By Ian Tobin, head of portfolio risk at Brady
The great irony of credit risk is that the harder it is to keep up, the more important it is to be ahead.
The problem is, today’s world is rife with geopolitical unpredictability. The US/China trade war, Brexit, prolonged low-interest rates and world leaders with something of a chaotic streak – not to mention a host of market-specific scenes such as the effect of US sanctions and Iranian activities on crude oil. Risk officers face a great geopolitical risk logjam of the likes rarely seen before.
In a globalised economy, everything is interlinked, and any one or any combination of these could derail a carefully planned counterparty credit risk strategy, through direct or indirect exposures – giving credit risk functions more to keep up with than ever. At the same time, all this risk is making boards nervous, and they are piling on pressure for those credit risk managers to be ahead of the game.
Some events are easy to anticipate – set pieces like Fed rate cuts for example. Others are more of a surprise – such as the Iranian drone attack on Saudi Aramco that caused a steep, if brief, crude oil price spike. In the last week, a deadlock on the new Brexit deal in Parliament has driven the latest in an apparently never-ending parade of politically driven currency swings. Even as the week drew to a close, on news that a revised withdrawal bill had been agreement, the British pound shot up from 1.23 to 1.29 against the US dollar.
However, as risk-sensitive as these scenarios are, sudden movements in commodity and currency markets are not the only events firms need to be alert to. In fact, businesses with particular exposure, regardless of the asset class in question, need to be aware of the liquidity risks associated with rating downgrades to customers and themselves.
At the drop of a geopolitical hat, counterparties may decide to mitigate their own risks by lowering credit limits, demanding upfront collateral or guarantees. The trouble is that, if a counterparty doesn’t have the reserves to fulfil additional collateral demands they run the real risk of going bust.
With all this in mind, businesses must find a way to dynamically manage credit risk and keep up with unpredictable events – easier said than done. Unlike some of the major FTSE listed corporates, mid-sized businesses don’t have an army of risk experts on-hand. Often, the smaller end of the market will attempt to manage risk by manually entering in key information into spreadsheets. While this may do the job when there are only a few trades, things can start to go wrong very quickly when that news breaks and it only takes one inputting error for all to go awry.
An alternative approach could be assessing the full risk profile of trading counterparties from a qualitative, as well as quantitative, perspective. This means pulling in all trades from across the organisation, indexing them properly and bringing powerful real-time analytics to bear on the data.
That changes the game from simply understanding what’s happened, quicker, to empowering the credit risk function to start asking questions. What if sanctions are tightened tomorrow – what would my exposure be? What about a second unexpected rate cut? What if both happen?
Add: how long has the debtor been trading, what state is their balance sheet in, and crucially, do they pay on time? Depending on the answers, a credit limit recommendation can be made which enables a firm to determine whether they need to take on less, or on occasions, more risk.
By being able to both ask these questions ahead of time and instantly understand the impact of an event in real-time, risk officers are able to deliver the heightened level of both insight and foresight that boards – and today’s geopolitical logjam – increasingly demand.