Risk Management

Managing counterparty risk

Published: Sep 2017
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Counterparty risk increasingly covers many different types of risk – and many different types of counterparty. How has this area evolved over the last decade, and what techniques can treasurers 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. This is an area which most treasurers will need to consider to some extent. A survey published earlier this year by the Association for Financial Professionals (AFP) on the strategic role of the treasury found that 49% of respondents played a lead role in counterparty risk analysis, with 24% playing a supporting role.

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. ES Venkat, Head of Asia Pacific Treasury Product Management at Bank of America Merrill Lynch, explains that counterparty risk incorporates a number of different elements, including financial investments with counterparties, bank relationships and relationships with suppliers.

Philipe Jaccard, Head of Liquidity at ANZ, likewise sees counterparty risk as a topic affecting many different types of relationship. “Counterparty risk usually refers to financial institutions such as banks, insurance companies, broker dealers, asset managers, custodians and commodity traders,” he says. “Commercial counterparties should also be included since they are the main sources of cash inflows and outflows.”

As such, counterparty risk includes a range of scenarios, such as the risk that the failure of a bank could result in the loss of a company’s deposits, or that changes to a bank’s lending policy could affect the company’s access to financing. Likewise, the company could suffer financial loss if the counterparty in a derivatives transaction failed to meet its obligations. Where supply chain exposures are concerned, disruptions in the supply chain could result in essential deliveries being delayed, incomplete or even failing to arrive at all – or customers could default on their payments, potentially resulting in liquidity problems.

With so many possible scenarios, it should be no surprise that counterparty risk is also connected to many other types of risk exposure. “If I look at the categories of risk that treasurers are focusing on at the primary level, these include credit risk, compliance risk and reputational risk,” says Venkat. “On the secondary level, they also need to consider operational risk, strategic risk, liquidity risk and market risk.”

The possibility of an adverse event leading to reputational damage is a particular concern for many companies in Asia. Aon’s Global Risk Management Survey 2017, which surveyed 2,000 respondents from public and private companies around the world, found that respondents in Asia Pacific ranked damage to reputation/brand as their top risk, followed by regulatory/legislative changes, increasing competition and failure to innovate or meet customer needs.

Changing landscape

Counterparty risk management is notable in that the parameters of this topic have shifted considerably over the last decade. For one thing, regulatory developments in recent years have made compliance risk a greater concern than in the past. “Where compliance risk is concerned, the rules are getting tighter and the need for transparency is growing,” says Venkat. “The amount of due diligence that treasurers need to undertake on their counterparties has become enormous, resulting in an additional burden.”

More widely, recent years have seen a notable shift in terms of the way in which counterparty risk is assessed. As Jaccard 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.”

He adds that at this point, pricing often “glossed out” specific counterparty risks. “Libor was one size fits all and open to manipulations,” he adds. “Control was managed purely in terms of limits, not price, and was often loosely enforced and only reported at quarter end.” In addition, Jaccard says that liquidity risk did not feature in the assessment of counterparty risk – and “liquidity risk arising from commercial activities was usually out of scope”.

After the financial crisis

Since the financial crisis and the arrival of Basel III, Jaccard says that financial institutions are now more tightly regulated by specialised regulators that are focused on a segment of the industry. He points out that the measures used by rating agencies to assess financial institutions “have been vastly expanded to cover credit, settlement, liquidity and regulatory risks”.

Jaccard notes that under Basel III, banks have had to meet higher capital requirements and liquidity requirements. “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.” Jaccard adds that various factors are applied to operational deposit to assess their stability – “for example, retail deposits are assumed to be 100% stable while corporate deposits are assumed at only 50%”.

At the same time, Jaccard says that a number of other developments have affected the management of counterparty risk since the financial crisis. For one thing, he notes that market-wide pricing such as Libor has not fared well because one size no longer fits all. At the same time, issues such as settlement and liquidity risk have become top of mind, with liquidity risk now extended to include commercial counterparties such as suppliers and customers.

Looking past credit ratings

One issue which came to light following the financial crisis was the disadvantage of relying on external credit ratings when monitoring bank risk. As David Blair, an independent treasury consultant based in Singapore, points out, the global financial crisis “showed us painfully” that credit ratings should not be relied upon. This was particularly underlined by the fact that Lehman Brothers maintained an investment grade rating until its collapse in 2008.

Subsequently, Blair says that some larger treasuries began to do their own credit analysis – but with such large volumes of data to analyse, it is unrealistic for smaller treasury teams to follow suit. While some treasurers have focused their attention on credit default swap spreads, Blair says that these display a level of volatility which is at odds with a treasurer’s need for operational effectiveness. He argues that implied ratings can provide a more stable value, noting that these can be readily accessed by treasurers who use market data providers.

Despite their limitations, credit ratings continue to play an important role in counterparty risk management. The FIS survey found that 92% of treasurers use external credit ratings to categorise their banks from a risk standpoint. However, the survey also found that many are adopting a more proactive approach, with 68% looking at country/region risk and 58% factoring industry into their risk evaluation.

Overcoming the challenges

Managing all of the risks included within the category of counterparty risk can be a challenging task. A survey published last year by FIS about treasury risk management and regulations found that 56% of respondents indicated moderate/severe difficult in the area of managing credit risk to commercial counterparties. Meanwhile, 54% of respondents cited difficulties in managing bank counterparty risk.

The way in which counterparty risk is approached will vary for different companies depending on their geographical footprint, their business model and their banking and investment strategy. When it comes to managing counterparty risk, Venkat says there are no shortcuts. “Treasurers need to put a robust risk framework and governance model in place and then see how they are managing each of the relevant categories of risk,” he says.

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. It is important to get all of these competing priorities on the same page within the acceptable risk limits.”

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. Parameters may be put in place for different types of counterparty.

Managing counterparty risk in practice

Kenneth Ng is Corporate Treasurer at DFS Group, a luxury retailer headquartered in Hong Kong. According to Ng, the company has paid more attention to managing its counterparty risk since the financial crisis, using daily monitoring to keep track of its risks.

As such, DFS Group uses a number of strategies to manage its exposures. “From a funding perspective, DFS limits its cash balance with each bank group,” says Ng. “From an operating perspective, DFS diversifies its risk by working with different banks simultaneously, and by utilising bank-independent platforms for forex trading and payment services.” When it comes to overcoming the challenges, Ng says, “We need to balance work efficiency and risk exposure management. Clear and frank communication is important not only within the company, but also with banks.”

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.”

He points out that treasurers also need to diversify their counterparty risk – although this creates a challenge in terms of cost, as diversification means that the counterparty will not be limited to the lower cost providers. “Also, this creates a challenge with the operational effort of moving assets and liabilities to maintain limits.”

Where different types of counterparty risk are concerned, Jaccard points out that there are other ways that treasurers can mitigate counterparty risk. “They can expand supply chain financing opportunities such as longer-term payments from suppliers and shorter terms from customers. 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.”

Meanwhile, companies can manage the risks associated with accounts receivable by undertaking rigorous credit checks before extending credit to customers, as well as by monitoring any changes in their payment behaviour.

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.

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