Credit Insight: The Backbone of Counterparty Risk Management

Abstract

An effective counterparty strategy must provide clarity on counterparties’ credit strength, individually and collectively, and have a desired “benchmark” level. Changing credit landscapes, aggregation challenges and inconsistent and irregular policy practices are just some of the challenges facing treasurers transitioning from a reactive counterparty risk management practice to a proactive benchmarked approach. The difficulty in developing an effective strategy lies not in identifying the sources of risk, but in understanding the credit risk and managing it. In response to these challenges, separately managed accounts, when used as a risk management tool, may be beneficial for risk mitigation due to their exposure flexibility.

Introduction

For those entrenched in the capital markets during the week of Lehman Brothers’ bankruptcy, September 15, 2008 remains an important calendar marker. Later market events are often marked to the anniversaries of that day. As we pass the sixth anniversary, credit concerns with financial intermediaries continue to demand attention from corporate treasury professionals.
Indeed, the subject of counterparty risk management remained front and center in treasury professionals’ line of sight for much of the last six years. Despite major efforts by financial regulators and the firms themselves to improve capital and liquidity positions, the treasury community still struggles to find an effective means to manage this risk.
As managers of institutional liquid investments, we saw the need firsthand from our readers who tried to understand this risk, not only in their investment portfolios, but also from their deposit banks, line of credit providers, swaps and forwards counterparties and so on. Over the years, service providers have made progress towards consolidating many such exposures, but important questions remain: How can I build confidence in managing current exposures and evaluating new ones? What do I do with the myriad of information on financial intermediaries? Is my counterparty risk too much or just right? How do I separate real credit issues from the noises generated by headlines?
As part of our FundIQ^® research on institutional prime money market funds, we take special interest in the group of large financial institutions prominently represented in the funds as well as in deposits, commercial lending, corporate and investment banking, and derivatives underwriting. A little over a year ago, we started a series of commentaries on counterparty risk management for corporate treasury functions. For this installment, we summarize some of our earlier writings and delve more into the credit aspect of risk management. We believe that, ultimately, counterparty risk is credit risk. The task is not complete until one can make counterparty decisions with solid credit understanding.
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