SOURCE: Derivatives Special Report

RISK MANAGEMENT
of the losses incurred during the financial
crisis might have been better mitigated had all
transactions been collateralised, and had they
been subject to an IM with specific segregation
arrangements.
Transactions cleared through a CCP will
be subject to an IM. A sizeable proportion
of OTC derivatives will, however, remain
non-cleared. For these transactions the Basel
Committee on Banking Supervision (BCBS)
and the International Organization of Securities
Commission (IOSCO) have issued rules
which will have the effect of subjecting a large
proportion of non-cleared transactions to IM
requirements. The requirement to post IM will
be bilateral – both counterparties to a trade
must post to one another on a gross basis with
specific segregation mechanisms which do not
allow IMs to be netted.
Under the BSBS/IOSCO rules a bank may
choose either to apply a standardised schedule
of IM requirements or to use its own models
to calculate IM under principles laid down in
the rules. It is unlikely that many institutions
will choose the former as the standardised
requirements are punitively high and would
likely render the bank uncompetitive. The use
of banks’ own models to calculate IM, however,
is likely to create reconciliation problems
between counterparties and there are a number
of industry initiatives which are seeking to
standardise IM requirements such as the ISDA
Standard Initial Margin Model for non-cleared
derivatives (SIMM).
Credit Valuation Adjustment
CVA is an adjustment to the value of a derivative
to account for expected counterparty
losses. The most sophisticated banks have been
calculating, and in some cases actively managing,
CVA for many years. Accounting and
regulatory changes have forced many smaller
banks to follow suit and CVA is now an important
component in the measurement and management
of counterparty risk along with other
valuation adjustments such as Debit Valuation
Adjustment, Funding Valuation Adjustment
and Liquidity Valuation Adjustment.
The management of CVA within financial
institutions (mainly banks) has undergone an
evolution which in many institutions is still
continuing. Banks often start by viewing CVA
Many institutions see their
exposure to CCPs as a cost
of doing business and
therefore quantify their
exposure to CCPs without
necessarily limiting it.
as a pure accounting and regulatory capital
calculation. Initial methodologies for the calculation
of CVA are often fairly simplistic and
typically apply historic probabilities of default
(PDs) to the expected counterparty exposure
to arrive at CVA. More sophisticated methodologies
typically follow, such as using market
implied PDs derived from Credit Default Swap
CDS spreads. Banks often find that there is no
CDS for many of their counterparties and they
therefore need to adopt a proxying methodology
to derive the PD.
Once a bank is in possession of a CVA calculated
on a market implied basis it is able to
price for counterparty risk. In the first instance
this typically involves putting procedures in
place to ensure that client transactions adequately
compensate for counterparty risk. This
may be followed by the implementation of an
internal transfer pricing mechanism whereby
CVA is charged to the P&L of originating business
lines or individual desks. This can have a
motivational effect on the front office to ensure
that risk is adequately compensated for and to
incentivise them to enter into transactions with
optimal counterparties.
The final stage in the evolution of CVA practices,
which many banks have not yet reached
or have chosen not to reach, is the establishment
of a desk to actively manage CVA. The
remit of such desks varies between institutions,
but usually includes hedging activities to reduce
the P&L volatility introduced by the CVA
charge and to manage concentrations to specific
counterparties, sectors or countries.
Regulatory capital
Regulatory capital has taken on an increased
importance since the financial crisis. For counterparty
risk Basel II/III permits three methods
of calculating counterparty exposure which
feeds into the regulatory capital calculation:
■ Current Exposure Method (CEM)
– banks apply a prescribed set of fairly
crude add-ons to the nominal value of
transactions. The method gives very
limited benefit for netting and collateralisation
and does not take into account
portfolio correlation or diversification
effects
■ Standardised Method (SM) – a more
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