A commentary on the approaches to measuring counterparty risk and why all institutions need not be leading edge.
With so much emphasis placed on changes that the major banks have to make in calculating their credit exposure and capital it is easy to forget that most of the world’s banks are not systemically important nor derive a huge amount of business from complex derivative products. Most financial institutions are not banks at all - asset managers, insurance companies and other institutions all need to have a methodology for measuring their credit exposure, but they may not need to adopt the same level of sophistication as the global banks. In this paper we explore the approaches that may be appropriate for smaller and less sophisticated institutions.
Before focussing on the needs of smaller institutions we will briefly review where the “leading edge” is. Recent years have seen huge innovations and regulatory developments in the field of credit risk measurement. Major financial institutions have developed sophisticated Monte Carlo models to calculate their credit exposure. Under the Basel II and III Internal Model Method Approach banks are allowed to use these models to calculate their regulatory capital for counterparty risk. The importance of Credit Valuation Adjustment (CVA) has risen, with the most sophisticated institutions setting up functions to actively manage CVA and calculate the CVA risk capital charge under the advanced method under Basel III.
A significant proportion of OTC derivatives will soon be cleared via central counterparties (CCPs) and a huge spend is underway to put in place the infrastructure to enable banks to deal through CCPs and support clearing services for clients that will not themselves be members of CCPs.
At the other end of the spectrum are the simpler institutions which largely ignore counterparty risk. If they take it into account at all, they look at it on a notional basis or perhaps apply the BIS 1 add-ons. The financial crisis demonstrated that financial counterparties are not too big to fail and we would recommend that no institution should ignore counterparty risk or consider it on a notional or highly simplistic BIS1 basis. Each institution needs to find the approach that best meets its needs.