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.

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, GMs financing subsidiary. Normally, performance risk is managed operationallyi.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 GMs 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

1 of 5 www.qfinance.com

The maximum likely increase in future credit exposure is defined relative to a timeframe and relative to a statistical confidence interval, typically 95%. To demonstrate this concept simply, assume a potential foreign exchange transaction as an expected value of zero with an annual standard deviation of , a duration of , and a normally distributed risk. This is illustrated in Figure 1.

Figure 1. Exposure distribution for GM The definite loss shows in which cases GM will owe money to the bank, while vulnerable profit shows cases where the bank may owe money to GM. It is called vulnerable on account of the default risk of the bank. Although the current exposure is zero, the vulnerable profit could be as great as 1.65 standard deviations using a 95% confidence interval. This is also known as the peak exposure. The probability-weighted average of all the exposure figures, both zero and positive, is known as the expected exposure. For the normal distribution case, the expected exposure is 0.40 times the standard deviation. To determine the expected loss conditional on default, we need to have two more pieces of information. One is the probability of default, which we will call . The other is the loss given default, i.e., the percentage of the exposure that we never recover, even after settlement or bankruptcy. We call this estimate . Given these assumptions, we may summarize: Peak exposure = 1.65# Expected exposure = 0.40# Expected loss = 0.40# For example, if GM determines the Euro volatility to be 15% per year, the contract to be three months in duration (0.25 years), its bank to have a default likelihood of 10%, and the loss given default to be 50%, its expected loss is (0.40 0.10 0.50 0.15 #0.25) = 0.0015 times the size of the transactioni.e., $1500 per million dollars hedged. In the case of a swap rather than a single forward transaction, the amortization of the swap payments reduces exposure over time, so that it does not necessarily rise with the square root of time. In this case, the peak and expected exposure can be determined as in Figure 2.

Figure 2. Exposure of a swap The peak exposure can be used to understand how much risk is being taken with respect to the counterparty, whereas the expected exposure is an indicator of expected losses.

Credit Risk Management Policy

Best practice credit risk management policy includes the following items: counterparty initiation and monitoring; contracting standards; credit authorities and limits; transaction approval process; credit risk reporting; a reserving and capital policy.

Counterparty initiation refers to the first time a company wishes to enter a transaction with a proposed counterparty. The credit department typically reviews available public information, credit agency reports, and counterparty financials before agreeing to trade with the counterparty. The financial status of the counterparty should be continually monitored to proactively detect situations where counterparty credit quality might deteriorate. It is also important to segregate counterparties according to legal entities; trading with a subsidiary of a triple-A company may provide little to no financial protection in the event of a default. Furthermore, 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.qfinance.com

against a loss to another legal entity of the same firm. For example, if a company is owed $1 million by subsidiary X, and owes $1 million to subsidiary Y of the same counterparty, and X defaults, it will still have an obligation to Y. Contracting standards refer to the types of contracts that may be entered with an appropriately initiated counterparty. For example, in most derivative contracts, a standard contract such as the International Swaps and Derivatives Association (ISDA) contract is used. Even standard contracts require customization, however. The Credit Support Annex (CSA) of the ISDA details the unilateral or bilateral collateral posting requirements of the counterparties. It also typically contains provisions for Material Adverse Changes (MAC) in the credit quality of the counterparties, perhaps calling for more collateral when credit ratings downgrade. Finally, the CSA details rules for termination of contractsfor example, upon failure to supply collateral. ISDA Master Agreements should be established to guarantee netting across different legal entities of the same counterparty. Credit limits refer to the amount of credit risk that may be taken to approved counterparties with approved contract forms. In most firms, credit limits are set on an aggregate basis by counterparty or credit ratingfor instance, the firm is unwilling to take more than $100 million in credit risk to any one bank with a AA rating. Credit authorities refer to the ability of any individual trader or trading desk to enter into new transactions with a counterparty, considering the possible impact on current or future credit exposure. Best practice firms use some measure of potential future exposure in setting their credit limits, although many focus only on current exposure. Some firms will also set portfolio concentration limits, for example, restricting the companys credit exposure to a particular industry. In all cases, firms must establish exception policies to deal with situations where credit limits are inadvertently or deliberately breached. Transaction approval is a verification process to ensure that, before an individual transaction is executed, all of its requirements have been met: Counterparty initiation, contracts, collateral provisions, collateral collection if applicable, and compliance with authorities and with limits. Some firms allow slack in the process, such as transactions under a given materiality threshold with an uninitiated counterparty. These are a practical consequence of business dealings, but credit risk departments should strive to minimize these occurrences. Credit risk reporting should address credit risk across the firm, whether risk is run in treasury, procurement, or sales. Aggregate receivables, potential future exposure, and aggregate collateral should be brought together in a comprehensive report by a non-netted legal entity. Best practice reporting includes portfolio risk measures, such as aggregate credit exposure, concentrations, and sensitivity of exposure to key economic drivers. A reserving policy for expected credit losses, to be taken as a charge against earnings and reversed if losses never materialize, should be established by the office of the chief financial officer. This practice ensures that business units are held responsible for credit risk in their contracting processes. Some firms also charge business units for credit risk usage, but practices vary considerably. As a general statement, if a firm puts a price on credit risk, then business units must ensure that the profitability of their projects includes a cost factor for the credit risk being used. In general, 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, credit risk calculations are sometimes used as a determinant in product pricing. For example, credit card companies will factor expected collection costs and losses into its fee structure for retail clients.

Credit Risk Mitigation

The most important credit risk mitigation tool is the collection of collateral and ongoing diligence with respect to enforcing collateral requirements. This may include the threat of forced terminations for failure to provide collateral. If collateral is not an option, due to contract limitations, then there are other options. When a company determines that it has too much exposure to a single counterparty, and it is unable to collect collateral, it may undertake several actions. First, attempts may be made to close out some
Managing Counterparty Credit Risk 3 of 5 www.qfinance.com

trading positions with the counterparty, or initiate new trading positions that have the effect of reducing the risk. Second, the company may attempt to novate a contracti.e., reassign the contract to a different counterparty for some consideration. Third, a firm may try to book out a trade, if it finds it has identical and offsetting trades to two different counterparties. All of these options require counterparty agreement. Barring these operational strategies, there are two financial strategies for mitigating credit risk. One is to obtain credit insurance for the actual realized loss to a defaulting counterparty. The other is to enter a credit default swap (CDS), which is essentially a contingent payment triggered by a counterparty credit event and made by a third-party derivatives trading counterparty. Insurance can be tailored to provide specific coverage of the actual realized loss, but because of its specificity, the insurance company margin can be seen as being excessive by some corporations. Credit default swaps can be cheaper, since they trade in broader over-the-counter (OTC) markets. Using CDSs to manage credit risk creates three problems. First, in most trading situations, the actual exposure is variable, making it difficult to target 100% protection. Second, in CDS markets, the payment triggering event may not correspond exactly to a counterpartys default event. For example, when Fannie Mae and Freddie Mac were put into receivership by the US government in 2008, this was classified as a default event in CDSs and synthetic collateralized debt obligations (CDOs), which were built from those CDSseven though there was no default. Third, as we learned in 2008, CDS spreads can become extremely high and can be subject to their own performance risk, as Lehman Brothers counterparties discovered.

Other Considerations
Contagion. Most models of credit focus on bilateral credit arrangements, without recognizing that credit relationships are multilateral. For example, GMs supplier mentioned above may depend on other suppliers for parts. While the supplier itself may be creditworthy, its own suppliers may not be creditworthy. GM may not know how vulnerable it is to its counterpartys counterparty. Consequences. While counterparty risk is often measured in terms of the counterpartys failure, it may be the case that default by a counterparty leads to much greater damage for a company. Many financial institutions were compromised in 2008 when the credit crisis caused a domino-like effect of systemic corporate collapse. Counterparty credit risk assessment, therefore, must include all the costs of counterparty failure, including the cost of lost reputation, lower credit rating, and, in the most extreme cases, bankruptcy.

Making It Happen
Set a corporate policy for credit risk management that recognizes the links to financial strategy. Identify corporate contracts and relationships with credit or performance risk. Model and quantify the organizations exposure to credit losses. Consider operational and financial credit risk mitigation where appropriate.

Conclusion
Although a relatively young discipline, credit risk management has matured rapidly. Improved risk measurement and reporting techniques paired with comprehensive credit risk policies can provide extremely effective protection against credit risk losses. The best risk management techniques are operational and legal, with collateral providing the best financial risk mitigation. Credit insurance and credit default swaps offer financial protection against default, but each at its own costwhich must be compared to the benefits of reducing the specific risk it is intended to mitigate.

Managing Counterparty Credit Risk

4 of 5 www.qfinance.com

More Info
Books:
Saunders, Anthony, and Linda Allen. Credit Risk Measurement: New Approaches to Value at Risk and Other Paradigms. 2nd ed. New York: Wiley, 2002. Servigny, Arnaud de, and Olivier Renault. Measuring and Managing Credit Risk. New York: McGrawHill, 2004.

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 RiskCase Studies and Strategies Managing Your Credit Risk

To see this article on-line, please visit

http://www.qfinance.com/financial-risk-management-best-practice/managing-counterparty-credit-risk

Managing Counterparty Credit Risk

5 of 5 www.qfinance.com