Risk Management

“I Would Love to Owe a Bank One Million Drachma”

In the first installment of a series, a treasurer lays out a plan for managing a multinational’s exposure to the euro-zone crisis.
Patrick GuidoJuly 31, 2012

Although the subject matter below is based on real-world experience, all characters, figures, and settings are fictitious and are not based on the financial situation or strategy of any specific company.


From: CFO, U.S. Multinational Fortune 500 Company
To: Treasurer
Priority: High
Subject: How can Treasury protect us in the euro zone?

From: Treasurer
Priority: High
Subject: Re: How can Treasury protect us in the euro zone?

Hi, Boss:

The treasury team has been working vigorously on a risk-management plan. We were planning on presenting something to you before the next board meeting, but let me offer you the nickel tour right now.

The situation in Europe is indeed dire. High debt levels, anemic growth, and increasing borrowing costs are pushing the “PIIGS” (Portugal, Italy, Ireland, Greece, and Spain) or “GIIPS,” to use the more politically correct acronym, toward insolvency and everyone else deeper into recession. Scenario analyses among investors, economists, and central banks range from full fiscal union to complete dissolution of the euro zone. One extreme would likely spark a rally in markets while the other would push Europe over the fiscal cliff and incite chaos.

Regardless of the outcome, there are several actions the treasury department can take now to protect the company. To use a consulting term, I would classify these actions as “no regrets moves,” meaning they would not disrupt current operations or come at a high cost to the company.

Pool cash in low-risk jurisdictions. We have gone country by country and taken inventory of all the financial risks we face in the euro zone. There is no risk more immediate than loss of our cash. Today we have significant amounts of cash flowing throughout the euro zone. Because our main European subsidiary is a euro functional entity, we hold the majority of that cash in euros. As the euro continues to depreciate, we are subject to foreign-exchange (FX) translation losses on our consolidated financials and economic losses upon conversion to U.S. dollars. Also, should a country fall out of the euro zone and revert back to its sovereign currency (e.g., the Greek drachma), we could see all bank accounts frozen in that country until such time as an orderly conversion can occur. This would limit our access to liquidity and almost surely result in losses, as any reemerging currency is likely to be devalued right out of the gate.

To combat these risks, we would like to start pooling as much cash as possible, in as few accounts as possible, in the healthiest European countries possible. Because physically pooling cash each day across dozens of bank accounts is cumbersome, expensive, and inefficient, we can implement something called “notional” pooling. Many banks now offer this as a way to consolidate cash without actually moving it. As long as we can get the cash to one of the pooling bank’s local accounts, we can get credit for it in one central location, preferably a bank account held by an operating subsidiary in a AAA-rated country such as Germany or Luxembourg. This will be a great tool in gaining visibility and control of our cash not only in Europe but also worldwide.

Avoid high-risk European banks and “buy American.” A close look at the financial health of some of Europe’s top-tier banking institutions reveals a system on the brink of collapse. Europe’s banks have enormous exposure to the governments, companies, and individuals of the highest risk countries. To the extent we do business with these institutions, we could experience major disruptions to our operations, whether they are lost access to credit and banking services or actual loss of cash. As a result, we have ranked all of our key European banking partners by sovereign debt exposure and credit-default swap spreads, both publicly available metrics. Going forward, we would like to limit the business we do with the higher-risk European banks, unless they are the only game in town. Instead, we will first look to one of our U.S.-based banking partners operating in the euro zone. Although U.S. banks have their fair share of issues, they are currently well capitalized and most have manageable exposure to European sovereign debt. This may hurt some relationships we have maintained for years, but business is business and we need to protect ourselves.

Hold cash in U.S. dollars, Japanese yen, or Swiss francs. I mentioned that we hold most of our cash in euros, given it is the local currency with which we do business in Europe. By converting all our cash balances to safe-haven currencies such as the U.S. dollar, Japanese yen, or Swiss franc, we can avoid both devaluation in the euro and potential legal battles over conversion should the euro disappear altogether. To be sure, this could create FX losses for our European subsidiary if conditions improve, but this exposure is well worth it, in our opinion. Conversion to a safe-haven currency can be easily accomplished with a simple spot FX trade with whatever bank holds the cash.

Increase the hedge ratios and consider long-dated options. As you know, our company maintains a cash-flow hedging program for its European business, hedging both FX revenues and expenses using forward contracts. Our policy allows us to hedge up to 100% of our total exposure, up to 24 months out. We typically use a rolling and layering approach, whereby we hedge 80% of the nearest fiscal quarter, 70% of the next closest quarter, 60% of the next quarter, and so on.

To reduce volatility further during the euro-zone crisis, we recommend increasing our far-dated hedge percentages. So instead of having less than 50% of next year’s exposures hedged, we would crank our hedge ratios up as high as the 100% policy limit. We see euro weakness and sluggish economic conditions in Europe well beyond next year and believe the greater protection is warranted. If you are uncomfortable locking FX rates so far out using forwards, now would be a good time to use options. Although premiums are up due to volatility, longer-dated, out-of-the-money FX options are more cost-effective and will allow us to benefit from any rally in the euro while providing a cap to losses should the euro continue its slide.

Borrow locally, but maintain backup liquidity. Just as our assets in Europe are subject to losses, so are our liabilities subject to gains. There is nothing I would love more than to owe a bank 1 million drachma when the shoe drops in Greece. Our U.S. dollars held in Europe will buy lots of euros, lire, punts, whatever, resulting in an economic gain on debt repayment. So to the extent we need capital, and to the extent we can get it from a healthy bank, we should be financing our euro-denominated assets with euro-denominated liabilities. Just to be safe, we have our global credit facility based in the United States on standby. Under the terms of the syndicated facility, made up mostly of U.S. banks, we can borrow in any major currency to finance our subsidiaries around the globe.

Happy to discuss.

The Treasurer

The author, Patrick Guido, is vice president and treasurer of publicly held VF Corp., a $10 billion global apparel and footwear company with brands that include The North Face®, Vans®, and Timberland®. Patrick has more than 17 years of experience in corporate finance. He earned an undergraduate degree from Georgetown University and an MBA from Vanderbilt University.