Home Business & Finance RISK MANAGEMENT GUIDELINES FOR DERIVATIVES

RISK MANAGEMENT GUIDELINES FOR DERIVATIVES

An Analysis of Current Laws and Regulations

Affecting Banking and Related Industries

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INTRODUCTION

New OCC and Federal Reserve Guidelines Establish a Framework for Risk Management by Banks. In this First Part of a Two-Part Article, the Authors Analyse the Regulators’ Requirements for Senior Management and Board Oversight, and for Market Risk and Credit Risk Management.

The recent collapse of Barings PLC (“Barings”), coming on the heels of a series of big losses involving derivatives trading by Orange County, Procter & Gamble, and Gibson Greetings Inc. (“Gibson”), once again reminded the world how risky derivative products can be. Despite the notorious losses and failures, the derivatives markets have become more specialised and sophisticated. Over the past decade, these markets have generated substantial profits for financial institutions offering derivatives products, while at the same time providing hedging tools for the users of such products.

U.S. regulators, like regulators in other countries, reacted to the Barings incident by examining the regulation and supervision of derivatives activities to prevent the same or similar occurrences in the United States.

The Office of the Comptroller of the Currency (the “OCC”) conducted a survey of derivatives activities of several major banking institutions that included Citicorp, BankAmerica Corp., First Chicago Corp., and Chase Manhattan Corp. After collecting responses from these banking institutions, Douglas Harris, the OCC senior deputy comptroller for capital markets, stated that American institutional exposure to Barings-like losses appeared minimal.

The participants in the derivatives market have not stood still. In an effort to avoid expected additional government involvement and interference, they have started to scrutinise and improve self-regulation in the industry. Early this year, a “Wholesale Transaction Code of Conduct” was drafted by several financial services groups, with the participation and co-ordination of the Federal Reserve Bank of New York, which attempts to regulate OTC derivatives activities. Moreover, six of Wall Street’s biggest securities firms have released a set of policies establishing a framework within which they will conduct their derivatives business.

The new standards, developed in co-operation with the Securities and Exchange Commission (the “SEC”) and the CFTC, provides for regulation of derivatives sales practices, capital standards, and reporting requirements.

But with banks being increasingly active in the derivatives market, the federal bank regulators have taken the lead in supervising derivatives. This article reviews the supervisory guidelines and examination manuals of the OCC and the Federal Reserve in light of recent regulatory concerns over derivatives activities.

 

 

BACKGROUND

Banks have long been involved in the purchase and sale of derivatives products such as futures, options, and swaps. Before the 1980s, such activities were only of moderate interest to bank regulators. Generally speaking, the use of derivatives by banks was expected to be limited to the management of interest rate and exchange rate risks associated with banking operations; the derivatives were limited to instruments for which the underlying asset was an asset that was permissible for direct purchase by a bank.

But the 1980s saw a dramatic change in the nature and extent of bank participation in the derivatives market. Banks became increasingly involved in (i) trading activities that were not necessarily related to the management of risk, and (ii) dealing in derivative instruments where the underlying asset was not necessarily one that banks could buy or sell. Furthermore, banks became active participants in the OTC derivatives market during the explosive growth of the swaps market during this period. It seems that commercial banks have suddenly become the primary (if not the principal) participants in both domestic and international swaps, futures, options, and other derivatives markets.

Currently, a bank holding company is authorised by the Federal Reserve to engage in the following derivatives activities:

acting as a futures commission merchant in the execution and clearance of futures contracts, including futures and options on futures contracts based on certain commodities or stock, bond, or commodity indices;

acting as a commodity trading adviser and providing investment advice with respect to the above-mentioned instruments;

trading for its own account in foreign exchange spot, forward, futures, options, and options on futures transactions;

trading for its own account, for hedging and non-hedging purposes, on futures, options, and options on futures contracts based on bank-eligible securities and on certain commodities or on stock, bond, or commodity indices; and,

acting as originator, principal, agent, or broker with respect to interest rate and currency swaps as well as swaps and OTC option transactions based on commodities, stock, bond, or commodity indices, or a hybrid of interest rates and such commodities or indices.

 

A national bank is authorised to engage in all of the above-mentioned activities except that it may not trade futures, options, and options on futures for non-hedging purposes for its own account.

The initial concern of bank regulators over derivatives activities by banking institutions was limited to the permissibility of bank purchases and sales of derivatives instruments, as well as the ability of banking institutions to implement risk management procedures associated with these instruments.

The OCC had published Banking Circular No. 79 in 1983, which for years had been the principal regulatory guideline for banks engaged in derivatives activities. But as the level of participation by banks in the derivatives markets increased, regulatory concerns focused on whether banks were properly managing the risks associated with these sometimes volatile and complex instruments. However, only recently has the supervision of derivatives activities become a principal priority for bank regulators.

Congress and other regulatory agencies, such as the SEC and the CFTC, have pressed bank regulators to intensify their scrutiny of derivatives activities and for assurance that bank involvement in these markets is prudent, consistent with the interests of other market participants, and not unduly risky to bank depositor interests. As a result, beginning in late 1993, bank regulators have issued guidelines, questions and answers, and examination manuals governing the derivatives activities of banks and bank affiliates.

The OCC issued Banking Circular No. 277, which established a comprehensive framework of risk management for national banks engaged in derivatives activities. The OCC issued a set of questions and answers regarding BC-277 to elaborate on its areas of concern. Finally, the OCC released a comprehensive procedures and examination manual on risk management of derivatives activities of national banks entitled Risk Management of Financial Derivatives (the “OCC Handbook” or “Handbook”).

The OCC Handbook is a 93-page manual of new examination procedures that will be used by bank examiners to examine national banks that use derivatives. The Handbook expands and implements the OCC guidelines on derivatives activities covered in the BC-277.

The Federal Reserve released its own handbook entitled Trading Activities Manual (“Federal Reserve Trading Manual” or “Trading Manual”) following the issuance of Supervisory Letter SR 93-69. Numbering 337 pages, the Federal Reserve Trading Manual covers risk management, financial performance, accounting, reporting, compliance, and ethics. Most recently, the Federal Reserve issued Supervisory Letter 95-17 (SUP), which is intended to complement Supervisory Letter 93-69 and the Trading Manual.

But despite increased examination and supervision of banks and bank holding companies by the OCC and the Federal Reserve with respect to derivatives activities, compliance with the guidelines and manuals has been deficient. At the recent ISDA annual meeting in Barcelona, Spain, the OCC’s Douglas Harris observed that national banks were not complying with all aspects of BC-277.

In particular, management deficiencies have been discovered in the following areas: (1) oversight by senior management and board of directors; (2) market risk management; (3) valuation systems; (4) liquidity risk management; and (5) netting systems.

 

 

SUPERVISORY GUIDELINES AND TRADING MANUALS: AN OVERVIEW

The OCC and the Federal Reserve guidelines are substantively similar in their emphasis on the use of derivatives products as an appropriate risk management tool; in their discussion of various risks involved in derivatives activities including market, credit, liquidity, operational, and legal risks; and in their prescription of managerial, operational, and internal control requirements for bank derivatives activities.

The Federal Reserve and the OCC guidelines take the same positions with respect to the following matters:

(i) The board of directors and senior management have the primary responsibility to supervise adequately a banking organisation’s derivatives activities;

(ii) Banking organisations must have written policies and procedures that establish and implement internal control and reporting systems with respect to derivatives activities;

(iii) Banking organisations must adequately identify, measure, and control the various risks associated with derivatives activities, including market, credit, liquidity, legal, and operational risks on an individual and consolidated basis (i.e., the need to capture a bank’s consolidated risk exposures created by derivatives activities in conjunction with other banking activities and exposures);

(iv) Banking organisations must engage in derivatives activities and control risks involved in accordance with the purpose and scope of a particular organisation’s participation; and

(v) Banking organisations must manage the legal risks involved in derivatives transactions and take steps necessary to ensure the legal enforceability of derivatives contracts with counterparties, and the advisability of using master agreements and netting provisions to reduce, to the maximum extent possible, net counterparty credit and other risks.

 

The OCC Questions and Answers, the OCC Handbook, and the Federal Reserve Trading Manual and Guidelines discuss in greater detail the above-mentioned aspects of risk management. The OCC Handbook focuses on off-balance sheet derivatives, including exchange-traded contracts and OTC, customised, privately negotiated traded contracts. Such transactions include, but are not limited to, swaps, options, caps, floors, collars, futures, forwards, structured debt obligations, and deposits, and various combinations thereof. Similarly, the Federal Reserve Trading Manual provides a comprehensive guide to the trading of derivative instruments in which banks and bank affiliates currently are engaged. The Federal Reserve Trading Manual also includes an introduction to and analysis of all the derivatives instruments.

 

 

THE ROLES OF BANKS IN THE MARKET OF DERIVATIVES

OCC BC-277 and the OCC Handbook specifically distinguish two roles banks play in the derivatives market: dealers and end-users.

A bank is a dealer when it markets derivative products to customers. A bank may also be an end-user in the derivatives market that uses derivatives as a substitute for cash market investments, a tool for interest rate risk management, or for other balance sheet management reasons. End-user banks may be grouped into (i) active position-takers; and (ii) limited end-users. Active position-takers use derivatives dynamically to manage risk and generally have large derivatives positions compared to their total asset size. They also tend to use more complex derivative structures than other end-users. Limited-end users are characterised by smaller portfolios, less complex products, and lower transaction volume.

Banks engaging in derivatives transactions must possess risk control functions commensurate with the extent and complexity of their activity. The management of derivatives activities should be integrated into a bank’s overall risk management system to the fullest extent possible using a conceptual framework common to the bank’s other businesses.

The Federal Reserve Trading Manual focuses on derivatives trading activities of banking organisations. It does not specifically address the derivatives activities of banking organisations as end-users of derivatives products. The Nontrading Guidelines effectively supplement the Trading Manual in providing a guideline for non-trading derivatives activities of banking organisations as end-users in the markets.

 

 

SENIOR MANAGEMENT AND BOARD OVERSIGHT

Both the OCC and the Federal Reserve place great emphasis on the supervision and oversight of derivatives activities by the board of directors and senior management of a banking organisation. The directors of a banking organisation that engages in derivatives activities must understand the derivatives business and the mechanisms used to manage inherent risk, and must properly supervise the banking organisation’s overall derivatives activities. Although not expected to be experts in the derivatives market, senior managers and directors are required by the OCC to have “sufficient understanding of the products and risks to approve the bank’s derivatives business strategy; to have general familiarity with the nature of the business, including an understanding of the nature of the risks taken; to limit the amount of earnings and capital at risk; and to review periodically the results of derivatives activity, including compliance with appropriate limits.”

 

 

THE OCC APPROACH

In the Handbook, the OCC outlines in great detail the responsibilities of the board of directors and senior management of a bank, including the following:

(i) Written Policies and Procedures: The board of directors must approve the bank’s written policies and procedures.

(ii) New Product Policy: The senior management of a bank must analyse the new product and activity. In assessing a new product, a bank must consider all significant risks and issues in the face of changing markets, organisation structure, systems, policies and procedures. Moreover, the approval process for new products should include a sign-off by all relevant departments, such as risk control, operations, accounting, legal, audit, and senior and line management.

(iii) Oversight of Risk Control: Risk control is the process through which the various risk exposures are identified, measured, monitored, and controlled. Fundamental to an effective risk management system are exposure limit systems, risk measurement capabilities, risk monitoring and reporting mechanisms, and segregation of critical operational and control processes. The board of directors and senior management of a bank engaging in derivatives activities must provide adequate resources (financial, technical expertise, and systems technology) to implement these measures effectively.

The risk management process takes various forms depending on the nature of the activity (dealer, active position-taker, limited end-user). If a bank acts as a dealer, it is preferable that the risk control function be a separate unit reporting directly to the board of directors. For limited end-users, the board of directors and senior management should remain responsible for ensuring proper risk control of the activity, although less frequent evaluations of risk taking are required. The OCC recommends the use of independent support personnel to report risk control activities to a committee, such as an Asset Liability Management Committee.

(iv) Risk Measurement: The board of directors and senior management of a bank, at a minimum, should assess the bank’s vulnerabilities on an ongoing basis in response to changing circumstances. All significant risks should be measured and integrated into a bankwide risk management system. In the OCC Handbook, the OCC cautions that management should recognise that measurement of some types of risk is an approximation. Moreover, certain risks, such as liquidity of a marketable instrument, can be very difficult to quantify precisely and can vary with economic and market conditions.

(v) Risk Limits: The board of directors should approve aggregate risk-taking limits at least once a year. The limits approval should constitute a part of the bank’s overall budget process. Moreover, a bank’s board of directors and senior management should use limits and exposure measurement systems to foster communication of position dynamics and changes in the bank’s overall risk profile.

(vi) Oversight of Audit Coverage: A bank must maintain qualified and independent audit personnel to identify internal control weaknesses and system deficiencies. The scope of audit coverage should be commensurate with the bank’s level of risk and volume of activity. For end-users, audit coverage is likely to be included within the scope of treasury audits (interest rate, foreign currency, and liquidity risk). Banks that function as dealers or active position-takers will need audit coverage of the additional financial and systems risks associated with these activities.

(vii) Oversight of Affiliates: The board of directors and senior management should establish policies and procedures addressing derivatives activities with affiliates, and senior management should ensure compliance with such policies and procedures.

(viii) Oversight of Management Information System: The information system should ensure that the board of directors gets information illustrating exposure trends, the adequacy of the compliance with policies and risk limits, and risk/return performance, while senior management should have detailed reports to assess risks involved in the bank’s derivatives operations.

(ix) Capital: A bank’s board of directors should ensure that the bank maintains sufficient capital to support the risk exposures (e.g., market risk, credit risk, liquidity risk, operations, and systems risk) that may arise from its derivatives activities. The board of directors should review significant changes in the size of scope of a bank’s activities in light of capital adequacy.

With respect to foreign banks, in the Questions and Answers the OCC specifies that senior management, as described in BC-277, may generally be the senior management of the branch office of a foreign bank, rather than the senior management of such bank’s overseas head office. However, senior management of the head office still has the obligation to outline appropriate risk limits and other controls within which branch management must operate, and establish effective reporting and audit functions to monitor and review the branch’s activities, including compliance with applicable limits.

 

 

THE FEDERAL RESERVE APPROACH

The Federal Reserve Guidelines and Trading Manual contain similar requirements, although not as detailed as the OCC’s. The Federal Reserve’s Trading Manual places great emphasis on the role of directors and senior management in the risk management of derivatives activities.

According to the Federal Reserve, the board of directors has ultimate responsibility for determining the level of risk an institution is willing to take. Senior management and the board of directors must understand the risks involved in a banking institution’s derivatives activities so that they can identify and assess risks; establish policies, procedures, and risk limits; monitor compliance with limits; delineate capital allocation and portfolio management; develop new product policy and review new exposures within the current framework; apply new measurements to existing products; and maintain adequate financial support and staff to manage and control the risks of the banking institution’s derivatives operation. Moreover, according to the Federal Reserve, a banking institution’s risk management process must be assessed not only by business line, but also in the context of the global, consolidated institution. The Federal Reserve Trading Manual places responsibility on the board of directors and senior management of a banking institution for the institution’s global risk management.

 

 

MARKET RISK MANAGEMENT

 

Market Risk

Market risk is the exposure arising from adverse changes in the market value (the price) of an instrument or portfolio of instruments. Such exposure occurs with respect to derivative instruments when changes occur in market factors such as underlying interest rates, currency rates, equity prices, and commodity prices, or in the volatility of these factors.

 

The OCC Approach

The OCC categorises market risk into two different types of exposures: forward risk and option risk. Forward risk is the potential loss due to changes in market value caused by changes in market factors (interest rates, foreign exchange rates, equities prices, and commodities prices), while option risk is the potential loss due to volatility, passage of time, and other relevant variables affecting the valuation of options. The primary measures of option risk include delta, gamma, vega or kappa, theta, and rho.

The OCC requires that each institution involved in derivatives activities establish an effective process for controlling market risk. According to the OCC Handbook, effective supervision of market risk includes:

(1) Appropriate supervision by the board of directors and senior management;

(2) Applicable written policies and procedure controls;

(3) A meaningful process for establishing market risk limits;

(4) Reliable market valuation systems;

(5) Accurate and validated risk measurement processes; and

(6) Timely and effective risk reporting, monitoring and exception approval processes.

 

Interest Rate Risk

In February of 1995, the OCC issued an advisory letter on managing interest rate risk exposures. Interest rate risk is the potential adverse impact of interest rate movements on a banking institution’s net income and economic value. The OCC expects all national banks to have effective interest rate risk management processes that consist of risk identification, measurement, monitoring, and control. Specifically, the OCC requires that banks have risk management practices that ensure:

(i) Risk Measurement. National banks should have systems to measure the amount of earnings at risk when interest rates change. The primary objective is to determine the direction and magnitude of exposure rather than to search for a precise measure. Major assumptions used to measure interest rate risk should be reviewed periodically and at least annually by a bank’s board of directors or a board committee.

(ii) Risk Monitoring. Reports on a bank’s interest rate risk profile should be reviewed at least quarterly by senior management and the board or a board committee. More frequent reviews are appropriate if the characteristics of the bank or the interest rate environment merit them. The reports should enable senior management and the board of directors to evaluate the amount of interest rate risk being taken, compliance with established risk tolerance, and whether management actions are consistent with the board’s expressed risk tolerance.

(iii) Risk Control. The board of directors of a bank should clearly communicate to senior management its tolerance for interest rate risk exposure. The board and senior management should establish clear lines of responsibility for measuring and monitoring risk exposures, and ensure that the bank maintains sufficient capital to support the level of interest rate risk exposure.

 

Risk Measurement

There is no uniform risk measurement system for all banks. Rather, the type and degree of risk a bank assumes determines the bank’s choice of risk measurement and control systems. For example, derivatives with complex risk structures require more sophisticated risk control mechanisms that rely on mathematical models to replicate price behaviour. Thus, dealer banks usually have the most sophisticated risk measurement systems. Limited end-users and active position-takers, though not required to have systems of the same standard as dealers, must have a reasonable understanding of the factors affecting the price of a derivative product to be able to measure and manage potential risks to earnings and capital. Moreover, the risk limits used to control market risk must be commensurate with the level of market risk exposure and the format of risk measurement employed by a bank. Banks employ different types of limits to control market risk exposures, such as earnings or capital-at-risk limits, loss control limits, tenor or gap limits, notional or volume limits, or option limits.

 

The Federal Reserve Approach

The Federal Reserve Trading Manual takes a similar approach to that of the OCC Handbook, distinguishing between forward risk and options risk, and discussing in detail the various kinds of market risk, such as interest rate risk, basis risk, foreign exchange risk, equities risk, commodities risk, and the various options risks.

Similar to the OCC’s approach, the Federal Reserve in its Nontrading Guidelines also differentiates levels of risk measurements among bank organisations so that an institution’s system for measuring risks involved in derivatives contracts in commensurate with the nature of the institution’s holdings and risk exposure. Generally, bank organisations should have the capacity to evaluate the risks of instruments prior to acquisition. Institutions with significant securities and derivatives activities are expected either to conduct their own in-house pre-acquisition analyses or make use of specific third-party analyses that are independent of the seller of counterparty. Notwithstanding information and analyses obtained from outside sources, the management of a bank organization is ultimately responsible for understanding the nature and risk profiles of the institution’s securities and derivatives holdings.

Moreover, institutions should periodically review the performance and effectiveness of instruments, portfolios, and institutional programs and strategies to determine whether their derivative holdings meet the various objectives, risk tolerances, and guidelines established by the institution’s policies. The Federal Reserve believes that the effective measurement of credit, market, and liquidity risks of many securities and derivative contracts requires mark-to market valuations.

With respect to market-risk measurement, the Federal Reserve in its Trading Manual seems to have recommended the value-at-risk approach, which measures the potential gain or loss in a position, portfolio, or institution that is associated with a price movement of a given probability over a specified time horizon. Other measurement methods, including standard deviation, correlation, and stress testing are also used to measure market exposures. Moreover, different methodologies such as nominal or notional measurement, duration measures, and volatility measures can be applied separately or in combination to calculate net risk positions, price sensitivities, and volatility.

The Federal Reserve also stresses that the fundamental controls over risks inherent in the derivatives activities lie in the imposition of risk limits. Moreover, regardless of the methodologies used, a banking institution should be able to relate aggregate exposure to the limit structure in order to evaluate potential loss to the banking institution.

 

 

CREDIT RISK MANAGEMENT

 

Credit Risk

Credit risk is the risk of loss due to a counterparty’s unwillingness or inability to pay its obligations. The Federal Reserve stresses that credit risk management is one of the critical control areas of a banking organization’s derivatives trading activities. The OCC takes the approach that credit exposure arising from derivatives activities should be addressed within the same framework used to asses credit risk in traditional banking activities. According to the OCC, counterparty credit risk can be managed effectively through appropriate measurement of exposures, ongoing monitoring, timely counterparty credit evaluations, and sound operating procedures.

Credit risk in derivative products comes in the form of pre-settlement and settlement risk. Pre-settlement risk is the risk of loss due to a counterparty defaulting on a contract during the life of a transaction. Frequently, this exposure is referred to as the replacement cost. For many off-balance-sheet derivatives, however, there is no advancement of funds or exchange of principal. Therefore, the risk of loss is conditional on the counterparty defaulting and the derivative contract having positive value to the bank (an “in the money” contract) at the time of default. The level of this exposure varies throughout the life of a derivatives contract and is known with certainty only at the time of default.

Settlement risk is the loss exposure arising when a bank performs on its obligation under a contract prior to the counterparty performing on its obligation. Settlement risk frequently arises in international transactions because of time zone differences. This risk is only present in transactions that do not involve delivery versus payment and generally exists for a very short time (less than 24 hours).

 

Credit Risk Control Process

Both the Federal Reserve and the OCC stress that, as in market risk management, effective credit risk management mandates effective oversight and supervision by the board of directors and senior management; written policy and procedures controls; strong credit review, approval, and limit processes; accurate and validated risk measurement systems; timely and effective risk reporting; monitoring; and exception approval processes. In addition, management is responsible for reviewing and monitoring documentation and establishing minimum documentation standards for derivatives transactions.

According to both agencies, counterparty credit risk should be strictly controlled through a formal and independent credit process. As with customers of traditional bank products, the credit department should periodically review the creditworthiness of derivatives counterparties. Consistent with the bank’s internal policies regarding traditional lending activities, banks should assign risk ratings to counterparties and maintain credit reserves.

 

Credit Enhancements and Early Termination Clauses

While the practice of using collateral, margining, and using third-party guarantees and early termination clauses with OTC derivatives is becoming more widespread, the OCC takes the position that these mechanisms should be considered a secondary source of repayment in lieu of a counterparty’s ability to meet cash flow demands through its ongoing operations. When using collateral or margin programs, banks must control the legal, operational, and liquidity risks involved. Moreover, the OCC cautions that the use of credit enhancement agreements to build up “risk-taking” positions with derivatives may present safety and soundness concerns. Such activities should only be undertaken after determining that the bank’s liquidity position will be maintained and that a satisfactory balance exists within the bank’s overall risk profile.

The Federal Reserve also points out in its guidelines that while master netting agreements and various credit enhancements may be used by banking institutions to reduce counterparty credit risk, a banking institution’s credit exposure should reflect these risk reducing features only to the extent that the agreements and recourse provisions are legally enforceable in all relevant jurisdictions.

 

Credit Risk Measurement

Credit risk measurement is an important part of credit risk management. According to the OCC, quantifying settlement risk is straightforward, because the exposure to credit risk is the amount of funds or assets delivered if payment before such amounts or assets due has been received. Measuring pre-settlement risk is much more complicated, and the method used should be commensurate with the volume and level of complexity of a bank’s derivatives activity.

Dealers and active position-takers should have access to statistically calculated loan equivalent exposures that represent the current exposure (mark-to-market value) plus an estimate of the potential change in value over the remaining life of the contract (“add-on”). The add-on is generally determined using the statistical analysis capabilities of simulation modelling. The current exposure calculation simply involves marking-to-market each derivatives contract. Limited end-users may elect to use a less sophisticated method for measuring the credit risk add-on (e.g., a percent of notional value times the number of remaining years to maturity) as long as other mitigating factors are in place. Examples of mitigating factors include restricting transactions to the highest quality counterparties or limiting contracts to mature, less volatile derivatives.

Moreover, banks should have an effective method for aggregating credit risk among individual counterparties and derivatives portfolios. However, the OCC points out in its Handbook that aggregation of credit exposures on a contract-by-contract basis will often overstate the level of credit risk because of timing considerations with respect to potential exposures. For example, if a counterparty has two derivative contracts (a six month forward and a two year swap), the peak exposures for these two contracts may be at six months and twelve months, respectively. Since loss due to credit risk is conditional on both positive replacement cost and counterparty default, it is logical to adjust the credit analysis to reflect the assumption that if this counterparty defaults at six months, all contracts will be settled at that time.

Furthermore, in order to measure credit risk effectively, an bank’s exposure reporting must be meaningful, timely, and accurate. Banks should be able to combine the loan equivalent figures with other credit risk exposures to determine the aggregate risk for each counterparty.

According to the Federal Reserve, in addition to the add-on method, an institution may choose to measure its maximum probable exposure using a near-worst-case scenario, or computing its average or expected exposure by developing a series of scenarios for market price movements, and assigning each scenario a probability. The Federal Reserve stresses that a banking institution must define a measurement methodology against which to compare limits and position measurement techniques, and that this methodology should be applied consistently across all instruments and types of capital market exposures. Credit Risk Limits

The OCC and the Federal Reserve both require banking institutions to have internal credit review and establish counterparty credit limits. The OCC emphasises that credit risk management should parallel the prudent controls applied in banks’ traditional lending activities. Separate limits should be established for pre-settlement risk and settlement risk. Documentation in the credit file should support purpose, source of repayment, and collateral. Evaluations of individual counterparty credit limits should aggregate limits for derivatives with the credit limits established for other activities, including commercial lending.

Moreover, banking institutions should monitor credit exposure on a timely basis. Credit monitoring requires timely reporting and distribution of accurate information about credit exposures such as line usage, concentrations, credit quality, limit exceptions, and significant counterparty exposures. The OCC points out in its guidelines that credit risk monitoring should be independent of the units that create financial derivatives exposures. In addition, to stressing the importance of timely monitoring, the Federal Reserve cautions banking institutions to maintain mechanisms that could promptly recognise unusual credit exposure build-ups or credit deterioration in a counterparty between regular reviews.

 

 

 

 

 

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