Counterparty Risk Management for Corporate Treasury Functions

One of the great lessons learned from the 2008 financial
crisis was that the financial world we lived in was not as safe as many had
imagined. This statement remains true today, despite recent industry and
regulatory efforts aimed at bolstering counterparty strength.

In
conversations with corporate cash investors, Capital Advisors has found an
increased awareness of counterparty risk management. As the topic remains a top
priority among risk managers at financial institutions (FIs), it is an even
bigger challenge to treasury practitioners who may have limited knowledge of
the complex, interconnected and concentrated world of finance.

This
article attempts to explain counterparty risk from the corporate treasurer’s
perspective, why it has become more difficult to track and manage and the key
principles of managing this risk. Since this is an all-encompassing topic the
focus is on the credit aspect of counterparty risk, as opposed to collateral
management, settlement risk or other operational and legal issues.

Counterparty Risk: The Corporate Treasurer’s Perspective

Although the industry’s concerns with counterparty risk are mainly
centered on transactions between FIs, corporate treasury also faces significant
challenges. In the past two decades businesses increasingly have become more
global, resource-dependent and multi-faceted. These new dynamics necessitate
the need for various trade finance, support agreements and hedging activities
with multiple financial intermediaries.

As financial instruments
grow more sophisticated and FIs become more complex, corporations feel
particularly challenged to identify, track, manage and mitigate counterparty
risk, due to a lack of expertise and resources as compared to their financial
counterparts.

For most small- to medium-sized enterprises (SMEs),
avoiding default by a financial intermediary is the main focus of their risk
management strategies, as more complex and expensive risk mitigation techniques
are not financially feasible. Capital Advisors’ focus is therefore on risk
prevention and diversification, which are more applicable to
resource-constrained treasury staff.

Consequences of
Counterparty Failure

Whenever a corporation fails to
receive financial benefits as agreed, counterparty failure has occurred.
Sometimes, pledged asset collateral or government intervention may lead to full
or partial recovery of the losses, but only after significant delay. At other
times, there may be no recovery due to the highly leveraged and high-risk
nature of financial intermediations.

It should be noted that it does not
always require a counterparty default for the investor to sustain a loss.
Sometimes, the counterparty may fail to deliver on its promises for reasons not
financially related, which may result in a time-consuming and costly legal
process to recover the funds. Thus, corporations must assess both the
counterparty’s willingness to pay and its ability to pay.

New Challenges in Counterparty Risk Management

Corporate risk managers may feel that their tasks have become more
challenging in recent years and those feelings are valid for several
reasons:

  • FIs have grown larger, more complex and have become more
    interconnected.
  • The 2008 financial crisis also resulted in significant
    credit deterioration from bad loans, trading losses and depleted capital.
  • Government support assumptions for large banks also have been reduced in
    many jurisdictions.

The Increasingly
Concentrated World of Banking

Since the repeal of the
restrictions on interstate banking by the Riegle-Neal Act in 1994, bank mergers
in the US have grown substantially, eventually resulting in an industry
dominated by a few very large players. Industry consolidation brings new
challenges to counterparty risk management because corporations are frequently
forced to maintain multiple banking relationships with a shrinking pool of
intermediaries.

Figure 1 below shows that, since 1994, the share of
US national deposits at the 10 largest banks almost quadrupled, from 11.9% to
45.0% in 2012. Similarly, the share of the 20 largest banks tripled, from 17.4%
to 54.5% over the same period. 

Figure 1:
National Deposit Concentration.

Capital Advisors Figure 1 Counterparty risk management
Source: FDIC Top 50 Commercial
Banks and Savings Institutions by Deposits.

To further
illustrate the effect of mergers on counterparty concentration, Figure 2 traces
the lineage of surviving entities from the top 20 banks in 1994. It shows that
as many as six of those banks are now part of JPMorgan Chase, five were
integrated into Wells Fargo and four into Bank of America.

To make
matters worse, many corporations now have counterparty exposures to the same
few large banks, which could become a systemic concern if one of the banks runs
into problems.

 Figure 2: Effect of Bank Mergers since
1994

Capital Advisors Figure 2 Counterparty risk management
Source: FDIC Top 50 Commercial Banks and Savings Institutions by
Deposits.

Deterioration in Counterparty Credit
Strength

The underlying credit strength in the largest FIs
has deteriorated dramatically in recent years, largely due to poor loan
quality, volatile swings in the capital markets and lax risk management
practices. Reduced government support assumption for the so-called ‘too big to
fail’ banks also has contributed to deteriorating credit quality at major
banks.

Figure 3 below lists the average Moody’s deposit credit
ratings of the top 20 US banks since 1994. It shows that the average rating
improved from A1 to close to Aa2 in 2008, before collapsing back to A2 by 2012.
Suffice it to say that increased concentration and deteriorating credit quality
present two distinct challenges for corporations in managing counterparty risk.
We should note that these challenges are not unique to US banks. As many
practitioners are keenly aware, financial situations at the eurozone’s banks
are perhaps more challenging than those of their stateside counterparts.


Figure 3: Average Ratings Trend among Top 20 US
Banks.

Capital Advisors Figure 3 Counterparty Risk Management
Source: Moody’s Investor
Services.

Counterparty Management
Principles for Corporate Treasurers

Given the importance
and complexity of counterparty risk management, how should a treasury
organisation approach this subject? Individual practices might vary, but we
believe the following principles should apply to all counterparty
situations.

Managing counterparty risk, not reacting to it: All too
often, counterparty risk becomes a high priority only after the
creditworthiness of a major counterparty is in question. Although
well-disciplined risk management practices may seem arduous and time consuming,
merely hoping that everything will be fine is not the right strategy. Likewise,
simply picking banks deemed ‘systemically important’ and expecting the
government to come to the rescue may is an increasingly imprudent course of
action as the political environment becomes less tolerant of bailing out big
banks with taxpayers’ funds. The time to start doing something about
counterparty risk is now.

Developing a detailed and conservative
umbrella risk policy: Among the reasons that can make counterparty risk
management seem daunting is that a corporation may have multiple access points
to the same FIs. Getting the overall picture is not always easy. Although
specific policies for deposits, cash sweeps, investments, credits and
derivatives may be sufficient, the selection criteria and monitoring procedures
governed by a common umbrella risk policy can minimise unforeseen counterparty
risk. This umbrella risk policy may detail the steps through which
counterparties are selected, how limits are calculated and tracked and the
measures to take when counterparty performance deteriorates.

Diversifying risk by setting limits according to risk profiles: As with all
credit risk management, a primary means of counterparty risk mitigation is
through diversification. Although this principle is widely recognised and
practiced at many places, additional measures used to fine-tune exposure limits
in accordance with predefined risk levels may enhance effectiveness. For
example, counterparties with stronger credit profiles may have higher limits.
Fundamental indicators, such as credit ratings, and market risk indicators,
such as credit default swaps (CDS) or bond implied ratings, may be used for
this purpose. Nonetheless, investors should be cautioned to recognise the
inherent shortcomings in credit ratings and CDS levels and use them with
caution.

Looking to professional managers for counterparty expertise:
Overseeing counterparty risk management can be a daunting task. In addition to
solvency risk, corporate treasurers often need to be concerned with other forms
of risk such as asset collateral, asset service and operational risk. The
technology required to track exposures and monitor limits may, by itself,
necessitate the need to engage specialists in counterparty risk management. On
the other hand, there may be external resources available to corporate
treasurers, such as the risk managers at their relationship banks, money market
funds (MMFs) and separate account managers.

Counterparty
Risk Management Best Practices

For implementation of
specific counterparty risk measures, corporate treasurers could do well in
looking to some of the common best practices among financial intermediaries,
and adapt them for their own use. The following are samples of these
practices:

  • Standardise contracts.
  • Use products with a
    central clearinghouse.
  • Consider requiring delivery versus payment
    (DVP).
  • Match collateral and margin posting with counterparty risk
    assessment.
  • Use tri-party repurchase agreements and third party
    custodians

Conclusion: Managing Counterparty Risk as an
Integrated Process

Counterparty risk is, at its very core,
the solvency risk of the financial intermediary. Corporate treasurers can
improve risk management by being proactive and developing a detailed and
integrated risk policy across business lines, diversifying risk by setting
appropriate exposure limits and seeking out professional resources where
available. By taking heed of the financial industry’s own best practices and
tackling the subject directly and systemically, corporations may find the task
less daunting than they feared.

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