Published: August 01, 2009
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.
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.
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.
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. [[[PAGE]]]
Concerns that state-controlled banks may become more domestic in their focus could ultimately lead some companies to transfer their cash management activities to banks with a clearer international strategy. In some cases, this is part of a broader strategy to rationalise bank relationships and centralise cash management. Corporates are reducing relationships with non-core banks at a rapid pace, preferring to concentrate on banks with which they have a strong relationship of trust, and recognising that centralising cash management brings a variety of benefits, including greater visibility, mobility and access to cash.
Treasurers need visibility over their counterparty risk in order to be able to monitor and mitigate it effectively.
In many cases too, however, corporate treasurers have fewer choices about which banks they work with. Many corporates, including investment-grade companies, have been made brutally aware of which banks are willing or able to continue providing support, and which are not. For example, many investment-grade corporates are seeing 20-50% of their syndicate banks decline their business as credit facilities are renegotiated.
Conversely, the banks that remain are becoming increasingly aggressive in demanding ancillary business, putting some corporates which already have highly efficient and concentrated cash management structures with a very few cash management banks under growing pressure to split up these structures to satisfy banks’ demands. Initially, this could seem to be an appropriate solution if companies are concerned about bank exposure. In reality, however, the efficiencies which can be gained through working with one or very few select cash management banks should outweigh credit concerns. If cash is concentrated using cash pools and then invested on a daily basis, the credit exposure to a cash management bank is minimal. In fact, there is a very real risk that these companies will lose efficiency and visibility, and incur higher costs than they had before, or fail to be able to take advantage of new opportunities for enhanced cash management.
This creates a serious challenge for treasurers: how do they maintain the most efficient cash management structures while satisfying the demands of banks on which they may rely for credit? Firstly, it is important to be absolutely professional when managing each banking relationship and understand clearly the value which each side needs from the other. It is also vital to have a clear visibility over the financial benefits of having efficient cash management structures. This ensures that any agreement with a bank makes sense from the company’s point of view. For example, it may be more cost-effective to offer to pay higher lending margins to banks which are not appointed as cash management banks in order to defend an efficient cash management structure. Another option is to invest in treasury’s systems infrastructure, such as connecting to SWIFT, that will make it easier to change banks and mitigate the extra costs normally associated with maintaining multiple banking cash management banking relationships. Increasingly, customers of SEB are using SEB’s Corporate Value Chain™ approach to understand, prioritise and achieve substantial cash management improvements and quantify the value of efficient cash management structures.
We have frequently heard that treasurers are moving ‘back to basics’ in their approach to risk and liquidity management. As companies become more conservative in their credit analysis, corporate and sovereign credit quality is eroded and concerns about payment capacity increase, we are seeing the reversal of the trend of the past few years towards open account. This is resulting in increasing volumes of traditional trade finance products, such as letters of credit (LCs) and other documentary credits. In many companies, this has not been an area on which treasurers have focused in the past, with responsibility for trade finance sitting in other departments such as shipping and invoicing departments. However, with substantial levels of working capital frequently tied up in inefficient document handling processes, and difficulties in forecasting cash flow effectively, treasurers are playing an increasingly important role in this area, applying skills in automating and optimising financial processes to trade finance. It also makes sense to work with a bank with expertise and flexible solutions in both cash management and trade finance to reflect the close inter-relationship between the two.
Treasurers are under pressure to manage credit risk more effectively, optimise cash management and working capital, and to keep credit channels open. These challenges can create competing demands unless treasurers maintain a clear view of what the business requires and where the greatest value is derived from their banking relationships, and where they can afford to negotiate. As treasurers seek to rationalise their banking partners, and build closer relationships based on mutual trust and understanding of each other’s business drivers, it is increasingly important to select banks with the necessary expertise across the financial supply chain, including trade finance as well as cash and working capital management.
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