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A bank taking on OTC derivatives positions, vis-à-vis HLIs should develop meaningful measures of credit exposure and incorporate these measures into its management decision-making process.
Exposure measurement methodologies which provide meaningful information for decision making are an essential underpinning of the credit risk management process for trading and derivatives activities. They form the basis of effective limit setting and monitoring, discussed in Section V. As banks’ trading and derivatives activities grow in complexity and as banks move in the direction of relying more on firm-wide credit modelling techniques, it is increasingly important that measures of exposure be based on meaningful methodologies that are subject to continuous improvements commensurate with changing market conditions and practices and the bank’s needs. In particular, there are three areas where individual banks and the industry should focus their efforts: (1) the development of more useful measures of potential future exposure (PFE) that provide a meaningful calculation of the overall extent of a bank’s activity with a given counterparty; (2) the effective measurement of unsecured exposure inherent in OTC derivatives transactions that are subject to daily margining; and (3) realistic and timely stress testing of counterparty credit exposures.
First, the banking industry must devote further resources to developing meaningful measures of PFE. Banks generally measure total exposure to a counterparty as the sum of the current replacement cost (mark-to-market exposure) and PFE. PFE is a measure of how far a contract could move into the money over some defined horizon (typically the life of the contract) and at some specified confidence interval. When added together with the current replacement cost, measures of PFE are used to convert derivatives contracts to “loan equivalent” amounts for aggregating counterparty credit exposures across products and instruments.
Banks must have an effective measure of PFE which gives an accurate picture of the extent of their involvement with the counterparty in relation to their overall activities. Peak exposure measures should be determined to serve as true loan equivalent measures. PFE should adequately incorporate netting of long and short positions, as well as portfolio effects across products, risk factors and maturities, and be analysed across multiple time horizons. Banks should seek greater industry consensus on the appropriate confidence interval, the volatility concept and calculation period, and the frequency with which volatilities are updated. Banks should also incorporate such improved measures of PFE into their management decision-making process. This would include the ongoing monitoring of mark- to-market exposures against initial estimates of PFE. Banks should use this measure of PFE for assessing whether counterpartie’ financial capacity is sufficient to meet the level of margin calls implied by their measure of PFE.
Second, banks must develop more effective measures for assessing the unsecured risks inherent in collateralised derivatives positions. Such unsecured exposures can take many forms, for example through the use of initial loss thresholds, potential gaps or delays in the collateral/margining process, and the time it takes to liquidate collateral and rebalance positions in the event of counterparty default. Even where OTC derivatives are subject to daily payment and receipt of variation margin (including initial margin), a bank can still face significant unsecured credit exposure under volatile market conditions.
Currently there is no clear industry consensus on how to measure this type of unsecured exposure. Many banks calculate just one measure of PFE, typically over the life of the contract. While such lifetime measures of PFE are appropriate for the purpose of comparing uncollateralised derivatives and loan exposures and measuring overall activity with a given counterparty, they do not provide a meaningful measure of the unsecured credit risk inherent in collateralised derivatives positions. Shorter horizons would be necessary to capture the exposure arising over the time needed to liquidate and rebalance positions and to realise the value of collateral in the event of a failure to meet a margin call or a default by the counterparty. Moreover, shorter horizons will be more appropriate for calibrating initial margins and establishing loss threshold amounts on collateralised derivatives transactions.
Third, banks must develop more meaningful measures of credit risk exposures under volatile market conditions through the development and implementation of timely and plausible stress tests of counterparty credit exposures. Stress testing should also evaluate the impact of large market moves on the credit exposure to individual counterparties and the inherent liquidation effects. Stress testing should also consider liquidity impacts on underlying markets and positions and the effect on the value of any pledged collateral. Simply applying higher confidence intervals or longer time horizons to measures of PFE 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.
