Morgan Stanley Roundtable on

Enterprise Risk Management and Corporate Strategy

New York City | June 21, 2005*
Photographs by Yvonne Gunner, New York

32 Journal of Applied Corporate Finance • Volume 17 Number 3 A Morgan Stanley Publication • Summer 2005
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John McCormack: Good morning and, persuade Moody’s or S&P to reaffirm or reality of the hedge. Will this approach
on behalf of the joint sponsors of this even raise a company’s credit rating. Both work, and can it be done without running
event—Morgan Stanley and the Commit- of these arguments suggest that risk man- afoul of Sarbanes Oxley?
tee of Chief Risk Officers, or “CCRO” agement may improve a company’s access To discuss these issues, we have assem-
for short—let me welcome you all to this to capital and reduce its cost of capital. bled a distinguished group that includes
discussion of corporate risk management. What risks are companies paid to bear? A three former academics—all of whom are
I’m John McCormack, I work in equity number of academics have used a concept now working in the private sector—as
research here at Morgan Stanley, and I will called “comparative advantage in risk- well as a number of corporate practitio-
be serving as moderator. bearing” to justify corporate decisions to ners. And let me start by telling you a
Our topic is the potential role of deriv- transfer certain risks while retaining oth- little about each of our panelists.
atives and risk management in increasing ers. To what extent can this principle be Charles Smithson is the founder and
the long-run profitability and value of used to guide corporate risk management principal owner of Rutter Associates, a risk
companies. Our main focus will be on decisions? For example, should oil com- management consulting firm that special-
the energy and financial service sectors, panies hedge much of their oil price risk, izes in measuring and managing credit
where the uses of derivatives and risk or banks hedge their interest rate risk— and market risks for financial institutions.
management are probably easiest to see. or should such risks be borne mainly by Prior to starting his firm in 1999, Charles
And to the extent we can come up with a the firms’ shareholders? Can energy and spent 15 years doing internal and exter-
persuasive explanation for how risk man- financial firms use the information pro- nal risk management consulting at Chase
agement adds value in these companies, vided by their operations to make their Manhattan Bank, Continental Bank, and
we can try to extend the framework to trading operations a reliable source of CIBC. Charles earned his Ph.D. at Tulane
other industries. profit? This is something the majors now and, before coming to New York in 1985,
Here are some of the questions that appear to be doing and that many finan- served on the economics faculty of Texas
we will address: cial institutions seem to do with their A&M University.
What are the primary goals of corporate “carry trade.” Tom Copeland has far too long a
risk management programs? Should such What should companies tell investors resume for me to even summarize here,
programs be designed mainly to reduce about their risk management programs? so I will just tell you that he has been
volatility in reported earnings, or are there To get recognition from the equity mar- Head of the Finance Department at
other aims that translate more directly kets—say, in the form of a higher P/E UCLA, Partner and Head of the Finance
into adding value for shareholders? For multiple—for having an effective risk practice at McKinsey, and Managing
example, academics like René Stulz have management program, companies may Director of Corporate Finance at Moni-
argued that risk management should need to find a way to communicate at tor Group, the well-known strategy
ignore modest swings in earnings and least their general risk management policy consulting firm. At present, he is a con-
cash flow while functioning mainly as a to their shareholders. But this has all been sulting director at Charles River Associates
kind of catastrophic insurance policy that complicated by FAS 133, which many and senior lecturer at MIT’s Sloan School
eliminates disastrous, “lower-tail” out- claim has made it impossible to hedge of Management.
comes. In a somewhat related argument, real economic exposures without caus- Harry Koppel is head of Corporate
Bob Anderson, who is Executive Director ing significant earnings volatility. Is this Risk Management at BP Finance and also
of the Committee of Chief Risk Officers a problem—and, if so, how do compa- carries the title BP Distinguished Advisor
and here with us today, has said that one nies deal with it? One recommendation on Risk. He is responsible for monitor-
good indication of an effective risk man- is to make economically sensible hedging ing BP’s global exposure to financial risks
agement program is its ability to help decisions and then report two earnings and, where appropriate, for designing and
* This is an edited transcript of the June 21, 2005 discus-
numbers, one that complies with GAAP implementing hedge strategies. He also
sion, with some material added subsequently. and another that reflects the economic looks after the Group’s portfolio of mar-

Journal of Applied Corporate Finance • Volume 17 Number 3 A Morgan Stanley Publication • Summer 2005 33
ROUN DTAB LE

ketable holdings. Harry has been with BP Prior to taking on that job, Bob was Chief Modigliani and Miller published their
since 1987, when he completed a research Risk Officer at El Paso Energy, where he pioneering paper on capital structure
fellowship at Imperial College in London. helped the company work its way out of back in 1958. The general assumption
He also has an extensive operational back- financial distress. among most finance theorists in the wake
ground, having earned degrees in Systems John Kapitan, until quite recently, was of M&M has been that risk management
Engineering and Operations Research at a Managing Director at ERisk, a consult- transactions entered into at competitive
universities in his native Colombia and ing firm that focuses on risk management market prices are at best “value neu-
later in the Netherlands. and the measurement and management tral.” And to the extent companies incur
Joe Sullivan, besides being a for- of economic capital at financial institu- transactions costs in attempting to hedge
mer derivatives professional like me, is tions. Prior to joining ERisk, John was a corporate risks, the whole process was even
Vice President and Treasurer of Airgas, colleague of mine at the consulting firm suspected to be value-reducing. Today
a distributor of industrial, specialty, Stern Stewart, where he was co-head of its there are clearly lots of successful enter-
and medical gases and related products. financial institutions practice. prises with risk management programs
Prior to joining Airgas in 1998, Joe was Trevor Harris is a Managing Director at that make at least some use of deriva-
Assistant Treasurer at Thomas & Betts Morgan Stanley and, until recently, served tives and other risk management tools. In
Corporation, a manufacturer of electri- as head of the equity research group that this sense, risk management has passed
cal and electronic equipment. At other I work in—namely, the global valuation the “market test” with flying colors. But
points in his career, Joe has been Direc- and accounting group. Before coming to the question that finance theorists have
tor of Corporate Finance at Scott Paper Morgan Stanley in 1999, Trevor was a ten- struggled with is this: In a world where
Company and a Cash and Securities ured professor of accounting at Columbia shareholders can readily diversify away
Manager at BT Futures Corp, a division University’s Graduate Business School. many of the risks faced by companies,
of Bankers Trust, where he first gained And, finally, my co-moderator in such as commodity and interest rate and
experience with derivatives. this discussion is Don Chew, editor of FX risks, how does risk management by
Andrew Sunderman is Chief Risk the Journal of Applied Corporate Finance. the corporation add value?
Officer of The Williams Companies, a Before coming to Morgan Stanley last And with that, let’s turn to Charles
company he joined in 1999. Both before year, Don was a partner of Stern Stewart Smithson. Charles, what is the latest aca-
and since joining Williams, Andrew has for 22 years—in fact, one of the founding demic thinking on how risk management
had extensive experience in trading energy partners. adds value?
derivatives. And as he will tell us, risk
management and the use of derivatives How Does Risk Management Charles Smithson: Thanks for your
recently played a critical role in moving Add Value? generous introduction, John. What you
Williams out of the financially distressed McCormack: Today’s topic—the relation- didn’t mention, though, is that my Ph.D.
condition it faced as little as three years ship between risk management, corporate is in economics, not in finance. It was
ago. Thanks in part to a carefully designed strategy, and shareholder value—is some- only after I joined The Chase Manhat-
and well executed risk management pro- thing I started thinking about when tan Bank in the mid-1980s that I began
gram, the company today has achieved working as a derivatives trader at UBS in thinking about financial economics—and
considerable respect on Wall Street. the 1980s. And it was something I was about derivatives and risk management
Bob Anderson, as I mentioned earlier, forced to think a lot harder about when in particular.
is Executive Director of the Committee running Stern Stewart’s energy consulting When I was teaching economics at
of Chief Risk Officers, a group of cor- practice in the ’90s. Texas A&M, my world view was the
porate executives whose purpose is to The relationship between risk manage- “deterministic” one that was the norm
bring companies together to share best ment and value has been a controversial for microeconomists at the time. By that,
practices in corporate risk management. subject in the finance literature ever since I mean that my focus was on expected

34 Journal of Applied Corporate Finance • Volume 17 Number 3 A Morgan Stanley Publication • Summer 2005
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If derivatives and risk management are going

to create value, they will do it in one of three
ways. Either they reduce taxes for the firm
and its shareholders—or they reduce reorga-
nization or bankruptcy costs—or they help
a company carry out its investment policy.
Of these three reasons to manage risk,
the one I seem to encounter most often is
the role of risk management in helping the
company carry out its investment policy,
its strategic plan.

Charles Smithson

outcomes, and I didn’t pay much atten- fied portfolios has the effect of reducing policies should not affect the total value of
tion to the distributions of outcomes. So the corporate cost of capital to the point the firm, or the value of its debt plus its
when I discovered that these new finan- where, at least according to the CAPM, equity. And the same is true of risk man-
cial instruments could be used to reduce the only risk that investors need to be agement at the corporate level. Like capital
the variance of corporate earnings and paid to bear is so-called “market” risk. structure and dividend choices, risk man-
cash flows, my immediate reaction was, That is, a stock’s market risk, or its beta, agement decisions are just different ways
“The job of our salespeople should be is all the investors care about when setting of dividing up the firm’s operating cash
easy—all companies are going to want the stock’s required rate of return. And flows and repackaging them for inves-
these things.” so, armed with this information, my new tors. And in well-functioning markets,
When I started exploring financial position on derivatives was the reverse of this repackaging function should not add
economics, I was fortunate to have as my previous one: “Given the ability of significant value because investors can do
my guide Professor Cliff Smith, who shareholders to hold well-diversified port- most of this repackaging on their own.
was at the time a consultant to Chase. folios, no publicly traded company will So, how then does risk management
Cliff responded to my enthusiasm about want to use these derivatives.” add value? As Cliff likes to put it, the
derivatives by giving me a reading list At that point Cliff gave me another way to answer this question is to turn the
that included articles on Modern Portfo- reading list—this one dealing with the M&M proposition upside down. That is,
lio Theory (MPT) and the Capital Asset M&M irrelevance propositions that John if risk management is capable of adding
Pricing Model (CAPM). The basic mes- mentioned earlier. The basic message of material value, it will do so in one of only
sage of MPT and CAPM is that the stock M&M is that, if three conditions hold— three ways: (1) by reducing the total taxes
market itself is an incredibly powerful (1) no taxes, (2) no transactions costs, and paid by the company or its investors; (2)
and effective risk management device. (3) fixed corporate investment policy—a by reducing “transactions costs,” includ-
The ability of investors to hold diversi- company’s capital structure and dividend ing the costs of reorganizing troubled

Journal of Applied Corporate Finance • Volume 17 Number 3 A Morgan Stanley Publication • Summer 2005 35
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companies and the “information” costs oil, charging a fee for processing it, and P/E multiple to a more stable earnings
faced by investors in learning about com- then giving it back to them for sale to the stream.
panies; and (3) by helping to ensure that end customer. Our analysis showed that Trevor, as a former academic and as
management follows the classic NPV rule about a third of the firm’s customers were the representative of the accounting pro-
and invests in all projects that are expected not profitable because they didn’t deliver fession at this table, would you comment
to earn at least the cost of capital. the oil on time and they tended to be late on the interaction between risk manage-
And this leads to my bottom line: If in paying as well. So we recommended ment and earnings volatility?
these derivatives—which have zero or even that the firm experiment with a new busi-
slightly negative net present values at origi- ness model: drop the bad customers and, Trevor Harris: In discussions with many
nation—are going to create value, they are to maintain the current scale of the refin- of my colleagues at Morgan Stanley and
going to do so in one of these three ways. ing process, replace those customers by its clients, I typically emphasize the limi-
Either they reduce taxes for the firm and purchasing oil directly in the spot market, tations of reported earnings and other
its shareholders—or they reduce reorgani- putting it through the refinery, and then accounting numbers. And in the past few
zation or bankruptcy costs—or they help selling the refined oil products. years, I’ve spent a good deal of my time
a company carry out its investment policy. The problem with this approach, trying to come up with adjustments to
Of these three reasons to manage risk, the however, is that refining takes about two financial statements that are designed to
one I seem to encounter most often is the or three weeks, which means that there’s produce something closer to what I like
role of risk management in helping the some oil price risk in this model. On to call “sustainable earnings.” But, in this
company carry out its investment policy, first hearing our proposal, the company discussion, where everybody is aware of
its strategic plan. In fact, this role is some- decided it was unwilling to take that risk the problems with accounting, I think
thing that Harry Koppel and I have talked and would prefer to keep the bad custom- my most constructive role is to start by
about at length in the context of BP—but ers. To address this problem, we formed a making the positive case for earnings, by
I’ll stop here and leave that to Harry. hedge portfolio of futures contracts one stressing the importance of the informa-
or two months out in crude oil and heat- tion that accounting provides.
McCormack: Before we turn to Harry ing oil and gasoline. And by reducing Some proponents of efficient mar-
and the other practitioners here, let’s hear the price variability by about 80%, our kets have argued that accounting or
briefly from the other two former academ- hedging program allowed the company to measurement systems should just “let
ics in our midst, Tom Copeland and Trevor shed its bad customers and process the oil the volatility happen, and the market
Harris. Tom, do you want to add anything themselves. will figure it out.” But I think there are
to what Charles has just told us? So, here’s a case where, as Charles was a couple of flaws in that argument, or
suggesting, risk management was used to at least a couple of good reasons to care
Tom Copeland: I agree with Charles that support a company’s key investment and about earnings volatility.
probably the most important function operating decisions. It allowed manage- For years now, academics in finance
of risk management is to help ensure a ment to pursue the value-maximizing and accounting have been devoting more
company’s ability to carry out its business strategy. attention to what they call “informa-
plan. And I can even think of an example tion asymmetries”—to the differences
where hedging with derivatives enabled a Why Earnings Might Matter between what management and outside
company to make a critical change in its McCormack: Although academics typi- investors know about the firm’s prospects
business model. cally dismiss the idea, people often tell for growth and profitability. And the
Years ago I was working with a large, me that a primary goal of corporate risk longer I’ve worked on Wall Street, the
privately owned oil refinery in the Medi- management programs is to smooth clearer it has become to me that inves-
terranean. The company was essentially reported earnings. The basic idea is that tors face major obstacles and significant
a tolling operation, taking other people’s the market is willing to assign a higher costs in finding out how businesses are

36 Journal of Applied Corporate Finance • Volume 17 Number 3 A Morgan Stanley Publication • Summer 2005
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In order to make decisions to retain or lay off

risks, companies need an in-depth understanding
of all their major risks and how those risks cor-
relate with each other. And if the company does
choose to manage its exposures with derivatives
or some other means, it needs to find a way to
show the market that its program is working the
way it’s supposed to. At present, outside inves-
tors cannot find that kind of information in GAAP
financial statements—nor do I believe that most
companies have a complete and comprehensive
enough understanding of their exposures to
always make the best decisions.

But, with today’s computing power, we expect

in the next five years to see some significant ad-
vances in the analysis of corporate risk exposures
and in companies’ ability to provide information
about their exposures. Part of the impetus for
such changes is coming from a relatively new
development in the investment community: the
proliferation of hedge funds that manage the risk
of their portfolios very differently.

Trevor Harris
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currently performing and how they are major risks and how those risks correlate little that companies do that doesn’t have
expected to perform in the future. with each other. Having reached that at least some speculative component. For
For better or worse, the information understanding, they then have to decide example, even in the case of Tom’s toll-
provided in financial statements is the whether the remaining exposures should ing operation, the company’s decision to
primary initial source of information that be managed, or are better left to the share- purchase oil at any given point in time
investors look at when pricing stocks. I’m holders. And if the company does choose involves a kind of speculation as to what
not saying it’s the only source, but I would to manage its exposures with derivatives the market for the refined product is going
argue that a firm’s financial statements are or some other means, it needs to find a to be a few weeks or months later. And
an important and even an essential source way to show the market that the pro- in fact this is true of any business: Com-
of information. gram is working the way it’s supposed to. panies that buy inventory in advance of
First of all, if you go way back to the And this is where I think that managing doing something with it could be viewed
basics, the reason accrual accounting earnings volatility can play at least some as hedging, as “locking in” the cost of a
exists is to smooth out the part of vola- role. As John suggested earlier, eliminat- key input. But by choosing to lock in
tility in cash flow that does not reflect ing all volatility in earnings is clearly not that cost today, as opposed to two days
what is expected to happen going for- the most important role of corporate risk ago or two days later, they are also making
ward. In this sense, accrual accounting management. But corporate risk officers a modest speculative bet about what they
allows investors to apply price-earnings should at least consider the effects of their expect prices and sales to do over some
multiples to some measure of a compa- decisions on earnings. interval of time.
ny’s earnings power. So the whole notion This is by no means a simple task— So my view is that the whole notion
of an accrual accounting system, which and, as I’m sure we’ll hear today, recent of trying to define what’s speculative and
has actually stood the market test over a trends in accounting have not made it what’s a hedge is almost beside the point.
long period of time, suggests that pure any easier. As accountants and regula- You will never be able to define “hedging”
cash flow measures of performance can tors in the U.S. and Europe have moved in a way that is transparent and mean-
be highly misleading—in fact, far more closer to a mark-to-market or fair value ingful. For this reason, corporate risk
misleading than earnings. approach, a major difficulty now facing management to my mind is really more
A second reason there may be some the investment community—and I work about thinking through these informa-
value to what many people call “earnings a lot with our analysts and institutional tion asymmetries and determining who
smoothing” has to do with the informa- clients on this issue—is how to interpret has the greatest comparative advantage in
tion asymmetries I mentioned earlier and the earnings volatility that results from managing a given risk.
the costs associated with providing inves- marking derivatives positions to market The last point I would make is that, as
tors with credible information. In a world when trying to project future earnings we look forward, we expect to see some
where information is costly, I would argue streams. Thanks to FAS 133 and IAS 39, significant developments in the analy-
that managing some risks at the corpo- analysts and investors now have infor- sis of corporate risk exposures. At the
rate level can serve to increase the value mation about the market values of those moment, as I suggested, outside investors
of the firm simply by reassuring investors derivatives positions. But the challenge is don’t have the ability to process all the
who don’t have sufficient information to use this information to estimate some information. But, with today’s computing
to manage those risks themselves. In his kind of forward-looking “normalized” power, we expect to see a completely dif-
opening comments, John raised the ques- earnings that can serve as a basis for valu- ferent environment five years from now.
tion of whether companies should retain ing the company. My expectation is that we are going to see
or lay off their commodity price risk or And that brings me to my next point: rapid evolution of risk management prac-
their foreign exchange risk. But in order the difficulty, and perhaps the futility, of tices with increases in companies’ ability
to make those decisions, companies need trying to distinguish between hedging to provide information about their expo-
an in-depth understanding of all their and speculative transactions. There’s very sures. And part of the impetus for such

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A company’s business strategy and its operations

are the engine that drives its value. And that
value comes from taking risks and choosing risks
wisely—from taking risks where there is a compar-
ative advantage. Once you understand the potential
risks associated with major investment decisions,
there are a number of choices. You can simply
retain the risk and leave it as is, or you can man-
age the risk by taking certain operating measures,
or you can transfer the risk to another party—say,
by using insurance or derivatives contracts. This
transfer of risk, or “hedging,” is a relatively small
part of the overall risk management process. The
first thing to keep in mind when making these deci-
sions is that where there is no risk-taking, there
is no possibility for above-normal returns and there-
fore no value added.

Harry Koppel

changes is coming from a relatively new risk management and the idea of com- based on the insurance market’s limited
development in the investment commu- parative advantage in risk-bearing. In ability to underwrite large, specialized
nity: the proliferation of hedge funds that fact, one of my favorite articles on the risks—while purchasing “claims only”
can manage the risk of their portfolios subject was a 1993 piece in the JACF insurance for smaller claims.
very differently. called “Corporate Insurance Strat- Harry, what is the current thinking at
egy: The Case of British Petroleum.” BP about the purpose of its corporate risk
The Case of BP That article described the company’s management program?
McCormack: Thanks, Trevor. Let’s unconventional decision to self-insure
now turn to Harry Koppel of BP. BP its large property and casualty losses Harry Koppel: Let me start by returning
has clearly thought a lot about corporate and product liability suits—a decision to your original question, “How does risk

Journal of Applied Corporate Finance • Volume 17 Number 3 A Morgan Stanley Publication • Summer 2005 39
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management add value?” At BP we begin earlier, a company’s business strategy and issuing debt in other currencies and then
with the assumption that a company’s its operations are the engine that drives its swapping that debt into dollars. So, for
value comes from its operations, from its value. And that value comes from taking example, we might borrow in Swiss francs
business model and its success in imple- risks and choosing risks wisely. and then swap into U.S. dollars. At the
menting the model. And that means that It’s also important to understand, to same time, we also have a preference for
the role of risk management is a derived the extent you can, the risk preferences floating-rate rather than fixed-rate debt,
or supporting one. But in order for risk of your shareholders. If your sharehold- mainly to avoid the illiquidity premium
management to play this supporting role, ers have made it clear that they want the that is built into fixed rates. For instance, if
a corporate risk manager has to under- company to retain its exposure to oil we issue fixed-rate, non-U.S. debt, we may
stand the big picture. prices, then you’re not likely to hedge oil use currency and interest rate swaps to give
To answer your question, it is also prices. Another example of risk-taking, us our targeted U.S. dollar floating-rate
important to make the distinction as John just mentioned, is our decision profile. And as a result of our decision to
between “hedging” and “risk manage- to retain our largest property and casu- hedge our currency exposure, you will see
ment,” two terms that are often used to alty exposures. Why did we do that? As in our Annual Report that we have several
mean the same thing, but shouldn’t be. Trevor was saying, it’s a matter of com- billions of dollars of currency derivatives—
And I will start by giving you a very suc- parative advantage. The size and diversity many of which have the effect of swapping
cinct definition of risk management: it of our operations, combined with years non-U.S. debt into U.S. dollars.
means “no surprises.” That’s something of operating experience, put us in a better
that we hold very close to our hearts at BP, position than any insurance company to Harris: Harry, would your use of swaps
from the CEO all the way down through evaluate, price, and bear those risks. to change the risk profile of your debt
ranks. What does that entail? It means, from one currency to another be clear to
first of all, measuring and understanding McCormack: On the other hand, you the outside shareholder or investor from
all your major risks. A large part of the risk also took out policies that insured you your financial statements?
manager’s task is to understand the risks against small losses.
the company is facing, and to provide a Koppel: You would find footnotes
picture of the downside possibilities as Koppel: That’s right. There are legal and showing our debt issues in terms of the
well as the upside opportunities. contractual requirements to take some of currencies they were issued in.
Once you understand the potential those policies. We also have to process a
risks associated with your major invest- number of claims, and we use the claims- Harris: But if I look at your debt struc-
ment decisions, you have a number of handling capability of our insurers to do ture, would I just see the original issue
possible choices. You can simply retain this. That’s something they can clearly do debt or would I have a way of seeing
the risk and leave it as is. You can man- better than we can. what’s actually been swapped and into
age the risk by taking certain operating But now let’s talk about BP’s currency what currencies? I ask because when we
measures. Or you can transfer the risk to exposure, which can be a more complex look at companies that have gone through
another party—say, by using insurance or issue. Since most of the commodities we the kind of transactions you’ve described,
derivatives contracts. This transfer of risk, sell are priced in U.S. dollars, we tend to it has not been clear to us what has taken
or what is called “hedging,” is a relatively view BP as a U.S. dollar company. And to place. On the basis of your financials
small part of the overall risk manage- better match the currency of our liabili- alone, we might conclude that your debt
ment process. The first thing to keep in ties and our assets, of our outflows and is still fixed-rate, non-U.S. dollar debt.
mind when making these decisions is that inflows, we generally aim to have our debt
where there is no risk-taking, there is no denominated in dollars. But because the Koppel: You may not be able to calculate
possibility for above-normal returns and lowest-cost debt is not always denomi- the net FX exposure of our debt from our
therefore no value added. As I suggested nated in dollars, we often find ourselves financials. But our Annual Report does

40 Journal of Applied Corporate Finance • Volume 17 Number 3 A Morgan Stanley Publication • Summer 2005
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include a clear statement saying in effect exposure. But if you can’t rely on finan- Sullivan: In our case, I don’t think it’s that
that we have swapped non-dollar cur- cial statements for something as simple as difficult to follow the trail of transactions
rencies into U.S. dollars with the aim the actual terms of the debt after taking because we change the composition of
of giving us mostly floating-rate, U.S. account of the effects of the derivatives, the fixed/floating mix only after consider-
dollar debt. then you’re really operating in the dark. ation of the entire liability portfolio—as
This is the information asymmetry prob- I said before, we manage our interest
Joe Sullivan: But does the accounting lem I was talking about. rate risk as a portfolio. But even with all
generally follow the way you manage the So, even if Joe’s company is actually the complexity introduced by fair value
portfolio of risk? At my company, Airgas, using derivatives to achieve what we would accounting, I think the analysts who
we bundle all our interest rate risk for all agree is a sensible interest rate expo- take the time to read our accounts and
management purposes. But the account- sure, it’s not clear that outside investors our supplemental disclosures will under-
ing rules require that we match specific have the information to appreciate what stand that the fundamental purpose of
derivatives with specific debt instruments you’ve effectively done. And in the effort our derivatives use is to transform our
and then declare them as either “fair mar- to get what they take to be an optimal debt so that it has the mix of floating and
ket value hedges” or “cash flow hedges.” portfolio construction, they could end up fixed we think is optimal for Airgas.
In cases where we have designated some- holding your shares for the wrong reason;
thing a fair market value hedge, we are they may end up under- or overexposed Harris: Let me make one more observa-
required to mark to market both the to a certain risk because they misjudged tion about accounting and disclosure,
derivative and the portion of debt that your company’s actual exposure. because I think this issue bears directly
it hedges. These mark-to-market effects on the relationship between risk man-
show up on our balance sheet—and the Copeland: Let me reinforce that point agement and value. Risk management
portion that is deemed “ineffective” runs with a simple example. When I was can influence value by affecting the way
through the P&L. And so even if our teaching at Harvard Business School, investors make their forecasts of future
bundle of derivatives provides an effective one of the students turned in a paper earnings. Regardless of whether you use
hedge for the bundle of debt instru- on the risk management of international FAS 133 or IAS 39, or whether you use
ments—which is how we manage our equities funds. He called up the manag- derivatives to hedge individual trans-
interest rate exposure—it would be dif- ers of ten funds and found out that they actions or on a portfolio basis, the fact
ficult for an investor to confirm that just all were concerned about international remains that most companies report their
from our GAAP statements. There really currency risk. Eight out of the ten funds debt in the form it was originally issued,
isn’t enough information in the footnotes actually hedged the currency risk of their and not as it has been transformed with
to allow investors to do that, which is why portfolio companies. How did they do it? derivatives. And unless the companies
Airgas relies on a combination of GAAP They treated the domicile of the firm’s also provide very explicit information
and supplemental disclosure. headquarters as the currency in which about what has been swapped out, the
the investment takes place. So, for exam- analysts’ forecasts will be based on what
McCormack: What role do the supple- ple, a company like Johnson & Johnson, are at best guesses about the liability
mental disclosures play here? How are which has global operations and hence all structure of the debt.
they likely to be used by investors? kinds of natural hedges, was treated as a If investors have this much trouble
U.S. dollar firm. And because the funds figuring out a company’s expected inter-
Harris: Well, to the extent investors are had very little idea of the actual currency est payments, imagine how difficult it
trying to forecast the future cash flows of exposures of their portfolio companies, is to understand all its other major risks
a business, they would need a good sense they were probably creating exposures and how they interact with each other.
of its exposure to changes in interest where none existed before. Because of this information gap between
rates, and how the firm is managing that how managers perceive and manage their

Journal of Applied Corporate Finance • Volume 17 Number 3 A Morgan Stanley Publication • Summer 2005 41
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Although we manage our interest rate exposure so

that our bundle of derivatives provides an effective
hedge for our bundle of debt instruments, it would
be difficult for an investor to confirm that just from
our GAAP statements. But we provide a significant
amount of additional information in our press re-
leases, on our conference calls, and in the MD&A
section of our SEC filings. So, even with all the com-
plexity introduced by fair value accounting, the ana-
lysts who take the time to read our accounts and
our supplemental disclosures will understand that
the fundamental purpose of our derivatives use is to
transform our debt so that it has the optimal mix of
floating and fixed.

Joe Sullivan

exposures and how investors perceive them sentation of that strategy in your financial in our press releases, on our conference
and integrate that into their analysis, most statements is not completely satisfactory calls, and in the MD&A (“Management
companies will find it helpful to take some from your point of view. Discussion and Analysis”) section of our
steps to reduce the volatility of their earn- SEC filings. In our press releases and tele-
ings—and if they don’t do that, they will Sullivan: I am not a fan of FAS 133…but conference materials we report what we
have to spend much more time and effort I hasten to add that our accounting and refer to as “adjusted debt.” This removes
explaining their hedging and risk manage- disclosures are as prescribed by GAAP. Of the mark-to-market impact of the deriv-
ment policies than they have in the past. course, GAAP is not forward-looking— atives portfolio, removes non-recourse
that is one of its shortcomings. debt, and adds in our off-balance sheet
The Case of Airgas accounts receivable securitization. The
McCormack: Joe, let me follow up on McCormack: Are you prevented from press release and teleconference slides
your last point and ask you to elaborate providing other information that might provide a reconciliation of adjusted debt
a little on your interest rate risk manage- allow your shareholder base to have a to GAAP debt.
ment policy at Airgas and how much better understanding of your hedging We also make very comprehensive
you disclose about your hedge book to policy? quarterly disclosures about risk manage-
the investment community. You men- ment in the MD&A in general and in the
tioned that you have a portfolio hedging Sullivan: No. In fact, we provide a signif- Quantitative and Qualitative Disclosures
strategy, and it also sounds as if the repre- icant amount of additional information section in particular. This includes the

42 Journal of Applied Corporate Finance • Volume 17 Number 3 A Morgan Stanley Publication • Summer 2005
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proportion of fixed-rate liabilities, how tion of our fixed rate liabilities between want to know our guidelines for fixed
we measure those fixed-rate liabilities, 40% and 60%. Currently we are nearer versus floating and why we have those
and the approximate expected impact 60% fixed. Some people consider that to guidelines. And as I also mentioned, we
on interest expense of a 25 basis-point be a lot of floating rate debt for a sub- tell them that we aim for somewhere
change in short-term rates, given current investment-grade company. But we are between 40% and 60% fixed rate debt—
levels of liabilities and credit ratings. We comfortable with that position because of and because they also know our debt
need this level of disclosure—and we need the very strong cash flow characteristics of balance, they are in a position to under-
it in print—to enable us to respond to the our business. stand our interest rate exposure. I don’t
questions that come from our analysts Airgas is a $2.4 billion company with believe that the analyst community feels
about our risk management practices. a 20% market share of the U.S. packaged that we face a significant interest rate
And by the way, I agree completely industrial gas distribution and hardgoods exposure as a result of that policy.
with Trevor’s point that there’s not market. The packaged gas business is very
enough required public information on stable but the hardgoods business is more Chew: So, you’re pretty confident about
derivatives positions for analysts to fore- subject to economic cycles. That side of the your ability to service your debt and
cast future cash flows under different business tends to give us a natural hedge avoid tripping debt covenants under vir-
economic scenarios. But I also don’t think against rising interest rates. When short- tually any interest rate scenario?
this is a material problem when analysts term interest rates go up, as they have been
forecast the impact of interest rate changes lately, our hardgoods revenue tends to go Sullivan: We are very confident about our
on our outstanding debt. Analysts tend to up as well—in fact, our same-store sales approach. We have plenty of room under
ask us to reveal our percentage of floating- have been increasing at double-digit rates. our existing debt covenants to accommo-
rate debt, which we are happy to do. They And because of this strong positive corre- date a jump in interest rates. If we had
make some assumption about the effect lation between our sales and interest rates, a covenant package like those that are
of our swaps based on what is reported the high proportion of floating-rate debt required for companies a couple of notches
in our disclosures. Some analysts go into provides what we feel is the right match down the credit scale, then I would be a
more depth than others; but at the end between our assets and liabilities. lot more concerned about rising interest
of the day they’re going to come up with rates. So, yes, rising interest rates could
something that’s reasonably close to the McCormack: How confident are you become a material concern for single-B
firm’s schedule of swap-adjusted interest that this correlation would hold up in credits with significant floating-rate debt.
rate exposure. the event of a very large spike in inter- But given our current debt rating, and
It’s really on the commodities side est rates? where our coverage ratio stands in rela-
where I think companies and their tion to our covenants, we feel our current
investors are facing the biggest risks. For- Sullivan: Though past performance is interest exposure is well under control.
tunately for Airgas, we don’t have a lot of not a guarantee of future results, the rela-
exposure there. But for a lot of companies, tionship has been pretty consistent over Chew: Let’s go back to the case of BP, then.
it’s possible for analysts to completely time. Harry, is BP’s preference for short-term
misunderstand a firm’s actual economic funding based in part on an assessment
exposure to commodity prices because Don Chew: Joe, do you discuss this kind that its revenues have a positive corre-
of the lack of transparency surrounding of correlation analysis during presenta- lation with inflation and interest rates?
derivatives positions and the difficulty of tions to analysts? Or did I hear you say it was mainly to
representing those positions in financial take advantage of the liquidity savings in
statements. Sullivan: It’s not part of our regular dia- short rates or, what amounts to the same
In terms of interest rate exposure, our logue, but it has come up during investor thing, to avoid the illiquidity premium
policy at Airgas is to keep the propor- calls. As I said earlier, analysts generally built into long rates?

Journal of Applied Corporate Finance • Volume 17 Number 3 A Morgan Stanley Publication • Summer 2005 43
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Koppel: We tend to fund short mainly So let’s now turn to Andrew Sunder- power generation (involving the conver-
because we know that, under normal man, who, as Chief Risk Officer of The sion of gas into electricity), the interstate
circumstances and over long periods of Williams Companies, has played an transportation of natural gas, and the
time, short rates will turn out to be lower important role in the company’s recent gathering and processing of natural gas
than long. There’s really no attempt here recovery from a difficult set of circum- and related natural gas liquids. When
to match the interest rate sensitivity of stances. Andrew, can you tell us about you view our portfolio of businesses, you
our liabilities with those of our assets. the challenge the company faced a couple can see that a large portion of our busi-
I think what is important in carrying of years ago in servicing its debt load, ness is highly dependent on commodity
out such a policy is to maintain the dis- and about the role of risk management in prices—and it’s important to keep in
cipline of the method, to implement it in helping bring the company back from the mind that these are the most volatile
a consistent way. We are not unwilling to brink of disaster? commodities in the world.
shift risks when the costs of doing so are So, once again, for a company try-
very low. When you have liquid markets, Andrew Sunderman: The first statement ing to continuously improve shareholder
as is the case with the U.S./Euro market, I would make is that much of risk man- value and strengthen its credit standing,
we start by finding the funding source agement and related kinds of financial a continuing focus on managing our
with the lowest all-in-cost interest rate. decision-making is more academic when commodity price risk is critical for us to
For instance, if the cheapest outcome you have a AA balance sheet. In the case of achieve these goals. In this sense, as both
involves the use of a Euro rate, we would Williams, which was a BBB-rated energy John and Charles suggested, an effective
fund in Euros and swap into U.S. debt. company with a trading and marketing risk management program can help a dis-
The transactions costs of so doing are unit operating in the wake of the collapse tressed company lower its cost of capital.
minimal and it’s fairly easy for manage- of the largest U.S. merchant energy trad-
ment to explain the company’s policy to ing company—and I’m talking of course McCormack: Andrew, can you tell us a
shareholders. about Enron—derivatives and risk man- bit about your disclosure policy, and can
agement were, and continue to be, an you comment on this issue of transpar-
The Case of important part of our overall strategy. ency that Trevor raised earlier?
The Williams Companies As John just told you, derivatives
McCormack: BP’s reliance on floating- and risk management played an impor- Sunderman: We have disclosed increas-
rate debt makes perfect sense to me. It tant role in our restoration to financial ingly more about how we use derivatives,
is a very large company, with operations stability from our distressed situation how we trade our portfolio, and what
that are geographically as well as opera- three years ago—a time when our bonds exactly is in it. Besides providing more
tionally diverse. And part of its overall were downgraded well below investment information in our filings, we make
risk management strategy is to fund grade and our stock was trading below trips to New York twice a year in which
those operations primarily with equity $1. As you drift downward, the finan- we present to our investors the entire
rather than debt. cial distress discount on your debt and 20-year spectrum of our power trading
But an investment-grade rating and equity grows pretty quickly. The role of book. This enables them to see when we
heavy reliance on equity is not neces- derivatives in this case has been mainly are using derivatives, why we are using
sarily the value-maximizing strategy for to eliminate the downside tail on our them, and exactly what the cash flows
all companies. In some cases, the use of risk, the possibility that a sharp drop in from them are going to be. This way they
derivatives and risk management can oil or gas prices could make us unable to know when we use derivatives to hedge
function to some extent as a substitute for service our debt. our production, our output.
equity capital. And the recent experience Williams operates in several distinct As a result of our efforts, a number of
of The Williams Companies provides a commodity businesses, including explo- publications have recently recognized our
good illustration of my point. ration and production of natural gas, disclosure and investor relations program

44 Journal of Applied Corporate Finance • Volume 17 Number 3 A Morgan Stanley Publication • Summer 2005
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Corporate risk management involves much more

than just the use of derivatives. For example, the
design of the firm’s supply contracts can be used
to manage risk. Risk management can also influ-
ence the kinds of assets the firm purchases, some
of which can provide a natural hedge for the firm’s
main businesses. And I imagine that these kinds
of strategic risk management mechanisms are
equally important for companies like BP. For com-
panies with lots of hard assets, decisions to invest
in assets can play a critical role in managing risk.

Andrew Sunderman

as the best in the energy sector. I person- also influence the kinds of assets the firm the value over and above the cost—of
ally have a lot of passion for this activity. purchases, some of which can provide a each of these alternatives. So, let’s say I
As Harry said earlier, risk management is natural hedge for the firm’s main busi- want to own a commodity like natural
supposed to support a company’s busi- nesses. And I imagine that these kinds of gas. I have two basic ways of doing it: I
ness and investment strategy—and that’s strategic risk management mechanisms can buy a futures contract or I can buy
the function it performs at Williams. By are equally important for companies a company. In making that decision, we
helping to understand, quantify, and in like BP. For companies with lots of hard will consider factors such as our own
some cases eliminate the possibility of bad assets, decisions to invest in assets can operating expertise that could make asset
outcomes, it has reassured our investors play a critical role in managing risk. ownership more valuable to us than to,
and given us the confidence to invest in say, financial buyers. And we also con-
our business while paying down $8 bil- Copeland: There are also ways to build sider the opportunities that ownership
lion in debt over the last three years. flexibility into organizations that have of that asset would give us to build on
the effect of reducing risk. You can and enlarge our own expertise. That to
Real Options as a Risk accomplish this by making more flexible me is a critical part of risk management;
Management Strategy investments, you can do it by having a it’s keeping in mind the big picture that
Sunderman: But, as Harry said, it’s AA capital structure like BP, or you can Harry was talking about.
important to keep in mind that corpo- do it by having a very active risk man-
rate risk management involves much ager. How do you decide which is the Copeland: So, what we’re really talking
more than just the use of derivatives. For preferred method at the margin? about here in part is the convergence of
example, the design of the firm’s supply risk management with what academics
contracts can be used to manage risk. Sunderman: At Williams we try to have been calling “real options”; it’s the
Risk management considerations can analyze the economic value—that is, idea that companies can manage some of

Journal of Applied Corporate Finance • Volume 17 Number 3 A Morgan Stanley Publication • Summer 2005 45
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Companies can manage some of their major

business risks by consciously building flexibility
into their operations, or creating what academ-
ics call “real options.” A good example is J&J’s
venture capital program, which takes minority
equity interests and deep-out-of-the-money
warrants in small firms likely to produce break-
through technologies. Although the investments
are relatively small, they have the potential to
create significant value for J&J by providing
new sources of profit and protecting its core
business from “disruptive” technologies. In this
case, the company has literally created a
portfolio of options, both financial and real.

Tom Copeland

their major business risks by consciously technologies materializes, the stock Let me also mention that at MIT
building flexibility into their operations. price jumps, the warrants move into today, engineering courses are teaching
Just to give you one example, at Moni- the money, and J&J ends up with a sig- real options as part of engineering design.
tor we advised a client that was building nificant equity ownership stake. This So I think we’re in a new age where the
a multi-billion dollar, high-tech clean creates value for J&J by providing new biggest risks today are not technical or
room. The facility was reengineered to sources of revenue and profits, and by environmental like Exxon’s Valdez, but
be more modular, thus enabling manage- protecting its core business from “dis- rather strategic risks—the possibility that
ment to respond to changes in technology ruptive” technologies. And it helps the you’re in the wrong business at the wrong
and changes in demand. target firms by providing what amounts time. And if I’m right, designing operat-
An even better example is provided to “just-in-time” equity fi nancing—by ing flexibility will become an increasingly
by Johnson & Johnson’s venture capi- which I mean that the equity needed for important part of long-term or strategic
tal program. It takes minority equity commercialization of the technology risk management.
interests and deep-out-of-the-money becomes necessary only if and when the
warrants in small firms that are con- technology and commercial opportuni- Koppel: This “real options” way of think-
sidered likely to produce break-through ties have materialized. J&J’s strategy ing is also part of BP’s project assessment
technologies. Because the warrants are is thus literally to create a portfolio of framework. As I suggested earlier, we
well out of the money, the investments options—both fi nancial options and start with a value proposition and then
are relatively small. But if one of the real options. analyze the risks that surround that

46 Journal of Applied Corporate Finance • Volume 17 Number 3 A Morgan Stanley Publication • Summer 2005
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value proposition. We consider not only decide you didn’t want to bear that credit Toward Enterprise-
the downside risks but also the upside exposure and transfer it to a third party Wide Risk Management
potential—and much of our practice is either with a new position or through the McCormack: We haven’t heard yet from
designed to preserve our access to that purchase of credit protection—say, in the Bob Anderson, who is Executive Direc-
upside. And that’s where the real options form of a credit default swap. tor of the Committee of Chief Risk
analysis that Tom Copeland just men- Today, however, that market is either Officers. Bob, how does your recent
tioned comes into the picture. very expensive or very illiquid, which experience with CCRO, and before that
There are, of course, some challenges has forced companies to manage much as Chief Risk Officer at El Paso, compare
in using real options theory to quantify of their credit risk through netting with what Harry and Andrew have been
the value of investments—and there’s an agreements. When you deal with com- telling us about risk management in the
article in the latest issue of the JACF by modities today as a non-investment-grade energy business?
Simon Woolley, one of my colleagues at company, most businesses now require
BP, that does a nice job of describing the basically 100% collateral posting for the Bob Anderson: My experience as a CRO
issues. But let me repeat that real options set fair value of that derivative in or out at El Paso was similar in many ways to
thinking has long been pervasive at BP. of that money. Alternatively, you do it what Andrew has just been through with
We devote plenty of time and analysis to through the contract. The number one Williams. We went through a period
exploring both the potential value and tool we use now is called master netting of financial difficulty and, as with Wil-
the risks of our strategic investments; agreements. Under these arrangements, liams, the use of derivatives in hedging
and whenever possible, we design those we would go to a BP and say that we commodity price risk played a big role in
investments to limit the downside while want all entities within Williams and all getting our lenders to work with us and
preserving our options. entities within BP to net their positions restoring our access to capital markets.
every day, and so each day we would send And now I’m running an organization,
Managing Credit Risk money back and forth to avoid any future the Committee of Chief Risk Officers,
Smithson: Andrew, are you responsible exposure from a default by a counter- whose purpose is to bring companies
for managing credit risk as well as com- party—though this is clearly something together to share best practices in corpo-
modity hedging at Williams? you wouldn’t have to worry about if you rate risk management. In my current role,
were transacting with a firm like BP. I get to hear a lot from various compa-
Sunderman: That’s right. I have the nies about their problems as well as their
title of Chief Risk Officer of Williams, Smithson: How did Williams manage to solutions. As a result, I’m in a pretty good
which means I’m responsible for analyz- find counterparties two years ago when position to assess both the current state of
ing, reporting, and developing strategies it was facing all the problems and con- risk management and what appear to be
to help our Risk Management Com- straints and your credit was out of favor? emerging practices.
mittee manage the commodity risk and One trend that I’m seeing very clearly
credit risk of the non-regulated units of Sunderman: Part of the answer is going is a major expansion of the focus of cor-
the corporation. And I’m also the Chief to sound very old-fashioned. Williams porate risk officers beyond the use of
Financial Officer of Williams Power, has been in business for almost 100 years derivatives to hedge specific financial
which was formerly our marketing and and had built up a lot of good relation- risks into something that people are now
trading entity. Credit risk management ships. Because of these long-standing calling “enterprise-wide” risk manage-
today is different than it was five years ago, relationships, some of our suppliers were ment. Ten years ago, risk management
when we had a very liquid credit default willing to give us good terms. In other was mainly about the use of swaps and
swap market. In those days, if you entered cases, however, we were forced to pay options to hedge interest rates and com-
into a contract and you had a customer cash up front. modity prices, the kind of thing I did
that was always paying late, you could while working for BP in the early ’90s.

Journal of Applied Corporate Finance • Volume 17 Number 3 A Morgan Stanley Publication • Summer 2005 47
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Back then, risk management was thought believe that we have reached the point businesses—anything that affects the
of as a pretty much decentralized, or com- where all publicly traded companies level and variability of cash flows going
partmentalized, activity that could help should have a well-thought-out risk forward. When viewed in that light, risk
the firm mainly by making modest con- management policy. And as John said in management is clearly a senior manage-
tributions to the P&L. But, as Harry has his opening remarks, companies should ment responsibility, one that requires
been telling us, the purview of today’s risk make an effort to understand their input from and coordination of different
manager is much broader; it encompasses comparative advantage or core competen- parts of the company at all operating lev-
all aspects of the corporation, including cies—and they should at least be aware els. And such internal coordination and
investment and operating decisions as of their options for transferring risks to understanding should in turn allow man-
well as financing. It’s about ensuring the third-party investors. Although good agement to give a confident reporting of
company’s access to capital and its abil- management will always be more art than the risk management program to out-
ity to carry out its strategic plan—and, in science, it’s probably fair to say that the siders, one that gives Wall Street a clear
this sense, it is a critical part of the busi- days of the cowboy CEO who shoots from picture of the program’s objectives and
ness model. the hip are numbered. This is not to say how the program is being carried out.
John earlier raised the question of that all companies are going to load up on
whether oil and gas companies should “quants” and attempt to model all their Risk Management and
be hedging their exposures to oil and exposures. What it does mean, however, Investor Clientele
gas prices. To answer that question, and is that risk management will increas- McCormack: Bob, you mentioned a
to make the right decision, management ingly be the responsibility of somebody divergence between companies’ appetite
needs to take a complete view of the near the top of the company—and that for certain risks and the risk preferences
firm’s operations, from the perspective an important part of that responsibility of their shareholders. Are you saying that
of outsiders as well as insiders. If a sharp will be to communicate the firm’s policy managers didn’t understand what their
drop in oil prices could make the firm to the investment community and other shareholders were looking for, or that
default on its debt—the condition that outside constituencies, possibly including they failed to understand the risks that
Williams was facing—then it will be regulators. That policy should attempt to underlay their own business?
worthwhile to hedge at least enough of strike a good balance between the firm’s
that exposure not only to avoid Chapter appetite and capacity for bearing risk, and Anderson: I think it was very clear to
11, but to carry out the investment plan. between the expected upside and the abil- management five years ago that analysts
For equity-financed firms like BP, the ity to weather some adverse outcomes. It and shareholders were looking for large
question becomes one of comparative was essentially an imbalance between risk and pretty much continuous increases in
advantage: Who is in a better position, appetite and capacity that got the energy EPS. With hindsight it seems to be an
or more willing, to bear the firm’s oil trading business into such trouble during extraordinarily silly idea that companies
price risk? Is it the firm’s shareholders, the last five years. In a number of cases, could grow their earnings at 15% a year
many of whom say they buy oil company top management had no idea of the risks in perpetuity. But the valuations that
shares for the oil price exposure, or is it that were being taken. investors were giving some companies,
investors who transact in the derivatives So, to repeat my basic point, risk man- especially in the tech sector, appeared to
markets? So, in this sense, today’s risk agement is in the process of becoming a reflect that expectation. Such valuations
managers must understand not only truly corporate-wide undertaking. It’s in turn had the effect of putting man-
how risk affects all the operations of the not just a series of isolated transactions, agement on a treadmill where they felt
firm, but what role such risk plays in the it’s a strategic activity. As Andrew said, pressure to produce this kind of clearly
expectations of the firm’s investors— it encompasses everything from oper- unsustainable earnings growth. And the
shareholders as well as creditors. ating changes to financial hedging to result was some aggressive accounting,
This may sound self-serving, but I the buying and selling of plants or new and a lot of bad acquisitions that were

48 Journal of Applied Corporate Finance • Volume 17 Number 3 A Morgan Stanley Publication • Summer 2005
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One trend I’m seeing very clearly is a major expan-

sion of the focus of corporate risk officers beyond
the use of derivatives to hedge specific financial
risks into something people are calling “enter-
prise-wide” risk management. Ten years ago, risk
management was mainly about the use of swaps
and options to hedge interest rates and commod-
ity prices. It was pretty much a decentralized, and
compartmentalized, activity whose main purpose
was to smooth earnings or make modest contribu-
tions to the P&L. But the purview of today’s risk
manager is much broader; it encompasses all as-
pects of the corporation, including investment and
operating decisions as well as financing. It’s about
ensuring the company’s access to capital and its
ability to carry out its strategic plan—and, in this
sense, it is a critical part of the business model.

Bob Anderson
driven in large part by cosmetic account- management program reassures credi- higher multiple on the firm’s earnings and
ing effects. tors and reduces the firm’s cost of debt, cash flow. And I think the Williams story
Today things are much more compli- it’s also likely to reassure equity investors provides even clearer evidence that risk
cated. Investors are paying less attention as well, particularly in cases where com- management can increase overall value. As
to earnings and putting greater empha- panies make aggressive use of their debt Andrew has told us, Williams now makes
sis on cash flow and returns on capital capacity. In other cases like BP, a good risk a point of publicizing its hedging pro-
than in the past. And risk management management program just reinforces a gram and, without taking correlation for
is playing a greater role in the valuation company’s reputation for having an effec- causality, the company’s market value has
process. Andrew has already provided tive corporate governance and financial clearly risen along with the extent of its
some evidence that creditors value risk management system, which in turn should disclosure program. The ability of a com-
management; and to the extent that a risk give the market the confidence to put a pany to communicate its exposure profile

Journal of Applied Corporate Finance • Volume 17 Number 3 A Morgan Stanley Publication • Summer 2005 49
ROUN DTAB LE

to outsiders, both shareholders and rating Sunderman: I would say it provides a who want exposure to a different kind
agencies, is to me the hallmark of a good cheap alternative that must be consid- of risk.
risk management program. ered. By eliminating the left-hand tail of Another way of putting this is that
our risk distribution, we give our lenders companies should not feel bound to their
Sunderman: In 1999 and 2000, inves- comfort and increase our debt capac- existing investor base, or what people
tors seemed to be rewarding companies ity—and this in turn can reduce our cost sometimes refer to as an investor “clien-
mainly just for revenue growth. During of capital. tele.” Companies are generally reluctant
the Internet bubble, companies that had to change clienteles, mainly because the
yet to realize a single dollar of economic McCormack: So, as I was suggesting selling that takes place during a change in
value were being valued at billions of earlier, Williams’s business model is clientele creates a lot of price volatility, at
dollars. In cases where investors’ expec- quite different from BP’s. It’s one that’s least in the near term while the shift is tak-
tations are clearly unrealistic, should it closer to that of an LBO, something we ing place. But, as I said earlier, this price
be management’s responsibility to bring are starting to see in the energy industry. volatility reflects the large information
those expectations into line with its abil- And I would guess that your combina- costs faced by investors, and the gener-
ity to deliver? tion of hedging and higher leverage is ally poor job that companies have done
Let’s come back to the case of Wil- likely to attract a somewhat different in communicating major policy shifts.
liams. In choosing to hedge much of our kind of investor than BP does. But, as I In most cases I’m aware of, companies
commodity price risk, we may have dis- think has become clear from your recent have failed to provide investors with the
couraged some kinds of investors from experience, if you find a way to add value, information necessary to evaluate, say, a
buying our shares—those investors who you will find investors who want to hold decision to cut the dividend to help fund
are looking mainly for a play on oil or your shares. a promising investment.
gas prices. But if investors really want And this leads me to ask the following
to bet on a company that takes com- Harris: I agree. The idea that all inves- question: As we move toward enterprise
modity risk, there are much more direct tors are the same is obviously wrong. So risk management, do we really have the
ways to get that exposure—commodity if you decide to make a major change analytical tools that would allow us to
futures and swaps will give you much in policy, such as hedging your price measure and monitor and manage the
more exposure for your dollar. I think it risk and levering up, you’re likely to be exposures internally? And if so, do we
is management’s responsibility to earn able to find a group of investors who are also have the means of making this
the highest return it can on the total attracted to the policy and want to buy analysis transparent to outsiders? As we
capital at its disposal, on the total assets your shares. Now, it’s true that when you discussed earlier, financial statements
under management. In a company like make that policy change, you will prob- provide very little guidance as to how
Williams, which generates large and ably experience a change in your investor companies are using derivatives—and a
fairly stable cash flows, my belief is that base; those investors who bought your lot of hedging activity still takes place
we will end up earning higher rates of shares mainly for the oil price exposure off the balance sheet. It’s one thing to
return by hedging and continuing to are likely to sell. But as long as you do a be able to get a clear picture of the firm’s
make fairly aggressive use of debt at good job of explaining your new policy asset/liability mix looking out one year.
lower costs of capital. and the way you run your business, you But many derivatives contracts go out
should be able to find a set of investors several years, and I’m skeptical that even
McCormack: So what you’re saying, willing to pay full value for your shares. corporate management, much less the
Andrew, is that risk management can Your shares will no longer attract peo- investment community looking on from
function as a cheap substitute for equity ple looking to add oil price exposure the outside, has the analytical capability
capital? to their portfolios, but they will find a to provide a good understanding of their
place in the portfolios of other investors exposures going out five years.

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Anderson: Well, it depends on the But the case of operations risk is dif- tent and coordinated way. More generally,
company. They range in size and sophis- ferent. Here there’s a pretty big hole and companies would like to understand the
tication from multinationals like BP a lot of work to be done. When I think of extent to which all their major risks—
to small operations like Black Hills in operating risk at a bank, I think in terms market, credit, and operations—are
Colorado. But with that qualification, of the telephones going down. But, in correlated. Most companies realize that,
my outlook is quite optimistic. Almost the case of energy companies and utili- in assessing their overall or net exposure,
all the energy companies that are part of ties, we’re talking about entire plants and they can’t simply add up the volatilities
my organization know how to measure major disruptions in service provision. associated with each of their major risks.
credit risk the way a bank would do it. There is now talk of making operations If you do that, you will overestimate your
A few years ago, most pipeline compa- risk part of companies’ regular report- risk, which in turn could lead you to do
nies viewed all credit exposures as 60-day ing profile, of including that risk in the too much hedging or keep too much cap-
receivables even though the pipeline con- MD&A section of their annual reports; ital on your balance sheet.
tracts with their customers were as long but there’s still a lot of work to be done Now, this kind of correlation analy-
as 15 or 20 years. That doesn’t happen in this area. sis is in a fairly early stage, and we’re
anymore. Today, those companies think That brings me to the case of busi- nowhere near the point that the banks
long and hard about potential credit risk, ness risk. Evaluating business risk is really have reached on this. But we’re a lot far-
about what affects both their own credit about building scenarios, and a lot of ther along than we were just three or four
ratings and those of their counterparties. companies today incorporate some form years ago when I was CRO at El Paso.
So, in this sense, we are taking elements of scenario planning into their cash flow And that’s one of the main reasons I’m
of the enterprise-wide approach that has analysis. So things are improving here as excited about working with the compa-
grown up in the banking and finance well. Two or three years ago, we were only nies in my organization. We’re building
industry and transporting them into the at the stage of reaching agreement on the consistency and standards. We’re work-
energy industry. four types of risk themselves, and we’ve ing together to develop a unified set of
Now, the degree of progress varies come a long way during that time. metrics that an outsider can use to com-
depending on the type of risk we’re talk- But what’s next? In my view, the big pare the exposures of Williams and El
ing about. I tend to think in terms of four improvements this year will come in Paso and BP and others. We will never
major categories of risk: market, credit, the form of better disclosure. A lot of get 100% comparability, but we’re mak-
operations, and business. I think that companies are going to showcase their ing progress.
most energy companies today have pretty emerging risk management practices
well mastered market risk. They have VaR in the MD&A section of their annual Smithson: The answer to Trevor’s ques-
measures and Monte Carlo price simula- reports. You’ll see a number of compa- tion about whether we now have the
tors to help them model the distribution nies talk about the concept of “economic tools for a truly enterprise-wide risk man-
of their operating cash flows over a range capital.” Economic capital is a measure agement system depends on the kind of
of different price scenarios—and they of the capital necessary to support an company we’re talking about. As Bob just
understand energy derivatives and how operation—a measure that is based said, new developments in risk manage-
they can be used to hedge their market mainly on the volatility of that opera- ment techniques tend to originate in the
exposures. This has all been rich territory tion. Although it’s long been used by securities and banking firms, where most
for consultants in the past few years. And banks in their RAROC systems, energy of the assets and liabilities can be readily
as I was just saying, energy merchants companies are now beginning to use it marked to market—and then they spread
have made major strides in understanding for the first time. to the industrial firms. And as Bob also
credit risk in the last year or so—though In addition to the growing use of eco- mentioned, it was market risks—inter-
among utilities, there is still considerable nomic capital, we’re also seeing attempts est rate risk, foreign exchange rate risk,
room for improvement in this area. to treat market and credit risks in a consis- equity price risk, and commodity price

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risk—that were the first major focus of Risk Management, focus on quarterly earnings—my sugges-
risk management programs. But about six Performance Evaluation, and tion is that they have no one to blame
years ago, the focus of risk management Management Incentives but themselves. And, more important,
began to shift at most financial institu- McCormack: On that note, let me bring if they’re not happy with their current
tions. Lots of the people who had spent John Kapitan into this discussion. As a investor group, there’s probably some-
a great deal of time and energy thinking consultant to financial institutions, John thing they can do about it.
about VaR and how to apply it were sud- has been personally involved in the pro-
denly asked to turn their attention to liferation of many of the new tools and Chew: They can either improve their dis-
credit risk. And that effort has—or at measures, including economic capital, closure—or they can go private.
least is about to—come of age. that Bob just described. John, would you
So what is the next “new thing” in give us your impression of the current state Kapitan: Yes, going private is an option—
risk management? I think it is the appli- of the art of risk management at financial and apparently a pretty popular one these
cation of the economic capital concept to companies, and tell us about the role that days.
industrial companies that Bob just cited. economic capital is playing today and is But let me now turn to this idea of
I am very excited about this idea because likely to play in the near future? economic capital that Charles Smithson
economic capital is really just a measure was telling us about. Much of our discus-
of risk—it’s a way of putting market risks John Kapitan: I’d be happy to. But let sion up to this point seems premised on
and credit risks and operational risks into me start by commenting briefly on this the idea that companies, if not the ana-
a single dimension. Once all risks can be question of investor clienteles that Trevor lysts and investors who follow them, have
quantified and aggregated, the manage- brought up a minute ago. I agree with accurate measures of risk. But we need to
ment of the firm can answer the payoff his statement that there are all kinds of qualify this assumption a little. There are
question: How much equity capital do investors out there, and I also agree with a lot of companies, including financial
we need to bear the collection of risks his suggestion that corporate policies can institutions, that have a long way to go
facing our firm? and do influence who buys their shares. before they have reached that point.
If you look at recent annual reports As Warren Buffett likes to say, compa- My own experience with a lot of finan-
and other disclosures by financial insti- nies get the shareholders they deserve. cial institutions suggests that if they choose
tutions, you will see that, instead of The way you communicate to your to make a major investment in a risk mea-
ROAs or ROEs, firms are increasingly investors and what you choose to dis- surement system—and by “major” I mean
talking about returns on economic capi- close—whether you provide only what’s anything from $500,000 for a fairly small
tal—returns to risk or, if you prefer, required or volunteer much more—has bank to $10 million for a large one—they
risk-adjusted return. So if I had to choose a lot to do with the kinds of investors can attain a reasonable degree of accuracy.
a single major advance in corporate risk you end up with. If you spend a lot of As both Bob and Charles mentioned,
management for the rest of this decade, time forecasting quarterly earnings, then financial institutions today are fairly well
my guess would be the widespread adop- you will find a lot of momentum traders down the path in terms of their ability to
tion of some kind of risk-based capital holding your shares. But if you downplay measure most market and credit risks. At
measure. Most financial institutions are earnings and talk instead about goals and the same time, most financials continue
already doing it, and my prediction is that policies, then you’re likely to attract lon- to struggle when measuring and manag-
it will spread to industrial companies. ger-term holders—and not just pension ing their operational risk. But that’s not
funds, but some pretty sophisticated an insurmountable problem; there are
value investors. shortcuts capable of providing reasonable
So, for those managers who like to “guesstimates” of operational risk.
complain about the shortsightedness of Now, once you make that investment
their investors—the intensity of investors’ and get a risk management system in

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Once you get a risk management system in place,

you have the ability of linking risk to capital—and
then all kinds of wonderful things can happen to
your organization. With the measures of economic
or risk capital provided by your system, you can now
calculate returns on economic capital—that is, risk-
adjusted returns that allow top management to com-
pare the performance of all the firm’s businesses
and investments. To the extent your managers’ re-
wards are tied to such measures, you end up with
a more reasonable, and probably more effective,
incentive comp program. And with the help of such
risk-adjusted returns, you can also make informed
decisions about your comparative advantage in risk-
bearing—about which businesses to be in, and which
businesses and risks to sell or transfer to others.

John Kapitan
place, you have the ability, as Charles be in, and which businesses and risks to your performance measurement system.
was saying, of linking risk to capital— sell or transfer to others. If you’re an exceptionally good manager
and then all kinds of wonderful things And this brings me to one other major in an E&P company, do you really want
can happen to your organization. With benefit of accurate risk measurement. In your results to depend in large part on the
the measures of economic or risk capital his opening comments, Charles said that behavior of oil prices? If you have a lot of
provided by your system, you can now perhaps the most important function of noise in your performance measurement
calculate returns on economic capi- risk management is to protect the firm’s system, how do you know if your strategy
tal—that is, risk-adjusted returns that ability to carry out its long-term strategy. is working? How do you know whether
allow top management to compare the I agree with that, but would also add that your managers are good operators, or just
performance of all the firm’s businesses a company’s ability to carry out its strat- lucky and riding favorable commodity
and investments. And with the help of egy depends in large part on keeping its price movements? By hedging and thus
such risk-adjusted returns, you can also stakeholders happy, particularly its man- removing the effect of oil price volatil-
make informed decisions about your agers and employees. And one thing I ity on its cash flow or earnings, an E&P
comparative advantage in risk-bear- really like about the idea of hedging away company effectively ends up with a much
ing—that is, about which businesses to non-core risks is the clarity it can bring to less “noisy” performance measure.

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And this is likely to be valuable for will not always work for a company like aim to use our own insurance company
two reasons. First, to the extent a man- Williams, we too have learned that there to handle these cases. We also have joint
ager’s rewards are tied to such measures, are insurance markets where it just doesn’t ventures, and our partners in such ven-
you end up with a more reasonable, and make sense to buy the insurance because tures often have a different risk profile and
probably more effective, incentive com- of our own diversification. want insurance. But, as you mentioned
pensation program. At the very least, you earlier, John, we continue to involve
avoid the tendency of many companies McCormack: And besides diversifica- insurance companies in processing claims
to pay very large bonuses when commod- tion, you also have built up an asset to take advantage of their operational effi-
ity prices move favorably, but also to pay knowledge that is comparable to, if not ciencies. In such cases, we’ve determined
bonuses in the down years since manag- better than, any insurance company’s. that outsourcing claims administration is
ers can always come up with reasons why a value-adding proposition.
they are not “accountable” for unfavor- Sunderman: That’s right.
able price movements. The other major McCormack: Let me ask you a little
benefit of less noisy performance mea- Koppel: And your record as a safe opera- more about this entity within BP that
sures has to do with the shareholders of tor also plays a big role. collects the risks of BP’s operating units.
E&P companies: because such investors But let me repeat this point about I assume that the units pay premiums to
always have the option of making bets diversification. Diversification has plenty the captive; and then, when something
on commodity price movements, they to do with our decision to self-insure bad happens, the losses all show up in the
must be expecting management to bring many of our risks, and it also turns out Channel Islands company?
some operating expertise to the table, to to be a critical factor in our overall risk
do something they can’t do for themselves management approach. Diversification Koppel: In some cases where we take out
simply by taking positions in oil futures. has always been a key part of our busi- insurance, the casualty losses are assumed
ness strategy. And business strategy, as by the captive insurance company.
The Corporate Risk I said earlier, is really the engine that
Management Center: drives our value. That value comes from McCormack: How does the fact that the
Structure and Processes taking risks—and from choosing to bear losses from any accident or surprise show
Sunderman: At Williams, we also think risks where we have a clear comparative up in the Channel Islands company and
our hedging policy has greatly improved advantage. not on the P&L of the individual units
our information systems and incentives. affect managers’ investment decisions
Much of what we’re doing today has its McCormack: Harry, let me ask you a ques- in those units? Does it encourage them
roots in the investment banking world tion about your procedures for assessing to overlook risks when getting into new
and our own marketing and trading and managing those risks. My understand- businesses or taking on new customers?
company. We have taken those concepts ing is that when you make these decisions
that were really designed for and built to self-insure at BP, you use traditional, Koppel: In the cases where the operat-
around financial institutions and applied actuarial types of approaches in evaluating ing companies pay premiums to the
them to our businesses. property and casualty risk. And I believe captive, it’s really no different than
But, as Bob mentioned, the area that you have an insurance subsidiary. insuring the risk externally. In assessing
now needs the most attention is opera- managerial performance, we try to iden-
tional risk. In thinking a bit about this Koppel: That’s right, we have an in- tify the sources of gains or losses. And
issue, I find it very interesting that BP house, or captive, insurance company if managers were systematically overlook-
chooses to self-insure its large product based in Guernsey. ing risks in their operating or investment
liability and environmental risk. And We are required to insure some risks decisions, this would show up in their
although what works for the super majors for legal and contractual purposes, and we results.

54 Journal of Applied Corporate Finance • Volume 17 Number 3 A Morgan Stanley Publication • Summer 2005
 ROUN DTAB LE

Williams’s business model is quite different

from BP’s, and the company’s combination
of hedging and higher leverage is likely to
attract a different kind of investor than BP’s.
But, as long as Williams earns high rates of
return on capital—and provided manage-
ment makes it clear to the market how they
are producing those returns and the risks
they are taking in the process—the company
will find investors willing to buy its shares.

John McCormack
Our insurance team and the cap- and hedge that production, only that the relations. In fact, there are a number of
tive play a coordinating function within manager’s performance will be evaluated policies at BP that, viewed as a whole,
BP—one that allows us to see the effects as if the firm had put on that hedge. This form a very cohesive set of processes for
of our risks in the context of the whole way, as long as the manager does a good managing risks at the project level, at
group, with losses in some areas being off- job of discovering and producing hydro- the business unit level, and at the Group
set by gains in others. A similar approach carbons, his or her project will be viewed level. We’ve also recently launched an
is used in managing the credit risk associ- as a success, even if a plunge in prices initiative at BP called “enterprise risk
ated with our receivables; we evaluate and ends up causing the value of the project management” where, as Bob was describ-
manage this on a corporate-wide rather to drop below expectations. ing earlier, we attempt to view all of our
than a business-unit basis. Is there any movement in BP or any major risks together to get an idea of our
other company here toward a system overall net exposure.
McCormack: It sounds as if this cap- where those kinds of potentially hedge-
tive is evolving into a corporate risk able risks get concentrated within a single, Sunderman: We too are moving toward
management center, one that’s manag- centralized entity? a more centralized and enterprise-wide
ing not just property and casualty risk system. We now have a single place to
but perhaps some others as well. To illus- Koppel: Our insurance captive is defi- analyze all commodity risk taken on by
trate what I mean by a risk management nitely not involved in hedging oil price the corporation through our contracts—
center, suppose one of your managers risk, and there is no CRO or corporate and the same is true of our credit risks,
makes an E&P investment today with risk management center at the Group with the exception of our regulated pipe-
a 15-year payback period. To protect level. But we do have some highly cen- line.
that investment against the risk of oil tralized policies. In addition to insurance, We have also spent a lot of time think-
price declines, that manager may want our funding policy is also administered ing about how to motivate our people. A
to hedge future production by locking centrally—and there are also very clear couple of years ago we put in place an EVA
in today’s high oil prices—and I don’t policies across the Group in terms of performance measurement and incentive
mean that the firm will literally go out interest rates, foreign exchange, and bank plan with some help from Stern Stew-

Journal of Applied Corporate Finance • Volume 17 Number 3 A Morgan Stanley Publication • Summer 2005 55
ROUN DTAB LE

art—and John McCormack can confirm Risk Management and debt commitments without matching
this, since he was with Stern Stewart and Credit Ratings long-term guaranteed cash flows.
in fact working with us at the time. The McCormack: How do credit agencies
incentive plan we developed for our line regard all this? Are they capable of under- McCormack: But the bond market
managers does try to distinguish good standing the consequences of enterprise seems to have a different opinion than
performance from good luck by using risk management, and the difference the rating agencies in this case.
performance measures that are adjusted between good and bad risk management
for changes in commodity prices. For programs? And how, if at all, does this Sunderman: I think the bond market
example, it removes the effect of com- affect the yield on your debt? Andrew, sees a lot of the same things the rating
modity price changes on a business unit’s your debt is trading at a price consistent agency sees, but it also appears to have
return on capital, thus providing us with a with a BBB or a BBB+ rating. But the recognized the future potential of the
measure of pure operating performance. debt is rated only B+. So, the rating agen- suite of Williams’ businesses as well as
cies seem to be lagging the market in this expected improvements in power com-
Kapitan: Some people argue that this is respect. Does this lag suggest that the modity markets. And it’s also important
the wrong way to go—that to the extent agencies have failed to appreciate your to keep in mind where the agencies are
the firm’s shareholders are bearing com- risk management program? coming from in the energy merchant
modity risk, managers should do the space. They’re still conscious of what
same. And they will say, “It’s okay to pay Sunderman: I think our rating reflects happened with Enron.
big bonuses to managers whose results mainly our past troubles, and so in this I like much of what the rating agencies
were mainly a result of good luck because sense I would say that the agencies are are doing today. They’re very deliberate;
shareholders got that value, too.” behind the curve. But, as long as our they’re trying to think things through in a
But while that logic may be appropri- management team continues to deliver systematic, methodical way. And they do
ate for top management—for the people on its promises, I think you’ll see the rat- respond well to companies that perform
who decide the firm’s risk profile—I don’t ings agencies catch up with what the bond the way management says it will—and
think it’s right to subject people at lower markets are saying—namely, that the com- credibility is very important in securing
levels in the organization to all those risks. pany is now clearly solvent, it’s no longer and maintaining a rating. But I don’t
Incentive plans in large organizations anywhere near bankruptcy, and it’s trad- think the agencies completely under-
need to be much more careful in how ing like an investment-grade company. stand everything that we present to them.
much and what kinds of risk they impose Now, when it comes to risk manage- They’re moving in the right direction, but
on operating managers and employees. ment, one concern of the rating agencies they’re not quite there.
Holding mid-level people accountable is Williams’ general policy of not own-
for things they have no control over or ing the power-generating assets that help McCormack: Bob, is there anything else
say in is not at all consistent with the idea us generate our revenue. We provide the that corporate officers can do to persuade
of pay for performance; and when the fuel, the asset owner provides the opera- the rating agencies of the benefits and
uncontrollables go the wrong way, the tional expertise to generate the power, effectiveness of their risk management
effect is demoralizing. In this sense, risk and then we take the output and sell it. programs?
management can play a role in convinc- And that business model has a large debt
ing people that the firm they work for is a component associated with it—because Anderson: My experience has been
true meritocracy, one where the connec- we’ve bought those options and we pay very similar to Andrew’s. The agencies
tion between operating performance and a fixed option premium every year for are clearly interested in risk manage-
rewards is pretty straightforward and not the right to do what we do. So, what the ment, and it has become a factor in their
distorted by financial “noise.” rating agencies see is a highly leveraged decision-making, but there’s a lot more
standalone business unit with long-term educating to be done.

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At our invitation, a representative really care about—and that’s liquidity. tify a certain rating—and let’s say it’s a
from S&P recently attended one of our And if your CEO and CFO don’t under- single A—while their rating seems stuck
CCRO discussion programs outlining stand that, the rating agencies are getting at BBB. And they wonder why they are
the aims and accomplishments of cor- smart enough to know that something’s only BBB.
porate risk management to date. And wrong. They now understand that even I think there are a number of differ-
I think we made some headway. Their though your company may have a great ent reasons for this disparity. Probably
energy analysts clearly understand much measurement system and a great CRO, if most important is that, in their desire to
more about the merchant energy busi- senior management hasn’t bought into it achieve comparability across companies in
ness, and the role of derivatives in that and isn’t going to take action based on it, a given industry, the rating agencies have
business, than they did a few years ago. it’s all kind of pointless. It’s liquidity—a their particular sets of ratios and models
Back in the late ’90s and early 2000s, I system for measuring it, monitoring it, that are not easy to challenge. Such mod-
was struck by their almost total lack of and ensuring it’s there when needed— els have been built up over the years using
comprehension of what was going on that is the rating agencies’ number one published information on all the different
inside energy companies—while, at the concern right now. companies they rate. And because of this
same time, the analysts who covered the reliance on models and the need for com-
banking sector were pretty much on top Sunderman: To add to that, S&P recently parability, the agencies have a hard time
of things. But the collapse of Enron and put out a statement that was based on the taking in specific information about a
the troubles throughout the industry have CCRO’s liquidity survey and the infor- particular company—say, a highly sophis-
clearly forced the agencies to upgrade mation the CCRO helped work through ticated and effective risk analysis system
their analytical skills and come to grips with them. In that statement they said that would enable the firm to operate
with emerging practices in risk manage- they were surprised by the number of with a significantly higher leverage. So,
ment. In fact, S&P has expressed interest highly rated energy companies that didn’t even if you have developed the most effec-
in working with us on another project. appear to have instantaneous access to tive, foolproof risk management system
What can a CRO do to make the case risk measures that the agencies consid- imaginable, don’t expect the agencies
to the agencies? Mainly two things. The ered critical, such as how much liquidity to raise your rating a couple of notches.
CRO should begin by explaining that his you would need in the event of, say, a You will get some credit for it—and more
or her main job is to put in place an ana- certain kind of price shock. The fact that credit as the agencies become more famil-
lytical framework for measuring all of a most companies said they don’t calculate iar with sophisticated risk management
company’s major risks and a set of con- such measures surprised and concerned approaches—but you probably won’t get
trols and procedures for monitoring and them. So, for that reason alone, I think as much credit as you think you deserve.
managing them—and the fact that the the agencies are getting smarter, and they I also agree with Bob’s point on the
company has seen fit to hire someone with are becoming more demanding in what agencies’ skepticism about how risk man-
the title of CRO should be interpreted as they ask for. agement systems are being used. As Bob
at least some indication of the company’s was saying, it’s all well and good to calcu-
commitment to the undertaking. Kapitan: Another thing that’s important late VaR, but the agencies want to hear
But that’s only a first step. What the to understand about the rating agencies about more than that. They want to know
agencies really want is the opportunity to is the extent of their reliance on indus- how a company’s metrics and monitoring
get your CEO and CFO in a room and try-wide ratios and rules of thumb. In processes affect day-to-day business deci-
ask them, “What is your chief risk mea- my work with financial services compa- sion-making. How does a given change
sure or indicator?” And if your CEO says, nies, I’ve seen a lot of my clients work in interest rates or a key commodity price
“Well, we have a great VaR engine,” then through their analysis and come to the affect the firm’s ability to service its debt or
they’re going to be disappointed, because conclusion that their current size, capital invest in maintenance or R&D or product
that has nothing to do with what they structure, and profitability would jus- support? What I think the agencies would

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According to a recent study, a dollar of “excess”

cash translates into as much as $1.50 of market val-
ue for risky companies with lots of growth opportuni-
ties. But for larger, mature companies, the last dollar
of cash can be worth as little as 60 cents. So, the
value of cash and excess capital seems to depend
on the company’s investment opportunities and the
risk of the business. And for companies without clear
growth prospects, large cash holdings appear to be
penalized by the market, presumably because inves-
tors don’t see a profitable use for the cash.

Don Chew
really like to hear, what would really impress necessary to support those businesses. of capital is a direct result of the amount
them, is that your risk management system And to the extent this kind of system cre- of risk we have within the entire portfolio,
is being used not just to avoid a meltdown, ates sustainable increases in profits—or a operationally as well as from commodity
but as a key component of the firm’s stra- less risky business—it should add to the exposure—and it also depends on the
tegic decision-making and its performance firm’s standing with creditors as well as market’s perception of how we manage
management and reward system. What I shareholders. that risk. And, in that regard, a good
have in mind here are the RAROC systems hedging program can help reduce your
developed by some banks—systems that McCormack: But to come back to my cost of capital.
assign economic capital to different opera- question, can a really good hedging pro-
tions based on their degree of risk and that, gram change your credit rating? More on Managing
in so doing, require the firm to earn higher Counterparty Credit Risk
rates of return on riskier businesses. If Sunderman: It certainly can’t hurt, espe- Smithson: Andrew, in addition to look-
applied to industrial companies—and, like cially when you’re faced with distress. But ing at S&P’s and Moody’s ratings, do
Charles, I think it’s only a matter of time even then, it’s clearly not sufficient by you also look at another kind of infor-
before this happens—this use of economic itself. I think what drives the credit rating mation—the implied ratings that are
capital could be the single most important is how you perform versus what you said generated by KMV?
way of getting companies to manage their you were going to do. I can’t overempha-
risk effectively. size that. The company has to solve its Sunderman: When you buy Moody’s rat-
That’s an important message to take own problems, and I think Williams has ings, the KMV implied rating comes with
to the rating agencies: We’re measur- proven it can do that. it. We also just purchased a new internal
ing our risks and we’re making sure our But, again, I think your credit rating credit system with tools very similar to
managers price the risks they’re taking by depends on your entire risk profile and KMV’s, and we plan on using that system
holding them accountable for the capital not just your hedging program. Our cost to evaluate our counterparties.

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Smithson: The KMV system essentially tection, the industrial company got the Koppel: In the case of BP, our profits
uses market data, especially the volatil- additional loan it needed. come both from taking positions and
ity of the stock price, to come up with But let me follow up on John’s question from market making. The rationale is
an implied rating. So, using KMV, you about whether risk management activities pretty straightforward: Because of the
can track what the market is saying about can affect a firm’s debt rating from S&P or scale and geographic diversity of our
both your risk and perhaps your capital Moody’s. Your answer, Andrew, was that operations, we have a very good under-
structure. it may help a little, but that other things standing of the oil and gas markets, and
Do you also track your Credit Default were much more important. But my guess our traders use that expertise to take
Swap (CDS) price in the market? I ask is that your risk management practices are their positions.
because the CDS price for Williams will likely to have a greater, or maybe a more
tell you the “instantaneous spread,” which immediate, effect on your implied KMV Chew: Do your trading operations
gives you a good idea about how the mar- rating and your CDS spreads than on deliver a fairly stable earnings stream?
ket is thinking about your credit. your debt ratings. In my experience, they And how do you communicate the value
are more sensitive instruments for detect- of your trading operation when you talk
Sunderman: We don’t keep track of ing changes in creditworthiness. to Wall Street?
those spreads. But they should be fairly
close to our bond spreads, which we do How Do Trading Operations Koppel: Our IR people can probably
look at regularly. And we may have found Add Value? respond to that question better than I
a creative way to use these credit swaps. Chew: The idea of comparative advantage can. But, as I said before, it seems clear
We sometimes have counterparties that in risk-bearing has come up a number of to me that our position as a global owner
won’t do business with us unless we post times today. And to me this idea raises the and operator of hard assets is bound to
collateral. One thing we have proposed question about the rationale for trading give us some good insights into the mar-
is to fund a credit default swap and make operations. For example, the trading oper- ket. And I think the market understands
the counterparty the beneficiary instead ations of large oil companies are routinely this advantage, and is willing to give us
of prepaying the collateral. As of yet we said to account for a certain portion of credit for that earnings stream in much
haven’t actually done a transaction like profits. And commercial and investment the same it way it values the earnings
that, but it could provide an interesting banks regularly attribute large portions from the rest of our businesses.
alternative to cash or LCs. of their earnings to fixed income and FX
trading. My question is this: Do these Chew: John, as an advisor to financial
Smithson: The use of credit derivatives trading profits come from taking what are institutions, what can you tell us about
by industrial corporations is still limited. essentially speculative positions, and turn- banks’ ability to generate trading profits
But I can think of one interesting use of ing out to be right more often than not? from the carry trade and their interest
credit derivatives by a middle-market Or do the profits really come from “market rate forecasts?
industrial company. Since middle-mar- making,” from minimizing positions and
ket companies don’t have direct access just collecting the bid/ask spread on cus- Kapitan: It’s really a matter of the bank’s
to capital markets, the firm had been tomer trades? I put the question this way core competencies, of what it’s in business
financing itself mainly through loans because a study I published years ago by a to do and how it expects to add value. To
from their house bank. When the bank couple of Oliver Wyman analysts reported the extent you are involved in the carry
balked at accepting more credit exposure, that the recurring FX trading profits of the trade, you are choosing to take interest
the industrial company bought “default old Chase Manhattan Bank came almost rate risk; you are in essence borrowing
protection” in the form of a credit default entirely from market making, while the short, whether through actual borrow-
swap that named the house bank as the speculative positions essentially netted to ings or deposit taking, and then investing
beneficiary. With this extra layer of pro- zero over time. those funds in mortgage-backed securi-

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ties or long-term Treasuries. Unless you’re In the process, you would be taking on a Chrysler, whose cash build-up got the
hedging, you have a mismatch between little bit of rate risk, at least temporarily, attention of Kerk Kerkorian. And I’ve
your assets and liabilities. And if that because you think that in the long term seen it on a smaller scale in a number of
mismatch is a primary source of a bank’s you’re going to be able to put that capital financial institutions as well. Some banks
profit, management and the board needs to use in core operations like lending. And with far more capital than profitable uses
to ask the question: what is our compara- this kind of temporary use of the carry for it have devoted themselves almost
tive advantage in taking that risk? Do we trade can make sense—you can unwind entirely to the carry trade, in some cases
have some insight that the bond traders the positions relatively easily because it’s with disastrous results. And that’s why, as
and the rest of the market don’t? such a liquid market and then either buy a general rule, the market wants you to
Now, I’m willing to consider the pos- back shares or increase dividends or put it return your excess capital in the form of
sibility that a large, money-center bank into core bank operations. dividends or stock repurchases.
can have some proprietary informa- So, I can see the carry trade as a useful
tion because of its flow of business and near-term strategy for reducing a bank’s Chew: To reinforce John’s argument, a
trade with customers. But even in this regulatory burden, but other than that finance professor at Georgetown named
case, the real underlying source of profit I would caution banks against trying to Lee Pinkowitz has produced a study
is likely to be the money they make on outtrade the bond market. called “What is the Market Value of a
their bid/ask spread as a market maker. Dollar of Cash Holdings?” The main
For smaller, regional, and middle-market Is Equity Expensive? finding of the study is that, for risky
banks, I think the best strategy is to avoid Koppel: John, your comment suggests companies with lots of growth opportu-
the carry trade and attempt to keep inter- that equity capital is expensive and that nities, a dollar of cash translates into as
est rate risk to very modest levels. In the there’s a significant penalty for having much as $1.50 of market value. But for
case of middle-market banks, the market too much of it. Do we have any evidence larger, mature companies, the last dollar
seems to be trying hard to determine how that the market penalizes companies for of cash can be worth as little as 60 cents.
much of their profits come from the carry carrying more equity than they need? So, the value of cash and excess capi-
trade. And my sense is that, in cases where tal seems to depend on the company’s
investors suspect that a large portion of Kapitan: My feeling is that if a company investment opportunities and the risk of
a bank’s earnings are not being generated carries a relatively small amount of excess the business. And for companies with-
by core bank operations, the bank’s shares capital, that’s not going to be a problem. out clear growth prospects, large cash
will carry a lower multiple. But it can become a major issue in cases holdings appear to be penalized by the
But having said that, I also think there where shareholders see a big cushion market—again, because investors don’t
is one reason the carry trade may make building up. First of all, idle cash earns see a profitable use for the cash.
sense for some banks—and that has to a low rate of return, especially after taxes By the same token, when companies
do with both the level and the design are taken out. But more important is the raise equity, there’s a lot of variation in
of capital requirements. In many cases, tendency of public companies to hoard how the market responds to those offer-
banks are required to hold more capi- capital and, in many cases, to waste it on ings. We know that the market responds
tal than they would probably choose to bad ideas. When capital is abundant, the to announcements of new equity offer-
hold if left unregulated. And because the folks in corporate strategy can be counted ings by marking down the shares by about
bank regulators don’t have specific capi- on to find ways to spend it. And even if 3%, on average. But there’s also a broad
tal requirements for bearing interest rate there aren’t any acquisitions or major distribution around this average: in some
risk, banks can do a kind of regulatory capital projects on the horizon, managers’ cases, companies announcing their inten-
arbitrage by borrowing short and putting natural instinct is to let the capital cush- tion to raise equity will see their stock
the capital in longer-term liquid securities ion keep building and building. We’ve price drop by as much as 10%; and in
that don’t require much capital backing. seen this in the case of companies like other cases, typically companies in high-

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growth sectors, the market response is We have found it possible to obtain call “segment profit after marking to mar-
often very close to zero. hedge accounting under IAS 39 for our ket.” This is a more cash-focused, accrual
So, in this sense, what might be thought economic hedges, but we have run into type of measure. We have told our ana-
of as the incremental cost of equity capital some obstacles. For example, although lysts that this measure does a better job
can vary widely among different compa- we hedge local subsidiaries’ currency of reflecting the economic reality of our
nies and circumstances. And the critical cash flows at the central level with respect business. And, as I mentioned earlier, our
factor seems to be the intended use of to the Group functional currency, both company’s disclosure practices were rated
the funds: are there profitable uses—or IFRS and FAS 133 effectively view the number one in the energy sector by Insti-
is management simply raising funds for functional currency only at the subsid- tutional Investor Research Group last year.
a rainy day or, even worse, cashing out at iary level. This disparity between the So I’m in favor of changing the rules
what they think is the top? accounting and the economic view forces on hedge accounting. Most of us under-
us to document some hedges in a way stand that financial statements are not
FAS 133 and that does not necessarily represent the economic reality. But by making it so dif-
Corporate Disclosure economic rationale, but it does achieve ficult to qualify for hedge accounting—it
Chew: Let me ask one more question the correct accounting treatment. So has been called a “privilege” rather than
before we go. Corporate executives have there are ways of dealing with the new a “right”—FAS 133 has moved account-
been highly critical of FAS 133, argu- accounting while carrying out our basic ing numbers even farther from economic
ing that it introduces artificial volatility risk management policy, but they may reality than they were before.
into income statements that acts as a involve structuring transactions a bit
deterrent to a sound hedging policy. In differently to comply with the account- Sullivan: That’s right. It’s as if the regula-
an article that will be published along ing standards while achieving essentially tors’ primary aim is to make the rules for
with this roundtable, Alex Pollock, the the same economic results. hedge accounting so tight that there’s no
former president of the Federal Home ambiguity on how to do it. But, in the
Loan Bank for almost 15 years, argues Chew: Let’s say that your policy is to process, they have created a lot of ambi-
that companies should make the right hedge a certain exposure, but FAS 133 guity. I like the idea of mark to market
hedging decisions and then present their prohibits hedge accounting treatment. accounting, but it needs to be applied
investors with what amount to two sets Is it worth including a statement in the consistently and comprehensively. What
of earnings numbers: one that complies MD&A part of your annual report saying FAS 133 gives us is mark to market, or
with FAS 133 and GAAP, and a “pro in effect that you’ve taken out a hedge that economic reality, for one side of the bal-
forma” number in which the firm’s hedge doesn’t qualify as a hedge according to the ance sheet—and in fact, it’s only one part
is effectively treated as a hedge—that is, FASB but you think it does a reasonably of one side of the balance sheet. And this
gains and losses are kept off the P&L and good job of hedging your exposure—and one-sided treatment makes corporate
run through a capital account instead. Is so you would like your investors to view financial statements a less reliable indi-
this a workable disclosure policy? your numbers as if you qualified for hedge cator of a company’s ongoing or future
accounting? Will this kind of “pro forma” earnings power, which is what I think we
Koppel: There are really two questions approach work with investors? really want these statements to measure.
to answer here. Do the new accounting
rules force you to do something different Sunderman: That is essentially what we McCormack: Well, let’s leave it at that.
from what you would otherwise do—for have been doing in our presentations to And let me thank you all for participat-
example, would they prevent you from analysts in the last two or three quarters. ing in this discussion.
hedging an exposure? And are there ways We start by presenting GAAP financial
to set up your hedges so that you can get statements and then we adjust those
hedge accounting treatment? numbers to arrive at a measure that we

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