The process of counterparty selection and assessment has changed dramatically over the last few years. When I first started in this industry counterparties were almost selected on the basis that they were active and had demand or supply. For many years, once the business drivers were identified a simple check of a counterparty’s credit rating was sufficient. Approval was given based on a rating and a volume or revenue number and once business has begun a downgrade was often the only reason to re-assess. Some beneficial owners wouldn’t even go that far preferring to just rely on their agent’s indemnity – despite these ranging significantly in quality. Of course now that’s not an option.
In 2008 it became very apparent that credit ratings were fallible and now the counterparty selection process is more complex and robust. With balance sheet management taking centre stage, credit ratings are often just a first hurdle and lenders are implementing internal continuous analysis to ensure counterparties are financially sound. More dynamic measures, which have an element of immediate market sentiment, are being sought and used to monitor this. Many firms are using algorithms which take into account a number of different factors to manage counterparty credit and define the levels and types of business they are able to undertake by counterparty, with overall limits, term availability, and haircut levels being defined for each individual firm. A one size fits all approach, where all counterparties are treated the same is becoming less common, and indemnities are viewed as only one factor.
Of course this introduces a level of uncertainty to the business, with the possibility that credit lines can be adjusted rapidly if the market sentiment changes, when the markets and banks need more stability and predictability in supply. Finding the middle ground is difficult but it is important to ensure your counterparties understand your process and are engaged fully in the process.
Establishing the appropriate factors that are relevant to individual firms or funds is key, but even once this is achieved the challenges of constant monitoring and adjusting are many. Without focused resource the only way to manage the process efficiently is with an element of automation, compiling data, calculating the factors and producing analysis for review. We have seen a number of clients, both agent lenders and beneficial owners reviewing their processes and developing automated solutions in this area, which ultimately must be a positive development for the industry.