Understanding financial risk
How to avoid getting your fingers burnt when dealing with complex financial instruments
RISK
Image: Istock
James Tickell
Partner, Campbell Tickell
Issue 64 | February 2023
As history relates, high finance is a tricky and very complex business. Many organisations have come to grief through unexpected changes in interest rates – either up or down – and the effects they may have on intricate financial arrangements made in connection with a large loan. Ironically, the very measures intended to reduce financial risk can end up being the biggest risk of all, and housing associations are well represented among those who have burned their fingers in this game.
This creates a series of dilemmas for board members, and particularly for those who serve on Audit and Risk Committees, or perhaps Treasury Committees. Some board and committee members may have specific expertise in the field, but unavoidably, they will tend to be in a minority, certainly at board level, where a mix of varied skills and expertise will be required.
Yes, boards can – and should – get expert financial advice, but to interpret that advice to good advantage they need a level of understanding to start with. They need to be able to understand the risks associated with complex financial instruments, define the risk appetite, and monitor what is going on in practice.
“We can’t be sure what’s next, but it’s a fair bet it will be an unpleasant surprise.”
Expect the unexpected
These days, unexpected events are almost a daily occurrence. A pandemic here, a war there, a disastrous experiment in fiscal policy nearer to home. We can’t be sure what’s next, but it’s a fair bet it will be an unpleasant surprise.
In simple terms, there are two kinds of loans that housing associations may take, although they may manifest an infinite series of variations. Household mortgages are the same, so the concept will be familiar to most readers.
One is the fixed-interest loan – you know where you are, and are insulated from unexpected changes; nice and simple. The trouble with that is that for much of the life of the loan, you may end up paying more than the going rate. With a variable rate loan, the risk of a massive increase in interest rates is significant, and there are different ways of managing and mitigating that risk.
Using complex financial instruments
That is where complex financial instruments come into play, many being known as interest rate swaps, or ‘IRSs’. With an IRS, the borrower is essentially paying the lender, or a third party, to assume some or all of the risk of interest rates shooting up.
But as mentioned above, these arrangements typically create new second order risks. If interest rates go down, the issuer of the IRS may end up charging the housing association borrower a substantial sum. In certain circumstances, the association may need to offer up property by way of collateral against its obligations.
The key point is that of managing complexity, thinking ahead to apparently unlikely combinations of circumstances, and scenario planning them in financial terms. It may be sensible to hold certain amounts of liquid funds, or to make sure that a portfolio of unencumbered property is available as potential collateral, in case either are needed at short notice.
Skilful management
As for the skills needed to manage these risks, a vital first step is a skilled and senior treasury manager, possibly at executive level, with demonstrable experience in these fields. Risk management becomes an ongoing work stream, not a monthly or quarterly event.
Training for all board members is necessary, if only to ensure that the risks, and the principles that drive them, are properly understood and regularly reviewed. And of course, there need to be board and committee members with direct experience of these matters too – not just one member, but perhaps two, maybe along with an independent committee member, who can truly hold the executives and advisors accountable with a good mixture of challenge and support.
Finally, it may well be sensible for the board or a committee to have its own treasury advisors, with a brief to ensure that the right questions are being asked, and the answers give good assurance.
On our website, we have published a longer follow-on article by Patrick Alderman of Link Treasury Services, which goes into more detail. We commend to you for careful study and thought. It seeks to set out the main issues that boards will face, the risks that need to concern them, and the ways in which IRSs work.
“Risk management becomes an ongoing work stream, not a monthly or quarterly event.”
