Treasury Today Group reviews how this area has evolved over the last decade and what techniques treasurers can use to manage their risk exposures.
Corporate treasurers are required to manage many different types of risk – and one category which has been the focus of considerable attention in recent years is that of counterparty risk. At its most basic level, counterparty risk refers to the risk that a counterparty will fail to meet its contractual obligations. In practice, however, this is a broad term which encompasses many different types of risk – and, indeed, many different types of counterparty.
The parameters of this topic have shifted considerably over the last decade, not least because of regulatory changes. “Where compliance risk is concerned, the rules are getting tighter and the need for transparency is growing,” says ES Venkat, Head of Asia Pacific Treasury Product Management at Bank of America Merrill Lynch. “The amount of due diligence that treasurers need to undertake on their counterparties has become enormous, resulting in an additional burden.”
Before and after
More widely, recent years have seen a notable shift in terms of the way in which counterparty risk is assessed. As Phillipe Jaccard, Head of Liquidity at ANZ points out, “The issues related to counterparty risk have evolved over time, and can be divided into pre-global financial crisis and Basel III, and post-GFC and Basel III.”
Before the financial crisis and Basel III, Jaccard says that counterparty risk was typically assessed by rating agencies on a different scale from corporates. “For example, the rating of financial institutions was done on the basis of the financial institutions’ quality of capital. Settlement risk was usually classified as a systemic risk related to a country’s financial infrastructure eg payment systems.”
More recently, Jaccard notes that under Basel III, banks have had to meet higher capital and liquidity. “The key measures of liquidity are the coverage ratio, forcing banks to maintain a buffer of High Quality Assets to insure a risk of cash outflow,” he says. “On the flip side of the balance sheet, banks must maintain a higher ratio of long-term debt or operating account deposits, which are considered as good as long-term debt because their operational nature makes them hard to move.”
Overcoming the challenges
Managing all of the risks included within the category of counterparty risk can be challenging. A survey published last year by FIS about treasury risk management and regulations found that 54% of respondents cited difficulties in managing bank counterparty risk.
Venkat points out that treasurers may face internal as well as external challenges. “Internally, it is important to get the board, management and all employees to accept the need for a strong risk culture and framework,” he says. “However, selling that idea can be challenging as there are conflicting priorities between different departments: sales wants to sell more; treasury wants to achieve a higher yield on investments and purchasing wants to get the cheapest deals.”
In order to address these challenges effectively, companies should have a clear counterparty risk management policy in place. This should define the types of counterparty risk exposure incurred by the company and set out how different risks should be identified and monitored, as well as defining the responsibilities of relevant people within the organisation. It should also detail the treasury’s eligible counterparties and set out the criteria which any new counterparties will need to fulfil before being added to the list.
Managing the risks
The diverse nature of counterparty risk means that different tools and techniques can be used to mitigate the different exposures which come under this umbrella. For financial institution counterparty risk, for example, Jaccard says that treasurers need to establish strict counterparty limits for assets and liabilities by currencies and jurisdictions. “These need to be maintained all the time, approved by the board and monitored daily.”
Companies can use different strategies to manage other types of counterparty risk. “They can expand supply chain financing opportunities such as longer-term payments from suppliers and shorter terms from customers,” says Jaccard. “Also, they can go beyond cash forecasting to stress their ability to survive in a cash crunch, for example the impact of an accident for an airline, or running out of supplies.”
In conclusion, managing counterparty risk is an important element of the treasurer’s role, and one which has become more challenging in recent years. By managing this area effectively, treasurers can reduce the risk that a counterparty default will result in negative consequences for the company – but this requires a proactive and rigorous approach.