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Current Approaches in Counterparty Risk Management

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Regional General Manager, IT2 Treasury Solutions06 April 2011Pole Yu, Regional General Manager, IT2 Treasury Solutions

More than three years after the global financial crisis, its effects continue to reverberate around the world’s financial markets. The emphasis of concern may have shifted from the banking to the sovereign sector, but the underlying issues for corporate treasuries remain the same: quantifying the real creditworthiness of all counterparties, assigning and managing appropriate counterparty dealing limits, and monitoring changes in creditworthiness with the necessary speed and sensitivity so that effective and timely responses to any sudden deteriorations may be made.

Sovereign debt issues amongst the weaker eurozone countries and the United States’ narrow avoidanceof a politically-provoked technical default – followed by an unprecedented downgrading by Standard& Poor’s – have caused uncertainty in the markets. Today’s global economy means that companiesoperating in financially strong areas and sectors are not immune to the risks of direct or indirect exposureto less creditworthy counterparties, whether they are corporate, banking or sovereign institutions. Theserisks may be experienced directly, because of the multinational nature of many companies’ businessoperations, or indirectly through the knock-on effects transmitted through the banking sector. Credit riskis encountered in treasury exposures, in investments, and in the commercial receivables book, so thecorporate sector should be included in the analysis, in addition to the sovereign and banking sectors.

Accordingly, a key element of prudent corporate treasury management is the evaluation of theapproaches to counterparty risk management that are presently attracting interest among the world’scorporate treasuries, combined with the modification of treasury policy to implement improvementsappropriate to the organisation. 

Credit Ratings Are No Longer Enough

More and more treasuries are now supplementing the use of classical credit ratings to evaluate counterparties’ creditworthiness with faster-moving and therefore more sensitive indicators – it is salutary to recall that Lehman Brothers carried an investment grade ‘A’ rating from Standard & Poor’s at the time of its collapse in 2008. In the more recent case of credit deterioration of some Eurozone countries, credit ratings were again found lacking as leading indicators of the mounting problems, with several commentators stating that the eventual downgrades came too late to be of real value to the investment community.

The rating agencies seem to have sharpened their response in the unfolding of the sovereign debt issue – but can the use of credit ratings alone now be regarded as best practice for corporate treasuries? Financial institutions have led the way in developing new, more effective approaches to credit evaluation. In the corporate treasury sector, the adoption of a range of market-linked measures has become best practice in the evaluation of counterparties’ creditworthiness.

One of the most widely adopted measures is tracking counterparties’ credit default swap (CDS) spreads. In fact, the performance of Lehman Brothers’ equity price and CDS spread both operated as accurate leading indicators of a rapidly deteriorating credit status in the weeks preceding the actual failure.

CDS spread monitoring is the basis of the recommended methodology of the US Association for Financial Professionals (AFP) for assigning a monetary value to non-performance risk, as required under FAS 157. It is appropriate to note that very few corporate treasuries actually use the CDS as a hedging instrument – the volatility that makes the CDS such a sensitive monitoring measure makes its use unattractive to the majority of corporates. In addition to CDS spread monitoring, there are several other measures for counterparty credit monitoring: these include equity and bond prices and indices, probability of default factors published by expert third parties and working capital ratios. Most now accept that no single indicator on its own can adequately answer the risk management objectives of treasury.

Corporate treasurers now enjoy a wealth of options in terms of tools to evaluate and monitor the performance and creditworthiness of their counterparty universe, so that they can supplement credit ratings with faster-moving indicators, as appropriate for their business-risk profile.

The Role of Technology 

Today’s credit management requirements are complex and the effectiveness of solutions depends on their integration with existing treasury technology, allowing the entire exposure to be monitored and sudden deteriorations for a given counterparty (or counterparty grouping) to be signalled via alerts and reported in real time, or at least on demand. The risk factors adopted as policy at a given treasury may be built into a number of treasury management system (TMS) functions, including mark-tomarket valuations and, for companies with US reporting obligations, for FAS 157 compliance purposes.In terms of counterparty risk management, the chosen risk factors may be applied to the allocation and management of counterparty trading limits, and to the continuous monitoring and analysis of counterparty exposures.

The actual solution mechanism can be highly automated, so that monitoring and the issuing of any necessary alerts can take place without direct human intervention. This provides a strong degree of management assurance that counterparty exposures are being objectively and effectively monitored. The setting up of the automated solution will include a straightforward configuration process that links and integrates the TMS’s risk management functionality with a reliable source of the selected risk indicators, such as equity prices and CDS spreads. Once the integration has been set up, the required data may be automatically “pushed” into the TMS whenever changes occur, or automatically “pulled” into the TMS at a pre-defined frequency, or imported on demand. Once the information has been updated, the TMS can automatically apply the changes in all relevant areas, including valuations, limit assignments and counterparty exposure analysis, so that all information reported by the TMS fully and accurately reflects the current situation. The provision of the necessary integration tools and automated functions to provide secure, hands-free counterparty exposure management is a standard feature of today’s treasury technology.

This overall process enables the derivation of a synthetic or “shadow” rating and its application within a TMS. With appropriate weighting of each factor, the synthetic rating (or individually weighted risk factors) may be employed by the corporate treasury as a sensitive, customised tool to ensure that counterparty exposures are evaluated and managed with the optimum speed and precision, enabling the organisation to detect sudden deterioration in a counterparty’s creditworthiness – and to take the necessary mitigating action, quickly and effectively.

 

Solution Scope and Performance

When corporate treasuries are determining the details of any upgrade to their counterparty exposure management infrastructure, they will naturally evaluate the required investment against the benefits of operating a best practice solution. One key factor is the objective determination of the level of counterparty risk that they are carrying versus the requirements of treasury policy, and then deciding, for example, whether it is appropriate to implement a hands-free, real-time solution, as opposed to an on-demand arrangement. The detailed cost justification will be specific for each corporate treasury, because of individual differences in policy and business profile, as well as differences in the size, location and quality of counterparty banks and issuing entities. The implemented policy may well be determined for reasons other than pure counterparty creditworthiness, such as the existence of important lending and other commercial relationships. So there may be radical differences in the appropriate level of risk management solution that should be adopted by corporations of similar type and size.

So what is the required response speed of a best practice counterparty limit management solution? A case can certainly be made for the real-time solution, with integrated monitoring of one or more marketsensitive creditworthiness indicators, such as the CDS spread. A fully automated solution that will issue alerts to nominated individuals if there is a sudden deterioration in creditworthiness for a counterparty (or counterparty grouping) provides the most robust and secure result, since, once set up, monitoring and alerting is not reliant on human intervention, and is significantly more dependable. In practice, the response to the automated detection of a pre-defined credit problem condition could be implemented to include the continued issuance of alerts and escalation processes until remedial action is initiated.
 
The technical elements of implementing an enhanced counterparty risk management solution should include an accommodation to the true scope of the composition of a credit exposure to a given counterparty. In practice, a corporate’s exposure to a given bank might include:
  • global bank account balances;
  • time deposits placed;
  • money market investments held, e.g. certificates of deposit (CDs), acceptances, repos, commercialpaper;„„
  • open foreign exchange (FX) deals, e.g. spots, forwards, swaps, futures, options;„„
  • open interest rate derivative deals, e.g. swaps, cross-currency swaps, options, swaptions, forwardrate agreements (FRAs), futures;„„
  • bond investments held;„„
  • equity investments held; and„„
  • collateral held against assets.

  • The diversity of these components – cash, investments, collateral, and instruments with streams offuture fixed and variable cash flows – indicates that the implementation of a complete and fully effectivesolution may in some cases be more complicated than it initially appears. The technical solution is quitedemanding; it needs to collect and manage information from multiple sources within and outside theorganisation, apply the chosen creditworthiness measures to each counterparty exposure, broadcastthe results and manage the response as required. Naturally, many corporations will not carry exposuresto all or even many of these asset classes. The important issue is that they should be investigated whena specific company’s trust exposure spectrum is analysed, to verify that the analysis is complete andaccurate.

     

    Navigating an Uncertain Future

    This article has outlined some of the considerations and approaches to counterparty exposure riskmanagement that organisations are taking in today’s corporate treasury industry. They will be ofinterest to corporate treasurers in the Asia-Pacific region and beyond, in their evaluation of routes forachieving best practice operations in this sensitive and important area. A strong solution means that theorganisation will be in a position to receive accurate early warning of an emerging creditworthiness issuewith a counterparty or group of counterparties, in any sector (sovereign, bank or corporate), ensuringthese organisations are competitively positioned to define and execute any necessary remedial action –perhaps in the early stages of a crisis when the speed and precision of the response may well be criticalto success, as recent experience shows. Implementing an optimal technology solution for counterpartyexposure management cannot of course eliminate the endemic risks and uncertainties of the financialmarkets – but it can certainly help with more assured navigation into the future.

     

    heading-icon-2Comments

    John, you make a really good point and from a vodenr perspective, I believe that regulators have gone too far. With multiple CCPs established across geographies, the concept of central clearing is quickly defeated. Additionally, with more stringent collateral management requirements, establishing an infrastructure to calculate calls in near real-time across several CCPs will come with a hefty price tag. Regulators should consider mandating one CCP to each asset class like the DTCC was for equities and listed FIs here in the U.S. There is some traction being made. For instance regulators are trying to create a body that would oversee cross jurisdictions like AFME for the FX asset class. However clearly there is still much more that needs to be done. If regulators took a more centralized approach, they could still achieve the core goal of central clearing (reduction of systematic market risk) while ensuring consistency and ultimately reducing costs.

    Marcela 02 June 2012, 9:45 pm
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