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How Counterparty Credit Risk Impacts Banks’ Risk Management Strategy

 
February 4, 2016

What is SA-CCR and how is it different from existing approaches?

To simplify the measurement of counterparty credit risk associated with OTC derivatives, exchange-traded derivatives, and long settlement transactions, the Basel Committee on Banking Supervision (BCBS) recently introduced a non-modelled approach that is relatively more risk sensitive. The Basel Committee’s new consultative document, The standardized approach for measuring counterparty credit risk exposures(BCBS279), addresses several concerns related to measuring counterparty credit risk. Due to take effect in January 2017, this approach replaces both the Current Exposure Method (CEM) and the Standardized Method (SM), which had several disadvantages.

Both CEM and SM methods do not differentiate between margined and unmargined trades; the SA-CCR method does this in a risk-sensitive manner. Additionally, neither CEM nor SM adequately take into account the volatilities caused by market stress such as the 2008-09 crash. The new SA-CCR method scores over these traditional methods in this regard, since it is calibrated to reflect stress-induced volatilities. Furthermore, the SA approach is designed such that national authorities and banks need not exercise discretion through standardization.

SA-CCR allows financial firms to optimize the counterparty credit risk leveraging the multiplier effect. It can be used to bring down the aggregate add-on, to recognize the presence of excess collateral or negative mark-to-market value of transactions.However, the multiplier is floored at 5% of the PFE add-on.

Here is an overview of the calculation methodology:

  • Calculation of adjusted notional amount: This is calculated at the trade level, where a supervisory measure of duration is added for interest rate and credit derivative asset class.
  • Application of maturity factor: This is applied at the trade level and is different for margined and unmargined transactions.
  • Application of supervisory delta adjustment: This is calculated at the trade-level and is applied to the adjusted notional amount.
  • Application of supervisory factor: This is applied to the effective notional amount for volatility.
  • Aggregation: This is aggregated from all trade-level inputs at the hedging set level and then at the asset class level. For credit, equity and commodity derivatives, a supervisory correlation parameter is applied.

What does SA-CCR mean for banks and their IT infrastructure?

This new standard, expectedly, will increase banks capital requirements, which may lead most of them to move to the Internal Model Method. The SA-CCR approach will have a considerable bearing on the IT infrastructure and data governance frameworks of banks, as the calculation will be not be as simple as was the case with the CEM approach. Banks will therefore need to invest either in revamping or upgrading concerned IT systems and processes. Further, the increased focus on management of portfolios having sizeable impact on counterparty credit risk, will lead banks to rethink their risk management strategy.

What should banks do?

Banks must craft comprehensive risk management strategies guided by the regulatory compliance timeframes. They should broadly look at:

  • Assessment of the SA-CCR approach with respect to existing IT systems (as-is analysis)
    • Conduct business and IT gap assessment for business-as-usual (BAU) activities
  • Implementation roadmap and actual implantation (to-be state)
    • Draw an end-to- end implementation roadmap for the development, testing, and go-live with SDLC approach
    • Conduct make vs. buy analysis to decide whether to develop in-house capabilities or deploy a third party product
  • Continuous implementation of subsequent change requests
    • Use a release management model
  • Integration of the as-is state with the decision making process related to risk management
    • Conduct a thorough process integration with stakeholder responsibilities clearly assigned

Is there scope for revisions to the SA-CCR approach?

We believe that the SA-CCR approach does not seem to appropriately capture true individual asset volatilities and correlations, and there are many areas where improvements are possible. Further, the hedging set has not been applied to different netting sets as per the new approach. This needs to be addressed too. What remains to be seen is how banks gear up to adopt this new approach for CCR capital management and subsequent CCR management, thereby repositioning the OTC portfolio for competitive advantage, and upgrading their IT environments within the stipulated timeframe.

Debashis Dutta is a Domain Consultant with the Banking and Financial Services (BFS) business unit of Tata Consultancy Services (TCS). He has over 22 years of experience in risk management and Basel compliance, and has served as a risk manager for several banks, as well as a manager with KPMGs financial risk advisory, prior to joining TCS. Dutta has a Ph.D. in risk management and an MBA degree from Jadavpur University, Kolkata. He has presented several papers on extreme value theory, value at risk, validation of credit rating systems, stress testing, and so on, at various global forums and industry events.