Reconsidering bank counterparty risk metrics and defenses

Companies are reviewing the mix of metrics they use to track the risk of bank counterparties. And they are taking a variety of actions to reduce harm should a relationship bank fail.

By John Hintze

The initial panic among banks’ corporate customers after the collapses of Silicon Valley Bank and other large regionals in March quickly evolved into discussions among corporate treasury executives about how to best gauge bank-counterparty risk and prepare for future bank failures. One executive impressed peers by describing a company system that pulls together API-assisted feeds from internal and external data sources to generate a daily report that an assistant treasurer receives at 6 a.m.

The report updates the status of the company’s banks, and if one blinks red then money may be transferred from it to another bank within hours.

The executive participated in one of several focus groups over the summer organized by the NeuGroup, which facilitates communication among corporate finance executives of mostly Fortune 500 companies to address issues in common. The aim of the focus groups is to delve into its members’ responses to a survey NeuGroup conducted in June about corporate treasurer departments’ reactions to the bank failures.

The survey’s findings echo insights from other sources, including a separate survey by the Association of Financial Professionals and advisers working closely with banks on asset-liability-management issues. Companies are reviewing the mix of metrics they use to track the risk of bank counterparties, and they are taking a variety of actions to reduce harm should a relationship bank fail.

One common action began last year, if for a different reason, and may impact companies’ relationships with their banks longer term. Before the Federal Reserve began hiking short-term rates at record pace in spring 2022, many companies were shifting operational funds away from bank deposits into money market funds, primarily in search of higher returns. While bank deposit rates have risen since, the turmoil in the banking sector last spring accelerated the trend, at least for a time.

Half of respondents to the NeuGroup survey reported shifting deposits to MMFs. The majority of the NeuGroup’s 280 member-companies were not directly exposed to the failed regional banks, because of their size, says Nilly Essaides, managing director of research and insight at the NeuGroup. Nevertheless, SVB’s demise was a wakeup call for all companies and preceded other bank troubles, including Credit Suisse’s collapse later in March and First Republic’s in May. More recently, the rating agencies downgraded or put on credit-watch a slew of banks.

“All that has contributed to corporate treasurers realizing they have to think differently about how they assess and work with their banks,” Essaides said. “Not just assess the risk, but also how much in deposits should they keep with banks?”

For some, concern about banks’ creditworthiness extends beyond smaller institutions.

“Some companies are not comfortable even with [global systemically important banks]and are keeping minimal money there,” she says, noting that besides Credit Suisse, other major banks have tested rough waters since the global financial crisis.

Bank deposits have long been the most popular destination for corporate cash, notes Tom Hunt, director, treasury services and payments at the AFP. The AFP’s most recent annual liquidity survey conducted in March, which captured the bank failures’ impact that month, recorded a 10 percent shift in balances away from deposits year over year. Most of that shift, Hunt says, has been to government MMFs, with some also heading to T-bills, Treasury securities and government agency bonds.

“It’s seen as a prudent move, taking some risk off the table,” Hunt said. “It does increase the concentration of risk in U.S. government securities, but they have the full faith and credit of the government backing them.”

Federal Reserve data shows deposits decreasing quarterly by mid-single digit percentages starting in 3Q 2022 through 2Q 2023, when deposits plummeted by 16.8 percent in March and 10.5 percent in April, immediately after the bank failures. In May and June deposits increased marginally, by 1.5 percent and 2.9 percent, respectively, as fear of more banks collapsing subsided.

Hunt noted that the number one driver for corporate treasuries to invest in MMFs has traditionally been yield, whereas the key driver for deposits has been their bank relationships. Generally, deposits have helped subsidize other bank products, whether undrawn revolving credits or various bank services. Consequently, there may be a price to pay for the deposit shift if it continues.

The current trend to hold as little as possible in bank deposits, Essaides says, could ultimately impact banks’ earnings and how they price their businesses in other areas.

“There were a lot of subsidies going into revolvers and other bank products for companies that held lots of deposits with their banks,” Essaides said. “Banks will have to start calculating adjustments in terms of what they require as compensation for certain products and services, whether it’s letters of credit, derivatives, or even cash-management.”

While deposit shifts could affect companies’ relationships with their banks longer-term, the NeuGroup survey revealed significant percentages of corporates reacting to the bank failures in other areas. Building a more robust internal risk assessment capability was reported by 41 percent of respondents, while 51 percent have increased the frequency of their bank-risk assessments. Given the rating agencies and banking regulators were clearly behind the curve flagging the big regionals before they collapsed, it’s unsurprising that nearly three quarters of survey respondents marked adding new metrics to spot potential counterparty risk.

Strategies to hedge risk

The metric that 88 percent of respondents said they use is credit default swap spreads—derivatives used to hedge the risk of an issuer defaulting on its bonds. CDS spreads are more accurate indicators when there is a significant volume of CDS traded on a specific bank, limiting their use as risk metric to the largest banking institutions.

The next most common indicators, checked off by more than 40 percent of respondents, is tracking the composition of a bank’s deposit base and its concentration of uninsured deposits, and its stock price.

The NeuGroup survey divides counterparty-risk indicators into market, structural and balance-sheet categories. In a summary of its findings it lists 25 indicators that respondents offered as metrics they track. Tracking all of them is clearly unrealistic, so companies must choose those they deem most fitting. Market indicators tend to be more forward looking, and Essaides points to banks’ 10-year bond spreads as one of the more popular ones among participants in the focus groups.

“A lot of people say the fixed-income side of the market is more in tune with what’s going on with banks than the equity side,” Hunt says, adding that a bank’s wider spreads on its bonds relative to peers probably warrants further investigation into the institution’s health.

Banks fail for different reasons, so while market metrics such as Bloomberg’s default risk metrics and market sentiment and news can provide early warnings, corporates appear to be favoring defenses, taking a variety of forms, to minimize the impact from bank failures that are bound to come sooner or later.

The 2023 AFP Risk Survey Report released in mid-September found that to protect against instability with banking partners, 48 percent of treasury departments appear focused on concentrating their organizations’ bank relationships with larger banks for services. In addition, the survey found, they are doing more due diligence into their relationship banks’ safety and soundness.

Forty percent of respondents to the NeuGroup’s survey reported they were looking to put in place a back-up bank for cash management services, Essaides said. NeuGroup members typically use the largest, too-big-to-fail banks for those services, so such a move would probably focus on mitigating operational risk should one of the banks get into trouble, rather than losing money from a failure.

Essaides adds that what a back-up bank would look like is unclear, since cash management tends to be a very “sticky” business that banks rely on for the steady fees. However, she says, “companies are considering having a back-up much more readily available, so they can switch quickly.”

A similar trend is occurring with the collection and disbursement, with companies seeking out alternative banks to maintain continuity of that function should its primary provider run into trouble, notes Prashant Patri, principal at Deloitte Risk and Financial Advisory.

Patri added that the recent bank scares have given corporate treasury, a cost center rather than service center, a bit more leverage to acquire the systems to review bank counterparty exposures and limits on a timely basis and, importantly, to understand where their cash and short-term investments are.

Treasurers have long sought the systems to provide that information, and Patri described last spring’s events as an “accelerant” in that direction.

“We’ve started to see that play out in the last six months, when our clients have come to us asking about enhancing the robustness of their treasury infrastructures,” Patri says.

Critical is bridging the metrics alerting companies to a looming bank failure to the mechanisms in place to deal with such an event—as quickly as possible.

Essaides recalls the focus-group participant whose company’s treasury infrastructure delivers a report each morning that, if it raises red flags about one of the company’s banks, can result in close to real-time action. The action could be transferring money, but it could also be looking more deeply into relevant structural and balance-sheet indicators that may be backward looking but can analyze more substantially a bank’s counterparty risk.

“If companies can’t respond to alerts by taking action, then it becomes kind of useless,” she says.

John Hintze is a frequent contributor to ABA Banking Journal.