Managing Counterparty Credit Risk - Part 1: Why Measure Counterparty Credit Risk?

May 6, 2013

There is currently a strong market focus on Counterparty Credit Risk and more specifically on Credit Value Adjustment (CVA). The attention is predominantly towards the issue of efficient CVA pricing as opposed to implications in terms of risk management and capital requirements. However, since the recent crisis, another issue has gained prominence; the significant losses that counterparty credit risk can cause if not correctly managed.

What is counterparty credit risk?

CCR is the risk that a party, usually to an OTC derivative contract, may fail to fulfill its obligations, causing replacement losses to the other party. This is similar to the standard definition of credit risk in the sense that the economic loss is due to the default of the obligor. However, it differentiates itself because of the uncertainty around the exposure at default. More specifically, the amount of exposure is uncertain due to the random nature of the contract’s pay-offs. Additionally, CCR has a bilateral nature, since depending on the point in time and the situation of the market, the exposure after close-out netting can either be positive (an asset) or negative (a liability).

Why measure counterparty credit risk?

Counterparty credit risk (CCR) is currently one of the most complex topics for financial institutions. This complexity comes from many different sources but is primarily related to the multiple definitions and uses of CCR. Therefore, the first question to ask yourself before modeling CCR is why do you want to measure it?

Business purpose

You want to determine the market value of your counterparty risk, which corresponds to the difference between the risk-free price of your exposure and the price including the credit risk of your counterparty. This is typically referred to as the Credit Value Adjustment (CVA) and can be considered as an exotic credit option. This computation is rather complex and has to integrate many features, including:

  • Expected Exposure: The computation of what is expected in terms of future exposures, for all the deals with the counterparty, and given changes in market factors;

  • Credit Risk Parameters: The drivers of credit risk, meaning the Probability of Default (PD), usually based on a term structure of hazard rates implied from CDS prices, the Recovery Rate (RR) and the different correlations, like Wrong-Way Risk (WWR) or systemic correlation;

  • Bilateral CVA: The final price of a derivative should integrate the CVA from the two sides of the deal (the risk that the other counterparty defaults and the risk of your own default). The adjustment due to your own PD is usually called Debit Value Adjustment (DVA);

  • Netting Agreements: Legal agreement that allows compensation between positions inside a netting pool with the same counterparty;

  • Credit Support Annexes (CSA): Collateral agreements that help limit CCR in an OTC transaction by forcing counterparties to post collaterals on a regular basis(usually daily);

  • Hedging: Hedging the credit risk can be achieved, totally or partially, through the use of contingent credit derivatives or credit indexes such as the CDX or the iTraxx. It is important to note that the hedges themselves include CCR;

  • Funding Value Adjustment (FVA): The additional cost of having to fund a position at a higher rate than the applicable risk-free rate (e.g. OIS rate vs. own cost of funding);

  • Incremental CVA: One of the key issues for financial institutions is that for each new “incremental” trade with a counterparty, they have to reconsider all the positions with that specific counterparty, in the same netting pool of the ISDA master agreement.

Accounting purpose

You want to integrate CCR estimates in your profit and loss account, according to accounting standards applicable to your institution. Under International Accounting Standard (IAS 39), banks are required to account for the fair value of OTC derivatives trades, which includes the recognition of fair-value adjustments due to counterparty risk. In addition, it will be required by IFRS 13, as of 1st January 2013, to record DVA for fair value measurement.

Regulatory requirements

You want to know the cost of capital for bearing CCR. In order to compute this amount, you should refer to the Basel requirements. This regulation differentiates between two types of CCR capital charges: one for the default risk and one for the market risk (usually referred to as CVA capital charge).

  • Default risk charge: is the capital charge to cover losses in case the counterparty defaults on its obligations and corresponds to a “hold-to-maturity” or banking book strategy.

  • CCR market risk charge: is the capital needed to cover losses from changes in the market value of counterparty risk, i.e. the volatility of the counterparty credit spread that can negatively impact the value of the contract. The default charge was first proposed by Basel II. However, due to the major losses during the financial crisis, related to the creditworthiness of derivative counterparties, Basel III has introduced the market capital charge. Each of these capital requirements proposes different solutions, with increasing level of complexity.

The default charge was first proposed by Basel II. However, due to the major losses during the financial crisis related to the creditworthiness of derivative counterparties, Basel III has introduced the market capital charge. Each of these capital requirements proposes different solutions, with increasing level of complexity.

Below is a summary of the Basel lll capital requirements approaches

 

A summary of the Basel lll capital requirements approaches

 

Risk management

You want to have a global and integrated view of the risks your institution is facing regarding CCR. For this reason, you will have to go beyond the regulatory requirements. Indeed, the objective of the capital requirements is to ensure that institutions can withstand major shocks in CCR. However, these regulatory models are developed on a “fit-for-all” basis and only focus on solvency, they do not provide sufficient information for proper risk management. Some topics that should be further investigated are:

Economic capital models for CCR

To go beyond the regulatory formulas, institutions need to develop their own models to assess the capital needed for CCR, which should account for

  • Correlation between credit spreads and market factors since the regulatory VaR model is restricted to changes in the counterparties’ credit spreads and does not model the sensitivity of CVA to changes in other market factors (i.e. interest rates);
  • Consistent treatment of recovery component that is fixed arbitrarily for market charge and calibrated on Loss Given Default (LGD) internal models for default CCR;
  • Modeling of the portfolio behavior until time horizon, considering for example management actions or constant level of risk assumptions;
  • Modeling of seniority effects, guarantees and parent support;
  • Proper integration of rating migration, that could be captured both by Incremental Risk Charge (IRC) models and using Basel II maturity adjustment multiplier;
  • Consistency in quantile estimation on the loss distribution (usually around 99.95% for ECAP models) and no use of multiplication factors on VaR and stressed VaR;
  • Stressed parameters in the Basel III distorts the impact of the hedging but also, the stressed exposures don’t correctly cover WWR;
  • Assumptions regarding margin period of risk (other than the 10 and 20 days appearing in Basel III) can be further challenged;
  • Better integration of market (CVA) and credit (default charges) components to avoid the potential double counting effect currently observed in the regulation;
  • Develop both consistent point-in-time CCR measures that react consistently and dynamically to changes on the market (for monitoring and immediate action), and through-the-cycle CCR measures that avoid procyclical and unstable behaviors (for capital computation).

Stress testing scenarios

Since the future cannot be entirely forecasted based on past behavior, a sound risk management should develop forward looking stressed scenarios to better understand what could potentially negatively affect CCR. Possible scenarios are:

  • Price runs with massive increase in credit spreads and later downgrades;
  • Insufficient eligible collateral after increased  haircuts on posting of collaterals;
  • Dry-up of collateral liquidity with subsequent collateral value decrease;
  • Default of a central counterparty for derivatives (CCP)

Model risk

Given their high level of complexity, CCR models have to be regularly reviewed in order to assess, and possibly measure, the underlying model risk. In order to minimize this risk, the following tasks should be performed:

  • Review by independent parties to ensure correctness of implementation and soundness of model assumptions;
  • Regular backtesting of model outcomes;
  • Monitoring and update of model parameters, like WWR;
  • Benchmarking on alternative modeling approaches

​Communication

One of the key factor for successful treatment of CCR is a transparent communication regarding major aspects on the model and the portfolio like:

  • Detailed reports on counterparties with the highest concentration in CCR;
  • Sensitivity of exposures to changes in market and credit variables;
  • Transparent communication on model assumptions, limitations and weaknesses.

Active management

  • CCR should be integrated in the top-down risk appetite framework of the institution, i.e. at least in its tolerance for deterioration of solvency ratio(s), accounting profit and liquidity ratios, and pro-actively managed by contingency plans if plausible adverse scenarios imply risk tolerance to be exceeded;
  • CCR retained from trading or credit portfolio management activities are limited by capital, earnings volatility and concentration limits. It is generally transferred to a specific CVA desk (different from the credit trading desk) for passive pricing per trade, but also for active mitigation and diversification at portfolio level.

 

Part 2

Part 2: Hot Topics Related to  Counterparty Credit Risk

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