Like a river permanently breaking its banks, counterparty risk, and the challenge of dealing with it, has spread from Wall Street to Main Street.
New economic and trading realities are reshaping the meaning and significance of the term. Is this yet another headache or an opportunity for CFOs and corporate treasuries?
The banking sector was almost frozen during the GFC because of inadequate counterparty risk data and measures. When the music stopped no one knew who owned the remaining chairs and which ones were safe to sit on. No one knew what their exposures really were, to whom, or where.
The lengthening shadow of the GFC inevitably raises questions about how well the new capital adequacy standard, BASEL III, will perform. Yet with banks having relative freedom to develop their own approach to implementing the standard we may see the benefits of new models in better business loan portfolios. Research led by Edward I. Altman confirms the benefits of adding qualitative data (court judgements, late filing of accounts) to quantitative (financial) data and opens up a new frontier in predictive modelling. Professor Altman has been a leader in the field of predictive credit default modelling for almost half a century.
Outside of the banking sector, counterparty risk is often cloistered under more familiar phrases. Concerns about political and economic uncertainty and increased regulatory burdens were near the top of the list of challenges identified in a recent survey of 300 directors and executives of private companies conducted recently by Thoughtpost Governance. Other concerns often mentioned were cash flow, solvency and funding issues.
These concerns reflect today’s realities. We do business at a more rapid pace, in much more connected economies, and in more integrated global supply chains using increasingly outsourced services. Across our economy retailers struggle with online competition, manufacturing shrinks, education exports have dived; and BHP has just cancelled its $30 billion Olympic Dam expansion. Disturbance or crisis in one part of an economy or supply chain reverberates.
Risk is about possible exposure to danger, harm and loss; of which there are many types. Counterparty risk typically refers to parties (banks, financial intermediaries and corporate treasuries) who trade financial and insurance instruments. It’s the risk that either of two or more parties will not meet (or default on) their contractual obligations. Beyond the banking sector usage of the term is growing to cover the financial risks associated with a failure or default, however caused, by anyone we do business with – not only customers but suppliers of raw materials, finance and outsourced services.
The speed of change makes it harder to keep track of who we are doing business with, let alone knowing how well they are managing their exposures. The former takes in character (individual and firm) and track record; the latter takes in quality of financial control, cash flow management, hedging ability, reserves, relationships that increase access to finance – and management skill, speed and agility when things go pear-shaped.
One issue for corporations is the location, scope and integration of specialist risk-management functions. Quality managers are particularly concerned with product risk and environmental risks. Similar risks are among the concerns of supply chain managers. Marketing managers are very sensitive to reputational risk. Treasury managers are directly concerned with credit risks, interest rate risks, currency risks and operational risks. While each specialist focuses on a particular type of risk, the areas overlap.
Without clear roles and boundaries and co-ordination mechanisms, emerging risks can be overlooked until it is too late. Attention to these matters as counterparty risk management policies are developed can achieve more targeted, prioritised and cost-effective risk management.
Good policies will also cover accurate and timely ways to measure counterparty risks, the process of setting limits and ensuring adherence to the limits, and ways of devising limits when risks are not measurable in financial terms.
Another issue is analytical tools and data. Credit ratings and related scores are important but their limitations need to be understood. Likewise, vendors of analytics tend to offer sophisticated packages that may lead users into overreliance.
Reports can give good information on the companies in the database, but there are always firms, typically smaller, privately-held firms here and overseas, that are not included. When these firms are important counterparties, gaps in tracking and analysis arise. In this area initiatives that focus on securing incremental improvement can achieve better results than glittering big-bang solutions.