Counterparty Credit Risk Limit Setting and Exposures

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This article, written by Avadhut Naik, global product manager at Quantifi, and Michael Bryant, managing director at InteDelta.

The measurement and management of counterparty risk is in the midst of a revolution. Within recent memory of most counterparty risk managers it all used to be so much simpler. Limits were set on the same basis as traditional lending, and exposure measured against those limits was quantified using simple add-on factors applied to the notional of each transaction. Regulatory capital was based on the simple methodology which has been specified under Basel I.

Basel II replaced the previous simplistic rules and gave banks the option of using internally built models to calculate regulatory capital. This can lead to significant capital savings but requires banks to invest in new systems, processes and quantitative personnel.

Recent regulatory activity has had a profound impact on counterparty risk management, most sue to central clearing and higher capital ratios. Mandating central clearing for derivative products effectively moves counterparty risk out of complex CVA and economic capital models into more deterministic and transparent margining formulas.

The ability for senior management to get a comprehensive view of the bank’s counterparty risks is a key priority. Consolidated risk reporting has been elusive due to front-office driven business models. This has resulted in a proliferation of systems, making the job of aggregating risks across business lines excessively complicated. Continuous development of new types of derivative payoffs and structured products has exasperated the problem. Banks are now taking a ‘top-down’ approach to risk management.

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