Introduction to Treasury Management: Unveiling the Liability Benchmark Framework
Introduction
Treasury management is a fundamental function within any organization, pivotal in managing the evolving net cash surplus or deficit resulting from the organization's financing activities. This article explores the core concepts of treasury management, focusing on the Liability Benchmark Framework, its application, and its role in supporting Treasury Management Practices (TMPs).
What is Treasury Management?
Treasury management involves using financial instruments to manage the evolving net cash surplus or deficit arising from an organization’s financing activities. It is crucial for effectively controlling associated risks. It's important to understand that the evolution of this surplus or deficit is determined outside the treasury function. The treasury team's role is to manage these risks and optimize performance within this framework.
Statement of Accounts vs. Treasury Balance Sheet
A key concept in treasury management is differentiating between the Statement of Accounts and the Treasury Balance Sheet. The Treasury Balance Sheet is a reorganization of the Statement of Accounts’ balance sheet. Every item in the Statement of Accounts is included in the Treasury Balance Sheet, but the layout is designed to aid the treasury team by reconciling to the net treasury position and easily identifying any balances capable of projection.
Introducing the Liability Benchmark
The Liability Benchmark (LB) framework is a structured approach to treasury management. It captures all elements of the balance sheet and presents them through a treasury management lens. This framework is not about using judgment to include or exclude specific reserves; it's about capturing everything and presenting it to reflect the net treasury position.
Application of the Liability Benchmark
Projecting Balance Sheet Elements
Once the balance sheet is re-balanced, each element needs to be projected to inform how the net treasury position will evolve. All non-treasury balance sheet items are reflected somewhere, with any unallocated balance assumed to remain flat. These projections should be maintained outside the treasury team to ensure objectivity.
Organizational Projections
Accurately reflecting the projections of the Capital Financing Requirement (CFR) involves identifying individual components and grouping them based on Minimum Revenue Provision (MRP) characteristics. This process includes the year of spend, the year MRP starts, the MRP basis, and the duration and rate where appropriate.
Minimum Liquidity and Other Assumptions
Essential inputs such as minimum liquidity, HRA pooling approach, pooled fund risk, and fixed/floating rate assumptions drive the benchmark for treasury purposes. Minimum liquidity refers to the amount of liquid investments sufficient to meet typical cash flow needs. The approach to HRA pooling determines whether housing authorities consolidate treasury positions or maintain separate HRA loan portfolios. Pooled fund risk considers whether allocations to pooled funds are liquid and can be sold to meet future cash flow requirements.
The Liability Benchmark Framework
The Liability Benchmark framework provides a structured and risk-managed approach to determining the optimum external loan profile. It aims to minimize gross balances by setting the optimum lowest risk profile for external loans. The framework includes the following components:
- Liability Benchmark (LB): Determines the optimum (least risky) loan profile and informs the borrowing strategy.
- Investment Benchmark: Targets the optimum investment balance, determining whether the organization is a long-term investor or if the investment balance is for managing liquidity.
By comparing existing loan commitments to the benchmark, under or over positions are identified. This helps in making informed borrowing decisions to meet the benchmark without exceeding it.
Borrowing Strategies and Interest Rate Views
A key aspect of borrowing strategies is understanding that risk comes from the uncertainty of future borrowing rates. The treasury team’s role is to manage this risk by reducing uncertainty, not by taking a view on where interest rates might go. Historical data shows that setting strategies based on interest rate forecasts can be risky, emphasizing the importance of the Liability Benchmark in informing borrowing strategies.
Revenue Impact and Risk Management
The Liability Benchmark framework helps quantify the uncertainty of rates, allowing authorities to understand their exposure to borrowing rate risks. This is particularly important for managing the net interest cost projections, which are crucial for financial planning. The framework provides the basis for determining actions required to optimize the loan profile and manage interest rate risks effectively.
Governance and Treasury Management Practices
The Liability Benchmark framework supports various Treasury Management Practices (TMPs), ensuring governance, transparency, and risk management across the organization. Key TMPs include:
- Credit & Counterparty Risk (TMP1): Focuses on reducing investment balances to minimize credit risk.
- Liquidity Risk Management (TMP1): Ensures adequate but not excessive liquidity balances.
- Interest Rate Risk Management (TMP1): Puts interest rate risk at the heart of decision-making.
- Refinancing Risk Management (TMP1): Determines the need for refinancing based on the optimum borrowing level.
- Price Risk Management (TMP1): Evaluates the appropriateness of exposing the organization to price risks.
Performance Measurement
Effective treasury management decisions are measured by the level of gross loans and investment balances. The Liability Benchmark framework provides the basis for relevant performance measurement by calculating the net debt rate or net surplus yield. This helps determine whether excess investments are a drag on performance and ensures that the treasury team is managing the net debt/surplus effectively.
Decision Making and Analysis
The framework enables objective decision-making by providing a benchmark to measure against. Key treasury decisions such as new borrowing, repayment, and investment purchases are considered within the context of risk. The Liability Benchmark framework helps determine the appropriate instruments to meet borrowing and investment objectives, encouraging organizational clarity and segregation of responsibilities.
Reporting and Management Information Requirements
New Code requirements emphasize the importance of prudential indicators in quarterly monitoring. The Liability Benchmark framework ensures that organizational projections are updated to reflect evolving corporate expectations, facilitating objective periodic monitoring against the set position.
Training and Qualifications
Professional treasury teams need the right knowledge and tools to manage the net surplus/deficit effectively. The Liability Benchmark framework empowers the treasury team to develop a better understanding of key treasury risk exposures and determine necessary actions with less dependency on external advisors.
Corporate Governance
The framework delivers transparency, integrity, and accountability to the treasury function by reducing reliance on third-party advisors. It ensures that strategic decisions are made based on corporate plans and that the treasury team engages with the wider organization to maintain accurate projections.
Conclusion
The Liability Benchmark framework is a comprehensive approach to treasury management, providing structure, risk management principles, and governance support. By focusing on minimizing gross balances and optimizing the loan and investment profiles, organizations can manage their net cash positions more effectively, ensuring long-term financial stability and resilience. The framework is endorsed by CIPFA and aligns with the spirit of the CIPFA Code, aiming to save the sector money and reduce risk.