A Dynamic Approach to Counterparty Risk

Four years on from the collapse of Lehman Brothers it has become clear that the benign pre-2008 market environment will not be returning anytime soon. Market volatility remains high and it is important that corporates acknowledge this to ensure they continue to effectively monitor their exposures to different types of risk.

The current cause for concern is the eurozone, which is not only about those banks and institutions centred in Europe but also those that have material exposures to its member states. This is very much an issue that business leaders are still coming to terms with. We have seen fixes intended to address the problems become ‘unfixed’ and a failure of a consistent approach to the issues plaguing the region. With new risks coming to the fore, corporates need to understand what impact these will have on their business.

Assessing the Banks

It is a difficult task to work out counterparty banks’ exposures to different types of risk and many corporates find it is not made easy for them. A first and important port of call, that corporates should not discount, is looking through a bank’s annual report and updates, as well as the wealth of detail provided by analyst reports. A good relationship between the corporate and its bank can help when trying to locate and look through the right detail, as not all treasury functions have the time or resource to dedicate due diligence to this. 

A second way to gauge counterparty risk is to look at credit rating agencies (CRAs). However, some may argue that CRAs have been discredited to a certain extent, as some institutions and investments that they gave superior ratings proved to be of less high quality than previously thought. In addition the complexity surrounding how corporates should read across the CRAs, which report differently in their own particular styles, adds to confusion as to what the ratings can tell a corporate about the level of risk to which a counterparty is exposed.

There is also the fact that underlying exposures are not static but evolve, particularly over the longer term. It is important for corporates to acknowledge that they need dynamic tools, sensitive to changes in the markets, in order to help them react swiftly to mitigate risk.

Dynamic Counterparty Risk Monitoring and Management

Post-2008, there has been increased discussion around credit default swap (CDS) pricing; these instruments have seen increased use by corporates to protect themselves against a default. CDS contracts are dynamic instruments, in that they can help corporates to place a finger on the pulse of the market and protect themselves in a timely and flexible manner. As these contracts are exposed to the counterparty risk of the seller, CDS pricing can be used to gauge the level of counterparty risk.

Given the complexity of using CRAs to assess counterparty risk, tracking CDS ratings and also share price movements are more comfortable tools for corporates to use. Not every corporate has, or needs, a sophisticated treasury division, and CDS ratings can be sourced either from their bank or a secondary information provider.

CDS and share prices are dynamic and allow for quick changes in portfolio positioning. A credit risk placed on negative outlook is not really what a corporate is looking for as the market moves too quickly, for example in reaction to European Central Bank (ECB) news, and the CRAs struggle to react in time to give corporates the information they require. Greek bonds are an example of where the CDS market has operated ahead of the rating agencies, as they were trading at junk levels several weeks before the agencies began to describe them as such in 2010. Further instances include Portugal, downgraded to junk in July 2011 although its CDS hardly moved, while in February 2012 Spain and Italy were both downgraded and considered to be less creditworthy than Chile and on par with Malaysia. Yet the markets did not move on the announcement as investors had already built this development as far back as November the previous year.

CRAs are important and their downgrades still have an impact on the market, but they no longer lead it especially when it comes to the European sovereign risk.  

Figure 1: Spanish Senior Five-year Credit Default Swap (CDS) Spreads

 
Spanish Senior Five-year Credit Default Swap (CDS) Spreads
1. Crisis talks ended with German chancellor Angela Merkel and French president Nicolas Sarkozy withholding €8bn of assistance and warning Greece it will surrender all European aid if it votes against a bailout package, (2 November 2011).
2. It is reported that there may be a European proposal to channel central bank loans through the International Monetary Fund, which could deliver as much as €200bn to fight the region’s debt crisis (2 December 2011).
3. Spanish banks lead lenders in buying back their own mortgage backed securities at distressed prices to bolster capital and stockpile eligible collateral for ECB loans (2 July 2012).
4. Speculation that European policy makers will boost the firepower of their bailout fund damped demand for the safest assets (25 July 2012).

Source: Bloomberg (31 August 2012)

Updating Policy

A clear strategy around counterparty risk, how it is monitored and trigger points, helps corporates gain a perspective of their investment and cash portfolio. It also encourages treasury managers to ask questions, so they are more aware of what could happen in the future and how to deal with different scenarios. Risk profile can be seen and understood, and, for liquidity generally, corporates can view what their operational cash requirements are and how they can optimise on the trading cycle. 

Corporates have been forced to undertake a thorough assessment of the risks they have and, since the fallout from the financial crisis, many corporates which lack a liquidity management policy are now looking to develop one. The policy should help when constructing a balanced investment portfolio, and ensure that corporates have the best possible return taking risk into consideration.

A significant shift seen by the industry is that banks have realised they need to up their game and that the customer cannot be expected to construct the liquidity management policy and portfolio without advice on what a good policy looks like. Working together, the corporate and its bank can develop a policy further; putting together an investment portfolio that matches a corporate’s short-, medium- and long-term needs.

In particular, there is a real gap in the support given to mid-sized corporates to help them understand what is happening in the risk world, how they should construct a proper treasury and liquidity management policy and how to execute it. Corporates need to avoid the accidents while trying to optimise on key business assets and resources, across the short-, medium- and long-term; cash management and risk management are difficult plates to keep spinning.

Allowing for discussion, a liquidity management policy can be put in place and executed within around five to six weeks. Following this, corporates should stay connected and speak to their banks for new perspectives on the markets, to review current and potential scenarios and how they would impact a corporate’s business.

Looking Forward

Many hard lessons have had to be learnt in the last few years and any corporate without an updated and regularly reviewed policy runs the unnecessary risk of a potential loss of a key corporate asset. It is a responsibility to manage corporate cash as part of looking after the management of that business and its employees. Noone would ignore health and safety issues, and for the future stability of the business neither should any worrying noises made the markets be forgotten. It is clear that banks have failed in the past, and that institutions and countries are in difficulty. Corporates must continue to look for warning signs and act appropriately, working with their banks to resolve the changing market landscape.

Some challenging risks are likely to stick around for years to come. While we all would like to take comfort from the pledges of support from the central banks, the reality is that the scale of the challenge facing the market is such that we have to be on guard and make sure we can understand the dynamics of market the best we can. Markets are moving quickly and dynamic instruments such as CDS ratings offer timely information and help keep an eye on the ball. With a liquidity management policy in place businesses will be better placed to weather any deterioration in financial markets.

A strong recommendation for treasurers is to start developing a suitable liquidity management policy for their company, if they have not got one in place already. This will help them better understand the market risks and allow them to establish strategies that will protect hard-earned cash.

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