Mitigating Counterparty Risk in a Volatile Environment

One of the major effects of the 2008 credit crisis on corporate treasury has been the wide range of risks that the function now has to manage. Assessing and analysing counterparty risk is now front of mind for treasurers as they look to drive efficiency and improve business performance. The degree of volatility and uncertainty in the current market has focused the department on improving risk management techniques. As the core business continues to concentrate on selling goods and services for profit, any unexpected financial disruptions, particularly where uncertainty prevails, can have a crippling effect.

Supply Chain Disruption

In direct response to the financial crisis, corporates moved cash into more easily-accessible accounts as centralising liquidity became crucial. Good liquidity management helps ensure the availability of funds to meet all cash outflow commitments for day-to-day operations, only now it is not just a corporate’s own liquidity which is of concern, but the liquidity of their entire value chain. The supply chain has become increasingly globalised and the link between supplier and buyer has significantly deepened. Many buying entities now work with a strategic supplier, who at some point during the relationship could come under financial stress. This has given rise to an interesting new trend in supply chain finance (SCF) as corporates look for ways to support their strategic suppliers in order to avoid potential disruptions ahead of time.

The Japanese tsunami provided an example of how a catastrophe can affect global supply chains, which can in turn have a huge impact on the performance of the corporate. If a company sells its goods mainly to one company, then it will need to hedge its risk against this buyer – this action is of enormous importance to the commercial function of the business. Even very successful companies, whom the market would never expect to falter in their financial performance, can encounter problems if they are selling goods to businesses who are not paying them.

The same problem can arise if the company places liquidity with a bank which is failing. Understanding the amount of exposure to financial institutions (FIs) is therefore a key priority for risk managers. Many are now forced to ask the difficult question: what would happen if an important business partner, bank or supplier were to go out of business?

Counterparty Risk

When it comes to risk, a corporate’s financial reputation can be tarnished by the standing of its counterparty. It is therefore crucial to have transparency across all interlinked business processes in order to accurately review operational and financial health. The treasury department can assist by effectively managing counterparty risk and analysing exposure in three areas: credit, performance and country risk.

Credit risk

The risk of not obtaining repayment of funds held by another party on your behalf, or alternatively not being paid monies due for goods or services already supplied, forms the basis of credit risk. Corporates must understand and mitigate a supplier’s credit risk position and be prepared to manage the impact of a default.

Performance risk

There are certain operational risks that need to be measured to ensure the counterparty is able to perform or deliver on their side of the agreement. The monies may be available, but the facilities may not be in place to fulfil the obligations set out in the contract.

Country risk

When transacting in a new country there are a number of risks that need to be considered. Political and social unrest must be assessed and currency and banking practices properly analysed. Equally, the legal framework in one country may not be as robust as another and safeguards may not be uniformly in place, which includes the risk of expropriation and nationalisation.

Assessing and Analysing Counterparty Risk

Corporates must take clear steps to reduce their counterparty risk and, therefore, they need to instigate a deeper analysis into fundamental business processes. It is important to assess all elements of the counterparty risk before making important business decisions and those choices should be preceded by thorough analysis. A holistic view of the company’s processes is a prerequisite and this may go beyond the solely financial aspects.

With a rigorous approach, corporates must review the full operational landscape and analyse risks which they may not have considered in the past, such as bank counterparty risk. The review must also include how the company sells the goods to the client, how they are purchasing the goods from the supplier and the counterparty risk connected to these activities.

Once a risk has been identified, it is essential that the right tools and guidelines are in place to monitor and track its potential implications across the supply chain. In trade finance there is a clear market trend towards the centralisation of banking relationships. Increasingly, companies are aware that counterparty risk is connected to trade finance and as a result they are looking for tools that will allow them to centralise, but at the same time keep the flexibility and efficiency of their processes.

Treasury centres must monitor their banking relationships in terms of where they are placing their cash. This will allow them to better understand the kind of risk they are entering into with their banking partner. Treasurers must also consider bank risk for other routine actions such as confirming letters of credit (L/C) and other documentary processes. There needs to be consistent monitoring and tracking of risks with very detailed methods and procedures.

How Banks Can Help

Banks have already begun to help clients by refocusing their business back to pure transaction banking, ensuring they are committed to helping treasury identify, manage and find solutions for counterparty risk. SCF, trade finance instruments, cash management and cash pooling are all examples of how centralisation allows the treasurer to have better monitoring of the risks involved, particularly if there are operations in a number of different jurisdictions.

Risk management is a critical function and at a time when credit is critical and liquidity a scarce commodity; counterparty risk must be properly assessed, analysed and monitored across credit, performance and country to ensure the long-term health of the business. Selecting the right banking partner is key.

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