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Bank Failures Reach 130 for the Year: Managing Counterparty Risk

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The number of bank failures for the year has reached 130.  As a Director of the Corporate Treasurers Council I was often was involved in discussions on how large corporations tried to manage counterparty exposures to banks.  I.E., what are the financial and operational consequences of one of my business partners experiencing severe financial distress or going belly up? Obviously, the first task is to have visibility of all sources of exposure to any one institution which is often easier said than done, and subsequently to conduct an analysis to determine if it makes sense to reduce the overall exposure. This has been especially difficult in recent times given the banks increased appetite for fee income. 

The discussion I am hoping to start here is:
1. How to organizations that are and are not multi-billion dollar companies manage
    counterparty risk exposure to banks and other financial institutions?
2. How do you measure and monitor it?
3. How do you access the financial health of your business partners? 

Answers

Scott Lane
Title: CFO and CRO
Company: TPG Credit Management
(CFO and CRO, TPG Credit Management) |

I have seen counterparty ("CP") risk managed most often as a credit risk (usually unsecured credit risk as well). That being, focusing in on the probability of default (PD) and loss given default (LGD also known as severity).

Risk of default:

To the extent available, one can look at spreads on the CP's debt (either directly on their debt or indirectly via credit default swaps). If the company is private, then of course this is a more difficult exercise but the end goal is still the same: what is the probability of default.

Loss given default:

There are three ways to look at this. (1) Notional / par value that is often referred to as exposure or maximum possible loss, (2) current or fair value of the contract with the CP (often called expected value), and (3) the risk adjusted loss or unexpected value. Usually all should be monitored, at a minimum the maximum exposures and current values.

Monitoring:

CP risk is a classic example of something that should be monitored at a risk committee level or senior management level to get an overview of concentrations with a particular CP across the business.

Ultimately what I have seen, in both large and small companies, is a spreadsheet that lists all counterparty relationships and then totals them by CP for both notional and fair value. Also included is the CP's current credit rating. This report is usually provided to senior management on a monthly basis (or more frequently if credit markets are volatile like they were a year ago).

Example:

Your firm has an account receivable from a customer that is for $10,000 with a reserve for bad debts (for accounting purposes) of 1% or $100 (1% being the expected loss based on prior experience with similar customers). In that siuation:

Notional or maxium loss is $10,000
Current value is $9,900

If you determine the probability that they will default (ie, not pay you back according to agreed upon terms) is 20% and if they do default you estimate that you will recover only 30% then your risk adjusted value would be $2,400 [$10,000*(1-20%)*30%] and your risk adjusted loss would be $7,600.

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