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.