An Intricate Dance

Steps to Managing Counterparty Risk Relationships

Following last year’s banking turmoil, counterparty risk management has been high on the treasury agenda. At the same time, evolving regulations are increasing banks’ scrutiny of their corporate clients. By embracing transparency and proactive risk management, treasurers can put their organisations in the best position to mitigate against this peril.

The upheavals in the banking sector in 2023, notably the collapse of Silicon Valley Bank, Silvergate Bank and Signature Bank in the US and the simultaneous but unrelated demise of Credit Suisse in Europe thrust counterparty risk back into the spotlight for corporate treasurers. The implications are far-reaching, reshaping how treasurers approach relationships with their banking partners.

The onus is on treasurers to diversify these partnerships and avoid over-concentration of assets with any single institution. However, the complexity of this task is underscored by the need to balance connections with banks that are also lenders.

François Masquelier, Chair, European Association of Corporate Treasurers (EACT), and CEO, Simply Treasury, notes: “Corporates often accumulate excess cash, but the proportion can become too large, leading to over-concentration. It’s vital to impose limits within their policies to mitigate this risk.”

While bank collapses are relatively rare headline-grabbing events, the strategic shifts taken by FIs can also catch even the largest corporates off guard. Masquelier recalls the case of RBS withdrawing from specific market segments in 2015,^[1] leaving major corporates to make alternative arrangements. “Even the largest corporates in Europe could face this situation,” he warns.

The interconnected nature of today’s financial systems also presents a challenge. This is true in the banking world, where systemic resilience has been bolstered following past crises, and the counterparty risk analysis has evolved.

Guillaume Magdelyns, Director, PwC Belgium, explains: “Banks now consider not only concentration but also correlation and cross-effects. For instance, if a supplier fails, this could trigger a chain reaction that jeopardises the corporate itself, creating a joint counterparty risk.”

Moreover, the rising focus on ESG criteria adds another layer of complexity. Banks are increasingly scrutinising their clients’ ESG performance, and those that fall short may be excluded from certain financial networks.

“In the future, if your company is the only one in your sector not achieving the targets, it will become more severe. You could become an outlier in your industry,” Magdelyns points out, highlighting the growing importance of sustainability in counterparty risk assessments.

In an era when the banking industry is better equipped but not immune to shocks, treasurers must remain vigilant. This is why treasurers must continuously evaluate their banking connections.

The fine art of diversification

When determining the optimal number of banking counterparties, treasurers face a delicate balancing act. Success lies in ensuring sufficient diversification to mitigate risk and maintaining manageable and profitable relationships with FIs.

Masquelier underscores the complexity of this task. “One of my clients, a mid-cap company, deals with 100 banks and maintains 200 bank accounts,” he reveals. The reason? Their operations in various countries require local banks to facilitate payments. However, Masquelier advises that firms generally focus on 10 to 12 core bank groups, particularly for those not bound to local or domestic banks.

“But of course,” he adds, “it depends on the company’s specific situation. For instance, those with significant debt profiles might need to work with more banks to handle syndication, depending on the region and the nature of their activities.”

The art of diversification extends beyond simply counting banking partners. It involves carefully distributing a firm’s financial activities across these partners to ensure each relationship remains profitable and mutually beneficial. If treasurers don’t share their wallet in such a way that is perceived as being equitable, some FIs might become dissatisfied with the returns and could even terminate the relationship. This fair distribution is crucial, particularly when a company works with a mix of global and domestic banks.

Yet, there’s a fine line between the optimal level of banking partners and over-diversification. While spreading assets across multiple banks can reduce risk, doing so too thinly can create fresh dilemmas.

“Over-diversification could lead to a treasurer losing control of their assets,” Masquelier cautions. The key is to find the right balance – ensuring that risk is mitigated without making the treasury operations unwieldy. When allocating business among banks, treasurers must consider the different products and services they require.

“A corporate might allocate 10% of its FX business to a bank, which seems fair if they have 10,” Masquelier adds. “But what if that bank handles only 5% of their borrowing? Comparing these contributions is difficult.”

Treasurers should endeavour to strike the right balance between fostering competition among their banks to secure the best deals and maintaining a fair partition of business to keep all partners content, unless the corporate no longer wishes to maintain a particular relationship.

“It’s always about finding the right balance – making sure that the pendulum doesn’t swing too far in either direction,” Masquelier asserts.

Be nimble, be ready, but be cautious

While assuming that a one-size-fits-all approach would work for this type of risk management might be tempting, the reality is more complex. For example, different investments require tailored strategies to balance risk and reward effectively.

“Treasury is supposed to manage the short-term liquidity, we’re not really supposed to place money for the longer term,” Masquelier stresses. Yet, some companies are venturing into more complex territory and using bonds as well as MMFs. Traditionally, bonds are used for trading, but there are pitfalls.

“When an event such as Covid hits and treasurers need to mobilise all their liquidity, bonds can be tricky,” Masquelier adds. “They’re volatile, and a firm might lose part of its principal, which is exactly what a treasurer should avoid.”

This highlights a broader point that, while higher yields from longer-term investments may be tempting, such strategies can introduce risks that may not align with the primary goal of capital preservation.

FX is another area where treasurers must tread carefully. The decision to take on FX risk depends heavily on a company’s activities and risk appetite. A treasurer might have an excess in certain currencies that could be useful for investment, but it is vital to have the minimum immediate liquidity required so as to be ready for any eventuality.

Some banks are diversifying from cash by investing in short-term liquid bonds, a strategy that comes with its own set of challenges.

Magdelyns outlines: “When banks don’t want a concentration on a certain issuer and short-term paper might not be liquid enough when entering into the longer term, they mitigate the risk. It could be three-year paper, but the volatility can be cancelled out with swaps or FX, for example.”

Given the current shape of the yield curve, treasurers would be wise to stay short-term. However, the longer end might be tempting in a normal curve environment. One option is to take a layered approach to cash management, where treasurers categorise their excess funds into strategic, reserve, and operational cash, with allocations depending on their specific business needs. Still, the lingering effects of the pandemic have left many corporates wary.

Masquelier observes: “Today, many treasurers and CFOs are demanding immediate liquidity, mainly due to the trauma caused by Covid.”

Leave the heavy lifting to tech – and the experts

As corporate treasurers navigate an increasingly complex financial landscape, technology can be critical in handling the risk under discussion. Indeed, advances in automation and data analytics offer significant benefits to treasurers.

“Over the past couple of years, we’ve seen platforms emerge that give treasurers a clear view of their liquidity options from the moment they walk into the office,” Masquelier says. These platforms enable treasurers to explore short- and medium-term investment opportunities, from commercial paper to MMFs, helping them optimise their portfolios while automating processes. “This automation mitigates risk and ensures better competition among counterparties, securing the best prices for treasurers,” he adds.

However, despite these advances, there is still a gap in the market. Masquelier notes: “A platform that consolidates all types of financial products in one place would be ideal. Such a solution doesn’t exist yet, but I’m confident it will in the future, especially as treasurers continue to seek comprehensive ways to manage counterparty risk.”

Technology plays a pivotal role in assessing this, but many treasurers still rely on traditional indicators including credit ratings, CDS [credit default swap] spreads, and stock prices, often supplemented by financial news from outlets such as Bloomberg and the Financial Times.

“The issue is that using these methods, the information can be outdated by the time the data is processed,” Masquelier warns. “Take Credit Suisse, for example. At the beginning of 2023, its balance sheet seemed acceptable, but within months, the situation deteriorated dramatically.”

For many corporates, the question arises: should they invest in sophisticated systems to assess counterparty risk as do banks? Finding a return on such an investment and securing the necessary budget would be a significant challenge. But other options do exist.

“I prefer to base my choice on MMFs managed by specialists who monitor the market daily,” asserts Masquelier. “If something is coming down the pipeline, they can react much faster than a corporate could. “It’s not our role as corporates to manage every aspect of risk. Outsourcing to experts is often a more practical approach.”

On the other side of the relationship, banks have a more sophisticated approach to risk management, driven in part by regulatory requirements.

Magdelyns elaborates: “Compared with corporates, banks have to measure counterparty credit risk using an almost one-size-fits-all formula. So even if a bank employee has a certain opinion, the formula is there to come to a standard conclusion.”

Banks are leveraging tools such as robotics to continuously scrape financial news worldwide that can be fed to AI for constant analysis. Using large language models (LLMs) and sentiment analysis, banks can predict the default of a counterparty months in advance. “It’s impressive, but is effective only when the data is available,” Magdelyns emphasises. This advanced monitoring enables banks to focus their efforts where they are most needed, identifying red flags early and engaging in meaningful discussions with counterparties.

Integrating such detection technologies into treasury platforms and systems could be game-changing for corporates.

Masquelier envisions: “Imagine a treasurer receiving an alert that doesn’t tell them something has gone wrong, but instead puts them on the front foot and lets them react if necessary. It may not be foolproof, but it could give them some analyses to stay ahead of the market.”

Ultimately, the role of technology in counterparty risk management is about more than just data collection. It’s about creating time for treasurers to focus on strategic decision-making. “Automation is essential,” Masquelier stresses. “Treasurers spend a significant amount of time producing reports and managing vast amounts of information, but that in itself is a risk. It’s almost better to have less information and more time to analyse and make informed decisions.”

While tools such as the TMS provide valuable insights for treasurers, the systems themselves are not making decisions. That is still a ‘burden’ for treasurers. “We need solutions that automate processes and help treasurers make faster, better decisions,” Masquelier adds. Ultimately, those who react quickly can save money and stay ahead of the competition.

Areas ripe for analysis

When assessing the counterparty risk of corporate clients, banks are leaving no stone unturned, employing various tools to dissect a company’s financial health and creditworthiness. This begins with a deep dive into financial statements and external credit ratings, but doesn’t stop there. Banks also scrutinise the business model, industry-specific performance, and how a company stacks up against its peers using KPIs tailored to each business sector.

Magdelyns explains that “liquidity and cash flow are front and centre,” emphasising that most solvency concerns reveal themself with liquidity symptoms. Beyond the numbers, banks examine qualitative factors such as the calibre of management and governance structures. Factors including how well a company has historically managed risk and how transparent its disclosures are weigh heavily in a bank’s analysis.

Banks scrutinise credit and behavioural history, as there is a predictive element here that is ripe for smart technologies to analyse.

“I’ve seen an extremely powerful behavioural model used by retail firms where it was possible to demonstrate that the highest statistically significant indicator of somebody withdrawing their money was the number of times they connect to the banking app,” Magdelyns reveals. This data has nothing to do with an actual funds transfer but instead just the app usage. “Behavioural data will increasingly be used with AI tools, for example, because there is unstructured data that banks want to capture,” he adds.

Legal and regulatory compliance is also a growing concern, particularly under stricter sanctions regulations and KYC requirements. Banks are increasingly vigilant about the legal risks associated with their corporate clients, with transparency and co-operation from the client playing a crucial role in the relationship.

Adding another layer of complexity, banks are now also analysing ESG risks associated with their corporate counterparties. “Commercial banks are under pressure from central banks, especially in Europe, to understand their ESG exposures,” Magdelyns notes.

This means banks must assess their clients’ current environmental impact and how they plan to transition to a lower-carbon future. This new dimension of risk analysis is challenging for banks and businesses, requiring a new level of data collection and transparency.

Create a robust planning playbook

Given the intense scrutiny from banks, achieving transparency is a vital strategy for treasurers to embrace to minimise their company’s perceived risk. “It’s about having financial stability, strong governance, and risk management processes in place,” Magdelyns advises.

Larger companies often have robust disclosure practices, but smaller firms might lag. In today’s data-driven environment, a lack of transparency can lead to lower credit ratings and less favourable terms from banks.

One often overlooked area is the business continuity plan. Banks are increasingly interested in how prepared a company is to handle disruptions.

“A bank I know was updating its policy to include a question about continuity planning, as it wanted to know how corporate clients would handle a disruption to the business,” Magdelyns shares. “Some corporates have quite a short plan, while others have a robust playbook based on real-life planning. Reinforcing those procedures is vital.”

As the counterparty risk requirements for corporates grows, so does the importance of a clear policy covering the breadth of the risk.

Masquelier asserts: “The clearer the policy, the better it is for the protection of the corporate treasurer, highlighting what they can and can’t do.” Regularly revisiting and updating this policy can protect the company and ensure that treasurers understand the limits of their risk-taking.

In this intricate dance between corporates and banks, transparency, proactive risk management, and strategic financial planning are essential activities for minimising perceived risk and fostering strong, mutually beneficial relationships.