Since the global financial crisis, corporate treasurers have become increasingly aware of liquidity crunch which had a systemic impact. In light of this, even with the consolidation of many large financial intermediaries which in turn reduces selection in many areas, it is imperative that careful scrutiny of these intermediaries is considered before entering into a relationship. It is important to note that financial intermediaries are not just limited to banks. The European Central Bank (n.d.) categorizes financial intermediaries into two brackets. MFI's (Monetary Financial Institutions) and OFI's (Other Financial Intermediaries). MFI's would include institutions such as credit institutions, non-credit institutions (money market funds) and central banks and other institutions. OFI's include institutions such as insurance corporations, pension funds, financial auxiliaries, mutual funds securities and derivatives dealers, and financial corporations which lend.
How does the treasury department mitigate organizational risk in relation to the intermediates it selects?
Organizational risk is a broad term. It is relative to the overall risk profile of a firm. To narrow this term down, organizational risk that relates to bank relationship would consist of liquidity, counterparty, insurance, interest rate, commodity and foreign exchange risk.
So how does a corporate treasury department avoid mitigate these risks? One way would be to apply the use of several financial intermediaries. Below is a list of how these risks can be mitigated:
Liquidity risk is one of the most crucial risks of any firm. Without liquidity a firm could ultimately lead to failure. The treasury department therefore has the responsibility to monitor and maintain the liquidity function of the firm. One way of doing this is to establish a relationship with a bank that is capable of processing payments quickly and cost effectively. In this case a relationship with a regional or commercial bank that has the technology to allow for real time assessment would be a key factor. For example if the bank has the capability of using SWIFT transactions (Kohn, 2004, p. 209) it enables a feasible way of making a global payment from one firm to another. The electronic payment systems have increased a firm's capacity to make more efficient use of its working capital by speeding up the cycle. Some of the other payment systems include the use of giro's, credit cards, debit cards, wire transfers and direct debits internet bill payment features. Having the ability to monitor the firms account via real time such as over the internet gives the firm the upper advantage to managing its cash flows along with the prompt receipt and disbursements of funds, thus often allowing for a more efficient working capital cycle, hence reducing the reliance on short term financing.
Counterparty risk - This can happen when one party fails to honor a contract with another party. If a firm keeps "all of its eggs in one basket" and the intermediary with which it does business doesn't honor a contract such as a credit line or roll over on short term credit it could cripple a firm's liquidity position. Being able to have access to more than one source for funding is vital. Having a policy in place to mitigate such risk is important. A clear example is noted by Clarke (n.d.) which suggests that if a firm holds 80% of its swaps, forwards and overnight deposits with one bank it could severely put the firm in jeopardy. Very often when financial intermediaries are in a bad position, they often offer lower market pricing in an attempt to increase their deposits and premiums so they can meet their own obligations. This should be a clear signal to treasurers on why they should spread out the firms "eggs" because having a relationship with more than one financial intermediary can often soften the blow of continued liquidity operations of the firm should one of its financial intermediates fail.
Interest Rate - Being able to access funding externally such as long term while also being able to obtain the best rate is important. While a regional bank may offer effective payment services, it may not offer the best long term rates. Other intermediaries such as commercial banks or other financial lenders may have the benefit over a regional bank; however, in most case borrowing from a financial institution that specializes in lending offer have higher rates. Another aspect of interest rates is that some financial intermediaries such as commercial banks offer swap options and charge a fee for such (Madra, 2008, p.404). A good example of interest rate swap is the fact that sometimes corporate borrowers prefer floating rates as opposed to fixed rates when borrowing, but prefer to use fixed payments on their debt. This is where a swap agreement comes in, which would enable the firm to swap the fixed rate payments for floating rate payments and use the floating rate payments to cover their coupon payments. Thus finding the right financial intermediate is important especially relating to fees and knowledge.
Foreign Exchange Risk/Commodity Risk - If a firm deals with the trade of goods overseas, it may need the services of a financial intermediary that has diverse products such as foreign exchange derivatives in order to mitigate FX risk. Financial intermediates' that commonly deal with this type of derivative (Kolb et al, 2007, p.6) are normally large commercial banks, investment banks, brokers, insurance companies and other financial institutions. As such the job of the treasurer would be to determine which intermediary it should opt for when assessing the risk nature of such a transaction as well as the transaction costs. If the firm has a vast amount of dealings that are global in nature, it would probably be wise to seek the services of a financial intermediary such as a commercial bank that has the technological capabilities as well as the ability to offer sound advice and also have service fees that are cost competitive. Insurance could play an important role here as well in order to hedge against risk such as loss of goods in transport or loss or loss of commodity such as crop in the event of a drought.
Insurance Risk - Most firms today have some form of insurance. As such financial intermediaries such as Insurance firms are often used to mitigate certain risks. Many firms need insurance for various reasons such as (Kohn, 2004, pp. 240/7) employee liability, vehicle insurance, fixed asset insurance, fire, theft, natural disaster, health, legal etc. Most firms are susceptible to risks associated with these factors and as such the negotiation of such policies can be quite extensive. Although the insurance industry has grown extensively and has aimed to much the same strategy as the banking sector in way of consolidation in achieving economies of scale, it remains highly competitive and as such the options and fees for such services lead to just as much scrutiny. Unlike the banking sector where sometimes it may be feasible to deal with smaller banks, it is the opposite in insurance. It is often safer to do business with a large insurance company that has global locations as opposed to doing business with smaller insurance firms (Kohn, 2004, p.251). While selecting reputable firms is often very important, the ability of the treasurer to select competitive pricing and services can serve to minimize costs thus freeing up potential liquidity but at the same time allow for the hedging against risks that could be prove to be costly, and could even be catastrophic to a firm such as a fire or natural disaster.
