Pension Risk Matters : Pension Risk News & Analysis : Investment Governance, Inc. : Pension Risk & Investment

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.

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If you missed "Will negative swap spreads be our coal mine canaries?" by Gillian Tett (Financial Times, March 30, 2010), it's a worthwhile read, especially given the pervasive use of triple A-rated sovereign bond yields as a proxy for the "risk-free" rate of return. A writer known as Bond Girl makes a similar observation in "10-year swap spread turns negative" (self-evident.com, March 23, 2010), adding that plausible explanations take the form of temporary and structural, respectively.

Consider the following:

• Pension funds and other long-term investors are driving up demand to receive swap fixed payments as part of their asset-liability management strategies.
• Some investors worry about the viability of governments to pay interest and debt on time.
• Corporate debt issuers seek to hedge these liabilities.
• Mortgage risk techniques are in flux, especially as the Federal Reserve Bank is no longer an active buyer of mortgage-backed securities. Read "Large-Scale Asset Purchases by the Federal Reserve: Did They Work?" (Federal Reserve Bank of New York, March 2010).

As if risk managers were not already challenged to deal with moving regulatory targets and market volatility, a negative swap curve adds to their concerns.

Editor's Note: On the topic of sovereign debt, a summary of Dr. Lucjan Orlowski's analysis of the Greek debt crisis and the likely impact on the U.S. dollar and euro will be posted shortly.

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