Why Counterparty Risk Still Matters
Economies around the world and many corporates have
experienced a cold dose of reality in recent years. Corporate treasurers who
experienced at first hand the series of seismic financial shocks since 2008 will
never again be able to chase yield at the expense of security.
hardly be blamed. Admittedly we have seen some green shoots of recovery since
the start of this year, whether reflected in increased merger and acquisition
(M&A) activity by US corporates or improved UK economic data. Yet there is
still much cause for concern. Economic growth in the eurozone remains elusive,
youth unemployment in many countries is either still rising or remains
stubbornly high and European market reforms proceed at a stop-go rate at
In addition to these macroeconomic scene setters, a number of
so-called ‘Black Swans’ have darkened our economic horizons. The US fiscal cliff
became yesterday’s news, at least for the moment, once Congress reached a
limited compromise agreement and the bail-in required as a quid pro quo for
rescuing Cyprus was resolved in a more or less coherent fashion. Nonetheless,
for a brief period these and other events served to call into question
previously inviolable, universal truths, such as the US dollar’s traditional
role as a safe haven and sanctity of government guaranteed deposits. The swan
sailed past and tranquillity returned to financial waters, but the collective
psyche of corporate treasurers was troubled and so security, above all else,
became and remains the mantra of investment policies everywhere.
Counterparty risk remains a primary concern, all the more so since the
unlimited coverage provided in the US via the Federal Deposit Insurance
Corporation (FDIC) lapsed at the end of 2012 and unguaranteed corporate deposits
turned out to be just that in the Cyprus bail-in.
With good quality
collateral in short supply, corporate treasurers are left only with the raw
material of their commercial judgement and the integrity of their risk
management processes to protect them. Counterparty diversification, adding to
the bank list for deposits or adding new instruments, is an initial and
understandable step, but it is simplistic to think that these alone offer
ultimate protection in the event of a market-wide stress.
Adding a new
instrument, such as commercial paper or money market funds (MMFs) may
unwittingly increase exposure to existing counterparties; rather like playing
Russian roulette only with more guns. Unless processes for recognising and
monitoring risk are simultaneously improved, diversification can result in
complexity, confusion and, ultimately, more risk.
How Can Counterparty
Risk Management be Improved?
As many corporate treasurers have found, to
the despair of their small teams, the only way to reduce risk in the liquidity
management process is granularity at all stages.
Last and for now, least, there is the thorny subject of yield. In
the battle of security versus liquidity versus yield, the last appears to have
lost the battle for the time being. That is a predictable outcome and a
relatively easy decision in such a low yield environment. But once again, the
question of sustainability rears its ugly head.
Corporate cash has been at
record levels and continues to build. It cannot be long before shareholders
start to question the dilution on earnings that such a self-imposed buffer
represents, so the question of return can never be dismissed entirely. Yields
up to one month are terminally low and the yield curve beyond one month is
generally every bit as unexciting. However, at the point where the contractual
term of one month is exceeded there is a distinct uptick in rates. In a market
where risk and reward are generally closely correlated, such displacement is
hard to explain. A 35-day deposit is hardly much riskier than a 30-day deposit.
The explanation for this phenomenon lies far from the trading floors, in
the pages of the Basel Accord and in particular the requirements of the
liquidity coverage ratio (LCR) that obliges banks to maintain high-quality
liquid assets in excess of outflows in a severe 30-day stress. Because of the
impact on buffer costs, a 35-day deposit is indeed significantly more valuable
than a 30-day deposit and markets are already reflecting the consequences, well
ahead of full implementation of Basel III. Treasury policy needs to take
account of the impact of regulation on the banks and therefore market
Contractual term in excess of the stress period is clearly one
way for banks to obtain stable funding but deposits linked to operational
balances are another, since these are deemed under the new accord to be more
stable. This reflects the real-life experience of every cash management bank.
As a result banks such as Barclays have developed products to reward
contractual maturity beyond the stress period, as well as operational stability
on account-based products. In other words, a small change in treasury policy to
place funds in time deposits with a 35-day maturity versus slightly shorter
maturities can lead to improved yield without material impact to security or
While security remains top of the agenda for most corporate
treasurers, the other ugly heads of investment management – liquidity and yield
– are never far away. In fact, one could say they are joined at the neck like
the mythical dog Cerberus and it takes a skilful and well-informed treasurer to
negotiate his way past the beast.