Several factors have converged to increase counterparty risk – that is, the chance that one party in a contractual agreement doesn’t fulfill its obligations. That’s especially the case when considering the risk within financial institutions, as Lance Pan, director of investment research with Capital Advisors Group, lays out in this whitepaper.
One factor driving this is consolidation within the banking industry. As this post from a few weeks ago lays out, just 16 years ago, the ten largest banks held assets equivalent to about 25% of U.S. GDP. By 2006, they held 58% and they’re now at about 70%. That makes it more difficult for companies to work with a diverse group of banking partners. Instead, many end up choosing from a steadily shrinking universe of financial institutions.
At the same time, the credit ratings of some of the largest banks have eroded over the past few years. In his whitepaper, Pan notes that the average Moody’s rating of the 20 largest U.S. banks dropped from almost an Aa2 to about an A2 since mid-2008. Among the factors driving this were lower loan quality and the banks’ greater use of complicated financial products.
While FDIC insurance provides protection for certain accounts with FDIC-insured institutions, within certain limits, it doesn’t come into play when a company’s counterparty is a non-bank subsidiary of a financial institution. “Unless the deposits are guaranteed, you have to rely on your assessment of how credit-worthy the institution is,” Pan said in an interview.
In addition, as companies themselves have grown more global and complex, it becomes more difficult to track the various ways their organization might interact with a particular financial institution. For instance, some re-purchase agreements may not readily identify the counterparty. Instead, you need to track down the information and then link it to the counterparty data coming from other areas of the company. “The exposure needs to be looked at across business lines,” Pan said in an interview, although he adds that software applications are available to help.
Once you have a handle on the organization’s counterparty risk, what best practices can you employ to mitigate it? Pan outlines a few:
- Diversify your list of counterparties, and then set limits for interaction with each according to their risk profiles. Not surprisingly, you’d probably assign a higher limit to counterparties that boast stronger credit profiles.
- Use standards contracts when possible. For example, the master repurchase agreement drawn up by an international body of swaps dealers, rather than one negotiated between two parties, likely will be more comprehensive.
- Similarly, try to stick to financial products that can be transacted through a clearinghouse. The collateral the other party will have to post should help to make your firm whole if the counterparty goes under.
- Consider requiring delivery-versus-payment. “You don’t want to give someone thirty days to make a payment,” Pan says.
The goal, Pan points out, is to manage the company’s exposure proactively, rather than trusting mechanisms that are supposed to come into play if the counterparty fails. Even if the mechanisms work, it may take months to retrieve your money. “That’s not a prospect any small- or mid-sized company wants,” he says.
By Karen Kroll