Country Risk Management and Wrong-Way Risk

The 2016 RMA Country Risk Survey pulls together views and analysis from 29 financial institutions on a wide range of topics around country risk. Often there is considerable consensus among respondents on the best practices and procedures to use in response to the shifting tides of global political and economic risks, and to the demands of regulators. On one topic, however, there is a notable lack of consensus: the issue of wrong-way risk. While most institutions see the management of wrong-way risk as a priority, there is no consensus on the actual definition of that risk, or its pricing. There is a notable variety, too, in how to measure and manage wrong-way risk. Does this reflect differing regulatory requirements, differing business models, or the fact that this form of risk is only beginning to be recognized as having a country-risk component?

In part, the variety of institutional approaches to wrong-way risk assessment from a country risk perspective may result from confusion over the difference between general and specific wrong-way risk. When the institution’s exposure to a particular counterparty is positively correlated with the probability of default of that counterparty, we have wrong-way risk. More precisely, when the exposure is positively correlated with the probability of default of the counterparty itself because of the nature of the transactions with the counterparty, the result is specific wrong-way risk. General wrong-way risk arises when the probability of default is positively correlated with general market risk factors, such as interest rates, inflation, or political tension in a particular region.

One might be tempted to say that specific wrong-way risk focuses on the nature of the counterparty and the collateral, while general wrong-way risk has a more overarching country or cross-border implication regarding the quality of the counterparty. However, there are clearly general wrong-way risk implications in the use of certain types of collateral in a cross-border or international transaction, such as government and other public entity bonds and, in some cases, corporate bonds. Furthermore, for a trust or custody institution engaging in securities financing transactions (i.e., transactions where securities are used to borrow cash or other higher investment-grade securities, or vice versa), shifts in interest rates or political tensions can quickly undermine the value of any collateral that underlines the transactions, triggering general wrong-way risk.

Survey Results on Wrong-Way Risk

What, then, can we glean from the 2016 RMA Country Risk Survey on the subject of wrong-way risk? Half of the survey respondents define wrong-way risk as an adverse correlation between the credit quality of a counterparty and the exposure to the counterparty; others define it as an adverse correlation between the credit quality of a counterparty and the collateral posted by the counterparty. The remainder of respondents see wrong-way risk as a combination of these, and also note a positive correlation between the currency of the trade and country of risk of the underlying reference asset; and a positive correlation between default probabilities and loss given default.

Management of wrong-way risk is a priority at most of the institutions surveyed, often driven primarily by the risk managers and for economic/regulatory capital calculations, although some say it is monitored but has no impact on pricing, capital, or returns. Half of respondents consider their exposures exhibit right-way risk, with wrong-way risk a concern only for a few products. Just under a third of respondents consider wrong-way risk to be a potential problem for all exposures, but only manage the risk for certain products or countries where they believe there is a high likelihood of it being material or a cause of concern.

There is a notably wide disparity in how institutions approach the pricing of wrong-way risk, with one third of respondents basing it on the judgment of credit valuation adjustment traders. The remainder are divided between those using a standard formula to price wrong-way risk, those pricing in the same way as no-way risk, and those including a credit charge and cost of capital in their pricing.

Over half of the respondents measure/manage wrong-way risk related to country risk when the underlying collateral provided by a counterparty for risk mitigation are sovereign securities. A third will do so when a cross-currency swap agreement with a systemically important bank or sovereign counterparty in an emerging market is involved, and 21% measure/manage wrong-way risk when there is an interest rate swap agreement with a systemically important bank or sovereign counterparty in an emerging market.

Just under half of respondents have a systematic way of measuring/managing country-related wrong-way risk and a similar percentage manage it only for some product and asset types. Less than half of institutions set limits for wrong-way risk, but of those that do the most common are limits by country and limits by asset class, with some setting limits based on the level of comfort in wrong-way exposure in the country. For trades with large wrong-way risk, many institutions carry out pre-deal checks and periodic reviews throughout the life of the trade; however, few assign separate country or sovereign risk limits for wrong-way risk. Most respondents do have procedures in place internally to identify, monitor, and control cases of specific wrong-way risk (either automated or with some manual check component), but almost half of respondents lack a systematic method to manage wrong-way risk specifically for commodities.

Over half of respondents use market risk shocks to stress wrong-way exposure, but only 41% can systematically quantify wrong-way risk within the counterparty credit risk systems. Many have to supplement day-to-day risk management metrics with manual inputs and bespoke stress testing.

Conclusions

The global market volatility and political shifts seen in the past decade or so have made it apparent that both specific and general wrong-way risk are a concern across a range of counterparties and collateral classes. Increasingly, institutions are grappling with the best way to conduct wrong-way risk analysis for financing transactions on a broad asset class of securities.

Based on our survey, it appears that institutions are increasingly equipped to identify and value specific wrong-way risk, but there is little consensus on best practices. Identifying and managing general wrong-way risk, both for counterparties and for collateral, remains a challenge.

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