Counterparty Credit Risk – Who controls the bank’s risk appetite?

Schwarze_Piste
  • Posted on Januar 16, 2025 by Dr. Andreas Ita

In a recent article in Risk.net, Orbit36 Managing Partner Dr. Andreas Ita comments on the new guidelines issued by the Basel Committee on Banking Supervision (BCBS) on counterparty credit risk management (https://www.risk.net/regulation/7960726/basel-stops-short-on-wrong-way-risk).

Encouragingly, the BCBS addresses the topic holistically and asks banks to improve their counterparty risk management practices in multiple areas, ranging from exposure measurement, margining practices and closeout procedures to due diligence, client monitoring and governance.

For board members and risk committees, it is important to know the shortcomings of Pillar 1 measures for highly leveraged counterparties. At Credit Suisse, a supposedly small exposure of less than $1bn RWA turned out to be the source of a $5.5bn loss when Archegos defaulted. The low RWA numbers for counterparty credit risk made it difficult for the Board of Directors to identify the true risk associated with the derivatives transactions in the notional amount of over $20bn.

While it is in the meantime understood that the Standardized Approach for Counterparty Credit Risk (SA-CCR) fails to capture Archegos-type exposures, the BCBS refrains from a renewed revision. Instead, banks should consider the material wrong-way risk (WWR) of highly leveraged counterparty exposures missed in RWA numbers by complementary risk exposure measures. The guidelines require banks “to rely holistically on a variety of non-equivalent risk metrics that assess all the material dimensions of CCR”, under both normal and stressed market conditions. This could for instance be Potential Future Exposure (PFE), notional amounts, stress tests or Economic Capital. In addition, an adequate strategy for managing counterparty credit risk, robust management reporting and competent people and the right risk culture in the organization are pivotal for banks engaging in complex transactions with leveraged counterparties.

“Archegos” has also highlighted the need for sound due diligence and monitoring. Banks are expected to perform a strong initial assessment when onboarding new clients and ongoingly understand a counterparty’s risk profile. A lack of transparent information provided by a counterparty is expected to be reflected in the internal credit rating, limit setting and margin requirements.

It will be interesting to see how the BCBS’ new guidelines will impact national regulations. Supervisors in the European Union, the UK and the US have already asked banks to improve their counterparty credit risk management practices. We believe that for banks with a significant derivatives or security financing business the creation of a separate counterparty risk management function will become standard. In our view, it is crucial that the expertise from experienced staff in trading, risk, compliance, legal and finance functions is combined to prevent siloed thinking.

Lastly, counterparty credit risk management is ultimately a board responsibility. To define and control the bank’s risk appetite and set appropriate limits, the Board of Directors needs to have a good understanding of the complex and multi-dimensional nature of counterparty credit risk. This may require additional skills in the Board of Directors Risk Committee.

Orbit36 has the expertise to support board members and senior managers in the demanding area of counterparty credit risk management. Please do not hesitate to contact us if you have any questions.

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