TREASURY AND  CASH MANAGEMENT ESSENTIALS

Treasury operations and controls

Treasury operations are exposed to particular risks such as fraud, error and failures of markets and systems. They are particularly susceptible because of the large amounts of money involved, their ability to make payments and the potential complexity surrounding their activities.

Internal controls

Treasury functions vary in their composition and scope and in how different organizations allocate tasks. For these reasons, when considering operational controls it is generally better to emphasize underlying principles rather than the detail of specific controls and reporting systems.

Control procedures in treasury generally cover the following areas:

  • Prior authorization and approval of financial transactions by delegated authorities.
  • Segregation of duties (see below).
  • Recording procedures, so that no transaction is omitted or recorded more than once.
  • Safeguards for access to systems and documents.
  • Reconciliation/ checking of records.
  • Measurement.
  • Reporting.
  • Internal audit.

Segregation of duties is designed to prevent fraud and detect errors. It is an essential approach that means no transaction or payment, internal or external, is ever carried out without at least one other person knowing about it. In a treasury’s activities, this becomes a general principle so that those executing and recording transactions (the ‘Front Office’) must not confirm or settle those transactions (which is the responsibility of the ‘Back Office’).

Figure 6: Segregation of duties in the dealing process

Segregation of duties in the dealing process

Businesses must be aware of counterparty risk, and dealing limits should be rigorously enforced.

Measuring treasury operations encourages a focus on targets. While there are many possibilities, some of the more important measures and targets could be as shown in the table below.

Table 3: Suggested key performance indicators (KPIs)

Suggested key performance indicators (KPIs)

Treasury operations should report these and other agreed measures to the treasury function, Financial Controller or CFO against pre-agreed schedules or triggers.

Tool: Treasury Controls
Counterparty risk

Counterparty risk is the risk to each party to a contract that the counterparty will not meet its contractual obligations, where counterparty is the other party to a financial transaction.

Counterparty risk arising from exposure to banks and other financial counterparties is often much larger than credit risk from an organization’s sales. Before the global financial crisis, some organizations paid scant attention to this, regarding banks as safe institutions. Times have changed: organizations are holding more cash, and banks’ credit (from the corporate perspective) has become weaker.

Counterparty risk with financial institutions does not arise from deposits alone. It can be found in many other places including:

  • Cash on local deposit by individual group subsidiaries
  • Cash in the process of collection through any medium such as checks, wires, automated clearing houses or payment cards
  • Cash in set-off arrangements such as notional pooling and concentration systems prior to final concentration
  • Derivative contracts that are ‘in the money’ (i.e. those that are worth more than their replacement value in the market)
  • Letters of credit, bank payment orders and bank guarantees (specifically the replacement risk in the event of a bank failure)
  • Custodianship arrangements for investments
  • General set-offs under contract or in local bank/financial institution resolution practice or in internationally agreed bail-in actions.

The legal entity (and in some cases the branch involved) must undertake counterparty credit analysis. In addition to using overall ratings reports, including ratings outlooks, the treasury function should look at the individual credit ratings of domestic and foreign counterparties, as well as those assumed to be seeking government support. It is also important for treasurers to make a considered assessment of governments’ ability and willingness to support their banks. However, ratings should not be relied upon exclusively as they can be slow to change and may effectively lag behind market events.

Getting ahead – The management accountant’s perspective

‘Market Implied Ratings’ (which estimate the probability of default by an individual, an organization or a country) can be very useful, as can share and bond-price movements. Another useful option is the equivalent Credit Default Swap or CDS pricing (a financial instrument for swapping the risk of the counterparty defaulting on a debt). CDS prices reflect much more than a debtor’s credit standing, however.

Treasurers can use each of these indicators as a trigger to suggest a change in credit limits. Due to the speed of change in financial markets, the treasurer must be able to reduce such limits (and the exposure, if need be) immediately and without further referral.

When managing credit risk in investing, the treasurer’s mantra is ‘SLY’: Security first, Liquidity second, Yield last. Yield can only be increased by taking on more credit risk or reducing liquidity. Credit risk can be reduced, for example, by diversifying counterparties and instruments.

Typical approaches include:

  • Using multiple banks with different characteristics for deposits, such as domestic, multinational and regional banks (in the UK, for example, Lloyds Bank, Deutsche Bank and SEB)
  • Investing with non-banks, for example via government securities, directly in corporate debt such as commercial paper, or in diversified funds such as money market funds
  • Larger corporates using repurchase agreements (‘Repos’). This is where a security is purchased from the counterparty at the start of the contract and sold back (‘repurchased’) at the end at a higher price, thus creating a return on the purchase price. If the counterparty fails to honor its repurchase obligation, the purchaser can sell the security in the market to recoup some or all of its investment.

TOOL
TREASURY CONTROLS
 

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