Counterparty Risk Management

by Rick Nason, PhD, CFA
Partner, RSD Solutions Inc.

I was asked by the Association of Financial Professionals to chair a roundtable discussion earlier this week at their AFP of Canada Treasury Management Forum in Toronto.  The roundtable discussion format is one that I like to participate in at conferences and this one was especially interesting.  By the number of people participating in the session it was definitely a topic that was top of mind with the audience.  The discussion we had was great and I appreciate the participation of all of those who were present.  Here are some of questions that we discussed along with my best attempt at a micro-encapsulation of the discussion.

1.  Are Canadian Bank clients isolated from counterparty risk issues?

·       Of course not.  Although the Canadian banks are considered to be amongst the strongest, the recent crisis has shown us that systemic risks can attack anyone and do so quickly.  Besides, most companies have global banking relationships.

2.  Is counterparty risk an issue if you are not heavily exposed to your bank?

·       Yes.  Counterparty risk is a two-way street.  At present you may not be exposed, but your bank might be exposed to you.  This may lessen the bank’s ability to finance you with as great a flexibility.  Also it is future potential exposure that is the key issue.

3.  How can you mitigate counterparty risk beyond the usual collateral / netting / tight legal agreements (ISDA’s and termination agreements)?

·       The best way to mitigate counterparty risk is to choose good bankers (the individuals that are your representative with the bank).  A good banker makes sure the lines of communication are two-way.

·       Be aware of the credit paradox of banks.  (Banks that specialize in lending to specific sectors.)  This may leave your bank exposed to a systemic risk in that sector that, in turn, your company gets caught up in.

4.  How can we monitor the strength of our banking group?

·       Looking at the Credit Default Swap rates for banks in your banking group is a more real-time indicator of the perceived strength of a bank than the credit ratings which are based on a business cycle and tend to be less reactive.

·       The change in the CDS spread over a short period of time may be just as relevant an indicator as the absolute level of the CDS spread.

5.  What can be done if one of our banks gets into trouble leaving us exposed on a transaction?

·       Not much.  The best way to fix a bad situation is to avoid it in the first place.  Diversification of banking group and being proactive at the first signs of trouble are the best proactive responses.