Targeted Review of Internal Models (TRIM): Review of observations and findings for Traded Risk
Discover the significant deficiencies uncovered by the EBA’s TRIM on-site inspections and how banks must swiftly address these to ensure compliance and mitigate risk.
The EBA has recently published the findings and observations from their TRIM on-site inspections. A significant number of deficiencies were identified and are required to be remediated by institutions in a timely fashion.
Since the Global Financial Crisis 2007-09, concerns have been raised regarding the complexity and variability of the models used by institutions to calculate their regulatory capital requirements. The lack of transparency behind the modelling approaches made it increasingly difficult for regulators to assess whether all risks had been appropriately and consistently captured.
The TRIM project was a large-scale multi-year supervisory initiative launched by the ECB at the beginning of 2016. The project aimed to confirm the adequacy and appropriateness of approved Pillar I internal models used by Significant Institutions (SIs) in euro area countries. This ensured their compliance with regulatory requirements and aimed to harmonise supervisory practices relating to internal models.
TRIM executed 200 on-site internal model investigations across 65 SIs from over 10 different countries. Over 5,800 deficiencies were identified. Findings were defined as deficiencies which required immediate supervisory attention. They were categorised depending on the actual or potential impact on the institution’s financial situation, the levels of own funds and own funds requirements, internal governance, risk control, and management.
The findings have been followed up with 253 binding supervisory decisions which request that the SIs mitigate these shortcomings within a timely fashion. Immediate action was required for findings that were deemed to take a significant time to address.
Assessment of Market Risk
TRIM assessed the VaR/sVaR models of 31 institutions. The majority of severe findings concerned the general features of the VaR and sVaR modelling methodology, such as data quality and risk factor modelling.
19 out of 31 institutions used historical simulation, seven used Monte Carlo, and the remainder used either a parametric or mixed approach. 17 of the historical simulation institutions, and five using Monte Carlo, used full revaluation for most instruments. Most other institutions used a sensitivities-based pricing approach.
VaR/sVaR Methodology
Data: Issues with data cleansing, processing and validation were seen in many institutions and, on many occasions, data processes were poorly documented.
Risk Factors: In many cases, risk factors were missing or inadequately modelled. There was also insufficient justification or assessment of assumptions related to risk factor modelling.
Pricing: Institutions frequently had inadequate pricing methods for particular products, leading to a failure for the internal model to adequately capture all material price risks. In several cases, validation activities regarding the adequacy of pricing methods in the VaR model were insufficient or missing.
RNIME: Approximately two-thirds of the institutions had an identification process for risks not in model engines (RNIMEs). For ten of these institutions, this directly led to an RNIME add-on to the VaR or to the capital requirements.
Regulatory Backtesting
Period and Business Days: There was a lack of clear definitions of business and non-business days at most institutions. In many cases, this meant that institutions were trading on local holidays without adequate risk monitoring and without considering those days in the P&L and/or the VaR.
APL: Many institutions had no clear definition of fees, commissions or net interest income (NII), which must be excluded from the actual P&L (APL). Several institutions had issues with the treatment of fair value or other adjustments, which were either not documented, not determined correctly, or were not properly considered in the APL. Incorrect treatment of CVAs and DVAs and inconsistent treatment of the passage of time (theta) effect were also seen.
HPL: An insufficient alignment of pricing functions, market data, and parametrisation between the economic P&L (EPL) and the hypothetical P&L (HPL), as well as the inconsistent treatment of the theta effect in the HPL and the VaR, was seen in many institutions.
Internal Validation and Internal Backtesting
Methodology: In several cases, the internal backtesting methodology was considered inadequate or the levels of backtesting were not sufficient.
Hypothetical Backtesting: The required backtesting on hypothetical portfolios was either not carried or was only carried out to a very limited extent
IRC Methodology
TRIM assessed the IRC models of 17 institutions, reviewing a total of 19 IRC models. A total of 120 findings were identified and over 80% of institutions that used IRC models received at least one high-severity finding in relation to their IRC model. All institutions used a Monte Carlo simulation method, with 82% applying a weekly calculation. Most institutions obtained rates from external rating agency data. Others estimated rates from IRB models or directly from their front office function. As IRC lacks a prescriptive approach, the choice of modelling approaches between institutes exhibited a variety of modelling assumptions, as illustrated below.
Recovery rates: The use of unjustified or inaccurate Recovery Rates (RR) and Probability of Defaults (PD) values were the cause of most findings. PDs close to or equal to zero without justification was a common issue, which typically arose for the modelling of sovereign obligors with high credit quality. 58% of models assumed PDs lower than one basis point, typically for sovereigns with very good ratings but sometimes also for corporates. The inconsistent assignment of PDs and RRs, or cases of manual assignment without a fully documented process, also contributed to common findings.
Modellingapproach: The lack of adequate modelling justifications presented many findings, including copula assumptions, risk factor choice, and correlation assumptions. Poor quality data and the lack of sufficient validation raised many findings for the correlation calibration.
Assessment of Counterparty Credit Risk
Eight banks faced on-site inspections under TRIM for counterparty credit risk. Whilst the majority of investigations resulted in findings of low materiality, there were severe weaknesses identified within validation units and overall governance frameworks.
Conclusion
Based on the findings and responses, it is clear that TRIM has successfully highlighted several shortcomings across the banks. As is often the case, many issues seem to be somewhat systemic problems which are seen in a large number of the institutions. The issues and findings have ranged from fundamental problems, such as missing risk factors, to more complicated problems related to inadequate modelling methodologies. As such, the remediation of these findings will also range from low to high effort. The SIs will need to mitigate the shortcomings in a timely fashion, with some more complicated or impactful findings potentially taking a considerable time to remediate.
FRTB: Harnessing Synergies Between Regulations
Discover the significant deficiencies uncovered by the EBA’s TRIM on-site inspections and how banks must swiftly address these to ensure compliance and mitigate risk.
Regulatory Landscape
Despite a delay of one year, many banks are struggling to be ready for FRTB in January 2023. Alongside the FRTB timeline, banks are also preparing for other important regulatory requirements and deadlines which share commonalities in implementation. We introduce several of these below.
SIMM
Initial Margin (IM) is the value of collateral required to open a position with a bank, exchange or broker. The Standard Initial Margin Model (SIMM), published by ISDA, sets a market standard for calculating IMs. SIMM provides margin requirements for financial firms when trading non-centrally cleared derivatives.
BCBS 239
BCBS 239, published by the Basel Committee on Banking Supervision, aims to enhance banks’ risk data aggregation capabilities and internal risk reporting practices. It focuses on areas such as data governance, accuracy, completeness and timeliness. The standard outlines 14 principles, although their high-level nature means that they are open to interpretation.
SA-CVA
Credit Valuation Adjustment (CVA) is a type of value adjustment and represents the market value of the counterparty credit risk for a transaction. FRTB splits CVA into two main approaches: BA-CVA, for smaller banks with less sophisticated trading activities, and SA-CVA, for larger banks with designated CVA risk management desks.
IBOR
Interbank Offered Rates (IBORs) are benchmark reference interest rates. As they have been subject to manipulation and due to a lack of liquidity, IBORs are being replaced by Alternative Reference Rates (ARRs). Unlike IBORs, ARRs are based on real transactions on liquid markets rather than subjective estimates.
Synergies With Current Regulation
Existing SIMM and BCBS 239 frameworks and processes can be readily leveraged to reduce efforts in implementing FRTB frameworks.
SIMM
The overarching process of SIMM is very similar to the FRTB Sensitivities-based Method (SbM), including the identification of risk factors, calculation of sensitivities and aggregation of results. The outputs of SbM and SIMM are both based on delta, vega and curvature sensitivities. SIMM and FRTB both share four risk classes (IR, FX, EQ, and CM). However, in SIMM, credit is split across two risk classes (qualifying and non-qualifying), whereas it is split across three in FRTB (non-securitisation, securitisation and correlation trading). For both SbM and SIMM, banks should be able to decompose indices into their individual constituents.
We recommend that banks leverage the existing sensitivities infrastructure from SIMM for SbM calculations, use a shared risk factor mapping methodology between SIMM and FRTB when there is considerable alignment in risk classes, and utilise a common index look-through procedure for both SIMM and SbM index decompositions.
BCBS 239
BCBS 239 requires banks to review IT infrastructure, governance, data quality, aggregation policies and procedures. A similar review will be required in order to comply with the data standards of FRTB. The BCBS 239 principles are now in “Annex D” of the FRTB document, clearly showing the synergy between the two regulations. The quality, transparency, volume and consistency of data are important for both BCBS 239 and FRTB. Improving these factors allow banks to easily follow the BCBS 239 principles and decrease the capital charges of non-modellable risk factors. BCBS 239 principles, such as data completeness and timeliness, are also necessary for passing P&L attribution (PLA) under FRTB.
We recommend that banks use BCBS 239 principles when designing the necessary data frameworks for the FRTB Risk Factor Eligibility Test (RFET), support FRTB traceability requirements and supervisory approvals with existing BCBS 239 data lineage documentation, and produce market risk reporting for FRTB using the risk reporting infrastructure detailed in BCBS 239.
Synergies With Future Regulation
The IBOR transition and SA-CVA will become effective from 2023. Aligning the timelines and exploiting the similarities between FRTB, SA-CVA and the IBOR transition will support banks to be ready for all three regulatory deadlines.
SA-CVA
Four of the six risk classes in SA-CVA (IR, FX, EQ, and CM) are identical to those in SbM. SA-CVA, however, uses a reduced granularity for risk factors compared to SbM. The SA-CVA capital calculation uses a similar methodology to SbM by combining sensitivities with risk weights. SA-CVA also incorporates the same trade population and metadata as SbM. SA-CVA capital requirements must be calculated and reported to the supervisor at the same monthly frequency as for the market risk standardised approach.
We recommend that banks combine SA-CVA and SbM risk factor bucketing tasks in a common methodology to reduce overall effort, isolate common components of both models as a feeder model, allowing a single stream for model development and validation, and develop a single system architecture which can be configured for either SbM or SA-CVA.
IBOR Transition
Although not a direct synergy, the transition from IBORs will have a direct impact to the Internal Models Approach (IMA) for FRTB and eligibility of risk factors. As the use of IBORs are discontinued, banks may observe a reduction in the number of real-price observations for associated risk factors due to a reduction in market liquidity. It is not certain if these liquidity issues fall under the RFET exemptions for systemic circumstances, which apply to modellable risk factors which can no longer pass the test. It may be difficult for banks to obtain stress-period data for ARRs, which could lead to substantial efforts to produce and justify proxies. The transition may cause modifications to trading desk structure, the integration of external data providers, and enhanced operational requirements, which can all affect FRTB.
We recommend that banks investigate how much data is available for ARRs, for both stress-period calculations and real-price observations, develop any necessary proxies which will be needed to overcome data availability issues, as soon as possible, and Calculate IBOR capital consequences through the existing FRTB engine.
Conclusion
FRTB implementation is proving to be a considerable workload for banks, especially those considering opting for the IMA. Several FRTB requirements, such as PLA and RFET, are completely new requirements for banks. As we have shown in this article, there are several other important regulatory requirements which banks are currently working towards. As such, we recommend that banks should leverage the synergies which are seen across this regulatory landscape to reduce the complexity and workload of FRTB.
7 Steps to Treasury Transformation
Treasury transformation refers to the definition and implementation of the future state of a treasury department. This includes treasury organization & strategy, the banking landscape, system infrastructure and treasury workflows & processes.
Treasury transformation refers to the definition and implementation of the future state of a treasury department. This includes treasury organization & strategy, the banking landscape, system infrastructure and treasury workflows & processes.
Introduction
Zanders has witnessed first-hand a treasury transformation trend sweeping global corporate treasuries in recent years and has seen an elite group of multinationals pursue increased efficiency, enhanced visibility and reduced cost on a grand scale in their respective finance and treasury organizations.
Triggers for treasury transformations
Why does a treasury need to transform? There comes a point in an organization’s life when it is necessary to take stock of where it is coming from, how it has grown and especially where it wants to be in the future.
Corporates grow in various ways: through the launch of new products, by entering new markets, through acquisitions or by developing strong pipelines. However, to sustain further growth they need to reinforce their foundations and transform themselves into stronger, leaner, better organizations.
What triggers a treasury organization to transform? Before defining the treasury transformation process, it is interesting to look at the drivers behind a treasury transformation. Zanders has identified five main triggers:
1. Organic growth of the organization Growth can lead to new requirements.
As a result of successive growth the as-is treasury infrastructure might simply not suffice anymore, requiring changes in policies, systems and controls.
2. Desire to be innovative and best-in-class
A common driver behind treasury transformation projects is the basic human desire to be best-in-class and continuously improve treasury processes. This is especially the case with the development of new technology and/or treasury concepts.
3. Event-driven
Examples of corporate events triggering the need for a redesign of the treasury organization include mergers, acquisitions, spin-off s and restructurings. For example, in the case of a divestiture, a new treasury organization may need to be established. After a merger, two completely different treasury units, each with their own systems, processes and people, will need to find a new shape as a combined entity.
4. External factors
The changing regulatory environment and increased volatility in financial markets have been major drivers behind treasury transformation in recent years. Corporate treasurers need to have a tighter grasp on enterprise risks and quicker access to information.
5. The changing role of corporate treasury
Finally the changing role of corporate treasury itself is a driver of transformation projects. The scope of the treasury organization is expanding into the fi nancial supply chain and as a result the relationship between the CFO and the corporate treasurer is growing stronger. This raises new expectations and demands of treasury technology and organization.
Treasury transformation – strategic opportunities for simplification
A typical treasury transformation program focuses on treasury organization, the banking landscape, system infrastructure and treasury workflows & processes. The table below highlights typical trends seen by Zanders as our clients strive for simplified and effective treasury organizations. From these trends we can see many state of the art treasuries strive to:
- be centralized
- outsource routine tasks and activities to a financial shared service centre (FSSC)
- have a clear bank relationship management strategy and have a balanced banking wallet
- maintain simple and transparent bank account structures with automatic cash concentration mechanisms
- be bank agnostic as regards bank connectivity and formats
- operate a fully integrated system landscape
Figure 1: Strategic opportunities for simplification
The seven steps
Zanders has developed a structured seven-step approach towards treasury transformation programs. These seven steps are shown in Figure 2 below
Figure 2: Zanders seven steps to treasury transformation projects
Step 1: Review & Assessment
Review & assessment, as in any business transformation exercise, provides an in-depth understanding of a treasury’s current state. It is important for the company to understand their existing processes, identify disconnects and potential process improvements.
The review & assessment phase focusses on the key treasury activities of treasury management, risk management and corporate finance. The first objective is to gain an in-depth understanding of the following areas:
- organizational structure
- governance and strategy policies
- banking infrastructure and cash management
- financial risk management
- treasury systems infrastructure
- treasury workflows and processes
Figure 3: Example of data collection checklist for review & assessment
Based on the review and assessment, existing short-falls can be identified as well as where the treasury organization wants to go in the future, both operationally and strategically.
Figure 4 shows Zanders’ approach towards the review and assessment step.
Figure 4: Review & assessment break-down
Typical findings
Based on Zanders’ experience, common findings of a review and assessment are listed below:
Treasury organization & strategy:
- Disjointed sets of policies and procedures
- Organizational structure not sufficiently aligned with required segregation of duties
- Activities being done locally which could be centralized (e.g. into a FSSC), thereby realizing economies of scale
- Treasury resources spending the majority of their time on operational tasks that don’t add value and that could be automated. This prevents treasury from being able to focus sufficiently on strategic tasks, projects and fulfilling its internal consulting role towards the business.
Banking landscape:
- Mismatch between wallet share of core banking partners and credit commitment provided
- No overview of all bank accounts of the company nor of the balances on these bank accounts
- While cash management and control of bank accounts is often highly centralized, local balances can be significant due to missing cash concentration structures
- Lack of standardization of payment types and payment processes and different payment fi le formats per bank
System infrastructure:
- Considerable amount of time spent on manual bank statement reconciliation and manual entry of payments
- The current treasury systems landscape is characterized by extensive use of MS Excel, manual interventions, low level of STP and many different electronic banking systems
- Difficulty in reporting on treasury data due to a scattered system landscape
- Manual up and downloads instead of automated interfaces
- Corporate-to-bank communication (payments and bank statements processes) shows significant weaknesses and risks with regard to security and efficiency
Treasury workflows & processes:
- Monitoring and controls framework (especially of funds/payments) are relatively light
- Paper-based account opening processes
- Lack of standardization and simplification in processes
The outcome of the review & assessment step will be the input for step two: Solution Design.
Step 2: Solution Design
The key objective of this step is to establish the high-level design of the future state of treasury organization. During the solution design phase, Zanders will clearly outline the strategic and operational options available, and will make recommendations on how to achieve optimal efficiency, effectiveness and control, in the areas of treasury organization & strategy, banking landscape, system infrastructure and treasury workflows & processes.
Using the review & assessment report and findings as a starting point, Zanders highlights why certain findings exist and outlines how improvements can be implemented, based on best market practices. The forum for these discussions is a set of workshops. The first workshop focuses on “brainstorming” the various options, while the second workshop is aimed at decision-making on choosing and defining the most suitable and appropriate alternatives and choices.
The outcome of these workshops is the solution design document, a blueprint document which will be the basis for any functional and/or technical requirements document required at a later stage of the project when implementing, for example, a new banking landscape or treasury management system.
Step 3: Roadmap
The solution design will include several sub-projects, each with a different priority, some more material than others and all with their own risk profile. It is important therefore for the overall success of the transformation that all sub-projects are logically sequenced, incorporating all inter-relationships, and are managed as one coherent program.
The treasury roadmap organizes the solution design into these sub-projects and prioritizes each area appropriately. The roadmap portrays the timeframe, which is typically two to five years, to fully complete the transformation, estimating individually the duration to fully complete each component of the treasury transformation program.
“A Program is a group of related projects managed in a coordinated manner to obtain benefits and control not available from managing them individually”.
Zanders
Figure 5: Sample treasury roadmap
Step 4: Business Case
The next step in the treasury transformation program is to establish a business case.
Depending on the individual organization, some transformation programs will require only a very high-level business case, while others require multiple business cases; a high level business case for the entire program and subsequent more detailed business cases for each of the sub-projects.
Figure 6: Building a business case
The business case for a treasury transformation program will include the following three parts:
- The strategic context identifies the business needs, scope and desired outcomes, resulting from the previous steps
- The analysis and recommendation section forms the significant part of the business case and concerns itself with understanding all of the options available, aligning them with the business requirements, weighing the costs against the benefits and providing a complete risk assessment of the project
- The management and controlling section includes the planning and project governance, interdependencies and overall project management elements
Notwithstanding the financial benefits, there are many common qualitative benefits in transforming the treasury. These intangibles are often more important to the CFO and group treasurer than the financial benefits. Tight control and full compliance are significant features of world-class treasuries and, to this end, they are typically top of the list of reasons for embarking on a treasury transformation program. As companies grow in size and complexity, efficiency is difficult to maintain. After a period of time there may need to be a total overhaul to streamline processes and decrease the level of manual effort throughout the treasury organization. One of the main costs in such multi-year, multi-discipline transformation programs is the change management required over extended periods.
Figure 7: Sample cost-benefit
Figure 7 shows an example of how several sub-projects might contribute to the overall net present value of a treasury transformation program, providing senior management with a tool to assess the priority and resource allocation requirements of each sub-project.
Step 5: Selection(s)
Based on Zanders’ experience gained during previous treasury transformation programs, key evaluation & selection decisions are commonly required for choosing:
- bank partners
- bank connectivity channels
- treasury systems
- organizational structure
Zanders has assisted treasury departments with selection processes for all these components and has developed standardized selection processes and tools.
Selection process for bank partners
Common objectives for including the selection of banking partners in a treasury transformation program include the following:
- to align banks that provide cash and risk management solutions with credit providing banks
- to reduce the number of banks and bank accounts
- to create new banking architecture and cash pooling structures
- to reduce direct and indirect bank charges
- to streamline cash management systems and connectivity
- to meet the service requirements of the business; and
- to provide a robust, scalable electronic platform for future growth/expansion.
Zanders’ approach to bank partner selection is shown in Figure 8 below.
Figure 8: Bank partner selection process
Selection process for bank connectivity providers or treasury systems (treasury management systems, in-house banks, payment factories)
The selection of new treasury technology or a bank connectivity provider will follow the selection process depicted in Figure 9.
Figure 9: Treasury technology selection process
Organizational structure
If change in the organizational structure is part of the solution design, the need for an evaluation and selection of the optimal organizational structure becomes relevant. An example of this would be selecting a location for a FSSC or selecting an outsourcing partner. Based on the high-level direction defined in the solution design and based on Zanders’ extensive experience, we can advise on the best organization structure to be selected, on a functional, strategic and geographical level.
Step 6: Execution
The sixth step of treasury transformation is execution. In this step, the future-state treasury design will be realized. The execution typically consists of various sub-projects either being run in parallel or sequentially.
Zanders’ implementation approach follows the following steps during execution of the various treasury transformation sub-projects. Since treasury transformation entails various types of projects, in the areas of treasury organization, system infrastructure, treasury processes and banking landscape, not all of these steps apply to all projects to the same extent.
For several aspects of a treasury transformation program, such as the implementation of a payment factory, a common and tested approach is to go live with a number of pilot countries or companies first before rolling out the solution across the globe.
Figure 10: Zanders’ execution approach
Step 7: Post-Execution
The post-execution step of a treasury transformation is an important part of the program and includes the following activities:
6-12 months after the execution step:
– project review and lessons learned
– post implementation review focussing on actual benefits realized compared to the initial business case
On an ongoing basis:
– periodic benchmark and continuous improvement review
– ongoing systems maintenance and support
– periodic upgrade of systems
– periodic training of treasury resources
– periodic bank relationship reviews
Zanders offers a wide range of services covering the post-execution step.
Importance of a structured approach
There are many internal and external factors that require treasury organizations to increase efficiency, effectiveness and control. In order to achieve these goals for each of the treasury activities of treasury management, risk management and corporate finance, it is important to take a holistic approach, covering the organizational structure and strategy, the banking landscape, the systems infrastructure and the treasury workflows and processes. Zanders’ seven steps to treasury transformation provides such an approach, by working from a detailed as-is analysis to the implementation of the new treasury organization.
Why Zanders?
Zanders is a completely independent treasury consultancy f rm founded in 1994 by Mr. Chris J. Zanders. Our objective is to create added value for our clients by using our expertise in the areas of treasury management, risk management and corporate finance. Zanders employs over 130 specialist treasury consultants who are the key drivers of our success. At Zanders, our advisory team consists of professionals with different areas of expertise and professional experience in various treasury and finance roles.
Due to our successful growth, Zanders is a leading consulting firm and market leader in independent consulting services in the area of treasury and risk management. Our clients are multinationals, financial institutions and international organizations, all with a global footprint.
Independent advice
Zanders is an independent firm and has no shareholder or ownership relationships with any third party, for example banks, accountancy firms or system vendors. However, we do have good working relationships with the major treasury and risk management system vendors. Due to our strong knowledge of the treasury workstations we have been awarded implementation partnerships by several treasury management system vendors. Next to these partnerships, Zanders is very proud to have been the first consultancy firm to be a certified SWIFTNet management consultant globally.
Thought leader in treasury and finance
Tomorrow’s developments in the areas of treasury and risk management should also have attention focused on them today. Therefore Zanders aims to remain a leading consultant and market leader in this field. We continuously publish articles on topics related to development in treasury strategy and organization, treasury systems and processes, risk management and corporate finance. Furthermore, we organize workshops and seminars for our clients and our consultants speak regularly at treasury conferences organized by the Association of Financial Professionals (AFP), EuroFinance Conferences, International Payments Summit, Economist Intelligence Unit, Association of Corporate Treasurers (UK) and other national treasury associations.
From ideas to implementation
Zanders is supporting its clients in developing ‘best in class’ ideas and solutions on treasury and risk management, but is also committed to implement these solutions. Zanders always strives to deliver, within budget and on time. Our reputation is based on our commitment to the quality of work and client satisfaction. Our goal is to ensure that clients get the optimum benefit of our collective experience.
Setting up an Effective Counterparty Risk Management Framework
Treasury transformation refers to the definition and implementation of the future state of a treasury department. This includes treasury organization & strategy, the banking landscape, system infrastructure and treasury workflows & processes.
In recent years, the counterparty risks that corporates are exposed to have dramatically changed. Besides the traditional default risk that corporates hold on their customers, there has been an increase in counterparty risk regarding the exposures to financial institutions (FIs), the total supply chain, and also to sovereign risk. Market volatility remains high and counterparty risk is one of the top risks that need to be managed. Any failure in managing counterparty risk effectively can result in a direct adverse cash flow effect.
There are two important factors that have resulted in greater attention being paid to counterparty risk related to FIs in treasury. Firstly, FIs are no longer considered ‘immune’ to default. Secondly, the larger and better-rated corporates are now hoarding a day’s more cash compared to their pre-2008 crisis practice, due to restricted investment opportunities in the current economic environment, limited debt redemption and share buy-back possibilities and the desire to have financial flexibility.
Several trends can be identified regarding counterparty risk in the corporate landscape. In a corporate-to-bank relationship, counterparty risk is being increasingly assessed bilaterally. For example, the days are over when counterparty risk mitigating arrangements, such as the credit support annex (CSA) of an International Swaps and Derivative Association (ISDA) agreement, were only in favor of FIs. Nowadays, CSAs are more based on equivalence between the corporate and FI.
Measuring and Quantifying of Counterparty Risks
The magnitude of counterparty risk can be estimated according to the expected loss (EL), which is a combination of the following elements:
- Probability of default (PD): The probability that the counterparty will default.
- Exposure at default (EAD): The total amount of exposure on the counterparty at default. Besides the actual exposure the potential future exposure can also be taken into account. This is the maximum exposure expected to occur in the future at a certain confidence level, based on a credit-at-risk model.
- Loss given default (LGD): Magnitude of actual loss on the exposure at default.
This methodology is also typically applied by FIs to assess counterparty risk and associated EL. The probability of default is an indicator of the credit standing of the counterparty, whereas the latter two are an indicator of the actual size of the exposure. Maximum exposure limits on the combination of the two will have to be defined in a counterparty risk management policy.
Another form of counterparty risk is settlement risk, or the risk that one party of the agreement does not deliver a security, or its value in cash, as per the agreement after the other party has already delivered the security or cash value. Whereas EAD and LGD are calculated on a net market value for derivatives, settlement risk entails risk to the entire face value of the exposure. Settlement risk can be mitigated, for example by the joining multicurrency cash settlement system Continuous Link Settlement (CLS), which settles gross transactions of both legs of trades simultaneously with immediate finality.
Counterparty Exposures
In order to be able to manage and mitigate counterparty risk effectively, treasurers require visibility over the counterparty risk. They must ensure that they measure and manage the full counterparty exposure, which means not only managing the risk on cash balances and bank deposits but also the effect of lending (the failure to lend), actual market values on outstanding derivatives and also indirect exposures.
Any counterparty risk mitigation via collateralisation of exposures, such as that negotiated in a CSA as part of the ISDA agreement and also legally enforceable netting arrangements, also has to be taken into account. Such arrangements will not change the EAD, but can reduce the LGD (note that collateralisation can reduce credit risk, but it can also give rise to an increased exposure to liquidity risk).
Also, clearing of derivative transactions through a clearing house – as is imposed for certain counterparties by the European Market Infrastructure Regulation (EMIR) – will alter counterparty risk exposure. Those cleared transactions are also typically margined. Most corporates will be exempted from central clearing because they will stay below the EMIR-defined thresholds.
It will be important to take a holistic view on counterparty risk exposures and assess the exposures on an aggregated basis across a company’s subsidiaries and treasury activities.
Assessing Probability of Default
A good starting point for monitoring the financial stability of a counterparty has traditionally been to assess the credit rating of the institutions as published by ratings agencies. Recent history has proved however that such ratings lag somewhat behind other indicators and that they do not move quickly enough in periods of significant market volatility. Since the credit rating is perceived to be somewhat more reactive they will have to be treated carefully. Market driven indicators, such as credit default swap (CDS)* spreads, are more sensitive to changes in the markets. Any changes in the perceived credit worthiness are instantly reflected in the CDS pricing. Tracking CDS spreads on FIs can give a good proxy of their credit standing.
How to use CDS spreads effectively and incorporate them into a counterparty risk management policy is, however, sometimes still unclear. Setting fixed limits on CDS values is not flexible enough when the market changes as a whole. Instead, a more dynamic approach that is based on the relative standing of an FI in the form of a ranking compared to its peers will add more value, or the trend in the CDS of a FI compared against that of its peers can give a good indication.
A combination of the credit rating and ‘normalised’ CDS spreads will give a proxy of the FI’s financial stability and the probability of default.
Counterparty Risk Management Policy
It is important to implement a clear policy to manage and monitor counterparty risk and it should, at the very least, address the following items:
- 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. Banks which provide credit support to the company will probably also demand ancillary business, so there should be a balanced relationship. While the pre-crisis trend was to rationalise the number of bank relationships, since 2008 it has moved to one of diversification. This is a trade-off between cost optimisation and risk mitigation that corporates should make.
- Eligible instruments and transactions (which can be credit standing dependent).
- Term and duration of transactions (which can be credit standing dependent).
- Variable maximum credit exposure limits based on credit standing.
- Exposure measurement – how is counterparty risk identified and quantified?
- Responsibility and accountability – at what level/who should have ultimate responsibility for managing the counterparty risk.
- Decision making to provide an overall framework for decision making by staff, including treatment of breaches etc.
- Key Performance Indicators (KPIs) – Selection of KPIs to measure and monitor performance.
- Reporting – Definition of reporting requirements and format.
- Continuous improvement – What procedures are required to keep the policy up to date?
Conclusion
To set up an effective counterparty risk management process, there are five steps to be taken as shown below; from identifying, quantifying, setting a policy to process and execute the set policy regarding counterparty risk.
Treasurers should avoid this becoming an administrative process; instead it should really be a risk management process. It will be important that counterparty risk can be monitored and reported on a continuous basis. Having real-time access to exposure and market data will be a prerequisite in order to be able to recalculate the exposures on a frequent basis. Market volatility can change exposure values rapidly.
* A credit default swap protects against default. In the event of a default the buyer will receive compensation. The spread (CDS spread) is the (insurance) premium paid for the swap.
