Counterparty credit risk

Counterparty credit risk

The Trading Book series
Background Counterparty credit risk is the risk that the counterparty to an over-the-counter (OTC) derivative or a repo-style transaction will default prior to the expiration of the contract and will not make all the payments required by the contract An economic loss would occur if the transaction or portfolio of transactions with the counterparty have a positive economic value at the time of default Since the contract value changes unpredictably over time as the market moves, only the current exposure is known with certainty, while future exposure is uncertain and is driven by market factors Moreover, since the contract value can change sign and either counterparty can default, counterparty risk is bilateral (unlike loans) Basel II capital treatment Under current regulation; capital is carried for the possible default of a counterparty under the credit risk framework The regulations provide three approaches to calculating the Exposure at Default (EAD) of an OTC or repo-style transaction, with the Current Exposure Method (CEM) being the simplest, and the Internal Model Method (IMM) being the most complex South African banks currently employ the CEM of calculating the capital required for counterparty credit risk, but some Tier 1 banks have indicated their intention to move to the IMM in the short to medium term Key changes introduced under Basel III The new proposals enhance the existing regulations relating to the calibration of EAD under the credit risk framework The proposals under Basel III primarily affect the more advanced IMM approach (as indicated alongside), but are likely to find their way into the CEM approach through a recalibration of its add-on factors The proposals also introduce a requirement to hold capital or the risk of the credit migration of non-defaulted counterparties (The Credit Valuation Adjustment (CVA) discussed overleaf) Measuring EAD under the IMM approach Key steps in calculating EAD under current regulations Generate market risk factor scenarios
Exposure 40 30 20 10 0 -10 -20 -30 -40 0 2 4

Market risk

Market-to-Future Changes introduced by Basel III proposals Marking-to-future must use stressed volatilities of market risk factors. This will give rise to a stressed EAD The regulatory floor for the period to close-out (the margin period of risk) is extended to 20 days for large netting sets or those containing complex instruments, and for illiquid collateral New requirements to improve the operational performance of the margin and collateral management units Enhanced controls relating to the additional liquidity risk imposed by the re-use of collateral More explicit requirements for stress testing counterparty credit risk exposures Stress testing should identify and stress those factors that are positively correlated to exposure (general wrong way risk) More onerous requirements for validation of counterparty credit risk models

Counterparty credit risk

Value positions

Valuation and illiquidity

8 10 Months

12

14

16

Aggregate and apply netting

8000 6000 4000 2000 Sum of Exposures

Adjust collateral

Exposure with Netting and Collateral applied 0.5 1 1.5 Time (years)

Obtain counterparty exposure profile

40 30 20 10 0

Potential Positive Exposure

Exposure

8 10 Months

12

14

16

Obtain counterparty exposure metrics

35 30 25 20 15 10 5 0

Effective Expected Positive Exposure

EE EPE Eff EE Eff EPE

Exposure

8 10 Months

12

14

16

Specific wrong way risk Captures instances where the creditworthiness of a counterparty is adversely correlated to exposure due to certain features of the design of the instrument The Basel III proposals require banks to establish processes to identify and monitor specific wrong way risk The proposals require adjustments to: - where specific instances of wrong-way risk are identified OTC EAD - e.g. where the counterparty and reference asset or reference entity in relation to a CDS or equity derivative are the same derivatives and repo-style - for highly leveraged counterparties or whose assets are predominantly traded assets PD transactions - Guidance is not provided relating to what constitutes a highly leveraged counterparty All R - A correlation multiplier of 1.25 is applied in the capital formula for large ($100bn) regulated financial institutions and unregulated financial institutions of any size

Basel III - January 2011

The identification of such instruments is inherently a manual process, and will require manual adjustments to the process of calculating risk weighted assets The treatment of specific wrong-way risk under the Standardised Approach is not dealt with in the December 2010 text

The proposed Credit Value Adjustment (CVA) Pillar 1 capital requirement Background The CVA is a valuation adjustment which reflects the creditworthiness of counterparties to OTC and repo-style transactions. As noted in the Valuation and Illiquidity section, there is no guidance in the accounting literature on how to incorporate the CVA into valuations, and a great disparity of practice exists The CVA Pillar 1 capital requirement reflects the capital requirement for unexpected variation in the P&L arising from movements in the CVA Banks that marked to market their CVAs experienced severe CVA volatility during the financial crisis. The variability of the CVAs reflected market turbulence, and to the extent that they left their CVA exposures unhedged, the P&L impact was severe Most derivatives dealers have established trading desks dedicated to the pricing and management of counterparty risks. Those desks have executed large amounts of hedges against their CVAs via credit default swaps and other derivatives Incentives to move toward central counterparties A central counterparty is an independent legal entity that interposes itself between the buyer and seller of a bilateral derivatives transaction The central counterparty provides the following benefits: - It performs multilateral netting of exposures and payments - It manages margins and collateral for all its counterparties - It increases transparency by making available information on market activity and exposures Under both the Basel II rules and the new proposals, exposures to central counterparties are risk weighted at 2%, provided they comply with the BIS / IOSCO Recommendations for Central Counterparties. These are currently being enhanced Given the onerous treatment of counterparty credit risk imposed by Basel III, there is a new incentive to develop central counterparties In South Africa, while derivative exchanges exist, the vast majority of derivatives activity is OTC. The sectorwide capital savings from a central counterparty for foreign exchange and interest rate swaps will be significant
South African daily OTC derivatives turnover, US$ billions, at April 2010

Regulatory scope CVA capital calculated on exposure to each counterparty, over the period of the effective maturity of the longest netting set with that counterparty Only required to include repo-style transactions in CVA charge if the regulator determines that they are material

OTC derivatives

Repo-style transactions

Within the banking or trading book, excluding transactions with a central counterparty Issues with the December 2009 proposal that are addressed All CVA hedges should be recognised The finalised rules extend permissable hedges to include single name CDSs, single name contingent CDSs, other equivalent hedging instruments referencing the counterparty directly, and index CDSs The recognition of these instruments under the Advanced CVA approach is conditional on the bank capturing any basis risk in its VaR model The CVA is potentially double counted via the maturity adjustment in the banking book capital charge under the Internal Ratings Based (IRB) approach for credit risk The BCBS states that the maturity adjustment in the credit capital calculation can be interpreted as additional capital requirements due to downgrades. Downgrades are more likely in the case of long term credits, and hence the anticipated capital requirements will be higher than for short term credits The final text allows for the elimination of the double counting by setting the maturity adjustment in the IRB capital calculation to 1, thereby capturing default-only risk, but only if the bank can demonstrate that migration risk is adequately captured in its specific VaR model No similar relief is provided under the Standardised CVA approach CVA is now measured as the 10-day 90% VaR, rather than over one year as originally proposed. This eliminates the 5x square root of time scalar There is no explicit mention of the need to apply the 3x multiplier to the VaR and stressed VaR under the Advanced CVA approach

Mean

99% 10 day VaR Tails

Pillar 1 CVA charge

CVA is double-counted in the proposed framework

Volatility Valuation CVA The CVA calibration is too high

Stress tests

Advanced CVA approach The Advanced CVA approach can only be used by banks with IMM approval for counterparty credit risk, and approval for modelling specific risk in the VaR model for bonds Thus, South African banks will not be able to use the modelled Advanced approach to CVA Current Market risk factors Stressed Expected exposure on a mark-to-future basis
99% 10 day VaR VaR of CVA

Issues with the December 2009 proposal that remain unaddressed The essential nature of the bond equivalent approach proposed in December 2009 is retained, despite the concerns expressed by the industry The bond-equivalent is a bad proxy for CVA risk The BCBS has indicated that, for the moment, there is no scope for more risk-sensitive and complex approaches P&L volatility arising from the CVA is very dependent on the accounting method used in valuing the OTC or repo-style transaction, and thus multiple approaches should be allowed for the calculation of the CVA capital requirement to reflect the underlying accounting treatment For CVAs calibrated to through-the-cycle estimates of counterparty credit risk, based on historic loss norms, P&L volatility is reasonably low, reflecting deviation from the long term norm. The CVA capital methodology in this instance should aim for a stable capital charge, in line with a through-the-cycle approach For CVAs based on market-implied adjustments from CDS spreads, more volatility will arise, which should be reflected in the CVA capital methodology, along the lines of the Advanced CVA approach

VaR The CVA capital methodology should follow the accounting

6 11.1 OTC foreign exchange OTC interest rate

Source: BIS Triennial Central Bank Survey

The CVA input into the VaR model follows a normal Expected Loss function, measured over the effective maturity of the longest netting set with the couterparty

EE

CVA = EL, f (LGDMKT, PDMKT, EE)

Market-implied PD

PDMKT

LGDMKT

Market-implied LGD Stressed VaR

Current

CDS spreads

Stressed

The CVA capital charge is the sum of the VaR and the stressed VaR Standardised CVA approach CVA capital charge = (Risk weight, EAD) The risk weight is derived from the counterpartys external credit rating EAD is the current exposure to the counterparty Contact Catherine Stretton Partner Financial Services Team +27 84 444 7033 cstretton@deloitte.co.za

Capital is measured over the effective maturity of the transactions with the counterparty