Counterparty risk: Are you in control?

Banking insolvencies, forced mergers, government interventions... The recent challenges of the banking sector have shown that 2008 lessons may have been forgotten.

This is a stark reminder of the importance of a strong Corporate Treasury department, and how up-to-date risk management policies and treasury processes are vital to any company. While the risk of counterparty defaults cannot be fully eliminated, preventative actions and good corporate governance will minimise the impact and cost to the business.

Having robust risk management policies supports the mitigation of key financial risks. These include:

• A counterparty risk policy highlighting and limiting the amount of exposure to each bank. Overall, exposure diversified across several financial counterparties based on credit ratings and ongoing monitoring should help diversify the risk of one counterparty defaulting. In addition, corporate treasurers may implement more restrictions to further reduce and tailor the concentration risk as per the company’s and investors’ risk appetite
• A liquidity and funding policy highlighting the source of funds, liquidity, and its management. A sound strategy will include a variety of funding options, such as committed and uncommitted lending facilities with a variety of financial counterparties. This also highlights the importance of keeping strong bank relationships with a diversified pool of lenders
• An investment policy will ensure all your deposits are not concentrated, reducing the risk and limiting the impact of any default or limitation of availability.

This is not an exhaustive list, but will give your company a solid foundation to mitigate counterparty risks. These policies should be assessed and reviewed on an annual basis to ensure they remain compliant and relevant.

The maturity level of your treasury department will dictate your ability to managing counterparty risk. Tools, solutions and technologies can be used to manage your counterparty risk on an ongoing basis including:

• Ongoing monitoring of exposure is a key component and will allow you to know your exposure at any point in time and ensure compliance with your policy. This can be achieved in a number of ways, but best practice would be to use a system to give you access to daily consolidated exposure reports
• Diversification and evolving limits will ensure you shy away from concentration risk and helps minimize the impact of a default by one counterparty on your overall business
• Active credit analysis and due diligence of your counterparties is a requirement to stay informed and abreast of latest developments. While not all event of defaults can be identified early, there are often warning signs or deterioration of credit ratings or Credit Default Swaps (CDS) prior to it
• Collateral and guarantees, including the use of Credit Support Annex (CSA) as part of your ISDA documentation to support in case of default
• Consider buying CDS or credit insurance to hedge against counterparty credit risk. These instruments can help transfer risk to other parties, acting as a form of insurance against defaults
• Perform regular stress testing and scenario analysis to ensure your counterparties remain viable in different situations and understand the potential impact should one of them go bankrupt
• Utilise systems and automation to build robust fit-for-purpose processes around your counterparty credit risk management policy to help reduce the reliance on manual spreadsheets. Nowadays, off the shelf solutions are available either through a Treasury Management System or specialist providers so don’t hesitate to explore

In conclusion, managing counterparty credit risk is an essential component of corporate treasury. By assessing, diversifying, and monitoring your counterparties, implementing clear credit policies, and utilising various risk management tools, you can protect your organization against the risk of potential financial loss. Remember that risk cannot be eliminated, but it can be effectively managed through a combination of strategies tailored to your specific business needs. An external review of the treasury department policies and processes may be a beneficial way to ensure the treasury function remains up to date with good practices and recent technological developments. Staying vigilant and informed is the best way to safeguard your corporate assets and financial stability.

If you find yourself with any treasury challenges, we would be happy to discuss these with you, and can provide support with:

• Help developing or enhancing your treasury policies, including your counterparty risk policy
• Diagnostic assessments to evaluate your policies and elevate your treasury function
• Design and implementation of counterparty credit risk management and treasury solutions to help you through your evolution journey
• Support with selection and implementation of Treasury technology around credit risk management
• Review and development of credit risk hedging strategies and associated accounting advice

If you would like to discuss potential solutions to these challenges, please do not hesitate to contact KPMG’s Corporate Treasury Services team.