Analysing treasury risk and return: the significance of counterparty risk

Have you ever tried to catch a rugby ball as it bounces across the ground towards you, or have you seen how even the great international players fumble as they try to catch the ball and lose it? Risk is often like that, just when you get a grip on it, it slips through your fingers and the game can be lost!  In much the same way counter party risk has changed and evolved rapidly in the last four years bouncing in three different directions and back again in such a way as to make it unpredictable and difficult to pin down. I’m going to look at some of these changes amongst banks, money market funds and funds generally and suggest how we might adapt to the new environment.

Risk is still something of a fuzzy concept, professionals and practitioners would like to offer clear and precise definitions of risk but that may never be possible. If you ride your bike to work you balance the health and other benefits against the real danger of being run over without any real quantitative assessment. In the US parents surveyed and given the choice were happy to allow their children to visit a neighbour with a swimming pool but would refuse permission to visit a home where a hand gun was known to be kept, but in fact, you guessed it, the child was more at risk using the neighbours pool.  Of course both risks were small and by accepting certain risks we are rewarded, in this case the children get to swim in the pool.

So overcoming risk or learning to live with risk must be a good thing;

Imagine you are travelling with one other person flying a single engine aircraft at 15,000 feet.  The engine fails, the plane is certain to crash and you head for the exit,  but there’s only one parachute.  One of you will jump with a parachute, the other without, so which passenger is in the position of greatest risk?

Of course the one with no parachute is certain to die, they face no risk, just a certain future, the person with the parachute takes all the risk, his parachute may not open, he may land in shark infested waters, nonetheless I’m willing to believe you would very much prefer to be the “risky” jumper with the parachute than the no risk jumper without one!

So we need to think about risk differently!

It’s now five years since the banking sector and much of the financial sector with it hit the buffers, and in that five years we have seen all manner of risk come and go and now return again, along the way our relationship with counterparties has changed sometimes in barely visible ways.

Phase one, before the disaster, it was almost inconceivable a bank could go bust, we generally had complete faith that our money was safe.  Did anyone here remove their savings and cash from the bank and keep it under their mattress as remains the case in some parts of the world?  There had not been a run on a bank in 150 years and, generally, banks did not go bust, so we were happy with them as a counter party.

Phase two, with Northern Rock, Iceland, Lehman and others we realised banks could go bust and some actually did fail, in the US more than 150 banks were allowed to fail during this period and were put into resolution or liquidation.

Phase three, was the phase where we all came to believe “governments will save the world”, and save our banks, we learnt the term “too big to fail” and governments did come to the rescue with bank deposits guaranteed, unlimited liquidity made available and other measures.  At this time depositors actually moved their funds to higher yielding Irish banks until they realised the state supporting them might fail.

Phase four, the present day – the immediate storm subsides, we survey the wreckage, and look at what remains. Politicians and policymakers resolve that this can never happen again, never again is the taxpayer to become the guarantor of last resort to this sector and they set about putting in place measures to ensure this. The question became how to turn aspiration into fact and we saw a flow of policy initiatives, these included;

Higher capital requirements, ring fencing of retail banking from so called “casino” banking, “living wills” that provide a bank under stress with contingency plans to wind down in an orderly resolution at a time of stress and finally “improved” regulation.

The suspicion still remains that this may not be enough. Last week at the 4th Local Authority Treasurers’ Investment Forum I presented a paper on this very subject and below I’ve highlited my key points including the argument that the European Union may be prepared to go further in its quest for “no more surprises” in the banking world, and this may yet again change your counter party relationship.  However the measures already taken have already had a profound effect on the banking landscape and counterparties;

Point 1 Declining bank credit quality:  far from credit ratings improving they are still in decline, investors have been forced to either compromise on credit quality criteria (for example TMSs have had to be amended to keep up with declining credit quality) or they have defaulted to the DMO and government bonds accepting much lower yields in order to underwrite their counter party risk.

Point 2 Investors are forced to consider other options. As well as the DMO and banks, if we are forced to consider funds for diversification or to improve yields, what are the benefits, what are the risks, and what are the counter party relationships?

In 2008  some, money market funds, “broke the buck” as they say in the US, meaning they traded below £1.00 or USD1.00 or €1.00. per share. This occurred because of individual defaults, Lehman cost one fund 1% of it’s value, but also because of liquidity defaults, meaning redemptions could only be met by selling securities at distressed prices which turned out to be lower than where those securities were “valued” when they did not need to be sold!

The latter, liquidity, has probably materially been resolved with the tightening of money market fund rules. In fact so tight are these rules now that the most secure liquid funds in the US would have a negative return without subsidy from their sponsors.  For Euros, funds are being closed to new investors or shut down because returns are so low, and in Sterling returns net of fees are close to 10 basis points for the most secure funds.  What has not changed is that these funds do provide vital counterparty diversification but depending on your risk appetite it comes at a price: 10 basis points for all government securities backing, 20 to 30 basis points for 50% gov / 50% non gov and around 60 basis points for all non-government securities.

Amongst funds, we believe your counterparty here is not the fund sponsor or the fund itself, but the underlying securities.  Credit rating agencies would have us believe differently and expressly ascribe a part of their rating to the strength of the underlying sponsor.  It is true that in 2008, quite a number of sponsors did step forward to protect their franchise and their name and paid their own shareholders money into these funds to make them whole. Today these funds are either loss making or borderline profitable, and we are already seeing some providers withdraw from the market.  Are we to rely on the sponsors to stand behind these funds in future?  There must be a risk that the shareholders of the sponsors draw a line and say “no more”.

Going forward it will be necessary to receive regular and complete statements on these funds, detailing every security held and either you or your adviser will need to hold an opinion as regards the contents. Funds do provide counter party diversification and if you are selective about yield and the underlying securities you can chose a fund that will meet your TMS requirements.

Point 3 In 2007, a typical counterparty list for a treasurer might have had upwards of fifty names on it with monies distributed across them, sometimes as many as 100 deposits were held limiting “risk” to no more than one or two percent per institution;

So what happened next?  It hardly needs explaining, some banks failed and disappeared, many were down-graded  and others merged in order to be saved further reducing the pool of available counter parties.  The result today, as few as a dozen banks appear on counterparty lists and of these perhaps as few as half are accepting deposits or paying more than a nominal interest rate.

What is the result?

1. Local Authorities, corporates and others are being forces to compromise their TMS terms, adjust those terms and accept lower credit quality institutions or maintain credit quality and accept zero or near zero returns on cash.
2. You are also being forced to move from having in the order of 50 counterparties with potential credit exposure of say 2% per counterparty to depositing with just say 6 institutions with as much as 20% exposure per entity.  Remember you may have more counter parties on your list but many don’t want your cash and once again we are now seeing rates decline.

Banks remain vulnerable to one of the most risky business models invented;  in summary, to a greater or lesser extent banks rely on the confidence of retail and corporate depositors to fund their loans and they rely on wholesale markets to plug the gap between the two.  What we have seen is that if confidence is undermined in one it becomes virtually impossible to rely on the other to make up a funding shortfall and no bank can survive a catastrophic loss of confidence without the support of government, the government needs something else to get it off the hook!

Point 4 Before we look at governments’ other “big bazooka”, let’s look at what has happened to these credit ratings, a steady decline since 2007 across all the major UK high street banks, a decline which may continue before credit ratings start to improve.

What we begin to see is that our core proposition of five or more years ago, where we thought that the safe thing to do was to hold money with banks, and the risky thing to do was invest with corporates and others is now flawed.  Now it looks like the risky thing to do is leave all ones funds with the bank and we need to evaluate whether corporates represent a better alternative and if so how we should access them and what value they do bring.

Point 5 Once one steps away from the DMO and government paper the case for banks as counterparties when compared with corporate looks an unequal one, there are simply more corporate bonds available, of better credit quality with, in aggregate, better yields.

However if you are not yet persuaded the following needs to be considered;  If governments are to prevent tax payers ever picking up the bill again, they need a new tool to do it, or a new weapon in their armoury, they need a new bazooka and the European Commission is designing one, and it’s probably not the one you are expecting.

Point 6 “A proposal for a directive establishing a framework for the recovery and resolution of credit institutions” from the European Commission. What the draft may propose is to hand powers to central banks, in our case the bank of England, which would allow them to re-order the capital structure of banks at a time of stress.

In 2008 and during the first and second phase of the Greek resolution, governments realised that the failure of a bank or banks would not just hit ordinary depositors. They realised that the bonds issued by the banks we in fact held by insurance companies, pension funds and other banks – all essential to the financial infrastructure. Governments realised that the destruction of these bonds would likely be fatal to the financial system itself and potentially more harmful than the destruction in whole or in part of deposits alone.  What we then saw was “haggling” over the “haircut” bondholders should suffer, i.e. how much their bonds should be written down. In a simple collapse they would have most likely been wiped out completely or become dependent on the liquidation proceeds of the institution which in any event would in the first instance accrue recovery proceeds to higher ranking depositors and not bond holders.

What may now be envisaged under the new proposals, and they are just that at present, is that powers may be provided that would allow an authority to determine haircuts for depositors if such haircuts were deemed necessary for an orderly resolution of the bank. The lesson of this proposal is that policy makers will consider any measures which may change your relationship with a bank as counter party. We need to be alert to these possible changes and their implications.

Banks have not become instantly more risky and less attractive as counterparties – in fact overall the steps described earlier should make them safer. It’s just that they may now be safer but riskier, meaning they are probably going to be less likely to fail in the first place but they will nonetheless be allowed to fail rather than be government supported, with a consequence of potential losses for depositors.  It is government’s intention that in future all stakeholders pay, including depositors.

Point 7  I believe funds should not be thought of as counterparties since they have no capital of their own to support their obligations beyond the securities they hold.  Meanwhile funds can provide access to diversified portfolios and the expertise to evaluate the risk in those portfolios.  A well structured fund portfolio will most likely have 60 or more holdings with counterparty risk of no more than approximately 2% per holding.

Investing in a fund, local authority cash does not touch the fund or its manager – it simply passes from the local authority to the fund’s segregated client account held on behalf of the fund at the custodian, and when we say on behalf of the fund this means on behalf of shareholders.  The funds normally remain there no more than 24 hours before transferring to the seller of securities that the fund has purchased.  Again the securities are then held in a segregated client account in the name of the fund for the benefit of shareholders.

All that remains is to ensure transparent reporting to verify this process.

So what may we conclude;

• banks remain important counterparties, they are probably going to be safer, less likely to fail, but they can fail nonetheless and deposit holders may pay,
• Money market funds do provide counterparty diversification but at a potential cost of a near zero return,
• corporate and other non-financial issuers can be found with better credit quality and higher returns and represent equally good or better counter party risk than traditional institutions and
• funds should not be assessed as counterparties, instead look to transparency and the underlying securities of a fund to assess and secure your counter party risk.

Robin Creswell is Managing Principal of Payden & Rygel’s London office. The company manages some USD40 billion (£25 billion) of cash and treasury assets on behalf of US corporations and offers approximately £2 billion of cash management services to UK and continental European corporations including the Payden Sterling Reserve Fund.