Counterparty credit risk
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Regulatory Capital Anatomy™
The JC’s untutored thoughts on how bank capital works.
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(Also known as CCR)
No, not Creedence Clearwater Revival. But, in the minds of a credit officer, something almost as hallowed, on which much of the Treatment of Counterparty Credit Risk and Cross-Product Netting under Basel II is predicated. A good place to start is Annex 4.
- Counterparty Credit Risk (CCR) is the risk that the counterparty to a transaction could default before the final settlement of the transaction's cash flows. An economic loss would occur if the transactions or portfolio of transactions with the counterparty has a positive economic value at the time of default. Unlike a firm’s
exposure to credit risk through a loan, where the exposure to credit risk is unilateral and only the lending bank faces the risk of loss, CCR creates a bilateral risk of loss: the market value of the transaction can be positive or negative to either counterparty to the transaction. The market value is uncertain and can vary over time with the movement of underlying market factors.
Section I: Definitions and general terminology
Transaction types include:
- Securities Financing Transactions (SFTs) are transactions such as repurchase agreements, reverse repurchase agreements, security lending and borrowing, and margin lending transactions, where the value of the transactions depends on market valuations and the transactions are often subject to margin agreements.
- Netting Set is a group of transactions with a single counterparty that are subject to a legally enforceable bilateral netting arrangement and for which netting is recognised for Regulatory Capital purposes under the provisions of paragraphs 96(i) to 96(v) of this Annex, this Framework text on credit risk mitigation techniques, or the Cross-Product Netting Rules set forth in this Annex. Each transaction that is not subject to a legally enforceable bilateral netting arrangement that is recognised for regulatory capital purposes should be interpreted as its own netting set for the purpose of these rules.
Note this definition of "netting set" is for all intents and purposes identical to the one in CRD IV:
The interpretation of the italicised section is key.
Section II: Scope of Application
This section provides that "The methods for computing the exposure amount under the standardised approach for credit risk or EAD under the internal ratings-based (IRB) approach to credit risk described in this Annex are applicable to SFTs and OTC derivatives.
- (4) Such instruments generally exhibit the following abstract characteristics:
- The transactions generate a current exposure or market value.
- The transactions have an associated random future market value based on market variables.
- The transactions generate an exchange of payments or an exchange of a financial instrument (including commodities) against payment.
- The transactions are undertaken with an identified counterparty against which a unique probability of default can be determined.
(5) Other common characteristics of the transactions to be covered may include the following:
- Collateral may be used to mitigate risk exposure and is inherent in the nature of some transactions.
- Short-term financing may be a primary objective in that the transactions mostly consist of an exchange of one asset for another (cash or securities) for a relatively short period of time, usually for the business purpose of financing. The two sides of the transactions are not the result of separate decisions but form an indivisible whole to accomplish a defined objective.
- Netting may be used to mitigate the risk.
- Positions are frequently valued (most commonly on a daily basis), according to market variables.
- Remargining may be employed.