Counterparty Risk Management

The world became much more uncertain as a result of the Global Financial Crisis (GFC). Decades old beliefs have to be re-thought as bank and sovereign failures probabilities rose. The immediate threat of global recession proved very resistant to central bank actions (with threats of unprecedented double and triple dip recessions). Regulators and Supervisors have sought to learn as much as possible from the GFC in order to identify criteria that could help avoid a future GFC. This has positioned future regulatory priorities around prevention, not cure.

Basel III represents a package of reforms that are intended to embed minimum standards for risk management in banks.

Basel III has sought to raise both capital and operational requirements. Capital for derivatives has been raised by applying stress criteria and introducing a CVA (Credit Value Adjustment) charge. Operational requirements cover reporting, stress testing, data, netting, collateral and the use of CCPs (Centralized Counter Parties).CVA is a quantitative capital add on intended to both ensure an increased degree of protection against correlated failures, and incentivize activities that are intended to reduce overall systemic risk.

Banks will need to plan the implementation of the new regulatory model. Key work-streams will include:

Models and scenarios helping size stressed capita and liquidity requirements
Reporting consistency, timeliness and completeness (BCBS 239)
Resolution – consistent and well thought through triggers and plans

Banks need to place risk at the center of their business –moving ahead of regulatory minimums. The key measure of success is the ability to form an overview of the risk profile of the business quickly and accurately – with Boards defining ‘quickly’ and ‘accurately’ conservatively. This will require material investment – integrating planning, strategy, and risk and technology functions.

Basel III steps well beyond Basel II in that it covers operational and strategic considerations. Therefore boards should define minimum standards in four areas to be confident of meeting the implementation challenge:

Measurement
Limit Framework
Collateral management (operations, legal process and disputes)
Clearing and Settlement

Standards defined must be in line with both regulatory judgment and peer group levels. Ultimately boards must apply their own judgment in a consistent and well documented manner. The use of experts (internal and external) adds value by ensuring seasoned judgment and experience is embedded in all areas so as to minimize costs, optimize use of capital and enhance the risk control framework. If done well, regulatory compliance should be confidently achieved.

About the Author

Mohan Bhatia is the General Manager and Domain Consulting Head for the BFSI Risk and Compliance unit. In his role he is responsible for capability development, thought leadership, developing innovative business and delivery models, engaging CROs, CFOs and CCOs, client satisfaction, engaging the analyst community, and revenues of the unit.

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