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.