Countering Counter Party Credit Risk in Developing Countries
– Nitya Jain
Counterparty credit risk is a chance that the other party involved in a transaction may default before the settlement of the transaction. This in turn leads to bilateral risk of loss for both the parties. The nature of this risk is bilateral because the eventual exposure post close out can turn into an asset or a liability. This makes proper credit assessment very necessary. Banks face this risk not in lieu of loans but in derivatives when the counter party fails to honor its commitments in relations to hedging, settlement, trading or various other financial transactions.
When private investors and sponsors venture into foreign countries, especially developing countries, counterparty credit risk becomes one of their main concerns. Often there is also regulatory or political uncertainty surrounding a transaction in developing countries thereby making it inevitable for the lender to try out all mitigation techniques. Notably, Counter Party credit risk can never be completely eliminated but can only be reduced.
Lenders and Investors while investing in developing countries look for ways of risk mitigation especially in cases where financial and credit assessments are not transparent. The financial regulatory norms of the developing nations often fail to curb the exposure to risk. There is a lack of banking supervision and effective financial institutions to ensure smooth working of the financial system. The BASEL recommendations II &III have also pointed out the lacunas in form of future requirements, namely, prompt corrective action, consolidated supervision, legal mandate to impose higher capital requirements, confidentiality rules etc. The II BASEL Accord has effectively instructed the banks in developing nations to catch up with credit risk concepts and measurement tools used by the banks of developed nations. Other challenges include – lack of risk data, high cost of implementation, lack of transparency and discipline.
The most obvious method that parties opt for while mitigating this risk in developing countries is by trading with only specific parties. They opt for counterparties with excellent credit reports so that the chances of them defaulting in future are overall low. However, trading selectively is not a full proof plan. Most of the counterparties do not have their independent credit ratings and their financial positions are ambiguous. Moreover, it is clear that even in developed countries there have been instances where parties with excellent credit ratings have miserably failed to honor their financial commitments. One of the biggest examples can be the case of Icelandic Banks of 2009 which thereby resulted, 3 major banks with triple ‘A’ credit status tumbled into financial crisis. Another example would be the fall of Lehman Brothers, when it became clear that apparent protection in actuality will be useless in case of a default of the derivative provider – unless one is prepared to deal with counterparty risk.
When a private lender or sponsor invests in a developing country protection from credit risk becomes inevitable to make the investment cost effective and timely keeping in mind the financially unsupportive background of the country. In this regard, the lender primarily looks up to the government of that country. This can be informed of a put and call option agreement or a guarantee given by the government. Basically, the lenders want to government to become the guarantee for the counterparty. Originally counterparty is supposed to cover the serviceable charges. In case it fails to cover them, the government shall excuse the non-payment. There can also be substantial payments arising from unforeseeable events like legal or political events, and originally the counterparty is supposed to bear them. In cases of such events, the lenders eventually look up to the government for support and stability. The government usually exempts or provides reliefs on these cases. However, as lucrative as this option may sound, most of the governments refuse to provide such guarantees. The reasons behind the refusal is simple – it burns a huge hole in the pocket of the government and often such liabilities are not worth the tax payer’s money. The common approach now a days is that of asking for non-binding external support from the governments, but not a secure guarantee.
Apart from Governmental support, there are numerous techniques that lenders deploy for securing their credit. One of them is by deploying guarantees multilaterally. Such guarantees can be in a form or loan or payment. Numerous institutions including the World Bank, the African Development Bank also run a guarantee program and various other banks are also considering similar initiatives. Another one of such options is procuring political insurance. It is a risk insurance that safeguards investors from the sudden unfavorable actions of government like civil unrest, terrorism, expropriation and various force majeure events. Further there are Export Credit Agencies which have special schemes for safeguarding investors from counterparty credit risk in developing countries. Herein they provide credit enhancement through banks, insurances or guarantee policies. The foreign investors also resort to standby letters to mitigate any possible risk. They arrange a standby letter of guarantee from a bank as a bank security. Other than these strategies, one of the most commonly used method is close out netting which allows amounts owed to a counterparty to be offset with those owed by the other counterparty. But this is possible only in cases of bi-directional transactions.
Developing Countries need foreign investment to enhance their economy. For this purpose, it is important for them to strengthen their financial system which would safeguard the investors from risk exposure. While every country is unique in terms of its market structure and needs, counter party credit risk is till date one of the biggest challenge that investors face while venturing into new countries. Herein credit enhancement becomes vital for private investors and lenders. The international financial reporting standards (IFRS) also requires all entities involved in international derivative transactions to consider Counter credit risk in the accounting fair value. A range of strategies are deployed by investors to counter the counterparty credit risk but a long-term solution lies only in revamping the internal financial structure of the country. Recent doubts concerning the constancy of major global financial institutions has increased the importance of managing counterparty credit risk. The ever evolving landscape of the market requires financial institutions to increase their reliability and credibility in terms of quantification and management of risks, both from an internal and a regulatory perspective. With this the significance of internal structures and regulatory frameworks to mitigate the investor risk also should also not be underestimated.
This article is authored by Nitya Jain. She is a fourth year student of law at Nirma University.