Risk Management Watch: Managing Counterparty Risk in Focus
Almost 60% of European and U.S. institutional investors believe another large financial firm will collapse within the next six months, according to a survey by Greenwich Associates. The study also finds that more than 75% of those polled see counterparty risk in credit default swaps as a serious threat to global financial markets.
The Counterparty Risk Management Policy Group III recently issued a report addressing the need for reform to address systemic risk. The group, comprised of senior management from major financial institutions, contends that only when risk monitoring is effective and critical information flowing into and out of risk monitoring processes can be distilled and compiled in a coherent and timely manner and made available to risk managers and key business leaders will there be reasonable prospects that business judgments can better anticipate and respond to contagion and systemic events. The Policy Group recommends that “large integrated financial intermediaries ensure that they employ robust, consistent pricing policies and procedures, incorporating disciplined price verification for both proprietary and counterparty risk trades.”
Now more than ever, firms are realizing the strategic importance of risk management. Corporate boards today face unparalleled levels of business complexity, new regulations and mounting shareholder demands. As a result, executive search firm, A.E. Feldman, says risk management jobs are evolving to better manage counterparty risk as well as initiatives to ensure that business objectives are met, losses are minimized and greater accountability is achieved. In short, risk is the name of the game.
In the wake of the collapse of Bear Stearns and amid widespread speculation about the financial health of other global banks, Greenwich Associates conducted a study of 146 institutions in North America and Europe (32 hedge funds and 114 banks and traditional long-only investors) to investigate how fears of counterparty risk were affecting institutional investment and trading strategies.
Among the vast majority of U.S. institutions, default swap (CDS) counterparty risk is a growing concern. In fact, 85% believes it represents a serious threat to global markets. Slightly more sanguine, 55% of institutions in Europe describe CDS counterparty risk as a significant danger. Hedge funds however, remain the most apprehensive. “At the other extreme are hedge funds, more than 90% of which said they see counterparty risk relative to credit default swaps as posing a significant threat to global markets,” says Greenwich Associates Consultant, Jay Bennett.
Moreover, the study also shows that most of the institutions surveyed believe another major financial services firm will fail as a result of the ongoing crisis in global markets - and they expect it to happen sooner rather than later. Almost 60% of survey respondents say they expect to see another major financial services firm collapse within the next six months. Meanwhile, another 15% think it will happen in six to 12 months. Greenwich Associates does however, reveal that he world’s largest and most sophisticated investors are less pessimistic than other investors.
“If you are looking for a silver lining in these findings, it seems that most institutions think we are currently in the most dangerous period for global financial services firms. Perhaps if the markets can make it through the next six months, the level of pessimism may begin to subside,” says Greenwich Associates Consultant, Frank Feenstra.
Nearly 80% of the institutions participating in the Greenwich Associates survey say their banks have tightened margin or collateral requirements since the outbreak of the global credit crunch. “The survey results indicate many of the banks widely viewed as being hit hardest by the credit crisis have been the most aggressive when it comes to tightening the margin and collateral requirements imposed on their trading clients, but even banks that have emerged relatively unscathed have tightened terms,” says Greenwich Associates Consultant ,Peter D’Amario.
Concerns about counterparty risk have caused institutions to cut back on their use of CDS, Greenwich Associates survey shows. Among fixed-income survey participants that employ CDS, 62% say increased counterparty risk has caused them to limit their use.
Among the survey’s findings:
- The most common method of managing counterparty risk (used by more than 70%) is to trade only with the most financially sound banks and broker dealers
- Almost 65% of participants also say they try to limit the concentration of exposure with a single counterparty
- About one-third of participants say they make use of cross-collateral arrangements and 5% say they use exchange products for hedging
Additionally, there is strong and growing support for a centralized CDS clearing system. According to the Greenwich Associates survey, 75% of the institutions polled say they believe the establishment of a centralized clearing entity would be effective in mitigating CDS counterparty risk. The survey also finds that seven out of 10 hedge funds say they would rather use a clearing entity operated by an exchange than one operated by the banks.
To learn more or inquire about job trends in risk management the lines of communication are open. Contact the Mitch Feldman, President of A.E. Feldman, and the firm’s executive recruiting team here.
