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Choosing a Counterparty Bank
by Jacqui Drew CA (SA), Senior Manager, Financial Instrument Solutions, Deloitte LLP
In the current economic environment, addressing the question for corporates of “Who do I transact with?” in respect of derivative transactions is an extremely pertinent and yet challenging one to answer.
When preparing this article, I took the opportunity to talk to corporate treasurers, system providers, treasury consultants and, of course, auditors to further understand the dilemmas faced, as well as the decisions to be made, when considering corporates’ choice of counterparties. Interestingly, the five common themes across all these stakeholders were:
- What mandates do I have available;
- Assessing who I want to transact with;
- Considering the creditworthiness of the counterparty;
- How counterparties perceive my credit risk; and
- Assessing whether I am getting a fair price.
However, the overriding principle across all of the above points is the development and maintenance of trusted relationships with the counterparty banks through good times and bad.
Before deciding which counterparty bank corporate treasuries would like to transact with, corporate treasuries need to fully appreciate which counterparties they have mandates with for transacting particular instruments. For example, corporates may have mandates with particular counterparties for specific types of trades or for specific geographical locations. Many corporate treasuries will only consider counterparty banks within the lending group when considering derivative transaction counterparties.
The overriding principle across all of the above points is the development and maintenance of trusted relationships with the counterparty banks through good times and bad.
It was clear from talking to corporate treasurers that in order to decide which counterparty they would transact with, they would analyse what type of instruments they wanted to enter into. Certain market participants are specialists in particular transactions and have better distribution across different products. For example, some counterparties are specialists in particular complex derivative trades and others for being able to trade in certain currencies or jurisdictions. A key aspect to consider is the link to the lending arrangements in place with each of the counterparties, and the desire to offer the business to these banks. Prior to the financial crisis, credit was freely available and counterparties were happy to lend to corporates without necessarily insisting on ancillary services. However, since the credit crisis, fewer banks are lending and those that are lending are faced with increased capital requirements; therefore, it is crucial for corporates to invest in building relationships that can withstand the good times and the bad. From the counterparty banks’ point of view, they are less willing to lend without the offer of ancillary services being made available to them. From the corporate perspective, spreading the risk amongst counterparties according to their risk appetite is a key consideration and will ensure that they are not overexposed to a particular counterparty.
The third key theme was the creditworthiness of the counterparties, taking into account the risk appetite of the entity and the relationships with each of the counterparties. Although in recent times there has been considerable news coverage over the reliability of the credit ratings as provided by the likes of Fitch, Standard and Poor’s and Moody’s (of course we all know that “Past performance is not a reliable indicator of future performance”), many corporates still use these ratings when assessing the creditworthiness of their counterparty banks. This is hardly surprising considering what other information they have to rely upon. However, although this is the main metric used, corporate treasuries are now also looking for ‘early warning signs’ for assessing creditworthiness and the liquidity of counterparties, such as reviewing their bond prices, equity prices and credit default swap (CDS) spreads. The use of CDS spreads as a measure of the credit risk of the bank has its limitations, and due to the lack of sophisticated systems at most corporates, it is difficult to convert these CDS quotes into something more meaningful. However, assessing the CDS spreads, and whether they have increased, is an indication of either the bank’s credit deterioration or liquidity concerns.