International Treasurer The Corporate Treasurer's Guide to Global Financial Management Apri l 3, 1995

Viewpoint

Banks & Derivative Counterparty Risk By joseph Neu

Recent events warrant more than a glance at bank counterparties' risk management prowess.

Corporate treasurers may not always see the financial risk management capabilit ies of their bank counterparties as a priority concern. Yet, the evidence is mounting that banks are not as adept at controlling their risks, especia lly those related to derivative instruments, as effectively as they would like everyone to believe. A per­ce ived increase in th eir operating risk and declining ea rnin g are beginning to impact bank cred it ratings.

A recent Wharton/Chase survey (see right), suggest that 35% of US corporate derivative users require a AA rating or better for their derivative counterparties. A f igure w hich rises to 60% when contract maturities exceed 12 months. This suggests that many treasurers­as they factor in a declining quality of ea rnings trend into credit limit reviews- may con­tribute to co ntinu ed ea rnin gs and ratin gs declines (a Catch 22) . Since most treasurers wi ll not wish to exit derivative markets entire­\'{ , 1T1ore should consider establishing bilateral OTC collateral arrangements (see "Collateral Support for Derivatives, " IT, 5/2/94) to manage increasing cou nterparty risk.

Trend factors

Obviously, it is easy to point to the biggest of the recent derivatives debacles: the billion dol­lar Barings loss. However, it invol ved an extreme wrong-sided bet on a futures index, re latively easy to manage, and not unidentified risks in propr ietary trading. Yet, you can see why it makes investors nervous: " If such prob­lems can happen trading futures, w hat can hap­pen with more exotic types of instruments?"

Systems inadequacies. Market vo latility and continued on back page

I Su rvey resu Its

1 Two Benchmarks for i Derivatives Use

Intense interest in corporate derivatives use has fed two new surveys: one conducted by Wharton/Chase and another by the TMA. Both aim to become benchmarks upon which the derivative activities of individual end-users can be compared to those of a wide sampling of US companies as a group.

Both the Wh arton/C hase and TMA surveys provide data to answer the questions everyone seems to want to know: who's hedging/trading what, how, and why? And more. A summary of their results was presented M arch 29 at a forum held at Coopers & Lybrand's offices in

1 New York. The briefing was sponsored by the Ce nter for Study of Fu tures and Options Markets at Virginia Tech and the TMA. Some highlights are below.

Wharton/Chase

A summary of the Wharton/Chase data was presented by Chase Manhattan Senior Vice President Charles Smithson. This survey was co ndu cted by the Wharton School's Weiss Center for Internat ional Financial Research w ith

How often does firm use derivatives to ...

Seldom to frequent ly Never

Hedge I ba lance sheet 40.4% 51.9%

I Hedge contract 75.4% 18.6% I comm"meot<

Arbitrage markets

1 to reduce 31.7% 60.7% funding costs

I Take a view to reduce 40.4% 52.5% funding costs (8.2% frequently)

Source: \r\lharton/Chase Survey, Executive Summary

continued on page 6

Banks & Derivative Counterparty Risk By Joseph Neu

Recent trends signal negative cred it ri sk and a need for coun­terparty limit rev iews and bilateral co ll ateral cons iderations.

page 7

Two Benchmarks tor Derivatives Use A briefing on the recent Wharton/Chase and TMA derivative end-user surveys.

page 7

Fuller's Use of EXIM Financing A middle market trea­sury helps its company finance sales to growth niarkets.

page2

Treasury's Role in Vendor Leasing Treasury invo lvement in program structuring and sa lesforce educa­tion pays dividends.

pageJ

Treasury Uses for US llCs By Raymond Young Price Waterhouse

Limited liab ility com­panies can be useful in Not1h American treasury organization and tax planning.

page4

london's Risk Systems lacking A Touche Ross (UK) survey reveals inade­quacies of financial institutions' risk man­agement systems.

page7

I

The Back Page

continued from page 7

adverse directional moves are part of the risks of tradi ng: risks that are supposed to be man­aged to prevent signi ficant losses. Perh aps, then, the root cause of the current ea rnin gs declin es is the inadequac ies of ri sk manage­ment systems (see the Touche Ross survey pro­f iled on p. 7). Even if the institutions w ith slid­; ng earn ings have state-of-the-art systems in place, "state-of-the-art" may not be enough.

O ne problem is that hardware and especiall y softwa re deve lopers have fo un d it hard to build in enough f lex ibility to keep pace w ith product innovation and customer demand. Propri etary sys tem s deve loped in -ho use , meanwhil e, prove expensive and ri sk being out-dated before completed-either in terms of th e product ri sks th ey were designed to manage or the way in wh ich these ri sks are measured. What's worse, product innovation and competitive pressures force banks to do deals before the ri sks are fully identified and tailored ri sk contro l systems are put in p lace.

These and other factors prevent an aggrega­tion of ri sk ac ro ss ri sk types and markets. Banks, therefore, often lack a timely, compre­hensive pi cture of how much of their capital is at risk.

Ratings agency moves. Such operat ing risk is prompting a response from ratings agencies. In his Ma naging Financial Risk, 1995 Yearbook, Chase Manhattan's Charles Sm ithson, notes some of their positive and negative comments on deri vatives. O n the positive side, Standard & Poors' has supported US mon ey ce nter banks' continued presence in derivatives mar­kets. Thi s has strong impli cat ions for industry conso l idation. Much more is being sa id and done on the negative side, where S& P has been watching banks' poor trading resu lts, and moved to either change some banks' debt out­looks or downgrade their rating.

After the infamous f irst half of 1994, S&P noted how "good risk management and diver­sity of trades are not as great safeguards as expected w hen markets converge in periods of stress ." Starting with Bankers Tru st in M ay 1994, these factors, along w ith " reputat ional ri sk, " we re ci ted as reaso ns fo r debt down­grad ings.

Investors, creditors, and trad ing counterparti es (as well as the financi al press) a1·e all watching thi s declining earnings trend closely as it con­tinu es. Th e March 28 Wa ll Street jo urn al, reported a Goldman Sachs $272 million dollar private debt issue that drew surprises fo r its need to pay a hefty 238 basis points over 10-

8

Year Treasuries. While limited pa rtnershi p con­ce rn s are present, tradi ng/ ri sk management fears are also a factor.

Followi ng closely on th is event, S& P is signal­in g negat iv e lo ng-term debt o ut looks for Go ldman Sachs as we ll as Bear Stearns, CS Fi1·s t Boston, Morgan Sta nley, PaineWebber, and Sa lomon, due to "the depth and duration of the earnings downturns." Bankers Trust (A2/A, subordinated), also continues to be battered. It offered debt recentl y at a spread of 112.5 bps over the seven yea r, w hich rose to plus 11 7 bps and sti ll went largely unsold according to C i t icorp's M arc h 27 US Ca pita l Markets W eekly Update.

With Glass-Steagall wa lls close to fa ll ing, the market seems ripe for consolidati on . On their own, however, consolidations w ill onl y mask the severity of losses with more assets.

If this is wrong, tell me why

Given these trends, fi nancial regulators wi ll be coming eve1· more persuasive ly back to the logic of the Fi sher Report (see IT, 1/9/95). Namely, that banks should see it in their in ter­est to disclose information to the market. What they disclose should demonstrate the effective­ness of th eir ri sk management and contro l in frastructure. Otherw ise, investors, cred ito rs, and customers are left to assume the worst w hen confronted w ith information about rat­ings downgrades and surveys suggesting sys­tems inadequacies.

Corporates ca n expect to see more pub li c di s­closure from their key bank relationships. They should read it and ask some less pub lic ques­tions as part of their bank eva luations. While a burd en admini strati ve ly , co ll ateral may be needed if responses are less than reassuring.

Regulators w ill soon be ask ing corporates to disclose too. And under OTC Code of Conduct guidelines (see IT, 2/6/95), banks may be ask­ing qu est ion s of the ir co rporate customers regarding ri sk management and contro l infra­structure- e.g., independent pric ing and ri sk measurement capabili ties.

Meanwhi le, ratings agencies and market ana­lysts, w ill be looking to reward f irms (bank and non-banks) th at disclose pos itive in fo rmation about ri sk management. For cmporate end­users, this is reason to disclose efforts to man­age financia l ri sk: both exposure to externa l market forces and the r isks generated by th e f inancial instruments (including counterparty cred it risk) employed in the process. •

Editor & Publisher Joseph Neu

Contributing Editors H al Davis

Donald Dunn

Professional Contributors Robert Herz

Associate National Director of Accounting and SEC Services

Coopers & Lybrand

Peter Connors Director, Tax Services

International Capita l Markets Ernst & Young

Jeffrey Wallace Managing Director

Greenwich Treasury Advisors

David Veres Partner

Rogers & W ells

Corporate Advisors Hans Pohlschroeder Assistant Treasu rer Colgate-Palmolive

David Ru sate Assistant Treasurer

Genera\ {:h•c..\m

Arvind Sodhani Vice President and Treasurer

Intel Corp.

A. John Kea rney Assistant Treasurer

Merck & Co.

juanita Hinshaw Vice Presidenl and Treasurer

Monsanto

Academic Advisors Lee Remmers

Professor INSEAD

Donald Lessord Professor

M assachusetts Institute of Technology

Ricl1ard Levich Professor

Stern School of Business New York University

Steve Hanke Professor

The Johns Hopkins University

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International Treasurer/April 3, 1995