Comprehensive counterparty risk monitoring was always a complex process. Today’s interconnected financial ecosystem has only served to amplify this complexity. Gone are the days when analyzing financial metrics was all that was needed to monitor counterparty risk. Now, everything from supply chain logistics to customer tweets and internal management issues can affect an entity’s business health. Given that numbers alone do not run the show anymore, counterparty risk monitoring should now include both financial and non-financial risk factors. In this blog, we take an in-depth look at counterparty risk monitoring and what it takes to conduct a comprehensive assessment of your counterparties.
What is counterparty risk?
Whether by choice, convenience, or compulsion, businesses need to interact with other entities as a part of their standard operating procedure. Counterparty risk is the probability that one of these ‘other parties’ fails to hold up their end of the bargain. Given today’s interconnectedness, one counterparty’s failure can easily put other entities in its business ecosystem at risk too (For a more in-depth look at counterparty ecosystems and why they need monitoring, check out part 1 of this blog series). Similarly, with financial arrangements, investors and lenders assume the risk that their borrowers may be unable to pay them back in full or that their investments may decrease in value over time. Such risks are part and parcel of the modern corporate environment. It is simply the cost of doing business in the 21st century. All of which makes the exercise of assessing and monitoring your counterparty’s business health an essential one today.
Types of counterparty risk
As we touched upon in our earlier blog, there are essentially two types of counterparty risk – quantifiable and non-quantifiable.
Quantifiable counterparty risk
The word quantifiable essentially means something that can be measured. Quantifiable counterparty risks, therefore, are those that can be calculated and assigned a numerical value to, making them easier to measure and monitor. If we take the example of a construction company, financial measures like the company’s cash flow, its credit rating, current evaluation, net profit margins, debt-to-income ratios, etc. are all metrics that can be calculated with decimal-point precision. These absolute values can then be used to measure the risk associated with investing or partnering with the company as any increase or decrease in them signifies a corresponding shift in counterparty business health.
Non-quantifiable counterparty risk
Non-quantifiable counterparty risks are ones that are ambiguous in nature and are therefore harder to measure. They are often risk factors that companies have very little control over, but which can, nevertheless, affect their ability to pay back corporate loans and/or stay in business. For example, even with great financials, the above-mentioned construction company can have real estate projects that derail due to external factors. These can include sudden environmental issues, political changes, accidents, or legal and non-compliance issues. The important fact is that while these risks may not have a computable financial impact on the company, they can cause problems that indirectly affect its bottom line. Even financial institutes are not immune to such risks. According to McKinsey, from 2008 to 2012, dealing with non-quantifiable risks such as operational mishaps and litigious events cost global banks around $200 billion.
Types of non-quantifiable counterparty risks
Systematic Risk
Systematic risks are threats that affect the entire market as a whole. Also known as volatility risk, market risk, and undiversifiable risk, such risks are never contained to a single industry, market vertical, or stock. They are usually caused by major social, political, economic, and environmental changes such as uncontrolled inflation, changes in interest rates, wars, political unrest, or catastrophic environmental events. Unfortunately, we do not have to look too far back into the history books for an example of systematic risk. The devastating Covid-19 pandemic serves as a classic illustration of an uncontrollable external event that caused economies to crash worldwide and affected almost every market segment and vertical globally.
Operational Counterparty Risk
Operational risk is the threat of losses stemming from a company’s way of doing business. These losses can be the result of flawed internal processes, a breakdown in corporate governance, fraudulent individuals, unsafe work practices, or unfair employment policies. For example, an understaffed or poorly trained sales team can cause a company to lose many sales opportunities. As you can see, such risks mostly arise from within the organization, making them distinct from other types of non-quantifiable risks. As operational risk changes from sector to sector, it should be an important factor when making investment or partnership decisions. A recent example of internal controls going awry is the Luckin Coffee fraud scandal. The discovery that the company’s chief operating officer had fabricated over $300 million worth of sales caused the Chinese beverage retailer’s shares to sink by 81%. The company also had to pay a $180 million fine levied by the SEC.
Reputational Counterparty Risk
Reputational risk is the financial threat that arises from external and internal events that adversely affect a company’s reputation. According to the World Economic Forum, almost 30% of a company’s market value is tied to its reputation. This being the case, reputational problems can cause a business to lose its brand value, precipitating an even bigger loss in terms of revenue and future growth prospects. And this is not just for the offending parties. Reputations can be tainted by association too. In 2013, US supermarket chain Target battled the reputational loss that came from a third-party data breach that left 40 million of its customer’s credit card data exposed. Even though the company was not at fault, the breach saw the retail chain’s sales fall by over 45% in the ensuing months. For smaller companies, such a dramatic loss in revenue may be impossible to recover from.
Systemic Counterparty Risk
Systemic risk is the probability that one negative credit event can set off a chain reaction of similar events, eventually bringing an entire system or industry down. A classic example of this is the Lehman Brothers collapse in 2008 which caused capital markets to freeze, sending the US economy into a windfall. While there have been several reforms and regulations introduced since then that aim at preventing this from ever happening again, systemic risk is in no way a thing of the past. It is therefore important to study the stability of your counterparty ecosystem and ensure that the interdependencies formed there do not lead to an accumulation of risk, which in turn could cause systemic failure to occur within your business network.
How to monitor counterparty risk comprehensively?
Counterparty risk cannot be avoided today. And what cannot be avoided, should at least be minimized and managed effectively. Part of managing counterparty risk is to evaluate your counterparties thoroughly during the loan underwriting or contract negotiation stage. Companies usually perform a stellar job at this, investing the time and investigative capacity needed to ensure that their business partners are credit-worthy and in good business health, to begin with.
However, not enough attention is paid to implementing a regular process of monitoring counterparties for signs of distress, financial and otherwise. In most cases, the initial watchfulness is followed by a bi-annual or annual counterparty review schedule that can prove ineffective in catching any sudden decline in the business health of a partnering entity on time. To be comprehensive, companies should abandon such sparse monitoring programs and switch to a system that tracks counterparties in real-time instead.
In addition, counterparty risk monitoring should include both quantitative and qualitative risk analysis to be comprehensive.
Quantitative counterparty risk analysis
Quantitative risk analysis is basically an examination of numbers and metrics. In other words, it is an analysis of all the financial data available on a business. Here, the numbers gleaned from company financial reports, analyst reports, past and present credit ratings, market analysis, and macroeconomic data are used to objectively evaluate a counterparty’s creditworthiness. There are several risk quantification measures. The following are some of the commonly used calculations that have historically shown a strong concurrence to counterparty risk:
Loss Given Default (LGD)
Exposure at Default (EAD)
Probability of default (PD)
Recovery Rate (RR)
Repayment Possibility (RP)
Expected Loss (EL)
Unexpected Loss (UL)
There’s no doubt that performing quantitative risk analysis is an important exercise when monitoring counterparty risk. After all, numbers rarely lie. However, relying only on this methodology has several drawbacks. For one, most of the information used is historical. It may therefore not give an accurate picture of an entity’s current financial health. For another, this kind of financial analysis is lagging in nature as it does not factor in forward-looking parameters sufficiently. Additionally, financial metrics cannot shed light on a company’s operational nuances, which, as we covered before, plays a pivotal role in maintaining its profitability and growth.
Qualitative counterparty risk analysis
Qualitative risk analysis is essentially the examination of unstructured digital data. This information is mostly non-financial in nature and can be found through online news sources, social media sites, and other digital portals. Such alternate information often contains a treasure trove of information that cannot be gleaned from a spreadsheet – the careful sentiment analysis of which can provide a more complete, current, and futuristic picture of a counterparty. A case in point here is the example of Greensill, a supply chain finance company based in the UK. In its last released financial statement, the company reported a profit of around $30 million. However, almost simultaneously, there were several news reports circulating that detailed the company’s problematic and opaque financing practices. This just goes to show the importance of augmenting financial analysis with qualitative data analysis if you want to get the full picture.
Of course, qualitative risk analysis is not without its complications. Such unstructured data can be difficult to measure objectively. And given that there are megatons of data available today, manually processing all of it to extract the relevant information needed is not a viable option. Moreover, the non-numerical nature of it also makes it harder to compare between different counterparties. Fortunately, AI-augmented monitoring systems such as TRaiCE can help overcome these obstacles. The TRaiCE BSI (Business Sentiment Index) is a digital risk index that collects, analyzes, and quantifies all the digital information available on an entity, making it easier for you to get one step closer to monitoring your counterparties comprehensively.
Conclusion
In most cases, a half-baked cake is inedible, unsavory, and hazardous to consume. What is true in the culinary world is just as true in the world of risk management and mitigation. Here, a half-baked approach to counterparty monitoring can produce disastrous results, as observed in the 2007-08 financial crisis. In today’s interconnected and often volatile economic environment, such an approach is fraught with risk. In the 21st century, due diligence in terms of counterparty risk monitoring requires that companies go above and beyond just quantitative risk analysis and include qualitative analysis as well. This will give them a more comprehensive and timelier assessment of their counterparties.
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