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Two tangles ahead: risk management and corporate governance.

Two tangles ahead: risk management and corporate governance

In the last few years, the world's attention has sharply focused on the rapidly and utterly unpredictable pace of political change around the globe. This geopolitical evolutions for the global implications for the global economy of the 1990s, and I'm afraid these implications are not yet fully appreciated.

Lifting currency controls in Romania, granting most-favored nation trade status to the Soviet Union, extending Poland duty-free access to many U.S. markets, and increasing East/West joint ventures are just a few exampels of what I think is ahead.

To manage the challenge, financial officers and portfolio managers will need skill, knowledge, and, of course, the best available resources. And they'll need to understand what are becoming two very important areas in corporate positioning: risk management and the changing trends in corporate ownership.

Risk on the rise

It's a safe assumption that the relatively stable environment of the 1950s and '60s is gone forever. Over time, our own commercial prime rate has been a barometer for change. For instance, during the 1930s and '40s, there was a 13-year span with absolutely no change in the rate. It changed only 15 times in the entire decade of the 1960s--all from 166 on--and the total change was within a range of 3.5 percentage points. However, in the 1970s, the prime rate changed 135 times and varied as much as 1,100 basis points. Then, in less than five months in 1980, the prime soared from 10 to 21.5.

Managing an enterprise when markets undergo fluctuations as wide and as frequently as these becomes extraordinarily risky. New tools have to be invented to hedge against these risks. And the uncertainty about the future price of basic commodities, notably crude oil and certain mineals, also has led to more innovative methods for managing commodity price-related risk.

Today, more efficient risk management products are avaialable to offset a company's vulnerability to unpredictable rate prices and value fluctuations. And, in the 1990s, for managers to leave a company or a portfolio at risk would be as fool-hardy as refusing to take out fire insurance on their own homes.

This is not to say that the risk management products of a financial intermediary are essential in every case. Treasurers of large global enterprises carrying both positive and negative exposure in a variety of currencies sometimes can engineer their own internal hedges. But even large multinationals with internal hedging strategies find it prudent to cover occasional unbalanced exposures with swaps and other techniques.

Fiduciaries and companies with more limited portfolios and those who tap capital and currency markets only occasionally have a correspondingly greater need to hedge their exposures.

New and improved

Most of you are familiar with conventional risk management products such as swaps, caps, and options. Some of you may also be using the next generation of derivative products: captions, which are options to buy or sell a cap, and swaptions, which are options to enter into or terminate a swap. The accounting for these products is esoteric.

Demand for the full range of these risk management products is growing. The market and interest rate and the currency swaps had outstandings estimated to surpass $1 trillion at the end of 1989.

Currency swaps are also growing rapidly as issuers and investors increasingly tap world markets. Cross-border security transactions increased at 43 percent compound annual rate throughout the 1980s and exceeded $4 trillion last year.

The commodities swap market is a much more recent development. We covered 60 million barrels of oil outside the U.S. last year with such transactions and have now received the necessary regulatory approvals to extend this to the domestic market as well. We're experimenting right now with the futures market for pulp.

The development of complex, custom-tailored variations on these products is limited only by the needs of customers--and the imagination of frisk management experts. One of Chase's people, for example, conceived the complex Malaysian bond issue hedge after being jolted from a deep sleep. He awoke with the unique concept for an off balance sheet dual currency swap option with a below-market interest discount rate known as a flexi-hedfge. The instrument allowed the Malaysian borrower to pay out the bond in two currencies--Swiss franc and U.S. dollar--at interest rates significantly below the Malaysian market.

I think a deal like this illustrates that risk management products do more than mitigate vulnerabilities to currency values and other factors. Risk management products allow borrowers to leverage lower funding costs in other countries and allow investors to increase the diversification of their portfolios with high potential equity holdings in countries worldwide.

To be sure, investors will be seeking these products in growing numbers. More and more, sophisticated clients with surplus funds are expecting financial transactions to accommodate their specific needs. This often requires an intermediary to execute two countervailing contracts customized fto the needs of both parties. I see this trend intensifying.

Asset management will increasingly demand the same level of financial engineering that corporations have used to manage their liability. And risk management products will play a fundamental role in this process.

No excuses

I'm fairly confident that in the 1990s it will become unacceptable for financial officers and portfolio managers to report to their clients or shareholders that their profits might have been better if not for unexpected changes in interest rates or currency values or commodity prices.

All financial risks that can be managed will have to be managed. In many ways, the growing array of risk management products is presaging the growth of a global mentality as opposed to an international mentality.

In crossing borders as we conduct business, we encounter differences in interest rates, currency rates, tax rates, and commodity prices. Global risk management is the key to moving from international financial management to global financial management for both issuers and investors of financial instruments.

Just as risk and volatility have grown, the sources and nature of these risks have shifted dramatically. As recently as the 1970s, Europeans and Asians paid as much attention to U.S. economic indicators, such as inflation and GNP, as they did to their own. They had no choice but to closely follow us.

As the dominant world economy, the U.S. was providing capital by investing in and building plant and equipment on a global scale. The sheer magnitude of the U.S. role could not be ignored overseas.

Today, we are increasingly feeling the consequences of the massive U.S. budget and trade deficit. Our share of world trade has declined. And we have become more dependent on foreign goods and foreign capital to finance our budget deficit. Where once U.S. interest rate moves were reprobated in other markets, now we find our rates responding to actions in Japan and in Europe.

Today, an economic event in Tokyo, Frankfurt, even Brazilia might lead to a factory closing or opening in rural Arkansas. Our monetary and our fiscal policies must give careful consideration to overseas forces.

Unfortunately, I fear the U.S. has lost some control of its own economic destiny. While Americans may lament this, as financial professionals we must pay significantly more attention to a much wider arena as we anticipate and manage risks in our environment.

New owners in

Corporate America

The question of who owns U.S. corporations has become more controversial of late. Some of us have gone so far as to suggest that the traditional publicly held corporation owned by its shareholders and governed by managers accountable to independent directors is becoming obsolete.

People point out that, while the total markety value of equity in publicly held companies and publicly traded companies had tripled in the past decade alone, the share of new capital that's been derived from the private placement of instruments has multiplied tenfold. Individual stockholders today not only have failed to participate in the market's growth but they have been net sellers.

During the second half of the decade, individuals disposed of more than half a trillion dollars in value of common stock, nearly 40 percent of their holdings. Most of these shares were bought by corporations to leverage buyouts, mergers, acquisitions, and takeovers, or to marshal defenses against some of these. Pension funds,. including corporate pension funds administered by investment managers or trustees, are the largest and the fastest growing group of shareholders today. They effectively own about two-thirds of the outstanding shares of the S&P 500 companies.

Now, it's not my intention to question the merits of this trend, but I do think we should understand what is causing it and what it implies for corporate management and capital markets in the future.

The traditional form of corporate governance, in which outside directors represent the collective values of rather faceless shareholders and oversee top management, is thought by some to be too unwielding, inefficient, and vulnerable for today's highly competitive environment. Although individual shareholder owners and corporate managers have not always had identical priorities, they have coexisted through a kind of creative tension in which shareholders urge their views on management for the most part through outside directors or proxy voting and occasional letter campaigns.

Enlightened managers responded prudently to shareholder concerns in order to maintain access to an important and inexpensive source of capital. But accommodating shareholder views rarely involves the basic management of the enterprise.

However, as the volume of shares held by individuals declined and the percentage held by institutions and professional money managers has increased, the opportunity to vote large blocks of shares has changed all that. Whether objecting to apartheid in South Africa, hiring practices, or inadequate environmental controls, these new owner surrogates no longer hesitate to lecture company managers on how and where to conduct their business.

LAte last year, the Fidelity Funds, one of the most powerful institutional investors, openly directed its portfolio managers to become far more active in voicing their opinions on management strategies and performance. But what does that imply for corporate management and capital markets in the future?

Trustees of public pension funds have begun using their equity leverage to affect the most fundamental changes in corporate governance, including the composition of boards of directors.

LAst year, after discussing environmental concerns with representatives of New York City's five pension systems and other pension funds, the Exxon Corporation created a new board committee to review the full range of public issues and added a director with a background in environmental matters.

Earlier this year, trustees of two of the nation's largest pension funds informed the General Motores Corporation that they expect to participate in naming the next CEO and to be consluted in formulating policies and objectives of the new management.

Many corporate managers view such direct involvement in corporate governance as mischievous meddling. But trustees of the largest public pension funds, with holdings too extensive to be easily disposed of without cratering markets, feel that they have no other way to express dissatisfaction with management than by using their voting clout.

The growing concentration of shares held by various institutional money managers has also raised concerns over excessive emphasis on short-term profitability. In the late 1970s, barely one-fourth of the shares of the New York Stock Exchange turned over in a year. Now that institutions have increased their holdings, closer to three-fourths are traded every year. This constant shifting among stocks by institutional investors seeking to maximize immediate returns has compelled many companies to refocus their s trategies even more on short-term performance. This impairs their ability to plan and invest for the future. Without adequate spending on research and long-term capital improvements, our U.S. companies cannot prosper in highly competitive global markets.

One way that has been proposed for U.S. corporations to resist the increasing activism of public pension fund trustees and lengthen the short-term horizon of institutional money managers is for corporate pension plan sponsors to take back from trustees the proxy-voting function they now exercise over corporate pension plan assets in their funds.

This would require certain disentangling of assets and comingled index funds. It would also require corporate plan sponsors to coordinate their efforts in much the same way that public pension funds organzied the Council of Institutional Investors in 1985 to focus their activities in the corporate governance area.

Personally, I feel a little schizophrenic about this proposal because my company is also an institutional money manager. We, too, have clients who want to maximize short-term profitability or voice their views on our fiduciary responsibilities. And we convey those urgings to the companies whose shares we happen to hold.

The challenge is to find an appropriate balance betwee near term and long term and between consructive and intrusive involement in corporate governance. A prudent company manager has to resist the templation to overreach for goals that exceed reasonable expectations.

Proceed with caution

Of course, of all the factors causing corporate managers to focus on short-term time horizons, foremost continues to be the hostile takeover. Corporations are seeking answers to not only the threat of takeovers but all the dilemmas the new corporate ownership climate creates. Many have instituted employee stock ownership plans, or ESOPs. Giving workers an equity stake in their company not only puts stock in "friendly" hands for the moment but it also tends to demonstrate increases in productivity near term.

However, companies that are majority-owned by employees must continue to guard against one significant downside risk: a tendency to become much too internally oriented.

Competitiveness by definition requires continuous awareness of subtle market shifts and receptivity to innovative thinking from all sources, both within and outside the company. Tough but necessary management decisions such as closing down an obsolete plant or eliminating an unprofitable product line are more difficult when it means that the owners themselves might suffer.

Frankly, a disturbing aspect of the fundamental changes in corporate ownership is the accompanying trend for corporate balance sheets to show far less equity and much greater dependence on debt. Some of the excesses that accompanied the move toward highly leveraged corporate buyouts, takeovers, and acquisitions are leaving far too many balance sheets very unbalanced.

Nonfinancial corporations have been shedding equity at a rapid rate since the early 1980s. In 1988 alone, U.S. firms dropped in equity accounts more than $130 billion. At the same time, corporate debt has been rising steadily, actually doubling, since 1983 to more than $2 trillion today in nonfinance company corporate debt.

The fact is that excessive debt often has a steep and very slippery downside. I suppose if one looks at the massive debt financing that passes for fiscal management in Washington, corporate debt doesn't look to ominous. The Federal government, for all its balance and payment deficits, trade deficits, off-book expenditures, and the annual smoke-and-mirrors budget exercise, is not going to file for bankruptcy. But it certainly sets a bad example for overleveraged companies that may.

As a banker, I would be one of the last people to argue that leveraged transactions are bad for companies and bad for the economy. I think many companies have thrived with higher debt loads. Some have actually reduced their leverage and debt successfully through asset sales, retained earnings, and new equity issues.

Whatever the future of leveraged transactions, corporations are quite unlikely to return to the low debt ratios of the '60s and '70s that were in large part a psychological outgrowth of the Depression. That alone might be sufficient reason to pay careful attention as we enter the uncertain economic climate of the 1990s.

It's too early to weigh the ultimate impact of these trends in corporate ownership in terms of our capital markets and our corporate competitiveness. We need to watch the developments carefully and continue to evaluate them. More of them represent threats, I think, than opportunities.

In the last few years, we've developed some wonderful, effective risk management tools to offset dangers from falling oil prices to rising interest rates. But dangers to our corporation's ownership and to our company's long-standing competitiveness aren't easily intermediated. It's probably what will make our jobs a little more fun in the 1990s.
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Author:Boyle, Richard J.
Publication:Financial Executive
Date:Jul 1, 1990
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