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 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.
The 2008 financial crisis placed a further spotlight on counterparty risk, institutions that to this point had been judged rock solid failed, these events gave rise to the proliferation of new regulation such as Basel III, Dodd Frank and EMIR. From a counterparty risk perspective this led to the creation of central counterparties (CCPs) through which the majority of OTC derivatives will be cleared. Even before the migration to CCPs an increasing proportion of transactions between counterparties were collateralised under a Credit Support Annex (CSA). More extensive use of collateral has led the most sophisticated banks to migrate responsibility of collateral management from its traditional home within operations to a front office function, where emphasis is placed on optimising the collateral to be delivered.