Counterparty Risk Management

Counterparty Risk Management

“Recent market events have driven home the critical importance of ensuring that financial institutions engage themselves with regulatory objectives, adjusting approaches to delivery as circumstances change, rather than just focusing mechanically on compliance with prescriptive rules”

What is counterparty risk?

Counterparty risk is the risk that a counterparty in a transaction will default prior to the expiration of the contract and will be unable to make agreed contractual payments. In this event, the risk can be quantified as the replacement cost – the cost in replacing the defaulted transaction at current market rates to meet the obligations. Sometimes, the counterparty can default on the expiry day, after the other party has met the obligation under the transaction in which case, the loss would be the entire
value of the transaction. This latter risk is also called as settlement risk in general and Her stadt Risk in particular. Efforts like real time gross settlement have to a greater extent facilitated in mitigating this latter risk. However counterparties defaulting prior to the expiration of the contract still loom large and the market players are grappling with this. Sometimes, counterparty risk is mistaken as the lending risk. The higher order feature that differentiates and distinguishes counterparty risk is the
inability to ascertain the exact exposure at any given future date. Take for example, in the case of a loan the due amount is the crystallized principal and the contracted interest portion on the principal for the period run. For the derivatives, such exact value is unknown and they are at the mercy at the market price movements. Some times their value can be both positive and negative.

In the case of a derivative transaction with a named counterparty, the market value is known only if the market rate is available. For any date in future, since the market rate is not known, the market value is unknown. At best one can work out its value with assumed rates. Therefore, if a counterparty to a derivative transaction defaults prior to the expiration of the contract, the said transaction will need to be replaced. And therefore, the maximum loss will be the replacement cost of the transaction

The need for counterparty risk management

Greenwich Associates, premier strategic consulting and research source for providers and users of financial services worldwide, in one of their recent surveys suggested that the players had become lax in their oversight of their practices prior to the start of the recent global crisis and they were also not proactive in terms of communicating information about portfolio composition and performance. More than three quarters of the institutions participating in this survey say counterparty risk represents a serious threat to global financial markets.

Thus, the root cause of the current financial crisis, to a greater extent, reflects the laxity with which the players were dealing with counterparty risk management. This has highlighted the critical importance of ensuring that a firm's senior managers have a transparent and robust oversight of counterpart risk management.

Why is it being necessitated in today’s environment?

Principle 6 of the Risk Management and Supervision enunciated by the Bank for International Settlements requires banks to actively monitor and control exposures and funding needs within and across legal entities, business lines and currencies, taking into account legal, regulatory and operational limitations.

The current upheaval in the global financial markets has caused more mayhem in recent times than the world has seen in its entire economic history. The financial market turmoil has not yet come to an end. In fact, it is reportedly intensifying yet again. More large financial institutions have failed or had to be taken over by others, while a number of markets have exhibited instability.

Thus, not only from a regulatory angle, even from the very survival of financial institutions, has the need for counterparty risk management been heightened.

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