Counterparty risks of pension funds are limited
Rating agencies such as Moody’s and S&P have recently downgraded a large number of investment and other banks. These banks frequently act as counterparties when pension funds engage in derivative transactions in order to manage their balance sheet risk. A deterioration in the credit rating of these banks may enhance the counterparty risk run by pension funds. However, research by DNB shows that this risk for pension funds is limited at present.
Pension funds make significant use of derivatives, mainly in order to manage the balance sheet risks arising from interest rate and exchange rate fluctuations. To a lesser extent, they also use derivatives as a vehicle for investment in certain investment categories, such as commodities. The use of derivatives hence decidedly contributes to efficient portfolio management and helps to control pension funds' investment risks. But by entering into derivatives contracts they expose themselves to counterparty risk. This risk notably depends on the following three factors:
- Credit rating: In the event of counterparty failure, the extent to which a pension fund would be able to actually realise any positive value from derivatives contracts would be uncertain. The lower the credit rating of the parties with whom pension funds do business, the higher the counterparty risk.
- Concentration: Where a pension fund depends on a small number of counterparties for its derivatives, a credit downgrade or even failure of one of these parties may have a serious impact (concentration risk). Moreover, in such cases a fund may find itself in the situation that it has no scope for replacing existing counterparties with new ones. A final form of concentration risk would arise if it emerged that one of a small number of parties dominated the market for derivatives or a certain type of derivative.
- Collateral: Insufficient collateral, or collateral that is of too low a quality, would result in a capital loss if a counterparty failed. In addition, a derived counterparty risk may arise if funds have difficulty in securely depositing the cash and other collateral received.
DNB research
The main objective of DNB's research was to chart the counterparty risk run by the pension sector. A group of 32 funds, with total assets under management of approximately EUR 714 billion, responded at short notice to the survey conducted by DNB. This swift response shows that the funds have sufficient information on the extent and nature of their exposure to counterparties.
Credit ratings of pension funds' counterparties
For the funds that participated in the survey, the total market value of derivatives, repos and deposits now outstanding with counterparties amounts to EUR 89.7 billion, with interest rate swaps (66%) and deposits (21%) forming the principal part.
Figure 1 shows that all exposures are to counterparties whose credit rating is at least ‘investment grade’ (minimum rating of BBB- for S&P/Baa3 for Moody’s). On the basis of this data, the credit rating of counterparties appears to be sufficient at the present time, thereby limiting the risk of failure.Concentration of pension funds' counterparties
In all, the funds that took part in the survey have outstanding positions at 57 different counterparties.
Figure 2 shows that the majority of the funds have adequately spread their derivatives over various counterparties: 93% of the parties have six or more different counterparties. DNB intends to carry out a closer examination at three pension funds because their concentration risk appears to be relatively high. At the same time, the large majority of the funds still have ample opportunity to do business with other counterparties should the credit rating of their current counterparties slip below an acceptable level. Moreover, it emerged from the information received that there is as yet no overdependency on any one counterparty, or on a small number of counterparties, in any of the derivatives markets under review.Collateral of pension funds' counterparties
The submitted data reveals that collateral given to pension funds by counterparties against derivatives amounts to 102% of the total value of outstanding derivatives: 62.4% of this collateral is in the form of cash funds and 37.6% in the form of bonds with a minimum rating of ‘investment grade’. Moreover, in by far the most cases, collateral is exchanged on a daily basis, thereby minimising the risk of differences arising between valuation and collateral. It can thus be concluded that funds ask for sufficient security, in the form of collateral of adequate quality, to contain any losses resulting from failure.
Conclusion
Analysis of the data submitted provides a relatively positive picture of the state of counterparty risk at pension funds. Note, however, that this picture is a snapshot: the past has shown that counterparty risks can mount up rapidly. In view of the current precarious economic circumstances, further downgrading of the credit rating of investment and other banks can certainly not be ruled out. Both the sector itself and DNB must hence remain vigilant regarding exposure to counterparty risks.
