Issues around insolvency of counter parties

Business works best when the parties to transactions can deal with each other with no fear of the sudden demise of the other party. It is part of capitalism that businesses fail, and indeed part of globalisation that countries fail too. Therefore we should prepare for it. It is a relatively new concept in corporate treasury. Treasurers did consider the credit risk of banks prior to 2008, but on a very low key basis and actually spent more time trying to sell their own credit.

We are used to credit risk in our trading operations in the form of receivables and the overall customer /supplier relationship but in dealing with banks, the numbers are usually larger by a whole scale of magnitude. Even if we are an overall borrower from the banking sector, there are usually some places where there is risk:

• There will probably be some cash on deposit somewhere in a large group
• There will be cash in the process of collection in the banking system through any medium such as correspondent arrangements, cheques, wires, ACH and cards, possibly exposing us to secondary insolvencies
• There will be cash in set off arrangements such as notional pooling designs and even in concentration systems prior to the physical concentration
• There will be derivative contracts in the money
• There will be letters of credit and bank guarantees in favour of the corporate
• There will be custodianship arrangements for investments, especially in pension schemes

Insolvency of bank counterparties

Unlike the corporate sector, where there are often warning signs, the insolvency of a bank will always be a surprise. In the case of Lehman, for example, deals for a trade sale were on the table until very late and even staff did not really think that the bank could ever actually fail.

In the case of Lehman, several issues arose which provide lessons for treasurers:

• Many counterparties of the bank could not lay their hands on documentation such as ISDAs
• Lehman could not lay their hands on documentation such as ISDAs
• Many counterparties did not understand what the documentation actually implied
• Much documentation was out of date or did not reflect the underlying commercial situation
• Set off of credit and debt balances are complicated
• Custodianship arrangements were, while seemingly compliant, actually quite weak

Of particular interest were the custodianship arrangements, where assets are held for the client and not taken onto the books of the bank. It is akin to stock remaining in the ownership of a supplier, such as with consignment stock. This arrangement is common when dealing with solicitors and in pension funds, where assets such as shares are held in nominee names ‘to the order’ of the client. Even cash was held by Lehman in this way, causing particular problems. It is worth asking your custodian exactly how your arrangements work. Could anyone else, for example, lay a claim to the assets held to your order in such arrangements?

The obvious lessons here are:

• Control your exposure
• Know your exposure
• Keep your documentation to hand
• Understand your documentation

By Will Spinney