Corporate Financial Risk Management Update - Edition 1
CFRM Update: Edition 1
Advisory
Corporate Financial Risk Management Update Edition 1
Welcome to the first edition of KPMG’s Corporate Financial Risk Management Update. This is a periodic publication that KPMG is issuing to finance and treasury practitioners. It seeks to provide an update on trends in treasury and financial risk management based on our observations and experience with a wide range of clients and market participants. In this issue we explore: • Trends in the Australian debt markets. • Basel lll update. What it means for businesses.
Contents Trends in the Australian debt markets Page 2 Basel lll: impacting banks’ relationships with business Page 5
• Managing the risks of a strong Australian dollar. • Changes to AASB 139. • Emerging issues in finance and corporate treasury. We trust you will find this material of value and interest.
Managing the risks of a strong Australian dollar Page 6 Changes to AASB 139 Page 9 Emerging issues in finance and corporate treasury Page 10 Credit value adjustment (CVA) Page 12
Corporate Financial Risk Management Update: Edition 1 / December 2010 © 2010 KPMG, an Australian partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.KPMG and the KPMG logo are registered trademarks of KPMG International. Liability limited by a scheme approved under Professional Standards Legislation.
Trends in the Australian debt markets
The following is an extract from Debt Market Quarterly Update Q3 2010.
Key themes • Global financial uncertainty and recent interest rate increases have resulted in the Australian dollar (AUD) hitting new highs.
The case for funding diversification continues to increase, with appetite returning for alternative funding solutions.
• Business lending volumes remain constrained. However, margins continue to tighten and banks remain hungry for quality assets. • Despite the large volume of debt maturing in 2011 and 2012, an opportunity exists to secure improved terms from lenders. • The case for funding diversification continues to increase, with appetite returning for alternative funding solutions.
Update on debt markets Global perspective The three key themes dominating the global finance market over the last quarter included: (i) the US housing foreclosure situation; (ii) inflationary pressures in the Asia Pacific region; and (iii) uncertainty in global currency markets.
The International Monetary Fund (IMF) has warned Australia and its Asia Pacific neighbours of the need to raise interest rates and cut government spending to manage the risk of inflation due to the economic strength seen in the region. As such, and with forecasts of further interest rate hikes, the strong AUD is expected to persist for some time. This development will negatively affect exporters but may benefit Australian borrowers of foreign debt in the shortterm.
Loan volumes Whilst banks remain cautious in their capital allocation, they are in fact hungry for quality assets. Contrary to the position 12 months ago, market sounding has suggested that a reduction in volume does not reflect a diminished appetite, but rather a reduced supply of deals. The contraction of syndicated loan market volumes (as reflected in the chart below), together with reduced levels of gearing on Australia’s corporate balance sheets and a continuing low level of new money funding, has contributed to a decrease in total aggregate business lending over the past 2 years.
Figure 1: Australian syndicated loan volumes 50 45 40 35 30 25 20 15 10 5
25,000 20,000 15,000
Volume (US$m)
3Q10
2Q10
1Q10
4Q09
3Q09
2Q09
1Q09
4Q08
3Q08
2Q08
1Q08
4Q07
3Q07
2Q07
1Q07
0
4Q06
10,000 5,000
0
Number of deals
Source: LoanConnector, 2010 Corporate Financial Risk Management Update: Edition 1 / December 2010 © 2010 KPMG, an Australian partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.KPMG and the KPMG logo are registered trademarks of KPMG International. Liability limited by a scheme approved under Professional Standards Legislation.
No. of deals Number of deals
US $m
40,000 35,000 30,000
Refinancing
Australian bond market
Over the last 2 years, tight credit markets have provided cause for concern for all CFOs despite record equity raisings in 2009 and the de-gearing of balance sheets. Debt refinancing remained challenging and in most cases resulted in higher margins and upfront fees.
At a recent round table discussion sponsored by the ‘Big Four’ banks, 10 of Australia’s largest corporations commented upon the Australian corporate bond market making reference to the fact that there was still ample room for growth2.
Transactions in the order of ~$60 billion were completed in 2009 and other than a select few, tenors were heavily weighted with a 3-year maturity1. With borrowers sensibly addressing their refinancing needs at least 12 months in advance, many of these 2012 maturities will need to be refinanced in 2011 making it a busy year for the syndicated loan market.
Standard & Poor’s has noted that the Australian bond market is in a prime position to shoulder a greater share of corporate finance, but that further regulatory reform is needed for this to occur3.
Whilst the need to refinance may present a challenge for some corporates, it can also provide an opportunity. Companies that completed refinancing in the first half of 2009 may have done so at relatively higher margins and incurred significant upfront fees. With longer tenors now available for the first time in 3 years and margins generally reducing over the past 18 months, borrowers can now take advantage of these improved conditions. Woodside and OneSteel provide good examples of borrowers who have successfully tapped the debt markets on improved terms, as detailed in the table below.
On a positive note, there have been some interesting alternative debt instruments issued, including hybrid notes and retail bonds providing realistic funding opportunities. Although the Australian private placement market has produced only limited publicly disclosed examples, deal activity has been noted with a number of corporates successfully tapping this market with fixed or floating-rate structures, competitive pricing and tenors of 5 to 7 years. On the covered bond front, Canadian Imperial Bank of Commerce’s (CIBC) debut issuance into the Australian market together with the potentially positive effects on the calculation of regulatory liquidity ratios has intensified the push by Australian banks for a covered bond market. The Australian Prudential
Table 1: Refinancing comparatives Deal in market/ recently completed
1H2009 Woodside Date
19-May-09
11-Oct-10
Amount
US$1.1bn
US$1.1bn
Tenor
3 years
5 years
Credit rating
A-
A-
Margin
225bps
165/170bps
Top-end upfronts
90bps
75bps
Top-end all-in margin
255bps
180/185bps
Date
02-Feb-09
31-Aug-10
Amount
A$223m
$590m
Tenor
3 years
3 & 4 years
Credit rating
NR
NR
Margin
240bps
195bps/220bps
Top-end upfronts
50bps
60bps/70bps
Top-end all-in margin
257bps
215bps/235bps
On a positive note, there have been some interesting alternative debt instruments issued...
Onesteel
Source: LoanConnector, 2010 1. Steve Lambert, Global Head of Debt Markets, National Australia Bank 2. Standard & Poor’s, Case Strengthens For Corporate Bonds In Australia, 4 Oct 2010 3. ibid Corporate Financial Risk Management Update: Edition 1 / December 2010 © 2010 KPMG, an Australian partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.KPMG and the KPMG logo are registered trademarks of KPMG International. Liability limited by a scheme approved under Professional Standards Legislation.
Regulation Authority has prohibited covered bond issuance by domestic banks in the Australian market because of its interpretation of the depositor protection provisions of the Banking Act 1959.
• a legally binding replacement capital covenant requiring that the issuer fund any redemption of the instrument with a similarly equity-like instrument
This has not constrained the whollyowned subsidiaries of Australian banks operating in New Zealand from issuing covered bonds in that market reflecting the absence of legal or prudential constraints on such issuance. The Reserve Bank of New Zealand released in October 2010 a Consultation Document on covered bonds in part dealing with issues of the need for specific legislation and the setting of permissible limits on maximum issuance.
There are obvious attractions to this structure. Interest payments are deductible for tax purposes and yet the equity classification improves credit metrics and can have favourable ratings implications. It is also a cheaper form of capital than straight equity and is not dilutive.
KPMG’s deal of the quarter The Santos hybrid is a world-first in that the notes received ‘high’ equity credit classification from Standards & Poor’s, which means it will be treated entirely as equity for credit purposes and as debt for tax purposes4. It is a structure likely to trigger further interest for borrowers seeking to diversify their funding arrangements. Key features leading to equity classification included: • mandatory deferral of interest for up to 5 years if the long-term corporate credit rating on Santos falls to ‘BB+’ or below
• first call date from year 5.
Securitisation Further momentum was evidenced in the asset backed securitisation (ABS) market with the recent FleetPartners Australia Ltd (FleetPartners) ABS issue. FleetPartners made its maiden public term ABS issue of A$178 million which was well oversubscribed, successfully placing the lower rated (A and BBB) with institutional investors. The deal offered further evidence of the growing depth of the ABS market. In addition to the public term ABS issue, KPMG’s Debt Advisory practice assisted FleetPartners in structuring the first ever publicly rated Australian operating lease open pool warehouse totalling A$850 million, providing a landmark funding diversification solution for FleetPartners.
• 60 year term to maturity • 100 basis point step up at year 7
Table 2: Alternative debt deals Date
Issuer
Debt instrument
Deal size
Oct-10
Canadian Imperial Bank of Commerce
Covered bond, 3yr, -48bps over swap –inaugural A$750m covered bond issuance in the Australian market. Collateral consists of fully insured residential mortgage loans – guaranteed MBS Securities
Oct-10
Primary Healthcare
Retail bond, 5yr, -4.0% margin, unsubordinated, A$150m unsecured, ranks after secured debt. The first retail bond in Australia, taking advantage of the amendment in ASIC Class Order 10/321 streamlining the documentation and sale process
Sep-10
Santos
European hybrid, BB rated, 7yr, 100%, equity credit from S&P, 8.25%
A$650m
Sep-10
Goodman
CMBS - $210m AAA rated tranche and $40m, AA rated ranch – 24 properties including warehouse distribution centres, business parks, industrial estates
A$250m
Source: ASX company announcements, 2010 4. Standard & Poor’s, Santos’ Subordinated Notes And ‘High’ Equity Credit Classification Explained In S&P Report, 14 October 2010
Corporate Financial Risk Management Update: Edition 1 / December 2010 © 2010 KPMG, an Australian partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.KPMG and the KPMG logo are registered trademarks of KPMG International. Liability limited by a scheme approved under Professional Standards Legislation.
Basel lll: impacting banks’ relationships with business
The proposals to reform the regulatory framework for banks, known as Basel III include: • redefining capital to emphasise common equity and tier 1 capital • higher minimum capital ratios • establishing capital buffers above minimum requirements • introducing a cap on permissible balance sheet leverage • introducing global liquidity and funding standards, including a short-term liquidity coverage ratio and a longerterm net stable funding ratio. What does this mean for borrowers? Although these changes are not due to be formally applied for some time, a period of ‘regulatory observation’ will commence sooner than this. Banks will as a consequence start a process of adjusting their balance sheet structures including their funding and liquid asset holdings. The scale of these changes has the potential to significantly impact banks’ business acceptance rules as well as accompanying pricing decisions. Another key outcome of Basel III is that recognisable liquid assets are to be confined for regulatory purposes, to a limited class of assets that for the first time will not include bank paper. This potentially limited supply of permissible liquid assets together with the imposition of a minimum liquidity ratio may therefore constrain new lending and the potential growth and size of banks’ balance sheets. Further the proposed ‘Liquidity Coverage Ratio’ requirements consider the composition of bank borrowings and recognise the potential demands on banks to repay them (‘funding run-off’). Thus shortterm borrowings by banks impose higher regulatory requirements for
‘offsetting’ liquidity holdings than do longer-term borrowings. For example, unsecured at call wholesale funding provided by corporate customers to banks that otherwise have no operational relationship with that bank, have an assumed 75 percent run-off rate thereby imposing significant ‘offsetting’ liquidity requirements on the bank and making it a comparatively unattractive source of funding. This may have ramifications for the wholesale short-term money market and make it a relatively unattractive source of funds for banks. A further impact on money markets is the proposed high run-off rates to be applied by regulators to unsecured at call funding provided by financial institutions, public sector entities and pension funds. By contrast regulators are proposing to apply minimal rates of assumed funding runoff for retail deposits and thus a limited need for banks to hold liquid assets against these deposits. Further to the proposed exclusion of bank paper (as an acceptable asset for liquidity purposes), a potentially significant inclusion in the proposed regulatory definition of liquid assets is well-rated and actively traded corporate paper. Regulators have not previously recognised such paper and banks will now have an incentive to buy and hold such paper as part of their balance sheets because of this new liquidity recognition. This need to balance holdings of liquid assets against the risks of funding run-off is repeated for the longer–term ‘Net Stable Funding Ratio‘ except that percentage regulatory scaling factors are not only applied to funding but also to the ‘liquidity’ of all assets rather than simply defining a permissible stock of liquid assets. Under this proposed ratio,
banks’ long-term loans are considered less liquid than shorter-term loans, and in a number of circumstances corporate bond holdings are to be treated as being more liquid than loans. As with the liquidity ratio, the scaling factors to be applied in the calculation of the regulatory net stable funding ratio will influence banks’ supply and demand for different types and maturities of assets and liabilities. For corporate customers, for example, banks may now prefer to encourage financing arrangements based on bond issuance versus direct lending – a development further encouraged by the proposed recognition of some types of corporate paper as ‘liquid assets’. Upward pricing adjustments to clear such emergent market supply and demand shifts seem probable. What does this all mean? In a nutshell, banks’ preferred sources of funding may be constrained; they will be required to better match the term of assets and liabilities (ie reduce the structural liquidity mismatch); and they will be made to invest in liquid assets with lower yields. For borrowers this means banks will be inclined to lend less, at a higher price, and for a shorter term. With the substantial level of refinancing volumes expected over the next 18 months, the need to take advantage of the competitive pricing and tenor currently in the market gains further credibility and perhaps a degree of urgency in light of the Basel III regulatory reform proposals. Many banking institutions have already started reassessing their current strategies in light of these Basel III proposals and balancing the need for growth relative to cost and return under the new regime, leaving the future funding landscape less than clear for many corporations.
Corporate Financial Risk Management Update: Edition 1 / December 2010 © 2010 KPMG, an Australian partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.KPMG and the KPMG logo are registered trademarks of KPMG International. Liability limited by a scheme approved under Professional Standards Legislation.
Managing the risks of a strong Australian dollar Disagreements about the appropriate setting of exchange rates and their adjustment has the potential to shake global confidence as markets move towards a more volatile trading period over the next couple of years. Never before have we seen so many market risk factors present at any one time. KPMG and Richard Hughes, Managing Director of Visual Risk, consider currency risk management.
Global risk factors • European sovereign risk issue – this crisis primarily affected five countries: Greece, Ireland, Portugal, Italy, and Spain. The governments of these nations habitually run large government budget deficits. A sovereign default by any of these countries would result in widespread and major bank losses that would threaten the solvency of many banks in Europe.
China is due for a slowdown – UBS economist expects a slowdown of investment and new construction in large cities and in the highend property market.
• The European and US banking systems are weak – the IMF estimated that large US and European banks lost more than US$1 trillion on toxic assets and bad loans between January 2007 and September 2009. These losses are expected to top US$2.8 trillion from 2007-10. The IMF estimated that US banks were about 60 percent through their losses, but British and Euro-zone banks only 40 percent. • The US deficit appears to be spiralling out of control – the US deficit shrank nine percent last fiscal year, but still topped US$1 trillion. For the 2010 fiscal year that ended on September 30, the government had a budget shortfall of US$1.294 trillion, down US$122 billion from the previous year’s record setting high. • Japan’s economy is persistently weak with no recovery in sight – Japan’s export-driven economy faces growing uncertainty due to the strong Yen and slowing global growth.
• China is due for a slowdown – UBS economist expects a slowdown of investment and new construction in large cities and in the high-end property market. A larger than expected fall in property transactions would negatively affect fixed-asset investment, demand for commodities and sentiment on banks. • Commodity price boom -– the federal government’s agricultural and resources forecaster is tipping Australia’s export earnings from key commodities to rise in the next year, after an estimated fall this year. The Australian Bureau of Agriculture and Resource Economics (ABARE) says commodity exports are expected to reach just over $202 billion in the 2010/11 financial year, up more than 23 percent from an estimated $164 billion last financial year. • Major global currency imbalances – the under-valuation of the Chinese currency and its peg to the US dollar constitutes a huge subsidy to Chinese exports that has played a major role in the creation of large global trade and balance of payments imbalances. This is particularly evident between China plus developing Asia on the one hand, and the US on the other. Individually and collectively the above global risk factors contribute to the prospect of acute volatility of the Australian dollar over the next couple of years. The graph over the page details the historical trends of the Australian dollar over the past 3 years.
Corporate Financial Risk Management Update: Edition 1 / December 2010 © 2010 KPMG, an Australian partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.KPMG and the KPMG logo are registered trademarks of KPMG International. Liability limited by a scheme approved under Professional Standards Legislation.
Figure 2: Historic trends of the Australian dollar
The key for Australian corporations in this environment is effectively managing their hedging strategies during sustained periods of volatility.
Source: OzForex / Reuters Visual Risk analysis, 2010
The key for Australian corporations in this environment is effectively managing their hedging strategies during sustained periods of volatility. This management needs to be conducted in a manner that is consistent with the risk appetite of their organisations, and with a framework in place to address and effectively manage the basic principles of market risk. One corporation in Australia has had favourable publicity due to its rolling hedge
or ‘declining hedge’ approach. This is not an uncommon strategy and has a number of advantages as it provides certainty in the near-term and flexibility in the medium to long-term. It also allows the organisation; which is an exporter, to take advantage of the interest differential between the Australian and the US dollars. The hedge program is implemented as per the table below:
Table 3: The declining hedge profile 0-6mths
7-12mths
13-18mths
19-24mths
25-30mths
31-36mths
100%
80%
60%
40%
20%
0%
Source: Visual Risk, 2010
Corporate Financial Risk Management Update: Edition 1 / December 2010 © 2010 KPMG, an Australian partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.KPMG and the KPMG logo are registered trademarks of KPMG International. Liability limited by a scheme approved under Professional Standards Legislation.
It can be seen from the illustration below, that the rolling hedge has delivered a less volatile outcome (i.e. smoother) result than simply following the spot rate. It has also marginally out performed the 36 months moving average rate due
to the AUD/USD interest differential, built into forward rates. In addition, the organisation has not been immediately exposed to the strengthening AUD and has time to adjust its business model.
Figure 3: Weighted average hedge rate and gain loss WRT hedging strategy
Source: Visual Risk, 2010
Whilst many understand the principles of managing financial risks, it is worth repeating them. The six basic principles organisations should have in place to manage market risk include the following. 1 Understand and quantify the organisations’ risk exposures (worst & best case) – it is useful to perform scenario models and sensitivity analysis on worst and best case situations. 2 Determine the organisations’ risk tolerance – determine its need to take risk. 3 State the organisations’ risk management objectives and hedging approach – what are the risk management objectives of the organisation and how will credit, operational and market risk of the business be managed? When deciding upon a hedging strategy the core problem is to strike a balance between uncertainty and the risk of opportunity loss. In establishing the balance we must consider the risk aversion and the risk preferences of shareholders.
4 Define risk metrics and policy guidelines – risk metrics are a set of financial models used by the organisation to measure financial risks. These include: standard deviation, value at risk, expected shortfall, marginal VAR, incremental risk, coherent risk measures and assessing risk measures. 5 Monitor, measure and report the risk – for more strategic and longerterm risk management, it is time to go back to basics. - measure - monitor - mitigate and report 6 Review, stress-test and refine the approach.
Corporate Financial Risk Management Update: Edition 1 / December 2010 © 2010 KPMG, an Australian partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.KPMG and the KPMG logo are registered trademarks of KPMG International. Liability limited by a scheme approved under Professional Standards Legislation.
Changes to AASB 139 Back to the future – simplifying hedge accounting for risk managers
The IASB’s much heralded Exposure Draft to simplify hedge accounting has been released.
on a myriad of technical issues that complicate the designation, measurement of effectiveness and accounting for hedges.
The Exposure Draft is the culmination of an extensive 12-month consultation period with stakeholders operating in derivative markets and exposed to business reporting under IAS 39.
The Exposure Draft contemplates:
KPMG in Australia and our clients participated in the Outreach program initiated by the IASB highlight anomalies between IAS 39 / AASB 139’s prescription and current corporate risk management practices. Many of the issues raised with the IASB resonate with Australian corporates re-financing balance sheets in global debt capital markets and managing foreign currency and commodity indexed cash flow risks. AASB 139’s hedge accounting rules provide an unwelcome layer of complexity for CFOs navigating investor sentiment, capital constraints and market volatility in the post-GFC macroeconomic environment.
• the ability to designate the hedged item to include a derivative component, highly relevant in the current environment where Australian corporates are refinancing AUD denominated in global debt capital markets
The release of the Exposure Draft carries with it the expectation of substantial change.
• removing the quantitative 80-125 percent criterion and retrospective test.
What are the key changes? At the very least, the Exposure Draft removes many of the technical anomalies with the current standard to better align derivative accounting with the economics of corporate risk management. In addition, the IASB has sought to ease the administrative burden with rule changes
• hedging risk component(s) in nonfinancial transactions – of particular interest to hedgers exposed to commodity and energy price risks
• deferring premiums paid on option-based cash flow hedging strategies to Other Comprehensive Income (OCI) reducing volatility in the income statement. Premiums will be recycled to the income statement when the hedged item impacts profit and loss or capitalised into the carrying amount of the recognised non financial asset or liability
On balance, the Exposure Draft is positive for corporate risk managers. The new standard will apply prospectively to hedging arrangements existing at, or entered into after, its implementation (scheduled for annual reporting periods commencing on or after 1 January 2013). Early adoption of the changes will be available provided all of the requirements of AASB 9 (the replacement standard) are also adopted. Whether the expectations of hedgers and their long-suffering finance and risk functions are to be met will depend on the feedback to the IASB. The signs are positive. The date for providing comments to the IASB on the Exposure Draft ends on 9 March 2011. KPMG will provide a detailed analysis of the impact of the Exposure Draft on derivative accounting in a series of forums and communications early in the New Year. Please contact Wayne Read (03) 9288 5867, [email protected], if you would like further information on the Exposure Draft.
In contrast, the Exposure Draft removes the discretion to de-designate a hedge relationship if the qualifying criteria are still met. The Exposure Draft does not address macro hedging strategies but does provide some rule changes to accommodate portfolio management practices.
Corporate Financial Risk Management Update: Edition 1 / December 2010 © 2010 KPMG, an Australian partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.KPMG and the KPMG logo are registered trademarks of KPMG International. Liability limited by a scheme approved under Professional Standards Legislation.
Emerging issues in finance and corporate treasury During the course of this year we have observed a number of reoccurring issues in the market worth sharing with treasury and finance practitioners. Some of these issues are ‘new’ and some of these are ‘old’ issues that are now reoccurring.
Credit risk
Procurement/sales contracts
One issue that treasury and finance practitioners may wish to ‘keep a weather eye on’ is the credit risk of large suppliers. If an organisation has negotiated a supply contract with a future delivery at a fixed price and the supplier fails to honour the contract, the price of the goods or service may have increased and the organisation will suffer a loss. Hence, the purchasing organisation will be entitled to compensation. Will the supplier have financial strength to pay the compensation? There have been instances of organisations experiencing losses from these issues. Given the treasury function manages credit risk of institutional counterparties, there could be an opportunity here for treasury and finance practitioners to ‘add value’ to the rest of the organisation.
Treasury and finance practitioners are responsible for managing currency and commodity risks. However, it is the procurement/sales function that negotiates procurement/sales contracts, which may include rise and fall clauses. We have observed organisations experiencing additional costs on supplier contracts as a result of the unexpected outcome of rise and fall clauses where the supplier has insisted on the use of its contract.
On a similar note, treasury and finance practitioners may like to think about the credit risk associated with futures ‘brokers’. The recent collapse of the broker ‘Sonray’ may provide cause to reassess this issue. Sonray collapsed and traders who used the broker and provided collateral to the broker are now unsecured creditors. This could cause one to ask whether the organisation has a policy of charging margin deposits with brokers, to counterparty limits; alternatively, is there a policy of diversifying the use of brokers so that the organisation does not build a concentration of counterparty risk with any one broker.
The reason for this is that the procurement function may consult the legal department because it knows the legal counsel must approve all non-standard contracts. However, does the organisation have a policy that material procurement/sales contracts with rise and fall clauses must be reviewed by treasury and/or finance? The answer is more than likely not. It is worth considering whether treasury policies should address this issue with similar clauses in procurement and sales policies. It may also be useful for the treasury/ finance function to conduct training of sales and procurement staff on these issues, particularly as staff in these areas may change and have the potential to make mistakes in this area. On a positive note, the early involvement of the treasury/finance function in the negotiation of procurement contracts has the potential to reduce risk and save the organisation money. Suppliers may be prepared to offer a fixed price, for example. With the involvement of the treasury or
10 Corporate Financial Risk Management Update: Edition 1 / December 2010 © 2010 KPMG, an Australian partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.KPMG and the KPMG logo are registered trademarks of KPMG International. Liability limited by a scheme approved under Professional Standards Legislation.
finance function, the procurement function can determine whether the premium that may be charged for the fixed price is fair.
Settlement issues A few years ago an investment bank was the victim of an attempted settlements fraud involving approximately A$150 million. The perpetrators (which included the bank’s own officers) were recently jailed for periods of up to 5 years. The fraud, which was nearly successful, involved the use of facsimile instructions to pay funds from a client account with the request timed near the close of business, just before a public holiday (to minimise scrutiny of the request for the second authorisation). According to reports the plot was discovered when a correspondent bank queried the name on a transfer request. This case illustrates that treasury and finance functions are potentially vulnerable to being defrauded in relation to settlements of large amounts – and therefore whilst the possibility of it happening is improbable, the impact is potentially high.
Pertinently, KPMG has just conducted its 9th biennial Fraud and Misconduct Survey. Survey respondents lost $345 million with an average loss per single incident of $3 million. Theft of ‘cash’ was the most common fraud. The survey makes a series of recommendations around electronic funds transfer pertinent to treasury functions. The full survey can be downloaded from www.kpmg.com.au.
ISDA (International Swaps and Derivatives Association) agreements
It may be timely for corporations to reassess the adequacy of settlement/vendor payment processes, instructions and the controls around treasury and payment systems.
During our work this year we have observed quite a few organisations that have missing or unsigned ISDA agreements. To some degree this is a housekeeping activity. However, given the heightened focus on credit risk and covenant compliance, finance and treasury practitioners should ask themselves what would happen in the event of counterparty default where there is an incomplete or ineffective ISDA agreement.
We have observed a number of issues related to settlement practices. For example, we note that banks are sending emails and facsimiles to their clients to change their standard settlement instructions (i.e. the account to where they want their funds directed). The question arises – how does the recipient (i.e. the corporate) know this is not a rogue settlements officer opportunistically redirecting the settlement of a large amount to his or her account, as the case study above illustrates. In addition to the issues mentioned above, we have also observed other issues associated with settlements. It may be timely for corporations to reassess the adequacy of settlement/vendor payment processes, instructions and the controls around treasury and payment systems.
Corporate Financial Risk Management Update: Edition 1 / December 2010 11 © 2010 KPMG, an Australian partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.KPMG and the KPMG logo are registered trademarks of KPMG International. Liability limited by a scheme approved under Professional Standards Legislation.
Credit value adjustment (CVA) Prior to the GFC, the credit spreads of major derivative dealers were typically quite stable and counterparty risk from exposure to major derivative dealers was perceived to be immaterial. The GFC brought about a dramatic increase in credit spreads and their volatility for most of the major derivative dealers. As a result, many dealers and end users of derivatives have found they must make credit value adjustments (CVAs) to their derivative positions to reflect the potential of counterparty default.
The GFC brought about a dramatic increase in credit spreads and their volatility for most of the major derivative dealers.
CVA is an adjustment made to the fair value of uncollateralised over-the-counter (OTC) derivative positions. It reflects the expected replacement cost of the derivative if the derivative counterparty were to default when the derivative is ‘in-the-money’. The amount of CVA increases as the credit riskiness of the derivative counterparty increases. Applying CVA typically reduces the fair value of a derivative. CVA can be calculated unilaterally or bilaterally: unilateral CVA adjusts for the risk that the counterparty defaults: bilateral CVA adjusts for the risk that either party to a derivative defaults. The fair value adjustment due to CVA can be positive or negative and is reflected in the profit and loss statements. For counterparties for which a liquid credit default swap (CDS) benchmark exists, CDS spreads can be used to calculate CVA. For counterparties for which no liquid CDS benchmarks exist, historical default and loss severity information for comparable companies – ideally based on both industry classification and credit rating – are often used to calculate CVA. Some end users of derivatives have ISDA credit support annexes (CSAs) in place with their dealer counterparties. These
govern the exchange of collateral between the end user and the dealer based on mark-to-market changes in the value of derivatives. For derivative positions subject to CSAs, there is no CVA. Many end users of derivatives prefer not to post collateral when the market values of their derivatives move against them, and therefore must calculate and apply CVA. The benefit to end users of not posting collateral is they don’t have to fund mark-to-market losses on their derivatives. Instead, they can cover losses on their derivatives over time using income. In effect, the derivative counterparty ends up funding an end user’s mark-to-market losses on its derivatives. There is a strong regulatory push to have most OTC derivative trades executed through central clearinghouse counterparties (CCPs). When a derivative trade is executed through a CCP, the position is marked-to-market regularly and subject to collateral exchanges reflecting changes in market value. Trading derivatives via CCPs eliminates the need for CVA. Regulators see derivative trading via CCPs as a means for significantly mitigating systemic risk in the derivative markets. However, many derivative end users may have to curtail or stop their use of derivatives for hedging if they have to trade via CCPs because the end users may be unable to fund mark-to-market losses on their derivatives. If the use of CCPs for derivative trading is enforced, derivative end users with concerns about funding losses on derivative positions may opt to continue using them, but may have to find additional or alternative sources for back up funding.
Contact us Mike Ritchie Partner in Charge Financial Risk Management T: +61 2 9335 8251 E: [email protected]
David Heathcote Partner in Charge Debt Advisory Services T: +61 2 9335 7193 E: [email protected]
Stephen Cheesewright Director Financial Risk Management T: +61 3 9288 5645 E: [email protected]
Scott Mesley Partner Debt Advisory Services T: +61 3 9288 6748 E: [email protected]
kpmg.com.au
Wayne Read Partner Audit T: +61 3 9288 5867 E: [email protected]
The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavour to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation. © 2010 KPMG, an Australian partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved. Printed in Australia. December 2010. WAN06850ADV. The KPMG name, logo and “cutting through complexity” are registered trademarks or trademarks of KPMG International Cooperative (“KPMG International”). Liability limited by a scheme approved under Professional Standards Legislation.
Advisory
Corporate Financial Risk Management Update Edition 1
Welcome to the first edition of KPMG’s Corporate Financial Risk Management Update. This is a periodic publication that KPMG is issuing to finance and treasury practitioners. It seeks to provide an update on trends in treasury and financial risk management based on our observations and experience with a wide range of clients and market participants. In this issue we explore: • Trends in the Australian debt markets. • Basel lll update. What it means for businesses.
Contents Trends in the Australian debt markets Page 2 Basel lll: impacting banks’ relationships with business Page 5
• Managing the risks of a strong Australian dollar. • Changes to AASB 139. • Emerging issues in finance and corporate treasury. We trust you will find this material of value and interest.
Managing the risks of a strong Australian dollar Page 6 Changes to AASB 139 Page 9 Emerging issues in finance and corporate treasury Page 10 Credit value adjustment (CVA) Page 12
Corporate Financial Risk Management Update: Edition 1 / December 2010 © 2010 KPMG, an Australian partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.KPMG and the KPMG logo are registered trademarks of KPMG International. Liability limited by a scheme approved under Professional Standards Legislation.
Trends in the Australian debt markets
The following is an extract from Debt Market Quarterly Update Q3 2010.
Key themes • Global financial uncertainty and recent interest rate increases have resulted in the Australian dollar (AUD) hitting new highs.
The case for funding diversification continues to increase, with appetite returning for alternative funding solutions.
• Business lending volumes remain constrained. However, margins continue to tighten and banks remain hungry for quality assets. • Despite the large volume of debt maturing in 2011 and 2012, an opportunity exists to secure improved terms from lenders. • The case for funding diversification continues to increase, with appetite returning for alternative funding solutions.
Update on debt markets Global perspective The three key themes dominating the global finance market over the last quarter included: (i) the US housing foreclosure situation; (ii) inflationary pressures in the Asia Pacific region; and (iii) uncertainty in global currency markets.
The International Monetary Fund (IMF) has warned Australia and its Asia Pacific neighbours of the need to raise interest rates and cut government spending to manage the risk of inflation due to the economic strength seen in the region. As such, and with forecasts of further interest rate hikes, the strong AUD is expected to persist for some time. This development will negatively affect exporters but may benefit Australian borrowers of foreign debt in the shortterm.
Loan volumes Whilst banks remain cautious in their capital allocation, they are in fact hungry for quality assets. Contrary to the position 12 months ago, market sounding has suggested that a reduction in volume does not reflect a diminished appetite, but rather a reduced supply of deals. The contraction of syndicated loan market volumes (as reflected in the chart below), together with reduced levels of gearing on Australia’s corporate balance sheets and a continuing low level of new money funding, has contributed to a decrease in total aggregate business lending over the past 2 years.
Figure 1: Australian syndicated loan volumes 50 45 40 35 30 25 20 15 10 5
25,000 20,000 15,000
Volume (US$m)
3Q10
2Q10
1Q10
4Q09
3Q09
2Q09
1Q09
4Q08
3Q08
2Q08
1Q08
4Q07
3Q07
2Q07
1Q07
0
4Q06
10,000 5,000
0
Number of deals
Source: LoanConnector, 2010 Corporate Financial Risk Management Update: Edition 1 / December 2010 © 2010 KPMG, an Australian partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.KPMG and the KPMG logo are registered trademarks of KPMG International. Liability limited by a scheme approved under Professional Standards Legislation.
No. of deals Number of deals
US $m
40,000 35,000 30,000
Refinancing
Australian bond market
Over the last 2 years, tight credit markets have provided cause for concern for all CFOs despite record equity raisings in 2009 and the de-gearing of balance sheets. Debt refinancing remained challenging and in most cases resulted in higher margins and upfront fees.
At a recent round table discussion sponsored by the ‘Big Four’ banks, 10 of Australia’s largest corporations commented upon the Australian corporate bond market making reference to the fact that there was still ample room for growth2.
Transactions in the order of ~$60 billion were completed in 2009 and other than a select few, tenors were heavily weighted with a 3-year maturity1. With borrowers sensibly addressing their refinancing needs at least 12 months in advance, many of these 2012 maturities will need to be refinanced in 2011 making it a busy year for the syndicated loan market.
Standard & Poor’s has noted that the Australian bond market is in a prime position to shoulder a greater share of corporate finance, but that further regulatory reform is needed for this to occur3.
Whilst the need to refinance may present a challenge for some corporates, it can also provide an opportunity. Companies that completed refinancing in the first half of 2009 may have done so at relatively higher margins and incurred significant upfront fees. With longer tenors now available for the first time in 3 years and margins generally reducing over the past 18 months, borrowers can now take advantage of these improved conditions. Woodside and OneSteel provide good examples of borrowers who have successfully tapped the debt markets on improved terms, as detailed in the table below.
On a positive note, there have been some interesting alternative debt instruments issued, including hybrid notes and retail bonds providing realistic funding opportunities. Although the Australian private placement market has produced only limited publicly disclosed examples, deal activity has been noted with a number of corporates successfully tapping this market with fixed or floating-rate structures, competitive pricing and tenors of 5 to 7 years. On the covered bond front, Canadian Imperial Bank of Commerce’s (CIBC) debut issuance into the Australian market together with the potentially positive effects on the calculation of regulatory liquidity ratios has intensified the push by Australian banks for a covered bond market. The Australian Prudential
Table 1: Refinancing comparatives Deal in market/ recently completed
1H2009 Woodside Date
19-May-09
11-Oct-10
Amount
US$1.1bn
US$1.1bn
Tenor
3 years
5 years
Credit rating
A-
A-
Margin
225bps
165/170bps
Top-end upfronts
90bps
75bps
Top-end all-in margin
255bps
180/185bps
Date
02-Feb-09
31-Aug-10
Amount
A$223m
$590m
Tenor
3 years
3 & 4 years
Credit rating
NR
NR
Margin
240bps
195bps/220bps
Top-end upfronts
50bps
60bps/70bps
Top-end all-in margin
257bps
215bps/235bps
On a positive note, there have been some interesting alternative debt instruments issued...
Onesteel
Source: LoanConnector, 2010 1. Steve Lambert, Global Head of Debt Markets, National Australia Bank 2. Standard & Poor’s, Case Strengthens For Corporate Bonds In Australia, 4 Oct 2010 3. ibid Corporate Financial Risk Management Update: Edition 1 / December 2010 © 2010 KPMG, an Australian partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.KPMG and the KPMG logo are registered trademarks of KPMG International. Liability limited by a scheme approved under Professional Standards Legislation.
Regulation Authority has prohibited covered bond issuance by domestic banks in the Australian market because of its interpretation of the depositor protection provisions of the Banking Act 1959.
• a legally binding replacement capital covenant requiring that the issuer fund any redemption of the instrument with a similarly equity-like instrument
This has not constrained the whollyowned subsidiaries of Australian banks operating in New Zealand from issuing covered bonds in that market reflecting the absence of legal or prudential constraints on such issuance. The Reserve Bank of New Zealand released in October 2010 a Consultation Document on covered bonds in part dealing with issues of the need for specific legislation and the setting of permissible limits on maximum issuance.
There are obvious attractions to this structure. Interest payments are deductible for tax purposes and yet the equity classification improves credit metrics and can have favourable ratings implications. It is also a cheaper form of capital than straight equity and is not dilutive.
KPMG’s deal of the quarter The Santos hybrid is a world-first in that the notes received ‘high’ equity credit classification from Standards & Poor’s, which means it will be treated entirely as equity for credit purposes and as debt for tax purposes4. It is a structure likely to trigger further interest for borrowers seeking to diversify their funding arrangements. Key features leading to equity classification included: • mandatory deferral of interest for up to 5 years if the long-term corporate credit rating on Santos falls to ‘BB+’ or below
• first call date from year 5.
Securitisation Further momentum was evidenced in the asset backed securitisation (ABS) market with the recent FleetPartners Australia Ltd (FleetPartners) ABS issue. FleetPartners made its maiden public term ABS issue of A$178 million which was well oversubscribed, successfully placing the lower rated (A and BBB) with institutional investors. The deal offered further evidence of the growing depth of the ABS market. In addition to the public term ABS issue, KPMG’s Debt Advisory practice assisted FleetPartners in structuring the first ever publicly rated Australian operating lease open pool warehouse totalling A$850 million, providing a landmark funding diversification solution for FleetPartners.
• 60 year term to maturity • 100 basis point step up at year 7
Table 2: Alternative debt deals Date
Issuer
Debt instrument
Deal size
Oct-10
Canadian Imperial Bank of Commerce
Covered bond, 3yr, -48bps over swap –inaugural A$750m covered bond issuance in the Australian market. Collateral consists of fully insured residential mortgage loans – guaranteed MBS Securities
Oct-10
Primary Healthcare
Retail bond, 5yr, -4.0% margin, unsubordinated, A$150m unsecured, ranks after secured debt. The first retail bond in Australia, taking advantage of the amendment in ASIC Class Order 10/321 streamlining the documentation and sale process
Sep-10
Santos
European hybrid, BB rated, 7yr, 100%, equity credit from S&P, 8.25%
A$650m
Sep-10
Goodman
CMBS - $210m AAA rated tranche and $40m, AA rated ranch – 24 properties including warehouse distribution centres, business parks, industrial estates
A$250m
Source: ASX company announcements, 2010 4. Standard & Poor’s, Santos’ Subordinated Notes And ‘High’ Equity Credit Classification Explained In S&P Report, 14 October 2010
Corporate Financial Risk Management Update: Edition 1 / December 2010 © 2010 KPMG, an Australian partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.KPMG and the KPMG logo are registered trademarks of KPMG International. Liability limited by a scheme approved under Professional Standards Legislation.
Basel lll: impacting banks’ relationships with business
The proposals to reform the regulatory framework for banks, known as Basel III include: • redefining capital to emphasise common equity and tier 1 capital • higher minimum capital ratios • establishing capital buffers above minimum requirements • introducing a cap on permissible balance sheet leverage • introducing global liquidity and funding standards, including a short-term liquidity coverage ratio and a longerterm net stable funding ratio. What does this mean for borrowers? Although these changes are not due to be formally applied for some time, a period of ‘regulatory observation’ will commence sooner than this. Banks will as a consequence start a process of adjusting their balance sheet structures including their funding and liquid asset holdings. The scale of these changes has the potential to significantly impact banks’ business acceptance rules as well as accompanying pricing decisions. Another key outcome of Basel III is that recognisable liquid assets are to be confined for regulatory purposes, to a limited class of assets that for the first time will not include bank paper. This potentially limited supply of permissible liquid assets together with the imposition of a minimum liquidity ratio may therefore constrain new lending and the potential growth and size of banks’ balance sheets. Further the proposed ‘Liquidity Coverage Ratio’ requirements consider the composition of bank borrowings and recognise the potential demands on banks to repay them (‘funding run-off’). Thus shortterm borrowings by banks impose higher regulatory requirements for
‘offsetting’ liquidity holdings than do longer-term borrowings. For example, unsecured at call wholesale funding provided by corporate customers to banks that otherwise have no operational relationship with that bank, have an assumed 75 percent run-off rate thereby imposing significant ‘offsetting’ liquidity requirements on the bank and making it a comparatively unattractive source of funding. This may have ramifications for the wholesale short-term money market and make it a relatively unattractive source of funds for banks. A further impact on money markets is the proposed high run-off rates to be applied by regulators to unsecured at call funding provided by financial institutions, public sector entities and pension funds. By contrast regulators are proposing to apply minimal rates of assumed funding runoff for retail deposits and thus a limited need for banks to hold liquid assets against these deposits. Further to the proposed exclusion of bank paper (as an acceptable asset for liquidity purposes), a potentially significant inclusion in the proposed regulatory definition of liquid assets is well-rated and actively traded corporate paper. Regulators have not previously recognised such paper and banks will now have an incentive to buy and hold such paper as part of their balance sheets because of this new liquidity recognition. This need to balance holdings of liquid assets against the risks of funding run-off is repeated for the longer–term ‘Net Stable Funding Ratio‘ except that percentage regulatory scaling factors are not only applied to funding but also to the ‘liquidity’ of all assets rather than simply defining a permissible stock of liquid assets. Under this proposed ratio,
banks’ long-term loans are considered less liquid than shorter-term loans, and in a number of circumstances corporate bond holdings are to be treated as being more liquid than loans. As with the liquidity ratio, the scaling factors to be applied in the calculation of the regulatory net stable funding ratio will influence banks’ supply and demand for different types and maturities of assets and liabilities. For corporate customers, for example, banks may now prefer to encourage financing arrangements based on bond issuance versus direct lending – a development further encouraged by the proposed recognition of some types of corporate paper as ‘liquid assets’. Upward pricing adjustments to clear such emergent market supply and demand shifts seem probable. What does this all mean? In a nutshell, banks’ preferred sources of funding may be constrained; they will be required to better match the term of assets and liabilities (ie reduce the structural liquidity mismatch); and they will be made to invest in liquid assets with lower yields. For borrowers this means banks will be inclined to lend less, at a higher price, and for a shorter term. With the substantial level of refinancing volumes expected over the next 18 months, the need to take advantage of the competitive pricing and tenor currently in the market gains further credibility and perhaps a degree of urgency in light of the Basel III regulatory reform proposals. Many banking institutions have already started reassessing their current strategies in light of these Basel III proposals and balancing the need for growth relative to cost and return under the new regime, leaving the future funding landscape less than clear for many corporations.
Corporate Financial Risk Management Update: Edition 1 / December 2010 © 2010 KPMG, an Australian partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.KPMG and the KPMG logo are registered trademarks of KPMG International. Liability limited by a scheme approved under Professional Standards Legislation.
Managing the risks of a strong Australian dollar Disagreements about the appropriate setting of exchange rates and their adjustment has the potential to shake global confidence as markets move towards a more volatile trading period over the next couple of years. Never before have we seen so many market risk factors present at any one time. KPMG and Richard Hughes, Managing Director of Visual Risk, consider currency risk management.
Global risk factors • European sovereign risk issue – this crisis primarily affected five countries: Greece, Ireland, Portugal, Italy, and Spain. The governments of these nations habitually run large government budget deficits. A sovereign default by any of these countries would result in widespread and major bank losses that would threaten the solvency of many banks in Europe.
China is due for a slowdown – UBS economist expects a slowdown of investment and new construction in large cities and in the highend property market.
• The European and US banking systems are weak – the IMF estimated that large US and European banks lost more than US$1 trillion on toxic assets and bad loans between January 2007 and September 2009. These losses are expected to top US$2.8 trillion from 2007-10. The IMF estimated that US banks were about 60 percent through their losses, but British and Euro-zone banks only 40 percent. • The US deficit appears to be spiralling out of control – the US deficit shrank nine percent last fiscal year, but still topped US$1 trillion. For the 2010 fiscal year that ended on September 30, the government had a budget shortfall of US$1.294 trillion, down US$122 billion from the previous year’s record setting high. • Japan’s economy is persistently weak with no recovery in sight – Japan’s export-driven economy faces growing uncertainty due to the strong Yen and slowing global growth.
• China is due for a slowdown – UBS economist expects a slowdown of investment and new construction in large cities and in the high-end property market. A larger than expected fall in property transactions would negatively affect fixed-asset investment, demand for commodities and sentiment on banks. • Commodity price boom -– the federal government’s agricultural and resources forecaster is tipping Australia’s export earnings from key commodities to rise in the next year, after an estimated fall this year. The Australian Bureau of Agriculture and Resource Economics (ABARE) says commodity exports are expected to reach just over $202 billion in the 2010/11 financial year, up more than 23 percent from an estimated $164 billion last financial year. • Major global currency imbalances – the under-valuation of the Chinese currency and its peg to the US dollar constitutes a huge subsidy to Chinese exports that has played a major role in the creation of large global trade and balance of payments imbalances. This is particularly evident between China plus developing Asia on the one hand, and the US on the other. Individually and collectively the above global risk factors contribute to the prospect of acute volatility of the Australian dollar over the next couple of years. The graph over the page details the historical trends of the Australian dollar over the past 3 years.
Corporate Financial Risk Management Update: Edition 1 / December 2010 © 2010 KPMG, an Australian partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.KPMG and the KPMG logo are registered trademarks of KPMG International. Liability limited by a scheme approved under Professional Standards Legislation.
Figure 2: Historic trends of the Australian dollar
The key for Australian corporations in this environment is effectively managing their hedging strategies during sustained periods of volatility.
Source: OzForex / Reuters Visual Risk analysis, 2010
The key for Australian corporations in this environment is effectively managing their hedging strategies during sustained periods of volatility. This management needs to be conducted in a manner that is consistent with the risk appetite of their organisations, and with a framework in place to address and effectively manage the basic principles of market risk. One corporation in Australia has had favourable publicity due to its rolling hedge
or ‘declining hedge’ approach. This is not an uncommon strategy and has a number of advantages as it provides certainty in the near-term and flexibility in the medium to long-term. It also allows the organisation; which is an exporter, to take advantage of the interest differential between the Australian and the US dollars. The hedge program is implemented as per the table below:
Table 3: The declining hedge profile 0-6mths
7-12mths
13-18mths
19-24mths
25-30mths
31-36mths
100%
80%
60%
40%
20%
0%
Source: Visual Risk, 2010
Corporate Financial Risk Management Update: Edition 1 / December 2010 © 2010 KPMG, an Australian partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.KPMG and the KPMG logo are registered trademarks of KPMG International. Liability limited by a scheme approved under Professional Standards Legislation.
It can be seen from the illustration below, that the rolling hedge has delivered a less volatile outcome (i.e. smoother) result than simply following the spot rate. It has also marginally out performed the 36 months moving average rate due
to the AUD/USD interest differential, built into forward rates. In addition, the organisation has not been immediately exposed to the strengthening AUD and has time to adjust its business model.
Figure 3: Weighted average hedge rate and gain loss WRT hedging strategy
Source: Visual Risk, 2010
Whilst many understand the principles of managing financial risks, it is worth repeating them. The six basic principles organisations should have in place to manage market risk include the following. 1 Understand and quantify the organisations’ risk exposures (worst & best case) – it is useful to perform scenario models and sensitivity analysis on worst and best case situations. 2 Determine the organisations’ risk tolerance – determine its need to take risk. 3 State the organisations’ risk management objectives and hedging approach – what are the risk management objectives of the organisation and how will credit, operational and market risk of the business be managed? When deciding upon a hedging strategy the core problem is to strike a balance between uncertainty and the risk of opportunity loss. In establishing the balance we must consider the risk aversion and the risk preferences of shareholders.
4 Define risk metrics and policy guidelines – risk metrics are a set of financial models used by the organisation to measure financial risks. These include: standard deviation, value at risk, expected shortfall, marginal VAR, incremental risk, coherent risk measures and assessing risk measures. 5 Monitor, measure and report the risk – for more strategic and longerterm risk management, it is time to go back to basics. - measure - monitor - mitigate and report 6 Review, stress-test and refine the approach.
Corporate Financial Risk Management Update: Edition 1 / December 2010 © 2010 KPMG, an Australian partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.KPMG and the KPMG logo are registered trademarks of KPMG International. Liability limited by a scheme approved under Professional Standards Legislation.
Changes to AASB 139 Back to the future – simplifying hedge accounting for risk managers
The IASB’s much heralded Exposure Draft to simplify hedge accounting has been released.
on a myriad of technical issues that complicate the designation, measurement of effectiveness and accounting for hedges.
The Exposure Draft is the culmination of an extensive 12-month consultation period with stakeholders operating in derivative markets and exposed to business reporting under IAS 39.
The Exposure Draft contemplates:
KPMG in Australia and our clients participated in the Outreach program initiated by the IASB highlight anomalies between IAS 39 / AASB 139’s prescription and current corporate risk management practices. Many of the issues raised with the IASB resonate with Australian corporates re-financing balance sheets in global debt capital markets and managing foreign currency and commodity indexed cash flow risks. AASB 139’s hedge accounting rules provide an unwelcome layer of complexity for CFOs navigating investor sentiment, capital constraints and market volatility in the post-GFC macroeconomic environment.
• the ability to designate the hedged item to include a derivative component, highly relevant in the current environment where Australian corporates are refinancing AUD denominated in global debt capital markets
The release of the Exposure Draft carries with it the expectation of substantial change.
• removing the quantitative 80-125 percent criterion and retrospective test.
What are the key changes? At the very least, the Exposure Draft removes many of the technical anomalies with the current standard to better align derivative accounting with the economics of corporate risk management. In addition, the IASB has sought to ease the administrative burden with rule changes
• hedging risk component(s) in nonfinancial transactions – of particular interest to hedgers exposed to commodity and energy price risks
• deferring premiums paid on option-based cash flow hedging strategies to Other Comprehensive Income (OCI) reducing volatility in the income statement. Premiums will be recycled to the income statement when the hedged item impacts profit and loss or capitalised into the carrying amount of the recognised non financial asset or liability
On balance, the Exposure Draft is positive for corporate risk managers. The new standard will apply prospectively to hedging arrangements existing at, or entered into after, its implementation (scheduled for annual reporting periods commencing on or after 1 January 2013). Early adoption of the changes will be available provided all of the requirements of AASB 9 (the replacement standard) are also adopted. Whether the expectations of hedgers and their long-suffering finance and risk functions are to be met will depend on the feedback to the IASB. The signs are positive. The date for providing comments to the IASB on the Exposure Draft ends on 9 March 2011. KPMG will provide a detailed analysis of the impact of the Exposure Draft on derivative accounting in a series of forums and communications early in the New Year. Please contact Wayne Read (03) 9288 5867, [email protected], if you would like further information on the Exposure Draft.
In contrast, the Exposure Draft removes the discretion to de-designate a hedge relationship if the qualifying criteria are still met. The Exposure Draft does not address macro hedging strategies but does provide some rule changes to accommodate portfolio management practices.
Corporate Financial Risk Management Update: Edition 1 / December 2010 © 2010 KPMG, an Australian partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.KPMG and the KPMG logo are registered trademarks of KPMG International. Liability limited by a scheme approved under Professional Standards Legislation.
Emerging issues in finance and corporate treasury During the course of this year we have observed a number of reoccurring issues in the market worth sharing with treasury and finance practitioners. Some of these issues are ‘new’ and some of these are ‘old’ issues that are now reoccurring.
Credit risk
Procurement/sales contracts
One issue that treasury and finance practitioners may wish to ‘keep a weather eye on’ is the credit risk of large suppliers. If an organisation has negotiated a supply contract with a future delivery at a fixed price and the supplier fails to honour the contract, the price of the goods or service may have increased and the organisation will suffer a loss. Hence, the purchasing organisation will be entitled to compensation. Will the supplier have financial strength to pay the compensation? There have been instances of organisations experiencing losses from these issues. Given the treasury function manages credit risk of institutional counterparties, there could be an opportunity here for treasury and finance practitioners to ‘add value’ to the rest of the organisation.
Treasury and finance practitioners are responsible for managing currency and commodity risks. However, it is the procurement/sales function that negotiates procurement/sales contracts, which may include rise and fall clauses. We have observed organisations experiencing additional costs on supplier contracts as a result of the unexpected outcome of rise and fall clauses where the supplier has insisted on the use of its contract.
On a similar note, treasury and finance practitioners may like to think about the credit risk associated with futures ‘brokers’. The recent collapse of the broker ‘Sonray’ may provide cause to reassess this issue. Sonray collapsed and traders who used the broker and provided collateral to the broker are now unsecured creditors. This could cause one to ask whether the organisation has a policy of charging margin deposits with brokers, to counterparty limits; alternatively, is there a policy of diversifying the use of brokers so that the organisation does not build a concentration of counterparty risk with any one broker.
The reason for this is that the procurement function may consult the legal department because it knows the legal counsel must approve all non-standard contracts. However, does the organisation have a policy that material procurement/sales contracts with rise and fall clauses must be reviewed by treasury and/or finance? The answer is more than likely not. It is worth considering whether treasury policies should address this issue with similar clauses in procurement and sales policies. It may also be useful for the treasury/ finance function to conduct training of sales and procurement staff on these issues, particularly as staff in these areas may change and have the potential to make mistakes in this area. On a positive note, the early involvement of the treasury/finance function in the negotiation of procurement contracts has the potential to reduce risk and save the organisation money. Suppliers may be prepared to offer a fixed price, for example. With the involvement of the treasury or
10 Corporate Financial Risk Management Update: Edition 1 / December 2010 © 2010 KPMG, an Australian partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.KPMG and the KPMG logo are registered trademarks of KPMG International. Liability limited by a scheme approved under Professional Standards Legislation.
finance function, the procurement function can determine whether the premium that may be charged for the fixed price is fair.
Settlement issues A few years ago an investment bank was the victim of an attempted settlements fraud involving approximately A$150 million. The perpetrators (which included the bank’s own officers) were recently jailed for periods of up to 5 years. The fraud, which was nearly successful, involved the use of facsimile instructions to pay funds from a client account with the request timed near the close of business, just before a public holiday (to minimise scrutiny of the request for the second authorisation). According to reports the plot was discovered when a correspondent bank queried the name on a transfer request. This case illustrates that treasury and finance functions are potentially vulnerable to being defrauded in relation to settlements of large amounts – and therefore whilst the possibility of it happening is improbable, the impact is potentially high.
Pertinently, KPMG has just conducted its 9th biennial Fraud and Misconduct Survey. Survey respondents lost $345 million with an average loss per single incident of $3 million. Theft of ‘cash’ was the most common fraud. The survey makes a series of recommendations around electronic funds transfer pertinent to treasury functions. The full survey can be downloaded from www.kpmg.com.au.
ISDA (International Swaps and Derivatives Association) agreements
It may be timely for corporations to reassess the adequacy of settlement/vendor payment processes, instructions and the controls around treasury and payment systems.
During our work this year we have observed quite a few organisations that have missing or unsigned ISDA agreements. To some degree this is a housekeeping activity. However, given the heightened focus on credit risk and covenant compliance, finance and treasury practitioners should ask themselves what would happen in the event of counterparty default where there is an incomplete or ineffective ISDA agreement.
We have observed a number of issues related to settlement practices. For example, we note that banks are sending emails and facsimiles to their clients to change their standard settlement instructions (i.e. the account to where they want their funds directed). The question arises – how does the recipient (i.e. the corporate) know this is not a rogue settlements officer opportunistically redirecting the settlement of a large amount to his or her account, as the case study above illustrates. In addition to the issues mentioned above, we have also observed other issues associated with settlements. It may be timely for corporations to reassess the adequacy of settlement/vendor payment processes, instructions and the controls around treasury and payment systems.
Corporate Financial Risk Management Update: Edition 1 / December 2010 11 © 2010 KPMG, an Australian partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.KPMG and the KPMG logo are registered trademarks of KPMG International. Liability limited by a scheme approved under Professional Standards Legislation.
Credit value adjustment (CVA) Prior to the GFC, the credit spreads of major derivative dealers were typically quite stable and counterparty risk from exposure to major derivative dealers was perceived to be immaterial. The GFC brought about a dramatic increase in credit spreads and their volatility for most of the major derivative dealers. As a result, many dealers and end users of derivatives have found they must make credit value adjustments (CVAs) to their derivative positions to reflect the potential of counterparty default.
The GFC brought about a dramatic increase in credit spreads and their volatility for most of the major derivative dealers.
CVA is an adjustment made to the fair value of uncollateralised over-the-counter (OTC) derivative positions. It reflects the expected replacement cost of the derivative if the derivative counterparty were to default when the derivative is ‘in-the-money’. The amount of CVA increases as the credit riskiness of the derivative counterparty increases. Applying CVA typically reduces the fair value of a derivative. CVA can be calculated unilaterally or bilaterally: unilateral CVA adjusts for the risk that the counterparty defaults: bilateral CVA adjusts for the risk that either party to a derivative defaults. The fair value adjustment due to CVA can be positive or negative and is reflected in the profit and loss statements. For counterparties for which a liquid credit default swap (CDS) benchmark exists, CDS spreads can be used to calculate CVA. For counterparties for which no liquid CDS benchmarks exist, historical default and loss severity information for comparable companies – ideally based on both industry classification and credit rating – are often used to calculate CVA. Some end users of derivatives have ISDA credit support annexes (CSAs) in place with their dealer counterparties. These
govern the exchange of collateral between the end user and the dealer based on mark-to-market changes in the value of derivatives. For derivative positions subject to CSAs, there is no CVA. Many end users of derivatives prefer not to post collateral when the market values of their derivatives move against them, and therefore must calculate and apply CVA. The benefit to end users of not posting collateral is they don’t have to fund mark-to-market losses on their derivatives. Instead, they can cover losses on their derivatives over time using income. In effect, the derivative counterparty ends up funding an end user’s mark-to-market losses on its derivatives. There is a strong regulatory push to have most OTC derivative trades executed through central clearinghouse counterparties (CCPs). When a derivative trade is executed through a CCP, the position is marked-to-market regularly and subject to collateral exchanges reflecting changes in market value. Trading derivatives via CCPs eliminates the need for CVA. Regulators see derivative trading via CCPs as a means for significantly mitigating systemic risk in the derivative markets. However, many derivative end users may have to curtail or stop their use of derivatives for hedging if they have to trade via CCPs because the end users may be unable to fund mark-to-market losses on their derivatives. If the use of CCPs for derivative trading is enforced, derivative end users with concerns about funding losses on derivative positions may opt to continue using them, but may have to find additional or alternative sources for back up funding.
Contact us Mike Ritchie Partner in Charge Financial Risk Management T: +61 2 9335 8251 E: [email protected]
David Heathcote Partner in Charge Debt Advisory Services T: +61 2 9335 7193 E: [email protected]
Stephen Cheesewright Director Financial Risk Management T: +61 3 9288 5645 E: [email protected]
Scott Mesley Partner Debt Advisory Services T: +61 3 9288 6748 E: [email protected]
kpmg.com.au
Wayne Read Partner Audit T: +61 3 9288 5867 E: [email protected]
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