New approaches to counterparty risk in Treasury

The speed at which companies have to face new challenges remains high. For the management of counterparty risks in corporate treasury, which is often based on tried-and-tested processes that have evolved over many years, a number of developments are also leading to a need for adjustment, but also to opportunities for further development, which we would like to examine in more detail in this article.

To do this, we will first look at the main drivers of change.

The macroeconomic uncertainties resulting from the intensifying global political and economic disputes will have a negative impact on companies in many areas. Supply chains and sales markets, as well as financial markets and capital flows, will shift as a result of geopolitical tensions and trade and customs conflicts.

The digital transformation provides technological innovations such as artificial intelligence (AI), machine learning and big data analyses, which have so far been used little in risk management but offer potential for more precise risk assessment, real-time control and automated decision-making. Digital platforms and fintech companies are working intensively on the development of corresponding solutions so that implementation does not necessarily have to result in complex in-house projects.

However, the downside of rapidly growing data networking and centralisation is the dependency on IT systems and the associated cyber risks, which make it necessary to consider business continuity (how long can the company manage without the individual systems?).

ESG risks are a third driver. Environmental, social and governance factors have become much more important in recent years and companies and financial institutions are increasingly taking ESG risks into account when making investments. Even if there are controversial political developments here, further regulatory requirements are more likely to be expected, as the consequences of climate change will be reflected in a variety of ways and the issue will return to centre stage in the medium term.

While the changes to the framework conditions for risk management are obvious, the specific measures for further development are not.

The centrepiece for dealing with counterparty risks is usually a combination of

• systematic selection of counterparties with whom financial transactions are conducted within the company (often in the form of a portfolio banking approach),
• a limit system that assigns the authorised counterparties an upper limit of permissible business, and
• a suitable risk assessment for existing business.

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

By defining a portfolio of counterparties, it can be ensured that all necessary markets (for financing, investment and also payment transactions) can be covered. Depending on the market position, counterparties can also be included that initially appear less suitable based purely on creditworthiness criteria, but are necessary to realise the business strategy by covering certain services or markets.

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

In the following sections, we look at approaches that develop the various components in different ways.

Automation and real-time overview

Especially in turbulent times and a volatile environment, a timely and complete overview of the risk situation is essential for effective management - this applies to all financial risks in treasury. Thanks to the improved possibilities for data exchange and system networking, all of the company's positions can be brought together in one central location with moderate effort, typically in the treasury management system or a data warehouse/data lake solution. In addition to in-house data, the market data used (e.g. rating or CDS spreads) is also required.

With the help of BI solutions, some of which are now directly integrated into the systems or, if they are separate applications, at least enable a simple system connection, interactive dashboards can be set up with the central overviews of counterparty risk. Depending on the system landscape, it is possible to achieve at least a daily overview or even an overview in real time, in which changed limits or limit utilisation are immediately visible and intraday information such as new transactions, changed prices or intraday account statements are included. The data flows themselves can be automated as far as possible in order to avoid a high level of manual effort.

In addition to the significantly increased transparency of risks, which allows counterparty risks to be managed close to the business, such an approach also makes it easier to analyse developments, e.g. in the form of observations of changes over time, and forms the basis for further steps.

Implementation of early warning indicators

Traditional limit systems determine the limit based on credit ratings from rating agencies. One difficulty associated with this is the different time horizon. Rating agencies tend to adjust their assessment slowly and focus on medium to long-term creditworthiness from a portfolio perspective. Counterparty risk typically looks at short-term investments on a counterparty-by-counterparty basis.

The inclusion of early warning indicators in counterparty risk is aimed at the differences: Based on the actual rating, additional information is taken into account in the limit determination, which is aimed at short-term changes in creditworthiness not yet taken into account in the rating.

While payment behaviour is an important indicator in customer and supplier relationships, the selection of financial counterparties is much more difficult. One possible approach here is to use textual information from online news and news tickers. For successful implementation, both the automated retrieval of the relevant news and a structured derivation of an indicator value and consideration in the limit system must be developed.

Another interesting option here is the consideration of credit default swap spreads, which are available for most major financial counterparties and reflect a market opinion on the probability of a credit default. As the spreads are based on standardised, market-traded products, they generally react quickly to new information and events that may influence the credit risk. Even though CDS spreads do not represent a perfect risk premium due to limited market liquidity, they are good early warning indicators and a good complement to credit ratings.

Dynamic limits for increased diversification

A desirable side effect of limit systems is the diversification of the investment portfolio. As diversifiable individual risks are not rewarded on efficient capital markets, it makes sense to spread the investment amount across different counterparties.

In a static limit system, in which the limits are revised regularly but at longer intervals, situations often arise in which the limits are clearly too large or clearly too small for the existing position. While limits that are too small are cancelled promptly via corresponding escalation or exception processes, there is no immediate pressure to act if the limits are too large - although this also eliminates the control effect.

A dynamic limit approach aims to create a flexible and responsive system that is able to adapt to changing market conditions. This is achieved by no longer basing limits solely on the creditworthiness of the counterparty, but also taking into account other factors such as the total volume of an investment or market volatility.

In addition to the specification of the precise dynamisation logic, successful implementation requires good automation of position determination and risk assessment, i.e. mapping in adequate systems.

Dynamic limits can be used either as a replacement or as a supplement for classic, static limits.

The examples presented show that there are also numerous approaches to optimising existing processes in the area of counterparty risk and that a better control effect can be achieved.

In addition, corresponding projects make it possible to review and, if necessary, expand long-standing methodologies, e.g. in risk measurement (e.g. to include the correct valuation of ESG-related financial instruments).

In this article, we have focussed on counterparty risk as the area of credit risk that is usually the responsibility of Treasury. In our April issue, we will revisit the topic of credit risk under the heading of operational credit management and, in particular, provide an insight into the use of credit insurance solutions.

Source: KPMG Corporate Treasury News, Issue 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