It is just over a year since the European sovereign debt crisis entered a more severe phase with Jose Manuel Barroso, European Commission (EC) president, warning that the crisis was extending beyond the peripheral eurozone countries. Funding just keeps getting more complicated for corporate treasurers it seems, unless you are lucky enough to be sitting on a large cash reserve.
Last month marked the fourth anniversary of the collapse of Lehman Brothers when funding and bank / counterparty risk first raced to the top of the agenda. So far, 2012 has continued where 2011 left off, with continued downgrades of governments and banks. During the banking crisis of 2008, many banks only survived as a result of, at times, controversial state intervention. Today, particularly in Europe, for some commentators the question has shifted from whether governments are willing to support individual banks to whether they are able to do so.
The acute pressure on the banking system and concerns about the financial standing of deposit takers and counterparties is set to continue. At the same time, fearing illiquidity in the debt markets and continued restrictions on lending imposed by banks seeking to repair damaged balance sheets, many boards have taken the decision to retain much larger cash balances than they might ordinarily.
Taken together, these are perhaps the most difficult conditions through which treasury teams have had to navigate in a generation. There are more assets to protect from a greater number of risks and this at a time when the usefulness of the traditional instrument panel that can assist them has been brought into serious question.
Such conditions will have prompted many treasurers to reassess what constitutes intelligent financial governance and risk controls.
The Difficulties in Assessing Financial Strength
There are myriad sources of data in relation to financial strength. The challenge is to make sure the available, often complex, information is put in its proper context and weighted appropriately.
Many companies typically only refer to minimum credit ratings within their treasury policies. Indeed, the published views of the main credit rating agencies (CRAs) in relation to any deposit taker or counterparty should form an important part of the picture for a treasurer deciding whether to transact with that entity. However, focusing solely on this single type of measure could be as foolhardy as ignoring it.
Before one even begins to consider the controversial questions thrown up by the way in which the CRAs are remunerated, it is undeniable that credit ratings are static, necessarily retrospective, measures. The CRAs do not provide any sort of inside view; they might be expert in analysing data but they are not privy to any information other than that which is publicly available. Furthermore, there is a growing body of post-2008 research which refutes the view that they have been any sort of meaningful predictor of default.
There is an appreciation on the part of an increasing number of treasurers that credit default swap (CDS) prices, the cost of insuring against an institution defaulting on its debt, might provide a key indicator in assessing a counterparty’s financial standing. Unlike with the snapshots provided by credit ratings, daily changes in CDS prices can be tracked. However, while the potential value of CDS data might be recognised, how to actually use this information is much less obvious and this might explain why treasurers, while aware of CDS pricing, have been reluctant to incorporate it into treasury policies.
Indeed, treating such data in a very simplistic way, will at best limit its value, or at worst lead to a fundamental misunderstanding of the position. For example, the setting of an arbitrary fixed CDS threshold to determine the acceptability of a counterparty will not be flexible enough for what can be a fast-changing environment and would open the treasury team to an obvious challenge around the defensibility of the barrier selected. Instead, a more dynamic use of the data, carefully cleansed, that looks at it as means to determine the relative standing of a counterparty is more likely to be successful.
Money Market Funds: A Ready-made Solution?
The difficulties and complexities inherent in this area have led many treasury teams, particularly in the US, to fall back on the use of money market funds (MMFs). In support of this approach are cited:
- Diversification benefits.
- The typically very short duration of the underlying investments.
- The ability to benefit from professional investment management expertise.
- The fact that many such funds have AAA ratings.
However, do these elements really result in additional security?
While there is a role for such funds for some investors and they have only in the last few weeks successfully avoided calls for greater regulation from the Securities and Exchange Commission (SEC), they are not without significant controversies. These should give the prudent treasurer pause for thought before MMFs are adopted as a safe haven in turbulent times.
It is not always appreciated that such funds have lost money on underlying investments not only during the crisis of 2008 but since then. Mary Schapiro, SEC chair, recently alluded to the fact that in 2007 to 2008 more than 100 such funds had to call on capital support from their sponsors, with 47 either receiving cash or having investments purchased at levels above the market price1. Many have suggested that sponsors have in more recent times also been subsidising their MMFs. Sponsors are not obliged to provide such support, however, and it is not guaranteed that they will, or will be allowed to, provide such support in future.
Perhaps most fundamentally, it is a common occurrence that an underlying holding within a MMF would not be within the treasury policy if held directly. Its being held within the fund does not reduce the risk associated with the particular instrument. Eric Rosengren, president and chief executive officer (CEO) of the Federal Reserve Bank of Boston, earlier this year pointed to CDS analysis that “highlights that credit markets are assigning a significant chance that some MMF instruments that current regulation deem permissible could in fact default”. 2
To illustrate some of the specific risks that such funds have continued to run, he cited the number of funds exposed to Dexia shortly before it was bailed out by the French and Belgian governments and sometime after key indicators were pointing to the increased risks. In this respect, it is crucial to appreciate that the AAA rating trumpeted by many MMFs is a fund rating and is in no way equivalent to an AAA credit rating. In our experience, well-known liquidity funds can have less than 10% of its assets invested in assets which have an actual AAA rating.
Perhaps reflecting these concerns there have been significant outflows in recent months. The Financial Times noted that by June 2012 assets had fallen by US$1 trillion from a peak of US$3.7 trillion. 3
An Alternative Approach
Rather than going down the outsourcing route offered by MMFs, and recognising the limitations of solely using credit ratings, there are a number of valid sources of data that treasurers can use to create bespoke dynamic benchmarks against which to monitor their own individual counterparties and establish appropriate tolerance thresholds. Principal among these are:
- Live market data, including bond yields, share price, dividend cover, CDS.
- Implied aggregate credit ratings based on data from the main CRAs.
- Bank financial strength ratings.
- Regulatory information including Tier 1 capital and liquidity ratios, while being mindful of inconsistencies across different regulatory jurisdictions.
In addition, it is important to determine the appropriate degree of importance to be ascribed to each. Taken together, this array of measures provides a more considered and comprehensive picture, a better instrument panel, than looking at any one or two measures in isolation.
How it Might Work
This instrument panel should be developed to meet the company’s specific requirements and should not simply incorporate all the above measures but also take account of:
- The company’s wider financial position, including the specific appetite for risk.
- Restrictions on the use of particular jurisdictions.
- Requirement for limits for terms and allocation of funds for different categories of counterparty.
- Currency requirements.
Clearly, there may well be relationship banks that it is necessary for a treasury team to use which will fall outside any thresholds set by a model they develop which takes into account the above. Nevertheless, this in itself is still useful to know and tracking the extent to which this is the case and flagging it to the board implies good oversight on the part of the treasury team.
More rounded and animated counterparty financial strength evaluation is not only useful from the point of view of analysing the strength of deposit takers as part of an investment policy. Treasury teams could use such a model to develop more robust assessments of the following:
- Providers of operational banking and nominee services.
- Corporate bond investments and debtors generally.
- Providers of insurances.
- Derivative counterparties, most commonly in relation to forward hedging.
In essence, a good model should help treasurers to move away from a reliance on long-term credit ratings, which are necessarily static and retrospective to sooner identify ‘outliers’, or banks that are weak/becoming materially weaker. At the same time, any sensible model has to be workable in practice; it will need to adjust for general volatility to avoid repeated precipitative actions while not losing sight of momentary spikes which suggest particular problems with specific banks that do require action on the part of treasurers.
Such a model will help treasury teams more clearly recognise and control investment risk, ensuring levels of risk are understood and commensurate with levels of return. Overall, it can be a key tool in the improvement of financial governance and operate as an effective early warning system.
1 Money Market Mutual Funds and Financial Stability’, Eric S. Rosengren, president and CEO, Federal Reserve Bank of Boston, Remarks at the Federal Reserve Bank of Atlanta’s 2012 Financial Markets Conference, 11 April 2012.
2 Money Market Mutual Funds and Financial Stability’, Eric S. Rosengren, president and CEO, Federal Reserve Bank of Boston, Remarks at the Federal Reserve Bank of Atlanta’s 2012 Financial Markets Conference, 11 April 2012.
3 FT.com www.ftalphaville.ft.com, 25 June 2012.
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