Why KYB should be at the forefront of corporate treasurers’ thinking

By:
Carol Dean
Published on:

Corporate treasurers are reassessing bank counterparty risk and re-engaging with the mantra of know your bank (KYB) as a direct result of the onslaught of new financial regulation impacting the banking sector.

The UK’s Association of Corporate Treasurers (ACT) recently noted in a report: “Credit risk arising from exposure to banks and other financial counterparties is often much larger than credit risk from an organization’s sales.”

With 30 relationship banks, the UK-based utility company National Grid has short-term – up to 365 days – and long-term counterparty limits for banks.

“We monitor all exposures against banks such as deposits and derivatives,” says Malcolm Cooper, global tax and treasury director. “If we exceed limits, we’re not allowed to trade with the bank.”

However, this doesn’t preclude National Grid from using a bank outside the group of 30 if it is offering an interesting idea.

As companies have held back on investments or acquisitions during the financial crisis, many corporates are now holding billions of euros/dollars of cash on their balance sheets. Treasurers need to stay aware that counterparty risk is a crucial part of risk management whether in relation to deposits, derivatives or borrowings.

 
 Martin O'Donovan, ACT
“Given the low interest-rate environment, there is a danger that in the search for yield depositors take on too much risk,” says Martin O’Donovan, deputy policy and technical director at the ACT. “Professional treasurers will know that the security and liquidity of cash takes priority over yield.”

In the new bank bail-in regime, bondholders and potentially depositors, in addition to shareholders, could be on the hook to help bail out a bank rather than the taxpayer.

However, while more bank creditors benefit from collateral or are preferred creditors, unsecured corporate creditors will come last in the pecking order with a disproportionate risk. “Perhaps more treasurers will want to receive collateral too?” says O’Donovan.

Cooper shares the concerns over counterparty risk in relation to deposits. Under the bank recovery and resolution directive, which is not expected to come into force until 2018, if a bank fails then deposits from large companies could contribute towards the cost of a bank failure.

“In one extreme, a company could lose money, while on the other it could take many years to get the cash back,” says Cooper.

If treasurers think their wholesale deposits carry an excessive risk, given the proportion of secured creditors ranking ahead, then those deposits could become hot money. Measures to make banks safer could perversely make bank liquidity more volatile.

“The risk [of putting money on deposit] is probably disproportionate to the return, as we don’t get much more than Libor, although banks do provide liquidity enabling companies to get their money back at short notice,” says Cooper.

“If a bank is offering a high yield then a company should be sceptical of that bank,” Cooper adds, highlighting that Iceland’s banks did just that before defaulting and were subsequently nationalized.

Diversifying from single bank relationships to other counterparties, such as corporate commercial paper (CP), or money market funds (MMFs), improves a company’s risk, the ACT notes. Bank credit ratings have deteriorated since the financial crisis and companies should be aware of bank ratings and their outlooks too.

Lars Cordi, vice-president and treasurer of Danish drinks company Carlsberg, says: “Our preferred way to manage bank counterparty risk is to aim for having a net-debt position versus the banks or by having netting agreements in place.

“To the extent we have a need in certain markets to place bank deposits, we strive to spread the risk on a number of the best-rated banks.”

National Grid manages surplus cash using bank deposits and MMFs and segregated funds that invest the money in an array of investments, including corporate CP and corporate bonds.

“You have to think about the counterparty risk,” says Cooper. “The best-rated banks may not pay the best yields, but if everyone put money with the more highly rated banks, such as HSBC and JPMorgan, they may refuse to take them. Credit ratings [of banks] are important as are reputations.

KYB is a mantra that is even more pertinent given the adoption of capital adequacy regulations under Basel III, although the premise behind the regulations is to make banks stronger and more robust.

“Banks have raised capital since the crisis to comply with Basel III regulations, but we think they need more,” says credit strategist Alberto Gallo at the Royal Bank of Scotland in a recent note. RBS calculates that the largest banks in Europe might need closer to €492 billion of gross capital and will have to cut assets by €1.8 trillion in the next few years.

Not surprisingly, treasurers are finding it difficult to understand the impact these new regulations are having, or will have, on the financial system, in particular the banking sector.