Setting up an Effective Counterparty Risk Management Framework
Compared with only a few years ago, today’s corporate treasurers are exposed to a much greater variety of counterparty risks within both their supply chains and financial institutions. This article provides guidance on how these counterparty risks can be effectively monitored and managed.
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.
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?
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.