SOURCE: Derivatives Special Report

RISK MANAGEMENT
The most advanced banks then turned their
attention away from market risk and started to
invest in counterparty risk measurement, developing
measures of Potential Future Exposure
(PFE) calculated using Monte Carlo simulation.
The use of collateralisation also became more
widespread as a mitigant for counterparty risk.
Banks initially used the Credit Support Annex
(CSA) to mitigate exposure to poorly rated
counterparties such as hedge funds with which
they were not prepared to take unsecured
exposure. The use of the CSA soon evolved
to be used on a bilateral basis between large
interbank counterparties.
The financial crisis provided an enormous
jolt to the financial system and shone a
light on counterparty risk management practices.
A plethora of financial regulation followed
and in the counterparty space one of the most
significant initiatives was the establishment of
central clearing counterparties (CCPs) through
which a large proportion of OTC transactions
will need to be cleared. All cleared transactions
will be subject to an Initial Margin (IM)
requirement but a large proportion of noncleared
derivatives will also require an IM.
The approach to Credit Valuation Adjustment
(CVA) has evolved equally rapidly along a
parallel path. For many years the largest banks
have been using hedging techniques to manage
their counterparty exposure. This activity
was, however, confined to a small number of
the most sophisticated banks. The introduction
of accounting regulations requiring a
CVA to form part of a bank’s reported P&L
accelerated the implementation of CVA. This
introduced considerable volatility into banks’
trading profits and increased the focus on the
management of CVA.
In its post mortem of the financial crisis
the BIS observed that banks’ losses from CVA
exceeded credit losses from actual defaults
but that banks failed to hold sufficient capital
against such losses. Basel III subsequently
introduced a capital charge which now
requires banks to hold regulatory capital for
CVA. There have also been a number of other
changes to the calculation of regulatory capital
for counterparty risk.
Traditional approach
We start the commentary on the evolution of
counterparty risk management with the way it
used to be. Elements of this approach remain
to a greater or lesser extent in all institutions.
The traditional approach focussed on the credit
assessment of the counterparty. Transactions
were largely uncollateralised and the measurement
of exposure was unsophisticated. Credit
risk managers based their assessment on due
diligence of the counterparty – a review of the
counterparty’s financial results, business model,
regulatory environment and management
quality - and came to a view on the limits they
were prepared to grant.
The traditional approach to counterpar-
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