The financial crisis and the collapse of Lehman Brothers in 2008 highlighted significant weaknesses in the ability of financial institutions to withstand economic shocks. A fundamental shift occurred in the perception of counterparty risk by corporate treasurers and forced a re-evaluation of risk management policies and practices. The vast majority of banks suffered multiple-notch credit rating downgrades, many of them falling below levels deemed acceptable by corporates for their transaction activity. As the financial strength of these institutions diminished, authorities began imposing on them minimum levels of capital and liquidity to be held, resulting in costs which are now largely borne by the corporate community.
In light of the rise in credit risk and increased regulatory costs, steps can be taken to make sure companies can effectively monitor and mitigate counterparty risk despite the future challenges they may face.
The Cost of Counterparty Risk
The change in the risk environment since the financial crisis has brought with it new costs for corporates. Aside from those unfortunate enough to have suffered actual losses due to default, corporate treasuries involved in derivative transactions as part of their hedging or trading activity will have experienced a deterioration in pricing. Banks now impose credit value adjustments (CVAs) when pricing a trade, mitigating their exposure by taking into account the market-derived counterparty credit risk over the life of the derivative. Calculation methods will vary between banks, but credit default swap (CDS) pricing will be the key input into modelling a CVA and it is the client who will bear the ultimate cost.
To protect from further exogenous economic shocks, many boards have mandated their treasuries to maintain a minimum level of liquidity – be it in cash reserves or committed bank lines. This results in a painful cost of carry for the company, but gives much-needed comfort for debt and equity investors. Focus has shifted firmly in favour of capital preservation in the investment of this excess cash with companies favouring short-dated, high quality products at the expense of yield opportunities of greater maturity or investment in lower-rated products. Emphasis is now on return of capital, rather than return on capital. They may also be forced to hold large amounts of liquidity to cope with cash flow volatility resulting from collateral and margin requirements.
Quantifying Counterparty Risk
As the financial crisis demonstrated, it can be difficult to gauge the true credit risk of any counterparty, especially that of a large and complex financial institution. However, it did teach us that we cannot be complacent, and as much due diligence as possible should be undertaken when selecting and evaluating our counterparties.
Most corporates lack the required resources to undertake a thorough credit analysis of every counterparty they deal with, so the majority rely on easily accessible and commoditised indicators such as credit ratings. As an independent assessment of financial strength they can be a useful starting point for structuring risk management policies, with many treasuries opting to set counterparty exposure limits purely on a ratings basis.
However, it could be argued that credit rating agencies (CRAs) have frequently been behind the curve throughout the financial crisis. For example, Lehmans filed for Chapter 11 bankruptcy as a single A- rated counterparty. A step further in the risk monitoring process would be to evaluate CDS levels as a leading indicator of financial distress, or use models which incorporate CDS rates in the calculation of implied default probabilities. One must be aware that all CDS prices are not liquid or efficient – trading activity by hedge funds and other market participants can distort pricing from fair value.
Corporates must also look outside the individual entity to the wider group and the country of domicile, taking into account potential support from the parent or sovereign in the event of default. Even with these tools the company will, at best, only have an indication of financial health. The focus must be on how to mitigate counterparty risk.
Managing Counterparty Risk
The costs of counterparty risk will be particularly severe for lower-rated corporates that are unable to trade on a collateralised basis. Those that can should consider implementing credit support annexes (CSAs) with their banks, resulting in not only reduced credit risk but better derivative pricing and potentially improved hedge effectiveness. However, they should be cognisant of the legal and operational costs involved, as well as the extra liquidity required to manage additional cash flow volatility due to collateral movements.
The selection of CSA threshold and payment frequency is an important consideration. As a large user of long-dated – and therefore credit intensive – derivatives, National Grid will ultimately be proposing to trade all its derivatives under zero-threshold, daily margined CSAs to give optimal pricing benefit while effectively mitigating counterparty risk. Anyone considering this approach should be aware of the increased operational burden and have sufficient systems and resources in place, or face the cost of outsourcing collateral management to one of the banks which provide such services. Operational hassle and cash flow volatility can of course be lessened by reducing collateral posting frequency and incorporating ratings-based thresholds into the documentation, but at the expense of pricing and risk management benefits.
Those unwilling or unable to put CSAs in place must evaluate which transactions will be most credit-intensive and incur greater CVA charges, such as large value long-dated cross currency swaps. Corporates could consider changing the tenor of their hedges, implementing phased or rolling hedging programmes, or using ‘credit auctions’ to allocate trades based on the CVA charge imposed. Mandatory break clauses in trade terms can also help reduce CVAs in longer maturity transactions. Hedging currency exposures with FX options instead of forwards can result in significantly reduced credit charges, while in many cases giving an optimal economic outcome. Evaluating the extent of credit adjustments in pricing is therefore important, but it is the economics of the hedge which must always take precedence.
The Regulatory Environment
As part of the policy response to the financial crisis, authorities are taking steps to mitigate counterparty risk faced by market agents. They plan to reduce systemic risk posed by over-the-counter (OTC) derivatives, by limiting excessive and opaque risk taking by participants in these markets. As part of the Basel III regulations, minimum liquidity standards are being imposed on banks. Minimum capital requirements are also being enforced, which are not designed to be “sufficient to cover the loss on the default of the counterparty, but rather the probability-weighted loss given such default” to quote from the document ‘Margin Requirements for Non-centrally-cleared Derivatives’ issued by the Basel Committee on Banking Supervision and the International Organisation of Securities Commissions (BCBS-IOSCO). To bridge this gap, regulators are promoting trading on a collateralised basis, with participants posting margin against movements in mark-to-market (MTM) valuation. A central aim of the 2009 G20 reform programme was to reduce the build-up of uncollateralised exposures within the financial system, using the following principles:
- All standardised OTC derivatives should be traded on exchanges or electronic platforms and cleared through central counterparties (CCPs).
- OTC derivative contracts should be reported to trade repositories.
- Non-centrally-cleared derivative contracts should be subject to higher capital requirements (as per the G20’s Pittsburgh summit declaration).
Although the precise impact on corporates remains unclear, the intention appears to be that those with sufficiently large derivative volumes would be made to provide potentially onerous reporting to trade repositories and post both initial and variation margin as part of their transaction activity. The potential impact on costs and liquidity are obvious, so corporates should ensure they are sufficiently educated before these regulations are enacted.
Effective counterparty risk management has become one of the most important roles of the corporate treasurer. Banks will continue to be downgraded and whether forced or voluntarily, it is highly likely that we will be faced with bilateral collateralisation or central clearing for all our derivative transactions. We must remain focused on effective hedging strategies when faced with higher derivative charges, adapt our risk management policies to encompass new regulatory changes and continue to be vigilant when monitoring the financial health of our counterparties.
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