Rationale A Separate Treasury Function Finance Essay
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This thesis derives the rationale for a separate treasury function from theory of the firm. A framework has been developed by drawing upon both the old theory of the firm (transaction cost economics) and the new theory of the firm (agency theory) to determine the appropriate governance structure to manage financial arrangements.
Formal analysis of corporate treasury functions and performance measurement research has not kept pace with the growth of treasury activities. Appropriate benchmarks provide management with information to manage financial risk and to more accurately assess treasury performance. A benchmark is required for core treasury tasks, including debt portfolio management.
Optimal treasury benchmarks are difficult to determine, due to the complexity involved in measuring financial exposures for firms which derive income from physical, rather than financial assets. The inter-relationships between financial risks, including maturity, interest rate and currency risk, further compound the problem. Decomposition of financial risk into these respective elements allows identification of the firm specific factors that influence financial exposure.
Treasuries are often classified as either active or passive managers, but a continuum of strategies is possible when managing financial risk, rather than points at either end of a spectrum. Tolerance levels around the benchmark constrain activity within a relevant range - the more active the treasury, the broader the range. Constraints allow the degree of activity to be file-tuned. The decision to actively manage risk depends upon whether value can be added in risk-adjusted terms. This is a function not only of whether opportunities exist, but also whether value can be added consistently, compared with a passive approach.
Respondents to an international survey on corporate treasury control and performance standards cited difficulty in setting benchmarks, particularly risk-adjusted benchmarks, as the major reason for not measuring treasury performance. Empirical determinants of benchmark structures for repricing risk, refunding risk and currency risk have been identified. A better understanding of the factors that determine financial risk will assist management when they are designing or refining benchmarks to manage financial risk and measure treasury performance.
A task such as this requires much encouragement and support. Special thanks are due to Majid Makki for invaluable advice and constructive criticism with every phase of the study.
I am grateful for assistance and advice from mentors at University of Lahore.
I am indebted to my family for helping in so many ways.
To the reader (and I hope there will be some) who thinks there is nothing left to represent my efforts, let rue assure yon that this task has filled many hours of my time and I am In danger of being bereft without it! However, a doctorate is not meant to be definitive, and this thesis is certainly not the last word on corporate treasury management and performance measurement. Much work remains to be done, so let me assure the reader that the long winter hours will not be spent in idleness.
Table of Contents
Tresury Framework: Introduction
Importance of research
Significant prior research
Research approach and data collection methods
The case for multiple methods in research
Field Studies and econometrics
Limitations in econometric techniques
Potential outcomes of research and chapter overview
THE CORPORATE TREASURY FUNCTION
The treasury function and value of the firm
Theory of the firm and the corporate treasury function
Rationale for a separate corporate treasury function
Transaction cost economics and treasury structure
Governance structures and imperfect capital markets
Treasury structure and role
The location of the treasury function
Agency theory and the treasury function
Agency theory in a treasury context
Organisational objectives, treasury objectives and constraints.
Definition of Risk
Types of Risk
Mitigation Techniques of Risk Management
Definition of Performance Measurement
Financial and Non Financial Aspects of performance Measurement
Review of Articles
The unexamined life is not worth living. (Socrates in Plato Apology : 38a)
The corporate treasury function has emerged as an important part of organisational structure since the 1980s. One reason has been greater uncertainty in financial markets. The need for increased financial sophistication has created opportunities as well as threats, and provided greater scope for value adding activities through risk management and more traditional financial management functions of funding and cash management. Part I of the thesis draws upon transaction cost economics and agency theory as foundations for developing a framework to analyse the corporate treasury function and its role and structure. The nature of risk and the rationale for financial risk management and treasury performance measurement are an integral part of this framework.
Chapter 1 sets out the research problem, the motivation for the research, the methods used to research the problem, and a summary of the research questions.
Since a major element in treasury evolution and growth has been financial risk, it is important to understand the nature of risk to manage it effectively.
1.2 Importance of research
The rationale for the existence of a specialist treasury function appears to lie in its ability to add value by structuring the firm's'" financial activities to reduce the impact of financial market imperfections, such as transactions costs, differential pricing, imperfect information and economies of scale. Potential benefits achieved through cost savings and risk management need to be weighed against additional operational and overhead costs incurred as a result of setting up a separate corporate treasury function.
Analysis of treasury performance is therefore necessary to determine whether benefits exceed costs and whether resources devoted to this activity are justified in practice as well as in theory. If corporate treasuries are to function efficiently and effectively, evaluation of performance against a relevant benchmark is essential. Yet there is a conspicuous lack of guidance in the literature on treasury performance measurement and evaluation.
Significant prior research:
Prior research that exists on treasury role and function has been descriptive and anecdotal rather than analytical. Tricker (1967) observed the beginnings of a separation between the roles of financial controller and treasurer in the US in the 1960s. Collier, Cooke and Glynn (1988:190) claim the corporate treasury function evolved in the late 1970s in the UK in response to `environmental changes that have increased financial risks and made more policy options available'.
In particular, four major factors have emerged which have created greater uncertainty and complexity in financial markets and increased the need for specialist financial knowledge in the Williamson vein.
First, deregulation of financial markets from the late 1970s, including the floating of the Australian dollar in December 1983 changed the nature of opportunities and risks involved in borrowing, investing and trading offshore for Australian corporations. Low interest rates in Australia during the 1960s and early 1970s (negative real rates of interest applied in some years) were replaced by higher and more volatile rates of interest (high in real and nominal terms) in the late 1970s and 1980s. This increased the holding costs of non-interest bearing financial assets and focussed greater attention on cash flow management.
Secondly, deregulation of the financial sector in Australia created price competition between Australian banks, and the entry of foreign banks changed the nature of banking relationships. Competition between banks allowed corporations to lower their cost of funds, something they were unable to do before the abolition of interest rate controls on banks in the late 1970s and early 1980s. This increased the need for market price information, and created opportunities for exploiting information asymmetries in financial markets.
Thirdly, increased growth in eurocurrency and other secondary markets, together with financial innovation in the form of new risk management products and unproved. telecommunications technology, made these markets more accessible to Australian. corporations. Moreover, these changes occurred together with a thin (almost non-existent) corporate debt market in Australia in the early 1980s. New opportunities for raising finance offshore and techniques for covering resultant risks, occurred at a time when domestic sources of debt finance were insufficient for die needs of Australian corporations.
Finally, the globalisation of the Australian economy has meant that many Australian corporations have expanded offshore and now have an increased presence in Europe, the United States and the Pacific Basin. In this environment, corporations with an international focus found themselves compelled by new risks, which have both an upside and a downside, to pay more attention to financial risk management.
There are strong arguments to suggest the financial environment in Australia in the late 1970s and early 1980s met Williamson's decentralisation criteria of uncertainty, complexity and specialist knowledge. It can be argued that Australian corporations, faced with the problem of remaining solvent and profitable in a more uncertain and complex financial environment, recognised the need for specialist treasury expertise, so a separate treasury function emerged within organisations.
A theoretical framework for analysing the corporate treasury function and its role and structure needs to draw upon theories of the firm. The dominant theories in recent years
have been based on either a transaction based view of the firm, or a behavioural, contracting cost view, firmly grounded in agency theory. Clarke and McGuiness (1987) draw a distinction between transaction cost economics (Coase 1937), called the old theory of the firm, and agency theory (Jensen and Meckling 1976) called the new theory of the fine. Both theories prove to be useful when analysing the corporate treasury function.
Transaction costs and agency costs
Transaction cost economics and market imperfections provide a rationale for the existence of the firm. They also arguably provide a rationale for the existence of treasury specialisation. This is due to the advantages of specialisation achieved through undertaking certain financial transactions within the firm rather than through the market. Agency theory opens the black box approach assumed in the old theory. It recognises that the ability of a single decision maker is limited, and only `boundedly rational' (Simon 1957). Bounded rationality creates a limit to firm size that can be overcome by delegating specialist tasks to treasury in pursuit of stakeholder goals.
The maximisation. of shareholder wealth is generally assumed to be the primary goal pursued by firms, but Berle and Means (1932), pre-empting agency theory, note that the assumption of maximisation of shareholder wealth is unrealistic in a world where managers are not large shareholders. Whether it will be the primary objective of a separate treasury function is a matter that has its underpinning in agency theory research.
Deregulation of decision rights
While the delegation of decisions to agents may improve prospects for specialisation and create transaction cost savings, the agency relationship that will be created as a result, incurs costs of its own. Agency theory provides a framework for dealing with problems, including self interest, which occur because of the decision to decentralise decision making. Appropriate specification of specific treasury objectives and constraints, compatible with maximisation of shareholder wealth and performance measurement, are examples of issues involved when delegating authority to treasury agents.
Borland and Garvey (1994) contrast an environment characterised by costless contracting where perfect information is available concerning every transaction, with an environment of imperfect information characterised by costly contracting. The challenging task presented by agency theory is to develop the governance structure that maximises benefits of specialisation and delegation provided by transaction cost economics, yet minimises the costs and hazards arising because of agency problems. In principle, the optimum trade-off will be where marginal benefits and costs within a particular treasury governance structure intersect. Marginal benefits arise from delegation of treasury transactions. Marginal costs arise from agency problems within the treasury environment.
Financial risk management
Treasuries have evolved as managers of financial transactions and financial risk. While potential cost savings from management of financial transactions are readily apparent, and the need to hedge financial risk is often taken as given, Smith and Stulz (1985) query whether hedging adds value to the firm. In both cost and risk management, benchmarks can assist in determining whether treasury has indeed added value.
The treasury function is complex, and varies between organisations. Developing a single benchmark to capture overall performance is not feasible for many organisations. Individual benchmarks need to be developed for various treasury tasks using finance theory and financial risk models since all treasury activities involve some trade-off between risk arid expected reward. To illustrate, cash management performance requires analysis of the trade-off between idle cash and transaction costs involved in moving funds in and out of short tern investments. For example, the cost of funding requires an analysis of the tradeÂoff between higher transaction costs associated with short term debt and higher agency costs associated with long term debt. Interest rate risk management requires targeting the interest rate sensitivity of net worth or equity as both cannot be managed simultaneously. Active management of foreign exchange risk may lower costs, but will require additional resources.
Techniques widely used to deal with these problems involving financial risk, include gapping, duration, simulation and optimisation models. All have limitations and some models are more suited to managing one type of risk rather than another. Duration models may assist in developing a benchmark for measuring performance in interest rate risk management for example, but a gapping approach may be more suitable for setting up an appropriate maturity benchmark. An optimiser may be useful for establishing a currency
benchmark that takes advantage of correlations between interest rates and exchange rates, but may have limitations when applied to (say) liquidity management.
Active versus passive management:
Besides determining benchmarks for performance measurement, a decision must be made concerning whether passive or active management of treasury risks is appropriate. A passive manager will attempt to imitate a performance benchmark, but an active manager will attempt to outperform it. Simulation models may be useful for active managers who need to consider the impact of forecasts on portfolio positions.
The objective of this thesis is to improve the efficiency and effectiveness of financial. risk management. This requires analysis of the nature of the treasury function, and the construction of relevant benchmarks to measure performance in carrying out treasury tasks.
Major research questions in the area are:
What is the rationale for a separate corporate treasury function and what is its role in an organisation with predominantly physical assets (eg a manufacturing business) rather than financial assets (barks)'?
How can conflict between shareholder and other stakeholder principals and treasury
agents be resolved when managing corporate treasury operations?
Does the management of financial risk by corporate treasurers have the potential to
add value to the firm, or should this be the responsibility of individual stakeholders?
Is a finance approach or a behavioural approach more appropriate when measuring the risk-reward trade-off for the corporate treasury function?
What are the determinants of interest rate, maturity and currency risk management structures? What factors should be considered when developing benchmarks for measuring and managing these risks?
Are financial markets efficient, or are there opportunities for corporate treasurers to add value by actively managing treasury risks?
The above questions are interrelated, but to make the research effort manageable, simplifying assuumptions are made initially so that they can be examined independently.
Research approach and data collection methods:
The major research effort in this thesis is empirical rather than analytical.
The case for multiple methods in research:
Research involves a series of dilemmas that arise because it is not possible to maximise both internal and external validity simultaneously. An extreme view is taken by McGrath, Martin and Kulka (1982).
.. all research strategies and methods are seriously flawed, often with their very strengths in regard to one (niethod) .. functioning as a serious weakness in regard to other, equally important, goals. Indeed, it is not possible, in principle, to do `good' (that is methodologically sound) research. (McGrath et al:70)
The alternatives within empirical research can be classified into experimental or non-experimental and laboratory or field studies. Both experimental and non-experimental methods are used in this thesis. The experiments are carried out in the field.
Field Studies and Econometrics:
Several methods are available to research problems relevant to treasury risk management_ and performance measurement. A statistical technique commonly associated with field studies in a corporate finance context is multivariate regression. This technique measures the relationship between an independent variable and two or more explanatory variables. An advantage is that it can separate out the joint effects of several explanatory variables.
Limitations in econometric techniques:
Data are collected in the field, and random sampling is usually possible, so it performs well on both realism and generalisability criteria. It is on the criterion of control that econometrics usually falls down. Data collected in the field, or the use of existing data often collected for another purpose, cannot be used to imply a causal connection between the dependent and independent variables due to lack of control.
Experimental research on the other hand is characterised by direct control of the independent variable, so that its impact on the dependent variable can be determined.Field experiments provide greater realism than laboratory experiments, but at the expense of control over the environment.
Experimental methods are an excellent way of generating data of better quality than data currently available.
Unfortunately, any choice of method cannot maximise on both internal and external validity simultaneously (Sekaran 1992). A field experiment scores higher on realism as it collects data in a real world environment, but lacks control as it becomes a composite test of the envirorunent, institution and other variables. The trade-off here is between for data that are more realistic and therefore more externally valid, but lack of control; and more precise, internally valid data which are lacking in realism. A decision has been made to conduct experiments in the field and to control institutional factors by creating a hypothetical treasury management task to test treasurers' ability to add value through active management.
The opportunity to arrive at the same or similar conclusions by different techniques is very useful (13irnberg, Shields and Young 1.990). Since each research method has inherent strengths and weaknesses, multiple research methods should be used. If the results from one research method can be reconciled with the results from another, conclusions can be drawn with greater confidence . Alternate methods have been used to add to the body of treasury knowledge, as no single method is suitable for all aspects of treasury research.
Potential outcomes of research and chapter overview
A research effort that considers all the issues to be addressed in setting up a treasury function and determining the objectives and scope of treasury operations will provide a framework for the management of financial risk and development of appropriate performance measurement systems and techniques.
The ability to develop benchmarks that more accurately assess the performance of treasury divisions will allow the firm to operate more efficiently and effectively in managing treasury operations and facilitate more informed strategic decisions concerning treasury operations.
Chapter 2 :The corporate treasury function:
The treasury function and value of the firm:
The existence of a corporate treasury function is a relatively recent phenomenon.One view of treasury is that its raison d'etre lies in its ability to exploit market imperfections and to achieve economies of scale through pooling and managing funds in a more efficient way than would be possible if transactions were managed individually. That view however ignores the issues of why a specialised treasury function should arise in some organisations and not others.
Theory of the firm and the corporate treasury function:
Why are some business activities performed by firms rather than by individuals? The answer to this question of why firms exist, may help to explain why treasuries exist, and the characteristics that create a need for a separate treasury function in some firms and not others.
To assemble the necessary factors to produce economic goods, transactions must be undertaken in material, labour and capital markets. "These lead to revenues and costs. Perfectly competitive markets would be characterised by no taxes or transaction costs (including knowledge transfer costs). Costless information would be available to all participants, all market participants would be pricetakers, and the same price would be charged to al I parties.
Coase (1937) argued that in a perfect market, given that there were no market imperfections, individuals could use the market mechanism to coordinate resources at the same costs as a firm. Therefore, there would be no potential to add value by organising the factors of production into a corporate structure. If conditions of perfect competition operated in all markets, supernormal profits and transaction costs would be zero, despite the organisational structure used. Material, labour and capital resources would be combined with technology to produce a surplus that could be distributed to the various stakeholders at prices determined by perfect competition.
Assets, both physical and financial are required to generate the surplus for stakeholders and these assets must be financed using funds obtained as debt, equity or a hybrid' product. To generate the surplus, entities engage in managing assets and claims against those assets. A combination of physical resources, including intangible assets, with financial resources and managerial skill achieves the surplus. No bounds to managerial skill would be assumed in perfect capital and labour market. It would be independent of the organisational structure utilised to achieve the surplus. An individual, using market transactions, could combine physical and financial resources with managerial skill to achieve the same surplus as a more complex organisational structure in a perfect market. A specialised treasury structure would not be able to achieve a higher residual for equityholders.
In reality, labour and capital markets are imperfect and complex and different skills are required to manage physical and financial assets. Individuals are unable to achieve the same surplus as more complex organisational structures. Assumptions of perfect capital markets and/or economic rationality must be relaxed to determine why treasury exists.
Rationale for a separate corporate treasury function:
Under imperfect market conditions, a firm may be able to increase revenue or reduce costs through a more appropriate governance structure that includes a specialist treasury function.
Transaction cost economics and treasury structure:
The finance model used to determine value of the firm is reviewed here to show how treasury can add value. If cashflows are more than sufficient to meet stakeholders' required return, supernormal profits will be positive and the value of the firm will increase. The value of the firm depends on future as well as present cash flows from production and is often written as follows:
Where V = value of the firm
(E)NCF; = expected net cash flows (before interest and
dividends) in period i
rK = required rate of return (weighted average cost of
An examination of [2.1] reveals that savings in financial transaction costs, which increase net cash flows, are not the only influence on the value of the firm. The firm's value is determined by discounting expected future cash flows from employment of physical resources and labour, at the appropriate risk adjusted rate of return.
If financial market information gathering and dealing are centralised within treasury, this provides benefits such as opportunities for netting, and better market rates due to the increased size of deals.
Financial resource elements have been decomposed in [2.2] to identify tasks where Will iainson 's delegation criteria apply.
V T E(NCF), [2.2]
[(+ rKd)(D/K) + (1 + rKe)(E/K)]
value of the firm
cost of debt capital
proportion of debt in capital structure cost of shareholders equity capital
proportion of shareholders equity in capital structureWhere V rKd D/K rKe E/K
value of the firm
cost of debt capital
proportion of debt in capital structure cost of shareholders equity capital
proportion of shareholders equity in capital structure
Within financial resources, debt and equity capital elements differ concerning uncertainty, extent and volume. Dividends, rights issues, and other decisions about shareholders' equity are infrequent and relatively certain. Market timeliness is not a consideration. Management of equity capital requires delegation of work rather than decision making authority as the need for specialist treasury expertise is limited'. The capital structure decision, which involves the relative proportion of debt and equity capital is also not a frequent, high volume decision and is therefore unlikely to be delegated to treasury. Due to specialist financial knowledge however, the treasurer may have an advisory role and/or may be responsible for implementing decisions made by a higher authority.
Debt capital on the other hand meets the criteria of uncertainty and extent. Debt funding needs frequent and timely monitoring to manage maturity risk, interest rate risk and currency risk if both offshore and domestic debt is used to fund operations. Interest rates on debt funding are externally imposed and subject to rapid and frequent change. Williamson's delegation criteria place debt funding firmly within the ambit of treasury. Due to bounded rationality and specialist financial knowledge, debt management has a lower value in use with operating units or the board than with treasury, Uncertainty, frequency and volume criteria create a need to delegate decisions concerning debt management to the treasurer who has specific knowledge.
Expected net cashflows:
The generation of cashflows from physical resources is unlikely to be the responsibility of treasury. Operating divisions have greater knowledge of product markets (or asset specificity) in which their goods are traded and are therefore better placed to make decisions concerning (say) management of foreign exchange revenues and costs and commodity price risk for example8. However, treasury may be delegated the role of arranging transactions in financial markets, in response to risk management decisions made by an operating division. Alternatively, if there are several divisions and opportunities for pooling exist, there may be partial delegation of authority and treasury decisions may be made within certain constraints set by the board. Treasury may lack specific knowledge of product markets but their specific knowledge of financial markets may create opportunities to add value to the firm with foreign exchange cash flows as well as in the management of debt capital for example.
Working capital management involves significant cash inflows and outflows in most organisations. As this is an area that involves routine receipts from debtors and disbursements to employees, creditors, governments and other stakeholders, it does not meet the uncertainty criterion, but Williamson's extent and volume criteria would apply. There may be a role for specialist financial knowledge to improve efficiency in liquidity management through pooling transactions, but the need for sophisticated treasury analysis is limited. Treasury's role in short term cash management may involve delegation of work, rather than decision making.
The dimensions under which financial transactions differ - uncertainty, timeliness, frequency and volume - are fuzzy. When applied to determine decentralisation, they may lead to points along a spectrum, with varying degrees of delegation rather than a discrete choice between full
delegation of financial decisions or delegation of work only.
Definition of Risk:
Risk is exposure to a proposition of which one is uncertain.
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