Adapting to a New World Managing Counterparty Risk & Bank Relations
by Erik Seifert, Head of Cash Management, Sweden
Although managing counterparty credit risk has always been part of the treasurer’s role, few treasurers have taken the time to focus on this function beyond a box-ticking exercise compared to those aspects of financial risk which have appeared more compelling, such as interest rate and FX risk. This was the case until 2007 and the start of bank collapses, government intervention and widespread credit downgrades. Inevitably, these events have resulted in a renewed focus on counterparty credit risk, not only within treasury, but at board level. In this article, we look at some of the ways in which companies are seeking to manage their counterparty risk and bank relationships more effectively, whilst managing competing demands from the board to optimise cash management and from banks to award new business.
Beyond credit ratings
As with any type of risk, treasurers need visibility over their counterparty risk in order to be able to monitor and mitigate it effectively. Few, if any corporate treasuries have sufficient resourcing and access to information to make independent credit decisions on financial counterparties, hence they have relied on the credit rating agencies for an independent, objective assessment of financial stability. However, as recent events have shown, the warning which appears on every advertisement for financial products, “Past performance is no indication of future performance, and your capital may be at risk”, is no empty statement. The assumptions and analyses of the rating agencies have been found lacking, as rating agencies cannot move quickly enough to reflect changing circumstances during periods of extreme market volatility, particularly in relation to liquidity assessment, which has made treasurers and CFOs question the reliability of the credit analyses on which they have previously relied. Consequently, many corporates started to use credit default swap (CDS) prices as a proxy for credit ratings during the crisis. For example, even before the collapse of the Icelandic banks, their CDS prices were sky high, indicating declining confidence in their creditworthiness, while these institutions still had investment-grade ratings from the credit rating agencies.
Even though many firms have had a credit policy in place for financial counterparties, this has been an administrative rather than risk management process in many cases. For example, although most organisations with a modern treasury management system (TMS) have the ability to monitor various types of counterparty limits, these have been used cursorily until recently.
Addressing various forms of counterparty risk
Corporate treasurers are now increasingly focusing on a variety of forms of credit risk: firstly, companies are becoming more circumspect about where they deposit surplus cash, investing for a shorter term and only with the strongest banks. An important consideration is to ensure that ISDA and Credit Support agreements are in place to ensure that netting arrangements are legally enforceable and that exposures are consistently calculated. Another way in which corporates are seeking to diversify their risk is by investing in money market funds (MMFs) which are growing in popularity.
Concerns about settlement risk are also becoming more significant. Treasurers are increasingly looking to CLS to eliminate settlement risk, in which 17 currencies are now eligible. There are now 60 CLS member banks, and over 4,600 third-party participants, an increase of over 50% in the past 12 months. Using CLS for settlement of FX and option trades also has the benefit of significantly improving back-office process efficiency, and the initial investment will therefore quickly pay for itself.
State ownership or independence
The perception of increased counterparty credit risk and frequency of credit downgrades has left many treasurers uncertain about which banks are the ‘safest’. Is a bank which has remained resilient through the crisis more secure than one which has received state support? Historically, many corporates in the private sector have preferred not to rely on banks which are state-controlled. Today, opinion is divided. On one hand, some believe that state-owned banks, or those with significant state support, may provide greater financial assurance than those which are not. On the other, particularly for multinational corporations, there is pressure on many state-supported banks to focus on the domestic retail and commercial market, as opposed to investing in the bank’s international capabilities.