| A capital idea!
OK, so Basel sounds impressive, but is there anything those outside the banking sector can learn from it? Perhaps. In this article John Robinson explores the validity of organisations holding 'rainy day' cash reserves against risk. Take a look at your organisation's risk profile and specifically, how it might fund the financial drain following a catastrophe. Extraordinary costs might include a substantial overtime bill, temporary and agency staff fees, specialist fees, fixed costs associated with unused services, reassurance marketing as well as the twin headaches of restoring quality and performance. Consider also how suppliers may become less willing to extend credit as they perceive your organisation’s growing instability, placing a new unexpected pressure on operations and a drain on reserves. Financial pressure and inflated premiums mean that large organisations increasingly choose to self-insure, accepting a proportionately large excess on claims in return for reduced up-front insurance costs. Is this a form of capital reserve? Maybe; there are two points to consider; first, do they hold the excess as a designated liquid reserve shown on the business plan, or alternatively do they choose to recognise outgoings as extraordinary balance sheet items only after the event. This is a matter of corporate policy and discipline since only the former represents a true reserve. Secondly, premium excesses are calculated against the insurable perils recognised by the insurance company and consequently do not account for the unquantifiable loss components associated with full-on corporate crises. These costs are of turnover proportions and a protected self-insurance reserve is almost certainly insufficient to ensure financial stability. For those who don’t self-insure, the obvious recourse is to tap existing cash reserves, provided you are lucky enough to have them. However, if the money is there, it should already be working for you and may be inaccessible in the short term, when you need it most. If this is the case, or if your organisation doesn’t hold a significant ready reserve of cash, then it will need to look to its bank or other funding agencies to extend borrowing facilities to see it through. Again, the arrangements can take time, a rare and precious commodity during an escalating crisis. Also bear in mind that as you disclose your circumstances, your bank may politely decline credit, viewing you as an organisation clearly reeling in the aftermath of a disaster and whose future relies on the funding it seeks. Your operational crisis could turn into a cash flow nightmare. So, should organisations follow the banks' adopted line and put money under the bed? First we must understand that there are some fundamental differences in rationale; a bank's capital reserve is set against its lendings. It is there to ensure it has the liquidity to fund its clients' debts should they go bad. Lending is a core part of its business and equates roughly to a trading organisation holding a quantity of liquid cash reserve against its outstanding creditors - an admirable proposition, but one that is unlikely to cut much ice other than in the normal course of managing daily cash flow. A formal capital reserve of the kind Basel imposes would therefore be anathema to most organisations, severely restricting their day-to-day business. But despite this, there can be little doubt that the concept of some kind of reserve or liquid fund is a good one - rainy day money does make sense - and we need to look for a middle ground that answers the cash conundrum. The so-called 'intelligent finance' packages now available to mortgage borrowers with savings are sold representing an opportunity for borrowers and lenders alike. These relatively simple financial vehicles allow householders to offset their mortgage debt to a building society or bank against savings they hold with the same organisation, paying and receiving no interest on the overlapping amount. The savings remain permanently accessible - i.e. liquid - to the mortgage borrower with the added incentive of paying no tax on the interest which would otherwise be accrued. It seems a simple step to extend this mechanism to organisations with borrowings and savings, offering them a tax-efficient means of holding a liquid capital reserve against a rainy day. Would it work? Ask your bank! So what should risk managers do? Press the embattled CFO for the immediate ring-fencing of a month's revenue and risk a disdainful riposte, or quietly shelve the matter on the grounds that it's not in the organisation's interest to tie up so much cash? The answer is of course, probably neither; as the Basel timeframe suggests, this is a matter for the long-term and ties in well with the general raising of risk awareness at board level brought about by the Turnbull Report. And if in the meantime a financial vehicle can be identified which helps organisations truly self-insure against the potentially devastating financial effects of crises then perhaps we should all consider climbing aboard. John Robinson is director of JRCPL, a leading provider of risk and continuity management services. Click here for more information on the Second Basel Capital Accord.
•Date:
4th April 2003 •Region: Worldwide •Type:
Article •Topic: BC
general |
There
has been much talk of Basel II in the press recently, or to give
it its full title, the Second Basel Capital Accord. Basel II imposes
tough risk management requirements on the banking community and
promises great advances in risk management running up to its adoption
in 2007. Basel II supersedes its forerunner, in that it adds two
new pillars of risk management – operational and market risk
- to the original credit risk capital adequacy framework. 
