Doing new things and launching new products is always exciting; however, from my experience, these innovative ideas often lead to long-term, ongoing problems. These real challenges can cost us significant amounts of money and management time to unravel. Stepping back to carefully consider how we might avoid such difficulties arising in the future doesn’t come naturally but is worthwhile. Here are three questions you should ask.
Is it a Structured Product?
Structured products are a classic example and, of all the things I’ve seen, are the easiest to avoid.
They may appear simple and attractive on the surface, such as structured deposits offering higher interest rates. However, these come with hidden risks, such as selling options embedded in the product. These options are credit, currency, or interest rate driven and may lead to significant losses when the underlying risks materialise.
If someone wants to sell you a structured product, ask yourself what’s in it for them. If you can’t answer that, don’t even consider it
Is it Long-Dated?
Another area of concern is long-dated assets; these may be bonds or loans. They seem attractive due to their yields but pose substantial risks the further we go out in time, especially when hedged with derivatives.
Long-dated derivatives can lead to greater margin calls, impacting liquidity during times of stress.
Additionally, basis risk from the credit spread differential between the asset and the hedge can cause P&L volatility, especially in a mark-to-market environment.
Does it Have the Illusion of Liquidity?
Investments that appear liquid in normal conditions can become illiquid in stressed markets. Structured assets or those requiring special hedging can be difficult to sell when needed most. Any associated derivatives complicate liquidation, often forcing reliance on the original counterparty, which is not ideal.
Why This Matters
The difficulties associated with new products are often disproportionate to the financial benefits they bring and unravelling the problems they bring consumes an inordinate amount of senior management's time. That's time spent dealing with the complications rather than strategic initiatives. The question then arises: why do we pursue new things?
The answer lies in the inherent excitement of new ventures and the desire to contribute to the business's bottom line, furthermore, the greater the pressure placed on the treasury to generate income, the more likely it is that we find riskier solutions. But that's not all.
Many of the long-term problems we have to deal with are created outside the treasury, often from a business initiative that wasn’t thought through.
This leads to the underlying problem sitting on the balance sheet, and the only place to manage it is in the treasury. Examples include many retail products that have structured risks (drawdown and repayment options); they are on the balance sheet for years, pay interest that doesn't naturally offset, and are subject to redemption, extension and withdrawals that we can't fully control.
This is where problems can arise particularly when the marketing and pricing of these products is outside the treasury.
If the motivation is to shift product, the sales volume can be achieved by adjusting the price, which may no longer truly reflect the risk you are getting into.
From what I’ve seen, it’s a tricky discussion that’s made worse if marketing and treasury are separate profit centres. The “you are taking my P&L” argument has been going on for years and is at the core of things.
What Can We Do?
We need to be clear about what we want from the treasury. Pressure for returns will inevitably lead to increased risk-taking, often by doing new things. For all but the biggest banks, this makes very little sense. But what about those risks outside the treasury that have the potential to haunt us?
Yes, there needs to be proper strategic thought; new products must align with the long-term objectives of the business, but this is vague. A more concrete approach is for the treasury to have a voice in product development and pricing
A solution I've come across is where the treasury is responsible for product pricing, while marketing focuses on volume.
The marketing team commits to the volume they will do and writes the internal ticket to manage that risk with the treasury.
Treasury is now on the hook for managing the risk, whilst any over- or under-hedging costs are picked up by marketing.
It’s amazing how this can focus discussion and create true collaboration to avoid costly mistakes. If it's something you don't do ask yourself this:
What measures do you have in place to foster effective communication and collaboration between treasury, marketing, and product development teams, and how do we ensure new products are priced to reflect their risk?
If you liked this sign-up for regular posts
留言