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Strategic Customer Management for SME Portfolios The article explores the management of Small and

Medium Enterprise (SME) customers and the ben-

Stephen Gildert efits that can be derived from the introduction of

Nick Vanstone a strategic approach. It provides practical insights

into how increased use of automated customer

management tools has been allowing retail banks

to reduce the cost of extending credit and improve

customer service.

25

Calculating Probability of Default for Basel The purpose of the paper is to develop a risk rating

II Compliance in Financial Institutions system for legal entities in the Wholesale and Small

and Medium Enterprises (SME) segments. It also ad-

Eduardo Borges da Silva dresses the calculation of Probability of Default (PD)

Armando Chinelatto Neto according to the guidelines of the new capital accord

International Convergence of Capital Measurement

and Capital Standards: A Revised Framework, also

known as Basel II.

41

Managing for the Financial Self-sustainability Brazil, a country that is home to one of the worlds

of Microfinance Institutions largest underground economies, has a latent de-

mand for productive credit. Millions of micro-entre-

Cristiano G. Colozzi preneurs are unable to carry out productive activities

due to lack of access to credit, mainly because they

are not formally established and lack the guarantees

the traditional financial system requires.

53

Challenges and solutions in Counterparty The article addresses the main concepts and funda-

Credit Risk (CCR) treatment mentals of the treatment necessary to calculate the

risk metrics and regulatory capital associated with

Carlos Antonio Campos Nogueira Counterparty Credit Risk (CCR). The piece takes ac-

count of the original text of Basel II and its updates,

and of the best practices. It focuses on the Internal

Model Method (IMM), but also mentions alternatives

where applicable.

53

Challenges and

Solutions in

Counterparty Credit

Risk (CCR) Treatment

54

Abstract

The crisis that rocked the financial markets and, con-

sequently, the entire global economy has its roots set largely

in inaccurate assessment of counterparty default risk. Those

counterparties were regarded as sound and solvent in mas-

sive volumes of derivatives markets exposures. The risks were

grossly underestimated and, as a consequence, OTC deriva-

tives (e.g.: CDSs and CLNs) issued by Institutions such as Leh-

man Brothers and AIG were treated by financial institutions

as basically risk free, based on their ratings and the belief in

too big to fail, or too big to be allowed to fail.

The need to contain additional complications through

realistic measurement of those risks and appropriate allocation

of regulatory and economic capital led the Basel Committee

for Banking Supervision (BCBS) to make adjustments to Ba-

sel II, adding new requirements and control parameters. This

took place mainly in documents published in late 2009 (see the

References).

Method.

concepts and fundamentals of the capital. Also in connection with cal-

treatment needed to calculate risk culating capital, only the references

metrics and regulatory capital as con- documentation was used, given that

cerns CCR, taking account of the origi- the Central Bank of Brazil is yet to set

nal contents of Basel II and its updates, its standards on this front.

as well as best practices. Its main fo-

cus lies on the Internal Model Method 1. Initial Definitions

(IMM), although alternatives are men- Before discussing the meth-

tioned as well, where applicable. ods, it is worth establishing the main

There was no intention of pro- concepts and terminology of CCR.

ducing a definitive paper, given the

subjects complexity and immaturi- Counterparty Credit

ty (its methods and fundamentals are Risk (CCR), Defined

still being defined), even among its Directly defined, it is the risk

references of excellence. Our goal, in- associated with the possibility of the

stead, was to introduce the main pa- default of a counterparty involved in

rameters for CCR measurement and a market transaction (or a set thereof)

55

before all of the transactions sched- tain exposure metrics to reflect the

uled cash flows are completed. characteristics of operations subject

CCR differs from operational to CCR. They include:

risk in loans and financings because of Expected exposure (EE): The

two basic factors: mean distribution of exposures on a fu-

Since many of the transactions ture date previous to the effective term

involved carry mutual payment obliga- of the lengthiest deal in a set of nettable

tions, the risk of default is bilateral. exposures. EE only takes positive mar-

The amount of the contract ket value predictions into account and is,

varies based on the market fluctu- therefore, always greater than the aver-

ations of the prices of commodities, age of market exposures when negative

securities and indices, all of which exposures are also considered.

affect the counterparties cash flows. Potential future exposure

At the end of the contract, the net (PFE): The high percentile of the dis-

amount of receipts and payments tribution of exposures on a future date

may be positive or negative for each previous to the effective term of the

of the parties involved. lengthiest in a set of nettable expo-

These differences complicate sures. It is a GiP (Gain in Potential)

the calculation of the basic parame- rather than a VaR, (Value at Risk), as it

ters that serve as inputs to determine uses the same confidence interval cri-

regulatory capital, in particular maturi- terion (99%, for example) to determine

ty M and the predicted exposure at de- that highest possible exposure on a fu-

fault (EAD). This requires application ture date (usually far more distant than

of more complex metrics than those in VaR) within this confidence interval.

used to calculate M and EAD for con- Effective Expected Expo-

ventional credit exposures. sure (EEE): The maximum amount of

The market transactions that the expected exposure (EE) until a cer-

typically involve CCR include: tain date.

SFTs (Securities Financing Expected Positive Exposure

Transactions), which translate into com- (EPE): Expected positive exposure EPE

promissadas operations in Brazil Repur- is the mean expected exposure EE.

chase Agreements - Repos - and similar). Effective expected positive

Assets-backed (securities exposure (effective EPE): Effective

and shares) and margin loans. EPE is the average over time of effec-

OTC derivatives. tive expected exposures (EEE).

Derivatives negotiated with

central counterparties Netting

Usually, two counterparties

Exposure Metrics group their operations into netting sets

Arriving at the Me and EAD pa- (sets of mutually netting exposures, or

rameters demands first defining cer- groups of nettable exposures).

56

sets) is a means to reciprocally offset and Close-out Netting

exposures between two counterparties Payments-flow netting is a normal

over the course of the combined matu- and routine operation between two coun-

rity of the operations involved. terparties with several contracts subject

Close-out netting rules are to CCR. Its purpose is to reduce the pay-

set by contract in a concomitant ments flow, simplifying and reducing the

and interactive manner, with con- cost of operations for both parties. Chart

tract termination clauses the so- 1 illustrates the netting of two swaps be-

called close-out clauses that deter- tween parties A and B (MtM is the marked-

mine the closure of all operations be- to-marked value of As exposures to B and

tween two counterparties when one vice-versa on the date of cash-flow deter-

of them defaults. mination and realization).

Chart 1

Payment Payment

Operation As MtM Bs MtM

from a to B from B to A

Swap I 25 20 -5 5

Swap II 30 45 15 -15

Non-netted

15 5

exposure

Netter

10 0

exposure

netting reduces the amount of the expo- tions cancellation.

sure for each of the counterparties. Two counterparties may enter into

Close-out netting, in its turn, is bilateral netting agreements for various

a process that takes place in the event netting sets and/or a global netting agree-

of a default by one of the parties, and ment (Master Agreement) that replaces

must be seated on a netting agreement and/or supersedes individual agreements

defining the make-up of the netting set in the event of doubt concerning the rules

and the applicable netting rules. It fa- (e.g.: the International Swaps and Deriva-

cilitates the settling of accounts, serv- tives Association ISDA model).

57

The netting sets covered by net- gin calls are posted when the differ-

ting agreements must involve careful cri- ence between the portfolios net worth

teria for: and the amount of the posted collateral

Maturities matching exceeds a certain threshold. The mar-

Number of exposures: the gin agreement between the parties de-

greater the number of exposures (for a fines the initial margin, the threshold,

given average correlation), the greater and the minimum collateral amount to

the effect of netting be posted at each margin call.

Diversication and correlation Therefore, when the thresh-

of the assets involved. old is broken, a margin call is required

Inclusion of exposures with and the counterparty potentially in

negative MtM and maturities similar debt must post an amount equal to or

to those with positive MtM (providing a greater than the minimum margin call.

safety cushion). There is, however, a response time for

Although not yet standardized in the call to be made. During this period,

Brazil, netting may theoretically be done the potential creditor counterparty has

cross-product, involving several deriva- a non-collateralized position. Should

tive products, which may help find a bet- the potential debtor counterparty de-

ter match of maturities and lead to more fault, there will be no mitigation ef-

appropriate hedging. fect for the outstanding balance. This

Netting agreements involving lapse of time is called margin risk pe-

more than two parties also lack regulato- riod (MRP). In December 2009 (BCBS

ry support, but are theoretically possible. Document 164 Strengthening the re-

silience of the banking sector), the

Margins, Margin Agreements Basel Committee determined mini-

and Collateralization mum MRP values:

It is common practice for the Five business days for netting

counterparties involved in operations sets made up of repo and reverse repo

subject to CCR to post collateral as a operations with daily margin calls and

means to mitigate risk in the event of ear- marked to marked daily. As an addi-

ly close-out due to a default by the party tional requirement, these nettings sets

posting the collateral. The amounts, lim- must contain a maximum of 5000 op-

its and form of the collateral (margins) are erations within a period of one quarter

usually established in the so-called Mar- and must not include illiquid assets.

gin Agreements. Margin Agreements Ten business days for net-

determine that one, both, or more (where ting sets with other operations (not

more than two) counterparties must post repo and reverse repo). As an addi-

collateral at operation start and periodi- tional requirement, these nettings sets

cally add to (adjust) their margins. must contain a maximum of 5000 op-

The starting collateral is re- erations within a period of one quarter

ferred to as initial margin (IM) and mar- and must not include illiquid assets.

58

Twenty business days for any net- If the period of margin calls (ad-

ting sets with more than 5000 operations at justments) is greater than one day, or,

any point during a quarter or containing an say, N days, the MRP in business days is

operation involving at least one illiquid asset. calculated as follows:

MRP = (F - 1) + N

F is the minimum margin ad- riod in days.

justment period as defined above (5, 10, Chart 2 summarizes the situa-

or 20 business days). tions above.

Chart 2

Any deal

Repo & similar OTC Derivatives involving illiquid

assets

N of operations

Up to 5000 > 5000 Up to 5000 > 5000 Any

per quarter

F 5 20 10 20 20

Prmg 4+N 19+N 9+N 19+N 19+N

Metrics, Effective and effective EPE in particular.

Maturity, and EAD

Having presented the main con- 3.1.1. Calculating

cepts, we address the calculation of the Expected Exposure

main exposure metrics and then move Let us assume that the finan-

on to determining EAD (expected expo- cial institution that is calculating its

sure at default). CCR has statistical models capable

of predictive calculation, at any fu-

3.1. Obtaining Effective ture moment within the modeling ho-

EPE from Models rizon, of the distribution of market val-

We begin with the method that ues (predicted MtM) of the operations

assumes the availability of sufficiently ro- in a given netting set.

59

Based on these market value dis- ty prices, stock prices, etc.). The resulting av-

tributions, value zero is assigned to all neg- erage is called Expected Exposure (EE).

ative value predictions, producing the expo-

sure distributions (negative values are not ex- 3.1.2. Calculating

posures for the counterparty calculating the Effective Expected Exposure

CCR). The model then averages the expo- (Effective EE, or EEE)

sure distributions, based on the several pos- Effective expected exposure is

sible values of the relevant risk factors (inter- the maximum expected exposure (EE)

est rates, foreign exchange rates, commodi- until a certain date, or, more formally:

k k-1 k

suming t 0 as the current moment and in the statistical model.

effective EE at t 0 as the current ex-

posure. From this point onwards, the 3.1.3. Calculating Effective

highest value of effective EE is pre- Expected Positive Exposure

served and becomes the value of ef- (Effective EPE)

fective EE. Effective EPE is the average over

Future moments tk (t 1, t 2 , t 3) time of the effective expected exposures

must be selected according to the rel- (EEE) or, more formally:

min (1 year,

maturity)

k=1

tk

Effective EE t x tk

k

Where tk = tk - tk-1 are the time tions ( tk) relative to the maturity of the

intervals between the dates of estimation netting set.

of future exposures.

We calculate effective EE (EEE) 3.1.4. Calculating

for k relevant future moments from the Effective Maturity (M)

perspective of risk factors (interest rates, The effective maturity of a portfo-

foreign exchange rates, inflation, com- lio of conventional credit operations (loans

modity prices, etc.). We then weight the and financings) is the result, in years, of the

EEEs obtained by their relative dura- weighted average:

t * FC

t

M=

FC

t

t

60

of the several operations weighted by the the uncertainty surrounding pay-

value of cash flow events, which is rather ment amounts leads to a more com-

simple in the case of operations of this kind. plex formula.

Effective EE x t x df + EE

k=1

k k k

tk>1 year

k

x tk x dfk

M= tk1 year

Effective EE x t x df

k=1

k k k

Where df k is the discount fac- ties in excess of one year, the simpli-

tor based on the risk-free rate used fied formula for conventional credit op-

to discount EE, and t k = t k - t k-1 rep- erations applies.

resent the time intervals between the

dates (k) of estimation of the future ex- 3.1.5. Calculating Expected

posures. Exposure at Default EAD

M is limited to a maximum of EAD is the effective EPE multi-

five years. In the absence of maturi- plied by (alpha).

pensate for the uncertainties inher- bility of default;

ent to the calculation of effective EPE, The greater the correlation

equating it to the EAD of typical cred- across assets; and

it operations. The greater the confidence

Financial institutions that are level used to produce the estimates.

calculating CCR may model , as long

as they abide by the minimum and max- 3.2. Obtaining Effective EPE

imum regulatory limits (regulators may where Models are Insufficient

even set a fixed value). The approach introduced in 3.1 as-

Alpha models developed by sev- sumes that the models supporting the de-

eral financial institutions and regulators termination of effective EPE take account

have been generating values that lie typ- of the mitigating effects o the collateral (in-

ically between 1.05 and 2.25. Alpha is itial margins and subsequent adjustments)

smaller (closer to 1.0): posted for the operations in the netting set.

The more numerous (more This may be complex and even impossi-

counterparties) the portfolio; ble, depending on the data available from

61

the database used by the Institution. In this overestimates the share of regulatory

case, the Accord and BCBS Document 164 capital associated with CCR.

(Strengthening) offer two alternatives: b) Application of the formula sug-

a) Using effective EPE with- gested in Paragraph 155 of BCBS Docu-

out considering the effects of collat- ment 164, which replaces and updates the

eral (margins). This may be inconven- approach mentioned in paragraph 41 of

ient, as it increases EAD and therefore Annex 4 of the Basel Accord, as follows:

add-on(IM) = E {Max[(MtM(t=Prmg) sion stands for the expected value of the

(MtM(t=0) + IM), 0] } sub-expression in brackets.

T = Exposure threshold for Calculation of effective maturity

margin calls M and EAD proceed as discussed in 3.1.3

MtM: Current marked-to-market and 3.1.4 above.

value of the contents of the netting set

IM: Initial margin (to cover an 4. Calculating the

eventual close-out). Factor K and the Share of

VM: Margin change (daily ad- Regulatory Capital for

justment to the initial margin to prevent the IMM

operation close-out). Having determined EAD and ef-

MTA: Minimum margin transfer value fective maturity M, we can proceed to

Prmg: Margin risk period. calculate the share of regulatory capital

N: periodicity of the margin (Pepr) for CCR, Internal Model Method

calls, as defined earlier. (IMM), using the formula:

sure) = 12.5 x K x EAD use the Basel II formula as applicable

The factor f, as defined in Circu- to the wholesale and financial institu-

lar No. 3.360 of the Central Bank of Brazil, tions class as provided by the Central

is currently set at 0.11 (or 11%), although it Bank of Brazil in its Public Hearing

can be modified by the regulator. Document No. 37 (EAP 37):

K= {LGD x N [ 1-R

] - PD x LGD} * (1 - 1,5 x b)

62

tion; rameter;

N-1 = reverse normal distribu- M = effective maturity (or effec-

tion function; tive term) as calculated in 3.1.3 above;

PD = Probability of Default pa- b = adjustment coefficient for ef-

rameter for the relevant counterparty; fective maturity M, calculated as:

termined as follows :

R = 0,12 x

(1 - e (-50))

+ 0,24 x [ 1- (1 - e (-50)) ]

Bear in mind that substitut- February 2011. The early version includes

ing Pepr (IMM) for the treatment dis- required application articles, particularly

cussed in Circular No. 3.360 for oper- when financial collateral is used as mar-

ations subject to CCR must abide by a gin in derivatives deals.

transition period similar to that appli- These standards are summa-

cable to exposures arising from con- rized below:

ventional credit operations (loans and Circular No. 3.360:

financings). This will probably imply Amount of the exposure in-

applying a transition or progression stead of EAD.

factor S, to be defined by the Central Articles 2-5 define CCR calcu-

Bank of Brazil according to the guide- lation.

lines discussed in EAP 37, article 166. Resoluo No. 3.263:

Addresses bilateral netting agree-

5. Regulatory Aspects ments governing the netting sets

Although the Central Bank EAP No. 37:

of Brazil has not yet published spe- Credit risk mitigation section (arti-

cific standards for treating CCR un- cles 75-96).

der the IMM (which is expected to oc- Rules for use: article 76.

cur before the application period for In- Acknowledgement of financial

ternal Ratings Based IRB models, on collateral.

Dec/28/2012, according to Comunica- Use of personal security.

do No. 19.028), some non-specific stand- Non-financial collateral.

ards do address the topic. In addition, an Application of haircuts.

early version of the generic standard for Article 89 addresses the bilat-

migration to IRB has been disclosed in eral netting agreements that govern

Public Hearing Document 37 (EAP 37) in the netting sets.

63

Description of the allocation meth- examples of additional topics that must

odology for the economic capital relative to be addressed are:

these exposures. Wrong-way risk (generic and

Description of policies applicable specific) observation and treatment;

to the risks associated with the presence of CCR management (based on the

an adverse positive correlation between: exposure metrics discussed here and with

PD and the amount of the expo- proven use thereof)

sure to the same counterparty. Modeling techniques that take

PD and market variables. collateral (margins) into consideration;

Pricing (including the calculation

6. Final Remarks of unilateral or bilateral Credit Value Ad-

The purpose of this article is to justment CVA);

introduce the definitions and basic met- Stress testing (scenarios and

rics of Counterparty Credit Risk, in ad- methods);

dition to providing guidance for the cal- Validation.

culation of the regulatory capital re- The Central Bank of Brazil is still in

quired for operations subject to CCR. the process of defining the applicable reg-

Of course, a comprehensive CCR imple- ulatory guidelines, and specific standards

mentation in full compliance with Basel are not yet available (at the time of the draft-

II and III requires far more than can be ing of this article, in November 2011).

Author

Has a degree in Physics (PUC - RJ) and a Masters Degree in Astrophysics and Elementary Particles (Centro Brasileiro de

Pesquisas Fsicas - CBPF/CNPQ). A practice leader in IT consulting, Mr. Nogueira has 27 years experience of service to

more than 40 companies in close to 70 projects. Managing Partner and founder of IntelliSearch.

E-mail can@intellisearch.com.br

References

Strengthening the Resilience of the Banking Sector do BCBS (Documento 164 de dezembro de 2009).

Circulares e resolues publicadas pelo Banco Central do Brasil, especialmente a Circular 3.360 e a Resoluo 3.263.

Edital de audincia pblica n 37 (EAP 37) publicado pelo Banco Central do Brasil em fevereiro de 2011.

CESARI Giovanni, AQUILINA John, CHARPILLON Niels, FILIPOVIC Zlatko, LEE Gordon, MANDA Ion Modelling, Pri-

cing, and Hedging Conterparty Credit Exposure a technical guide Springer (2009).

GREGORY Jon Counterparty Credit Risk: The new challenge for global financial markets Wiley (2010).

The calculation of counterparty risk exposure values for financial derivatives, securities financing transactions and long

settlement transactions (FSA Handbook, release 115 de julho de 2011).

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