The credit crisis and regulatory responses have forced banks to substantially update their counterparty risk management processes. New regulations in the form of Basel III, the Dodd-Frank Act in the U.S. and European Market Infrastructure Regulation (EMIR) have dramatically increased capital requirements for Counterparty Credit Risk. In addition to implementing new regulatory requirements, banks are making significant changes to internal counterparty risk management practices.
There are three main themes inherent in these changes. First, better firm-wide consolidated risk reporting has become a top priority. Second, centralised counterparty risk management groups (CVA desks) are being created to more actively monitor and hedge credit risk. Third, banks are making significant investments in technology to better support the firm-wide risk reporting and CVA desk initiatives.
This paper will explore some of the key changes to internal counterparty risk management processes by tracing typical workflows within banks before and after CVA desks, and how increased clearing due to regulatory mandates, affects these workflows. Since CVA pricing and counterparty risk management workflows require extensive amounts of data, as well as a scalable, high-performance technology, it is important to understand the data management and analytical challenges involved.
CVA desks or specialized risk control groups tasked with more actively managing counterparty risk are becoming more prevalent, since banks that had them generally fared better during the crisis. To establish a basis for comparison, it is important to review counterparty credit risk pricing and post-trade risk management before the advent of C VA desks. The case where a corporate end-user hedges a business risk through a derivative transaction provides a useful example.
The corporate treasurer may want to hedge receivables in a foreign currency or lock in the forward price of a commodity input. Another common transaction is an interest rate swap used to convert fixed rate bonds issued by the corporation into floaters to mitigate interest rate risk. In all of these cases, the corporate treasurer explains the hedging objective to the bank’s derivatives salesperson, who structures an appropriate transaction. The salesperson requests a price for the transaction from the relevant trading desk, which provides a competitive market price with ‘credit’ and ‘capital’ add-ons to cover the potential loss if the counterparty were to default prior to maturity of the contract. The credit and capital charges are based on an internal qualitative and quantitative assessment of the credit quality of the counterparty by the bank’s credit officers.