Routine Counterparty (CP) Credit Risk Reviews – Alternatives Proposed

Does ‘an Annual Review for every CP’ make sense?

Most text books and training sessions, hence most in-house credit policy documents, stipulate that every customer (and often suppliers as well) should be reviewed as to credit worthiness at least once every year. Such a review usually coincides with publication of annual financial statements by the Counterparty (CP).

This methodology harks back to the early half of the 20th century, after WWII, when change was linear (slow but steadily positive) and most Counterparties published audited financial statements or were fully covered by acceptable collateral.

Apart from the odd market collapse, each of which was discounted as an aberration and after which the steady state resumed, most CPs’ businesses progressed from year to year. Therefore the annual review merely served to satisfy auditors and bank regulators that enough diligence was being applied to keep the creditor companies and banks respectively safe from suffering excessive bad debt.

As we approached the second millennium, by the Gregorian calendar, the linear progress steady-state had evaporated but even as we draw near to 2015 most corporate and bank policy documents still require annual credit risk reviews for all Counterparties or Clients.

Credit Risk Review Policy Revision Recommendations

Regarding the timing and required depth of CP Credit Risk reviews each organisation should adopt a policy appropriate to its particular circumstances. Therefore this discussion highlights some alternative policy approaches in order to provide ideas to be considered by policy makers.
It is submitted that the most appropriate approach for a business to adopt may be the application of a different assessment and review policy to each of several sub-portfolios identified within the overall counterparty array.

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ALTERNATIVE RISK ASSESSMENT AND REVIEW POLICY OPTIONS DISCUSSED IN THE ARTICLE

Why not a ‘no credit analysis or review at all’ policy?
1. Building a sub-portfolio of diverse counterparties that are not financially transparent and/or are ‘start-ups’
2. Restricting CP exposures to a ‘short-list’ of what are considered low risk entities.
What about the 80% of Counterparties that warrant regular review?
1. Proposed Review-Minimum Policy for Relatively Minor Exposure CPs
2. Review Policy for CPs that do not Qualify for the Review-Minimum treatment

What about CPs that are Margined, should they be treated differently?

The Article Conclusion

The identification of sub-groups within your risk portfolio and application of the appropriate review policy to each will both improve the efficient use of expertise and reduce risk overall.

Adopting this approach will enable internal credit risk assessment and management experts to dedicate more time to monitoring higher risk counterparties and the relevant business environment. To read the article click here.