The Official Blog of Acuity Knowledge Partners

Counterparty Risk: A Multifaceted Risk

Published on September 23, 2016 by Prashant Gupta

Since the 2008 credit crisis, which saw the failure of large financial institutions such as Lehman Brothers, Fannie Mae, and Freddie Mac, markets have considered Counterparty Credit Risk (CCR) as the key financial risk. The global financial crisis exposed the entire industry, particularly financial institutions (FIs), to this new, complex, and dynamic risk. The complexity of transactions, collateralization, and structures such as special purpose vehicles enhances counterparty risk. In addition, counterparty risk presents a challenge because it is expressed as a blend of credit risk with other types of risks such as liquidity and market risks.

It is important to note that privately negotiated contracts, such as OTC derivatives, are exposed to counterparty risk. Depending on market movements, the contract value can move north or south, which makes CCR bilateral in nature, as either party can default. Aggravating the counterparty risk is the “wrong-way risk,” which occurs when exposure to a counterparty is adversely correlated to the credit quality of the counterparty.

Following the recent financial and economic crises, FIs and regulators are working together to develop a robust suite of rules to reduce CCR. These include involving central counterparties, reconciling the daily collateral portfolio, diversifying exposure across different counterparties, trading with creditworthy counterparties, and netting and hedging FIs’ exposure.

The implementation of tougher Basel III guidelines, such as the addition of a new capital charge for credit value adjustment risk and the independent review of CCR, has further signaled the need to reduce CCR. In recognition of this, banks have been improving their practices around CCR, including giving the Risk Management division more authority to manage risks.

However, one cannot say that the guidelines under Basel III and new regulations would completely set the system free of all risks. Rather than relying on regulations, banks should improve their own practices, such as using a specialized team of analysts to regularly analyze the credit of counterparties; conducting stress tests under a range of scenarios on a consolidated basis; applying strict limits on specific trades, exposures, or concentrations; leveraging the full potential of netting arrangements by squaring off positive and negative positions with the same counterparty in the event of a default; and contracting with high-quality entities (central counterparties) for clearing and settlement.

The successful implementation of these approaches should help banks limit their exposure and avoid the risk of a substantial portion of their capital turning sour, and also help monitor and manage their range of exposure.

Our credit-risk specialists help clients identify weakening credits through the use of credit assessment scorecards that assess counterparty risk. These scorecards are based on qualitative and quantitative credit risk parameters and specific industry-segment benchmarks and weightings that produce a numerical credit score, which can be mapped to the Ratings Services credit rating scale. We cover entities across FIs such as commercial banks, investment banks, brokers, and multilateral trading facilities.

What's your view?
Thank you for sharing your Comments

Share this on

About the Author

Prashant is part of Private Equity & Consulting team and has been with the company for over 11 years. He has a total work experience of over 16 years and has rich exposure working on a variety of research and analysis assignments serving clients ranging from top asset managers, PE firms to bulge bracket investment banks.

He has extensive experience working on assignments covering in depth end to end credit analysis covering capital structure analysis, corporate structure analysis including guarantees and structural subordination case, covenant compliance analysis, financial modeling & valuation, asset recovery analysis, relative value analysis of HY bonds, amongst others.

Prashant holds an MBA in Finance and a Bachelor’s degree in Engineering (Electronics). He is also a CFA charterholder.

 post image 2 Blog
Bright spots in distressed debt investing amid r....

Key takeaways: The macro economy began deteriorating during 2022 in the form of l....Read More

 post image 2 Blog
A new dawn for fixed income assets following an ....

After a dismal 2022, fixed income investors have a lot to look forward to in 2023, a....Read More

 post image 2 Blog
Private debt: a risk to financial stability?....

Introduction Private debt, which refers to loans not provided by banks or public markets,....Read More

 post image 2 Blog
Private debt gaining traction as an asset cla

Investors globally continue to shift away from traditional asset classes towards alternati....Read More

 post image 2 Blog
SPACs were hot in 2020 and are hotter now!

Special-purpose acquisition companies (SPACs) have become a notable trend in the IPO world....Read More

 post image 2 Blog
Early-stage companies – A case of fallen an

We are now almost 12 months into a global pandemic with no clear end in sight. When global....Read More

Like the way we think?

Next time we post something new, we'll send it to your inbox