The Evolution of Counterparty Credit Risk

Although the recent crisis has brought a heightened focus, counterparty credit risk theory and practice have been evolving for over a decade. Initially banks addressed the problem from their traditional financing experience while investment banks approached it from a derivatives perspective.

As the industry consolidated in the 90’s, culminating with the repeal of Glass- Steagall in 1999, there was substantial cross-pollination of ideas and best practices. In particular, investment banks started to apply traditional derivatives pricing technology to the problem of assessing and quantifying counterparty risk. Consolidation and the necessity to free up capital as credit risk became increasingly concentrated within the largest financial institutions drove a series of innovations. These innovations involved both methodologies and management responsibilities. Policy responses to the crisis in terms of dramatically increased capital requirements and additional provisions for systemically important institutions are also influencing the evolution of counterparty risk management.

Counterparty risk management is evolving from passive risk quantification to active management and hedging. The term CVA (credit value adjustment) has become well-known and represents a price for counterparty credit risk. Substantial responsibility is being transferred from credit officers to ‘CVA traders’, groups with the responsibility of pricing and managing all the counterparty risk within an organisation. As various extensions to the reserve and market models have been implemented, a general consensus has emerged that essentially replaces portfolio theory and reserves with active management. Banks today tend to be distributed along the evolutionary timeline by size and sophistication where global banks have converged to the consensus model whilst smaller and more regional banks, together with other financial institutions such as asset managers, are closer to the beginning stages. Basel III and new local regulations are playing an important role in accelerating the timeline. This paper traces the evolution of counterparty credit risk based on actual experiences within banks that have had considerable influence.

Reserve models are essentially insurance policies against losses due to counterparty defaults. For each transaction, the trading desk pays a premium into a pool from which credit losses are reimbursed. The premium amount is based on the creditworthiness of the counterparty and the future exposure, accounting for risk mitigants such as netting and collateral (margin) agreements and higher level aspects such as the overall level of portfolio diversification. Aggregate credit risk to each obligor is managed through exposure limits. Originally, reserve models used historical (usually ratings based) assessment of the probability of default (PD) rather than market credit spreads. Premiums are comprised of two components – the expected loss or CVA and the potential unexpected loss within a chosen confidence level, also referred to as economic capital. Traditional pre-merger banks and their eventual investment banking partners all used reserve models but the underlying methodologies were very different.

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