Prudent business leaders seek to minimize the impact of risk from all sorts of macroeconomic events: oil price fluctuations, the Canadian dollar’s rapid decline in value, the Euro’s volatility and Russian geopolitical concerns. But most business leaders seek help minimizing risks like these after the fact, even though they know they should address risk at exactly the opposite time.
Identifying risks that go beyond the headlines, long before obvious problems are looming, is key, says Douglas V. Wyatt, executive vice president, senior commercial banker at Fifth Third Bank.
Smart Business spoke with Wyatt about identifying and mitigating corporate financial risk.
What kinds of conversations should business owners have with their bankers regarding risk?
Your banker should talk with you about the impact of both well-known and lesser-known current events to understand the ‘headline risk’ — the obvious problem — and the risks that lie beneath the headlines.
Some businesses know they have certain risks, but they don’t realize others. Your banker can help you confirm risks you see and identify potential flash points you may not be aware of.
Your banker should also help you identify your risk tolerance and help you create policies and procedures around it. There is market-driven cost to any sort of hedge you put on protecting against a future event. Just because you have a risk doesn’t mean you need to or can afford to hedge against it.
How do you determine whether a hedge is financially viable?
A shock analysis can help identify a business’s risk tolerance. For instance, what if a currency or a commodity moves 5 percent or 20 percent? Is it meaningful? How much will it cost to mitigate?
Some business owners may believe they have a high tolerance for volatility or risk until they see an analysis that truly paints a picture of the potential impact.
What does hedging against risk cost?
The cost is based on the asset class that’s being protected, the volatility of that asset class, the underlying risk and the duration of time the business is looking to hedge. Assessing risk is a dynamic process. Once the hedge is implemented, it is reviewed frequently to determine how effective it is. As market conditions change, that hedge may need to be restructured. For instance, when a bank attempts to hedge against an event with a long time frame, there’s far greater uncertainty. That means there’s more volatility and higher cost with that hedge.
What are some risks bankers typically discuss with a business owner?
A banker often examines a business’s operations to identify risks that exist from a currency standpoint. A banker will also examine commodity input and output as well as the impact the interest rate environment has on both a business’s debt and its current and future expected cash flows. Global operations will be examined to assess what currency risks may be apparent, including direct foreign exchange risk and indirect economic risk that occur when a business pays or receives U.S. dollars from its importing or exporting activities.
From a commodity standpoint, a banker will help companies identify various inputs and outputs in their business practices to make them aware of risks that they may not have fully realized or quantified. For instance, with interest rates at historically low levels, there can be an impact on the company’s cash and use of cash, as well as its longer-term debt structure and debt cost. If beneficial, a banker will help the company take advantage of the current interest rate environment to assist in keeping its cost of capital at a competitive level over the next three to five years.
The bottom line, however, is that there is no one strategy for hedging risks. Specific strategies are determined by risk appetite, organizational structure and product suitability for the underlying risk. It’s important to talk openly with your banker about your operations and your risk tolerance to determine a plan that’s right for you.
Fifth Third Bank. Member FDIC.
Insights Banking & Finance is brought to you by Fifth Third Bank
