Counterparty Risk Management in Focus
An abrupt end to the era of low interest rates and subdued inflation exposed the vulnerability of some banks and underlined why counterparty risk continues to rank highly on corporate treasury’s risk agenda. TMI asks whether today’s data-driven world has added to the challenge or offers the ultimate solution to mitigating it.
The banking crisis of March 2023 that brought down three US banks – Silvergate, Silicon Valley (SVB) and Signature – and caused the demise of Credit Suisse will, with luck, prove to be only a faint echo of the global financial earthquake of 2008. A prompt and targeted damage limitation exercise appears for now to have been successful, with the Swiss bank entering a shotgun wedding with rival UBS and a swiftly completed deal for HSBC to acquire SVB’s operations in the UK.
Across the Atlantic, the Federal Reserve engineered significant US dollar liquidity measures in co-ordination with other major central banks to calm volatile markets. Meanwhile, another vulnerable-looking US regional bank, San Francisco’s First Republic, was rescued by 11 major banks that collectively provided a lifeline of up to $30bn.
There were, nonetheless, concerns that a domino effect could see the industry’s casualty list extend to major names. In the days following SVB’s collapse, there were reports that nervous US bank customers had moved their deposits from small and midsize regional banks to the perceived safety of major names such as Bank of America, Wells Fargo and Citigroup on the basis that they are “too big to fail.”
Deutsche Bank’s share price briefly skidded until analysts deemed that Germany’s biggest bank was relatively robust following several years of extensive restructuring. In Switzerland, the union of Credit Suisse and UBS has apparently shifted some of their business to local rivals such as Zürcher Kantonalbank (ZKB), the largest of the country’s state-owned cantonal banks. Investors have focused on other industry names that they sense may be less robust. More recently, attention shifted to Toronto-Dominion Bank, with reports that bearish short sellers have accumulated US$3.7bn in bets against Canada’s second-largest lender.
Over the years, corporate treasury teams have been advised that maintaining a small group of key relationship banks is more efficient, but sudden unions such as that of the two major Swiss banks can be cause for reassessment. “Having the right number of banks means maintaining a delicate balance,” says Shaun Kennedy, Group Treasurer, Associated British Ports (ABP). “While more diversity can be helpful, it also means there is more to keep an eye on.” ABP uses around 15 banks, located across various jurisdictions globally that include Scandinavia and Japan as well as Europe and the US.
“We diversify our FX and other hedging across the entire group and apply a limit to how much we have with any one bank,” adds Kennedy. “We follow a fairly conservative treasury policy, which doesn’t allow for excessive exposure to any one bank and avoids any bank that isn’t of the highest credit quality.”
The crisis has clearly caused treasurers to rethink their banking relationships by proving that even good banks can fail – or come under pressure – even in Europe.
Causes for concern
For the reasons Cited by Kennedy, the big banking names were, unsurprisingly, beneficiaries of the crisis – but they weren’t the only ones. Credit ratings agency Moody’s reported that of the US$550bn in deposits that were shifted in the second half of March, around US$250bn went into MMFs, primarily driven by investors opting for government funds that concentrate on short-maturity Treasury securities.
Potential future threats to financial stability have persuaded the Bank of England (BoE) to toughen its stance in areas such as leveraged funds, where it is setting minimum buffers that liability-driven investment (LDI) funds should hold to be able to withstand shocks in the UK government bond market. Other measures include a tightening up of the rules for MMFs so they can better withstand the risk of sudden investor withdrawals.
“The speed at which nervousness spread across the highly interconnected banking sector after SVB’s problems emerged is clearly a big cause for concern, with the ease of digital transactions intensifying likelihoods of runs on deposits,” commented Susannah Streeter, Head of Money and Markets at financial services group Hargreaves Lansdown. “We’ve been going through one of the most aggressive rate-hiking cycles in decades, so it’s little surprise the BoE is highly attuned to further problems that could emerge on the horizon.
“It now plans to ‘war-game’ potential stresses by involving institutions involved in market-based finance, which is a sensible move to ensure greater readiness if further knock-on shocks to the system emerge.”
Several reasons are cited for expectations that the industry will endure further pressures over the coming months. While higher interest rates have improved their net interest margin, many European banks are under both regulatory and market pressures to return more money to their customers. Higher rates are encouraging investors to look beyond banks for products offering better yields, with MMFs appearing more attractive to many. There are also concerns that some banks are overly exposed to the commercial real estate (CRE) market, where office valuations have been dented by the twin impact of the Covid-19 pandemic and increased popularity of homeworking.
“Bigger banks, which are not focused in niche areas and have a more diversified portfolio, are recognised as being less at risk,” says Patrick Kunz, Managing Director, Pecunia Treasury & Finance. “The crisis has clearly caused treasurers to rethink their banking relationships by proving that even good banks can fail – or come under pressure – even in Europe. Treasurers have had to assess how safe each of their relationship banks is and if, say, the company holds £3bn in a single account whether it now makes sense to spread that amount more widely. And MMFs are deemed to be more secure, in addition to larger banks.”
Kunz suggests that ratings agencies are not necessarily the best guide as to what constitutes a safe haven. “Lehman Brothers failed despite still enjoying a high rating,” he notes. Banks’ ratings are also subject to a lagging factor and a downgrade may sometimes be allocated relatively late in the day.
“Nonetheless, many clients still rely on these agencies, while others have a more complex model that uses a range of indicators that include credit default swaps [CDSs], although these can be highly illiquid instruments.”
Four areas of resilience
Counterparty risk management and mitigation has, of course, regularly featured over the years in the list of issues that keeps corporate treasury and finance teams awake at night. So, the banking sector’s recent bout of volatility are less a wake-up call and more of a reminder that maintaining their cash, liquidity, and payment channels requires an action plan for as many potential risk scenarios as possible.
“Most large corporations have learnt to be careful and have kept their policies and procedures firmly in place,” Sarah Boyce, Associate Director – Policy and Technical, the Association of Corporate Treasurers (ACT). “At the same time, the stable financial conditions that prevailed for a long time after the global financial crisis encouraged a degree of complacency, as many people grew accustomed to low interest rates and subdued inflation. And newer entrants to both the corporate and financial side simply lack any previous experience of the type of volatility we’ve seen recently.”
The recent bank casualties also reconfirmed the need for CFOs and treasurers to automate liquidity planning, risk management, and cash forecasting to improve financial resilience, says Bob Stark, Global Head of Market Strategy at cloud-based finance and platform provider Kyriba. He suggests that the focus should be directed at four areas in particular:
- Business continuity. Treasury needs to maintain operations without interruption even when offices are disabled or inaccessible. Automation tools such as TMS can help CFOs better plan for growth when headcount is limited or the company is downsizing.
- Real-time liquidity planning. End-of-day visibility is no longer sufficient. Treasurers and CFOs need the ability to see, protect, and move cash in an instant.
- Reducing vulnerability to rising interest rates and FX volatility. Teams must understand and quantify the exposures of market rates on their balance sheets, income statements, and cash flows in order to react and plan ahead.
- Control of bank counterparty exposure limits. Exposure-limit reporting empowers treasury teams to rebalance cash, investments, and borrowing decisions to meet corporate risk directives.
It would also be no surprise if recent volatility had triggered a renewed interest by some corporates in IHBs. “The swift succession of interest rate rises over the past year triggered demand for more efficient financing including looking internally to control more expensive and/or unnecessary borrowing,” Stark reports.
“Last summer in particular saw a revived interest for IHBs as the interest rate hikes went into full swing. While most large organisations already had cash pooling in place, treasury teams invested in IHB structures to ensure they were unlocking as much cash as possible.”
The ACT’s Boyce adds that IHBs are set up by corporates more as a response to rising interest rates and the need to actively manage cash than by banks’ sector volatility. “The issue of trapped cash could often be left unaddressed when interest rates were negligible, but with rates suddenly rising once again that cash suddenly becomes more valuable.”
In today’s data-driven world, treasury automation is essential, Stark adds. As SVB’s sudden demise demonstrated, adverse events now happen in real-time and decisions must be taken within hours rather than days. “Corporates want to make real-time decisions, which means treasury must also be able to digest information and deliver projections, including counterparty reporting, in real-time. Treasury must be able to answer on-demand questions such as, ‘What happens if my bank is unavailable?’ and have the necessary business continuity in place to action leadership decisions.”
AI can help in all facets of this decision-making, he adds. “You can use APIs to unify enterprise data and enrich that data with AI to model liquidity scenario. For example, AI will help predict the cash flow impact of late-paying customers, which can then trigger the treasurer to optimise their own liquidity through investing, borrowing, or working-capital programmes. “AI and data analytics can better prepare treasury to protect their balance sheet, income statement, and cash flow from danger.”
However, a data-driven world also has its downsides, notes Kunz. “It can mean that banks such as Deutsche Bank suffer when treasurers are alerted to what appears to be potential risk, even when it is either exaggerated or ungrounded. Readily available information can also spark a crisis more quickly.”
Confidence through experience
The good news is that the past 15 years have forced treasury on at least two occasions to become more adept in its handling of counterparty risk. Both the global financial crisis and the pandemic underlined the importance of stress testing and the need for treasury to match counterparty risk with free cash flow and risk management.
“Back in 2008-09 corporates had to ask the question, ‘How many days’ survival do we have left?’ and similar questions were asked when Covid-19 struck,” Stark recalls. “There is a need to build different contingencies into scenario planning so it can then be presented to the higher levels within the organisation.
“We learnt a lot during the pandemic and those best practices have been maintained. So, treasury was well prepared for the latest crisis and was ready to take whatever action was needed in response to various ‘what if?’ scenarios. Treasury teams are used to being asked these questions and are ready to answer them, instead of the hysteria that would have been the case 10, or 20 years ago.
“We’ve seen resurgent inflation, FX volatility, and much talk of another recession, yet we appear to have come through the worst. Treasury is more confident than it was on earlier occasions and much of that confidence comes from treasurers being prepared for a range of scenarios.”
And for investing, the key is diversification and not having all the eggs in one basket, says Kunz. “I regularly ask clients, ‘Do you know your current cash position – and what it is likely to be in three, six, and 12 months’ time?’ If the response is positive, then cash can be invested for a longer period to attract a better return.
“Most of our clients have a multibank strategy – some are moving away from cash deposits and employing something more complex. But this is as much in response to rising interest rates as it is counterparty risk. Banks lack the flexibility in product offering and the (counterparty) risk diversification that some MMF platforms offer.”
