Time for Corporates to Stress Test FX?
The SIBOS 2011 Issues Preview Edition had an interesting article around Tim Keaney’s (vice chairman and CEO at BNY Mellon) views on growth opportunities for banks. 4th on his list (of 4) is FX volatility. It’s not so much the presence of FX that interested me but rather it’s qualification with ‘volatility’. Now that’s the astute bit and where banks should be pushing for growth with corporates.
For corporates, rate changes in minor / exotic currencies have always been of concern but the major bastions of trade like the US$ are too often ignored. However, when major currencies (such as USD, CAN and AUD) move so fast, and so far, it’s a real wake up call to the CFO and business. The P&L suffers and so does cash, often ‘dropping’ out of the numbers as a surprise some time after the sale or purchase was done.
The recent financial issues around the world have introduced a few new dynamics to the control of FX by corporates:
- higher volatility of FX (both in terms of velocity and quantum)
- reduction in access to cash resources
- decline in sales margins.
These new dynamics lead to:
- a real and present danger that FX rates will move materially and in a corporate’s financial reporting period
- any resulting cash losses are harder to compensate for with new cash funding
- already slimmed profit margins are slimmed again.
As a result, there is a significant opportunity for banks to better service their customers on FX.
FX has of course always been an issue for corporates that interact with currencies other than their own and as a result a natural source of income for banks who can assist in dealing with such risks through FX trading. However, corporates do not automatically take out FX instruments to cover sales or purchases. Sure, the biggest purchases and sales a corporate makes (in value terms) might get covered and many larger organisations might take a blanket approach to currencies, perhaps swapping out a % of their likely net receipts at quarterly intervals (let’s call that treasury). But this is by no means a universal practice. I am afraid that the standard approach is to do nothing.
The corporate’s bank doesn’t lose out totally in this reluctance of the corporate to pro-actively manage FX risk, since the bank will invariably be holding and transacting the currencies for the corporate and be asked to convert to £ on an ad hoc basis. So the bank makes a margin but this is unpredictable business and the corporate sees little benefit from such a utility conversion (the bank’s role is almost invisible). The scene is now set for the bank to work with its customer to explain and manage FX risk so the customer benefits and fully values their service – and values it very highly indeed. I’ll give an example:
If I invoice a US company US$1m but my home currency is £ then I’d actually like to receive £, whereas my customer will invariably want to pay me in US$. So I win the big deal and invoice my customer on 12 July 2011 the big US$1m. The spot rate is then 1.5833 so I book a sale of a cool £631,592. Even better, my customer then pays me on 19 August, which is great because I am preparing cash for the August payroll and I am £620,000 short. So I swap my newly acquired US$ for £, which happens automatically for me because the customer pays US$ to my £ bank account. But I only get £604,555 because the USD has weakened; a loss of £27,038 – that’s 4.3% of my sales price by the way and I am now £15k short for payroll. My bank makes a good margin on the US$ conversion but they are invisible to me and adding no value. If the bank had worked with me to initiate FX contracts, then I would not have exposed myself to a £27k loss (I am ok that the bank earns £7k or so margin) and importantly I would be able to pay the payroll.
The weird thing is that a CFO faced with a potential £27k loss (or more) that could pay an insurance policy of £7k at the outset to avoid it with certainty would surely do so. But that just isn’t happening and as a result the CFO is exposing the business to severe risk. There is much talk of Stress Testing in the Basel III world of banks, but surely the corporate needs to be stress testing as well? CFOs really need to be asking themselves a number of ‘what if?’ questions, to stress test their business. In the above example, what if the US$ weakened over the 30 day period from 1.5833 to 1.9000? Sounds extreme but perhaps we need to look at extremes in the new world. In that scenario, I’d lose £100,000 of cash, which is 17% of the sales value. That could have a catastrophic impact on my funding. The potential for an extreme loss of £100k focuses the mind on risk and I really hope would push the CFO to cover the risk with an FX contract.
Recent history should be a real wake up call to all corporate. Banks should be actively pushing FX product because the opportunity to make a real difference to corporates is very real – it’s all about stepping up to be seen as a value added service provider and working to the customer’s agenda. Encouraging your customer to stress test scenarios may assist in bringing the issue to the fore.
OK, so there is competition for my bank out there in the form of e-platforms and other banks. There are two issues here (1) Trust and (2) Collateral.
- I trust my bank and don’t want to have a 3rd party handling my money, even if they use a bank client account
- I can’t be bothered to open a new bank account, to supply a deposit, or I don’t have the cash for the deposit, so my main bank gets the deal – my main bank should roll an FX position into my existing security without much hassle. For me, my main bank wins and has a very strong competitive advantage.
I’ll say again, most corporates just don’t bother to cover their FX risk at all. They almost certainly don’t stress test either. So get out there bankers and convince your customers why they need to start covering their risk and how you can help them. Perform stress tests for them, especially if you are providing lines of credit that are exposed by FX movements.
