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Capital-Markets Activities Manual
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
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
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.
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
• 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).
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 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
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.
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
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.
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
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
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,
- 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
- 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
• Counterparties should establish clear internal policies and methodologies
for setting initial margins based on the volatility of the value of the
• When setting haircut levels, counterparties should ensure that
appropriate asset price volatility measures are considered over the appropriate
• 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
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
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
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
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
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
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
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
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CREDIT RISK LIMITS
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