Managing Counterparty Credit Risk

by David Shimko

Executive Summary
• • • • Counterparty risk exposure is the financial measure of performance risk in any contract. Many contract exposures are managed through operational or legal means; this article focuses on financial risk management. Counterparty credit exposure equals current exposure (accounts receivable minus collateral) plus an adjustment for potential future exposure based on possible increases in future net receivables. A comprehensive credit risk management policy addresses counterparty initiation and monitoring, contracting standards, credit authorities and limits, the transaction approval process, credit risk reporting, and reserving and capital policy. Credit risk mitigation is best handled through collateral, but there are legal and financial means to mitigate credit risk as well. Credit insurance can fit the exposure perfectly, but may be costly. Credit default swaps are linked to credit events and payments that may not correspond exactly to counterparty exposures, but may be cheaper than credit insurance.

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Defining Counterparty Risk
Counterparty risk is the risk to each party of a contract that the counterparty will not live up to its contractual obligations; it is otherwise known as default risk. Counterparty risk relates closely to performance risk. It arises whenever one entity depends on another to honor the terms of a contract. If a parts supplier fails to provide steering wheels to General Motors, GM will be damaged because of its inability to deliver complete cars. The resulting profit reduction is defined as the exposure that GM runs to its supplier. Similarly, GM runs a credit exposure to its customers who have not yet paid for their cars. This would include dealers and end customers who are financed by GMAC, GM’s financing subsidiary. Normally, performance risk is managed operationally—i.e., GM would use alternative suppliers, reserve supplies of steering wheels, and contractual nonperformance remedies to manage its performance risk. Also, to manage risk to its dealers, it may retain title to vehicles, verify insurance coverage, obtain some advance payment, and use legal means to minimize their collections risk. In addition to these counterparty risk situations, GM will experience counterparty risk from its derivative contracts. Suppose GM wanted to purchase steering wheels on an ongoing basis from a European supplier, and protect itself from devaluation of the US dollar. It would likely enter a foreign exchange swap transaction with a bank. After entering the contract, rates would continue to change, bringing the contract in-the-money to either GM or the bank. If the dollar were to devalue, the contract would move in-the-money to GM, which would expose GM to the possible failure of the bank to honor its contract. Conversely, if the dollar were to strengthen, the bank would have an in-the-money contract with GM, and subsequently become concerned about GM’s possible default risk.

Measuring Counterparty Risk
Counterparty risk exposure can be divided into accounts receivable exposure and potential future exposure. If collateral is held as a bond for performance risk, the amount of the collateral is deducted from the gross exposure calculation. If the collateral itself is risky, such as a deposit of traded securities rather than cash, the collateral may not get full credit. Therefore, total credit exposure can be defined as follows: Current exposure = Maximum of {Accounts receivable (A/R) – discounted collateral value} and 0 Potential future exposure = Current credit exposure plus maximum likely increase in future credit exposure

Managing Counterparty Credit Risk

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its expected loss is (0. while vulnerable profit shows cases where the bank may owe money to GM. credit risk reporting. credit agency reports.40 × 0. and the loss given default to be 50%. the percentage of the exposure that we never recover. both zero and positive.65σ#τ Expected exposure = 0. We call this estimate λ. One is the probability of default.40σ#τ Expected loss = 0. the peak and expected exposure can be determined as in Figure 2. we may summarize: Peak exposure = 1. its bank to have a default likelihood of 10%. To demonstrate this concept simply. the amortization of the swap payments reduces exposure over time. even after settlement or bankruptcy. Credit Risk Management Policy Best practice credit risk management policy includes the following items: • • • • • • counterparty initiation and monitoring. typically 95%. a reserving and capital policy.50 × 0. Counterparty initiation refers to the first time a company wishes to enter a transaction with a proposed counterparty. To determine the expected loss conditional on default. In the case of a swap rather than a single forward transaction. credit authorities and limits. the vulnerable profit could be as great as 1. The credit department typically reviews available public information.25) = 0. Figure 1. the expected exposure is 0. The financial status of the counterparty should be continually monitored to proactively detect situations where counterparty credit quality might deteriorate. which we will call π. Furthermore. Figure 2. The other is the loss given default. Although the current exposure is zero. Exposure of a swap The peak exposure can be used to understand how much risk is being taken with respect to the counterparty.15 × #0. For the normal distribution case.e. trading with a subsidiary of a triple-A company may provide little to no financial protection in the event of a default. The probability-weighted average of all the exposure figures. a duration of τ.0015 times the size of the transaction—i. and a normally distributed risk.The maximum likely increase in future credit exposure is defined relative to a timeframe and relative to a statistical confidence interval. This is also known as the peak exposure. if GM determines the Euro volatility to be 15% per year.. In this case. transaction approval process.e.. whereas the expected exposure is an indicator of expected losses. $1500 per million dollars hedged.65 standard deviations using a 95% confidence interval. assume a potential foreign exchange transaction as an expected value of zero with an annual standard deviation of σ. i. one should assume in general that a benefit of trading with one legal entity cannot be netted Managing Counterparty Credit Risk 2 of 5 www.40πλσ#τ For example. This is illustrated in Figure 1. so that it does not necessarily rise with the square root of time.qfinance. the contract to be three months in duration (0. is known as the expected . It is also important to segregate counterparties according to legal entities. Exposure distribution for GM The definite loss shows in which cases GM will owe money to the bank. It is called vulnerable on account of the default risk of the bank.40 times the standard deviation. and counterparty financials before agreeing to trade with the counterparty. Given these assumptions. contracting standards.10 × 0.25 years). we need to have two more pieces of information.

but practices vary considerably. then business units must ensure that the profitability of their projects includes a cost factor for the credit risk being used. procurement. the formula to adjust project NPV (net present value) for credit is as follows: Project NPV = Starting NPV – Expected PV of credit losses – Cost of credit risk × PV of credit risk consumed for unexpected credit losses In the marketing department. These are a practical consequence of business dealings. firms must establish exception policies to deal with situations where credit limits are inadvertently or deliberately breached. and sensitivity of exposure to key economic drivers. Finally. contracts. should be established by the office of the chief financial officer. whether risk is run in treasury. the firm is unwilling to take more than $100 million in credit risk to any one bank with a AA rating. This practice ensures that business units are held responsible for credit risk in their contracting processes. such as aggregate credit exposure. and compliance with authorities and with limits. In most firms. restricting the company’s credit exposure to a particular industry. before an individual transaction is executed. to be taken as a charge against earnings and reversed if losses never materialize. and owes $1 million to subsidiary Y of the same counterparty. In all cases. it may undertake several actions. It also typically contains provisions for Material Adverse Changes (MAC) in the credit quality of the counterparties. if a company is owed $1 million by subsidiary X. credit limits are set on an aggregate basis by counterparty or credit rating—for instance. credit card companies will factor expected collection costs and losses into its fee structure for retail clients. Transaction approval is a verification process to ensure that. Best practice reporting includes portfolio risk measures. if a firm puts a price on credit risk. The Credit Support Annex (CSA) of the ISDA details the unilateral or bilateral collateral posting requirements of the counterparties. This may include the threat of forced terminations for failure to provide collateral. upon failure to supply collateral. In general. Best practice firms use some measure of potential future exposure in setting their credit limits. the CSA details rules for termination of contracts—for example. Credit Risk Mitigation The most important credit risk mitigation tool is the collection of collateral and ongoing diligence with respect to enforcing collateral requirements. Credit risk reporting should address credit risk across the firm. Contracting standards refer to the types of contracts that may be entered with an appropriately initiated counterparty. For example. First. all of its requirements have been met: Counterparty initiation. due to contract limitations. although many focus only on current exposure. Some firms will also set portfolio concentration limits. Even standard contracts require customization. but credit risk departments should strive to minimize these occurrences. Aggregate receivables. attempts may be made to close out some Managing Counterparty Credit Risk 3 of 5 www. it will still have an obligation to Y. and it is unable to collect collateral. For example. credit risk calculations are sometimes used as a determinant in product pricing. and aggregate collateral should be brought together in a comprehensive report by a non-netted legal entity. If collateral is not an option. For example. or sales. Credit authorities refer to the ability of any individual trader or trading desk to enter into new transactions with a counterparty. Some firms also charge business units for credit risk usage. When a company determines that it has too much exposure to a single counterparty. As a general statement. and X defaults. perhaps calling for more collateral when credit ratings downgrade. in most derivative contracts. collateral provisions.against a loss to another legal entity of the same firm. concentrations. collateral collection if applicable. Credit limits refer to the amount of credit risk that may be taken to approved counterparties with approved contract forms. however. Some firms allow slack in the process. A reserving policy for expected credit . considering the possible impact on current or future credit exposure. such as transactions under a given materiality threshold with an uninitiated counterparty.qfinance. potential future exposure. ISDA Master Agreements should be established to guarantee netting across different legal entities of the same counterparty. a standard contract such as the International Swaps and Derivatives Association (ISDA) contract is used. then there are other options. for example.

there are two financial strategies for mitigating credit risk. its own suppliers may not be creditworthy. reassign the contract to a different counterparty for some consideration. a firm may try to “book out” a trade. when Fannie Mae and Freddie Mac were put into receivership by the US government in 2008.. the company may attempt to novate a contract— . GM may not know how vulnerable it is to its counterparty’s counterparty. which is essentially a contingent payment triggered by a counterparty credit event and made by a third-party derivatives trading counterparty. Third. credit risk management has matured rapidly. the insurance company margin can be seen as being excessive by some corporations. First. as Lehman Brothers’ counterparties discovered. the payment triggering event may not correspond exactly to a counterparty’s default event. Credit default swaps can be cheaper. this was classified as a default event in CDSs and synthetic collateralized debt obligations (CDOs).e. CDS spreads can become extremely high and can be subject to their own performance risk. Improved risk measurement and reporting techniques paired with comprehensive credit risk policies can provide extremely effective protection against credit risk losses. which were built from those CDSs—even though there was no default. positions with the counterparty. in the most extreme cases. Counterparty credit risk assessment. All of these options require counterparty agreement. it may be the case that default by a counterparty leads to much greater damage for a company. Using CDSs to manage credit risk creates three problems. or initiate new trading positions that have the effect of reducing the risk. Third. in most trading situations. While the supplier itself may be creditworthy. as we learned in 2008. GM’s supplier mentioned above may depend on other suppliers for parts. therefore. Model and quantify the organization’s exposure to credit losses. Many financial institutions were compromised in 2008 when the credit crisis caused a domino-like effect of systemic corporate collapse. but each at its own cost—which must be compared to the benefits of reducing the specific risk it is intended to mitigate. One is to obtain credit insurance for the actual realized loss to a defaulting counterparty. must include all the costs of counterparty failure. if it finds it has identical and offsetting trades to two different counterparties. and. Insurance can be tailored to provide specific coverage of the actual realized loss. Identify corporate contracts and relationships with credit or performance risk. with collateral providing the best financial risk mitigation. including the cost of lost reputation. Barring these operational strategies. bankruptcy. Credit insurance and credit default swaps offer financial protection against default. Making It Happen • • • • Set a corporate policy for credit risk management that recognizes the links to financial strategy. Other Considerations Contagion. but because of its specificity. For example. Most models of credit focus on bilateral credit arrangements. Consider operational and financial credit risk mitigation where appropriate. Second. in CDS markets. Conclusion Although a relatively young discipline. The other is to enter a credit default swap (CDS). Managing Counterparty Credit Risk 4 of 5 www. the actual exposure is variable. without recognizing that credit relationships are multilateral. making it difficult to target 100% protection. For example. Consequences. The best risk management techniques are operational and legal. lower credit rating. since they trade in broader over-the-counter (OTC) markets.qfinance. While counterparty risk is often measured in terms of the counterparty’s failure.

qfinance. Arnaud de. please visit http://www.qfinance. and Olivier Renault. Measuring and Managing Credit Risk. Servigny. and Linda Managing Counterparty Credit Risk 5 of 5 www. 2002. 2nd . New York: Wiley. See Also Best Practice • Credit Ratings • Forecasting Default Rates and the Credit Cycle • Investing Cash: Back to Basics • Minimizing Credit Risk Checklists • • • Derivatives Markets: Their Structure and Function Hedging Credit Risk—Case Studies and Strategies Managing Your Credit Risk To see this article on-line. 2004. New York: McGrawHill. Credit Risk Measurement: New Approaches to Value at Risk and Other Paradigms. Anthony.More Info Books: • • Saunders.