Evaluating Credit and Counterparty Risk

by Kathleen Hughes, Head of Global Liquidity for EMEA, J.P. Morgan Asset Management

Credit and counterparty risk has fallen since the height of the global financial crisis, but it remains one of the most important concerns for corporate treasurers. Indeed, treasurers need look no further than the ongoing fiscal issues in the Eurozone (particularly the threat of sovereign default in Greece) to see why credit and counterparty risk always needs to be evaluated carefully and systematically.

In this article we take a closer look at credit and counterparty risk, explaining what it is, how it can be assessed and measured, and how it can be evaluated and managed within a cash portfolio.

What is credit and counterparty risk?

Credit and counterparty risk arises when an investor enters into a transaction with some form of payment obligation from another party, be it with a bank, a company or a government institution. This is because there is a risk that the bank, company or government will not be able to meet its repayment obligations.

Credit and counterparty risk simply refers to the risk that an issuer will default. The greater the potential for default, the higher the level of credit and counterparty risk.

For example, if an investor buys a debt security from a corporate issuer that gets into financial difficulties, there is a risk that the issuer may fail to repay the principle on the loan, or meet its interest payments. If this happens, then the issuer is said to be in ‘default’. Credit and counterparty risk simply refers to the risk that an issuer will default. The greater the potential for default, the higher the level of credit and counterparty risk.

However, the day-to-day concern for treasurers is not simply that a company or government will default, but whether there is a perceived risk that it might. A downgrade, or just the possibility of a downgrade to the credit quality of a debt security, can have a negative impact on price and liquidity, and lead to losses or a breach of investment policy guidelines.

The negative impact that credit downgrades can have for investors has been highlighted recently in Greece, where liquidity in the Greek government bond market dried up and short-term yields surged after Standard & Poor’s cut Greece’s sovereign credit rating to sub-investment grade status. The situation in Greece has also shown how counterparty risk can spread, as the threat of contagion has led to sovereign downgrades in other highly indebted Eurozone countries (Portugal and Spain).

Risk must be measured comprehensively

It’s therefore imperative that treasurers ensure that the credit quality of all the securities that they invest in is always fully assessed and that counterparty risk is managed very carefully within a cash investment strategy. Treasurers must also ensure that they know their full exposure to any particular counterparty.

For example, a company may have counterparty exposure to a particular bank through investments such as deposits, short-term securities and bonds. It may also use the same bank for lending, transactional services and managing foreign exchange and interest rate risks.

Furthermore, if the company invests in money market funds it may also have indirect counterparty exposure to the same bank, as the bank may issue commercial paper or may provide liquidity for the asset-backed commercial paper that the money market funds invest in. Therefore the total counterparty exposure to the bank may be much greater than expected. 

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How to assess credit and counterparty risk

Credit and counterparty risk should be fully assessed prior to purchasing an investment or entering into a transaction. The level of risk then needs to be monitored throughout the life of an investment or contract so that timely action can be taken if there is any significant change in its risk profile.

Ratings agencies
Many investors use credit rating agencies such as Standard & Poor’s, Moody’s and Fitch to provide a useful starting point when initially assessing the credit quality of investments and issuers. The rating agencies provide credit ratings for short- and long-term debt securities and their issuers. Ratings are provided for banks, corporates and sovereign issuers including state and national governments.

It is important to keep a close check on the agencies’ credit ratings because of their powerful influence on fixed income markets. If an issuer is placed ‘on watch’ for a ratings change or a change in credit outlook by one of the major credit rating agencies this can have a swift and significant impact on the market value of its debt.

But credit ratings should only be treated as one aspect of the credit analysis process. Investors need to be aware that credit ratings are ‘lagging indicators’, primarily based on data already in the market. Therefore, rather than being accepted wholly at face value, credit ratings should be augmented by further analysis so investors can be confident they fully understand the risks involved in a particular security, issuer or market.

In-house credit analysis
Some companies may be in a position to dedicate in-house resources to perform fundamental credit analysis, often as part of the treasury function. However, an organisation needs to be sure it has the capabilities and resources to match or exceed the quality of credit analysis available through third-party specialists. If companies do hire internal credit teams, they should ensure that the teams have proven expertise in analysing the bank and finance sector. Companies also need to consider whether credit analysis is the most efficient use of internal resources.

 

Outsourced credit analysis
If risks cannot be monitored, managed or hedged effectively internally, then treasurers need to consider partnering with an expert investment manager with strong credit analysis capabilities. Treasurers must ensure, however, that their chosen investment manager has the best possible credit resources. Therefore, a rigorous and comprehensive due diligence process should be undertaken.

Treasurers need to ask searching questions about the expertise of an investment manager’s credit analyst team. For example, how much experience do they have? Are they focused only on short-term securities, or are they part of a wider fixed income team? How much investment has an investment manager put into its credit team?

Finally, treasurers should ensure that any outsourced credit capabilities are reviewed at regular intervals, including any time there are changes to the team membership or process.

Measuring the credit quality of issuers

Whether you intend to conduct credit risk analysis or outsource it as part of an asset management mandate, it is important to understand the factors that should be assessed to determine an issuer’s credit-worthiness — and how it compares against its peers.

Credit quality analysis for financial institutions
The global financial crisis highlighted the different business risks and financial risks associated with banks. Although many banks that got into financial difficulty were ultimately supported (either directly or implicitly) by government action, treasurers should not expect governments always to step in to bail out depositors and investors. Therefore, treasurers should carry out rigorous risk evaluation of their banking counterparties to ensure they avoid becoming a hostage to events and reliant on government action in the future.

A bank’s credit quality will be linked strongly to the strength of its franchise, particularly the quality and size of its retail deposit base (generally seen as the most stable form of bank funding). A strong market share in profitable lines of business will also contribute to a higher credit rating, as will healthy financial measures, such as capital adequacy, asset quality, earnings and liquidity ratios. 

To guard against deteriorating credit quality, banks should be stress tested for their resilience in the event of severe economic downturn or a sharp fall in the value of assets. This will typically involve assessing a bank’s capital reserves and earnings power, then setting these against its asset quality. Investors should also be aware of regulation or proposed legislation in different markets that may have an impact on banks’ capital, earnings or access to liquidity.

If treasurers invest directly in bank obligations or securities issued by banks, it’s particularly important that they are able to keep track of  the sweeping bank reforms that are happening in every country where governments have had to provide support for their financial systems, and to ensure that they fully understand how their banking counterparties will be impacted. Due to the twin factors of uncoordinated global banking reform and the fact that large multinational banks operate in multiple jurisdictions the changing regulatory landscape will impact banks differently from one location to the next. It is incumbent for treasurers to be aware of the effect of potential banking reform on all the banks that they do business with and on a country by country basis. The task of monitoring the impact and scenarios of potential banking reform is a full-time job and can take up a lot of treasury resources and may be something that treasures look to outsource.

Credit quality analysis for sovereigns
Although government debt is generally considered very low risk, it cannot be assumed that all sovereign institutions can or will honour their debt obligations. As the recent government debt crisis in Greece has highlighted, market concerns of a sovereign downgrade can have a significant impact on the value and liquidity of any portfolio holding a high proportion of that country’s government securities. Overseas investors also face the added risk that deteriorating sovereign credit quality will be accompanied by a weakening currency, further amplifying potential losses.

It is important to keep a close check on the agencies' credit ratings because of their powerful influence on fixed income markets.

Credit analysis needs to assess both a sovereign’s willingness and its ability to pay its debtors. Willingness can be assessed from the strength, transparency and accountability of a country’s political system. Ability will depend on a country’s economic strength, its existing debt levels and the scope it has to control its debt, for example by boosting growth or reducing spending.

As well as assessing ability, investors will want to take a view of government policy on managing debt. For example, is a country likely to increase inflation to reduce its debt burden and, if so, what is the likely economic and sovereign-rating impact? Or, in the case of the Eurozone, where governments have limited monetary tools to reduce their borrowing requirement, investors will want to examine how effectively fiscal tools are being used to manage debt levels. Investors need to ask if these countries are cutting spending by enough to put their debt profile on a sustainable path. They also need to consider whether higher taxes can be feasibly introduced in countries with an existing high tax burden and whether severe fiscal tightening measures have any chance of success if they spark significant social unrest and popular protest?[[[PAGE]]]

Managing credit and counterparty risk in a portfolio

Robust credit analysis is the first line of defence in managing potential credit or counterparty risk. Thereafter, processes should be in place so that credit and counterparty exposure can be properly monitored and reported on an ongoing basis and to ensure that exposures can be known at any time across all parts of the business including overseas subsidiaries and entities.

Treasurers should also maintain strict limits on the maximum investment exposure allowed to an individual issuer or security depending on its credit quality. These limits should be specified as part of a company’s formal investment policy and agreed at board level. Furthermore, investment policies should specify what will be the agreed course of action if an investment or issuer is faced with downgrade or default.

In particular, the investment policy should specify who in the company (e.g., treasurer, investment committee, the board) should be notified in the event of a deterioration in the credit quality of an investment or issuer. Any downgrades should then generally be assessed on a case-by-case basis rather than by imposing a blanket policy to remove a security from a portfolio if it becomes non-compliant.

Most importantly, however, a formal review process needs to be put in place so that the decision to hold or sell can be decided and approved in a timely way. 

Conclusion – make sure you know all your risk exposures

Although the global economic backdrop is improving, stresses remain in the global financial system – as evidenced by ongoing sovereign debt issues in the Eurozone. Therefore, treasurers must remain vigilant and ensure that they have put in place rigorous credit and counterparty risk controls.

This means having the resources available to assess the credit risk of individual issuers and securities, as well as taking a holistic view of counterparty risk exposures right across a company’s financial activities – including indirect as well as direct exposures through relationship banks and money market funds.

In practice, many treasurers will not have the resources or expertise in place to fully evaluate credit and counterparty risk. It is therefore recommended that treasurers seek out trusted and long-established asset management partners with strong and stable credit analyst resources.

Treasurers themselves should also ensure that internal investment policies and processes are updated so that risks are evaluated across all of a company’s activities and relationships, not just at the individual security level.

J.P. Morgan Asset Management’s recently published paper, A practical guide to evaluating counterparty and sovereign risk, provides a more comprehensive look at the issues treasurers need to address within their own policies and processes to ensure that credit and counterparty risk is properly controlled at all times. Please contact your usual J.P. Morgan Asset Management representative to get a copy of this paper.  

* Source: iMoneyNet as at 30/04/2010 using historical FX rates.

** RMB for qualified China domiciled investors only. The RMB fund is managed by China International Fund Management Co. Ltd (CIFM), a joint venture with JPMorgan Asset Management (UK) Ltd. in China.

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