NOVARUM :: Counterparty Credit Risk

Counterparty Credit Risk

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Two types of operating models have emerged over the past decade to manage CCR:

The Credit Portfolio Model, favored by firms with an existing centralized loan portfolio management team reporting to an independent risk or financial control function. Under this operating model, CCR originated by each OTC derivative business is aggregated and managed centrally against approved portfolio limits. Risk transfer is effected through internal pricing agreements that attribute a credit and capital charge to the CCR created. The advantages of this centralized operating model are well documented and quantifiable, including: cost efficiency, corporate consistency, independence and control. The disadvantages are qualitative, centered around: perceptions of monopolistic pricing behavior and bureaucratic inflexibility. Since the cost of credit and capital represents a material proportion of the available mark-up on an OTC derivative transaction, the potential for internal dispute is significant. Therefore, for this operating model to be viable, senior management must actively moderate potential disputes through continuous consultation and education.

The Self Insured Model, favored by firms that fully allocate the cost of balance sheet and capital usage to each originating business. Under this operating model, each OTC derivative business is responsible for the credit and capital costs associated with the CCR it originates and retains. The role of the independent control function is restricted to establishing and monitoring CCR limits within which originating business units are required to operate. The advantages of this devolved operating model are qualitative, but significant. Once an OTC derivative business accepts ownership and accountability for the CCR it originates, it is invariably more proactive and innovative in the management and hedging of CCR. Disadvantages include the replication of CCR management resources across multiple business units and the cost and complexity of maintaining a consistent risk governance over these business units to ensure the validity and effectiveness of the credit risk mitigation they employ.

Successful risk management begins with a clear alignment of the capital and credit costs of retaining CCR with the cost of hedging CCR.