Proposed changes to Counterparty
Credit Risk in Basel Accord
Presentation to PRMIA/ISDA seminar
London, March 8 2010
Maxine Nelson, FSA
Strengthening the resilience of the banking sector
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Agenda
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Background
Proposed changes summary
CVA loss charge
Central counterparties
Asset value correlation
Wrong way risk
Margin period of risk
Collateral management
Backtesting
Stress testing
Shortcut method
Alpha
Conclusion
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What is CCR?
The counterparty credit risk is defined as the risk that the
counterparty to a transaction could default before the final
settlement of the transaction’s cash flows.
• Bilateral risk of loss
• Value of exposure changes over time as market
risk factors change
• Applies to
– OTC derivatives
– Securities financing transactions
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What is calculated under CCR rules?
• A loan equivalent Exposure at Default (EAD)
• 3 ways of calculating EAD
– CCR mark to market method
– CCR standardised method
– CCR Internal Model Method (IMM)
• Changes generally focus on IMM
– IMM uses “Effective Expected Positive Exposure”
(EEPE) “metric” times Alpha
– EEPE assumes diversification, granularity and no
wrong-way risk
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Strengthening capital requirements
• Raise capital buffer
• Reduce procyclicality
• Strengthen risk management
• Incentives to move bilateral OTC
derivatives to central counterparties
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Key Issues Identified
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Credit valuation adjustments (CVA) causing large mark-tomarket losses
Higher correlation between financial institution asset
correlation
Central counterparties not sufficiently used
Wrong way risk not adequately captured
Long close-out periods for large netting sets; complex
trades; illiquid collateral
Initial margin increased (in-dept amount)
Securitisations risky
Backtesting
Stress testing
Use of own estimates of alpha
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CVA Charge
Regulatory framework does not capture volatility of CVA losses
• CVA VaR not currently practical
• Bond equivalent approach
– Market risk framework
– P&L from CVA as being long a hypothetical
bond issued by the counterparty where:
– Notional of the “bond” total EAD of a counterparty (treated
as fixed)
– Maturity of the “bond” Effective Maturity (M) of the longest
dated netting set of a counterparty
– Time horizon one year
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Central Counterparties
Need strong risk management procedures for preferable capital
treatment
• Incentivise the use of CCPs
• Increased capital for non-CCP deals
• Exposure for trades with CCP
– Zero exposure to remain for exposures to MtM and
posted collateral
– Developing non-zero capital charges for default
/guarantee fund exposures – in line with BIPRU
• Update CPSS/IOSCO requirements
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Asset Value Correlations (AVC)
Financial institutions more correlated
• AVCs for financial firms were 25% or more higher than
AVCs for non-financial firms
• 1.25x multiplier for financial firms AVC
• AVCs between financial firms would be 15%-30%
• Non-linear relationship between capital and AVC
• Broad definition of financial firms includes banks,
broker dealers, hedge funds, highly levered entities
• Applies to all exposures to financial (e.g. loans) – not
just CCR
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General wrong way risk
Positive correlation between PD and market risk factors
• Calculate EEPE using parameters from more
conservative of
– Recent experience
– Period of stress
• Reduces cyclicality
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General wrong way risk (continued)
Positive correlation between PD and market risk factors
Stress testing
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To identify general WWR
Monitor WWR by region, industry, etc
Part of senior management MI
Manage the risk
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Specific wrong way risk
Legal connection between underlying and counterparty
Specific WWR charges for:
– Single name credit default swaps
– Equity derivatives referencing single
counterparty
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Margin Period of Risk
Losses due to longer close-outs and “fire sales”
Margin periods of risk
Current
Conditions
Proposed
OTC
SFT
OTC
SFT
Netting sets with legally enforceable margin
agreements
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Netting sets with legally enforceable margin
agreements containing more than 5,000 trades
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20
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Netting sets with legally enforceable margin
agreements containing an illiquid trade
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5
20
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Netting sets with legally enforceable margin
agreements containing more than two disputes
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20
10
Netting sets with legally enforceable margin
agreements containing more than 5,000 trades
or an illiquid trade and more than two disputes
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40
40
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Collateral Management
Collateral management practices not robust
• No benefit from collateral agreements with
downgrade triggers to be made explicit
• Controls for reuse of collateral
• If can’t model collateral jointly with exposure
– Calculate own haircuts under the standard of financial
collateral comprehensive method with own haircut
– Use supervisory haircuts estimates
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Collateral Management (cont.)
Collateral management practices not robust
• Performance of collateral
management department
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Data integrity
Reuse of collateral
Collateral concentration tracked
Timely and accurate collateral calls
Regular reporting
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Collateral Management (cont.)
Securitisation collateral riskier
• Securitisations double haircut of
corporate collateral with same rating
• Resecuritisations ineligible as collateral
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Back testing
Shortcomings in back-testing approaches
More explicit requirements for:
• Senior management involvement
• Part of risk management
• Independent review
• Acceptable criteria
• When testing must be carried out
• Range of tests needed
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Stress testing
Existing risk management not adequate to help prevent unforeseen
losses
• Senior management engagement
• Multi-factor stress testing
• Quarterly joint movement of exposure and PD
• Exposure stress testing
• Regular reporting
• Severe shocks – impact on capital resources and
requirements
• Less severe shocks for day-to-day monitoring
• Reverse stress tests
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Shortcut method
Collateral at t = 0 not reflected appropriately
• Allows Effective EPE to be calculated by banks
that could not model EPE with margin
agreements (but can otherwise model EPE)
• Adjusted to reflect collateral not received at t = 0
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Alpha
Mis-specification of alpha numerator
• Alpha is a broad brush adjustment multiplied by
effective EPE to derive EAD
• Insufficient evidence exists to recalibrate Alpha
• Nature of portfolio risk suggests Alpha floors (1.4
standard; 1.2 own estimate) should be maintained
• Concern exists over mis-specifications in Alpha
own estimates
• Enhanced requirements to avoid mis-specification
in models when banks use their own estimates of
Alpha
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Counterparty Credit Risk Changes
Further questions?
Email baselqis@fsa.gov.uk
and your supervisor
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Wrap-up
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Proposed changes summary
CVA loss charge
Asset value correlation
Central counterparties
Wrong way risk
Margin period of risk
Collateral management
Backtesting
Stress testing
Shortcut method
Alpha
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