Basel III counterparty risk management: covering systemic risk
The challenge of the Basel II reform was to establish a risk management system, tailored to each financial institution, aimed at implementing a robust and stable banking system. After the 2008 financial crisis, a second objective was introduced by new regulation: protection against systemic risks. The Basel III reforms on counterparty risk in the trading book are at the heart of this new orientation through six key measures:
Coverage and governance of Wrong Way risk
Wrong-way risk is defined by the International Swaps and Derivatives Association (ISDA) as the risk that occurs when exposure to a counterparty is adversely correlated with the credit quality of that counterparty.
To illustrate this risk, let's take an interest rate swap (the fixed rate is payed, the floating rate is received) with a counterparty that is financed entirely at the floating rate. When rates increase, the profitability and thus the value of the interest rate swap rises, however, the quality of the counterparty financed at the floating rate decreases because of its rising financing cost.
This risk has two components:
- The general Wrong Way Risk, which is the risk that the probability of default of a counterparty is correlated in a non-specific way to the value of the contract (e.g. through macro-economic factors)
- The Specific Wrong Way Risk, which is the risk that exposure to a counterparty is inversely correlated to the probability of default of the counterparty (e.g. poorly structured guaranteed loan products in which the loans are guaranteed by an entity included in the basket, or by one of its subsidiaries)
The Wrong Way General Risk is defined as a systemic risk. Since this risk is difficult to measure, it is now considered non-specifically in the calculation of the EAD (exposure at default). Too imprecise, the measures of Basel II didn't allow anticipating and assessing the losses linked to General Wrong Way Risk during the last financial crisis. The Basel III reform requires identification of exposures that give rise to a strong General Wrong Way Risk. This identification requires scenario analysis and stress testing to determine risk factors that are correlated positively with the creditworthiness of the counterparty. These scenarios must take into account major crises in which the relationships between risk factors change. In addition, the Basel III reform requires banks to establish procedures to monitor and control General Wrong Way Risk by product, by region, industry, and according to specific areas of their activities. This risk must also be taken into account in the governance of the Bank, particularly through monitoring reports to the Executive Committee and the Board of Directors.
Monitoring and governance of General Wrong Way Risk reflects the will of the Basel III reform to improve the coverage of systemic risks.
The introduction of stress parameters in the calculation of the Effective EPE
The introduction of stress parameters in the calculation of Effective EPE (expected positive exposures) also reflects this desire.
Effective EPE is used to calculate the expected exposure on a trading book position. The calculation method on this kind of exposure in Basel II did not require considering scenarios as extreme as the last financial crisis.
The Basel III reform endorses as such the use of Effective EPE for the calculation of the EAD. But to ensure that the model is used conservatively, parameters such as volatility or correlation are imposed. Thus, the calibration parameters, used in the formula of Effective EPE, shall be based on a period that includes a period of stress. This period shall be three years and must include a period of stress which corresponds to the period used for calculating the Stressed VaR on the trading book.
Including a period of stress in the calculation of Effective EPE allows calculating the exposure of banks in times of crisis, so they can hedge against losses related to systemic risk.
The coverage of Credit Valuation Adjustment
Credit Valuation Adjustment (CVA) is defined by the difference between the value of the portfolio without risk and value of the the portfolio which takes into account the default risk of the counterparty. The CVA thus corresponds to the market value of the credit risk of the counterparty.
During the 2008 financial crisis, the valuation of credit risk in the trading book has increased sharply, which resulted in heavy losses related to credit valuation adjustments. These losses were even more damaging since the Basel II reforms did not provide any specific measures to protect against them. To hedge against the risk of losses on the CVA, the Basel III reform introduces a specific capital charge.
This capital charge is calculated through an approximation method that uses a bond with characteristics similar to the counterparty studied (notional, maturity, and spread). The risk on the spread of the CVA represents the biggest part of losses of the CVA during the financial crisis of 2008. Since this approximation method uses the spread of the counterparty directly, it can capture the full spread risk of the CVA.
The application of a coefficient on the correlation between asset values for large financial institutions
The financial crisis of 2008 highlighted the strong correlation between credit deterioration of various global financial institutions and the high sensitivity to systemic risk of financial institutions relative to firms in other industries. Indeed the correlation between asset values (asset value correlation) of financial institutions was 25% higher than the market during the crisis. The safeguards of Basel II have been surpassed during the 2008 financial crisis by the increased sensitivity of financial institutions.
Therefore, the new reform forces the incorporation of this important correlation in the calculation of regulatory capital. A coefficient of 1.25 is thus applied to the correlation between asset values to reflect the increased risk inherent to exposure to other financial entities. This factor applies to all exposures of the trading book superior to $100 billion (increase of the threshold of $ 25 to $ 100 billion was made official in July 2010).
The increase in the margin period of risk in the OTC market
The margin period of risk in the OTC market is the period from the last exchange of collateral covering a set/group of transactions to be cleared/settled with a defaulting counterpart until that counterpart is closed out and the resulting market risk is re-hedged.
This indicator assesses the liquidity in the OTC market of securities on compensations. During the last financial crisis, the minimum 10 days required by Basel II for illiquid securities proved insufficient. The Basel III reform hopes to increase the margin period of risk in the OTC market. This measure is to enhance the capture of liquidity risk in the OTC market so that longer delays in transaction in times of financial crisis can be accounted for. The main points of the reform of the Margin Period of Risk are the increase of the regulatory threshold of 10 to 20 days for non-cash nettings and the doubling of this threshold in case there is a history of conflict with the counterparty.
Central Counterparty (CCP)
The opacity of the OTC derivatives markets is an obstacle to effective risk management and creates uncertainty and a significant risk of loss of market confidence, especially in times of crisis. This loss of market confidence was omnipresent during the last financial crisis.
To reduce this opacity, the Basel committee wishes to promote the use of central counterparties on the OTC market. These central counterparties can act as intermediaries between buyers and sellers of derivatives and possess a clearing house to protect stakeholders against counterparty risk in a bilateral relation.
Indeed a member of a clearing house can handle all transactions with the central counterparty with high credibility, rather than with individual counterparties with different risk profiles. As a central counterparty for a number of market participants, a CCP has the ability to net on a multilateral basis rather than bilateral. Multilateral netting is effective to the extent that it is able to, more than the bilateral netting, reduce the overall exposure.
The Basel Committee intends to reduce systemic risk through the widespread use of central counterparties in the OTC market, while framing risk management of the CCPs.
The generalization of transactions via the CCPs is implemented through incentives designed to increase the regulatory capital cost of assets acquired bilaterally compared to those acquired through a CCP.
Improved risk management of CCPs is achieved by the strengthening of initial margins and transaction guarantees. CCPs are also required to establish procedures to limit, monitor, and control the risks of transactions. In addition, the Basel III Committee proposes that market exposure of banks with a central counterparty and collaterals will be subjected to a moderate weighting of 2% , so that banks are aware that their exposure to CCPs are not without risk.
The reform of counterparty risk under Basel III is specifically designed to improve the coverage of systemic risks. This reform is a response to the financial crisis of 2008. Firstly it handles the coverage of risks in the trading book by introducing new capital charges. Secondly the reform aims specifically at anticipating market cycles by promoting better risk management and a more transparent organization of the OTC derivatives markets.