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.

Request A Copy

RELATED INSIGHTS

Whitepapers

Cost of Trading and Clearing OTC Derivatives in the Wake of Margining

Over-the-counter (OTC) derivatives markets continue to be impacted by regulatory changes. These interrelated changes are affecting financial institutions and their business operations. For example, rising capital requirements are impacting profitability and return on equity market participants are now being forced to clear standard OTC derivatives trades through Central Counterparties (CCPs). Soon, there will even be margin requirements for the remaining nonstandard, uncleared derivatives (MRUDs). This is prompting firms to better assess and manage costs (funding, collateral, capital) in a consistent manner at a trade, desk and business unit level. The question is, how much of these costs can be passed on to clients?

Whitepapers

Comparing Alternate Methods for Calculating CVA Capital Charges Under Basel III

The global financial crisis brought counterparty credit risk and CVA very much into the spotlight. The Basel III proposals, first published in December 2009, introduced changes to the Basel II rules that reflected the need for a new capital charge against the volatility of CVA.

Whitepapers

How the Credit Crisis Has Changed Counterparty Risk Management

The credit crisis and regulatory responses have forced banks to substantially update their counterparty risk management processes. New regulations in the form of Basel III, the Dodd-Frank Act in the U.S. and European Market Infrastructure Regulation (EMIR) have dramatically increased capital requirements for Counterparty Credit Risk.

Let's Talk!

Schedule a personalised demo today

Loading...