

-0.59%

Source: Aberdeen Group, January 2013

Interest rate risk was rated as the top priority (3.64 out of 5.00) by respondents. Fluctuating interest rates have left organizations with few viable options. Interest on federal funds, known for their "default-free" characteristic, are offering historically low returns as of January 18, 2013, and as per the Federal Reserve's announcement, will continue to remain low until 2015. However, many small businesses often don’t qualify for loans from banks and many financial institutions still follow a strict lending policy. Therefore many small businesses aren't exactly benefiting from these low rates. Companies which are in need of a steady and reliable stream of sizable cash may not be able to meet their needs through treasury bonds alone due to their low yields. Other options are even less viable as the risk associated with private investments can be fairly substantial. Without any federal guarantee on private investments, companies are forced to leave large amounts of cash idle on their books, adding to liquidity issues.

Counterparty risk (3.61out of 5.00) follows closely on the heels of interest rate risk as one of the top areas of concern for organizations today. Structured financial products, such as a derivative, derive their value from other financial assets and may involve multiple parties. Often times, these instruments, based on complex mathematical models, involve multiple trading partners. This makes it hard to identify the source of the capital, the exact number of stakeholders involved in the transaction, and their level of exposure to price fluctuations of the security. Hence, it is not surprising to find counterparty risk as one of the top concerns for any organization today.

Risk Visibility In addition to the prioritization of different risks, we also asked respondents to rate their organization's visibility into different types of risks. A rating of one (1) denotes no visibility and a rating of five (5) denotes excellent visibility (Table 1).

As expected, respondents reported maximum visibility into their organization's credit risk position (3.69 out of 5.00), followed by reputational risk (3.30 out of 5.00). It is not uncommon for organizations to

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track and maintain the credit histories of their clients. This is particularly true for any organization which offers a supply chain financing solution. In addition, the post-2008 economic crisis has brought poor credit issues to the forefront, compelling many financial institutions and organizations to take a critical look at their line of credit and establish processes and systems to aid credit-risk monitoring. Hence, it is of little surprise that organizations report a high visibility across this risk metric.

Reputational risk is another interesting risk type. The intent of most organizations is to maximize their stakeholder's interest and one way of ensuring that is by retaining existing customers and attracting new ones. In other words, establishing a brand, which in turn is a function of business reputation. According to the March 2012 report, B2B Social Media Marketing: Are We There Yet?, leading companies reported a 186% greater increase in year-over-year social buzz (positive social mentions) and 230% more market leads from social media channels compared with all other companies. Therefore in effect, any endeavor that an organization takes has an impact on reputational risk. With this premise in mind, organizations, particularly in the age of social media, are more likely to track and monitor their brand than in the past. Additionally, the last few years have seen a spike in the number of incidents where an organization's confidential data was compromised. This has brought focus to IT Governance, Risk, and Compliance (GRC) and is evident by the increase in the number of solution providers which now focus on this aspect. With this information on hand and additional resources, more companies now track reputational risk compared to other risk types.

Risk Exposure Finally, we asked respondent to rate the change in their organization's level of exposure to these risks. Respondents reported a 5.23% increase in credit / liquidity risk exposure level since 2011. Surprisingly, commodity risk reported a decline in exposure level of 5.03%. At first glance this appears contrary to current media reports, since the prices of many raw materials have fluctuated widely. For instance, crude oil, which is used in several production processes, has been a topic of great controversy for this very reason since 2011. However, it is also important to note that the manufacturing industry is still on its path to recovery and many plants are not operating at their optimal capacity yet. As plant production and housing construction picks up, prices of many raw materials are likely to rise, possibly exposing companies to a higher commodity risk.

Risk Tracking and Benchmarking It is important to note that organizations cannot assess their risk position unless they regularly track and measure their exposure. According to the survey, 58.3% of the respondents regularly benchmark and track credit risk while less than half of that (22.2%) regularly benchmark and track commodity risk. Unfortunately, ignorance is not bliss when it comes to risk and investment management. According to the April 2012 report, Financial

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Planning, Budgeting, and Forecasting: Risk-Adjusted Strategies to Enable Accuracy (FPBF), leading companies are almost two times as likely as All Others (44% vs. 23%) to systematically monitor key risk indicators.

Figure 2: Risk Benchmarking and Tracking Rate

Source: Aberdeen Group, January 2013

Strategies and Capabilities of Today and Tomorrow While the identification of key market drivers, risk types, and exposure level is a critical component of any treasury and risk management function, it is only one part of the equation. The second part, which is just as critical if not more so, often focuses on strategies and capabilities to mitigate and manage those risks.

The majority of survey respondents (63.6%) cite improvement in cash flow forecasting capabilities as one of the top strategic action used to account for risk (Figure 3). Improved financial forecasting can make it possible for organizations to anticipate the next big expense and plan their investments and / or schedule payments to their stakeholders in a timely manner, alleviating liquidity issues and ensuring business continuity.

58.3%50.0%

41.7%

27.8% 27.8%22.2%

16.7%

0.0%0.0%

13.0%

26.0%

39.0%

52.0%

65.0%

Percentage of Respondents, n = 36

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Figure 3: Top Strategic Actions

Source: Aberdeen Group, January 2013

On a similar note, real-time financial reporting capabilities can offer organizations accurate and timely insight into the cash position as and when transactions occur rather than waiting until the reporting period. Such visibility can improve cash flow management and is in fact a key strategic action, as cited by 54.5% of respondents.

It is important to mention organizations' strategic focus on integrating treasury and risk management functions (18.2%). For many organizations, these are still two separate functions, where visibility in one doesn’t necessarily warrant visibility into the other. According to the survey, only 29.6% of respondents have integrated treasury and risk management capabilities in place (Table 2). Integration reduces the time lost due to switching between applications, paving way for more efficient and seamless operations. According to the 2012 ERP Benchmark survey, leading companies are almost two times as likely (76% vs. 41%) as their Laggard counterparts to integrate business applications.

Capabilities to Realize Strategies: Today and Tomorrow Most of the capabilities listed in Table 2, below, support the strategic actions of Figure 3. Forecasting, real-time reporting capabilities, and integrated treasury and risk management systems and processes highlight the importance of reporting accuracy and visibility into current operations to gauge an organization's financial health. Not only do these three capabilities have a high current implementation rate (35.7%, 35.7%, and 29.6% respectively) but many respondents, 50% for forecasting and real-time reporting each and 40.7% for integrated treasury and risk management capabilities, expressed interest in embracing these capabilities in the next 12 months. It is important to note that organizational capabilities and a formalized approach/ documentation is one of the first steps in the path to

12.1%

18.2%

21.2%

54.5%

63.6%

0.0% 13.0% 26.0% 39.0% 52.0% 65.0%

Seek Board of Directors buy-in

Integrate treasury withrisk management

Invest in a treasury and riskmanagement platform

Provide real-time access to financial data

Improve cash flow forecasting

Percentage of Respondents, n = 36

All Respondents

"We use balance sheets and cash flow [statements] to determine near term risks. Lack of financial risk management can severely impact the profit margin across each product."

~ Stacy Cordier, Vice President, Treasury, Retail

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embracing technology to achieve economies of scale and efficiencies. For instance, adoption of an integrated treasury and risk management solution is plausible only if the line of business managers understand the need to collaborate, integrate different functions (treasury and risk management in this case), and reduce redundancies. Therefore, organizational capabilities in table 2 reflect the evolving mindset necessary prior to embracing a new technology solution.There is also an overarching emphasis on formalization and standardization of processes as indicated by the percentage of respondents who are either currently implementing or planning to implement a formalized process for cash flow forecasting (35.7%) and risk management (34.5%).

At the same token, 43.3% of respondents cite implementation of enterprise-wide standardized treasury and risk management processes as a key capability while an additional 23.3% are planning to undertake such initiatives in the next 12 months.

Standardization ensures uniformity and consistency while reducing information clutter. Considering the massive information overload and interest in "big data" since 2011, this is of great significance today as standardization can help companies distinguish critical financial data indicators from all other data.

For instance, when we asked respondents to select the top three key performance indicators from a limited list of 20, there was little consensus on the top three. Days Sales Outstanding (DSO) and total annual banking fee were the most favored metrics cited by 34.8% of the respondents, which is still less than the half of the total sample size.

Table 2: Top Capabilities: Present and Future Trends

Capability Current

Implementation Rate

Plan to Implement

Aging analysis for receivables 62.1% 24.1%

Formalized process for cash flow forecasting 35.7 % 50.0 %

Credit evaluation capability 35.7 % 32.1 %

Formalized process for financial risk management

34.5% 41.4%

Real-time visibility and control into all cash account balances

35.7% 50.0 %

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Capability Current

Implementation Rate

Plan to Implement

Integrated treasury and risk management 29.6% 40.7%

Source: Aberdeen Group, January 2013

Technologies in Play and Future Trends In addition to capabilities, organizations are also deploying technology solutions in support of their strategic objectives. This section sheds light on some of the highly leveraged technology solutions. Fifty percent (50%) of respondents currently have a bank-hosted treasury workstation (Figure 4) and 13.6% plan to follow suit in the next 12 months. A treasury workstation is often considered a nucleus of corporate cash management, as it provides access to all financial data at a single location. Financial data often includes account balances, transaction history, forecasts, and investment portfolio information, among other critical data.

A treasury workstation offers the benefit of consolidating all critical data in one location, reducing time spent on gathering data from different sources and time to decision-making. That said, while a bank-hosted treasury workstation relieves the pain of hosting and solution maintenance for the organization, it also leaves the organization at the mercy of their bank in term of functionality offerings.

Figure 4: Technologies — Current and Future Trends

Source: Aberdeen Group, February 2013

In spite of the ubiquity of Accounts Payable (AP) and Accounts Receivables (AR) solutions, the current implementation rates are fairly low. These

25.0%

32.1%

34.8%

41.7%

46.2%

48.0%

50.0%

50.0%

41.7%

7.1%

13.0%

20.8%

11.5%8.0%

8.3%

13.6%

0.0% 14.0% 28.0% 42.0% 56.0% 70.0%

Financial Analytics tool

Treasury Management system

Risk Management solution

Cash Management solutionAccounts Payable (AP) solution

Enterprise Resource Planning(ERP) Treasury module

Accounts Receivables solution (AR)Bank-hosted Treasury workstation

Percentage of Respondents, n = 36

Currently Use Plan to Implement within 12 Months

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solutions have been around for a while yet many companies still rely on paper-based invoices. According to the February 2012 study, Common Concerns and Shared Strategies: AP and AR Lessons from the Best-in-Class, 43% of invoices are still paper-based. However, 67% and 35% of respondents are considering automation of AP and AR processes, respectively, as a critical strategy to reduce costs and achieve operational efficiency.

Similar to AP and AR solutions, in spite of the ubiquity and abundance of options for cash and risk management solutions, current deployment rates are fairly low at 41.7% for cash management and 34.8% for risk management solutions. With regards to cash management, many organizations still rely on the "look at the cash flow statement" approach to manage cash rather than an automated system.

Even though many organizations understand the role and impact of effective risk management in ensuring business continuity, many organizations still view it as a tier-two function. Still there are a few organizations which tend to address operational disruption after the occurrence of an adverse incident rather than taking a proactive approach to prevent it in the first place. According to the October 2011 study, Enterprise GRC Management for Financial Executives: Best Practices for ROI Evaluation, 15% of the respondents cite relying on the "only know something is wrong after it occurs" approach to manage risk. Additionally, according to the December 2010 study, Effective GRC Management: Positioning Your Company for Growth, only 25% of companies have tools in place to enable management access to the company's current risk status. Additionally, as Figure 4 indicates, only 25% of respondents are leveraging financial analytics today but 41.7 % plan to implement these solutions in the next 12 month. Financial analytics is used to collect and analyze data from different financial units and systems, thereby reducing time to decision making and enabling faster access to critical information. According to the FPBF study, companies using business analytics are able to reduce their time-to-decision making by 13% compared to 10% for companies which don’t have a business analytics solution in place. Also, organizations which have business analytics in place were able to provide 74% of their stakeholders with access to financial performance data, compared to 62% of stakeholders in companies without business analytics tools. On a complimentary note, 8.7% of organizations currently leverage predictive analytics for treasury and risk management and an additional 21.7% plan to do so in the next 12 months. In addition to supporting capabilities, companies are also looking at technology solutions to help them get ahead of the financial risks facing their organizations. For instance, while only 29.6% have already implemented capabilities to support integrated treasury and risk management solutions, 40.7% are planning to implement these capabilities in the next 12 months. However, capabilities implementation is just one of the milestones in the treasury and risk management integration journey. Many organizations continue on with implementation of supporting technologies.

Integrated treasury and risk management capabilities and solutions enable organizations to have a holistic view of risk across cash, debt and

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investments, and financial risk management activities. These types of comprehensive treasury and risk management solutions are particularly useful for organizations expanding globally into new markets, where local regulatory and market requirements present challenges to the central treasury.

Treasury and Risk Management Report Card We've discussed market pressures, strategies to alleviate them, and systems and processes to support the treasury and risk management functions. But how are companies performing in today's economic environment and how does it compare to previous years? Table 3 presents companies performance across some of these treasury and risk management indicators.

Table 3: Treasury and Risk Management Report Card

Key Performance Indicator Result

Average return on short-term (less than 3 months) capital investments 1.74%

Average cost of short-term (less than 3 months) borrowed capital 2.30%

Percentage of loans which were ultimately written off as bad debt over the last year 1.88%

Number of days required to collect organizational data for regular (e.g. quarterly) financial reporting 8.43 days

Number of days required to report global cash position 5.93 days

Accuracy of global cash forecasting (Average variance) '+' denotes that actual forecast overshot the budgeted forecast

+1.25%

Change in percentage of loans written off as bad debt over the past year

Increased by 5.75%

Change in total annual banking fees over the past year Increased by 8.54%

Source: Aberdeen Group, January 2013

Two of these metrics, number of days required to collect organizational data for regular (i.e. quarterly) reporting and number of days required to report global cash position, warrant further discussion. According to Figure 1 on market pressures, 14.7% of respondents cite the inability to keep up with market volatility as one of the biggest concerns. Therefore, if an organization on an average requires eight days to collect financial data and almost six days to report global cash position, it is probably not agile enough to respond to the dynamic economic environment and will be inept at alleviating that market pressure. This is yet another reason why companies

"[Biggest room for improvement within Treasury and Risk are in the areas of…] near real time information aggregation and reporting; visibility to market dynamics via credible matrices."

~ General Manager, Information Technology,

Financial Services

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should explore and invest in analytics and real-time reporting capabilities to reduce delay in access to information and to expedite decision making.

According to the November 2012 report, Real-Time Financial Reporting: Ensuring Continuous Compliance and Transparency While Reducing Costs, leading companies which have real-time financial reporting capabilities in place, reported a 38.9% reduction in time needed to close their books at the end of the quarter, compared to a 6.2% increase in time reported by their peers who lagged in the adoption of such capabilities.

Concluding Remarks Treasury and risk management is a critical function for every organization, irrespective of size or industry type. Whether formal or informal, every organization in some way monitors its cash position to fulfill current commitments and to plan ahead. However, organizations which invest in systems and processes to support this function are better equipped to respond to the dynamic economic environment and mitigate risk in a timely manner than those who wait to react after the fact. The following steps are some of the proposed actions for building a robust and agile treasury and risk management function:

• Identify key performance metrics to track treasury and risk management. In this survey alone, we identified 20 metrics which organizations use to track and measure their cash flow position and risk exposure level. This list is by no means exhaustive and may vary depending on size, type, location, and other attributes of the organization. By identifying absolutely critical metrics, companies can reduce data to a more manageable level. Lack of reliable metrics to measure program success was cited as a top challenge by 14.7% of respondents.

• Appoint and equip treasury and risk management officers with resources to regularly monitor and address the company's cash and financial risk position. Limited resources (i.e. staff and budget) are cited as one of the biggest challenge by 58.8% of respondents when it comes to initiating a treasury and risk management initiative.

• Invest in technology solutions to systematically monitor cash position and to gauge risk exposure levels in a timely manner. Responding after the fact defeats the entire purpose of risk management. Response time is a critical factor. A lack of technical capabilities was cited as one of the biggest challenge by 29.4% of the respondents with regards to effective treasury and risk management.

• Integrate different technology solutions to expedite processes and to gain a holistic view of the treasury and risk management function. According to the 2012 ERP benchmark survey, leading companies are almost two times as likely (76% vs. 41%) than their

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Laggard counterparts to integrate their business applications for complete and auditable system of records. Inability to integrate different solutions is cited as one of the biggest challenge by 26.5% of the respondents in the treasury and risk management space.

For more information on this or other research topics, please visit www.aberdeen.com

Related Research

Real-Time Financial Reporting: Ensuring Continuous Compliance and Transparency While Reducing Costs; November 2012 Financial Planning, Budgeting, and Forecasting: Risk-Adjusted Strategies to Enable Accuracy; April 2012 B2B Social Media Marketing: Are We There Yet?; March 2012 Common Concerns and Shared Strategies: AP and AR Lessons from the Best-in-Class; February 2012

Putting Your Cash to Work: Reducing Risk and Maximizing Returns with Treasury and Payments Management; February 2012 Enabling Compliance and Business Improvements through XBRL; April 2011 Enterprise GRC Management for Financial Executives: Best Practices for ROI Evaluation; October 2011 Effective GRC Management: Positioning Your Company for Growth; December 2010

Author: Ankita Tyagi, Senior Research Associate, Financial Management and Governance, Risk, and Compliance (GRC), ankita.tyagi@aberdeen.com, LinkedIn

For more than two decades, Aberdeen's research has been helping corporations worldwide become Best-in-Class. Having benchmarked the performance of more than 644,000 companies, Aberdeen is uniquely positioned to provide organizations with the facts that matter — the facts that enable companies to get ahead and drive results. That's why our research is relied on by more than 2.5 million readers in over 40 countries, 90% of the Fortune 1,000, and 93% of the Technology 500. As a Harte-Hanks Company, Aberdeen’s research provides insight and analysis to the Harte-Hanks community of local, regional, national and international marketing executives. Combined, we help our customers leverage the power of insight to deliver innovative multichannel marketing programs that drive business-changing results. For additional information, visit Aberdeen http://www.aberdeen.com or call (617) 854-5200, or to learn more about Harte-Hanks, call (800) 456-9748 or go to http://www.harte-hanks.com. This document is the result of primary research performed by Aberdeen Group. Aberdeen Group's methodologies provide for objective fact-based research and represent the best analysis available at the time of publication. Unless otherwise noted, the entire contents of this publication are copyrighted by Aberdeen Group, Inc. and may not be reproduced, distributed, archived, or transmitted in any form or by any means without prior written consent by Aberdeen Group, Inc. (2013a)