Companies and their managements need complex financial products, but must have the ability to control them

January 2014 | EXPERT BRIEFING | RISK MANAGEMENT

financierworldwide.com

Almost all enterprises use complex financial products, for example to reduce the risk of interest and currency fluctuations. However, such products have a complex risk profile and an amount of money far greater than the initial invested capital may be lost. Medium-sized enterprises in particular face the question of how they can – or must, against the background of personal liability – control or mitigate these loss risks.

Complex financial products are often found in the form of a derivative. The best known examples in the corporate realm are currency and interest rate derivatives. Both types of derivatives are used in their simplest form to secure specific position ( e.g., a foreign-currency denominated supply obligation) or to secure portfolio risks (e.g., the risk of a change in the interest rate of a loan portfolio) through macro-hedging instruments.

Interest rate swaps frequently become part of financing transactions on request of the lender to secure against the risk of a change in the interest rate of a loan with a variable interest rate. What is often forgotten in this respect, however, is that besides the market risk, the swap entails additional risks which would not be found in a loan with a variable interest rate in this form.

The risk profile poses an even greater challenge in cases where derivatives are designed for ‘speculation’ purposes. Recent instruments include the so-called ‘Spread Ladder Constant Maturity Swaps’, with which enterprises and the public sector have bet on the difference (‘spread’) between short and long-term interest (or vice versa) profiles. The Federal Court of Justice (Bundesgerichtshof, BGH) ruled in a groundbreaking decision in 2011 that an ‘information symmetry’ has to be created between the bank and the customer within the scope of the consultancy contract. In this respect, the knowledge of the relevant specialists within the bank is imputed as ‘institutional knowledge’ of the whole bank (Wissenszurechnung).

It goes without saying that, on practical grounds alone, the bank employee handling the sale of the derivative certainly cannot provide the customer with the entire knowledge of the institute without extensive written elaboration. At best, the person will have a rough idea of the functioning of the derivative. In this connection, complex financial products and, above all, financial derivatives, entail a structural risk which arises from the interactive intensification of market and legal risks.

The market risk of a financial derivative can already only be understood if at least rough probabilities of failure can be calculated on the basis of value-at-risk models (VaR). Thus, how is it possible for a financial director or treasurer who only occasionally uses complex financial products and has never drawn up risk profiles in the trading realm of a bank to understand and monitor the risks of the product? Assuming at this point that only somewhat differentiated risk management systems – as are required at banks by the German Banking Act (Kreditwesengesetz, KWG) and on this basis by the Federal Financial Supervisory Authority’s Minimum Requirements for Risk Management (Mindestanforderungen an das Risikomanage-ment, MaRisk BA) – can mitigate the risks of complex financial products, then consequentially enterprises should likewise revert to these risk management systems when using corresponding products.

Practice has shown, however, that this is frequently not the case with medium-sized enterprises and occasionally also larger, listed enterprises. In this respect, there are some who still hold the view that stock corporations (and by analogy companies with limited liability as well) are not obliged to revert to product-specific and hence standard bank risk management systems, even in the case of risks that jeopardise the company’s existence as a going concern. However, what use is it to the director to follow this opinion and expose the enterprise to risk by referring to less convincing, legally formal argumentation? It would be better to investigate at this point whether the applicable regulations of bank supervisory law are also appropriate outside the context of the bank (which is the case if the structural risk of the financial products is at issue) and whether they are conducive to an early identification of risks (which is the case if VaR proceedings are stipulated).

In all events, a risk-conscious CFO in a board position must instruct the treasurer to implement a product-specific and bank-specific risk management system which, to the extent appropriate, can be oriented towards the MaRisk BA. Risk determination, risk control and risk inventory, as well as the personnel and operational measures securing the respective processes, are stipulated therein. It goes without saying that the personnel requirements for securing the processes, for medium-sized enterprises in particular, present significant burdens.

The special part of the MaRisk (BA) even requires, in respect of the risk of a change in the interest rates, that banks conduct a daily market-value or cash-value based risk analysis in the banking book which should also be applied for enterprises which often hold the instruments for a longer period of time.

The outlook is bleak for CFOs of medium-sized enterprises who neither can nor want to afford the organisational structures required to manage complex financial products. This is a dilemma. Without hedging the relevant positions, the CFO puts the enterprise at risk of currency and interest fluctuations, which in turn could “pose a risk to the company as a going concern” within the meaning of Sec. 91 para. 2 German Stock Corporation Act (Aktiengesetz, AktG), and with hedging, these risks could be eliminated but other, equally significant risks, could arise. A possible alternative – and this would be a new way of handling of long-term risks – could be to delegate risk management to a person who is more familiar with the details of the relevant risk management tools.

The obvious addressee would be the bank which sold the financial product. The Stock Corporation Act generally permits such a delegation; naturally only to the extent the board is informed by the service provider in such good time that it can take the measures required to mitigate the risk. In the past, it was discussed whether or not the relevant consulting agreement with the bank (Beratungsvertrag) already contains duties of the bank to inform and warn after the sale date, and such duties to inform and warn are part of the current discussion of regulations, and may be introduced into the German Securities Trading Act (Wertpapierhandelsgesetz, WpHG) in cases of structural inequality (strukturelles Ungleichgewicht) with the imminent MiFID reform and its implementation.

CFOs and officers should first of all conduct a financial review to obtain an overview of the risks. Secondly, they should approach their contractual partner and point out that possibly – and this will depend on the individual case – market observation and warning duties are already required. Thirdly, when concluding new contracts, corresponding obligations of the contractual partner should be agreed over the contractual term, irrespective of how the financial product is otherwise documented. Once corresponding contracts exist which cover all of the relevant obligations pursuant to the MaRisk BA that could structurally be applied to enterprises, CFOs will be able to sleep peacefully.

Dr Oliver Kessler is a partner at Oppenhoff & Partner. He can be contacted on +49 (0)69 707968 215 or by email: oliver.kessler@oppenhoff.eu.

Dr Oliver Kessler

Oppenhoff & Partner