All Quiet on the Credit Front?

Despite a tide of general optimism for global financial markets as we move into 2014, there are grounds for wondering whether it will be all plain sailing. A couple of developments in the US should provide food for thought for corporate treasurers everywhere; these being the proposed
Cornyn-Toomey bill
, which creates a bankruptcy provision for US banks, and the critical reception of the first report by the US Treasury Department’s Office of Financial Research. Together, they should trigger alarm bells in the global corporate treasury community. Members should consider their present processes and policies in core business areas such as counterparty risk management and liquidity management, verify that they are adequately prepared for future storms and, if necessary, initiate any improvements needed.

The congressional bill in question is proposed by Republican senators John Cornyn and Pat Toomey. Should it be it voted into law, the bill would end taxpayer bailouts of failing US banks by shifting the bankruptcy risk onto shareholders – and presumably also onto bond and commercial paper holders, and to depositors and certificate of deposit (CD) holders with positions in excess of the prevailing insurance limits.

It might seem unlikely that such a radical piece of legislation will materialise in anything approaching its current form. Yet the fact that it is being advocated should prompt prudent treasurers to verify the effectiveness of their counterparty risk management environment, so that they could quickly quantify and analyse their exposure to the US banking sector.

The US Treasury Department
Office of Financial Research’s (OFR) report on asset management and financial stability
, published last September, attracted
severe criticism from asset management industry experts
. ‘If asset management firms make bad investment decisions, that might also be bad for the economy, so maybe they should be more heavily supervised and regulated…’ is a précis of the report offered by the Securities Industry and Financial Markets Association’s asset management group (SIFMA AMG) and the Investment Adviser Association (IAA).

The OFR itself says it will take more time to create an effective early warning system of major events that would have substantial negative impact on the global markets. In summary, this reaction clearly indicates that Dodd-Frank-related developments with respect to securing financial stability as represented in the OFR report have
not yet instilled confidence within the finance industry
.

News and opinion such as this suggests that the underpinnings of the global financial system are less secure and transparent than corporate treasurers might wish. Uncertainties and lack of clarity about the scope – and probable consequences – of any new major credit event would still present a significant and dangerous issue were it to occur now. The positive differences in 2014 over 2008 include much tighter application of controlling regulation such as Sarbanes-Oxley (SOX), through the expanding enactment of Dodd-Frank and the European Market Infrastructure Regulation (EMIR), the recapitalisation/restructuring of many banks, and numerous technology developments and expert publications relating to financial risk and liquidity management that have transpired over the past five years. However, the true situation is not as clear or secure as might be hoped this far down the line from the onset of the crisis.

These developments do highlight the contention that there remains much room for improvement at the government level and beyond. Corporates should remain vigilant in the related business areas, and should actively use or develop their own systems and processes to provide them with the analysis and timely reporting for prudent counterparty risk, liability and liquidity management.

Counterparty Risk Management

Prior to 2008, corporate treasuries almost exclusively used classic ratings published by the credit ratings agencies assuming they used anything at all. Limits might be recorded and monitored in the treasury management system (TMS) or they might simply be maintained manually.

The major defect of credit ratings revealed by the crash was that they lacked the sensitivity to react to fast-moving events such as Lehman Brothers’ deteriorating creditworthiness, which was still investment grade when the organisation ultimately failed. A few companies using more market- sensitive tools such as credit discount swap (CDS) spreads were able to detect the serious negative changes materialising at Lehman and take evasive action in time. Further, manual systems lacked the objective control quality and transparency – let alone real time or near real time performance – that can be delivered by effective automation.

Since then, all TMS systems have upgraded the scope and effectiveness of the counterparty and liquidity risk management tools offered to the user community, so they now generally provide effective solutions for corporate treasurers.

The use of CDS spreads has never really acquired great popularity among corporates globally. The instruments are seen as exotic tools, for use primarily by the wholesale banking, dealing and investment sectors. Today, corporate treasurers seeking instruments to act as leading indicators of sudden declines in counterparty creditworthiness often look at equity prices and indices (to monitor earnings and growth outlook) and bond prices and indices (to monitor expectations of future debt service repayment capability), and credit ratings (which have improved in scope and sensitivity post-crisis).

Treasurers do not usually regard themselves as credit analysts, yet it seems they have no option but to remain active and innovative in measuring and monitoring their bank counterparties’ credit status, for the prudent allocation and management of limits.

The application of fair value measurement IFRS 13 requires the use of credit valuation adjustment (CVA) in certain circumstances, and this can sometimes lead to exposure/hedge relationships moving outside hedge accounting boundaries, and therefore requiring remedial action to be taken. IFRS 13 can require quite powerful technology support to accommodate the Monte Carlo simulations needed for CVA derivation.

In all cases, corporate treasuries should regularly review their counterparties’ creditworthiness, and adjusting, opening and closing lending and dealing limits accordingly. It is probably practical for a corporate to use a combination of several credit factors – including ratings and market-sensitive indicators – to evaluate counterparty creditworthiness, with external expert advice if needed from a specialist consultant to verify their initial conclusions.

A further factor to consider – especially for the application of technology to support the process – is the frequency with which credit status should be monitored, given the alarming speed with which the creditworthiness of certain banks has deteriorated in the recent past. An automated twice-daily update would be a reasonable minimum, especially when there are many counterparties to evaluate. Some would hold that real time monitoring and alerting represents best practice.

Liquidity Management Considerations

Treasurers need to be aware of their own organisation’s creditworthiness, and the direction and scale of any likely change, when considering their strategic financing plans. For many companies, bank and capital market liquidity tightened or evaporated entirely in 2008. Accordingly, it is always important to evaluate current liquidity against projected needs. The current debt market may be seen to present opportunities to increase the proportion of longer-term liabilities in the portfolio, while rates remain at levels which are very low compared with the history of the last 30-40 years.

This year’s re-financings may perhaps be judged, with hindsight, as offering a unique opportunity to extend the maturity profile of the debt portfolio despite the relative yield cost of doing so, given the strategic benefits of securing longer term liquidity for the business.

Possible Follow-up Actions

This commentary was conceived in response to two recent developments, both of them ultimately related to the after-shocks and lessons of the financial crisis. It is certainly not advocating any sudden or dramatic actions; however it does intend to point out a couple of areas in which the outlook for corporate treasurers is less clear or secure as might be supposed. Treasurers and chief financial officers (CFOs) are ultimately out on their own in measuring and anticipating many forms of financial risk.

There is no sense in running down risk defences at a time of generally positive economic outlook; fair weather in fact provides an optimum environment for prudent analysis and planning, and for the introduction of any indicated changes. There’s no excuse for being caught twice…

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