Counterparty Risk Management for Corporate Treasury Functions

Abstract

Experience has taught us that even seemingly strong counterparties can fail without warning. Counterparty risk management has become more challenging in recent decades due to concentrated exposures, complex financial instruments and deteriorating bank credit. Corporations should manage risk proactively, have an integrated risk policy across business lines, diversify risk by setting exposure limits according to risk criteria and seek out professional resources where available.

Introduction

One of the great lessons we learned from the 2008 financial crisis was that the financial world we lived in was not as safe as we thought. This statement remains true today, despite recent industry and regulatory efforts aimed at bolstering counterparty strength.
In conversations with corporate cash investors, we found an increased awareness of counterparty risk management. As the topic remains a top priority among risk managers at financial institutions, it is an even bigger challenge to treasury practitioners who may have limited knowledge of the complex, interconnected and concentrated world of finance.
In this whitepaper, we attempt to explain counterparty risk from the corporate treasurer’s perspective, why it has become more difficult to track and manage and the key principles of managing this risk. We should note that since this is an all-encompassing topic, our focus is on the credit aspect of counterparty risk, as opposed to collateral management, settlement risk or other operational and legal issues.

Counterparty Risk – The Corporate Treasurer’s Perspective

What is Counterparty Risk?
Counterparty risk refers to the risk that a party in a contract may not fulfill its contractual obligations. In essence, counterparty risk is a form of credit risk. It is an indirect risk as opposed to direct risk from unsecured borrowings, such as bonds and deposits.
For example, in an interest rate swap transaction with an investment bank, the investor may fail to profit from its winning contract if the bank becomes insolvent prior to the contractual date, rending the agreement worthless. For some transactions, asset collateral, margin balances and third-party guarantees may protect against counterparty risk, although such support mechanisms also may introduce new dimensions of counterparty risk.
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