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 simplier. Limits were set on the same basis as traditional lending, and the 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 specified under Basel I.
The wave of change started as institutions, led by the banks, began to improve their internal measurement of counterparty risk. Simplistic add-on approaches were replaced by more sophisticated add-on methodologies, which were able to take into account portfolio effects and close-out netting. Many leading institutions went a step further and replaced the sophisticated add-on methodologies with Monte Carlo simulation. However, not all institutions deemed it necessary to move this far, and for many a more simplistic approach may still be appropriate (see InteDelta’s publication – Counterparty exposure: sometimes simple is good enough).
Basel II replaced the previous simplistic rules for the calculation of regulatory capital and gave banks the option of using their own internally built models to calculate regulatory capital. This can lead to significant capital savings but requires banks to invest heavily in new systems, processes and quantitative personnel.
Recommended Whitepapers and Articles
Measurement and Management of Counterparty Risk
Optimising Capital Requirements for Counterparty Credit Risk
How the Credit Crisis Has Changed Counterparty Risk Management
Managing Credit Risk by Counterparty Selection