4 Steps to Recharge Your Counterparty Risk Approach

Nearly five years after the recent Great Recession, corporations are still haunted by some of the same pitfalls and risks that preceded the crisis. Corporate treasurers continue to juggle unprecedented amounts of cash across multiple, potentially risky bank counterparties and invest these funds based on stale investment policies with sometimes inflexible limits. Despite improvements in technology, treasurers’ task of funding ongoing business and taking advantage of opportunities for growth is becoming more challenging as cash is spread over more and more countries and banks. It is vital for corporate treasurers to reevaluate their investment policies to ensure effective visibility and governance.

On the surface, corporations appear to be operating in a safer environment than they were in 2008. Yet many regulations passed to strengthen domestic and global financial systems have not yet been finalized or implemented, and there remains considerable uncertainty amongst regulators as to exactly how and when some of these regulations will be put into place. Economists have suggested that many of the underlying problems that caused the Great Recession have not been fixed, potentially making another crisis inevitable.

An uncertain reality

  • Credit agency ratings are lagging indicators of counterparty failure. There is only a 43% correlation between agency ratings and credit default swaps (CDS) spreads* – failing to identify all inherent risks.
  • Banking regulation has been slow to be passed, with only 39.7% of the total rulemaking requirements affiliated with Dodd-Frank having been finalized.**
  • Some existing regulations have caused deposits to flow from smaller banks to larger banks under the perception that they are safer. “Too big to fail” still exists in the public mind.
  • Proposed money market fund reforms could make this proven investment vehicle less attractive and incompatible with treasury’s goals of preserving principal, maintaining liquidity and earning returns. This could leave treasurers scrambling for better alternatives to hold their cash.

The continued economic stress and other events have slowly dissolved the “default protection” of funds placed with banks and investment organizations worldwide. And while pending or passed banking regulation may eventually help improve the financial atmosphere, consumers and investors skittish about the global economic recovery remain hesitant to spend or invest.

The treasurer’s dilemma
Corporations are asked to do more with less and often do not have the resources or in-house expertise to comprehensively re-evaluate their counterparty risk. They may be relying on investment policies that have not been updated to keep up with the tremendous changes to the financial system over the last several years. New regulations are driving companies with older, more rigid investment policies to place cash with less familiar counterparties, which is at odds with the corporate treasurer’s need for greater flexibility in placing larger cash balances with a few financially stable banks.

A treasurer’s choice
Treasurers that want to succeed in today’s uncertain environment must act. First, they must build out counterparty risk tools that improve visibility to potential operational risks. Second, they must push their boards to update company investment policies. While both of these tasks can be daunting, the end result of having greater visibility into the potential risks and the ability to adapt investments with the ever changing financial climate will prove to be invaluable.

4 steps to help recharge your counterparty approach
Following this simple model, corporations will be better prepared to choose stronger counterparties able to support the company’s expanding capital needs.

  1. Identify the right metrics
  2. It is crucial for your company to look beyond traditional market perceptions and bank credit ratings. By implementing an automated, well-balanced process of regularly updating and monitoring a more comprehensive risk outlook, your organization will be in a stronger position to calculate a more accurate total risk score. Implementing the right measuring tools (see figure 1) and weighting of metrics is only the first step.

  3. Consider broader use of risk metrics
  4. Now is the time to think differently about managing counterparty risk – primarily, the importance of looking beyond basic treasury operational risk. Rather than relying solely on traditional agency ratings and measurement processes to evaluate counterparties, you can better ensure accuracy by accessing up-to-date information including a broader set of metrics. These include capital strength, asset quality and resiliency, and growth and profitability. Advice from a trusted partner can help put your organization on the right path.

  5. Set counterparty limits
  6. With a focus on reliability and security, a proven best practice to optimize liquidity payout is to place balances with bank counterparties that offer the highest risk-adjusted return.

    • Execute deposit placement using a risk-adjusted approach.
    • Set deposit limits with banking partners by ranking the counterparties by their risk rating, and be sure to have a sufficient deposit cushion to avoid a regular breach of your investment policy.
    • Determine deposit limits by grouping banks into tiers and assigning a percentage of total balance capacity to each tier.
    • Update your investment model more frequently.
  7. Update your investment policy
  8. Use integrated risk metrics to help formulate an investment policy that can adapt to the changing financial environment. Follow this simple checklist to get started.

    1. Review investment instruments and limits.
      • Incorporate logic to handle potential changes to money market fund rules.
      • Segment cash according to funding needs (e.g., short, medium, long-term).
    2. Utilize a broad set of risk metrics.
      • Evaluate all touch points with a particular counterparty including foreign exchange, commodities and money market funds.
      • Determine the advantages of new regulation and consider how banks will adopt their products to function within the new policies.
    3. Review approved counterparty criteria and limits.
      • Define and weight a comprehensive set of risk metrics beyond agency ratings to determine acceptable counterparties and set limits.
      • Define the use of risk-adjusted returns to execute investments within policy limits.
James McKenzie

James McKenzie
Executive Director, J.P. Morgan Treasury Advisory Solutions Group

As head of the Treasury Advisory Solutions team, James works with his partners in sales and product to develop, market, and sell global solutions to multinational corporations designed specifically to meet each client's strategic needs. James has more than 15 years of experience driving and implementing change in a global corporate treasury environment. His areas of expertise include risk management, treasury structuring and control/visibility, global liquidity and cash concentration, short-term investment and debt management, foreign exchange, international cash management and operations, and cash forecasting.

For more information, please contact James McKenzie at james.m.mckenzie@jpmorgan.com

* Source: Capital IQ as of 12/3/2013 – S&P short-term rating and CDS 1-year spread correlation
** Source: Davis Polk & Wardwell Dodd-Frank Progress Report "As of July 15, 2013, only 39.7% of the total rulemaking requirements affiliated with Dodd-Frank have been met with finalized rules."

Up Up

Copyright © 2014 JPMorgan Chase & Co. All rights reserved.