How should corporates address and monitor the counterparty risk? It is a tricky question, isn’t it? It's clear that counterparty risk is real, and more real than ever since those dark weekends in early Spring when some (totally unrelated) banks had some resounding setbacks. I don't know any treasurers who aren't asking themselves this question: how can I better manage this risk, and am I doing enough? What are the alternatives to better mitigate my risk? These are the existential questions that treasurers are entitled to ask themselves.
“If you take the view that these are standards that you can set once and all, then they’re doomed to fail”, said David Aikman, professor of Finance at King’s College. It is true that we should learn lessons from the recent events. Bank runs come back to haunt regulators, governments and… treasurers. As is always the case after a financial crashes or crises, questions are asked, and legislators take the opportunity to tighten the screws and make control and prevention rules more rigid. It is therefore to be feared that Basel 3, which is currently under review at European level, will bear the brunt of this, as will the reform of Money Market Funds and other regulations. Even if the problem lies elsewhere and the solution unsuitable, we know that sometimes the legislator or supervisor must take measures, as a matter of principle, to demonstrate that he is acting in the common good. Here, we must remember that the idea would already be to apply all the same rules, in the same way, and to be controlled in the same way too. Unfortunately, this may not always be the case. This is a good time to revisit our processes and improve our management of a risk that has once again become a major concern for all treasurers.
Counterparty risk is the likelihood or probability that one of those involved in a transaction might default on its contractual obligation. Counterparty risk can exist in credit, investment, and trading transactions. Counterparty risk is the likelihood or probability that one of those involved in a transaction might default on its contractual obligation. Bank counterparty risk can exist in credit, investment, and trading transactions. The numerical value of a borrower’s credit score reflects the level of counterparty risk to the lender or creditor. The treasurers should consider the bank that’s taking their deposits to assess whether there’s significant default or counterparty risk.
What has changed is the speed with which a situation can evolve. Social networks, as we saw with Meme Stocks or SVB, can be formidable and lightning-quick in their sentences. When things go wrong, they go very fast (too fast). And so, whatever the tool or strategy, you run the risk of being late and missing the exit in time. So, we need to monitor risk, but above all we need to prevent and anticipate it through diversification. Recent experience has taught us that counterparties can fail with little warning (e.g., Silver Gate Bank, SVB, CS, Signature Bank). It goes so fast that reactions can only be too late. Counterparty risk management has become more challenging in recent decades due to concentrated exposures, complex financial instruments, higher and fast rising interest rates, evolving bank credit and domino effects with highly correlated businesses and economies. Counterparty risk is not at all new, but more critical in the current economic context. Corporate and treasury organizations should (ideally) manage their risks proactively, have an integrated risk and bank relationship policy across business lines, diversify risks by setting exposure limits according to risk criteria, minimum credit ratings, and seek out professional resources where available or tools.
One of the great lessons we learned from the recent financial crisis following the pandemic was that the financial world was not as safe as we thought. This statement remains true and applicable to all crises. Despite huge industry and regulatory efforts aimed at bolstering the strength of the whole financial system, our world remains fragile and banks even the largest ones do not escape this cruel logic. Treasury peers have shown an increased awareness of counterparty risk management. The issue remains a major priority among risk managers at financial institutions. Therefore, you can easily imagine that it is an even bigger challenge to treasurers who have limited access and knowledge of the complex, interconnected and concentrated mysterious world of finance. This counterparty risk given the accelerated pace of events became more complicate. It is extremely difficult to track and manage this risk and the key drivers for managing it properly. Corporate treasurers are applying basic principles and tools to monitor and assess this risk. When tools are basic, results can only be poor and do not remove risks. The way to measure this risk are limited and the results are poorer and poorer given the acceleration of events (e.g., SVB or Crédit Suisse). From a treasurer’s perspective, the risk is that defaulting banks cannot repay deposits or that it cannot deliver the financial hedging instrument, (i.e., delivery risk).
There are no magic recipes or tricks. Treasurer's means are limited and so shifted because of the speed of information transmission. For FX transactions, we can imagine using collateral or “CSA” agreements to mitigate the risk of counterparty default. The cost of collateral is more than offset by the more aggressive hedging price (as it is less risky for the banker). For investments, the use of pledge-backed tri-party-repo transactions or money-market funds helps to limit this risk. It should be noted that the use of collateral is tantamount to transferring counterparty or credit risk to liquidity risk (including interest-rate risk). As financial instruments become more sophisticated and financial institutions become more complex, corporations feel particularly challenged to identify, track, manage and mitigate counterparty risk due to a lack of expertise and resources as compared to their financial counterparts. For most small- to medium-sized corporations, avoiding default by a financial intermediary is the focus of their risk management strategies, as more complex and expensive risk mitigation techniques are not financially feasible. Treasurers, when you carefully think about it, can only focus on risk prevention and diversification, which are more applicable to the resource-constrained treasury staff. Fortunately, it seems that solutions are emerging to give (more) comfort to treasurers re. this risk (e.g., Treasury Spring platform).
There are different types of counterparty risk. We have listed them below, without claiming to be exhaustive. So, we have the business and trade, including receivables and payables through financial intermediaries; trade guarantees and short-term lending, including letters of credit, banker’s acceptances, unfunded commitments and revolving credit lines; repurchase agreements and reverse repurchase agreements, as well as securities lending arrangements; derivatives, including currency forwards, interest rate swaps, asset swaps, credit default swaps, total return swaps and options on swaps (OTC derivatives – and risk of non-delivery); etc.…
We can only advise treasurers to have an ad hoc counterparty risk and banking relationship policy, to avoid working with just anyone. Secondly, to limit the number of products used, and to choose them based on principal preservation. Then, the best you can do without investing too much time is to set up an effective alert system, monitor CDSs and other credit ratings, and finally the stock market price, if the company is listed. It is also important to have an automated system that alerts you to changes in value at a percentage to be defined. For example, a downward change in share price of 3%, etc. Alas, SVB's bank run was, or would have been, difficult to predict, especially on a weekend, like Crédit Suisse, which had been convalescing for a long time. This is not a panacea, nor is it satisfactory. However, doing more is no guarantee of results either. Indeed, the marginal effort would be enormous for a result that is often disappointing. There is a market out there that can provide a more effective and immediate service than agency ratings. The platform mentioned above (i.e., Treasury Spring) will offer this type of highly awaited service. On the other hand, to the question of whether this risk has increased over the last few years, we can say that it has.
The treasurer’s role has evolved and therefore he/she may feel their tasks have become more challenging since COVID. These feelings may be valid. Indeed, banks have grown larger, they are clearly more complex and have become more interconnected; the recent couple o financial crises have resulted in significant deterioration of credit, liquidity, and capital conditions at many financial intermediaries despite efforts to rebuild loss-absorbing capital. The government support assumptions for large banks (i.e., bailouts) have been significantly scaled up in developed countries.
The increasingly concentrated world may be one factor explain the difficulties. Bank mergers have grown substantially, eventually resulting in an industry dominated by a few very large global players. Paradoxically, failing institutions during the financial crisis and financial regulators’ efforts in tackling the “too-big-to-fail” risk resulted in even higher concentration in the financial industry. The effect is bigger risks resulting from mergers on counterparty concentration. At the end of the day, many corporations now have counterparty exposures to the same few large banks, which may become a systemic concern if one of the banks run into problems. In parallel, underlying credit strength in the largest banks deteriorated dramatically in the years after the last crises, largely due to poor loan quality, volatile swings in the capital markets, poor ALM strategies, fast-growing interest rates after negative rates for years, and lax risk management practices. Reduced government support assumptions also have contributed to lower credit ratings of major banks. A lesson from the last crisis was that counterparty risk among large financial institutions is exaggeratedly correlated. The $5-billion-plus “London Whale” trading loss at JPMorgan Chase, a decade ago was another example of how a bank with a presumably strong risk management track record could fall victim to complex derivatives losses, or Société Générale with Jérôme Kerviel. All too often, counterparty risk becomes a high priority only after the creditworthiness of a major counterparty is in question. Isn’t it funny? But so true.
Although well-disciplined risk management practices may seem arduous and time consuming, hoping that everything will be fine is maybe not the right approach. Likewise, simply picking banks deemed “too-big-to-fail” and expecting the Governments or Central Banks to come to the rescue is no longer the prudent course of action, as the political environment has become less tolerant of bailing out big banks. Eventually, counterparty risk management may seem daunting as corporations may have multiple access points to the same financial institutions. Getting an overall and comprehensive picture is not always simple. The limits must be regularly reviewed, recalculated, monitored and they may lead to actions when counterparty performance deteriorates. The best piece of advice is risk mitigation through diversification. Although this principle is widely recognized and, additional measures used to fine-tune exposure limits in accordance with predefined risk levels may enhance effectiveness. Looking to professional managers for counterparty expertise could be a solution, although never guaranteed of success. Overseeing counterparty risk management can be a daunting task. The technology required to track exposures and monitor limits may, by itself, necessitate the engagement of specialists in counterparty risk management.
For implementation of specific counterparty risk measures, corporate treasurers may succeed by looking to some of the common best practices among banks, which could later be applied to Corp’s. For example, why not standardize contracts? Using products with a central clearing house? Considering delivery versus payment (DVP)? Matching collateral and margin posted? Why not better assessing and monitoring counterparty risk potentially with third party specialists? By matching collateral and margin posting with counterparty risk assessment? By using tri-party repurchase agreements and third-party custodians? We don’t have the answer, unfortunately. However, we know we must all take actions to refine our counterparty risk management.
Managing counterparty risks should be an integrated process. Recent events, as explained, have taught us that default can fail with little, or even no warning. Despite constant attempts by financial supervisors and regulators to improve counterparty strength and mitigate as much as possible systemic risks. Corporate treasurers continue to face number of challenges with evolving economic situation, high volatility, and complex political context. This risk came back into the limelight. We learned it must be managed. In general, it may be improved by adopting best practices, by being (more) proactive, by revisiting policies, and by developing a detailed and integrated procedures across the group. Treasurers can also diversify risk by setting appropriate exposure limits (based on credit rating or other triggers) and seeking out professional external resources or solutions, when available.
Managing this risk remains a tricky business, because whatever the solution, it's always unpredictable. Unfortunately, there is no perfect solution. As the treasurer is not remunerated based on the return generated, it is in his/her interest to invest his/her funds by prioritizing security over yield. This is known as optimization. Nevertheless, it's complex because it's imperfect, and the time factor has become critical with the advent of social networks.
François Masquelier, CEO of Simply Treasury – Luxembourg – May 2023
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 (EACT)