Gianni Baroncini Valerio Meloni 1 Definition Examples Regulation Measuring Management 2 This type of risk occurs when exposure to a counterparty is negative correlated with the credit quality of that counterparty. There are two types of wrong-way risk: - Specific wrong way risk arises through poorly structured transactions, for example, those collateralized by own or related party shares; - General or conjectural wrong way risk arises where the credit quality of the counterparty may for non-specific reasons be held to be correlated with a macroeconomic factor which also affects the value of derivatives transactions. 3 Consider an investor who takes a long position in shares of Bank A. To hedge the investment, the investor buys from Bank B put options on those shares. If the credit and capital profiles of Banks A and B are similar, then the investor is taking on wrong way risk. To avoid it, the investor should purchase puts from a counterparty whose credit quality is independent from Bank A. 4 Taking a long position in an Interest rate swap, where a counterparty pays variable and receives a fixed rate, but whose credit quality is significantly correlated with interest rates. In this case, an increase in interest rates will raise both the value of the derivative and the likelihood of the counterparty defaulting. 5 An institution takes a short position in a currency with a counterparty based in this country; If a country crisis leads to a counterparty defaulting, the currency will have a depreciation. The value of the position will then have an unexpectedly increase, so a very high exposure, leading the institution to experience a potentially severe loss. 6 Basel II highlighted wrong-way risk as an area which should be specifically addressed by banks in their risk management practice as far back as 2001. However, only in recent time wrong-way risk has become a more important area for risk managers. There are a number of reasons for this. In part it is due to the advancements in credit derivative trading that bring creditworthiness into the trading book as a market factor. It also is due to the sub-prime crisis in 2007, the subsequent market volatility and the increasing attention being paid to credit risk. 7 Each separated legal entity to which the bank is exposed must be separately rated. A bank must have policies acceptable to its supervisor regarding the treatment of individual entities in a connected group including circumstances under which the same rating may or may not be assigned to some or all related entities. Those policies must include a process for the identification of specific wrong way risk for each legal entity to which the bank is exposed. Transactions with counterparties where specific wrong way risk has been identified need to be treated differently when calculating the EAD for such exposures. Exposure amount at default, or EAD, is calculated as the product of alpha times Effective Positive Exposure (EPE), as specified below: EAD= α x EPE 8 • Specific wrong way risk A bank is exposed to “specific wrong-way risk” if future exposure to a specific counterparty is highly correlated with the counterparty’s probability of default. A bank must have procedures in place to identify, monitor and control cases of specific wrong way risk, beginning at the inception of a trade and continuing through the life of the trade 9 • General wrong way risk Banks must identify exposures that give rise to a greater degree of general wrong-way risk. Stress testing and scenario analyses must be designed to identify risk factors that are positively correlated with counterparty credit worthiness. Such testing needs to address the possibility of severe shocks occurring when relationships between risk factors have changed. Banks should monitor general wrong way risk by product, by region, by industry, or by other categories that are germane to the business. Reports should be provided to senior management and the appropriate committee of the Board on a regular basis that communicate wrong way risks and the steps that are being taken to manage that risk. 10 • Credit Valuation Adjustment Banks will be subject to a capital charge for potential mark-tomarket losses (credit value adjustment – CVA – risk) associated with a deterioration in the credit worthiness of a counterparty. 11 • Central Counterparties (Clearing House) Subject to the completion of the revision of the CPSS-IOSCO standards, the Committee will apply a regulatory capital enhanced CPSS-IOSCO standards. The Committee will issue a set of rules relationg to the capitalisation of bank exposures to central couterparties (CPPs). This set of standards will be finalised after that an impact study is complete and after CPSS-IOSCO has completed the update of its standards applicable to CCPs. The Committee intends for these standards to come into effect at the same time as other counterparty credit risk reforms. 12 There are different models to measure Wrong-way risk; All of theme are a manipulation of measurement approaches used for credit risk(CVA, EPE) to consider a positive correlation between the exposure and the probability of a default; All these methods must be implemented with a Monte Carlo simulation. 13 Starting from CVA(credit value adjustment): M CVA (1 R ) E ( Max (V ( t ), 0 ) T t ) * h ( t ) * DF ( t ) dt 0 Where: -V(t) is the replacement value of the derivative at time t; -Τ is the time at which Party B defaults; -h(t) is the probability density function for Τ (i.e., the hazard rate function); -R is the expected recovery rate; -DF(t) is the risk-free discount factor for time t; -M is the maturity date of the derivative contract; -E(Max(V(t),0)|T=t) is called “default option”. 14 The first and simplest method to adjust CVA is to use “alpha” multiplier to increase the Expected Net Exposure=E[max(v(t),0)|T=t]; In this case the probability of default is still uncorrelated with the Net Exposure; Estimates of alpha reported by banks range from 1.07 to 1.10. 15 The second method to consider Wrong-way risk into CVA is to create a correlation between h(t) and the Expected Net Exposure; We could write also h(t) as function of V(t): h ( t ) exp[ a ( t ) b * V ( t ) ] Where: -b is a constant parameter, which measures the amount of wrong-way risk in the model; - a(t) is a function of time; -σ is a constant measuring the amount of noise; -ε is a N(0,1). 16 The last method to consider Wrong-way risk into CVA is the use of Gaussian copula to create a correlation between time to default and the Expected Net Exposure; The replacement value of the derivative can be simulated with a shifted lognormal distribution; The correlation between time to default and replacement value can be simulated with a bivariate Gaussian copula[X(t),X(v)]. 17 The outcome of X(t) will be used to tell us when Party B defaults; If Party B does default before the maturity of its contract with Party A, we observe the value of X(v). This draw is used to tell us the replacement value, from Party A’s perspective, of the derivative contract under a lognormal model; A high value for X(v) will result in a replacement value owed from Party A to Party B; Party A’s loss at the time of Party B’s default is valued as the product of loss-given-default and the value of a default-contingent option. 18 Another measurement approach is to manipulate the EPE(Expected positive Exposure), that is the expected positive mark-to-market value averaged over time; Insert in the model a significant positive dependency between the probability of counterparty’s default and the mark-to-market value. 19 Monte Paschi Siena during 2010, in order to reduce its counterparty risk (and so also the wrong way risk), decided to indirectly join at the central counterpart LCH. Clearnet London for the OTC activity. The uses of a clearing house is the simplest way to bear this kind of risk. More specifically to the wrong way risk, at December 2011, there was in progress a progectual activity in order to identificate and manage correctly the wrong way risk. 20 The management of wrong way risk for Unicredit bank is, respect to Monte Paschi, in a more advanced state. Indeed, in respect of “General worng way risk”, Unicredit knows to have some exposure, but its impact is insignificant, and it is controlled through the setting of limits. In respect of “Specific wrong way risk”, the structure of proposed transactions is carefully reviewed, with special recourse to the financial instruments that are pledged as collateral. Unicredit does not accept as collateral financial instruments issued either by the counterparty in the envisaged transaction or by any affiliated entity of the counterparty. 21 Crédit Suisse, is one of the most advanced banks to manage wrong way risk. Indeed, they have multiple processes that allow them to capture and estimate wrong way risk. The first level is “Credit approval and reviews”, in which the Credit Risk Management division monitor counterparty exposure and its creditworthiness. Credit limits are sized to the level of comfort the CRM officer has with the strategy of the counterparty, the level of disclosure of financial information and the amount of risk mitigation that is present in the trading relationship (for instance the level of collateral) 22 The second level is the “Exposure adjusted risk calculation”, in which trades that feature specific wrong way risk have higher risk weighting built into the exposure calculation process compared to “right way” trades. For example, regarding the equity finance, if there is a high relatedness between the counterparty and the underlying equity, exposure is calculated as full notional ( and so with zero equity recovery). A third levels the “Wrong way risk monitoring”, regular reporting of wrong way risk at both individual trade and portfolio level allows wrong way risk to be monitored and corrective action taken taken by CRM in the case of heightened concern. For example, scenario risk reporting in order to capture wrong way risk at the industry level, a set of defined scenarios are run on the credit portfolio each month. 23