By Joseph Neu
Assessing bank counterparty risk became a front-and-center topic for most treasurers in the wake of the Lehman collapse. And chances are the subject has been coming up in conversations again frequently as the eurozone sovereign debt crisis fails to resolve itself and the global economic recovery stalls. The question is, have assessments and reporting matrices developed in response to the banking crisis in 2008 kept pace with the changing dynamics of government support, regulation and banks’ short-term funding mechanics?
Adding layers of analysis
Initially bank counterparty risk assessment reporting focused on the amount of government support pledged and available to assist banks in each major jurisdiction. From there treasurers looked to CDS spread indicators along with rating and rating outlook signals. Clearly, government support capacity is not what it was and CDS spreads, not to mention rating agency opinions, are today viewed with a more jaundiced eye.
Another potential avenue of analysis to explore is the ratios recommended by prudential bank regulators and the internationally applicable new Basel rules. In addition, the ratios and their assumptions are being subjected to stress tests, with results to inspect. However, assessing a bank’s ability to meet regulatory requirements for capital and liquidity, using a tangible common or the liquidity coverage ratio, will only prove useful when a consensus is reached on
how they are defined and what should be considered adequate.
Ears perked up at a NeuGroup meeting earlier this year when a treasurer asked a senior banker how banks determine when one of their peers may be in trouble. Every treasurer would love to have partner banks pass on to them when they put a bank on “safe settle” status, but this information is almost never shared. Banks are similarly reluctant to respond explicitly to the how question. However, the banker did point to the importance of liquidity and suggested banks look at who shows signs of vulnerability during periods when liquidity drains from the market.
This suggests that monitoring partner banks’ liquidity operations is the next layer of analysis that treasurers need to perform. It will require fairly detailed knowledge of how each partner bank pursues short-term funding under a variety of market conditions.
Changing Bank Liquidity Ops
To bolster a more general understanding of how banks are conducting liquidity operations these days, there are a series of recent posts on the Financial Times’ Alphaville blog that offer insight. One from September 1 highlights an analyst report from UBS on the situation with French banks (recently under the spotlight). It depicts the challenges of reliance on wholesale funding as (especially US) Money Market Funds have stopped investing in European bank paper.
More interesting though, is a post from August 31 noting how repo market funding has evolved in response to current collateralization requirements for interbank funding. As a result, wholesale funding-reliant banks have had to turn more aggressively to collateral swaps, also known as long-dated repos. Essentially, a bank in need of high-quality liquid assets to pledge as collateral for a secured lending agreement in interbank markets will execute a swap or repo transaction in the shadow banking system, i.e., with an insurance firm, pension fund or other asset manager. These entities must be willing to lend (as a yield pick-up opportunity) such an asset from their portfolio for a period in exchange for the riskier asset of the bank.
Monitoring these swap rates and comparing them to the benchmark indices being created in major banking jurisdictions could prove useful. Also, since these rates may become more meaningful than Libor in some cases, they can be an alternate indicator for cost of funds as well. This will impact what banks charge and capacity across products.
And this is surely just the tip of the iceberg in terms of how wholesale bank funding is evolving.
Thus, treasurers that gain a better picture of a counterparty’s liquidity profile should also be in better position to determine when signs of a liquidity squeeze might portend other trouble, e.g., a bank dropping out of a credit facility, being reluctant to roll a hedge coming due, or less likely to bid aggressively on a swap. Useful indications all.