| 5.1. | Counterparty credit risk is defined in Chapter 3 of this framework. It is the risk that the counterparty to a transaction could default before the final settlement of the transaction in cases where there is a bilateral risk of loss. The bilateral risk of loss is the key concept on which the definition of counterparty credit risk is based and is explained further below.
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| 5.2. | When a bank makes a loan to a borrower the credit risk exposure is unilateral. That is, the bank is exposed to the risk of loss arising from the default of the borrower, but the transaction does not expose the borrower to a risk of loss from the default of the bank. By contrast, some transactions give rise to a bilateral risk of loss and therefore give rise to a counterparty credit risk charge. For example:
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| | (1) | A bank makes a loan to a borrower and receives collateral from the borrower.1
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| | | (a) | The bank is exposed to the risk that the borrower defaults and the sale of the collateral is insufficient to cover the loss on the loan.
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| | | (b) | The borrower is exposed to the risk that the bank defaults and does not return the collateral. Even in cases where the customer has the legal right to offset the amount it owes on the loan in compensation for the lost collateral, the customer is still exposed to the risk of loss at the outset of the loan because the value of the loan may be less than the value of the collateral the time of default of the bank.
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| | (2) | A bank borrows cash from a counterparty and posts collateral to the counterparty (or undertakes a transaction that is economically equivalent, such as the sale and repurchase (repo) of a security).
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| | | (a) | The bank is exposed to the risk that its counterparty defaults and does not return the collateral that the bank posted.
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| | | (b) | The counterparty is exposed to the risk that the bank defaults and the amount the counterparty raises from the sale of the collateral that the bank posted is insufficient to cover the loss on the counterparty’s loan to the bank.
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| | (1) | A bank borrows a security from a counterparty and posts cash to the counterparty as collateral (or undertakes a transaction that is economically equivalent, such as a reverse repo).
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| | | (a) | The bank is exposed to the risk that its counterparty defaults and does not return the cash that the bank posted as collateral.
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| | | (b) | The counterparty is exposed to the risk that the bank defaults and the cash that the bank posted as collateral is insufficient to cover the loss of the security that the bank borrowed.
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| | (2) | A bank enters a derivatives transaction with a counterparty (e.g. it enters a swap transaction or purchases an option). The value of the transaction can vary over time with the movement of underlying market factors.2
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| | | (a) | The bank is exposed to the risk that the counterparty defaults when the derivative has a positive value for the bank.
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| | | (b) | The counterparty is exposed to the risk that the bank defaults when the derivative has a positive value for the counterparty.
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1 The bilateral risk of loss in this example arises because the bank receives, i.e. takes possession of, the collateral as part of the transaction. By contrast, collateralized loans where the collateral is not exchanged prior to default, do not give rise to a bilateral risk of loss; for example a corporate or retail loan secured on a property of the borrower where the bank may only take possession of the property when the borrower defaults does not give rise to counterparty credit risk.
2 The counterparty credit risk rules capture the risk of loss to the bank from the default of the derivative counterparty. The risk of gains or losses on the changing market value of the derivative is captured by the market risk framework. The market risk framework captures the risk that the bank will suffer a loss as a result of market movements in underlying risk factors referenced by the derivative (e.g. interest rates for an interest rate swap); however, it also captures the risk of losses that can result from the derivative declining in value due to a deterioration in the creditworthiness of the derivative counterparty. The latter risk is the credit valuation adjustment risk set out in Chapter 11 of this Framework.
