Banks must close the loop on counterparty credit risk

Following a series of market and industry credit risk events, regulatory scrutiny of counterparty credit risk (CCR) management practices is increasing. Now, more than ever, banks must ensure they are optimising their approaches to credit risk mitigation

The Covid-19 pandemic, the Russia-Ukraine war, the UK’s liability-driven investment (LDI) crisis and the Archegos Capital Management default have all shone the spotlight on counterparty credit risk in recent years. Regulators are also sharpening their focus on CCR practices. In April 2024, the Basel Committee on Banking Supervision issued a consultation on guidelines for CCR management, which closes at the end of August. Banks, for their part, must adapt to changing regulations and prepare their responses to the Basel Committee’s draft guidance.

In a recent Risk.net webinar, conducted in collaboration with S&P Global Market Intelligence, four industry experts analysed the impact of recent credit risk events on the industry. The panel discussed the strategies that can be deployed to optimise CCR management – from enhanced customer due diligence and collateral collection to effective monitoring of wrong-way risk (WWR) – and implementing a holistic approach to CCR.
 

Counterparty credit risk events

Of all the market and industry CCR events in recent years, the panel shared the opinion that the Archegos default has had the most significant ramifications for CCR practices. Matthias Arnsdorf, global head of CCR quantitative research at JP Morgan, explained: “Covid-19, Russia-Ukraine and the UK LDI crisis were all big events that had a massive impact on the wider economy globally. The Archegos crisis was much more concentrated in the financial industry. Still, in terms of counterparty risk, I think it will have the biggest impact going forward because it was a failure of counterparty risk management. There were a lot of failures across the board, and a lot of lessons to be learned.”

Kanwardeep Ahluwalia, co-head of global markets risk and deputy chief risk officer, Emea at Bank of America, noted that firms’ losses in the wake of Archegos’s default varied widely. He also underlined the importance of firms monitoring risk in the moment to respond to such scenarios effectively.

“We tend to focus on the underwriting of risks in preparation for risk management events. But it is worth remembering that, for all the underwriting we undertake, there will always be situations that need to be managed promptly. You need to set up your institution to handle risk management in the here and now, when market conditions involving a counterparty are changing rapidly.”

While the Archegos default may have had the most significant impact on CCR management, the other events have also highlighted deficiencies in current processes. Allan Cowan, global head of financial engineering, Financial Risk Analytics at S&P Global Market Intelligence, said: “There is a common theme across these events. We’re looking at extreme market shocks that have caused outside losses, and some leveraged or concentrated portfolios dropped quickly. These events point to deficiencies in monitoring of really concentrated portfolios and having actionable mitigation strategies against those.”

Cowan also raised the importance of financial institutions’ modelling capabilities to understand the impact of tail events on portfolios by modelling jumps in the market and WWR. He also emphasised the need to consider liquidity risk as part of CCR management. “Many of the liquidity problems we’re seeing stem from margin-driven defaults where the need to post margin is exacerbating the jumps in the market,” he said.
 

Counterparty due diligence

Supervisors are increasingly arguing that banks capture the risks posed by large counterparties. The Basel Committee’s proposed guidelines introduce new measures, and the Bank of England, the European Central Bank and the US Federal Reserve are also looking to tighten their guidance. However, there are question marks over the extent to which banks can realistically enhance due diligence processes if clients are not prepared to divulge sensitive trade data.

Abraham Izquierdo, managing director, traded and treasury risks at Grupo Financiero Banorte, agreed with the importance of understanding counterparty positions but also pointed out the difficulties in gathering the information. “It’s important to have access to the complete set of exposure, concentration and leverage of a certain entity,” he said. ”It’s also useful to understand the intention behind some of the exposures. For instance, is it to hedge, and why is that hedge in place? However, it can be difficult to access this and validate the reliability of the information.”

There was consensus across the panel about the varied availability of counterparty information, although Arnsdorf flagged that institutions could be more consistent in information-gathering processes. “The sort of due diligence that you have, and the transparency, varies greatly by client. But there probably is more that can be done internally to ensure you have the same level of transparency across the board,” he said.

The competitive nature of risk reports and trade data means the counterparties are often reluctant to disclose this information. Regulatory guidance for large counterparties on what should be shared would be considered beneficial, but banks can also proactively manage potential exposure. “In a competitive market environment, counterparties will tend to push business to banks seeking less information,” Cowan noted. “Regulatory guidance on what should be divulged would be helpful to ensure consistency across the industry, but expecting counterparties to expose all of their trading activities is unrealistic. Banks should also plan to manage these situations by stress-testing the worst-case scenarios.”
 

Modelling wrong-way risk

Regulators have indicated concerns that banks are not paying enough attention to WWR. The Basel Committee’s new guidelines also stipulate that it should be included in exposure measurements. The panel agreed with the importance of WWR, but also highlighted the technical challenges entailed in monitoring it. “WWR, where the portfolio value is directly linked to the default event, is a well-known problem that has been appreciated from the start of counterparty risk modelling,” said Arnsdorf. “However, it probably doesn’t get the attention it deserves, partially because it’s difficult to model.”

“Modelling WWR can be challenging, particularly when calibrating the models [because of limited data],” agreed Cowan. “However, the data challenges aside, quite a few models in the literature developed following these events and crises can help. As long as these models are parameterised so that the inputs are variables that make sense to the market, then you can use them as a stress test. So, even if you can’t calibrate properly, you can stress-test what would happen if equity prices were to drop 50%, for example. I think this approach would have helped uncover some of the larger losses in recent events.”
 

Collateral collection

Collateral collection is a vital component of a credit risk mitigation strategy, but the types of collateral posted raise different challenges for banks. Cash remains the predominant form of collateral, but banks must consider whether they will accept other forms, including corporate bonds, within the credit support annex (CSA). So-called dirty CSAs, which include corporate bonds, can present several challenges from a CCR perspective. “Taking on corporate bonds can create funding requirements and liquidity drags if you can’t generate funding from the collateral,” cautioned Ahluwalia. “This needs to be considered for normal and stressed market conditions. It’s also essential to know that you have some offsetting activity to help minimise exposure to funding spikes or pricing issues and uncertainty.”

Strong modelling capabilities are intrinsic to managing the risks presented by the different types of collateral. “There will always be an appetite for a broad set of collateral,” said Cowan. “One of the challenges is understanding how that collateral may move, particularly how it may jump. It may look well collateralised in benign markets, but it’s really about how the exposures move against each other that is critical to model into valuation adjustments [XVAs] or CCR.”

Alongside modelling capabilities, other approaches were also raised that can play an essential role in fully capturing exposure. Arnsdorf said: “It can be challenging to model corporate bonds in your exposure profile, as you have to understand the composition of your collateral over time, which you can’t necessarily predict. Often, you just use a simple haircut approach, but other metrics, such as stress-testing, which are less model-intensive, are useful to properly capture risk and backtest your portfolio.”
 

Monitoring CCR holistically

For CCR to be appropriately managed, financial institutions must take a holistic approach to ensure that not only are the frameworks correctly applied and the relevant metrics used, but that the different functions collaborate effectively. The language surrounding CCR can be crucial in facilitating this integrated approach. “There should be a common language between traders and risk managers on risk factors such as credit derivatives, spreads, bell curves, volatility surfaces, and so on,” said Izquierdo. ”It’s also essential to have the same language in underlying models, which is sometimes tricky because the front office uses one system and the risk team uses a different system with different logic, language and pricing models. But, to have a truly integrated process, you need to speak the same language.”
 

Conclusion

The impact of high-profile CCR events, notably the Archegos scandal, is keenly felt by CCR managers across the industry. With new guidance and regulations looming, banks need to review their approach to CCR and get ready for change. Enhanced customer due diligence, modelling WWR and a broadening range of collateral collection demands all present significant challenges. However, as the industry strives to improve its approach to CCR management, there are always new techniques and methods to explore and test. 

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