Financial risk management

Carolyn ClarkeManaging PartnerPwC Mongolia

www.pwc.com

PwC

Why is dealing with risk a critical business priority?

October 2011

2

PwC

PwC survey

October 2011

3

“Risk management is seen as a necessary evil in our organisation, and the group risk manager is still trying to sell the benefits”

CFO

PwC

Continuum of risk

October 2011

4

Known risks Emerging risks Unknowable risks

Happened before

Cause

Impact

Probability

Several competing plausible models as to how reality might unfold

Unforeseeable

Have not yet emerged

e.g. earthquake, major debtor default, supplier failure

e.g. major terrorist act, climate change

Black swans

e.g. volcanic ash cloud?

PwC

What do we mean by „High Impact‟ Risk?

October 2011

5

Likelihood

Imp

ac

t

1

2

4

3

11 12

9

10

7

5

8

6

Any inherent risk scenario

where the impact could be catastrophic:

• may arise from any category of risk (strategic, operational, financial etc)

• may be known, unknown or emerging

PwC

The challenge of dealing with high impact risk

• Traditional risk management approaches tend to downplay the importance of risks with low probabilities of occurrence attached to them

• Events with a low probability of occurrence are difficult to assign meaningful measurement to – impact and probability

• Challenge to get people engaged in fully considering remote probability risks – some may not even be foreseeable at all

• Often unclear whether controls over high impact / low probability risks are really working

• Lack of experience in dealing with such risks within the company – because they happen relatively infrequently

• High impact risks may correlate with others, causing them to occur or magnifying the combined impact

October 2011

6

PwC

Value destruction in companies

October 2011

7

39% 28%

19% 14%

Demand shortfall

Customer retention

Integration problems

Pricing pressure

Regulation

R&D

Industry or sector downturn

JV or partner losses

Macroeconomic

Political issues

Legal issues

Terrorism

Natural disasters

Cost overrun

Operating controls

Poor capacity management

Supply chain issues

Employee issues incl. fraud

Regulation

Commodity prices

Debt and interest rates

Poor financial management

Foreign exchange

Liquidity risk

Accounting problems

Strategic Operational

Hazard Financial

Bribery and corruption

PwC

Financial risk management objectives

October 2011

8

Protect the organisation against unforeseen losses, maintain earnings stability, maintain certainty of cash flow, protect ability to meet budget

Benefit where possible from favourable movements in market rates without exceeding the risk attitude of the corporation

Deliver shareholder value

PwC

Areas of financial risk

October 2011

9

Risk created by market conditions and movements

Debt and interest rate

• Exposure to interest rate movements

• Repayment schedule

• Ability to extend credit

• Covenants

Foreign exchange

• Transactional risk in contracts in foreign currencies

• Exposure where cash held in foreign currency

• Exposure to movements in MNT

Market (commodity) price risk

• Impact of movements in commodity prices

• Competitor price risk

• Inflation

PwC

Areas of financial risk

October 2011

10

Risk related to structure and business

Credit risk

• Counterparties unable to meet obligations

Liquidity risk

• Insufficient cash to meet existing or future requirements

• Ineffective use of cash and working capital

PwC

Areas of financial risk

October 2011

11

Regulatory and compliance risk

Tax risk

• Changes in tax regulation

• Interpretation of tax regulation

• Failure to comply with requirements

• Failure to take advantage of tax opportunities

Legal risk

• Changes in legal framework

Other regulatory or compliance risk

• Changes in regulatory framework

• Failure to comply with regulation

PwC

Areas of financial risk

October 2011

12

People and performance risk

Poor financial management

• Lack of experience to take advantage of financial opportunity

• Failure to identify opportunities

• Lack of understanding of finance and implications

• Actions not taken quickly enough in response to changing circumstances

• Inaccurate budgeting, forecasting and monitoring

• Suboptimal investment decisions

Accounting errors

• Mistakes resulting in compliance risk

Fraud risk

• Misappropriation

• Misrepresentation

PwC

Approaching financial risk management

October 2011

13

1. Managing risks in isolation

Separate identification of exposures.

Hedging takes place by sub-risk type and by specific transaction.

Easy to implement.

2. Using a portfolio approach

Aggregate exposure identification

Hedge take place on both portfolio and transaction level

Provides better control on residual risk and can reduce cost of hedging

Requires effective and adequate systems infrastructure.

PwC

Financial risk management approach

October 2011

14

Debt

Trade FlowsCommitted

Flows

Uncommitted

Flows

Committed

Uncommitted

Non-Trade Flows

Committed

Uncommitted

FX

Interest

Equity

Commodity

• Sensitivity

• VaR

• What-If

• Worst case

• Profit &loss

• etc

Risk appetite

Return objectives

Meet?

LIMITS

Sets

Yes

No

Mitigating Action

Yes

No

Review optimal strategy

Recognise

sourcesConsolidate Manage

Measure

and control

Link to

strategy

BENCHMARKS

Sets

FX

Interest

Equity

Commodity

He

dg

e s

trate

gy

(Po

rtfolio

Ap

pro

ach

)

PwC

What is the best strategy?

Debt

Trade FlowsCommitted

Flows

Uncommitted

Flows

Committed

Uncommitted

Non-Trade Flows

Committed

Uncommitted

FX

Interest

Equity

Commodity

• Sensitivity

• VaR

• What-If

• Worst case

• Profit &loss

• etc

Risk appetite

Return objectives

Meet?

LIMITS

Sets

Yes

No

Mitigating Action

Yes

No

Review optimal strategy

Recognise

sourcesConsolidate Manage

Measure

and control

Link to

strategy

BENCHMARKS

Sets

FX

Interest

Equity

CommodityH

ed

ge

stra

teg

y

(Po

rtfolio

Ap

pro

ach

)

EXPOSURE ANALYSIS

• Quality of forecast• Forecast horizon• Business cycle• External business factors

DEFINE/QUANTIFY

• Risk appetite• Return• Objectives

ESTABLISH RISKQUANTIFICATION TOOLS

PwC

Maturity in managing financial risk

October 2011

16

Sophistication

Maximise shareholder value

Ensure earnings stability

Control losses

Riskidentification

Riskmeasurement

ControlRisk

control

Risk/return analysis

Capital allocation

based on RAPM

Strategicadvantage

Pricing and remuneration

based on RAPM

Tier 1 bank

Objectives

Typical large

multinational

Typical large

corporate

Tier 1 bank

PwC

Strengthen checks and balances

Be prepared: anticipate and scenario plan

Show leadership and shape culture

Understand risk

What are the four key lessons?

October 2011

17

Thank you

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