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Why banks struggle with counterparty risk management

 

[This post is a follow-up to James Babicz’s post Dec 6 dealing with the importance of CVA.]

Effective counterparty risk management begins at the trading and credit valuation adjustments (CVA) desks. Traditional risk management functions that were typically done by the middle and back offices must now be inserted into the front office so they can be executed as trades occur and proper hedging can take place.

To make an impact, counterparty exposures, risk sensitivities and trading events must be monitored intraday, and CVA must be allocated in near real time as trades are executed. The requirement to deal with counterparty risk in near real-time creates significant difficulties for many banks.

For example, the volume of data and metrics for trading desks, risk managers and analysts has become ever more complex. In addition to examining traditional measures, such as current exposure and concentrations, financial institutions must now produce more comprehensive analysis that better represents the overall credit risk in the trading book.

Measures such as CVA, debit valuation adjustments (DVA), potential future exposure (PFE), and term-structure of deltas (credit and market) must be used to produce both management and regulatory reports related to counterparty risk. .. Regulatory and accounting requirements, such as Basel III, FDIC FIL 53, FASB 157 and IFRS 9, also require these types of measures in various forms.

Today, banks encounter many business challenges in creating an effective environment to manage counterparty risk through CVA. The main issues include:

      • Data integration/Data quality– Often, the most difficult part of managing CVA is ensuring that data has been properly validated and standardized, and fully aggregated to ensure the calculations run smoothly and produce reliable results.Without methods to aggregate and validate data, CVA desks and risk managers often find themselves dealing with missing or incomplete portfolios, incorrect counterparty data, questionable P&L information, and many other frustrating and time-consuming problems.
      • Intraday sensitivities– CVA trading is a multidimensional problem that requires Monte Carlo simulation. Traders need timely and accurate risk factor sensitivities (deltas, gammas, scenario analysis) to make informed hedging decisions.  However, given the computational intensity and time required to generate these sensitivities, the numbers are typically not updated on an intraday basis. Even when the sensitivities are refreshed, compromises are often made to ensure the batch runs do not fail.  These compromises include analyzing fewer scenarios and analyzing only subsets of the overall portfolio.These compromises lead to shortcomings in understanding the dynamics driving the volatility with respect to measuring counterparty risk, evaluating limit thresholds and executing hedges.
      • Real-time event monitoring and response – Because of the dynamic nature of the trading book, the real-time monitoring process must be scalable and automated. Traders and risk managers need the ability to monitor triggers and events throughout the trading day. When significant events happen, automated alerts should be sent, and specific actions should be taken. In particular, many of these events should trigger an automated intraday call to update sensitivities or an alert to alter a hedge. Some examples of events relevant to CVA and counterparty risk include:
        • Additional termination events (ATEs), such as rating downgrades.
        • Large movement in single-name CDS, index CDS, volatility, rates and FX rates.
        • Limit breaches.
        • Rate reset provisions and other credit-related events.

Unfortunately, many organizations rely on individual traders and risk managers to manually monitor such events. Too often, significant intraday issues may not be noticed until the overnight risk calculations have been completed. Without continuous monitoring, traders and risk managers can only practice reactive risk management rather than being proactive.

These challenges have made it time-consuming and costly for banks to manage counterparty risk and CVA. These areas require near real-time environments with unparalleled scalability.

Learn more about the importance of effective counterparty credit risk management; industry practices in CVA pricing; and the necessary IT infrastructure changes in this report: Countering Counterparty Credit Risk Using Credit Valuation Adjustment (CVA).

 

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