Counterparty risk can be defined as being the risk that a counterparty to a transaction may default prior to the expiration of the contract and be unable to make agreed contractual payments.
It has risen up the agenda for corporate treasurers since 2008, with experience revealing that the banking and financial crises had their roots in poor credit standards and portfolio risk management. The crises revealed a widespread inability or failure to:
- Evaluate the impact of the changing economic environment on credit worthiness of counterparties.
- Progressively refine and sophisticate risk management configuration.
When these lapses occur, counterparty-driven concerns directly lead to large-scale recovery-focused asset sales that result in markets seizing up and a deepening state of crisis. The ensuing sell-off affects all but the safest assets and leaves key elements of the global financial system dysfunctional. Thus, counterparty stability directly impacts on financial stability.
In such a scenario credit and money markets get stuck and equity prices plunge, while banks and other financial institutions (FIs) see their ability to access funding impacted and their capital base shrinking due to accumulating mark-to-market losses. Credit spreads surge to record levels, equity prices touch historic lows and volatilities soar across markets, indicating extreme financial market stress.
Principles of Risk Management Philosophy
When counterparty concerns are not adequately addressed, the financiers face serious challenges and the system undergoes significant change as risk management practices come under critical review. Regulators step in to guide the financial markets – sometimes with stringent prescriptions as we have seen with the Basel III and Solvency II capital adequacy regimes. Governments may have to intervene with rescue packages, which typically have some very bitter medicine attached.
The sixth of the ‘Principles for Sound Liquidity Risk Management and Supervision’, issued by the Bank for International Settlements (BIS) requires banks to actively monitor and control exposures and funding needs within and across legal entities, business lines and currencies, taking into account legal, regulatory and operational limitations.
Given the lessons already learnt from the 2008 financial crisis, going forward the following should be regarded as the main principles of any firm’s risk management philosophy:
- Reorienting risk management function as a business enabler.
- Broadening the discussion on risk issues.
- Providing for more qualitative inputs over quantitative risk modelling.
- Revision of incentive structures to better align them with risk-reward outcomes.
- Increasing the focus of business lines on risk-adjusted earnings, thus leading to real-time risk management.
- Exploring non-bank funding options as an alternative
Such real-time credit systems allow credit managers to assess credit exposure to counterparty risk throughout the life of a transaction. Credit officers and treasuries are better able to manage crisis situations and to adjust limits as the creditworthiness of a counterparty changes. A real-time credit system ensures that any changes in the credit limit of a counterparty are immediately reflected in the sales and trading system, or the financial supply chain.
Needless to say such a system calls for institutionalising sophisticated risk management processes, including a robust stress-testing and economic capital allocation framework at an FI. This should be coupled with strong validation mechanisms to ensure the integrity of collateral management policies; credit risk mitigation; disclosures and the adequacy of the management information system; the impact of various elements of the portfolio, as well as the results of the process for validation.
Sample Exposure Analysis for Counterparty Risk
The named counterparty may have entered into several transactions of differing types, maturities and currencies. In such a case, a simple exposure analysis for arriving at the total (gross or netted) counterparty risk will be as follows:
Valuation process on a real time basis covering pricing of products: For such a valuation, both static and dynamic data is required. Depending on the dynamic data used, the valuation process will be classified as mark-to-market or mark-to-model. The four steps are:
- List all the transactions entered into with a named counterparty.
- Apply valuation process. Collect static data and dynamic data of the products; apply mark-to-market or mark-to-model on real-time basis to re-work pricing and to calculate different Greeks, which measure the sensitivity of the value of a portfolio to a small change in a given underlying parameter.
- From re-pricing rework all the exposures and aggregate to find out gross or consolidated exposures.
- Apply netting if there is an internal policy for monitoring and compare it with limits prescribed for the counterparty.
However, it should be stressed that the implementation of advanced approaches, particularly for credit risk, is a data-intensive exercise. As a minimum requirement, banks are likely to need acceptable historical data for the past five to seven years for computing risk parameters such as probability of default, loss given default and operational risk losses.
Ideally quantitative risk modelling involves periodic validation, to satisfy regulators that it is able to detect and overcome implementation shortcomings and ensure model performance. In this validation certain stability parameters such as calibration, profit and loss attribution, variance of hedged portfolio and cost of hedging will be focused. Intrinsic validation exercises will cover valuation scenarios, assumptions for future scenarios, and multiple inputs for projection, to arrive at an intrinsic value that permits informed decision making. The price verification procedure will cover back testing and a review of tools. Market risk limitations such as coverage gaps, stale prices, gaps in objectivity, lack of transparency and any potential conflict of interest will also have to be taken care of. To ensure quality, reliability, independency, consistency and comprehensive coverage, counterparty risk models will need periodic testing and validation.
The upheaval in global financial markets of the past five years has caused more chaos than the world has witnessed in its entire economic history. Financial market turmoil has not yet come to an end, indeed reports suggest that further phases are yet to come and treasurers are still experiencing the upheaval to usual bank funding procedures. More major financial institutions have either failed or been rescued by their peers via takeovers or by taxpayer-funded bail-outs, while a number of markets have exhibited instability.
Counterparty risk has steadily moved up the corporate agenda, particularly after the Lehman episode of September 2008. Market events have driven home the critical importance of counterparty risk management, not only from a regulatory angle but to ensure the very survival of financial institutions and of funding for corporates. Many have turned away from bank funding and found alternative financing from commercial paper or other avenues, but longer-term any and all financing options are welcome. Whatever routes are chose, counterparty risk management will be a key element in any strategy.
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