Why RMA performed the study
RMA undertook this study to determine the current state of practice and planned development relating to the measure and control of counterparty credit risk. In our series of market risk studies, this is the first on the subject of counterparty credit risk. The long-term objective of the RMA market risk studies series is to identify best practices and provide an ongoing benchmark in the area of counterparty credit risk and other market risk activities.
The survey reflects RMA's growing effort to help members understand market risk. It provides a benchmark by which participants can review the practices of counterparty credit risk and provides a better picture of how institutions use IT to measure and monitor counterparty credit risk. The survey also aids members as they take an inventory of the state of counterparty credit risk metrics and provides the basis for further exchange of information.
Thirty-one large institutions based in North America, Europe, and Asia participated in the spring 2004 Web-based survey by answering 94 mostly multiple-choice questions. It resulted in 144-page final report.
The study is the result of an initiative taken by RMA's Market Risk Council whose members include Aleem Gillani, chief market risk officer, PNC Financial Services Group; Jonathan M. Boylan, senior vice president, Market Risk Review, KeyBank; Enrico Dallavecchia, managing director, JPMorgan Chase & Co.; and David Dougherty, senior vice president, Group Risk Management, RBC Financial Group. Phil Stern, senior manager, Market Risk Policy, RBC Financial Group, helped in crafting and editing the survey and in vetting the final online version.
What a summary of the results shows
Convergence among participants' responses was found in a number of key areas.
Mitigation:
- The respondents use of collateral, netting, and early termination clauses to mitigate derivatives risk.
Credit Risk Calculations:
- The measure of counterparty credit risk is the sum of mark-to-market (MTM) plus potential future exposure (PFE); and in a few cases adjusted to reflect the probability of counterparty default.
- The reallocation of exposure limits between derivative products for the same counterparty is permitted, and about half of those that permit for this also permit for reallocation between affiliates of the same counterparty and over one-third permit reallocation from lending to trading products.
Enforceability Criteria:
- Most banks rely on a combination of industry-sponsored opinions (ISDA and TBMA-ISMA/GMRA) and in-house legal review to establish recognition of netting, collateral, and repo enforceability. Industry-sponsored opinions to date do not address enforceability of ETCs and, not surprisingly, responses are more diverse.
Collateral:
- Where collateral is deemed to be enforceable, 64% of respondents both net collateral and measure Potential Future Exposure on a reduced, time-to-liquidation (TTL) basis, and of these, 70% reduce the TTL period to between 7 and 15 business days.
- Collateral is included in most derivatives arrangements with top counterparties-on average 65% of their top 25 names worldwide, and 59% of their 15 top non-U.S. names.
- US dollar and government bonds and supranational corporate securities are the most widely accepted forms of collateral. Equally accepted are the euro, British pound, and Japanese yen and government and supranational securities.
- Having collateral, which is consistent with their enforceability standards, permits greater exposure with a counterparty.
Early Termination Clauses (ETCs):
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Of the 26 financial institutions that use ETCs, 62% report having exercised them. The results of exercising an ETC are widely varied. While most (58%) of those exercising the clause report that they were ultimately successful, one-third of those successes required negotiation or litigation to complete.
Credit Risk IT Structure
- Over 60% of respondents report the use of in-house designed systems for credit risk measurement, exposure querying/analysis and limit monitoring.
- Most responding institutions report that their systems are capable of tracking, netting and collateral agreements; margins calls made; margin calls received; and collateral portfolios.
- Current systems, and those planned within the next 18 months, support regulatory capital and economic capital calculations for most institutions and the balance plan to implement this capability soon after.
Hedge Funds
- 2/3 of financial institutions have hedge funds as counterparties and perform due-diligence of their hedge fund customers at least annually. The majority consolidates exposure across funds in groups of funds.
Coming Soon: A Hedge Fund Study
A similar study to determine the current state of practice and planned developments relating to hedge funds will begin in 2005. RMA is undertaking a benchmarking survey to learn more about the lines of business that financial institutions have with hedge funds, including trading lines, hedge-fund financing, financing a fund of funds, prime brokerage activities, and the range of custodial services organizations provide to hedge funds. This survey will also help participants learn more about other areas affecting institution's relationships with hedge funds, such as operational risks, staffing issues, IT systems and architecture, and limits setting.
This landmark benchmarking survey will establish standards of practice for financial institutions and their dealings with hedge funds.
Institutions that would like to participate in the study should contact RMA research analyst Fran Garritt at 215-446-4122.