By Bryan Richardson
A synopsis of 2012 NeuGroup best practices for managing counterparty risk that will be just as critical in 2013 and beyond.
Five years ago counterparty risk was a seldom-heard term. But in 2012 it was on the agenda of nearly every peer group for at least one of their meetings. TMS vendors and other technology and service providers have developed counterparty risk modules to add to their product offerings, and most corporates have developed some type of risk monitoring and assessment model. Financial institutions have shown a considerable level of recovery since the depths of the crisis but remain downgraded. It is anyone’s guess when, and even if, their AAA ratings will return. Should the dust ever settle from this reshaping of the industry, memories may shorten and other priorities encroach on these risk management practices. But until then following is a list of sound practices that emerged from the multiple discussions on this topic in 2012:
- Develop a robust framework for counterparty risk management. J.P. Morgan’s Sat Khuntia suggested a more sophisticated risk assessment framework, illustrated below. Several members already use some variation of a more detail-rich analysis which takes into account both static or slow-to-change metrics (e.g., ratings) and more dynamic measures (e.g., CDS). The outcome of the model ranks banks in the three different categories and in a combined ranking, depending on what weight is assigned to each category, and can be used to choose, for example, the strongest partner in a particular region, and to spread deposits: a higher proportion with the stronger and less with the weaker (the ranking should of course be weighed against other parameters like service availability and business needs).
- Monitor by committee. Several members referenced a regularly scheduled meeting of those individuals that work closely with key counterparties. One has a monthly meeting within treasury to review the risk report and share their views and knowledge about the various banks. Another member affirmed this approach, noting that he is part of a weekly meeting on counterparty risk that includes non-financial counterparties. Another member noted that they have a large bank group with two revolvers. This broad exposure to so many banks has prompted the formation of a “bank contingency committee.” The value of the committee approach is the inclusion of the broader insight from other stakeholders who might have additional information for consideration.
- Train your monitors. One way to enhance the counterparty monitoring process is to send your staff to a specialized training program. S&P and likely other rating agencies and sources offer just such training. This action demonstrates a commitment to the process and to the people in the spotlight responsible for carrying the load of the evaluations. It also allows them to beef up the financial component of the review process.
- Adjust your policies. With the widespread downgrading of bank ratings, many companies have found themselves grappling with compliance breaches to their investment or banking policies that require a minimum credit rating. We are in a new world where single A is the new triple A and policies should be adjusted accordingly to reflect the new reality rather than pursuing repeated exceptions and waivers.
- Understand your diversification trade-off. In a move to increase bank diversification for cash management and to spread the cash it has on its balance sheet, one member company went from three to six core banks a few years ago, in part to be able to shift deposits from one bank to another more easily. So how many should you have for appropriate diversification benefits without having to go too low on the totem pole? J.P. Morgan’s Sat Khuntia suggests that five to six banks is a good number and that companies should consider using banks that are backed by different sovereigns, on the basis that a repeat of 2008-style bank bailouts would be “impossible.” Counterparty risk, consequently, is an important concern, as all 5-6 banks are not necessarily equally strong, and their relative strengths may shift over time.
- Counterparty caps should be absolutely reasonable. Portioning up bank exposure is all well and good but an absolute cap per counterparty is still required vs. just a percentage of the total per bank. For some that can be an awfully big number. How it is determined differs between companies. In addition to being an absolute number, caps should be reasonable. J.P. Morgan’s Dean Byrne recommends that companies apply a reasonableness tests to their limits. He noted: “Counterparty limits on the corporate side are far, far lower than we set from the bank side.” He conceded that credit risk will remain an important factor but you should also look at bank pricing going forward because it will “reflect what banks want to do,” i.e., what services they want to be in and what they are good at.
- Make your ISDA work for you. Many companies have re-worked their ISDAs to better represent the new landscape. One has a cross-functional team led by legal working on an ISDA overhaul project, making sure that threshold amounts, credit events, mergers, termination events and all terminology are appropriately revised. Their rigorous process ensures the end result is strong contracts. If a bank doesn’t like them, they use another bank. Having the same terms for ISDAs and CSAs across multiple banks means that the next bank will have less of a case to say they can’t or won’t meet certain terms the others have agreed to.
This is best started with a friendly bank that values your business and uses its agreement language, or clauses it seeks for the ISDA to become the benchmark for other banks to meet.
- Set CSA triggers carefully. CSAs bring value in their management of risk over the life of a trade and the ability to negotiate better pricing and more trade capacity. Members discussed the need for both parties to fully understand what exactly each side is expected to do when a CSA trigger is tripped. Going through this exercise has caused some to maintain relationships without a CSA. One member shared that his company’s move to have all CSA relationships has created numerous administrative issues.
- Stay ahead of your counterparty. Some companies have incorporated proactive strategies to manage the breadth and depth of their individual bank counterparties. One works to predict which banks might drop out of the credit facility or the relationship altogether. While not necessarily dropping them first, this company shifts business away in preparation. Another company has used their counterparty review meetings to rank counterparties, which led to a more definitive “proactive exit” in a case where a regional bank was downgraded.
Financial counterparty risk management will likely remain a significant topic for companies over the next few years, particularly as the eurozone crisis continues to flow in and out of the headlines. But perhaps memories will fade and the industry will regain its strength and the exercises around managing this risk will become optional or discontinued—until it happens all over again.
In the meantime, the last thing anyone needs is a surprise that could have been prevented by more closely minding the store. Therefore a frequent review of your financial counterparties using a robust set of measures should go a long way toward helping everyone sleep well in 2013.