Monitoring counterparty risk – A 21st century imperative to limit risk exposure

There’s no doubt that the twenty-first-century economy is an interconnected one. While this has produced a fiscal environment where opportunities abound, it has also increased business risk exposure levels significantly. In today’s interconnected business setting, credit management can no longer be solely focused on customer risk, therefore. Rather, it should now include the whole ecosystem of counterparties a business interacts with. Similarly, counterparty risk management needs to move beyond just contract negotiations and underwriting analysis to a system where business associates are analyzed on an ongoing basis and monitored for signs of distress regularly. This 360-degree risk monitoring methodology is the only way a business can truly limit its risk exposure in the present corporate environment.


A web of business interconnections that represent all the counterparties a business interacts with
Monitoring your business ecosystem is now an essential requirement to limit risk exposure

Your counterparty ecosystem explained

Why your counterparty ecosystem needs monitoring

The role of real-time data and monitoring explained with the Evergrande example

What is needed for comprehensive counterparty monitoring today?

Conclusion


Your counterparty ecosystem explained


A long time ago, English poet John Donne said, “No man is an island”. Nearly 400 years later, his famous words ring especially true for businesses today. Even most brick-and-mortar stores today have an ecosystem of counterparties they depend on to maintain profitability and growth numbers. These include, but are not limited to, its:

  • Customers

  • Suppliers

  • Distributors

  • Trading partners

  • Strategic partners and

  • Banking partners


And what can be considered a positive for traditional businesses is almost a prerequisite for those riding the digitalization wave. Companies, especially those with global markets, can only thrive if they have an established network of business partners. This necessary web of counterparty interconnections is both a blessing and a curse. With it, a business can grow faster, innovate more efficiently, and create better value propositions for its customers. In other words, with a robust counterparty ecosystem, your business can go where no business has gone before! On the flip side of the equation, however, the interconnected nature of your business ecosystem means that what affects one counterparty can easily affect you too.

A pie chart that shows all the counterparties that form your business ecosystem
Your counterparty ecosystem is essential for business continuity and growth

Why your counterparty ecosystem needs monitoring


Like their natural counterpart, business ecosystems are symbiotic in nature. This simply means that counterparties within the ecosystem depend on each other for business continuity and growth. So, when each member is doing their part, the system is stable and working like a well-oiled machine. Conversely, when one member collapses, it can set off a domino effect that impacts even the healthiest links in the chain. A devastating example of this is the infamous Lehman Brothers debacle.


In 2007, Lehman Brothers was the 4th largest investment company in the U.S. That year, it reported a record profit of over $4 billion, revenues of close to $60 billion, and an all-time-high stock price of $86. There’s no doubt that the 150-year-old investment company was in peak financial health by most fiscal standards. A year later, however, it declared bankruptcy and completely disappeared from the banking space. In what became a lesson on how-not-to-manage-your-counterparties, Lehman Brothers failed to properly monitor their acquired network of lenders. Many of these lenders focused on doling out subprime loans, one of the premier causes of the real estate bubble. When the housing market crashed, these lenders predictably defaulted. This loss along with its ill-advised investments in mortgage-backed securities spelled doom for the one-time investment giant. The bankruptcy sent shock waves across the financial world and is widely regarded as the kick-off moment for The Great Recession of 2008.


More recently, the Covid-19 pandemic is testing the resilience of capital markets and supply chain ecosystems worldwide and a lot of them have been found wanting. Around 90% of Fortune 1000 companies experienced supply chain disruptions due to the pandemic causing over half of them to lower their growth forecasts significantly. Such disruptions can cause delays in deliveries, unfulfilled orders, and even product withdrawals; all of which can cause reputational harm and hurt future revenue prospects for companies dependent on their network of suppliers and distributors. Undoubtedly, globalization has increased the complexity of counterparty management. Intersecting risks that were once local, and therefore more containable, have now become international in nature, making monitoring and subsequent recovery a lot harder.


The role of real-time data and monitoring explained with the Evergrande example


Earlier this month, Chinese property giant Evergrande, which racked up debts to the tune of $300 billion, missed a crucial interest repayment deadline. This caused Fitch Ratings (one of the premier credit rating agencies in the world) to declare that the company was in default. This follows months of will-they-won’t-they (default) speculations. The crisis is set to have financial ramifications for a whole host of Evergrande’s counterparties. This is especially true for those who did business with the company on a day-to-day basis such as material suppliers, construction firms, or interior decoration companies. These SMBs now stand to incur massive losses that could leave them bankrupt. In addition, with the Chinese government prioritizing the repayment of domestic lenders, international investors are set to bear the brunt of the credit losses incurred.


As big a shock as this was, the writing was on the wall as early as 2018 when China’s central bank put Evergrande on its watchlist of corporations that could cause systemic risk. Or in 2020 when the real estate giants dealt with the twin strikes of the pandemic lockdowns (which tanked property values) and the Chinese government’s efforts to crack down on real-estate borrowing. This caused the company to face a cash crunch. Things got so bad for them that they resorted to paying suppliers with property instead of cash. Had investors and counterparties caught these red flags early, they would have been able to save themselves a lot of heartburn in the ensuing months.


These early warning signs underscore the need for a counterparty risk monitoring process that is supplemented with up-to-date data, advanced analytical tools, and an ability to monitor risk daily instead of on an annual or bi-annual basis.


What is needed for comprehensive counterparty monitoring today?


There are essentially 2 types of counterparty risk – quantifiable and non-quantifiable. As the names suggest, quantifiable risks are those that are tangible and can be measured while non-quantifiable risks are ones you cannot assign a numerical value to. No matter the mathematics of it though, both types of risks have equal potential to harm a business. In other words, a decrease in cash flow can cause as much damage as a data breach or a negative review can. A case in point here is the infamous Pepsi commercial starring supermodel Kendall Jenner. Released in April 2017, the commercial was meant to present the soft drink company as a socially conscious, millennial-friendly brand. The tone-deaf nature of the advertisement, however, had the opposite effect and the company suffered all-time low Purchase Consideration scores (a metric that points to future sales revenue) and Brand Perception scores for over 8 months after the commercial aired.

A donut chart that depicts how risk analysis is a function of quantitative and qualitative metrics
Comprehensive risk analysis requires an assessment of both quantitative and qualitative metrics

It then follows that for risk monitoring to be truly effective, every aspect of it should be analyzed. In essence, counterparty risk monitoring can only be comprehensive when quantitative and qualitative risk indicators are factored into the equation. Regarding one without the other would be like trying to shoot an arrow with one hand tied behind the back – a hampered process that is unlikely to give you the results or the coverage you are looking for. In an upcoming blog, we will delve deeper into the importance of quantitative and qualitative analysis in developing a gap-free counterparty risk monitoring system. So, stay tuned for that.



Conclusion


Carrying out a comprehensive analysis of your business ecosystem is now an essential requirement if you want to navigate the treacherous post-Covid financial landscape unscathed. Of course, thoroughly and regularly assessing every business that you transact with is a time-consuming and formidable task, especially if you have international counterparties. That is what makes using AI-augmented, automated systems such as TRaiCE such a good choice. Such systems can monitor your entire business ecosystem comprehensively and daily allowing you to concentrate on what matters most, adding more value to your customers, and taking your business forward.


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