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.  

Prepping for Book Club

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

I facilitate a book club for the alumni of the Faculty of Management at Dalhousie University where I am an Associate Professor of Finance.  (Brew and Books – check us out on Face Book!)  The book for tonight is “Shop Class as Soul Craft:  An Inquiry into the Value of Work”, by Matthew B. Crawford (published by The Penguin Press, 2009). 

This non-fiction book describes the author’s experiences of giving up a high profile role as the head of a think tank to become a partner in a vintage motorcycle repair shop.  Quoting from the book jacket, “A philosopher / mechanic destroys the pretensions of the high-prestige workplace and makes an irresistible case for working with one’s hands”.  I highly recommend the book, especially for those who have uncritically jumped on the Richard Florida (Who’s Your City) and other knowledge worker / creativity worker bandwagons.

I was getting my notes together for tonight’s meeting when I came across this quote. 

“The mechanic and the doctor deal with failure everyday, even if they are expert, whereas the builder does not.  This is because the things they fix are not of their own making, and are therefore never known in a comprehensive or absolute way.”

Isn’t that a little bit like the plight of the corporate risk manager?  Doesn’t the corporate risk manager face failure everyday as the situations or incidents that arise are rarely of their own making? 

I recognize that it is the role of the risk manager to put in place systems and procedures that prevent or at least mitigate negative risk events happening.  The perception (hope, falsehood?) is that the risk manager is a control manager.  However the reality is that realized events are often beyond the control of even the most thoroughly prepared risk manager.  World events are not of the risk manager’s making, nor are they under the control of the risk manager - no matter how expert they may be.

The situation for the financial risk manager is even more pronounced, as no matter how large their financial institution of fund may be, they are mere minnows in the ocean of the world’s financial markets.  Nothing in their expert toolkit can prevent or foresee the specifics of a tsunami until it is too late.

Despite my best intended efforts, I will not be in complete control of tonight’s book club meeting.  While I will attempt to steer the discussion as I believe to be most appropriate, I know that the thoughts of the book club members are not of my own making, and thus not under my control.  That is an optimistic comment, as it has the potential to produce many wonderful surprises – not only for me, but for the book club members as well.  Perhaps risk managers should also celebrate the fact that not everything is of their own making and thus not under their control.

 

Plato vs. Freud

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

Have you ever wondered what some of the great thinkers might have thought about our current practices of risk management?  While reading on a topic totally unrelated to risk management (?), namely religion, I came across this wonderful description about how Plato and Freud thought about the ability of humans to reason.  I quote:

“Plato argues that the highest form of human nature is reason, and that reason works to make our passions subservient in order to reach our true end.  Freud, by contrast, argues that reason is not supreme but is the handmaiden of passions.“[1]

Now what made this passage particularly interesting and timely for my tiny brain is that I had just finished Akerlof’s and Shiller’s book “Animal Spirits: How Human Psychology Drives the Economy, and Why it Matters for Global Capitalism” (Princeton Press, 2009).  In this book, Akerlof and Shiller argue that the “Animal Spirits” of humans often override the assumed rationality of the economic man and thus we get economic events such as the recent economic crisis.

When thinking of these “Animal Spirits” or the passion versus rationality divide in the context of risk we quickly realize that it is a rich avenue for thought and exploration.  We tend to think of risk managers as being rational, controlled and analytical.  Passion is seldom a word that is associated with the risk manager, much less the risk department.  But is a risk manager truly devoid of passion?  Are senior managers devoid of passion when they make judgments about risk?  What about Board Members?  The answer of course (when framed in this blunt way) is that risk managers, mangers, and even Board Members are always making decisions based at least as much on passion or animal spirits as they are reason and rationality.

A follow-up question is to ask whether or not this is a bad thing?  To that I would argue that the question is a moot point, as there is little to nothing that we as risk managers can do about it.  However we do need to be cognizant of it, and incorporate the fact somehow into our analysis and suggestions.  That requires empathy as well as creativity – along with a host of other skills.

In several recent talks (see for example “Beyond Behavioural Finance”) I have argued that risk managers need to think like sociologists.  Perhaps we also need to spend a bit of time boning up on our philosophy.

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[1] Foster, Richard J., and Gayle D. Beebe, 2009, “Longing for God:  Seven Paths of Christian Devotion”, IVP Books, Downers Grove, IL