Risk Assessment

The financial crisis posed a number of problems for organisations and once-reliable risk models were called into question. As the economy climbs towards recovery, Magnus Attoff, head of financial risk management and treasury controlling at Ericsson, tells Steve Coomber that now is the time to reassess risk management strategies.

Based in Sweden, Ericsson has a huge global operation. In 2008, for example, it posted revenues up 11% of SEK 208.9bn, had an operating income of SEK 23.5bn (excluding Sony Ericsson) and cashflow of SEK 24bn, with cash conversion at 92%.

At Ericsson, the treasury function involves the usual set of responsibilities, such as cash management, cash centralisation, asset management, investment of gross cash and so on. However, one slight difference from conventional practice is the treatment of the foreign exchange (FX) control function.

"As a big multinational operation with a small domestic currency, Ericsson is very exposed to FX and is therefore, from a treasury point of view, responsible for both FX risk management and FX controlling," says Attoff. "Even internationally, it is fairly unusual that the treasury has that sort of responsibility."

Shattering assumptions

Having been in financial risk management for many years, Attoff is in a good position to assess the impact of recent events. They are, he says, leading risk management professionals, and many other finance people, to question many of the assumptions they held about financial risk.

"The current turmoil in the financial market, and resulting volatility, has shown that a lot of the common generalisations don't work when the situation in the real world becomes too volatile," he says.

"Before the financial crisis we had a reduction of volatility throughout the markets, which was understandably deemed not to be a risk. But as it turned out, that was an artificial situation. The increased volatility we have seen since definitely shows that many of these risk measures are inadequate."

Fortunately, Ericsson was better placed than a lot of businesses to cope with the current situation. This is partly due to Ericsson's experiences during the telecoms crisis of 2001-2002, which taught the company to adopt a conservative approach regarding cash level and liquidity risk in financial investments.

The credit market for Ericsson dried up during the crisis, and the company learnt the hard way that it is not a good time to fix a problem when you are right in the middle of it. Better preparation was therefore required.

"You need to be very prudent, and make sure that you have sufficient funds raised in the good days, when people are willing to lend you money. In the end we raised capital through equities and sold off a lot of operations to raise capital," says Attoff. "Ever since, we've been holders of both net and gross cash, which of course was a big advantage when the financial crisis hit the rest of the world, because we had money at a time when everyone else was looking for it."

Before outlining the challenges that Ericsson has encountered as a result of new market conditions, and the steps being taken to deal with this, Attoff notes the impact of IAS 39.

"Companies either went towards external reporting, taking greater responsibility for understanding FX, hedging and everything that treasury did, or, since treasury was doing all the hedging and therefore had a better insight into the operation, gave treasury end-to-end responsibility for looking at the exposures, the hedging and understanding the outcome."

Another issue, says Attoff, is that treasury is often seen as an extension of the internal bank, where the operating units hedge their exposure with the internal bank and in turn, the internal bank does the transaction externally. So the treasury has derivatives that should reflect the business exposure. When reviewing risk, however, treasury looks at the derivatives as the financial exposure.

The hedge accounting standards require you to release and record hedges based on the underlying exposure. This means that you need to look past the internal derivatives that the operating units have, and actually look at what it is that they are doing that generates the exposure, he explains.

"I think that a lot of the time there are treasury functions that still live in this black box in the middle, and do not look at the operating units, as we've done. We're actually looking at the exposures in the transaction, the operating units in sales and purchases to check that it is a reasonable hedge transaction, because that is not always the case."

Ericsson has, says Attoff, moved away from the concept of hedging cashflows in the business and into hedging the impact of accounting from FX-exposures. As he explains, treasuries tend to live in a cashflow world and view the timing of transactions in terms of when the cashflow occurs.

"That's not the case with operating transactions. If you purchase something into inventory, from a transaction point of view you've already raised your financial liability because you have an AP to pay, even though there has been no cashflow whatsoever,’ says Attoff.

"So, the timing of the transactions – when the FX exposure appears in our books – is not on a cashflow basis, it is on an accounting basis. Understanding the timing differences makes it more difficult, but if we get it right we are able to enter into a hedge transaction that is actually offsetting accounting exposures. And then it works a lot better."

A new challenge

Setting the impact of IAS 39 to one side, the recent financial upheaval has posed some serious challenges for financial risk management at Ericsson.

To start with, the ability to trade certain currencies was compromised by the fallout from the financial crisis. Some currencies became non-tradable such as the Romanian leu and the Hungarian forint. When a company's strategy is to be fully hedged, as Ericsson's is, this presents a difficult dilemma.

"Of course, then you say, is that a position that we are taking now? Is it a trading position, or what sort of position is it, from a risk management point of view?’ says Attoff. ‘There are still problems in this regard, and there are still currencies that haven't recovered properly."

Another issue was the impact on the Value at Risk (VaR) measure.

"Value at Risk depends on correlations between different rates," says Attoff. "So, if there is a correlation between rates you can have proxy hedging, and proxy hedging will limit your volatility. But when all correlations break, as they did between government and bank risk, between different currencies, and so on, and at the same time volatility increases, the VaR measurement itself balloons."

This creates a major problem for the risk manager because, although the same positions are being held, suddenly the main risk measure has increased, placing it outside acceptable limits, meaning a lot of positions need to be closed, even though nothing has really happened.

"We closed down a lot of positions," say Attoff. "The problem in this case was that the general view of VaR as a risk measure was very unfortunate in the recent crisis, because when you have these big volatilities there will be people making money on their position, and others losing it. Because all the risk went up, everyone had to close down their positions, so even those that actually made money couldn't invest further and weren't able to provide the market with liquidity."

The mutual distrust in the interbank market also had an unfortunate effect on FX pricing. After the collapse of Lehmans, interbank lending ceased almost overnight. The interbank lending freeze created a very strange yield curve on the bank depo side, which is used for FX forwards.

"The FX forwards became very badly priced, so that was an area where we stopped matching because it started to roll short, even though it was costing us on the cash side,’ says Attoff. ‘For us, having a lot of liquidity isn't a big problem, but it certainly would be for others in the market. Either they take the increased finance risk, or they pay up in order to match and get longer dated forwards."

So what has Attoff taken from the events of the last year and the challenges posed to financial risk managers?

"There are no free lunches," he says. "You have to understand the reason for results; your return on risk. It could be, for example, that you are in two different markets, as some entities are, like a retail and a financial market, and those are priced differently and you make an arbitrage between them. That's fine, as long as you understand it."

Splitting commercial flows from financial or trading is also beneficial, says Attoff.

"Separating commercial and trading flows makes it easier to capsulate trading, to see what decisions are being made, what risks are being run, and what the P&L is from those. The point of the exercise is really to understand the results, and to be able to capsulate as clearly as possible the areas where the firm takes risks and the return on those risks. When you mix in commercial flows, which are a lot larger, it really blurs the picture."

Another lesson from the crisis, notes Attoff, is the importance of having additional risk measures to compliment VaR.

"VaR is still useful, but you should be aware that value at risk is a risk number that is applicable on a normal day on the job. When you get havoc in the system then the VaR number in itself isn't really showing the risks. Instead, it tends to exaggerate the problems," says Attoff.

"So VaR is still useful, you still need to have a longer view, looking at risk over time. However, you also need back-up risk measures; a palette of other supporting risk measures."

If financial crises can be said to have any upside it is that they force organisations to reassess the way they run their business, in a way that they might not do otherwise. Recent events, for example, have led Ericsson to reappraise its approach to financial risk management, hopefully making it more resilient to financial shocks in the future.

For Attoff, these have been challenging times, but interesting nevertheless. Although, as Attoff admits, things might have turned out much worse had it not been for Ericsson's strong cash position.

"From a positive point of view, things have been very volatile and difficult but the situation has never been life threatening for Ericsson," he says. "I'm also sure that if I had been in a company with very slim capital or liquid resources I would definitely have an ulcer by now, which I don’t."