Appunti di Corporate Finance

Introduction to corporate financial risk management

• Introduction
• Types of corporate risk
• Corporate financial risk management

Introduction to enterprise risk management

“The social purpose of the corporation is to seek its highest long-run expected value. The role of management in achieving that mission is to create and project a compelling strategic vision of the company’s future – one that enlists the support and commitment of all stakeholder groups whose continued participation is important to the firm’s future – and to design the organization in ways that help guide and motivate employees in carrying out the vision.”

The quote captures the importance of risk governance and the accountability of those overseeing the management of our organizations Enterprise Risk Management (ERM), so:

• Increasing governmental concern, monitoring and regulation following credit crisis has further emphasized the need for improved risk management
• Increasing attention toward a holistic approach to risk management

The Committee of Sponsoring Organizations of the Treadway Commission (COSO) definition of enterprise risk management:

“Enterprise risk management is a process, effected by an entity’s board of directors, management and other personnel, applied in strategy setting and across the enterprise, designed to identify potential events that may affect the entity, and manage risk to be within its risk appetite, to provide reasonable assurance regarding the achievement of entity objectives”.

Canada is a world leader in ERM, along with Australia. The U.S. is also active in ERM but not to the level of Canada

• 2011 Conference Board of Canada (CBoC) published the findings of an online survey on prevalent practices sent to 392 organizations;
• 89 respondents (22.7%)
• Most organizations had dedicated risk management group for ERM. – Majority had one to three full-time staff.
• 56% of organizations experienced delay in implementation.

Why? Barriers

• Establishment of an ERM framework/policy
• Organizational change
• Lack of knowledge, time, executive support and resources
• Resistance to cultural change
• More focus on operational risk

Survey results good for benchmarking.

Experience by Industry (The chart shows the number of organizations)

Corporate governance oversight of ERM

Corporate Governance Oversight of ERM is a function of BoD

The responsibility of the BoD is driven by various factors:

• Fiduciary duty toward shareholders;
• Regulation (e.g Sarbanes – Oxley Act).
• Listing requirements (e.g. New York Stock Exchange)
• Best practices

The oversight responsibilities can be attributed/delegated to Committees inside the Board. The Audit Committee is responsible for the oversight duties over management’s risk policies and guidelines. As a consequence, proper information flows from the management toward the Audit Committee are established

Sarbanes – Oxley Act (SOX) (2002)

• The Act was passed to improve the accuracy and transparency of financial reports and corporate disclosures, as well as to reinforce the importance of ethical standards
• Compliance with SOX involves risk management issues for the BoD in the acknowledgment process of risks. CEO and CFO are responsible for signing off financial statements
• The Audit Committee is composed by independent directors and, in general, one of them is a financial expert

Excerpt from NYSE’s corporate governance rules

Discuss policies with respect to risk assessment and risk management;

Commentary: While it is the job of the CEO and senior management to assess and manage the listed company's exposure to risk, the audit committee must discuss guidelines and policies to govern the process by which this is handled. The audit committee should discuss the listed company's major financial risk exposures and the steps management has taken to monitor and control such exposures. The audit committee is not required to be the sole body responsible for risk assessment and management, but, as stated above, the committee must discuss guidelines and policies to govern the process by which risk assessment and management is undertaken. Many companies, particularly financial companies, manage and assess their risk through mechanisms other than the audit committee. The processes these companies have in place should be reviewed in a general manner by the audit committee, but they need not be replaced by the audit committee.

Formalization of risk management process

• Evidence shows that best performers have formalized the risk management process
• ERM assists BoD and senior executives in risk intelligent strategic decisions
• Chief Risk Officers (CFO) provide and overview of the organization from the financial risk perspective
• Internal Audit supports the risk management process. It ensures that risks are evaluated correctly, processes are effectively implemented, risks are reported, review of the management of key risks
• External auditors identify risks and, moreover, detect deficiencies in risk responses as they assess the internal controls concerning core processes that affect financial reporting
• The business units are the owners of the different kinds of risks

Types of corporate risk

Business risks

• They have a firm specific nature
• They are not speculative. If they happen, the entity faces losses
• They are mostly evaluated according qualitative approaches
• Companies are paid to take (strategic risk) or to mitigate them (Operational Risk)

Financial risks

• They are priced and observed by capital markets
• They are mostly measured by quantitative approaches
• They are determined by exogenous factors
• Companies are paid to manage them
• They affect the conditions (cost, rate of return and availability) of the funded financial sources
• They affect the financial equilibrium between inflows and outflows. Such risks are originated in the strategic process, against which they are implicit
• They are determined by the changes of market prices that are factors external to the entity. Individual companies cannot affect the risk causes

Corporate Financial Risk Management σ (Earnings/Cash Flow/Capital)

Market risk and counterparty risk

Market risk

• Currency risk, that is the risk that changes in the exchange rate affecting the expected cash flows
• Interest rate risk, that is the risk that changes in interest rates affecting the cash flows
• Equity price risk, that is the risk that changes in equity prices, affect the cash flows or the strategy
• Commodity price risk, that is the risk that changes in commodity prices affect the cash flows
• Liquidity risk, that is the risk that the entity is unable to fund increases in assets and meet financial obligations as they come due

Counterparty risk

Credit risk is defined by the losses in the event of default of the borrower, or in the event of the deterioration of the borrower’s credit quality. The losses concern both the outstanding capital and unpaid interests at the moment of default

• In a financial transaction, settlement risk is defined by the losses in the event that a counterparty defaults to deliver cash versus securities and vice versa

Corporate financial risk management

Corporate Financial Risk Management Management of financial risks for non-financial companies.

It affects:

• Day to day experience for financial treasuries
• Corporate governance
• Benchmarking of policies

Conflicts of interest and corporate governance failures at universal banks during the stock market boom of the 1990s: the cases of Enron and WorldCom

The re-entry of commercial banks into the securities business transformed U.S. financial markets during the 1990s. Beginning in the 1980s, federal regulators and courts began to open loopholes in the Glass-Steagall Act of 1933 (Glass-Steagall), which had effectively banished commercial banks from the securities industry. In 1989, the Federal Reserve Board permitted bank holding companies to establish “Section 20 subsidiaries,” which could underwrite debt and equity securities to a limited extent. By 1996, Section 20 subsidiaries were able to compete effectively with securities firms as a result of the Federal Reserve’s liberalization of the rules governing those subsidiaries. In 1998, the Federal Reserve took a more dramatic step by allowing Citicorp, the largest U.S. bank holding company, to merge with Travelers, a financial conglomerate that owned a major securities firm, Salomon Smith Barney (SSB). That merger produced Citigroup, the first U.S. universal bank since 1933, and it placed great pressure on Congress to repeal Glass-Steagall. In November 1999, Congress enacted the Gramm-Leach-Bliley Act (GLBA), which removed the most important Glass-Steagall barriers and allowed commercial banks to affiliate with securities firms and insurance companies by forming financial holding companies.

In adopting GLBA, Congress determined that the potential benefits of combining commercial and investment banking outweighed concerns about promotional pressures and conflicts of interest that were reflected in Glass-Steagall. Congress concluded in 1999 that Glass-Steagall was obsolete and counterproductive. Congress therefore dismissed the relevance of Glass-Steagall’s findings that the combination of commercial and investment banking during the 1920s had produced a wave of speculative financings, an unsustainable economic boom, and the distribution of high-risk securities that inflicted massive losses on unsophisticated investors.

GLBA essentially ratified the securities powers that bank holding companies had already obtained through the Federal Reserve’s Section 20 orders. By 1999, forty-five banking organizations (including all of the twenty-five largest banks) had established Section 20 subsidiaries. Three of those banks – Citigroup, J.P. Morgan Chase (Chase) and Bank of America – ranked among the top ten underwriters for U.S. securities in 1999. During 1999-2000, Citigroup’s investment banking fees exceeded $6.6 billion and accounted for more than a fifth of Citigroup’s total revenues. In 2000, Citigroup, Chase and Bank of America ranked among the top ten underwriters of global securities, along with three major foreign banks (Credit Suisse, Deutsche and UBS) and four U.S. securities firms (Goldman Sachs, Merrill Lynch, Morgan Stanley and Lehman Brothers). That group of top global underwriters remained essentially the same during 2001-05.

The six domestic and foreign banks included within that group achieved their status in large part by acquiring securities firms in the United States and UK.

Competition between commercial banks and securities firms helped to stimulate a spectacular growth in the issuance of corporate securities during the late 1990s. Total underwritings and private placements of corporate securities in U.S. financial markets more than tripled, from $860 billion to $3.12 trillion, during 1994-2001. This rapid expansion in corporate issues contributed to the stock market boom of 1994-2000, which was comparable to the great bull market of 1923-29. Unfortunately, as in the 1920s, the stock market boom of the 1990s was followed by a sharp decline during 2000-02.

The drop in stock prices accelerated between December 2001 and October 2002, as investors reacted to reports of accounting fraud and self-dealing at many “new economy” firms that had been viewed as “stars” during the stock market boom of the 1990s. The sudden collapses of Enron and WorldCom were especially shocking to investors. With assets of $63 billion and $104 billion, Enron and WorldCom represented the largest corporate bankruptcies in U.S. history. Investigations and lawsuits revealed that universal banks played central roles in financing the rapid growth of Enron and WorldCom, and in promoting the sale of their securities. Government officials penalized universal banks for their involvement with Enron and WorldCom, and officials also brought enforcement actions against universal banks for a wide range of other misconduct related to their securities activities, including

• (i) Conflicts of interest among research analysts, resulting in the issuance of biased & misleading reports to investors,
• (ii) Manipulative and abusive practices connected with initial public offerings (IPOs), and
• (iii) Late trading, market timing and other abuses involving mutual funds.

This chapter is part of a larger project that will examine the role of universal banks during the U.S. economy’s boom-and-bust cycle of 1994-2002. In particular, I intend to consider whether the combination of commercial and investment banking activities during the 1990s created promotional pressures and conflicts of interest that

• (i) Caused universal banks to underwrite risky securities and extend speculative loans,
• (ii) Led universal banks to issue offering prospectuses and research reports that promoted the sale of those risky securities without proper disclosure of the investment risks, and
• (iii) Induced universal banks to disregard legal prohibitions on deceptive practices and their own policies against abusive transactions.

This chapter focuses on the involvement of universal banks with Enron and WorldCom. While many scholars have analyzed the Enron and WorldCom scandals, to my knowledge only two legal academics – James Fanto and Hillary Sale – have given substantial attention to the role of universal banks in those scandals. The analysis in this chapter builds upon their important work.

The evidence presented below supports several conclusions.

First, the desire for investment banking fees caused universal banks to enter into structured-finance transactions with Enron, even though bank officials recognized that the transactions

• (i) Were inherently deceptive,
• (ii) Were contrary to their banks’ risk management policies and
• (iii) Exposed their banks to serious reputational risk and legal liability.

Second, universal banks competed for investment banking mandates by providing extraordinary financial favors to senior corporate executives of Enron and WorldCom, notwithstanding the obvious corruption inherent in those favors.

Third, universal banks distributed offering prospectuses and research reports that encouraged investors to buy Enron’s and WorldCom’s securities, even though bank officials knew or should have known that the promotional documents were materially misleading and failed to disclose significant investment risks. Indeed, some banks quietly arranged hedging transactions to reduce their credit exposures to Enron and WorldCom concurrently with their publication of materials encouraging investors to buy the companies’ securities. Other banks fired analysts who published critical reports about Enron.

Finally, universal banks repeatedly extended credit to Enron and WorldCom in order to attract investment banking business, even though bank officers had serious concerns about the financial viability of both companies.

Thus, the Enron and WorldCom episodes demonstrated an appalling failure of corporate governance safeguards at universal banks as well as their clients. The actions of universal banks with respect to Enron and WorldCom also revealed the existence of promotional pressures, conflicts of interest, speculative financing and exploitation of investors, which were similar to the perceived abuses that caused Congress to separate commercial and investment banking in 1933. Beyond the injuries suffered by investors and the broader economy, the universal banks’ misconduct related to Enron and WorldCom raises troubling questions about the risks to the financial system created by the commingling of commercial and investment banking. By November 2006, universal banks had paid $15 billion, and had surrendered creditor claims of about $3 billion, in order to settle enforcement actions, civil lawsuits and bankruptcy proceedings related to Enron and WorldCom. The losses suffered by universal banks, which have not yet been fully determined, far exceed the fees they received from Enron and WorldCom. For example, Enron and WorldCom paid Citigroup about $330 million, but Citigroup has already paid nearly $5 billion to settle claims related to its work for those companies.

The magnitude of the foregoing losses indicates that GLBA’s regulatory scheme is not adequate to control the risks posed by universal banking powers to our largest banks – the same banks that are most likely to receive “too big to fail” treatment from financial regulators.

Enron

Enron’s management, led by Kenneth Lay and Jeffrey Skilling, transformed Enron from an operator of natural gas pipelines in the 1980s to a highly diversified company with four primary business segments at the end of the 1990s.

Enron’s major segments were

• (i) Transportation Services, which operated Enron’s traditional natural gas pipelines and an electric utility,
• (ii) Wholesale Services, which operated trading markets for futures contracts and other derivative instruments based on a wide range of commodities,
• (iii) Energy Services, which sold energy products to commercial and retail customers, and
• (iv) Broadband Services, which sought to be “the world’s largest marketer of bandwidth and network services [and] … the world’s largest provider of premium content delivery services.”
• (v) Enron also made extensive “merchant investments” in a wide array of ventures, including foreign power plants, foreign water systems, and many speculative, high-technology companies.
• (vi) Enron also became a de facto financial institution by the late 1990s, due to its heavy involvement in trading commodities and financial instruments. Skilling was the architect of Enron’s financial services strategy, which grew out of his success in establishing a “gas bank” at Enron in the early 1990s. The “gas bank” was very profitable.

Enron tried to extend Skilling’s “gas bank” concept by creating trading markets and risk management products for a wide variety of commodities, including electricity, water, pulp and paper, coal, steel and broadband.

This chapter focuses on four types of transactions, which banks arranged for Enron despite their clear awareness of the deception a