Over the last five years, the focus on counterparty risk within corporate treasury departments has increased substantially. Before the global financial crisis, most banks, in particular the bigger institutions, were considered to be relatively low risk counterparties. But as markets began to rapidly deteriorate towards the end of 2008, treasurers were suddenly confronted with a scenario which they never imagined possible just a few months before. Namely, that one or more of the major banks could fail and that deposits held with those institutions might not be fully repaid.

In the wake of the crisis, many treasury professionals had to reassess a number of their old assumptions about how best to measure and manage their company’s exposure to counterparties. This was especially true, with regard to the role of credit ratings. Today, counterparty risk has become one of the most significant issues facing corporate treasurers. It is a reality which is frequently reflected in survey data. In the 2012 Asia Pacific Corporate Treasury Benchmarking Study conducted by Treasury Today, in association with J.P. Morgan, 51% of the corporate treasurers who participated said that they were more focused on counterparty risk than they were 12 months ago, with only 6% of respondents reporting a decline.

The proportion of respondents in the European version of the Study who stated that counterparty risk had increased for their company over the past 12 months was even higher. In what is perhaps a reflection of heightened levels of risk resulting from the ongoing sovereign debt crisis in the Eurozone, 62% of respondents stated they believed counterparty risk had increased over the previous 12 months. And with 15 major banks – including Citigroup, Morgan Stanley, and RBS – hit with downgrades by the ratings agency Moody’s in June 2012, it seems probable that counterparty risk will remain high on the corporate treasurer’s agenda for some time to come. But let’s take a closer look at other sources of counterparty risk, as well as ways to measure and mitigate exposures.

What is counterparty risk?

Counterparty or ‘credit default risk’ can be defined simply as the risk that someone you do business with – be it a corporation, bank, or government – will be unable to meet their payment obligations to you. For example, if a bank gets into severe difficulties there is a risk that the bank may not be able to repay deposits made by its corporate clients.

In basic terms, the higher the odds of a default are, the higher the level of counterparty risk. It is important to note however that it is not only the actual chance of a default that counts – but also the level of risk perceived in the markets. If a bank, corporation or even a sovereign nation faces a downgrade in their credit worthiness, then everything from market value to liquidity status could potentially be affected.

However, before a treasurer can act to mitigate counterparty risk, he or she must first be able to identify the different sources of risk facing the organisation. The table opposite provides a good starting point.

Why credit ratings alone are no longer sufficient

Pre 2007/8, most corporate treasurers considered credit ratings alone to be adequate for the purpose of measuring the level of their counterparty exposures. But this was to change irrevocably when the financial crisis shook global markets in 2008. The turning point came with the fall of Lehman Brothers, whose credit rating at the time placed it safely within the accepted ‘investment grade’ band. The investment bank’s collapse was to have profound implications for the way corporate treasuries measure and manage counterparty risk – in particular with respect to the ratings agencies.

“The ratings agencies were heavily criticised when the world economy collapsed,” says Dmitry Pugachevsky, Director of Research at Quantifi, a leading provider of risk management software for the global OTC markets. “At the time, some argued that they did not follow closely enough what was happening during the crisis, that counterparty risk management in financial companies and other types of company was changing and the agencies were maybe lagging behind. Risk was not being truly reflected in the ratings.” But if ratings agencies are no longer a sufficient measure of counterparty risk alone, then what are the available alternatives?

The solution adopted by many corporates was not to focus on any one specific method, but a range of different indicators. Most treasurers still view credit ratings as an important measure of counterparty risk. For instance, according to Treasury Today’s 2012 Asia Pacific Benchmarking Study, 81% of respondents cited ratings agencies as their main method for measuring their exposure to counterparties. Once again, in the 2012 European Corporate Treasury Benchmarking Study, the figure was even higher – the ratings agencies reports were the most popular tool used to measure counterparty risk (amongst 89% of respondents).

But a number of additional checks are also being employed by corporates – ranging from CDS spread monitoring to the analysis of equity market data. According to Pugachevsky, CDS spread monitoring has proved to be a particularly useful method for measuring counterparty exposure. He believes that one of the principal reasons for this is their ability to provide up-to-the-minute data on the markets – something which could make all the difference when a crisis strikes.

“You can criticise CDS markets for being slightly speculative, or even seriously speculative – but with credit default swaps you do get a more up-to-date picture of what is going on in markets. You definitely see daily moves – so when there is a negative outlook or some negative views on a bank or company then CDS markets react immediately. So CDS markets – as well as equities and bonds – would definitely be part of the bigger picture treasurers should be looking at when measuring counterparty risk,” he says.

In most cases however, the correct method for measuring and managing counterparty risk really depends on the particular type of exposure a corporation is facing. Below we describe in more detail some of the appropriate responses to the major forms of counterparty exposure.

Deposits and investments

The key to effectively managing the counterparty risks associated with deposits and investments is cash visibility. An accurate, up-to-date understanding of each of the institutions the corporation banks with is of crucial importance if a corporate is to correctly measure their level of market exposure. To accomplish this, some corporates remain committed to using traditional methods, such as spread sheets, while others have moved to install specialist software that offers real-time updates and ongoing monitoring and analysis of all the corporation’s counterparty exposures.

Diversification is the most effective way to protect deposits and investments from counterparty risk. Both should be spread out and held in multiple banks and institutions, geographical areas, and asset classes to minimise the likelihood of a loss of capital in a crisis.

Borrowing

The credit crisis again highlighted the importance of keeping a close check on the institutions you borrow money from. In particular, corporates should look out for circumstances that could lead to institutions they use altering their lending policies. While there is no risk to current agreements, banks which offer revolving credit facilities may well, in crisis conditions, choose to increase the price of such a facility or even not to renew it.

Foreign exchange

The main concern for corporates when undertaking foreign exchange transactions is settlement risk. This risk is sometimes referred to by the name Herstatt after the German bank which failed during the 1970s leaving a number of unsettled FX payments to its various counterparties. It occurs when a payment to an overseas partner is sent but no corresponding funds are received in return.

The best way to eliminate this form of risk is through a service called Continuous Linked Settlement. CLS uses a third-party intermediary to settle FX trades instantly, paying out in the respective currencies when each party confirms that they have the funds to proceed with the transaction. Then, should one of the parties fail to meet the terms of the deal, the amounts originally paid out would then be returned to the relevant parties.

Derivatives

Counterparty risk presents a serious problem for corporates conducting derivatives transactions. It is of vital importance when conducting such deals that the counterparty with whom the agreement has been made is able to fulfil their side of the contract. Take interest rate swaps, for instance. Should two parties undertake a fixed for floating interest rate swap, each party remains responsible for making the original interest payments – meaning that if counterparty fails, you will remain liable to pay the original interest payment. To mitigate such risk a corporate needs to monitor all its derivative positions carefully and regularly carry out internal audits to prevent or detect systematic or fraudulent abuse of positions.

Accounts receivable

Accounts receivable, or in other words money that is owed to a company by its clients, is an unequivocal example of counterparty risk. If a company extends credit to its clients there is always some chance that they will not receive payment on time, or possibly not receive any payment at all, should the client end up defaulting on the debt.

Either way, the end result is inevitably that actual cash flow will not match predicted cash flow – a scenario which left unchecked could potentially become a source of liquidity problems for the corporate. All customers therefore should be checked thoroughly in advance to any extension credit to identify those who pose an excessively high credit risk. Such careful checks should continue to be carried out to existing debtors – paying particular attention to changes in payment behaviour which could possibly indicate that they are experiencing financial difficulties.

Trade financing and leasing

Although trade financing can be used by a corporation as a means of mitigating counterparty risk, it does not eliminate all the risk from a trade. Common risk management procedure for trade financing would involve assessing both the creditworthiness of the organisation providing the trade finance and the legal counterparty in the leasing agreement.

It is important to be aware of the level of regulation existing to provide you protection in instances of default. Some trade finance providers and leasing companies belong to international banking groups, while others do not. It is therefore essential to carefully assess the balance sheets of any trade finance provider prior to conducting any business with them.

Supplier risk

Supplier risk is an important, yet sometimes neglected facet of counterparty risk management. Disruption to the supply chain can have severe consequences, as the recent financial crisis illustrated. When suppliers began to go out of business during the credit crisis, many of their clients soon followed, unable to stay solvent without the necessary materials or funding to continue operating. In order to effectively manage supplier risk a corporate should examine each level of its supply chain and identify at each stage the appropriate action to be taken should the risk posed become a reality. It may be useful to draw up a supplier risk intelligence checklist, as outlined in the July/August 2012 edition of Treasury Today.