This month, PwC's Finance and Treasury team published the following booklet to help companies understand the new requirements of IFRS 7 and encourage management to make the most of the opportunity to review and refine their fair value measurement techniques. I hope readers find it useful.
Since the collapse of Lehman Brothers and the near-demise of AIG, regulators in the US and Europe are concerned about the systemic risks arising from over-the-counter (OTC) derivatives, and in particular Credit Default Swaps (CDS). As a result, both sides are seeking initiatives to improve financial stability through measures including standardisation of OTC derivatives and the establishment of Central Counterparties (CCP) clearing centres.
The understanding is that the wider use of CCP for OTC derivatives has the potential to improve market resilience by lowering counterparty credit risk and increasing transparency. But how does this CCP work? How different it is from existing bilateral OTC transactions?
In a bilateral OTC market, participants trade directly with one another. Where a collateral agreement is in place, collateral is posted between parties reflecting the mark to market changes in the value of the OTC contacts. As for a CCP, the trading itself remains on a bilateral basis. Once a trade agreement is reached, it is transferred, or “novated” to the CCP. In other words, the single contract between the two initial counterparties is replaced by two new contracts, each with the CCP.
The CCP structure brings about a number of benefits. First, the overall counterparty credit risk is reduced as the CCP can net multilaterally. The resulting multilateral net position is the bilateral net position between each participant and the CCP. The second benefit from having a CCP is that it simplifies monitoring of credit risk, settlement, and improves management of collateral. The CCP can also ensure consistency in the marking to market process, clearing process and margining across its participants. From the regulators’ perspective, the CCP offers greater transparency, easier supervision of risks and further stability in the OTC derivative market by spreading risks among the CCP participants.
In my view, while most corporate treasurers would conceptually agree with the benefits of a CCP, they may not necessarily agree with its practicality and its flexibility especially in the context of non financial businesses. Corporate treasurers are concerned that in the process of reducing credit risk, liquidity risk is introduced instead. The collateral which corporate treasurers have to put up in a CCP system will undoubtedly increase their cost of dealing, complicate their hedging activity and may introduce serious cash-flow problems.
It seems that from a non-financial world perspective, the incentive to use a CCP is not overwhelming. Corporates are unlikely to use equity or credit derivatives for which the benefits of using a CCP are better recognised.
Furthermore, mandating non-financial companies to use CCP might be harmful as it may discourage smaller corporates from hedging their financial risks due to the implicit incremental capital requirements. This in turn leads to greater business risk and may restrict business activities.
If you would like to share your view on the CCP, please use the comment facility below.
Whilst there can be no question credit markets have improved since the dark days of the beginning of the year, borrowers continue to find raising or extending existing credit lines challenging.
One of the big stories of the year has of course been the bond market and we have seen an increase in the number of borrowers considering obtaining external credit ratings and issuing bonds for the first time. Issuers with low investment grade ratings, particularly those on ‘negative watch’, have also made maintenance of their ratings a mission-critical goal to ensure continued access to the investment grade market.
In recent months, some companies have issued sub-investment grade bonds, a market which has been shut for nearly two years. Notwithstanding this improvement in market conditions, issuing bonds is not an option available to every borrower and consequently reliance on banks remains high.
Banks remain cautious and often reluctant to advance loans to new customers. As a result, the cost of extending maturities of existing facilities with incumbent banks or refinancing with new lenders is often still expensive, even for the most creditworthy of companies. However, during the third quarter, we have seen the upward pricing pressure on many forms of bank lending abate somewhat. Although we have yet to see significant falls in the pricing of bank loans, we have some confidence that, in the absence of further major economic shocks, the peak for the pricing of credit may now have passed.
Whilst the UK clearers subject to significant state influence have been set specific new lending targets, the goal of boosting lending is still subject to the more cautious lending standards being adopted throughout the bank sector over the last twelve months. Therefore, careful presentation of a company’s credit proposition is still necessary, if this capacity is going to be tapped by borrowers which do not currently have lending relationships with these banks.
Banks also remain focussed on minimising the capital they must put aside for new loans. This increases the attractiveness of Asset Based Lending from a lender perspective which in turn can have pricing benefits for borrowers. Pricing increases on asset backed loans have therefore been less marked than increases on corporate credit. Asset based lending does, however, require the ceding of security to lenders, which does not suit all borrowers. One other noticeable trend in the market this year has been the increasing popularity of convertible bonds.
In the current recession, borrowers and lenders continue to monitor covenant compliance vigilantly. The importance of monitoring forward looking compliance is hard to over-emphasise given the price of a covenant reset continues to be very high: margin increases of 150bps to 300bps plus substantial fees. We have been involved in many transactions where borrowers have raised new equity to reduce leverage and improve the terms of new credit.
There is no doubt that many challenges remain but there are also growing reasons for optimism as we move towards 2010. Click to read PwC's Debt Markets Update - Q3 2009 (PDF download).
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