FinTechSystemsTMS Priorities for Corporates After the Credit Crisis

TMS Priorities for Corporates After the Credit Crisis

“We need to know our exposure to Lehman Brothers, NOW!” Little more than a year ago, this desperate cry echoed around the world’s treasury departments. Old assumptions about the value of credit ratings (and the safety of bank deposits) vapourised in an instant. Corporate treasury systems – and especially the availability, completeness and accuracy of their reporting – were put to the test in response to a seismic shock that dwarfed even the Herstatt Bank collapse way back in 1974. Not all responses could reasonably be judged to have reflected best practice risk management reporting and analysis.

Corporate treasury departments’ immediate reaction to the pressing requirement for Lehman exposure information varied in direct proportion to the quality of systems support that they enjoyed. The best-served operations had this information instantaneously available in real time, or at least very rapidly via an on-demand exposure report. Others found themselves struggling with spreadsheets, a range of boutique systems, and manual records – and perhaps having to telephone or email treasury centres and subsidiaries’ finance offices around the world to try to assemble the necessary information. Could they be sure that the results that they cobbled together were complete and dependable? How long did it take them to complete their response – and how effective was it?

At the recent Sibos conference in Hong Kong, financial risk analysis – and especially credit exposure management – was the most discussed topic. This transpired, of course, as a direct response to the continuing ramifications of the financial crisis, with the general consensus that better solutions must be defined and implemented as a matter of extreme priority.

Historically, corporate treasuries have lagged behind financial institutions in the adoption of innovative techniques; but the crisis has catalysed a new wave of urgency in the corporate community, especially in the field of effective financial risk management. This new focus has swiftly resulted in an urgent re-prioritisation of treasury technology projects. The changes relate in particular to new demands for the efficient, effective and rapid availability of counterparty exposure information, and also for the urgent adoption of a new set of sensitive and powerful counterparty risk indicators that will help treasurers to identify and avoid future Lehman-style cases.

Effective Counterparty Exposure Management – What do You Really Need?

There has been an important re-definition of the components of a complete counterparty exposure analysis; and the application of this new definition has directly impacted the technical framework of counterparty limits management in the corporate treasury. The essential change relates to the realisation of the true scope of the composition of a credit exposure to a given counterparty, which in reality includes:

  • Bank account balances.
  • Time deposits placed.
  • Money market investments held: certificates of deposit (CDs), acceptances, repos, commercial paper.
  • Open foreign exchange (FX) deals: spots, forwards, swaps, futures.
  • Open interest rate derivative deals: swaps, cross currency swaps, options, FRAs, futures.
  • Bond investments held.
  • Equity investments held.
  • Collateral held against assets.

In business terms, credit exposure analysis applies to three areas: investments, dealing commitments with forward-dated cash flows (such as derivative settlements) and credit lines. The credit line case relates to risk exposures that might be created if a facility were to be reduced or cancelled as a consequence of a negative change in the creditworthiness of the lending organisation. An additional level of complexity is reflected in cases in which the exposures are distributed throughout a global subsidiary network, or which are shared with third parties through joint venture structures.

It is when coping with the extreme events that start and punctuate financial market meltdowns that speed, as well as accuracy becomes critical to achieving an effective response. On occasions such as the Lehman event, all treasurers would prefer to have real-time-visibility of the complete exposure position, so that ameliorating action can be planned and executed as swiftly as possible. Besides speed, this approach has the added advantage of being hands-free: the information is updated and presented automatically, without the need for human intervention. It therefore enjoys a very high level of dependability. The next best solution is the facility to run a report on demand.

In either case, the essential underlying technology is an integrated treasury management system (TMS) based on a single central database that is fully updated automatically when new information is entered or uploaded. In the case of counterparty exposures, this requires that all remote operations are constantly connected with the central TMS, directly or using a browser-based functionality. With such technology, the corporate treasurer can be confident that they are basing their counterparty exposure management decisions on accurate and complete data. In the past, some treasurers may have been to content to accept the slowness and lack of precision and reliability of spreadsheet and manual exposure reporting processes; today, treasury departments are noticeably more ready to justify the necessary TMS investment to support really effective counterparty exposure management. In either case, the treasury team can concentrate on managing the risk, without having first to measure it.

New Tools to Measure Counterparty Credit Risk

When Lehman failed, it was still carrying an investment grade ‘A’ credit rating. Clearly, those corporates who had relied solely on credit ratings to allocate lines to counterparties were viciously shocked as events unfolded. There has been a strong response with regard to rectifying this situation among corporate treasurers, with increasing levels of demand that TMS solutions must now incorporate sufficiently sensitive and fast-moving counterparty risk indicators in their armoury of functionality to assess credit far more accurately.

Some treasuries identified Lehman’s deteriorating credit condition before the issue became critical. They were therefore able to unwind their exposures in advance of the actual crisis. These organisations report that they were using risk indicators directly derived from dynamic financial markets. The most commonly quoted method relates to the credit default swap (CDS) spread curve; this is the Association for Financial Professionals (AFP) recommended methodology for assigning a monetary value to non-performance risk (as required under FAS 157). There are other good credit risk indicators presently available, based on counterparties’ and issuers’ bond and equity prices and indices. The requirement of the market today is sufficiently complex that effective solutions depend on their integration with the TMS, so that the full exposure is reported in real time, as needed. The risk factors adopted as policy at a given treasury may be derived from a range of internal and external sources. Some corporates prefer to define and derive their own key risk indicators, whereas others prefer to rely on indicators published by reputable third parties. So there is a range of new risk modelling tools that require integration with the TMS for their effective deployment.

The new risk factors may be built into a number of TMS functions, including mark-to-market valuations and, where applicable, for FAS 157 compliance processes. In terms of counterparty risk management, they may be applied to the allocation of limits, and to the ongoing monitoring and analysis of counterparty exposures. The necessary process may be regarded as the derivation of a synthetic or ‘shadow’ rating which is employed as a sensitive tool to help ensure that counterparty exposures are evaluated and managed with the optimum speed and precision.

Conclusion

According to Wikipedia, Herstatt Bank’s failure was one of the factors that led to the creation of the continuous linked settlement (CLS) platform – a mere 28 years later! In the case of the recent crisis, there are many signs that the corporate treasury industry is already self-organising to put in place the tools to help to manage similar future events much more effectively. The difference today is that affordable technology is now available to deal effectively with issues that are correctly seen to be really critical – such as counterparty exposure risk management. This is reflected in the significant levels of interest in deploying the necessary solutions that is now evident in the corporate TMS marketplace.

New proposed European legislation seeks to regulate the over-the-counter (OTC) derivatives market by channelling it through exchanges and clearing houses. Such arrangements would require substantial margining, and this additional and potentially costly overhead is attracting sharp criticism from the corporate treasury industry. As corporates use OTC derivatives for hedging, not speculation, this idea seems to miss the critical point, and it has potentially serious impact on companies seeking to marshal their assets for new commercial investment as European commerce struggles out of the recession. More relevant regulation would be directed at assuring the validity and transparency of hedging operations that employ OTC derivatives.

Technology alone cannot, of course eliminate the underlying risks of new financial crises such as the credit crisis. But – at least in the case of counterparty exposure risk management – a strong TMS implementation enables corporate treasurers to navigate such crises with enhanced levels of confidence. The team can focus on their professional treasury management duties, relying on the accuracy and completeness of the information they’re using, and on the sensitivity and reliability of their modelling of counterparty risk.

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