- CRE51 — Counterparty credit risk overview
- Counterparty credit risk definition and explanation
- Scope of counterparty credit risk charge
- Methods to calculate counterparty credit risk exposure
- Methods to calculate CCR risk-weighted assets
- Minimum haircut floors for securities financing transactions (SFTs)
- Counterparty Risk (Definition, Examples) | How to Reduce?
- Example 2
- How to Reduce It?
- #1 – Repo Transactions
- #2 – OTC Derivative
- #3 – Forex Forwards
- Comparison Between Counterparty Risk and Credit Risk
- Recommended Articles
- Traded Market & Counterparty Credit Risk | Deloitte Switzerland
- Overhaul of the market risk framework
- OTC derivatives
- Market risks
- Related publications:
- Counterparty Credit Risk & XVAs
- Derivative valuations
CRE51 — Counterparty credit risk overview
Banks are required to identify their transactions that expose them to counterparty credit risk and calculate a counterparty credit risk charge. This chapter starts by explaining the definition of counterparty credit risk. It then sets out the various approaches that banks can use to measure their counterparty credit risk exposures and then calculate the related capital requirement.
Counterparty credit risk definition and explanation
Counterparty credit risk is defined in CRE50. It is the risk that the counterparty to a transaction could default before the final settlement of the transaction in cases where there is a bilateral risk of loss. The bilateral risk of loss is the key concept on which the definition of counterparty credit risk is based and is explained further below.
When a bank makes a loan to a borrower the credit risk exposure is unilateral.
That is, the bank is exposed to the risk of loss arising from the default of the borrower, but the transaction does not expose the borrower to a risk of loss from the default of the bank.
By contrast, some transactions give rise to a bilateral risk of loss and therefore give rise to a counterparty credit risk charge. For example:
A bank makes a loan to a borrower and receives collateral from the borrower.1
The bank is exposed to the risk that the borrower defaults and the sale of the collateral is insufficient to cover the loss on the loan.
The borrower is exposed to the risk that the bank defaults and does not return the collateral.
Even in cases where the customer has the legal right to offset the amount it owes on the loan in compensation for the lost collateral, the customer is still exposed to the risk of loss at the outset of the loan because the value of the loan may be less than the value of the collateral the time of default of the bank.
A bank borrows cash from a counterparty and posts collateral to the counterparty (or undertakes a transaction that is economically equivalent, such as the sale and repurchase (repo) of a security).
The bank is exposed to the risk that its counterparty defaults and does not return the collateral that the bank posted.
The counterparty is exposed to the risk that the bank defaults and the amount the counterparty raises from the sale of the collateral that the bank posted is insufficient to cover the loss on the counterparty’s loan to the bank.
A bank borrows a security from a counterparty and posts cash to the counterparty as collateral (or undertakes a transaction that is economically equivalent, such as a reverse repo).
The bank is exposed to the risk that its counterparty defaults and does not return the cash that the bank posted as collateral.
The counterparty is exposed to the risk that the bank defaults and the cash that the bank posted as collateral is insufficient to cover the loss of the security that the bank borrowed.
A bank enters a derivatives transaction with a counterparty (eg it enters a swap transaction or purchases an option). The value of the transaction can vary over time with the movement of underlying market factors.2
The bank is exposed to the risk that the counterparty defaults when the derivative has a positive value for the bank.
The counterparty is exposed to the risk that the bank defaults when the derivative has a positive value for the counterparty.
Scope of counterparty credit risk charge
Banks must calculate a counterparty credit risk charge for all exposures that give rise to counterparty credit risk, with the exception of those transactions listed in CRE51.16 below. The categories of transaction that give rise to counterparty credit risk are:
Over-the-counter (OTC) derivatives
Long settlement transactions
Securities financing transactions
The transactions listed in CRE51.4 above generally exhibit the following abstract characteristics:
The transactions generate a current exposure or market value.
The transactions have an associated random future market value market variables.
The transactions generate an exchange of payments or an exchange of a financial instrument (including commodities) against payment.
The transactions are undertaken with an identified counterparty against which a unique probability of default can be determined.
Other common characteristics of the transactions listed in CRE51.4 include the following:
Collateral may be used to mitigate risk exposure and is inherent in the nature of some transactions.
Short-term financing may be a primary objective in that the transactions mostly consist of an exchange of one asset for another (cash or securities) for a relatively short period of time, usually for the business purpose of financing. The two sides of the transactions are not the result of separate decisions but form an indivisible whole to accomplish a defined objective.
Netting may be used to mitigate the risk.
Positions are frequently valued (most commonly on a daily basis), according to market variables.
Remargining may be employed.
Methods to calculate counterparty credit risk exposure
For the transaction types listed in CRE51.4 above, banks must calculate their counterparty credit risk exposure, or exposure at default (EAD),3 using one of the methods set out in CRE51.8 to CRE51.
The methods vary according to the type of the transaction, the counterparty to the transaction, and whether the bank has received supervisory approval to use the method (if such approval is required).
For exposures that are not cleared through a central counterparty (CCP) the following methods must be used to calculate the counterparty credit risk exposure:
Standardised approach for measuring counterparty credit risk exposures (SA-CCR), which is set out in CRE52. This method is to be used for exposures arising from OTC derivatives, exchange-traded derivatives and long settlement transactions. This method must be used if the bank does not have approval to use the internal models method (IMM).
The simple approach or comprehensive approach to the recognition of collateral, which are both set out in the credit risk mitigation chapter of the standardised approach to credit risk (see CRE22). These methods are to be used for securities financing transactions (SFTs) and must be used if the bank does not have approval to use the IMM.
The value-at-risk (VaR) models approach, which is set out in CRE32.39 to CRE32.41. For banks applying the IRB approach to credit risk, the VaR models approach may be used to calculate EAD for SFTs, subject to supervisory approval, as an alternative to the method set out in (2) above.
The IMM, which is set out in CRE53. This method may be used, subject to supervisory approval, as an alternative to the methods to calculate counterparty credit risk exposures set out in (1) and (2) above (for all of the exposures referenced in those bullets).
For exposures that are cleared through a CCP, banks must apply the method set out CRE54. This method covers:
the exposures of a bank to a CCPs when the bank is a clearing member of the CCP;
the exposures of a bank to its clients, when the bank is a clearing members and act as an intermediary between the client and the CCP; and
the exposures of a bank to a clearing member of a CCP, when the bank is a client of the clearing member and the clearing member is acting as an intermediary between the bank and the CCP.
Exposures to central counterparties arising from the settlement of cash transactions (equities, fixed income, spot foreign exchange and spot commodities), are excluded from the requirements of CRE54. They are instead subject to the requirements of CRE70.
Under the methods outlined above, the exposure amount or EAD for a given counterparty is equal to the sum of the exposure amounts or EADs calculated for each netting set with that counterparty, subject to the exception outlined in CRE51.12 below.
The exposure or EAD for a given OTC derivative counterparty is defined as the greater of zero and the difference between the sum of EADs across all netting sets with the counterparty and the credit valuation adjustment (CVA) for that counterparty which has already been recognised by the bank as an incurred write-down (ie a CVA loss). This CVA loss is calculated without taking into account any offsetting debit valuation adjustments which have been deducted from capital under CAP30.15. This reduction of EAD by incurred CVA losses does not apply to the determination of the CVA risk capital requirement.
Methods to calculate CCR risk-weighted assets
After banks have calculated their counterparty credit risk exposures, or EAD, according to the methods outlined above, they must apply the standardised approach to credit risk, the IRB approach to credit risk, or, in the case of the exposures to CCPs, the capital requirements set out in CRE54.
For counterparties to which the bank applies the standardised approach, the counterparty credit risk exposure amount will be risk weighted according to the relevant risk weight of the counterparty.
For counterparties to which the bank applies the IRB approach, the counterparty credit risk exposure amount defines the EAD that is used within the IRB approach to determine risk-weighted assets (RWA) and expected loss amounts.
For IRB exposures, the risk weights applied to OTC derivative exposures should be calculated with the full maturity adjustment (as defined in CRE31.6) capped at 1 for each netting set for which the bank calculates CVA capital under either the basic approach (BA-CVA) or the standardised approach (SA-CVA), as provided in MAR50.12.
For banks that have supervisory approval to use IMM, RWA for credit risk must be calculated as the higher of:
the sum of RWA calculated using IMM with current parameter calibrations; and
the sum of RWA calculated using IMM with stressed parameter calibrations.
As an exception to the requirements of CRE51.4 above, banks are not required to calculate a counterparty credit risk charge for the following types of transactions (ie the exposure amount or EAD for counterparty credit risk for the transaction will be zero):
Credit derivative protection purchased by the bank against a banking book exposure, or against a counterparty credit risk exposure.
In such cases, the bank will determine its capital requirement for the hedged exposure according to the criteria and general rules for the recognition of credit derivatives within the standardised approach or IRB approach to credit risk (ie substitution approach).
Sold credit default swaps in the banking book where they are treated in the framework as a guarantee provided by the bank and subject to a credit risk charge for the full notional amount.
Minimum haircut floors for securities financing transactions (SFTs)
Chapter CRE56 specifies the treatment of certain non-centrally cleared SFTs with certain counterparties (in-scope SFTs). The requirements are applicable to banks in jurisdictions that are permitted to conduct in-scope SFTs below the minimum haircut floors specified within CRE56.
Counterparty Risk (Definition, Examples) | How to Reduce?
Counterparty risk is referred to the risk of potential expected losses that would arise for one counterparty on account of default on or before the maturity of the derivative contract by another counterparty to such derivative contract.
It is prevalent in all types of transactions when they are undertaken through a centralized counterparty or if the trades are undertaken in the over-the-counter (OTC) market; however, the quantum of risk is comparatively very high in the case of OTC derivate contracts.
ABC Bank invested in the non-convertible debentures of ray housing finance, which have a maturity of 10 years and pays a semi-annual coupon of 5% per annum. If ray housing finance fails to make payment of coupon and principal amount, the risk arising from that for ABC Bank is counterparty risk.
Alpha bank entered into an interest rate swap (IRS) agreement with the beta bank to pay a fixed interest of 5% on a notional amount of $ 25 million payable semi-annually and receive a floating rate 6-month LIBOR.
To account for the risk arising from such an IRS contract, Alpha bank is required to calculate its exposure at default through a method known as the current exposure method, which is the maturity of the derivative contract, type of contract (interest or forex contract) and credit rating of the counterparty, i.e., Beta bank and accordingly need to keep a certain amount of capital as provision for the default arising from such counterparty risk.
Let’s undertake calculations some hypothetical data.
Thus 0.38 million dollars is the amount of provision alpha bank will account for the counterparty risk arising out entering into an interest rate swap agreement with the beta bank.
Popular Course in this categoryCredit Risk Modeling Course
4.6 (319 ratings) 1 Course | 3+ Hours | Full Lifetime Access | Certificate of Completion
How to Reduce It?
- One of the most effective ways to reduce counterparty risk is to trade only with high-quality counterparties with high credit ratings such as AAA etc. This will ensure better CRM and decreasing the chances of future losses.
- Netting is another useful tool to reduce this risk. Usually, there are multiple trades undertaken by the financial between them, such as between two counterparties. There may be various; some will have a positive value (MTM gain), and some will have a negative value (MTM loss). By netting such positions, the loss can be reduced drastically, and counterparty risk can be reduced substantially.
- Collateralization is another useful tool to reduce this risk and involves placing high-quality collateral such as cash or liquid securities, reducing net exposure.
- Diversification is another handy tool to reduce if not necessarily to eliminate the risk. By trading with multiple counterparties, there won’t be a single counterparty with significant exposure, which will facilitate a single counterparty.
- This risk is to shift from bilateral trades to centralized trades. All transactions are undertaken with a centralized counterparty (such as exchanges and clearinghouses), which eliminate the specific risk but give rise to systematic risk.
This is very important and goes beyond credit risk and is prevalent in most of the transactions undertaken.
#1 – Repo Transactions
These are short term trade agreements between financial institutions, which are usually secured by liquid collateral securities on which haircut is applied to mitigate counterparty risk.
#2 – OTC Derivative
As mentioned above, these are bilateral trades between two counterparties and mostly take the form of interest rate swaps (IRS).
#3 – Forex Forwards
Such contracts are usually for more extended periods and involve an exchange of notional amounts and carry a high amount of counterparty risk.
Comparison Between Counterparty Risk and Credit Risk
|Particulars||Counterparty Risk||Credit Risk|
|Meaning||This also originates from inability or failure to make a payment; however, the amount of exposure is not predetermined.||Credit risk is the possibility of loss on account of default due to the inability or unwillingness of a borrower to meet its liability. In this case, the amount of loss is predetermined.|
|Scope||It is most relevant in derivatives markets and especially OTC trades.||Credit risk finds its relevance in loans and advances given by banks and financial institutions.|
|Subset||This is a subset of credit risk.||It includes counterparty risk as well.|
|Exposure||Risk Exposure on account varies the MTM position on the date of default.||Credit risk exposure is mostly predetermined and doesn’t vary.|
This is a significant risk that needs to be well monitored and involves complex computation due to its inherent complexity and multiple factors.
It is observable in derivative instruments, which are itself ever-evolving, adding more to its complexity.
Financial institutions, including banks, run a massive position in derivative exposure, which attracts counterparty risk and needs to manage it effectively. Past events have shown this risk to have a catastrophic impact on the global financial markets.
This has been a guide to What is Counterparty Risk & its Definition. Here we discuss the importance of counterparty risk and how to reduce it along with examples. You can learn more about from the following articles –
Traded Market & Counterparty Credit Risk | Deloitte Switzerland
Since the financial crisis, there have been a number of significant evolutions in the risk management of traded portfolios. This changing landscape has meant that financial institutions have had to step up their game in the measurement and management of their Market Risks and Counterparty Credit Risks, both from a regulatory as well as an internal risk perspective.
Overhaul of the market risk framework
On the market risk side, the Basel Committee has undertaken a fundamental overhaul of the market risk framework to address significant weaknesses that led to an undercapitalisation of certain trading activities prior to the crisis.
The latest rules, referred to as the fundamental review or the trading book (FRTB), introduce a new sensitivity-based standardised approach (SA) for measuring the market risk capital requirement, as well as stricter acceptance criteria for the banks opting for an internal model approach (IMA).
In the management of OTC derivatives, it has become a prevalent practise to include certain costs in the pricing of OTC derivatives that in many cases have previously been ignored.
The crisis revealed that counterparty credit, funding and liquidity risks associated with OTC derivatives can be very substantial (e.g. CVA losses caused by US monoliners) and ought to be mitigated.
Market participants incur counterparty credit risk hedging costs through their CVA management activities. Other costs include capital, funding and liquidity costs.
Deloitte supports financial institutions in managing the risks arising from their traded portfolios. The team assists clients across all facets of market and counterparty risk management, from providing regulatory insights to model development and implementation.
We assist organisations in assessing and developing market risk management and measurement methodologies.
Our services include development and review of internal models to address key regulatory concerns, as well as end-to-end implementations.
Additionally, we help financial institutions in interpreting the forthcoming regulatory changes, in particular FRTB, assessing the impacts and advising on strategies to optimise requirements.
- FRTB for structured products
The impact of an internal model under FRTB: What is the value of an internal model approach in the structured products business?
- FRTB for structured products tool
Deloitte has developed an integrated risk management solution for structured products portfolios, providing a user with a combined view of both internal risk metrics as well as regulatory capital measures. The solution integrates an internal model approach (IMA) alongside a standardised approach (SA) risk charge calculation.
Counterparty Credit Risk & XVAs
We help our clients in developing suitable models for a large variety of purposes such as: regulatory exposure calculations, XVA calculations and, stress testing. We leverage our internal solutions to provide impact assessments and benchmarks. Furthermore, the team supports organisations by providing insights on the management of risks and associated capital requirements.
- Capital management under SA-CCRBasel III has introduced a new standardised approach for measuring counterparty credit risk (SA-CCR), which impacts both RWA and leverage ratio calculations. Going forward, banks will be faced with the strategic challenge to effectively manage capital for OTC derivatives under the new SA-CCR regime.
- Breaking down XVAs
A sensitivity-based approach for trade-level allocations
- OTC derivatives tool
Deloitte has developed an integrated OTC derivative solution that derives the relevant exposure profiles and liquidity metrics for portfolios spanning a wide range of different product classes. The tool provides a unified framework with a simultaneous full portfolio revaluation, allowing for a consistent derivation of all relevant risk metrics:
- Counterparty Credit Risk: expected positive exposure (EPE), potential future exposure (PFE)
- Liquidity Risk: expected cash flow profile, worst-case cash-flows
- OTC derivatives liquidity outflows
An industry drive towards collateralisation of OTC derivatives has sparked a shift from counterparty credit risk (CCR) towards liquidity constraints. Going forward, banks will have to closely monitor the liquidity requirements from their derivatives businesses, and can leverage their existing CCR frameworks to consistently manage liquidity risk.
Our team has in depth derivative valuations expertise, and helps clients in developing and validating their pricing models.