top of page

Credit Risk in Treasury

Credit Risk in Treasury


The Treasury function has several roles. At the highest level these include hedging and trading. The risks that are incurred are:

  • Market risk (Interest rate & foreign exchange risk)

  • Liquidity risk

  • Operational risk

  • Credit risk

For corporate and retail bankers, the inclusion of credit risk in this list may be a surprise. But the deals done create credit risk for the bank. Therefore, credit risk in Treasury needs to be carefully monitored and controlled.

What sort of things create credit exposures?

Anything that involves the payment of cash. For example, deposits made and bonds/money market instruments purchased. It doesn’t stop there.

Derivatives like interest rate, currency swaps and options also create credit exposures. How?

At inception, the trade value (mark-to-market) will be close to zero (this depends on bid-offer spreads). Later market prices will have moved. This leads to a valuation affect. If you are making money the trade will have a positive market value. This positive value is due to the future cash flows you will pay and receive. Therein lies the risk. If your counterparty defaults you lose your profit. That’s a credit exposure. It’s the reason why we collateralise or margin call derivatives. There is more.

Every time you pay away or receive money you can be in danger of creating credit exposures. That’s why we don’t deliver bonds before they are paid for and why foreign exchange uses continuous settlement. It reduces the risk of non-payment.

Capturing and reporting all these credit exposures requires good systems. Ideally the system can tell a dealer in real time what the counterparty credit exposure is. This should include things like maturing transactions and accrued interest. The system will also contain limits. Breaching these limits will flag the risk.

Counterparty credit needs to be carefully evaluated.

Credit analysis is a specialist skill and should be segregated from those working in Treasury. It’s normal to see counterparty limits taper with maturity as the uncertainty of time increases risk. Small firms frequently use ratings thresholds as a fall back. For example, no exposures beneath AA rating. This may save on resources but is not fool proof. Credit ratings can migrate (deteriorate) and the role of rating agencies has been questioned. Outsourcing the analysis in this way needs to be discussed and thought through at a Board level.

You will have noted that segregation has been referred to. It’s safe to say that once a counterparty credit limit has been granted then dealers will use it. If the Treasury is a profit centre, there is an incentive to deposit with counterparties that pay the best rates – often weaker credit risks.

Large deals with weak counterparties mean that when default rates increase the sums involved can threaten stability.

The actual losses incurred will depend on the seniority of the debt involved. Whilst you may think that counterparty default on a $10 million exposure will lead to a $10 million loss this may not be the case. The Loss Given Default will vary from 100% to 0% depending on the counterparty and creditor ranking. More sophisticated banks model this risk to determine how much capital is being used.

First Published by Barbican Consulting Limited 2017

bottom of page