On June 29, 2011, the Office of the Comptroller of the Currency, Federal Deposit Insurance Corporation, Board of Governors of the Federal Reserve System and the Office of Thrift Supervision issued its latest thinking on derivatives trading by banks. "Interagency Supervisory Guidance on Counterparty Credit Risk Management" considers the role of senior management, methods to measure risk, ways to manage risk and model validation.
Given the increasing number of institutional investors that deploy derivatives - directly or indirectly via third party organizations - for return enhancement or risk minimization purposes, this twenty-six page document is worth a read. Anything that impacts the costs of major derivatives dealers is likely to have a trickle down impact on pensions, endowments, foundations and family offices.
The list below offers a preview of takeaways from the regulators' perspective.
- Assessment of counterparty credit risk models should reflect their "conceptual soundness," along with "an ongoing monitoring process that includes verification of processes and benchmarking; and an outcomes-analysis process that includes backtesting."
- Develop a comprehensive process surrounding bank monitoring of collateral.
- Discuss how to control "wrong-way risk" which occurs "when the exposure to a particular counterparty is positively correlated with the probability of default of the counterparty itself."
- Banks need to regularly measure the "largest counterparty-level impacts across portfolios, material concentrations within segments of a portfolio (such as industries or regions), and relevant portfolio-and counterparty-specific trends."
Pension fund investment committee members can use the guide to draft or add to an existing questionnaire for interviews they conduct with their asset managers, banks and consultants.