Open Letter to CFOs, Board Members, and Corporate Fiduciaries
Being deemed Too Big To Fail saves the banks, not their corporate counterparties.
Two important questions that every organization should be asking are 1) Why do you do business with Bank X? and 2) How do you evaluate and mitigate the risks of this relationship? In recent years, the world's largest banks have proven that not only are they Too Big To Fail (TBTF), but they are Too Big To Manage effectively. These institutions are the primary counterparties to every major multi-national corporation, and in just the last few years, all have been fined repeatedly by pretty much every regulatory or oversight body – including the SEC, CFTC, OCC, Federal Reserve, NYMEX, FINRA, and the British Financial Services Authority – for a variety of offenses including comingling client funds and defrauding investors. If your primary counterparty has been repeatedly cited, by numerous regulators, for incompetence and fraud, how do you justify doing business with them and protect your organization while doing so?
Cognitive dissonance is the feeling of distress caused by holding two conflicting ideas at the same time, or taking actions that contradict our knowledge. In order to live with this irrational behavior, we reduce the importance of the factors causing this discomfort and engage in a number of cognitive biases that make us more comfortable with our decisions. If you are an investor or a fiduciary for an institution who uses swaps to reduce volatility in foreign exchange, interest rates, or credit, you should be aware of the impact these biases are having on your decision-making. These institutions are enormous, which sometimes makes them the only place to transact certain business in a large enough size for multinational corporations. However, corporations should weigh the benefits of these transactions with their risks and have a sense of when the risks outweigh the benefits of the transactions. I'm not saying don't enter into these transactions, but rather embrace the distress caused by them so your exposure to them does not sink the corporate ship.
As a financial analyst, I often discuss corporate finances with CEOs and CFOs, and am struck by the unwillingness of multi-billion-dollar corporations to devote the time or resources to understand and mitigate their counterparty risk. Corporate memories are often short, and we live in a world where most investors transact with the expectation that governments will continue to successfully intervene to ensure the liquidity of all markets. It wasn't long ago that corporate CFOs were stuck with millions of dollars in Auction Rate Securities (ARS), sold by these same banks, which proved to be considerably less liquid than advertised. When the Fukushima nuclear reactor began melting down, yen marks froze until governments intervened. The functioning of the European economy is entirely dependent on the European Central Bank (ECB) supporting the sovereigns through the banking system. As corporate cash positions build, and currency fluctuations impact EPS, CFOs are doing considerably more unilateral business with these same institutions that failed them before and have leveraged exposure to markets that can surprise even the savviest investors.
When I ask executives how they evaluate and manage counterparty risk exposures, I rarely get an answer that indicates much consideration has been given to the subject. The most common response is that "our counterparties are the big banks, and if they fail we have bigger problems than our currency hedge." Every time I hear this, it is like fingernails on a chalkboard. Being deemed TBTF saves the bank, not you! In fact, you are more likely to be abused because regulators will give them considerable leeway to "secure their balance sheet" by means that do not require government funds. That means taking funds from clients and counterparties, rather than taxpayers. You may have "legal" standing, but recovering funds through courts has not been fruitful in recent years.
The paradox of risk-taking is that liabilities become assets, and assets become liabilities. As managers and fiduciaries, we are entrusted to distinguish between the two. It has been suggested that we are in an era of peak profits, peak collateral, and peak confidence in central bank policies, which means the problems of illiquidity and impaired collateral are not the issues of the day; however, now is the time to put plans in place for when the environment is not as accommodating. If you wait to evaluate your risks and plan of action until a problem manifests, you are too late. That "cash cushion" you were expecting to give you the flexibility to manage through the difficult time, will become an illiquid IOU from a TBTF counterparty, which should not be a surprise as that counterparty was repeatedly cited for violating "Fair Dealing" standards. That IOU does nothing to help you mange through the crisis, and exacerbates your problems with litigation and a lack of confidence in your ability to manage, at a time when confidence is critical to outmaneuvering your competitors.
A few years ago, the financial system failed, and little has been done to correct the problems. In fact, moving debts to sovereign balance sheets may have increased the risks. If you are a corporate fiduciary, I implore you to take the time to critically evaluate your risk exposures and counterparties. Now is the time to put a strategy in place that protects your firm and your investors, from the next crisis. If that crisis never comes, we will all be grateful, though your efforts will go unrecognized as little more than prudent management. However, if the delicate balance fails to hold, ignorance and excuses will provide little comfort to those disgraced by failing to prepare for what they knew was a possibility. Banks have fleeced corporate counterparties in the past, and it is my sincere hope that boards and managers are actively working to ensure that does not happen again.
Tom Clancy, CFA
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