Setting up an Effective Counterparty Risk Management Framework

In recent years, the counterparty risks that corporates
are exposed to have dramatically changed. Besides the traditional default risk
that corporates hold on their customers, there has been an increase in
counterparty risk regarding the exposures to financial institutions (FIs), the
total supply chain, and also to sovereign risk. Market volatility remains high
and counterparty risk is one of the top risks that need to be managed. Any
failure in managing counterparty risk effectively can result in a direct adverse
cash flow effect.

There are two important factors that have resulted
in greater attention being paid to counterparty risk related to FIs in treasury.
Firstly, FIs are no longer considered ‘immune’ to default. Secondly, the larger
and better-rated corporates are now hoarding a day’s more cash compared to their
pre-2008 crisis practice, due to restricted investment opportunities in the
current economic environment, limited debt redemption and share buy-back
possibilities and the desire to have financial flexibility.

Several
trends can be identified regarding counterparty risk in the corporate landscape.
In a corporate-to-bank relationship, counterparty risk is being increasingly
assessed bilaterally. For example, the days are over when counterparty risk
mitigating arrangements, such as the credit support annex (CSA) of an
International Swaps and Derivative Association (ISDA) agreement, were only in
favor of FIs. Nowadays, CSAs are more based on equivalence between the corporate
and FI.

Measuring and Quantifying of Counterparty
Risks

The magnitude of counterparty risk can be estimated
according to the expected loss (EL), which is a combination of the following
elements:

  1. Probability of default (PB): The
    probability that the counterparty will default.
  2. Exposure at
    default (EAD):
    The total amount of exposure on the counterparty at
    default. Besides the actual exposure the potential future exposure can also be
    taken into account. This is the maximum exposure expected to occur in the future
    at a certain confidence level, based on a credit-at-risk model.
  3. Loss given default (LGD): Magnitude of actual loss
    on the exposure at default.
This methodology is also typically
applied by FIs to assess counterparty risk and associated EL. The probability of
default is an indicator of the credit standing of the counterparty, whereas the
latter two are an indicator of the actual size of the exposure. Maximum exposure
limits on the combination of the two will have to be defined in a counterparty
risk management policy.

Another form of counterparty risk is settlement
risk, or the risk that one party of the agreement does not deliver a security,
or its value in cash, as per the agreement after the other party has already
delivered the security or cash value. Whereas EAD and LGD are calculated on a
net market value for derivatives, settlement risk entails risk to the entire
face value of the exposure. Settlement risk can be mitigated, for example by the
joining multicurrency cash settlement system Continuous Link Settlement (CLS),
which settles gross transactions of both legs of trades simultaneously with
immediate finality.

Counterparty Exposures

In
order to be able to manage and mitigate counterparty risk effectively,
treasurers require visibility over the counterparty risk. They must ensure that
they measure and manage the full counterparty exposure, which means not only
managing the risk on cash balances and bank deposits but also the effect of
lending (the failure to lend), actual market values on outstanding derivatives
and also indirect exposures.

Any counterparty risk mitigation via
collateralisation of exposures, such as that negotiated in a CSA as part of the
ISDA agreement and also legally enforceable netting arrangements, also has to be
taken into account. Such arrangements will not change the EAD, but can reduce
the LGD (note that collateralisation can reduce credit risk, but it can also
give rise to an increased exposure to liquidity risk).

Also, clearing
of derivative transactions through a clearing house – as is imposed for certain
counterparties by the European Market Infrastructure Regulation (EMIR) – will
alter counterparty risk exposure. Those cleared transactions are also typically
margined. Most corporates will be exempted from central clearing because they
will stay below the EMIR-defined thresholds.

It will be important to
take a holistic view on counterparty risk exposures and assess the exposures on
an aggregated basis across a company’s subsidiaries and treasury activities.

Assessing Probability of Default

A good
starting point for monitoring the financial stability of a counterparty has
traditionally been to assess the credit rating of the institutions as published
by ratings agencies. Recent history has proved however that such ratings lag
somewhat behind other indicators and that they do not move quickly enough in
periods of significant market volatility. Since the credit rating is perceived
to be somewhat more reactive they will have to be treated carefully. Market
driven indicators, such as credit default swap (CDS)* spreads, are more
sensitive to changes in the markets. Any changes in the perceived credit
worthiness are instantly reflected in the CDS pricing. Tracking CDS spreads on
FIs can give a good proxy of their credit standing.

How to use CDS
spreads effectively and incorporate them into a counterparty risk management
policy is, however, sometimes still unclear. Setting fixed limits on CDS values
is not flexible enough when the market changes as a whole. Instead, a more
dynamic approach that is based on the relative standing of an FI in the form of
a ranking compared to its peers will add more value, or the trend in the CDS of
a FI compared against that of its peers can give a good indication.

A
combination of the credit rating and ‘normalised’ CDS spreads will give a proxy
of the FI’s financial stability and the probability of default.

Counterparty Risk Management Policy

It is
important to implement a clear policy to manage and monitor counterparty risk
and it should, at the very least, address the following items:

  • Eligible counterparties for treasury transactions, plus acceptance
    criteria for new counterparties – for example, to ensure consistent ISDA and
    credit support agreements are in place. This will also be linked to the credit
    commitment. Banks which provide credit support to the company will probably also
    demand ancillary business, so there should be a balanced relationship. While the
    pre-crisis trend was to rationalise the number of bank relationships, since 2008
    it has moved to one of diversification. This is a trade-off between cost
    optimisation and risk mitigation that corporates should make.
  • Eligible
    instruments and transactions (which can be credit standing dependent).
  • Term and duration of transactions (which can be credit standing
    dependent).
  • Variable maximum credit exposure limits based on credit
    standing.
  • Exposure measurement – how is counterparty risk identified
    and quantified?
  • Responsibility and accountability – at what level/who
    should have ultimate responsibility for managing the counterparty risk.
  • Decision making to provide an overall framework for decision making by
    staff, including treatment of breaches etc.
  • Key Performance Indicators
    (KPIs) – Selection of KPIs to measure and monitor performance.
  • Reporting – Definition of reporting requirements and format.
  • Continuous improvement – What procedures are required to keep the policy up
    to date?

Conclusion

To set up an
effective counterparty risk management process, there are five steps to be taken
as shown below; from identifying, quantifying, setting a policy to process and
execute the set policy regarding counterparty risk.

Zanders counterparty risk management

Treasurers should
avoid this becoming an administrative process; instead it should really be a
risk management process. It will be important that counterparty risk can be
monitored and reported on a continuous basis. Having real-time access to
exposure and market data will be a prerequisite in order to be able to
recalculate the exposures on a frequent basis. Market volatility can change
exposure values rapidly.

* A credit default swap protects
against default. In the event of a default the buyer will receive compensation.
The spread (CDS spread) is the (insurance) premium paid for the swap.

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