The objective of this research paper is, first, to bring some clarity on how to deal with Counterparty Credit Risk (CCR) in the current financial environment by detailing some of the multiple aspects and challenges involved. Secondly, the goal of this document is to study the conditions for the effective risk management of CCR. This will be achieved by detailing and comparing capital requirements, identifying inconsistencies in prudential regulations and applying the various capital approaches on some typical portfolio strategies observed within financial institutions.
CCR started essentially as a valuation issue. Slowly, market practice and standardised tools have emerged, for example the use of CVA desks. However, during the recent crisis, another issue came to prominence; the significant losses that CCR can cause if not managed properly. In response to this pressing matter, regulators have developed a number of alternative approaches to measure this new type of risk, including both standard default risk and market risk, leading to various types of capital requirements. The purpose of this paper has been to assess the impact of these different methodologies on some typical portfolio strategies. This is of critical importance in understanding the potential incentives of moving from one approach to the other, and the necessary solutions to manage and possibly mitigate capital requirements.
Nevertheless, in the event of another credit crisis, simply realising what is required will not be sufficient in avoiding major losses. What is also required is sound and active risk management. Financial institutions should develop their own internal models to deal with regulatory inconsistencies, complemented with forward looking measures (not only referring to past historical data), and take appropriate actions to mitigate CCR. For all these reasons, it is necessary to have reliable and transparent models that not only provide reporting information, but also enable risk managers to assess the potential impact of their decisions.
Progressing in the direction of active CCR management requires a clear vision of all the aspects and challenges involved. In this paper, we have summarised some of these elements to help risk managers grasp the depth and complexity of the topic.