Exploring new avenues for counterparty risk in corporate treasury

The pace is set to remain high for companies as they seek to address fresh challenges. As a result, corporate treasury management of counterparty risk, which is often based on tried-and-tested processes that have evolved over many years, will need to adapt as well. At the same time, however, we will see opportunities for further development. We will explore all of this in more detail in this article.

We will start off by looking at the main drivers of change.

Macroeconomic uncertainties resulting from the escalating political and economic conflicts around the world will affect companies in many sectors. Geopolitical tensions as well as trade and tariff conflicts will cause supply chain disruptions and shifts in sales markets, financial markets and capital flows.

For one thing, digital transformation is making technological innovations such as artificial intelligence (AI), machine learning and big data analytics available. These have so far been little used in risk management, but they offer potential for more precise risk assessment, real-time control and automated decision-making. To this end, digital platforms and fintech companies are working tirelessly to develop appropriate solutions, avoiding the need for complex in-house projects.
On the downside, however, the rapid growth in data networking and centralization also means greater dependence on IT systems and the associated cyber risks, which in turn requires careful consideration of business continuity (how long can the company function without individual systems?).

A third driver is ESG risk. Environmental, social and governance factors have become far more important in recent years, and companies and financial institutions are increasingly taking ESG risk into account in their investments. Despite the controversial political developments in this area, further regulatory requirements are more likely to be introduced, as the consequences of climate change will be felt in a variety of ways and the issue will come back into focus in the medium term.

While the change in the risk management framework is clear, the specific action needed to develop it further is less so.

The core of counterparty risk management is usually a combination of 

• systematic selection of counterparties with whom the company conducts financial transactions (often in the form of a portfolio bank approach), 
• a limit system that assigns an upper limit of permissible business to the approved counterparties, and 
• an appropriate risk assessment for existing business.

The limit system needs to take into account the company's own financial capacity, i.e. it needs to ensure that the default risks associated with the investment and trading business are still manageable in the event of a crisis given the company's financial strength and liquidity. 

By defining a portfolio of counterparties, a company can ensure that it is able to cover all necessary markets (for financing, investment and payment transactions). In some cases, depending on the market position, counterparties may be included that initially appear less suitable based purely on creditworthiness criteria, but which are necessary to implement the business strategy by covering certain services or markets.

Risk measurement must include a suitable methodology to quantify the counterparty risk resulting from the various financial instruments and positions, both at the individual transaction level and in terms of the portfolio effect. Collateral, maturity and realizability must be taken into account appropriately.

We will now look at approaches that develop the various components in different ways.

Automation and real-time overview
It is precisely in turbulent times and a volatile environment that a timely and complete overview of the risk situation is essential for effective control – this applies to all financial risks in Treasury. Improved data exchange and system networking options now make it possible to combine all of the company's positions in a central location, typically in the Treasury Management System or a Data Warehouse/Data Lake solution, with moderate effort. In addition to in-house data, relevant market data (e.g. rating or CDS spreads) is also required.

By using BI solutions, which are now partly integrated directly into the systems or, if they are separate applications, at least allow for a simple system connection, interactive dashboards with the central overviews of the counterparty risk can be set up. This can be done on a daily basis, or even in real time, so that changes to limits or limit utilization are immediately visible and intraday information such as new transactions, price changes or intraday account statements can be incorporated. To a large extent, the data flows themselves can be automated to avoid the need for frequent manual input.

Not only does this approach significantly increase risk transparency, allowing counterparty risk to be managed close to the business, it also makes it easier to analyze developments, for example by looking at changes over time, and provides a basis for further steps.

Implementation of early warning indicators
Conventional limit systems determine the limit based on credit ratings from rating agencies. These ratings have varying time horizons, which can cause difficulties. Rating agencies tend to adjust their assessments only slowly and focus on medium- to long-term creditworthiness from a portfolio perspective. By contrast, counterparty risk typically considers short-term investments on an individual basis for each counterparty.

Incorporating early warning indicators in counterparty risk is aimed at these differences: Starting from the actual rating, additional information is taken into account in determining the limit, which is based on short-term changes in creditworthiness that have not yet been taken into account in the rating.

While payment behavior is an important indicator in customer and supplier relationships, selecting financial counterparties is much more complex. A possible approach here is to use textual information from online news and news tickers. If this approach is to be implemented successfully, it is necessary to develop a system that automatically taps into the relevant messages and derives a structured indicator value that can be incorporated into the limit system.

Another interesting option here consists of taking into account credit default swap spreads, which are available for most major financial counterparties and reflect the market's opinion pertaining to the probability of a credit default. Given that the spreads are based on standardized, market-traded products, they tend to react quickly to new information and events that could affect credit risk. Though not a perfect risk premium due to limited market liquidity, CDS spreads are good early warning indicators and a good supplement to credit ratings.

Dynamic limits for enhanced diversification
A welcome side effect of limit systems is the diversification of the investment portfolio. It makes sense to distribute the investment amount among various counterparties because diversifiable individual risks are not rewarded in efficient capital markets.

When using a static limit system, in which the limits are regularly but infrequently revised, you will often encounter situations in which the limits are clearly too large or too small for the existing position. And while limits that are too low can be quickly resolved via escalation or exception processes, there is no immediate pressure to act when the limits are too high – however, the control effect is also lost.

With a dynamic limit approach, on the other hand, the aim is to have a flexible and responsive system that is able to adapt to changing market conditions. It achieves this by basing limits not only on the creditworthiness of counterparties, but also on other factors such as the total volume of an investment or market volatility.

To implement dynamic limits successfully, you need to specify the exact dynamic logic and automate the position determination and risk assessment well. This means mapping the limits in adequate systems.

Dynamic limits can be set up to replace or supplement traditional static limits.

Our examples show that there are numerous approaches to optimizing existing counterparty risk processes and achieving effective control.

Such projects also enable long-term methodologies, e.g. in risk measurement, to be reviewed and, if necessary, expanded (e.g. to include the correct valuation of ESG-related financial instruments).

We have focused on counterparty risk, which is usually the responsibility of Treasury. In our April edition, we will take a closer look at operational credit management and provide insights into the use of credit insurance solutions.

Source: KPMG Corporate Treasury News, Edition 151, January/February 2025
Authors:
Nils Bothe, Partner, Finance and Treasury Management, Corporate Treasury Advisory,KPMG AG
Dr. Dirk Bondzio, Senior Manager, Finance and Treasury Management, Corporate Treasury Advisory, KPMG AG