Published: October 01, 2010
In the current economic environment, addressing the question for corporates of “Who do I transact with?” in respect of derivative transactions is an extremely pertinent and yet challenging one to answer.
When preparing this article, I took the opportunity to talk to corporate treasurers, system providers, treasury consultants and, of course, auditors to further understand the dilemmas faced, as well as the decisions to be made, when considering corporates’ choice of counterparties. Interestingly, the five common themes across all these stakeholders were:
However, the overriding principle across all of the above points is the development and maintenance of trusted relationships with the counterparty banks through good times and bad.
Before deciding which counterparty bank corporate treasuries would like to transact with, corporate treasuries need to fully appreciate which counterparties they have mandates with for transacting particular instruments. For example, corporates may have mandates with particular counterparties for specific types of trades or for specific geographical locations. Many corporate treasuries will only consider counterparty banks within the lending group when considering derivative transaction counterparties.
The overriding principle across all of the above points is the development and maintenance of trusted relationships with the counterparty banks through good times and bad.
It was clear from talking to corporate treasurers that in order to decide which counterparty they would transact with, they would analyse what type of instruments they wanted to enter into. Certain market participants are specialists in particular transactions and have better distribution across different products. For example, some counterparties are specialists in particular complex derivative trades and others for being able to trade in certain currencies or jurisdictions. A key aspect to consider is the link to the lending arrangements in place with each of the counterparties, and the desire to offer the business to these banks. Prior to the financial crisis, credit was freely available and counterparties were happy to lend to corporates without necessarily insisting on ancillary services. However, since the credit crisis, fewer banks are lending and those that are lending are faced with increased capital requirements; therefore, it is crucial for corporates to invest in building relationships that can withstand the good times and the bad. From the counterparty banks’ point of view, they are less willing to lend without the offer of ancillary services being made available to them. From the corporate perspective, spreading the risk amongst counterparties according to their risk appetite is a key consideration and will ensure that they are not overexposed to a particular counterparty.
The third key theme was the creditworthiness of the counterparties, taking into account the risk appetite of the entity and the relationships with each of the counterparties. Although in recent times there has been considerable news coverage over the reliability of the credit ratings as provided by the likes of Fitch, Standard and Poor’s and Moody’s (of course we all know that “Past performance is not a reliable indicator of future performance”), many corporates still use these ratings when assessing the creditworthiness of their counterparty banks. This is hardly surprising considering what other information they have to rely upon. However, although this is the main metric used, corporate treasuries are now also looking for ‘early warning signs’ for assessing creditworthiness and the liquidity of counterparties, such as reviewing their bond prices, equity prices and credit default swap (CDS) spreads. The use of CDS spreads as a measure of the credit risk of the bank has its limitations, and due to the lack of sophisticated systems at most corporates, it is difficult to convert these CDS quotes into something more meaningful. However, assessing the CDS spreads, and whether they have increased, is an indication of either the bank’s credit deterioration or liquidity concerns. [[[PAGE]]]
Liquidity, as well as the ‘perceived rating of the bank in the market’, is also taken into greater account by corporate treasuries. More transparency by the banks, in terms of managing liquidity risk, is key for corporate treasuries and is a requirement of ‘IFRS 7: Financial Instruments: Disclosure’, and there is increased emphasis being placed on liquidity risk management by the United Kingdom Financial Services Authority (FSA).
With so much emphasis being placed on the credit-worthiness of the counterparty bank, surely the banks are doing the same for corporates?
The FSA’s new liquidity regime, introduced last December, aims to protect “customers, counterparties and other parties” from the “potentially serious consequences of imprudent liquidity risk management practices”. It appears that most large corporate organisations have predetermined limits by rating as well as standard procedures should the exposure increase beyond that limit.
An interesting question posed, particularly in light of recent market events, was the monitoring of credit risk using country ratings and how much emphasis is placed on such ratings. This is more applicable for those companies operating in emerging markets where the country ratings are below that of acceptable counterparty rating in developed markets. As a result, bank ratings in these jurisdictions are capped at the country rating. We are also aware that some corporate treasuries in these regions will put in place guarantees to further protect themselves.
In light of the credit crisis, we are aware of one corporate that held a significant portfolio of derivative transactions which were financially advantageous and expected to be so for some time due to the low interest rate environment. Concerned over the credit worthiness of the counterparty banks, they negotiated Credit Support Annex (CSA) agreements with their banks so that cash collateral was placed with the corporate. This is certainly not the norm across corporates, but it allowed the company greater confidence in its position. Obviously, such a situation could also be unfavourable, in which case the company would be required to pay the relevant amount.
With so much emphasis being placed on the creditworthiness of the counterparty bank, surely the banks are doing the same for corporates? Absolutely.There is no doubt that the credit risk of the corporate is assessed, factored into the pricing and subsequent valuations of financial instruments. But how do banks manage this risk? In the inter-bank market, banks negotiate CSAs and cash collateral is placed on a daily basis. This reduces their credit risk significantly. However if this same process is applied between corporates and banks it will pose significant challenges for the corporates.
Building relationships is a fundamental driver in a successful partnership with your bank and corporates should not underestimate its importance.
For example, systems need the functionality to support margin payments for such agreements, and there needs to be sufficient liquidity available to put up large volumes of cash on a daily basis. While few companies have yet been in the situation where their banks insist on such CSAs, this may change in the future in the light of the increased capital requirements for banks, the wish to move the risk of corporate positions off the banks' balance sheet and the introduction of the OTC derivatives reform. We believe that it is unlikely that non-financial companies will be obliged to clear OTC derivatives through a central counterparty, unless their positions pose a ‘systemic risk’. However, one concern is that counterparty banks will be subject to excessive capital charges when dealing with corporates so that they are obliged to pass on this cost to the client, or to limit the tenor of the derivatives traded. This we are already seeing amongst some corporates hedging their foreign currency risk; although their exposure extends over a number of years, they are only able to hedge on a rolling 3-month basis. The end result may be that corporates will be forced to enter into CSA agreements in order to achieve a fair price or to obtain the desired hedging. At a minimum, a cost benefit analysis will be required to balance the considerations mentioned above.
As commented earlier, we are aware of one corporate that was able to enforce CSA agreements in 2008 when their derivative positions represented significant assets. When questioned, the company attributed this success to the strength of their relationships with the banks and their ability to negotiate. However, this is not the norm, and many corporate organisations feel threatened by the concept of CSA’s. This is particularly due to concerns about liquidity risk and the requirement to post collateral and manage margin accounts. For most corporates, the administrative burden is too great in terms of system capabilities and resource constraints. Another challenge for some of the smaller corporates, if this is implemented, will be the need to perform fair value calculations of their positions on a daily basis in order to be comfortable with the margin calls requested and have back-up systems in place to deal with these margin requests. For many corporates, this is beyond their current capabilities and hence, will place strain on existing systems and require manual intervention. However, although many corporate treasurers have been requested to set up CSAs, there has been considerable push-back and some have been successful in avoiding them. [[[PAGE]]]
Leading on from this is the important issue of whether corporate treasuries are receiving a fair price from their banks and the process involved in obtaining such a fair price. As would be expected, most treasuries of larger multinational companies have front-office systems with real time access to Bloomberg or Reuters, and therefore they have an indication of the fair price even before contacting the banks.
The process of contacting the banks, obtaining competitive bids, negotiating pricing and selecting the best price differs amongst corporate treasuries, and may differ across product types within the same company. Some treasuries use an auction process, some contact the banks simultaneously on the phone, and some utilise external consultants to perform such services for them. Each approach has pros and cons depending on the complexities of the business. At one end of the spectrum is outsourcing of the entire process, which has the benefit of automated systems with real time information and reduced manual intervention error; at the other, the process in calling the banks directly and performing their own analysis of what would be deemed a fair price is entirely manual. As one treasurer put it, “we like to speak to people, not systems”. The approach adopted for each treasury operation will differ depending on the skills and capabilities of the treasury staff, the access to market data and the reliability of systems that are in place. It was clear from the discussions with the relevant corporate treasuries that a “pragmatic and holistic approach is adopted” and it is not necessarily the highest bidder who wins the deal. However, in order to be confident that you are getting a fair price, the key areas to focus on are: having access to real time information; putting banks in competition; knowing the market; and having a trusted relationship with the banks and external consultants.
Building relationships is a fundamental driver in a successful partnership with your bank and corporates should not underestimate its importance. Being able to call on your relationship manager at the counterparty bank when you most need them is critical, but would be easier if this relationship had developed over the years. This was further exemplified at the recent Association of Corporate Treasurers conference held in April 2010, where participants indicated that a desire for a trusted relationship between corporates and banks remains a key priority. It is a ‘give and take’ relationship: what do you want from your bank, and what are you willing to give to your bank, in good times and in bad. Clearly a mutually beneficial relationship is vital to securing the most appropriate and cost effective deals for the organisation, as well as considering banks’ ongoing lending commitments.
How Thought Leadership Can Reduce the Cost of Sales by Patrik Havander, Havander & Partners A focused attention on the costs incurred by the global sales and marketing processes is becoming increasingly important for corporate banks and their transaction banking departments. While the client/bank relationship remains vital, research has shown that in fact relationship selling […]
