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Trading and Capital-Markets Activities Manual

Trading Activities: Counterparty Credit Risk and Pre-settlement Risk
Source: Federal Reserve System 
(The complete Activities Manual (pdf format) can be downloaded from the Federal Reserve's web site)

Broadly defined, credit risk is the risk of economic loss from the failure of an obligor to perform according to the terms and conditions of a contract or agreement. Credit risk exists in all activities that depend on the performance of issuers, borrowers, or counterparties, and virtually all capital-markets and trading transactions involve credit exposure. Over-the-counter (OTC) derivative transactions such as foreign exchange, swaps, and options can involve particularly large and dynamic credit exposures. Accordingly, institutions should ensure that they identify, measure, monitor, and control all of the various types of credit risks encountered in their trading of both derivative and non-derivative products. 

Credit risk should be managed through a formal and independent process guided by appropriate policies and procedures. Measurement systems should provide appropriate and realistic estimates of the credit-risk exposure and should use generally accepted measurement methodologies and techniques. The development of customer credit limits and the monitoring of exposures against those limits is a critical control function and should form the backbone of an institution's credit-risk-management process. The most common forms of credit risks encountered in trading activities are issuer credit risk and counterparty credit risk. Issuer risk is the risk of default or credit deterioration of an issuer of instruments that are held as long positions in trading portfolios. While the short time horizon of trading activities limits much of the issuer credit risk for relatively high-quality and liquid instruments, other less-liquid instruments such as loans, emerging-market debt, and below-investment-quality debt instruments, may be the source of significant issuer credit risk. 

Counterparty risks, the most significant credit risks faced in trading operations, consist of both ''pre-settlement'' risk and ''settlement'' risk. Pre-settlement risk is the risk of loss due to a counterparty's failure to perform on a contract or agreement during the life of a transaction. For most cash instruments, the duration of this risk exposure is limited to the hours or days from the time a transaction is agreed upon until settlement. However, in the case of many derivative products, this exposure can often exist for a period of several years. Given this potentially longer-term exposure and the complexity associated with some derivative instruments, banks should ensure that they fully assess the pre-settlement credit risks involved with such instruments. This section discusses the nature of the credit risks involved in trading activities and reviews basic credit-risk-management issues. 

Settlement risk is the risk of loss when an institution meets its obligation under a contract (through either an advance of funds or securities) before the counterparty meets its obligation. Failures to perform at settlement can arise from counterparty default, operational problems, market liquidity constraints, and other factors. Settlement risk exists from the time an outgoing payment instruction cannot be recalled until the incoming payment is received with finality. This risk exists with any traded product and is greatest when delivery is made in different time zones. Issues and examination procedures regarding settlement risk are discussed at length in section 2021.1. 

CREDIT-RISK-MANAGEMENT ORGANIZATION 

An institution's process and program for managing credit risks should be commensurate with the range and scope of its activities. Institutions with relatively small trading operations in noncomplex instruments may not need the same level of automated systems and policies, or the same level of highly skilled staff, as firms that make markets in a variety of cash and derivative products. 

Credit-risk management should begin at the highest levels of the organization, with credit-risk policies approved by the board of directors, the formation of a credit-risk policy committee of senior management, a credit-approval process, and credit-risk management staff who measure and monitor credit exposures throughout the organization. Although the organizational approaches used to manage credit risk may vary, the credit-risk management of trading activities should be integrated into the overall credit-risk management of the institution to the fullest extent practicable. With regard to policies, most complex banking organizations appear to have extensive written policies covering their assessment of counterparty creditworthiness for both the initial due-diligence process (that is, before conducting business with a customer) and ongoing monitoring. However, examiners should focus particular attention on how such policies are structured and implemented. 

Typically, credit-risk management in trading operations consists of (1) developing and approving credit-exposure measurement standards, (2) setting counterparty credit limits, (3) monitoring credit-limit usage and reviewing credits and concentrations of credit risk, and (4) implementing minimum documentation standards. In general, staff responsible for approving exposures should be segregated from those responsible for monitoring risk limits and measuring exposures. Traders and marketers should not be permitted to assume risks without adequate institutional credit-risk controls. 

Institutions with very large trading operations often have a credit function in the trading area; staff in this area develop a high level of expertise in trading-product credit analysis and meet the demand for rapid credit approval in a trading environment. To carry out these responsibilities without compromising internal controls, the credit-risk-management function must be independent of these marketing and trading personnel who are directly involved in the execution of the transactions. While the credit staff in the trading area may possess great expertise in trading-product credit analysis, the persons responsible for the institution's global credit function should have a solid understanding of the measurement of credit-risk exposures in trading products and the techniques available to manage those exposures. The examiner's review of credit-risk management in trading activities should evaluate the quality and timeliness of information going to the global credit function and the way that information is integrated into global exposure reports. 

Examiners should evaluate whether banking institutions- 

  devote sufficient resources and adequate attention to the management of the risks involved in growing, highly profitable, or potentially high-risk activities and product lines; 
  have internal audit and independent risk-management functions that adequately focus on growth, profitability, and risk criteria in targeting their reviews; 
  achieve an appropriate balance among all elements of credit-risk management, including both qualitative and quantitative assessments of counterparty creditworthiness; measurement and evaluation of both on- and off-balance-sheet exposures, including potential future exposure; adequate stress testing; reliance on collateral and other credit enhancements; and the monitoring of exposures against meaningful limits; 
  employ policies that are sufficiently calibrated to the risk profiles of particular types of counterparties and instruments to ensure adequate credit-risk assessment, exposure measurement, limit setting, and use of credit enhancements; 
  ensure that actual business practices conform with stated policies and their intent; and 
  are moving in a timely fashion to enhance their measurement of counterparty-credit-risk exposures, including refining potential future exposure measures and establishing stress-testing methodologies that better incorporate the interaction of market and credit risks. 

To adequately evaluate these conditions, examiners should conduct sufficient and targeted transaction testing. See SR-99-3 (February 1, 1999). 

CREDIT-RISK MEASUREMENT 

Appropriate measurement of exposures is essential for effective credit-risk management in trading operations. For most cash instruments, pre-settlement credit exposure is measured as current carrying value. However, in the case of many derivative contracts, especially those traded in OTC markets, pre-settlement exposure is measured as the current value or replacement cost of the position, plus an estimate of the institution's potential future exposure to changes in the replacement value of that position over the term of the contract. The methods used to measure counterparty credit risk should be commensurate with the volume and level of complexity of the instruments involved. Importantly, measurement systems should use techniques that present a relevant picture of the true nature of the credit exposures involved. Some techniques used to measure pre-settlement risk can generate very large exposure estimates that, by definition, are unlikely to materialize. Unrealistic measures of credit exposure suggest important flaws in the institution's risk-management process and should receive special examiner attention.

Pre-settlement Risk 

Pre-settlement credit exposure for cash instruments is measured as the current carrying value, which for trading operations is the market value or fair value of the instrument. Market values can be obtained from direct market quotations and pricing services or, in the case of more complex instruments, may be estimated using generally accepted valuation techniques. For derivative contracts, credit exposure is measured as the current value or replacement cost of the position, plus an estimate of the institution's potential future exposure to changes in that replacement value in response to market price changes. Together, replacement cost and estimated potential future exposure make up the loan-equivalent value of a derivative contract. 

For derivative contracts, pre-settlement exposure to a counterparty exists whenever a contract's replacement cost has positive value to the institution (''in the money'') and negative value to the counterparty (''out of the money''). The current replacement cost of the contract is its mark-to-market value. If a counterparty defaults on a transaction before settlement or expiration of the deal, the other counterparty has an immediate exposure which must be filled. If the contract is in the money for the non-defaulting party, then the non-defaulting counterparty has suffered a credit loss. Thus, all deals with a positive mark-to-market value represent actual credit exposure. The replacement cost of derivative contracts is usually much smaller than the face or notional value of derivative transactions. 

Some derivatives involving firm commitments, such as swaps, initially have a zero net present value and, therefore, no replacement cost at inception. At inception, the only potential for credit exposure these contracts have is what can arise from subsequent changes in the market price of the instrument, index, or interest rate underlying them. Once market prices move to create a positive contract value, the contract has the current credit-risk exposure of its replacement cost as well as the potential credit exposure that can arise from subsequent changes in market prices. 

Options and derivative contracts which contain options (for example, swaptions and rate-protection agreements) face both current and potential credit exposure. However, a difference with option contracts is that they have a positive value at inception reflected by the premium paid by the purchaser to the writer of the option. The value of the purchased option may be reduced as a result of market movements, but cannot become negative. The seller or writer of an option receives a premium, usually at inception, and must deliver the underlying at exercise. Therefore, the party that buys the option contract will always have credit exposure when the option is in the money, and the party selling the option contract will have none, except for settlement risk while awaiting payment of the premium. 

Potential Future Exposure 

Potential future exposure is an estimate of the risk that subsequent changes in market prices could increase credit exposure. In measuring potential exposure, institutions attempt to determine how much a contract can move into the money for the institution and out of the money for the counterparty over time. Given the important interrelationships between the market-risk and credit-risk exposures involved in banks' derivative activities that have been emphasized over the past two years of financial-market turbulence, examiners should be alert to situations in which banks may need to enhance their current computations of potential future exposures and loan equivalents used to measure and monitor their derivative counterparty credit exposure. 

Estimating potential exposure can be subjective, and firms approach its measurement in several different ways. One technique is to use ''rules of thumb'' or factors, such as percentages of the notional value of the contract, similar to the ''add-on'' factors used in bank risk-based capital. Institutions using such an approach should be able to demonstrate that the rules of thumb or factors provide adequate estimates of potential exposure. For example, differences in the add-ons used for different instruments should reflect differences in the volatility of the underlying instruments and in the tenor (or maturity) across instruments, and should be adjusted periodically to reflect changes in market conditions and the passage of time. 

A more sophisticated and complex practice of measuring the potential exposure of derivatives is to statistically estimate the maximum probable value that the derivative contract might reach over a specified time horizon, which sometimes may be the life of the contract. This is often done by estimating the highest value the contract will achieve within some confidence interval (for example, 95, 97.5, or 99 percent confidence) based on the estimated distribution of the contract's possible values at each point in time over the time horizon, given historical changes in underlying risk factors. The specified percentile or confidence level of the distribution represents the maximum expected value of the contract at each point over the time horizon. 

The time horizon used to calculate potential future exposure can vary depending on the bank's risk tolerance, collateral protection, and ability to terminate its credit exposure. Some institutions may use a time horizon equal to the life of the respective instrument. While such a time horizon may be appropriate for unsecured positions, for collateralized exposures, the use of lifetime, worst-case estimates of potential future exposure may be ineffective in measuring the true nature of counterparty risk exposure- especially given the increasing volatility and complexity of financial markets and derivatives instruments. While life-of-contract potential future exposure measures provide an objective and conservative long-term exposure estimate, they bear little relationship to the actual credit exposures banks typically incur in the case of collateralized relationships. In such cases, a bank's actual credit exposure is the potential future exposure from the time a counterparty fails to meet a collateral call until the time the bank liquidates its collateral-a period which is typically much shorter than the contract's life. For some institutions, more realistic measures of collateralized exposures in times of market stress are needed. These measures should take into account the shorter time horizons over which action can be taken to mitigate losses. They should also incorporate estimates of collateral-recovery rates given the impact of potential market events on the liquidity of collateral values. 

Institutions with vigorous monitoring systems can employ additional credit-risk-measurement methodologies that will tend to generate more precise and often smaller reported exposure levels. Some institutions already calculate such measures by assessing the worst-case value of positions over a time horizon of one or two weeks-their estimate of a reasonable liquidation period in times of stress. Other institutions are moving to build the capability of estimating portfolio-based potential future exposures by any one of several different time horizons or buckets, owing to the liquidity and breadth of the underlying instrument or risk factor. Some institutions measure the ''expected'' exposure of a contract in addition to its maximum probable exposure. The expected exposure is the mean of all possible probability-weighted replacement costs estimated over the specified time horizon. This calculation may reflect a good estimate of the present value of the positive exposure that is likely to materialize. As such, expected exposure can be an important measure for use in an institution's internal pricing, limit-setting, and credit-reserving decisions. However, expected exposure is by definition lower than maximum probable exposure and may underestimate potential credit exposure. For this reason, expected exposure estimates are not frequently used as loan-equivalent amounts in assessing capital adequacy from either an internal or regulatory basis. 

Statistically generated measures of future exposure use sophisticated risk-measurement models that, in turn, involve the use of important assumptions, parameters, and algorithms. Institutions using such techniques should ensure that appropriate controls are in place regarding the development, use, and periodic review of the models and their associated assumptions and parameters. The variables and models used for both replacement cost and potential exposure should be approved and tested by the credit-risk-management function and should be subject to audit by independent third parties with adequate technical qualifications. The data-flow process should also be subject to audit to ensure data integrity. Equally important are the approval and testing of information systems that report positions. The functions responsible for managing credit risk should validate any modifications to models made to accommodate new products or variations on existing products. 

Aggregate Exposures 

In measuring aggregate pre-settlement credit-risk exposures to a single counterparty, institutions may use either a transactions approach or a portfolio approach. Under a transactions approach, the loan-equivalent amounts for each derivative contract with a counterparty are added together. Some institutions may take a purely transactional approach to aggregation and do not incorporate the netting of long and short derivatives contracts, even when legally enforceable bilateral netting agreements are available. In such cases, simple sum estimates of positive exposures may seriously overestimate true credit exposure, and examiners should monitor and encourage an institution's movement toward more realistic measures of counterparty exposure. When they exist, legally enforceable closeout netting agreements should be factored into these measurements, whatever approach is used to obtain them. Master close-out netting agreements are bilateral contracts intended to reduce pre-settlement credit risk in the event that a counterparty becomes insolvent before settlement. Upon default, the non-defaulting party nets gains and losses with the defaulting counterparty to a single payment for all covered transactions. All credit-risk-exposure measures should fully reflect the existence of such legally binding netting agreements as well as any other credit enhancements. 

Some financial institutions measure potential credit-risk exposures on a portfolio basis, where information systems allow and incorporate netting (both within and across products, business lines, or risk factors) and portfolio correlation effects to construct a more comprehensive counterparty exposures measure. The portfolio approach recognizes the improbability that all transactions with a given counterparty will reach their maximum potential exposure at the same time as is implicitly assumed under the transactions approach. The portfolio approach uses simulation modelling to calculate aggregate exposures through time for each counterparty. As discussed in section 2070.1, ''Legal Risk,'' gains and losses may be offset in measuring potential credit-risk exposure with the portfolio approach. If legally enforceable netting is not in place, then the sum of contracts with positive value under the simulation should be used as a measure of potential exposure. Contracts with negative value should only be considered as an offset for gains when netting is deemed to be legally enforceable. If executed correctly, the portfolio approach may provide a more realistic measurement of potential credit exposure for the portfolio than simply summing the potential worst-case exposures for each instrument in the portfolio. Whatever approach is used, the credit-risk-management function should clearly define the measurement aggregation methodology and apply it consistently across all instruments and types of capital-markets exposures. 

In addition, examiners should ensure that an institution has adequate internal controls governing exposure estimation, including robust model-review processes and data integrity checks. Examiners should be aware that some banks may need to develop more meaningful measures of credit-risk exposures under volatile market conditions by developing and implementing timely and plausible stress tests of counterparty credit exposures. Stress testing should evaluate the impact of large market moves on the credit exposure to individual counterparties and on the inherent liquidation effects. Stress testing also should consider liquidity impacts on underlying markets and positions, and their effect on the value of any collateral received. Moreover, stress-testing results should be incorporated in senior management reports and provide sufficient information to trigger risk-reducing actions when necessary. Simply applying higher confidence intervals or longer time horizons to potential future exposure measures may not capture the market and exposure dynamics under turbulent market conditions, particularly as they relate to the interaction between market, credit, and liquidity risk. Examiners should determine whether stress testing has led to risk-reducing actions or a redefinition of the institution's risk appetite under appropriate circumstances. 

Global Exposures 

While an institution may use various methods to measure the credit exposure of specific types of instruments, credit exposures for both loans and capital-markets products should be consolidated by counterparty to enable senior management to evaluate the overall counterparty credit risk. To obtain an aggregate, institution-wide credit exposure for a customer in the global credit-risk-management system, many institutions use the risk in commercial loans as a base and convert credit-risk exposures in capital-markets instruments, both on- and off-balance-sheet, to the same base using loan-equivalent amounts. Together these two measures can be added to any other credit exposures to get the total credit exposure to a given counterparty. 

CREDIT ENHANCEMENTS 

As the derivatives market has expanded so has the number of market participants with lower credit ratings. Accordingly, institutions have increased the use of credit enhancements in the derivatives marketplace. Some of the more common credit enhancements include the following: 

  Collateral arrangements in which one or both counterparties agree to pledge collateral, usually consisting of cash or liquid securities, to secure credit exposures arising from derivative transactions. 
  Special-purpose vehicles (SPVs) that can be separately capitalized subsidiaries or specially designed collateral programs organized to obtain a triple A counterparty credit rating. 
  Mark-to-market cash settlement in which counterparties periodically mark transactions to market and make cash payments equal to their net present value, thus reducing any exposure to a preset threshold. 
  Option-to-terminate or ''close out'' contracts which give either counterparty, after an agreed upon interval, the option to instruct the other party to cash settle and terminate a transaction based on the transaction's net present value as quoted by agreed-upon reference dealers. The existence of the option allows both parties to view the transaction as having a maturity which is effectively reduced to the term of the option. 
  Material-change triggers that convey the right to change the terms of or terminate a contract if a pre-specified credit event occurs such as a rating downgrade, failure to pay or deliver, an adverse change in the counterparty's financial standing, or a merger event. Credit events may trigger the termination of a contract, the imposition of a collateral requirement, or stricter collateral terms. 

Credit enhancements and other non-price terms should be tailored to the counterparty and closely linked to assessments of counterparty credit quality. 

Collateral Arrangements 

Collateral arrangements are becoming an increasingly common form of credit enhancement in the derivatives market. There are generally two types of collateral arrangements. In the first type, the counterparty does not post collateral until exposure has exceeded a pre-specified amount (threshold). The second type of collateral arrangement requires an initial pledge of liquid assets (initial margin) and often involves calls for additional collateral based on a periodic marking to market of the position. This type of arrangement is intended to reduce the frequency of collateral movements and protect the institution against unanticipated swings in credit exposure. Collateral agreements can require either one or both counterparties to pledge collateral. Increasingly, collateral arrangements are being formed bilaterally, where either counterparty may be asked to post collateral, depending on whose position is out of the money. 

The use of collateral raises several important considerations. Similar to other credit enhancements, collateralization mitigates but does not eliminate credit risk. To the extent that collateral is sufficient, credit risk is transferred from the counterparty to the obligor of the collateral instrument. However, institutions should ensure that over-reliance on collateralization does not compromise other elements of sound counterparty credit risk management, such as the due diligence process. In addition, collateralization may reduce credit risk at the expense of increasing other risks, such as legal, operational, and liquidity risk. For instance, heavy reliance on collateral-management systems poses increased operational risk. Collateral agreements must be monitored, the collateral posted must be tracked and marked to market, and the physical safekeeping of the collateral must be ensured. Finally, the use of collateral is potentially more costly than other forms of credit enhancements, in part because it requires a substantial investment in systems and back-office support. 

The fundamental aspects of a collateral relationship are usually specified in a security agreement or in the credit annex of a master netting agreement. The calculation of required collateral is usually based on the net market value of the portfolio. The amount of required collateral and appropriate margin levels are largely determined by the volatility of the underlying portfolio, the frequency of collateral calls, and the type of counterparty. In general, the higher the volatility of an underlying portfolio, the greater the amount of collateral and margin required. Frequent collateral calls will result in smaller amounts of margin and collateral posted. Institutions should be aware that if volatility increases beyond what is covered in the predetermined margin level, credit exposure to a counterparty may be greater than originally anticipated. For this reason, institutions generally revalue both the portfolio and the collateral regularly.

The amount of collateral and margining levels also should be based on the type of counterparty involved. Policies should not be overly broad so as to compromise the risk-reducing nature of collateral agreements with certain types of counterparties. Indeed, policies governing collateral arrangements should specifically define those cases in which initial and variation margin is required, and should explicitly identify situations in which lack of transparency, business line risk profiles, and other counterparty characteristics merit special treatment. When appropriate to the risk profile of the counterparty, policies should specify when margining requirements based on estimates of potential future exposures might be warranted. 

Securities that are posted as collateral are generally subject to haircuts, with the most liquid and least volatile carrying the smallest haircuts. Acceptable forms of collateral traditionally include cash and U.S. Treasury and agency securities. However, letters of credit, Eurobonds, mortgage-backed securities, equities, and corporate bonds are increasingly being considered acceptable collateral by some market participants. Institutions that actively accept collateral should ensure that haircuts for instruments accepted as collateral are reviewed at least annually to reflect their volatility and liquidity. 

Collateral arrangements sometimes include rehypothecation rights, in which a counterparty repledges collateral to a third party. Institutions with rehypothecation rights may be exposed to the risk that the third party holding the rehypothecated collateral may fail to return the collateral or may return a different type of collateral. Institutions should ensure that they review the legal issues arising from collateral arrangements carefully, especially when rehypothecation rights are involved and when different locales can claim jurisdiction over determining the effectiveness of security interests. Rehypothecation of collateral may have an impact on a counterparty's right to set off the value of the collateral against amounts owed by a defaulting counterparty. In addition, institutions should review the laws of jurisdictions to which they are potentially subject to determine the potential effects of stays and the competing claims of other creditors on the enforcement of security interests. 

Institutions with collateralization programs should establish policies and procedures that address position and collateral revaluations, the frequency of margin calls, the resolution of valuation disputes, the party holding the collateral, the window of time allowed for moving collateral, trigger thresholds, closeout rights, and rehypothecation. In addition, these policies and procedures should address the process of overriding credit limits, making margin calls, and waiving margin requirements. 

In September 1998, the Committee of Payment and Settlement Systems and the Eurocurrency Standing Committee (now the Committee on the Global Financial System) of the central banks of the Group of Ten countries published a report entitled ''OTC Derivatives Settlement Procedures and Counterparty Risk Management'' that recommended that derivatives counterparties carefully assess the liquidity, legal, custody, and operational risks of using collateral. The report made the following specific recommendations to counterparties: 

  Counterparties should review the backlogs of unsigned master agreements and outstanding confirmations and take appropriate steps to manage the risks effectively. 
  Counterparties should assess the potential for reducing backlogs and associated risks through use of existing or new systems for the electronic exchange or matching of confirmations. 
  Counterparties should assess the potential for clearinghouses for OTC derivatives to reduce credit risks and other counterparty risks, taking into account the effectiveness of the clearinghouse's risk-management procedures and the effects on contracts that are not cleared. 

In March 1999, the International Swaps and Derivatives Association (ISDA) published its 1999 collateral review. The ISDA collateral review was an assessment of the effectiveness of existing collateral-management practices and recommendations for improvements in those practices. Among the market-practice recommendations for counterparties arising from the ISDA collateral review were the following: 

  Counterparties should understand the role of collateral as a complement to, not a replacement for, credit analysis tailored to the risk profile presented by the counterparty, type of transaction, size of potential future exposure, term of risk, and other relevant factors. 
  Counterparties should assess the secondary risks of collateralization, for example: 

 - Legal risk. The risk that close-out netting provisions under a master agreement are not enforceable upon the counterparty's insolvency, thus allowing the bankruptcy representative to ''cherry pick'' and repudiate contracts. 
 - Operational risk. The risk that deficiencies in information systems or internal controls could result in losses. 
 - Credit risk. Replacement-cost risk when a counterparty defaults prior to settlement, and settlement risk
 - Correlation risk. Default may be highly correlated with the market value of the contract, as was the case with dollar-denominated instruments held by counterparties in emerging-market countries. 
 - Liquidity risk. Close-out provisions triggered by a ratings downgrade may create substantial liquidity demands at a time when meeting those demands is particularly costly. 

  Counterparties should centralize and automate the collateral function and reconciliation procedures and impose a rigorous control environment. 
  Counterparties should coordinate the collateral, payments, and settlement functions in order to maximize information flows regarding counterparties and markets in stress situations. 
  Counterparties should consider the use of a wider range of assets as collateral and accept cash when a collateral-delivery failure occurs. (Counterparties often do not wish to accept cash because of the costs of reinvestment.) 
  Counterparties should establish clear internal policies and methodologies for setting initial margins based on the volatility of the value of the derivative position. 
  When setting haircut levels, counterparties should ensure that appropriate asset price volatility measures are considered over the appropriate timeframe. 
  Counterparties should ensure that collateral agreements address the potential for changes in credit quality over the course of the transaction. 

Other Credit Enhancements 

Adequate polices should also govern the use of material-change triggers and close-out provisions, which should take into account counterparty-specific situations and risk pro-files. For example, close-out provisions based on annual events or material-change triggers based on long-term performance may prove ineffective for counterparties whose risk profiles can change rapidly. 

In evaluating an institution's management of its collateral arrangements and other credit enhancements, examiners should assess not only the adequacy of policies but should determine whether internal controls are sufficient to ensure that practices comply with these policies. Accordingly, in reviewing targeted areas dealing with counterparty credit risk management, examiners should identify the types of credit enhancements and contractual covenants used by an institution and determine whether the institution has sufficiently assessed their adequacy relative to the risk profile of the counterparty. Finally, examiners should be alert to situations in which collateralized exposures may be mis-estimated, and they should encourage management at these institutions to enhance their exposure-measurement systems and collateral-protection programs accordingly. 

COUNTERPARTY ASSESSMENT 

As with traditional banking transactions, an independent credit function should conduct an internal credit review before engaging in transactions with a prospective counterparty. Credit guidelines should be employed to ensure that limits are approved for only those counterparties that meet the appropriate credit criteria, incorporating any relevant credit support. The credit-risk-management function should verify that limits are approved by credit specialists with sufficient signing authority. 

The quick credit-approval process often required in trading operations may lead financial institutions to conduct only summary financial analysis. Institutions should ensure that the level of financial analysis is adequate and that all transactions have formal credit approval. If the credit officers prefer not to establish a formal line for a new relationship, a transaction-specific written approval should be given based on the potential exposure from the transaction. In making such one-off approvals, credit officers and credit-risk management should keep settlement risks in mind.

Broad policies that were structured in the interests of flexibility to apply to all types of counterparties may prove inadequate for directing bank staff in the proper review of the risks posed by specific types of counterparties. The assessment of counterparties based on simple balance-sheet measures and traditional assessments of financial condition may be adequate for many types of counterparties. However, these assessments may be entirely insufficient for those counterparties whose off-balance-sheet positions are a source of significant leverage and whose risk profiles are narrowly based on concentrated business lines, such as with hedge funds and other institutional investors. 

General policies calling for annual counterparty credit reviews are another example of broad policies that may compromise the integrity of the assessment of individual counterparties or types of counterparties-especially in cases when a counterparty's risk profile can change significantly over much shorter time horizons. Moreover, credit-risk assessment policies should also properly define the types of analysis to be conducted for particular types of counterparties based on the nature of their risk profile. In addition to customizing fundamental analyses based on industry and business-line characteristics of a counterparty, stress testing may be needed when a counterparty's creditworthiness may be adversely affected by short-term fluctuations in financial markets-especially when potential credit exposure to a counterparty increases when credit quality deteriorates. 

A key responsibility of examiners has always been to identify areas where bank practices may not conform to stated policies. These efforts are made especially difficult when bank policies lack sufficient granularity, or specificity, to properly focus bank counterparty risk assessments. Accordingly, examiners should ensure that a bank's counterparty credit risk assessment policies are sufficiently defined to adequately address the risk profiles of specific types of counterparties and instruments. Policies should specify (1) the types of counterparties that may require special consideration; (2) the types and frequency of information to be obtained from such counterparties; (3) the types and frequency of analyses to be conducted, including the need for and type of any stress-testing analysis; and (4) how such information and analyses appropriately address the risk profile of the particular type of counterparty. This definition in policy is particularly important when limited transparency may hinder market discipline on the risk-taking activities of counterparties-which may have been the case with hedge funds. 

Even when credit-risk assessment policies appear to be sufficiently defined, examiners should place increasing emphasis on ensuring that existing practice conforms with both the stated objectives and intent of the organization's established policies. Quite often, in highly competitive and fast-moving transaction environments, examiners found that the analyses specified in policies, such as the review of a counterparty's ability to manage the risks of its business, were not done or were executed in a perfunctory manner. 

Necessary internal controls for ensuring that practices conform with stated policies include actively enforced documentation standards and periodic independent reviews by internal auditors or other risk-control units. Examiners should evaluate an institution's documentation standards and determine that internal reviews are adequately conducted for business lines, products, exposures to particular groups of counterparties, and individual customers that exhibit significant growth or above-normal profitability. As always, examiners should evaluate the integrity of these internal controls through their own transaction testing of such situations using targeted examinations and reviews. Testing should include robust sampling of transactions with an institution's major counterparties in the targeted area, as well as sufficient stratification to ensure that practices involving smaller relationships also adhere to stated policies. 

In stratifying samples and selecting counterparties and transactions on which to base targeted testing of practices and internal controls, examiners should incorporate measures of potential future exposure, regardless of whether such exposures are collateralized. As evidenced in banks' experience with hedge fund relationships in 1998, meaningful counterparty credit risks during periods of stress can go undetected when only unsecured exposures are used in transaction testing. 

OTC and Exchange-Traded Instruments 

Assessing the financial health of counterparties is a critical element in effectively identifying and managing credit-risk exposures. Before con-ducting transactions, institutions should conduct due-diligence assessments of their potential credit-risk exposure to all of the parties that might be involved in the transaction. For OTC transactions, this generally involves a single counterparty. For exchange-traded instruments, involved parties may include brokers, clearing firms, and the exchange's clearinghouse. In exchange-traded transactions, the clearinghouse guarantees settlement of all transactions. 

An institution's policies should clearly identify criteria for evaluating and approving both OTC counterparties and, for exchange-traded instruments, all entities related to a transaction. For counterparties, brokers, and dealers, the approval process should include a review of their financial statements and an evaluation of the counterparty's ability to honour its commitments. An inquiry into the general reputation of the counterparty, dealer, or broker is also appropriate. At a minimum, institutions should consider the following in establishing relationships with counterparties and the dealers and brokers used to conduct exchange-traded transactions: 

  the ability of the counterparty; broker; and clearinghouse and its subsidiaries, affiliates, or members to fulfil commitments as evidenced by capital strength, liquidity, and operating results 
  the entity's general reputation for financial stability and fair and honest dealings with customers 
  a counterparty's ability to understand and manage the risks inherent in the product or transaction 
  information available from state or federal regulators, industry self-regulatory organizations, and exchanges concerning any formal enforcement actions against the counterparty, dealer, broker, its affiliates, or associated personnel 

With regard to exchange-traded transactions, institutions should assure themselves that sufficient safeguards and risk-management practices are in place at the involved entities to limit potential pre-settlement and settlement risk exposure. Exchange clearinghouses generally use a variety of safeguards to limit the likelihood of defaults by clearing members and ensure that there are adequate resources to meet any losses should a default occur. These safeguards can include (1) financial and operating requirements for clearinghouse membership, (2) margin requirements that collateralize current or potential future exposures and periodic settlements of gains and losses that are structured to limit the buildup of these exposures, (3) procedures that authorize resolution of a clearing member's default through close-out of its proprietary positions and transfer or close-out of its client's positions, and (4) the maintenance of supplemental clearinghouse resources (for example, capital, asset pools, credit lines, guarantees, or the authority to make assessments on non-defaulting members) to cover losses that may exceed the value of a defaulting member's margin collateral and to provide liquidity during the time it takes to realize the value of that margin collateral. Institutions should assure themselves of the adequacy of these safeguards before conducting transactions on exchanges. 

Due diligence is especially important when dealing with foreign exchanges; institutions should be cognizant of differences in the regulatory and legal regimes in these markets. Substantial differences exist across countries, exchanges, and clearinghouses in fundamental areas such as mutualization of risk, legal relationships between the clearinghouse and its members, legal relationships between the clearinghouse and customers, procedures in the event of default, and segregation of customer funds. These considerations are particularly important for institutions such as futures commission merchants (FCMs) that conduct trades for customers.1 

Continue to COUNTERPARTY CREDIT RISK LIMITS 

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