All Quiet on the Credit Front?
By Kelvin Walton
Plain Sailing into 2014?
More than five years on from the multiple meltdowns of the global financial crisis, all seems set fair for achieving a reasonably prosperous New Year in most of the world’s developed economies – with positive knock-on effects for the rest of the world.
However, a couple of developments in the United States should certainly provide food for thought for corporate treasurers everywhere, as we move into 2014 on a tide of general optimism for global financial markets. These developments are the proposed Cornyn-Toomey bill, which creates a bankruptcy provision for US banks, and the critical reception of the first report by the US Treasury Department’s Office of Financial Research. Together, these should trigger some alarm bells in the global corporate treasury community; they should surely provide a stimulus for corporate treasurers to consider their present processes and policies in core business areas such as counterparty risk management and liquidity management, to verify that they are adequately prepared for future storms – and, if necessary, to initiate any indicated improvements.
The congressional bill in question is being proposed by two Republican senators, Messrs Cornyn and Toomey. This bill, should it be it voted into law, would end taxpayer bailouts of failing U.S. banks. This radical change would shift the bankruptcy risk of U.S. banks onto the shareholders – and presumably also onto bond and commercial paper holders, and to depositors and CD holders with positions in excess of the prevailing insurance limits.
It may seem relatively unlikely that such a radical piece of legislation will materialise in anything approaching its current form; but the very fact that it is being put forward should prompt prudent treasurers to verify that their counterparty risk management environment is properly effective, so that they could quickly quantify and analyse their exposure (in this case) to the U.S. banking sector.
The U.S. Treasury Department’s Office of Financial Research’s report on asset management and financial stability (which was published in September 2013) has run into severe criticism by asset management industry experts. ‘If asset management firms make bad investment decisions, that might be bad for the economy, so maybe they should be more heavily supervised and regulated…’ is the precis of the report offered by the Asset Management Group of SIFMA (‘SIFMA AMG’) and the Investment Adviser Association (‘IAA’). The OFR itself says it will take more time to create an effective early warning system of major events that would have substantial negative impact on the global markets. In summary, this reaction clearly indicates that Dodd-Frank related developments with respect to securing financial stability as represented in the OFR report have not yet secured the confidence the finance industry.
News and opinion such as this suggests that some of the underpinnings of the global financial system are not as secure and transparent as corporate treasurers might prefer. Uncertainties and lack of clarity about the scope – and probable real consequences – of any new major credit event would still present a significant and dangerous issue if they were to occur in 2014. The positive differences today compared with 2008 include the much tighter application of controlling regulation such as SOX, through the expanding enactment of Dodd-Frank and EMIR, through the recapitalisation and restructuring of many banks, and through the numerous technology developments and expert publications relating to financial risk and liquidity management that have transpired over the last 5 years. However, the true situation is not as clear or secure as might be hoped this far down the line from the first onslaught of the crisis.
These developments do highlight the contention that there is still much room for improvement at the government level and beyond – and that corporates should remain vigilant in the related business areas, and should be actively using or developing their own systems and processes to provide them with the analysis and timely reporting that they need for prudent counterparty risk, liability and liquidity management.
Counterparty Risk Management
Prior to 2008, corporate treasuries almost exclusively used classic credit ratings published by the ratings agencies to manage the allocation of deposit and other dealing limits to bank counterparties – if they used anything at all. Limits might be recorded and monitored in the TMS (treasury management system) – or they might simply be maintained manually.
The major defect of credit ratings as revealed in the 2008 crash was that they lacked the sensitivity to react to relatively fast-moving events such as the deterioration of Lehman Brothers’ creditworthiness – which was still investment grade when the organisation ultimately failed. A few companies had been using more market sensitive tools such as CDS (credit discount swap) spreads, and these organisations were able to detect the serious negative changes that were materialising at Lehman, and to take evasive action in time.
Further, manual systems lacked the objective control quality and transparency – let alone real time or near real time performance – that can be delivered by effective automation.
In the ensuing time, all TMS systems have upgraded the scope and effectiveness of the counterparty and liquidity risk management tools that are offered to the user community, so that they now generally provide effective solutions for corporate treasurers.
The use of CDS spreads has never really acquired great popularity among corporates globally. These instruments are seen as rather exotic tools, for primary use by the wholesale banking, dealing and investment sectors. Today, corporate treasurers seeking instruments to act as leading indicators of sudden declines in counterparty creditworthiness often look at equity prices and indices (to monitor earnings and growth outlook) and bond prices and indices (to monitor expectations of future debt service repayment capability), as well as credit ratings (which have improved in scope and sensitivity since the crisis).
Treasurers do not usually see themselves as credit analysts, and yet it seems that they have no option but to remain active and innovative in measuring and monitoring their bank counterparties’ credit status, for the prudent allocation and management of limits.
The application of IFRS 13 requires the use of CVA – credit valuation adjustment – in some specific circumstances, and this can in some cases lead to exposure / hedge relationships moving outside hedge accounting boundaries, and therefore requiring remedial action to be taken. IFRS 13 can require quite powerful technology support to accommodate the Monte Carlo simulations needed for CVA derivation.
In all cases, corporate treasuries should be regularly reviewing their counterparties’ creditworthiness, and adjusting, opening and closing lending and dealing limits accordingly.
It is probably practical for a corporate to use a combination of several credit factors (including ratings and market-sensitive indicators) to evaluate counterparty creditworthiness, with some external expert advice if needed (perhaps from a specialist consultant) to verify their initial conclusions.
A further factor to consider – especially for the application of technology to support the process – is the frequency with which credit status should be monitored; given the alarming speed with which a bank’s creditworthiness has occasionally deteriorated in the quite recent past, an automated twice daily update would be a reasonable minimum, especially when there are many counterparties to evaluate. Some would hold that real time monitoring and alerting represents best practice.
Liquidity Management Considerations
Treasurers need to be aware of their own organisation’s creditworthiness, and the direction and scale of any likely change, when considering their strategic financing plans. For many companies, bank and capital market liquidity tightened or evaporated entirely in 2008. Accordingly, it is always important to evaluate current liquidity against projected needs – and expectations. The present debt market may be seen to present opportunities to increase the proportion of longer term liabilities in the portfolio, whilst rates remain at levels which are very low compared with the history of the last 30 or 40 years.
2014 re-financings may perhaps be judged (with hindsight) as a having offered a unique chance to extend the maturity profile of the debt portfolio despite the relative yield cost of doing so, given the strategic benefits of securing longer term liquidity for the business.
Possible Follow-up Actions
This article was conceived in response to two recent developments, both of which are ultimately related to the after-shocks and lessons of the financial crisis. It is certainly not advocating any sudden or dramatic actions; however it does intend to point out a couple of the areas in which the outlook for corporate treasurers is not as clear or secure as might be thought. Treasurers and CFOs are ultimately out on their own in measuring and anticipating many forms of financial risk.
There is no sense in running down risk defences at a time of generally positive economic outlook; fair weather in fact provides an optimum environment for prudent and perceptive analysis and planning, and for the introduction of any indicated changes.
There’s no excuse for being caught twice…
Cornyn-Toomey bill: http://www.cornyn.senate.gov/public/index.cfm?p=InNews&ContentRecord_id=0ad834a5-fdea-418f-84a7-969d521409c9
OFR Report on Asset management and Financial Stability: http://www.treasury.gov/initiatives/ofr/research/Documents/OFR_AMFS_FINAL.pdf
Dechert discusses the Office of Financial Research’s Report on Asset Management and Financial Stability: http://clsbluesky.law.columbia.edu/2013/10/23/dechert-discusses-the-office-of-financial-researchs-report-on-asset-management-and-financial-stability/
SIFMA AMG & IAA Criticize OFR Report on Asset Management: http://centerforfinancialstability.org/wp/?p=3345