From the September Special Report issue of Treasury & Risk magazine

Know Thy Banking Partners

In the wake of the financial crisis, corporate treasuries are paying closer attention to the risks they’re exposed to in dealing with their banks.

The events of the last five years have reshaped companies’ understanding of the risks they face when dealing with their banks. While concerns about bank counterparty risk have subsided from the levels seen in the immediate wake of the U.S. financial crisis and during the various flare-ups of Europe’s sovereign debt crisis, the lessons have sunk in.

“Corporate treasurers certainly have wakened up to the fact that when it comes to the banks they’ve dealing with, things can happen,” said Matthew Dunn, senior manager in Deloitte’s treasury risk management practice. “Things can happen fairly quickly. As we saw in the crisis, even large banks could not exist anymore overnight. It really can happen that fast.”

The crises resulted in many conversations between corporate treasurers and their banks, said Greg Kavanaugh, head of the global liquidity product team at Bank of America Merrill Lynch. “Whether it was the economic crisis in 2007-2009 or the sovereign debt crisis in Europe, we witnessed clients rechecking their policies, rechecking their counterparties and checking where they stand with them,” Kavanaugh said.

“That reactive response, whether to the economic crisis or the sovereign debt crisis, has diminished as the economies that our clients conduct business in have stabilized,” he added.

Global regulators’ efforts to ensure that banks are properly capitalized have helped eased treasurers’ concerns.

Dunn pointed out that in the United States, the Federal Deposit Insurance Corp. has pushed for a bank leverage ratio as high as 6%, double what is required under Basel III. “For corporates dealing with these large banks, it lowers the risk,” he said. Dunn noted, though, that banks face additional costs to comply with new regulations and hold more capital, and those costs are likely to be passed on to their customers, including corporate buyers.

Kavanaugh said that it was not just the regulators’ actions, but banks’ responses to the new requirements that proved reassuring.

Greg Kavanaugh of Bank of America Merrill Lynch“I think the level at which banks have capitalized and discussed their healthier capital base has been very important,” said Kavanaugh, pictured at left. “For example, some banks would appear to be ahead of some of the anticipated regulatory requirements, even though all of those regulatory requirements haven’t been fully fleshed out.”

Regulators’ efforts have also given treasurers benchmarks to use when they’re assessing the health of their financial institutions, said Michael Berkowitz, head of liquidity management services and corporate market management for Citi Treasury and Trade Solutions North America.

“Within Basel III, the Tier 1 capital ratio is one metric corporate treasurers can look at in terms of the financial strength of banks,” Berkowitz said, noting that while Basel I included a Tier 1 capital ratio, the Basel III ratio is viewed as a much better indicator of banks’ financial strength. “It provides reassurance to the extent that banks have adequate ratios within the capital ratio requirement. And certainly, to the extent that they’re not meeting the minimum thresholds, it provides something that corporate treasurers need to look further into.”

 

Tracking Counterparty Risk

As corporate treasurers consider the possibility that one of their banks could run into problems, perhaps the biggest response has been an expansion in treasuries’ monitoring of their banks.

Dennis Gannon, a senior director with CEB, an Arlington, Va.-based advisory company, said the focus on counterparty risk has created “a new normal of due diligence and monitoring that goes on—bank reviews, heat mapping, contingency planning—that simply was not there 10 years ago.”

One practice Gannon sees emerging among treasury departments is the use of a counterparty risk dashboard to track the health of banks and assist in making decisions about which banks to use.

“Most of the analysis and dashboards are being done in-house, typically with some element of external automated data, whether it’s from Bloomberg or somewhere else,” he said. “Generally speaking, credit ratings, [credit default swap] levels and other indicators of bank health—Tier 1 capital ratios or things like that—will make up the bulk of the dashboard.”

Michael Berkowitz of CitiCorporations used to rely mostly on credit ratings to monitor their banks, said Citi’s Berkowitz, pictured at left. “Today it’s a much more nuanced view,” he said. “While credit ratings have a role, they’re essentially static instruments that are retrospective in the way they’re put together. There are now a number of other metrics corporate treasurers would look at.”

Some of things treasury teams look at can be evaluated every day, Berkowitz said, such as credit default swap spreads or stock and bond prices. “They’re also looking at financial metrics that are reported on a quarterly basis—the capital ratios, a financial institution’s equity base, liquidity, loan loss reserves, funding profile, and other business metrics, such as their geographic diversification,” he said. “Earnings stability would be among the other metrics we see corporate treasurers looking at.

“It’s become a lot more complex, but I think also a lot more balanced,” Berkowitz said.

“We’re seeing some of our clients using [Federal Financial Institutions Examination Council] data that’s available,” said Mark Webster, a partner at consultancy Treasury Alliance Group. “It’s got all the operating ratios—you can pull the operating reports for any bank in the United States and compare them to peer groups.”

The European sovereign debt crisis brought another change in treasurers’ assessments of counterparty credit risk, Berkowitz said. “A lot of the counterparty risk work had been geared to institutions, and now you had to start thinking about sovereigns as well,” he said. Corporate treasurers “are not only thinking about the counterparty risk of banks, they’re thinking about sovereigns and about other instruments they’re investing their short-term cash in as well, whether that’s commercial paper, money market funds that would aggregate commercial paper and other instruments, and so on,” Berkowitz added.

Edward Altman, a finance professor at New York University’s Stern School of Business who devised a formula, the Z-score, for predicting corporate defaults, cautioned that coming up with a method for predicting which banks are going to run into problems has proven more difficult than building a model to identify which industrial companies are likely to default.

“It’s my experience that failure prediction models have done fairly poorly when it comes to financial institutions,” Altman said. “It always seem that the latest banking crisis is caused by something fairly unique to the current situation and not necessarily correlated with prior bank crises.”

In terms of frequency, a CEB survey last year of more than 60 finance executives found that the biggest group, 32%, said they monitor their banks “as needed.” Twenty-one percent said they monitor their banks weekly, 16% do so daily, another 16% monthly, and 10% quarterly. Just 6% of the executives said their company had no monitoring process.

CEB’s Gannon emphasized that treasuries’ efforts don’t stop at monitoring. “On top of that is a mitigation strategy,” he said. “In the last couple of years, treasury teams have gone to the next level—knowing what to do if somebody gets to level we’re uncomfortable with, what’s our actual exit strategy.

“It’s monitoring for the sake of looking for triggers and thresholds that would make you take action to shore up your exposure or mitigate risk in other ways,” Gannon added.

Deloitte’s Dunn said the concerns about their banks also fueled companies’ upgrades of their treasury technology in recent years. “They’re leaving old systems and coming into systems that are robust, that allow them more flexibility to analyze the data and forecast their cash flows out into the future,” he said.

Companies used to rely more on banks for such data, Dunn said. “Now they want the information themselves so they can proactively manage it without waiting for the bank to tell them what their position is.”

Kavanaugh said he is seeing more companies using global liquidity structures, such as pooling, to better manage their cash positions. He said the trend was a response to risk, as companies work to gain increased visibility into their cash on a global basis, as well as an effort to improve their returns on that cash. “We’re in a very low-interest-rate environment, and companies want to increase their interest without increasing their risk.”

Mark Webster of Treasury Alliance Group noted that some companies, such as retailers, may end up dealing with banks that they view as somewhat risky because they need them in a certain region. “By doing pooling, you can use those banks but pull the money out.

“Pooling lets me move my balances, as long as I’m careful where I’m pooling them,” he said. “But if I’m pooling with Bank A, then I’m increasing my counterparty risk with Bank A, even though I’m pulling it from Banks B and C and D.”

Companies’ interest in being able to change providers quickly is a factor when they consider SWIFT, Webster added. “If I’m working with Banks A, B, and C and using them all through SWIFT, and something happens to A, with SWIFT it’s easier to switch.”

 

How Many Banks?

If companies are worried about stresses affecting their banking partners, one approach would seem to be to do business with a larger number of banks. But it’s not clear to what extent the concerns have influenced the longstanding trend of companies consolidating the number of banks they deal with.

Companies have been shrinking the number of banks they use, in order to improve efficiency and cut costs, said Treasury Alliance Group’s Webster. The worries about additional bank casualties mean “most corporate treasurers are saying, ‘We are not trying to get it down to one or even two, because we are concerned about counterparty risk,’” Webster said.

Companies are worried not only about their financial exposure to their banks, but about what a bank’s problems could mean for their operations, Webster added. “Long term, I may not lose any money, but short term if there’s a problem, there’s an operational risk,” he said. “I may have wires that don’t get out, or checks that don’t get paid or get held—problems that get cleared up but cause me some big operating problems in the meantime.”

CEB’s Gannon said he isn’t seeing companies expand the number of banks they deal with. “Bank group consolidation is still more or less the norm among large treasury teams.” Although companies are more aware of the value of a diversified bank group, “we still do see many treasury groups looking for one global bank or one regional bank,” Gannon said.

“Our advice is to at least have some layer of redundancy in relationships that allows you to, say, have a [new] cash management bank up and running in relatively short order,” he added. “It’s too expensive to have multiple cash management banks in one region, we understand that, but we’ve seen companies be successful maintaining secondary relationships with banks in volatile regions—so if something happened, it’s not a matter of having to get someone on the ground and opening accounts from scratch.”

John Colon, a managing director at consultancy Greenwich Associates, noted that even if large corporates want to do business with more banks, they face practical constraints on which banks they can work with.

“When you look at a big company, especially a big multinational, it has a particular set of needs,” Colon said. “Frankly, there aren’t that many banks that can meet that set of needs when I’m looking for banks that can provide me with global cash management or help with global supply chain finance.”


Read the September Special Report on Liquidity.

Related:
Getting a Handle on T&E
Should Companies Care About Bond Market Liquidity?
Rewriting the Rules: How New Financial Regulations are Expected to Impact Corporate Liquidity Management
The Next Evolution of the US Payments System

 

Page 4 of 4
Comments

Advertisement. Closing in 15 seconds.