Counterparty Credit Risk Guidance From Bank Regulators

Posted on July 7, 2011 by Susan Mangiero

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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V is for Value at Risk or Vacuous - Take Your Pick

Posted on January 6, 2009 by Susan Mangiero

In case you missed it, Joe Nocera wrote a user-friendly and quite interesting article about Value at Risk and the role of mathematical models in dealing with uncertainty. In "Risk Mismanagement" (January 2, 2009), this New York Times business columnist intimates that financial professionals may have relied too much on a single number, no matter how often it is updated.

This blogger wholeheartedly agrees with the premise that risk, in its totality, cannot be succinctly captured with one number, one metric, one tool, one time period and so on. While Value at Risk, a statistical measure of likely loss during a given business time interval such as a trading day, can be helpful as ONE gauge of financial exposure, it can also be of limited use if underlying assumptions do not accurately capture "typical" price behavior for a particular financial instrument. Expressed as a single number, VaR is often measured in dollars (Euros, etc) and is deemed by some as an easy way to compare trading risk across banks/companies/portfolios. It can be calculated in several ways and is provided as part of company SEC filings and bank regulatory reports.

Alas, reality intervenes.

I won't repeat what Mr. Nocera so eloquently wrote in his lengthy piece but will add the following:

  • Numbers can guide but not replace solid decision-making by rational human beings.
  • No single number can measure the many types of risks that investors and traders face.
  • Even a collection of numbers can lead to bad decisions if not supplanted with common sense and a key understanding of qualitative and quantitative portfolio risk drivers, both in isolation and in conjunction with one another. We need look no further than market outcomes in 2008 to know that bad news can beget bad news (i.e. the notion of contagion and compounding of risk factors).
  • Longer term investors such as pensions, endowments and foundations should acknowledge that Value at Risk is designed more as a tool for short-term (trading) decisions.

An important area not addressed by the article is the nature and extent of due diligence being conducted by institutional investors and their consultants before allocating monies to various asset managers. I've yet to see too many institutional investors publish a comprehensive Risk Management Policy that is separate and distinct from an Investment Policy Statement (assuming that even an IPS exists). Besides Value at Risk, Sharpe Ratio, Standard Deviation, Correlation Coefficient(s) and maybe an Information Ratio and Tracking Error(s), how much risk management analysis is being conducted before institutions say "here's my money?" The current state of pension disclosure reporting leaves us mainly in the dark about how plan sponsors drill money managers on the topic of risk identification, measurement and management. Unless you're a mushroom, too little sunlight is not necessarily a good thing.

Editor's Note: Check out www.gloriamundi.org for a broad array of papers on the topic of Value at Risk. I've also written a book entitled Risk Management for Pensions, Endowments and Foundations (John Wiley & Sons). While some of the statistics are dated, it includes some good case studies and checklists. (I am in the process of updating the book.)

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