Assessing Counterparty Risk Remains a Tough Task for Corporate Treasurers

If there's one area of treasury where there's no magic formula or miracle solution, it's counterparty risk management.

As we saw recently (Spring 2023), banks could go bankrupt and default. And so, more than ever, it is essential to be able to manage this risk dynamically and in real time, or else face more serious problems and be prepared to lose some or all the principal entrusted to your banker. There is no infallible method, but there are some common-sense solutions that you need to adopt and integrate to sleep comfortably at night and avoid any annoyance with your CFO. That's what we're going to talk about in this article.

Counterparty risk assessment

Assessing counterparty risk is a critical task for all corporate treasurers to ensure the financial stability and security of their organization and to protect the company’s money. Counterparty risk refers to the risk that a counterparty (such as a customer, supplier, or financial institution) will fail to fulfill its financial obligations. There are solutions, best practices, and recommendations. However, we should keep in mind that treasurers do not always have time, resources, and tools to properly manage this risk. In order no to be blamed, better to set up policies, framework and use instruments enabling to mitigate this specific risk.

Managing counterparty risk remains a real concern for all treasurers and CFOs. As there are no miracle solutions, you need to apply a series of preventive measures and follow good practice. But it is also important to bear in mind that although a corporate client has a duty to work with its partner banks and to share its business, including its deposits, it should not do so at any price. Risk must remain a key consideration. We therefore recommend that you also consider guaranteed deposits or tri-party repo's as a short-term investment alternative. Indeed, with solutions like Treausry Spring, it becomes easy to access guaranteed deposits without the bilateral complexities of negotiating a tri-partite repo, and makes it possible to really mitigate risk. This is undoubtedly an excellent alternative, just as the use of money market funds can be to a reasonable and proportionate extent.

Here are steps and strategies to best assess counterparty risk:

Let's take a look at some valuable tips and best practices for managing counterparty risk, while avoiding excessive or unmanageable system investments. Please note that even if we mainly focus to bank counterparty, there are also the customers. These clients must be treated slightly differently. Not all treasury department are in charge of customer’s credit risk.

Collect Information:

Gather comprehensive information about the counterparty, including financial statements, credit reports, and historical payment records. You may also want to consider their industry reputation and news about their financial health. There are no miraculous sources for this type of information, despite a few specialists: financial data agencies, Bloomberg, Refinitiv, or Dun & Bradstreet among others. Of course, the financial press is a big help. However, we have recently seen that the time factor is so short that by the time you react, it may be too late, because a treasurer is not "in the market" in the same way as other pure specialists, such as money market fund managers, for example.

Credit Analysis:

Perform a thorough credit analysis to evaluate the financial strength and creditworthiness of the counterparty. This includes assessing their balance sheet, income statement, and cash flow statement. Look for signs of financial stability and the ability to meet obligations. Unfortunately, for this task, treasurers need ad hoc tools to crunch figures and calculate ratios and indicators, with all the uncertainty of the exercise. Please also note that in Europe ECB helps by assessing systemic banks’ creditworthiness.

Credit Scoring Models:

Utilize credit scoring models or credit rating agencies to assign a credit score to the counterparty. These models provide a standardized way to assess credit risk based on financial metrics and historical data. The ratings are also simple opinions and therefore, not a guarantee of creditworthiness. As for all other items listed, they are additional indicators. But no one is sufficient to give the guarantee of financial health.

Industry and Market Analysis:

Consider the counterparty's industry and market conditions. Economic factors, industry trends, and market competition can affect their ability to meet obligations. The economic context may help giving indicators and alerts, including contagion risks. It is clearly a complement in the analysis.

Diversification:

Diversify your counterparty risk by not relying too heavily on a single counterparty. Spread your exposure across multiple counterparties to reduce the impact of any single default. It is the best piece of advice. The diversity in counterparties, in products of placement, in geographical regions. Some products are better positioned on a risk scale, even if it may impact return. Here again, we must mention the guaranteed deposits to give a broader scope of counterparties, while securing with collateral the assets placed. The solution exists (as mentioned above) and should be contemplated to diversify and mitigate risks. it becomes a best practice in treasury.

Contractual Protections:

Review and negotiate contracts with counterparties to include clauses that mitigate risk, such as collateral requirements, guarantees, or termination clauses in case of default. Against a bank for a simple deposit, the protections are extremely limited. Nevertheless, on money market funds or tri-party repo’s the framework and financial regulations are strong(er) and give additional comfort.

Monitoring:

Continuously monitor the financial health of counterparties, especially those with significant exposure. Regularly update credit assessments based on changes in their financial position or market conditions. However, whatever the frequency, we must keep in mind that it is never enough, and that crisis could arise and develop fast when confidence in the bank suddenly disappears. We saw many banks runs in the recent years since the GFC.

Use of Derivatives:

Consider using derivatives like credit default swaps (CDS) to hedge against counterparty risk. CDS can provide insurance against potential defaults by counterparties. Hedging is a way to mitigate risks, but it has a cost of hedging, of managing and of revaluating products.

External Ratings:

Rely on external credit ratings provided by reputable credit rating agencies to assess counterparty risk. These ratings can offer an independent assessment of creditworthiness. As already said, an opinion from the best agencies do not consist of a guarantee of financial solidity.

Scenarii Analysis:

Conduct scenario analysis to assess how potential adverse events or economic downturns could impact the counterparty's ability to meet obligations. This can help you prepare for different risk scenarios. Here again, easier to say than to apply.

Stress Testing:

Perform stress testing on your company's financial position to determine the impact of counterparty defaults. This can help you understand the potential losses and plan accordingly. What is your risk tolerance is a key question to assess the policy for asset management and types of products you will use.

Establish Risk Limits:

Define risk limits for different counterparties based on their creditworthiness. Set thresholds for exposure to high-risk counterparties. This is a very important recommendation. The limits against counterparties, products, tenors, etc… They should be part of your dedicated asset management policy.

Review Internal Policies:

Ensure that your company has clear policies and procedures for assessing and managing counterparty risk. Regularly review and update these policies to adapt to changing market conditions. This piece of advice is applicable to all policies. Each time the economic context changes, it may be time to review policies and to ensure they are still adapted to circumstances.

Legal and Regulatory Compliance:

Stay informed about legal and regulatory requirements related to counterparty risk management in your industry and jurisdiction. Comply with reporting and disclosure obligations. The role of EACT and local associations is essential as they can give treasurers useful information on future regulations and potential impacts. Recently the Basel 3 rules have been reviewed by the EU Commission and some changes could have be impactful for treasurers, directly or indirectly.

Seek Professional Advice:

Consider seeking advice from financial experts, credit analysts, or risk management consultants to enhance your counterparty risk assessment processes. There are specialists selling services and information. Nevertheless, again it is not a guarantee of creditworthiness. It is unfortunately not an exact science.

In conclusion, we would recommend assessing counterparty risk on an ongoing basis and with regular and strict processes that require a combination of financial analysis, risk management strategies, and vigilance to adapt to changing economic circumstances. It's a critical aspect of corporate treasury and risk management to safeguard your organization's financial well-being. The recent bank crises in Switzerland or in the US have reminded financial professionals the risks of bank counterparties. “Better safe than sorry” as rightly described by the wise saying.

François Masquelier, CEO of Simply Treasury, Luxembourg

Disclaimer: This article was prepared by François Masquelier in his personal capacity. The opinion expressed in this article are the author’s own and do not necessarily reflect the view of the European Association of Corporate Treasurers (i.e., EACT).