Risk Management

Counterparty risk: know your limits

Published: Jul 2014
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In simple terms, counterparty risk is defined as the possibility that someone you do business with will be unable to meet their obligations to you. The higher the odds of a default are, the higher the level of counterparty risk. This is all well and good on paper, but as any treasurer knows, counterparty risk is far more nuanced in reality. It’s a multi-faceted threat that is constantly changing and evolving. In this article, we re-emphasise the need for treasurers to keep on top of counterparty risks, examining both existing and emerging threats.

In the not so distant past, the majority of corporate counterparty risk management frameworks were based on credit ratings on the grounds that they provide simple and independent metrics of creditworthiness. There is no need to explain the negatives of this over-reliance on credit ratings, which have been well documented in the global press. One positive impact of this dependency, however, was that it functioned as a wake-up call to banks, ratings agencies and corporates alike.

Yet despite the significant progress that has been made post-crisis in understanding and managing counterparty risk, many corporate organisations still lack formal counterparty risk exposure policies or frameworks, not to mention the appropriate knowledge or tools to analyse and monitor these exposures. So how can treasurers stay on top of counterparty risk?

Start at the source

Effective measurement and control of counterparty risk starts with identifying the different sources of risk facing the organisation. The following table, while by no means exhaustive, provides a good starting point, outlining a number of traditional sources of counterparty risk.

In addition to these more traditional sources of counterparty risk, new threats are constantly emerging. One of these is the risk of working with corrupt or ‘undesirable’ counterparties. Indeed, there is a growing global trend for both regulators and consumers to hold corporates accountable for the actions of the third parties that they choose to interact with.

“As such, organisations cannot afford to neglect the non-financial due diligence they must now do to comply with US and UK anti-bribery laws,” says Ian Barclay, Managing Director at investigations, intelligence and risk management specialist, Stroz Friedberg, Hong Kong. “Failing to adequately assess the counterparties that the company does business with can not only expose the organisation to reputational damage, but to operational risk, government investigations, financial penalties and potential criminal liability,” he notes.

Newspaper headlines certainly provide plenty of evidence to support this. For instance, GlaxoSmithKline Plc (GSK)’s third-quarter 2013 sales of pharmaceuticals and vaccines in China fell 61% after an anti-corruption probe began. And now that the Chinese police have charged a number of GSK China personnel with corruption, the company is attempting to clean up its act by stopping payments to doctors who promote its products. While everyone supports the company’s action against corruption, from a competitive standpoint, this bold move could prove very costly in what is a $1 trillion-a-year global industry.

The GSK China scandal also highlights the need to be aware of country risk when identifying and measuring counterparty exposures: bribery between sales staff and doctors is a well-documented challenge in China. Since the nature of business is only becoming more international, treasurers must ensure country risk is firmly on their counterparty radar.

Once counterparty risk sources have been accurately identified, it is time to consider the best way to measure and manage any threats. This helps the treasurer to ensure that undesirable exposures do not develop in the first place.

Measure and manage

To be clear, there is no silver bullet for measuring and managing counterparty risk. Companies will use a variety of tools and modelling techniques, largely dependent on their size and sophistication. These may range from quantitative approaches such as expected exposure and probability of default calculations, through to more qualitative measures such as assessing the strength of the counterparty’s management team.

Despite there being no one size fits all tool or technique for measuring and managing counterparty risk, there are some useful rules of thumb that the majority of companies can follow. It might seem obvious, but ensuring that the full counterparty exposure is being managed and measured is one such simple, yet significant rule. The section below outlines some additional appropriate ‘rule of thumb’ responses to the major forms of counterparty exposure. It should be noted, however, that the correct method for measuring and managing counterparty risk depends on the particular circumstances of the corporation, and its counterparty risk policy (more on this later).

Source of risk Threat posed In particular, watch for …
Deposits Potential loss of deposits in instances of bank failure.
  • Large deposits.
  • Overexposure to any one bank/financial institution.
  • The bank/financial institution’s credit rating.
Investments Loss of investment – whether bonds, equities or another instrument.
  • Maturity of investment.
  • The credit status of the company/institution/vehicle.
  • Market changes.
  • Sovereign credit rating downgrades.
Borrowing Changes in bank lending policies could affect the level of your repayments and/or the ability to refinance.
  • Mergers, acquisitions and consolidation activity by your lending banks.
  • Changes to a bank/financial institution’s credit policy.
Trade financing In trade finance arrangements, the supplier sometimes runs the risk of losing the balance payment.
  • Changes to the credit status of the trade financier.
  • Legal recourse in case of default.
Leasing In leasing agreements, if the leasing company were to fail you could lose the right to the use of the leased goods.
  • Terms of the leasing arrangement.
  • Changes to the credit status of the leasing company.
Foreign exchange Settlement risk – sending a payment to settle a foreign exchange deal but receive nothing or less than you were expecting in return.
  • Market changes resulting in big fluctuations in exchange rates.
  • Large settlement exposures in exotic currencies.
Derivative instruments If the other party fails to fulfil its obligations under the agreement you will have to meet the original payments.
  • Settlement risk for derivatives is greatest in the over-the-counter (OTC) markets. Regulation is attempting to reduce this risk through the use of central counterparties (CCPs) but treasurers should be aware of the risk potential where derivative transactions are concerned as non-financial counterparties are often exempt from the mandatory clearing requirements being brought in under these new regulations.
Accounts receivable Default or late payments.
  • Late payments.
  • Changes in the payment behaviour of your customers.
  • Changes to your customers’ credit status.
Suppliers Delays in the supply chain.
  • Changes in the credit status of your suppliers.
  • Late/incomplete deliveries.

Source: Treasury Today Best Practice Handbook, Managing Risk in Treasury

  • 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 spreadsheets, 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 ultimately 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, asset classes and a variety of tenors to minimise the likelihood of a loss of capital in a crisis situation. Updating the company’s investment policy is also critical here. Best practice determines that integrated risk metrics should be used to help formulate an investment policy that can adapt to the changing financial environment.
  • Borrowing: The recent global financial crisis highlighted the importance of keeping a close check on the institutions the company borrows money from. In particular, corporates should look out for circumstances that could lead to financial institutions altering their lending policies and prices. While there should be no great risk to current agreements, banks which offer revolving credit facilities may, in difficult conditions or as a result of regulatory changes (such as Basel III), choose to increase the price of such a facility or perhaps 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). 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: Despite regulatory progress towards central clearing, counterparty risk still presents a 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. 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.Within the derivative portfolio, corporates can also look to identify or create offsets to minimise aggregate counterparty exposures. As Andrew Bailey (AMCT, MSTA), National Grid Money Markets Team told Treasury Today: “Where possible, trading should take place on a collateralised basis (using bilateral credit support annexes (CSAs) with minimal thresholds, or trading on a cleared basis), while managing potential liquidity risks that may arise from mark-to-market volatility and resultant collateral requirements. Break clauses can be inserted in longer-dated instruments. Companies should also be cognisant of secondary effects of counterparty risk, such as credit value adjustment (CVA) charges, which can in part be managed using credit auctions and options.”
  • Accounts receivable: Accounts receivable, is a prime source 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 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 of any extension of credit to identify those who pose an excessively high credit risk. Such careful checks should continue to be carried out on existing debtors too – paying particular attention to changes in payment behaviour which could possibly indicate that they are experiencing financial difficulties.
  • Trade financing and leasing: While trade financing can actually 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 also important to be aware of the level of protection available 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.

You can’t beat them all

Finally, while every effort should be made to keep a lid on counterparty exposures, even the best risk analysis or tools in the world will still not prevent certain defaults. In addition to a robust counterparty risk management framework, therefore, controls and guidelines should be put in place for when the inevitable happens.

Counterparty risk management policy

An effective counterparty risk management approach should always include a clear policy. According to consultancy firm Zanders, basic items to cover in this policy should include:

  • A list of eligible counterparties for treasury transactions, plus acceptance criteria for new counterparties – for example, to ensure consistent ISDA and credit support agreements are in place. This will also be linked to the credit commitment.
  • Eligible instruments and transactions (which can be credit standing dependent).
  • The term and duration of transactions (which can also be credit standing dependent).
  • Variable maximum credit exposure limits based on credit standing.
  • Exposure measurement guidelines – how is counterparty risk identified and quantified?
  • Responsibility and accountability guidelines – who should have ultimate responsibility for managing counterparty risk?
  • Key performance indicators (KPIs) to measure and monitor performance.
  • A definition of reporting requirements and format.
  • An overall framework for decision-making by staff, including treatment of breaches.
  • Continuous improvement measures – what procedures are required to keep the policy up-to-date?

Source: Zanders

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