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(The article featured
below is a selection from Hedge
Funds and Private Equity: Risk Management and Regulatory Update, which is
available to subscribers of that publication.)
Fed Governor Views
Enhanced Counterparty Credit Risk Management as Key to Securitization Reform
In the coming reform
of securitization, noted Federal Reserve Board Governor Randall S. Kroszner,
financial institutions must strengthen their counterparty credit risk
management, mainly through more extensive stress testing. In remarks at a
seminar in Geneva, he said that in the current crisis risk managers did not
fully contemplate the possibility that many participants would need to unwind
their positions at the same time, that such actions might present substantial
losses for several key counterparties, and that collateral posted as protection
for positions would fall in value at the same time.
One source of the
problem was a failure to do adequate stress testing. Also, even when risk
managers at financial institutions had some understanding of these issues, they
found it difficult to demand more collateral or guarantees during good times
because no risk manager wanted to be the first to do so.
Financial markets
have developed mechanisms that are specific to the control of counterparty risk.
The simplest of these is the posting of collateral against counterparty
exposures. Ensuring the efficacy of collateral is challenging even under
ordinary circumstances, said the official, and may leave counterparties
especially vulnerable to large sudden changes in market prices, also known as
'gap risk' .
The Fed governor
observed that a central counterparty or clearinghouse is a sophisticated
convention for mitigating counterparty credit risk. The NY Fed is currently
vetting a process to create a central counterparty in the credit derivatives
market. In markets with a clearinghouse, all trades are intermediated through a
central counterparty. This arrangement can vastly reduce counterparty risk,
enthused the governor. The central counterparty runs a balanced book, he pointed
out, and as a general matter has no direct market exposure. In the case of a
member's default, the central counterparty can draw upon the proprietary margin
of the defaulting member, its own reserve fund, and the assessment of members
for share purchase.
According to Gov.
Kroszner, counterparty credit risk management should be focused on its
effectiveness in different market situations and its implications for financial
stability, which in turn underscore the importance of stress testing and
scenario analysis focused on market-wide events. Such stress tests would include
the potential for key counterparties to fail or suffer difficulty at the same
time, he noted, or market liquidity to erode and remain low for some time, and
for market participants to view the financial institution itself as an impaired
counterparty.
In his view,
properly designed stress tests can provide information that typical statistical
models may leave out, such as abnormally large jumps or market moves,
evaporation of liquidity, prolonged periods of market distress, or structural
changes in markets. Stress tests are most useful when they aim to include
potential secondary or knock-on effects, he emphasized, which are often
difficult to model with standard techniques. In these ways, stress tests can
serve as a complementary tool to other risk measures. It is also important for
banks to conduct stress tests across several markets, Mr. Kroszner said, since
some counterparties are key players across many financial markets and their
inability to repay could cascade across those markets.
Many benefits
accompany effective stress testing. For example, based on the results of their
stress tests, banks may reassess their participation in certain markets and
exercise greater caution to account for potential tail risks and better protect
themselves in times of market wide stress. One of the first things they may do
is increase their internal assessments of capital needs for these activities,
given the added risks that stress tests reveal. They may wish to restructure
contracts or alter terms.
Financial
institutions also might ask for higher initial margin, given that subsequent
calls may not provide as much risk mitigation during distress. They may wish to
ask for more collateral, or ensure that the collateral is less linked to the
counterparty's condition or broader market distress. Or they might look for
other ways to enhance their assessment of counterparties, and, perhaps more
importantly, the potential for counterparties to encounter difficulties during
market wide stresses. Moreover, they may wish to conduct more of their trading
and hedging on more organized exchanges or with clearinghouses, to benefit from
their safeguards.
In addition, banks
acting collectively may decide to take action to improve the quality assurance
performance of markets during future times of stress. For their part, trade
associations in the banking industry may consider additional safeguards to
reduce the impact of systematic risks among counterparties. For example, banks
may collectively act to remove uncertainty associated with back-office
inefficiencies and related risks in the credit default swaps market. Another
example is an attempt to enhance mortgage markets so that there is greater
standardization of data and simpler, more homogeneous provisions in the
securitizations, and less reliance on third-party monitoring.
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