Refining Credit Risk Metrics

• Rating is not and will not be sufficient. The fact that the issuer pays puts a doubt on where the loyalty of the agencies lie. Ratings are seldom good early warning indicators either but they will probably continue to serve as a standard component for any credit risk model.
• Early warning indicators.
• We cannot 100% automate risk management which requires we have to include subjective measures or gut feel if you wish.
• Black Swan[1] – expect the unexpected and develop mitigation plans.
• Good local knowledge will remain key and increase in importance.

[1] A large impact and hard to predict, and rare event. "Black Swan" theory refers only to events of large consequence and their dominant role in history. The theory was described by Nassim Nicholas Taleb in his 2007 book The Black Swan.

Banks Balance Sheets Lacks Transparency

Counterparty risk is a major concern for corporates today especially if the counterpart is a bank. It is virtually impossible to understand the true risk that lies in its balance sheet making it very hard to manage the excess liquidity.

The banks must improve the accounting standards and make the accounts as transparent and open as the corporates. We need a paradigm shift in evaluating and regulating the financial sector.

HBR - 6 Mistakes in Risk and Working Capital Management

Treasury is getting on the agenda of the board as I have discussed earlier. This is proved by Harvard Business Review starting to discuss treasury topics. In the March edition of HBR they list 6 ways companies mismanage risk and in the May edition they list 6 mistakes or "don'ts" of working capital management. The articles are well worth reading. They describe the changing role of treasury when managing the cash flow has become more important than managing earnings short term. The first "don't" HBR lists in working capital management is "don't manage to the income statement". I agree - cash KPIs are here to stay.

“Fed Lacked Tools”

I here quote San Francisco Federal Reserve Bank President Janet Yellen from MarketWatch today: "Fed and Treasury Department suffered from a "shortage of tools" in preventing the collapse of Lehman Bros. in September".

Of course, the whole system was built up in an ambition to prevent bankruptcies and thus instability in the financial system. But it did not because it is not possible to regulate away bad management. This means that the whole Basel framework and the concept of 100% automated risk management and arm's-length banking has to be questioned.

The new regulatory framework must be built on relationship banking principles and a survival of the fittest environment for banks. The regulation has to shift focus from in detail describe how the banks' shall perform risk management to a system that can manage bank defaults from spreading into the real economy.

Research on Interest Rate Policies

The European Treasurers' Peer Group today released a survey on IR policies for corporates. High level conclusions:

• Corporates are generally inclined to adopt an active (i.e. adjusting to market expectations) hedging strategy on IR. The main reason is that it is hard to define what the corporation’s IR risk actually is.
• The board and management often have an opinion of expected interest rates.
• Natural hedges means matching interest duration with the underlying business with e.g. large part of floating rates since low rates are pro-cyclical to low earnings or a portfolio of long term investments with large portion of fixed rates to match.
• The interest rates are extremely low in a historical perspective and inflation is expected to rise. Several respondents assumed it is good time to change to a higher ratio of fixed rates.
• The increased counterparty risk makes it difficult to hedge long term ÍR with derivatives. With what financial institutions are you prepared to enter a 10 year IR swap?
• Banks sometimes opt on a certain interest hedging policy.