32 TMI | THE SOUTHAFRICANTREASURER NEXT GENERATIONTREASURY We cannot escape risk, but we canmanage it. LEON SANDERSON Founder,WazoWaza Capital Leon is the founder of WazoWaza Capital, a consulting business that focuses on capital management and financial risk management across industry. His career, over 25 years, has spanned Risk Management and Markets Trading with his most recent corporate posting being Head of Equity Trading, Structured Trading and Quantitative Analytics at Absa Capital. He holds a PhD in Risk Finance and is a CFA Charterholder. such events. The concept of equilibrium, a key assumption in our mechanistic models of finance does not sit comfortably in a world that is evolving. Rather, a model consistent with Schumpeter’s creative destruction offers a better starting point, i.e., the constant product and process innovation that sees the replacement of the old with the new is an essential fact about our systemof commerce. Change is a constant! Which events warrant action?The constructive and immaterial, or the destructive? Which events are you currently hedging? You can only prepare for change if you have a consistent process! At a company level, our function is to protect ourselves against the effects of destructive change to our business. We need to understand the good and the bad and be able to act against unwanted risk(s), (or change, synonymously). This process constitutes a risk management programme, typically entailing the following steps: 1. Risk identification – this aspect requires a thorough understanding of our business and proper examination of our income statement and balance sheet to understand what variables cause variability (positive or negative). Do we really understand our revenue streams and which event(s) could bereave us of them? Do we understand the difference between variation and risk? 2. Measurement metrics – having identified sources of risk, it becomes crucial to quantify the extent of such risk(s). This is usually done through several risk measurement metrics ranging from simple spot equivalent positions to value-at-risk, capital-at-risk, earningsat-risk, for example, and stress testing, depending on the sophistication of the company involved with the analysis. Risk quantification leads to a deeper understanding of exposures. 3. Monitoring and control – if we can attach a metric to an identified risk, it means that we have a sense of the economic damage that could be caused as a result of that risk or change. We should judge this against the benefit of having the risk, such as the amount of profit or other advantage that we would derive from retaining the risk exposure. Typically, we would not want to have unbounded amounts of any risk and would impose limits to control these risks. It is important, therefore, to ensure that we set our controls (limits) to be reflective of the identified risks and that these accurately control the exposure that will ultimately feed through to our income statement. Our process is, therefore, to monitor the measured risks against limits on a periodic basis and to ensure the correct level of control of our risks. This includes testing exposures against limits and taking actions to rectify excesses. The blind reduction of variation may play well to a chosen metric, but the false confidence afforded by an increase in certainty when it does not matter may not offer any protection against the fire when it does. 4. Manage and challenge – risk management is most successful in an environment where the risks are transparently discussed and understood. It is of the utmost importance to dissect the risks and to understand whether our understanding of its impact to the balance sheet and income statement is correct; whether our measurement is correct; and if we are adequately compensated for the risk. Part of the process of challenging and testing risk measurements would be to ensure that we have captured all our risks. Throughout the whole process we need to continually revisit all our assumptions and revisit our risk appetite and business understanding given market changes – this step is vital and often neglected in practice. We need to embrace and understand our relationship with risk – this is a prerequisite for a resilient treasury environment. It is vital that we recognise variation is inevitable and, in many respects, healthy and necessary. We cannot escape risk, but we can manage it. Target the pain NOT the gain! In the words of Billy Joel: We didn’t start the fire It was always burning, since the world’s been turning We didn’t start the fire But when we are gone It will still burn on, and on, and on, and on, and on, and on, and on, and on Change will endure; on, and on, and on … Are we ready to manage it? n
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