Quantifi, a provider of analytics and risk management solutions to the global credit markets, released today a white paper titled “The Evolution of Counterparty Credit Risk – An Insider’s View,” co-authored by David Kelly, Quantifi’s director of Credit Product Development, and Jon Gregory, author of “Counterparty Credit Risk: The New Challenge for Global Financial Markets.” The paper traces the changes in theory and practice pertaining to counterparty credit risk and outlines the current priorities for banks.
“Counterparty credit risk has become they key element of financial risk management, as highlighted by the failure of institutions like Lehman, Bear Stearns, and AIG. This is a challenging area that has been evolving over the last few years,” comments Gregory. “The question now is, how will banks address counterparty credit risk moving forward? Both David and I have worked inside the world’s largest banks and we authored this paper in an effort to share our perspective on how these institutions are addressing counterparty risk and how we see the market moving forward.”
The white paper reviews how banks have innovated counterparty credit risk management and focuses on the trend of moving credit risk from a traditional “reserve model” towards the “market model.” The reserve model involved transaction fees that were essentially insurance policies against losses due to counterparty defaults. Later, in response to the need to free capital and increase capacity, banks began to price and hedge counterparty credit risk like other market risks in what was known as the market model.
This evolution inspired important innovations with regard to active management, bringing forth the contingent credit default swap (CCDS) and the start of addressing active management from the input end of the portfolio simulation. According to the white paper, the next needed step in the evolution is a focus on correlation in portfolio simulation, which still remains an open problem.
Kelly comments, “Banks are continuing to evolve counterparty credit risk management. We’ve seen increased focus on wrong-way risk, collateral risk, centralisation of credit risk management, and the usage of debt value adjustment (DVA). These initiatives are certainly not new as banks have known about these risks prior to the crisis, but as firms place even greater priority on counterparty credit risk, we look forward to seeing increasing adoption of these innovations and witnessing the industry’s continued evolution.”
Rohan Douglas, CEO of Quantifi, notes, “Counterparty credit risk has been and continues to be a crucial concern for banks. Quantifi is committed to partnering with our clients to help them understand and manage counterparty risk through our groundbreaking solutions and tools. We are pleased to have the opportunity to author this paper with Gregory, a true thought leader in the industry.”