Measuring counterparty risk and exposure can be challenging. As has been noted in the press, it is going on five years after the financial crisis and many companies and banks are still falling short when it comes to assessing risk from counterparties.
This weakness has also been noted in the NeuGroup universe where many members have admitted they do not yet have a formalized counterparty risk policy. Or if they do, not very robust or specific ones. Still, it is something on their minds, and just about all members use some measurers. In many cases, NeuGroup members use a hodgepodge of mix of credit ratings, CDS levels and other monitoring tools.
At a recent NeuGroup Treasury Investment Managers’ (TIMPG) meeting, one member explained how following the crisis it moved to a more systemized approach with scores and ranking for evaluating counterparty risk. Prior to this move, limits on credit were based on credit agency ratings. Currently the company monitors multiple factors, including ratings, credit score, market cap, debt spreads, Tier 1 capital, net income, and return on equity. All of these factors are combined and weighted to produce a ranking of counterparty banks.
The above tools allows the company to categorize by score and ranking to find potential problem targets, much like a rating agency. When these problems are first detected, the counterparty is monitored or watched and if needed, limits are then set for allocation of business by each category. The “problem” bucket identifies when it is time to unwind. If counterparty is in the “watch” bucket, the company can continue to trade, but it will not add to this exposure. Every quarter a formal analysis is conducted with the treasurer to discuss who moved and why they moved. This analysis is not incorporated into the policy, which still used rating agency guidelines, but is used rather as a tool
for analysis.
When Lehman failed, many members had to change their policy on the fly as conditions degraded, so more formal policies have been put into place as a result. As one member pointed out, as investors, “would you buy bank paper that is in trouble to get a higher yield while at the same time using the bank for critical services?” A good question and a reminder that counterparty risk management is here to stay as a result of the financial crises versus being a reactionary fad.