Counterparty risk is the risk that a counterparty in a transaction will default prior to the expiration of the contract and will be unable to make agreed contractual payments
Experience has shown, normally banking and financial crises have their roots in lax credit standards, poor portfolio risk management, and their inability or failure to (i) evaluate the impact of the changing economic environment on credit worthiness of the counterparties and (ii) progressively refine and sophisticate risk management configuration.
When these happen counterparty driven concerns will mount and they will directly lead to large-scale realisation-focus / redemption-driven asset sales, resulting in global financial markets seizure and deeper state of crisis. The ensuing sell-off will affect all but the safest assets and leave key parts of the global financial system dysfunctional. Thus, counterparty stability will directly impact the financial stability.
In such a scenario, credit and money markets will get frozen and equity prices will plummet, banks and other financial firms will see their access to funding eroded and their capital base shrink, owing to accumulating mark to market losses. Credit spreads will surge to record levels, equity prices will see historic low and volatilities soaring across markets, indicating extreme financial market stress.
Thus, when counterparty concerns are not adequately addressed, the financial services sector will get into numerous and serious challenges and changes. Risk management practices will certainly come under critical review – both as an issue of compliance, and as part of broader attempts to preserve and generate margins in an increasingly competitive environment. Regulators will step in to guide the market sometimes with stringent prescriptions. Governments may have to intervene with rescue packages. And of course these rescue packages will come with bitter medicines.
Principle 6 of the Risk Management and Supervision enunciated by the Bank for International Settlements requires banks to actively monitor and control exposures and funding needs within and across legal entities, business lines and currencies, taking into account legal, regulatory and operational limitations.
Given the lessons learnt already from the financial crisis, going forward following aspects of the firm’s risk management philosophy would become important – casting risk management as a business enabler, broadening the discussion on risk issues, providing for more qualitative inputs on top of quantitative risk modelling, revision of incentive structures to better align them with risk-reward outcomes and increasing the focus of business lines on risk-adjusted earnings.
A bank may execute transactions only if credit lines have been approved and are available for a designated counterparty. No trade may be finalized without confirming the availability of sufficient credit. Electronic broker credit pre-screening schemes may be preferred to the practice of brokers switching counterparties. In the event of default by counterparty, a bank could lose the positive market value of the positions it has with the defaulting party or, if default occurs in the middle of settlement, it could lose the entire principal of the deal. In addition, its reputation will get tarnished.
Thus a comprehensive approach to counterparty risk management can be folded mainly under actors, methods, correlations, and best practices. The actors could be the actual counterparty (credit rating, real time exposure), the originator (status, liquidity), the originator’s creditors & shareholders and the regulator. The methods could be predictive, market price and actuarial methods. The correlations could be across firms and industries and across time for the same firm. The correlations could be with the economy and the credit quality too. The best practices framework would comprehensively cover counterparty exposure and counterparty risk policies. The ideal risk organization would compose of independent set of personnel for transaction function & risk function. Normally they would further decompose into setting limits for different parameters.
Going by the recent unpleasant experiences in the market place, one could wish separate internal models for each counterparty category and mapping of scales to a common scale. The ability to precisely calculate the probability of default based on the internal score would be the next in the best practices list.
The named counterparty may have entered into more than one transaction of different types and different maturities and in different currencies. In such a case, a simple exposure analysis for arriving at the total (gross or netted) counterparty risk will be required through valuation process on a real time basis covering pricing of products and calculating different Greeks. For such valuation one will need static data and dynamic data. Depending on the dynamic data used valuation process will be classified in to Mark to Market and Mark to Model and this would involve four steps
1st Step – List out all the transactions entered into with a named counterparty
2nd Step – Apply valuation process – collect static data and dynamic data of the products, apply Mark to Market or Mark to Model on a real time basis to rework pricing and to calculate different Greeks
3rd Step – From repricing rework all the exposures and aggregate to find out Gross or consolidated Exposures
4th Step – Apply netting if is an internal policy for monitoring and compare with limits prescribed for the counterparty
A typical counterparty risk management system will ideally cover credit lines, usage information population, daily/ad hoc intraday reassessment, netting, speedy processing, customized value added what if tools and regulatory requirements – correlation, full Greeks, PV, revaluation, yield curve and exotic transaction.
Real-time credit systems also allow a bank’s credit managers to assess the credit exposure to counterparty throughout the life of a transaction. Credit officers are better able to manage crisis situations and to adjust limits as the creditworthiness of a counterparty changes. A real-time credit system ensures that any changes in the credit limit of a counterparty are reflected in the sales and trading system immediately.
Needless to say, this would call for institutionalising sophisticated risk management systems, including a robust stress-testing and economic capital allocation framework, coupled with strong validation mechanisms to ensure the integrity of the policies on collateral management, credit risk mitigation, disclosures and adequacy of the management information system, impact of various elements of the portfolio, as also the results of the process for validating.
It needs to be, however, borne in mind that implementation of advanced approaches, particularly for the credit risk, would be a data-intensive exercise. At the minimum, banks may need to have acceptable historical data for the past five to seven years for computing the risk parameters such as probability of default, loss given default and operational risk losses.
Ideally the quantitative risk modelling will require periodic validation to satisfy regulators, to detect implementation bugs and to ensure model performance. In this validation certain stability parameters like calibration, profit and loss attribution, variance of hedged portfolio and cost of hedging will be focused. The intrinsic validation exercise will cover valuation scenarios, assumption for future scenarios, multiple inputs for projection to arrive at intrinsic value to enable informed decision making. The price verification procedure will cover back testing and review of tools. The market risk limitations such as coverage gaps, stale prices, gaps in objectivity, lack of transparency and potential conflict of interest will need to be taken care of. To ensure quality, reliability, independency, consistency and comprehensive coverage, the counterparty risk models will need such periodic testing and validation
The recent upheaval in the global financial markets has caused more mayhem in recent times than the world has seen in its entire economic history. The financial market turmoil has not yet come to an end. In fact, it is reportedly intensifying yet again. More large financial institutions have failed or had to be taken over by others, while a number of markets have exhibited instability.
With global and regional banks still under stress, counterparty risk has moved up the agenda in recent years – particularly after Lehman episode. The market events have driven home the critical importance of counterparty risk management. Thus, not only from a regulatory angle, even from the very survival of financial institutions, has the need for counterparty risk management been heightened