There is a clear need within the counterparty risk manager community for more tools and better access to data related to credit risk analytics, according to Jonathan Di Giambattista, managing director of risk and performance analytics at Fitch Solutions. Di Giambattista bases his judgement on a recent survey of 85 counterparty risk managers in buy side firms carried out in October last year by the solutions provider owned by ratings giant Fitch.
According to the survey, the majority of counterparty risk managers are dissatisfied with their ability to gain access to the data that is driving the internal risk ratings process. There is a lot of data that needs to be better integrated and it needs to be more easily accessed by these managers, claims Di Giambattista.
“One of the results that jumped out at us was that the vast majority of buy side firms do absolutely no hedging of counterparty risk. They are not actively participating in the credit default swap (CDS) market to hedge out their exposures to counterparties. Most of the respondents cited that hedging was simply too expensive and they preferred instead to manage counterparty risk,” he elaborates.
However, it is in the active management of this counterparty risk that the challenges lie. The process involves the setting of limits and collateral requirements, a robust set of exposure monitoring tools and a significant degree of monitoring for early warning of credit events on their counterparty portfolios. “It is not surprising that 75% are not yet set up to trade on central counterparties (CCPs) and this has not necessarily changed since the Lehman collapse,” adds Di Giambattista. There is seemingly a lot still to do to adequately tackle the task of monitoring counterparty risk in the post-Lehman world.
A broad theme throughout the results was that there is a significant increase in the monitoring of credit risk for counterparties and this is a particularly challenging area. Counterparty risk managers have become increasingly involved in the monitoring of credit risk and, according to the survey results, 63% of respondents deal with fewer counterparties than they did before Lehman defaulted. The process of whittling down counterparties into a shortlist has become more rigorous.
“There was some general sentiment that diversification was a good thing in the past but now they are coming to realise the challenges of monitoring these counterparties is such that having fewer counterparties allows for better monitoring of credit quality standards,” he explains. These market participants have therefore decided to narrow down their number of derivatives counterparties and apply more stringent credit monitoring and credit quality standards for how they are setting collateral requirements.
“Interestingly enough, as they are getting more involved in monitoring counterparty credit risk, market participants are actually finding that they are least satisfied with the standalone risk measures they have for those counterparties,” adds Di Giambattista. “Survey respondents cited that the internal workflows have changed somewhat and they are posing some unique challenges for their ability to monitor counterparty credit risk.”
According to the survey, two thirds of counterparty risk managers are now being forced to adhere to a central counterparty credit risk assessment process. Often, these assessments are done by a separate analytical unit or a formal ratings group in a larger institution and risk managers are provided the end data. These teams draw up a shortlist of approved counterparties against the internal risk management policies, guidelines, modelling methodologies and regulatory requirements. The counterparty risk manager then takes over to manage how counterparty risk is managed within that shortlist, he explains.
“Interesting to note that while two thirds are using a centralised assessment, there is still a third not using a formal credit assessment process. It is also interesting that 60% of firms are dependent on their own credit risk assessment to determine whether they are trading with a good counterparty. Only 40% looked at secondary market liquidity as a reason whether or not they will trade,” he continues.
Fitch Solutions is seeing an increase from the buy side and sell side in formalising the process for assigning credit risk assessments. There is also still a large dependence on agency ratings and what these agencies are saying about the creditworthiness of the financial institution, adds Di Giambattista. These central risk assessments are then being heavily used for capital requirements purposes for capital allocation under Basel II.
Di Giambattista contends that these centralised ratings have become “gospel” within these firms and there is a lack of real transparency for end users into the data that has gone into producing them. “These counterparty risk managers need good transparency into the data used within predicting future credit events impacting future credit ratings. They need to integrate these signals into their day to day practices. Post-Lehman, the turmoil that credit risk issues caused means there is a need to better tackle this space,” he says.
Instead of just looking at a rating, there is a need for the counterparty risk manager to be able to screen for the drivers of those ratings. This includes data around areas such as fundamental financials, agency ratings, capital adequacy, sovereign support, market signals, sovereign risks and ratings, industry standing and management quality.
There is also a need to be able to anticipate future credit events by looking at external credit risk assessments. “If you have a model driven methodology that is coming out of your central risk assessment team, it is probably worth going out and looking at what an external assessment of that credit risk would be. This could be a vendor model or an opinion from a ratings agency,” he elaborates.
There is a need to look for early warning signals by benchmarking counterparty performance relative to the rest of its peers and using relative risk indictors when the market begins to fluctuate, he continues. There is also a need to track news flow – being alerted about announcements and news items related to a portfolio of counterparties.
“We have seen that the CDS market and derived metrics are the best early warning signals available on counterparties. From the CDS market you can get everything from a probability of default on individual entities to relative risk levels by region or within a sector. But cardinal values in the CDS market are very difficult to rationalise,” he explains.
Di Giambattista reckons the survey results demonstrate the clear need for more tools and better access to data surrounding credit risk monitoring. “There is also an ever broadening scope of risk that is looking at how sovereigns interplay with counterparty risk exposure,” he adds.
Catherine Downhill, director of integrated data services at Fitch Solutions, adds: “There are three key needs around acquiring timely and accurate data for counterparty risk purposes. The first relates to the central risk assessment area where the counterparty risk managers are looking for a range of data such as ratings, company financials and historical data in order to determine their counterparty shortlist and capital charges.”
She concludes: “The second key area was the need for appropriate tools to support the decision making process when determining exposure limits and collateral requirements. People are really looking for timely and high quality data that can be delivered either in a very easy to integrate data feed or via a user interface that would allow for peer analysis tools. The final need is to understand what is going on in the market and receive early warning signals of future credit events. People are looking for timely market data such as CDS pricing and market-based risk measures.”
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