Counterparty risk continues to feature highly in the minds of advisers and investors, especially in relation to structured products. Advisers need to be able to show they have followed a due diligence process that justifies the use of products backed by a particular bank.

Counterparty risk, otherwise known as default risk, is the risk that an organisation does not pay out on a credit derivative, credit default swap, credit insurance contract or other trade or transaction when it is supposed to.

Risk assessment

For structured products, counterparty risk is the risk of a client losing money not because of the performance of the product, but because of the failure of the bank that backs the product.

Advisers are well-versed in assessing the investment risks associated with myriad products available but for many people counterparty risk is relatively new and there is no easily accessible independent assessment of it.

Even the professionals and regulators can be caught unawares, as the Lehman Brothers debacle illustrates.

The best that can be done is to put in place a framework that illustrates that due diligence has been undertaken and that, at the time of sale, it was reasonable to assume the institution in question would still exist at the end of the product to pay investors what they would be owed.

To this end the following five factors need to be considered:
Credit rating
Credit default swap (CDS) rates
Financials
Share price
Bond yield

1. Credit rating

There are three main credit rating agencies: Standard & Poor’s, Moody’s Investors Service and Fitch Ratings. They provide well-known letter-based ratings ranging from AAA as the most creditworthy to C for exceptionally high levels of credit risk. But, as was shown in the case of Lehman Brothers, which all three agencies rated at least A at the time of its demise, they can make errors.

Credit ratings have more than one component: the rating itself and a rating outlook and rating watch.

The rating outlook, which can be positive, negative or neutral, indicates the likely rating trend over a one to two year period. It reflects financial or other trends that have not yet reached the level that would trigger a rating action, but which may do so if such trends continue.

The rating watch indicates a heightened probability of a rating change and the likely direction of such a change. These are designated as ‘positive’, indicating a potential upgrade, ‘negative’ for a potential downgrade, or ‘evolving’ if ratings may be raised, lowered or kept the same.

As a snapshot, the basic credit rating provides a sensible starting point for analysis.

2. Credit default swap rates

The CDS rates reflect the cost of insuring the risk of a counterparty defaulting. These rates are expressed in basis points, so a CDS rate of 162 would equate to an annual premium of 1.62% of the amount invested to insure against default by the counterparty. The higher the CDS rate, the more likelihood there is of default.

CDS rates vary over time so it is worth looking at where the rate stood over the past year and where it stands relative to other counterparties.

CDS rates are available from a number of providers’ websites.

3. Financials

There are many ratios that can be calculated from a counterparty’s report and accounts. Many of these might be found on the counterparty’s own website or on financial websites.

Numbers to look for in particular are Tier 1 capital ratio and regulatory capital ratio – in both cases the higher the number, the better.

Also worth exploring are liquidity ratios, such as the interbank ratio – money lent to other banks divided by money borrowed from other banks – (again the higher the number, the better) and net loans divided by total assets (the lower, the better).

4. Share price

The trend in the share price will give an indication of what other people are thinking about the outlook for the bank, and is worth looking at when comparing counterparties.

5. Bond yield

Find a bond issued by the counterparty and look at the yield. If it is rising then the market is demanding higher rates for lending to the counterparty, suggesting confidence is falling. In the absence of a yield chart, use a price chart and turn it upside down.

Both share prices and bond yields need to be compared to trends among peers and in the market as a whole to give a true perspective.

Keeping tabs on a counterparty

How can all this information be used? The following table gives an idea of how the above might be incorporated into a scoring system that can be used to show consistency of approach and provide a methodology for keeping tabs on a counterparty over time.

Counterparty scoring system
Indicator	Indicator range	Score
Credit rating	AAA to A	3 points for AAA down to 1 for A
Rating outlook	Neutral, positive, negative	0, +1, -1
Rating watch	Positive, negative, evolving	+2, -2, 0
Credit default swap rate	0 to no cap	Deduct value expressed as a %.Eg. CDS 162 = -1.62
Tier 1 capital ratio		Add value to score
Regulatory capital ratio		Add value to score
Interbank ratio		+1 for >100, -1 for<100

Further rows can be added for other variables and a record of scores maintained for comparison with other counterparties and as an historical record of how a counterparty is faring.

All the data that is used will be historical, hence the importance of looking at trends, rather than just a point in time, to make a fair assessment.