Counterparty Credit Risk Management: Supervisory Guidance (Revised June 2026)
FederalAgency guidance
Ask Donna
How this section applies to your facts.
FDIC Financial Institution Letters › Counterparty Credit Risk Management: Supervisory Guidance (Revised June 2026)
Text
In June 2026, this document was revised to remove references to reputational risk.
Office of the Comptroller of the Currency
Federal Deposit Insurance Corporation
Board of Governors of the Federal Reserve System
Office of Thrift Supervision
Interagency Supervisory Guidance on Counterparty Credit Risk Management
June 29, 2011
Table of Contents
I. Introduction ............................................................................................................................................ 2
II. Governance
1. Board and Senior Management Responsibilities ............................................................................................... 3
2. Management Reporting .................................................................................................................................... 3
3. Risk Management Function and Independent Audit ......................................................................................... 4
III. Risk Measurement
1. Counterparty Credit Risk Metrics ..................................................................................................................... 4
2. Aggregation of Exposures ................................................................................................................................ 5
3. Concentrations .................................................................................................................................................. 6
4. Stress Testing ................................................................................................................................................... 7
5. Credit Valuation Adjustments .......................................................................................................................... 8
6. Wrong-Way Risk ............................................................................................................................................ 10
IV
......................................................................... 7
5. Credit Valuation Adjustments .......................................................................................................................... 8
6. Wrong-Way Risk ............................................................................................................................................ 10
IV. Systems Infrastructure Considerations ........................................................................................... 11
V. Risk Management
1. Counterparty Limits ........................................................................................................................................ 13
2. Margin Policies and Practices ......................................................................................................................... 14
3. Validation of Models and Systems ................................................................................................................. 15
4. Close-out Policies and Practices ..................................................................................................................... 16
VI. Managing Central Counterparty Exposures ................................................................................................. 16
VII. Legal and Operational Risk Management ..................................................................................................... 17
1. Legal Risk Arising from Counterparty Appropriateness................................................................................. 18
VIII. Conclusion ..................................................................................................................................................... 19
Appendices
A: Glossary .......................................................................................................................................................
................................................. 18
VIII. Conclusion ..................................................................................................................................................... 19
Appendices
A: Glossary ........................................................................................................................................................ 20
B: Detail on Model Validation and Systems Evaluation .................................................................................... 23
2
COUNTERPARTY CREDIT RISK MANAGEMENT
I. Introduction
This guidance discusses critical aspects of effective management of counterparty credit risk
(CCR), and sets forth sound practices and supervisory expectations for an effective CCR management
framework. CCR is the risk that the counterparty to a transaction could default or deteriorate in
creditworthiness before the final settlement of a transaction’s cash flows. Unlike the credit risk for a
loan, when only the lending banking organization1 faces the risk of loss, CCR creates a bilateral risk of
loss because the market value of a transaction can be positive or negative to either counterparty. The
future market value of the exposure and the counterparty’s credit quality are uncertain and may vary
over time as underlying market factors change. The guidance is intended for use by banking
organizations, especially those with large derivatives portfolios, in setting their risk management
practices, as well as by supervisors as they assess and examine such institutions’ management of CCR.
For other banking organizations without large derivatives portfolios, risk managers and supervisors
should apply this guidance as appropriate, given the size, nature, and complexity of the CCR risk profile
of the banking organization.
CCR is a multidimensional form of risk, affected by both the exposure to a counterparty and the
credit quality of the counterparty, both of which are sensitive to market-induced changes
zations without large derivatives portfolios, risk managers and supervisors
should apply this guidance as appropriate, given the size, nature, and complexity of the CCR risk profile
of the banking organization.
CCR is a multidimensional form of risk, affected by both the exposure to a counterparty and the
credit quality of the counterparty, both of which are sensitive to market-induced changes. It is also
affected by the interaction of these risks, for example the correlation2 between an exposure and the
credit spread of the counterparty, or the correlation of exposures among the banking organization’s
counterparties. Constructing an effective CCR management framework requires a combination of risk
management techniques from the credit, market, and operational risk disciplines.
CCR management techniques have evolved rapidly over the last decade, along with increased
complexity of derivative instruments under management. Banking organizations substantially improved
their risk management practices during this time; however, in some cases, implementation of sound
practices has been uneven across business lines and counterparty types. Further, the financial crisis of
2007-2009 revealed weaknesses in CCR management at many banking organizations, such as
shortcomings in the timeliness and accuracy of exposure aggregation capabilities and inadequate
measurement of correlation risks. The crisis also highlighted deficiencies in the ability of banking
organizations to monitor and manage counterparty exposure limits and concentration risks, ranging from
poor selection of CCR metrics to inadequate system infrastructure.
To address these weaknesses, this guidance reinforces sound governance of CCR management
practices, through prudent board and senior management oversight, management reporting, and risk
management functions
ability of banking
organizations to monitor and manage counterparty exposure limits and concentration risks, ranging from
poor selection of CCR metrics to inadequate system infrastructure.
To address these weaknesses, this guidance reinforces sound governance of CCR management
practices, through prudent board and senior management oversight, management reporting, and risk
management functions. The guidance discusses relevant topics in risk measurement, including metrics,
exposure aggregation and concentration management, stress testing, and associated characteristics of
adequate systems infrastructure. It also covers risk control functions, such as counterparty limits,
margin practices, validating and backtesting models and systems, managing close-outs,3 managing
1 Unless otherwise indicated, “banking organizations” refers to national banks in the case of the Office of the Comptroller of the
Currency (OCC); federal and state savings associations and savings and loan holding companies in the case of the Office of Thrift
Supervision (OTS); state member banks and bank holding companies in the case of the Federal Reserve Board (Board); and state
nonmember banks in the case of the Federal Deposit Insurance Corporation (FDIC). The U.S. branches and agencies of foreign banks
supervised by the OCC, the Board and the FDIC also are considered to be banking organizations for purposes of this guidance.
2 In this guidance, “correlation” refers to any form of linear or non-linear inter-relationship or dependence between factors.
3 A close-out is the process undertaken by a banking organization following default of a counterparty to fully collect on all items due
from that counterparty.
he OCC, the Board and the FDIC also are considered to be banking organizations for purposes of this guidance.
2 In this guidance, “correlation” refers to any form of linear or non-linear inter-relationship or dependence between factors.
3 A close-out is the process undertaken by a banking organization following default of a counterparty to fully collect on all items due
from that counterparty.
3
central counterparty exposures, and controlling legal and operational risks arising from derivatives
activities.
CCR management guidelines and supervisory expectations are delineated in various individual
and interagency policy statements and guidance,4 which remain relevant and applicable. This guidance
offers further explanation and clarification, particularly in light of developments in CCR management.
However, this guidance is not all-inclusive and banking organizations should reference sound practices
for CCR management, such as those advanced by industry, policymaking and supervisory forums.5
II. Governance
1.
Board and Senior Management Responsibilities
The board of directors or a designated board-level committee (board) should clearly articulate
the banking organization’s risk tolerance for CCR, by approving relevant policies, including a
framework for establishing limits on individual counterparty exposures and concentrations of exposures.
Senior management should establish and implement a comprehensive risk measurement and
management framework consistent with this risk tolerance that provides for the ongoing monitoring,
reporting, and control of CCR exposures.
Senior management should adhere to the board’s established risk tolerance and establish policies
and risk management guidelines appropriately.6 At a minimum, policies should outline CCR
management standards that are in conformance with this guidance
t and
management framework consistent with this risk tolerance that provides for the ongoing monitoring,
reporting, and control of CCR exposures.
Senior management should adhere to the board’s established risk tolerance and establish policies
and risk management guidelines appropriately.6 At a minimum, policies should outline CCR
management standards that are in conformance with this guidance. More specifically, they should
address the subjects discussed in this document, such as risk measurement and reporting, risk
management tools, and processes to manage legal and operational risk. Policies should be detailed and
contain a clear escalation process for review and approval of policy exceptions, especially those
pertaining to transaction terms and limits.
2.
Management Reporting
Banking organizations should report counterparty exposures to the board and senior management
at a frequency commensurate with the materiality of exposures and the complexity of transactions.
Reporting should include concentration analysis and CCR stress testing results, to allow for an
understanding of exposures and potential losses under severe market conditions. Reports should also
include an explanation of any measurement weaknesses or limitations that may influence the accuracy
and reliability of the CCR risk measures.
4 See, for example, Supervisory Policy Statement on Investment Securities and End-User Derivatives Activities, 63 FR
20191, April 23, 1998. Examination guidance on CCR is contained in various agency publications including: FDIC, Capital
Markets Examination Handbook; Federal Reserve, SR 99-03 and Trading and Capital Market Activities Manual (to be
amended as appropriate to reflect this guidance); OTS, Examiner Handbook, Section 660, “Derivative Instruments and
Hedging”; the OCC’s Banking Circular 277, and “Risk Management of Financial Derivatives” (Comptroller’s Handbook,
January, 1997)
cy publications including: FDIC, Capital
Markets Examination Handbook; Federal Reserve, SR 99-03 and Trading and Capital Market Activities Manual (to be
amended as appropriate to reflect this guidance); OTS, Examiner Handbook, Section 660, “Derivative Instruments and
Hedging”; the OCC’s Banking Circular 277, and “Risk Management of Financial Derivatives” (Comptroller’s Handbook,
January, 1997).
5 Industry, policymaking, and supervisory groups include, but are not limited to, the Counterparty Risk Management Policy
Group (CRMPG), Committee on Payment and Settlement Systems (CPSS), International Swaps and Derivatives Association
(ISDA), Institute of International Finance (IIF), Group of Thirty (G30), Group of Twenty Finance Ministers and Central Bank
Governors (G-20), International Organization of Securities Commissions (IOSCO), Senior Supervisors Group (SSG), and Basel
Committee on Banking Supervision (BCBS). Documents produced by all of these groups were drawn upon in developing this
guidance.
6 Relevant supervisory guidance discusses establishment of CCR policies and procedures.
4
Senior management should have access to timely, accurate, and comprehensive CCR reporting
metrics, including an assessment of significant issues related to the risk management aspects discussed
in this guidance. They should review CCR reports at least monthly, with data that are no more than
three weeks old. It is general practice for institutions to report:
• Total counterparty credit risk aggregated on a firm-wide basis and at significant legal entities.
• Counterparties with the largest exposures, along with detail on their exposure amounts.
• Exposures to central counterparties (CCPs).
• Significant concentrations, as outlined in this guidance.
• Exposures to weak or problem counterparties.
• Growth in exposures over time. As a sound practice, metrics should capture quarterly or monthly
changes, supplemented (where relevant) by year-over-year trend data
ies with the largest exposures, along with detail on their exposure amounts.
• Exposures to central counterparties (CCPs).
• Significant concentrations, as outlined in this guidance.
• Exposures to weak or problem counterparties.
• Growth in exposures over time. As a sound practice, metrics should capture quarterly or monthly
changes, supplemented (where relevant) by year-over-year trend data.
• Exposures from over-the-counter (OTC) derivatives. When they are material, additional product
class break-outs (for example, traditional lending, securities lending) should be included.
• A sufficiently comprehensive range of CCR metrics, as discussed in the CCR metrics section.
• A qualitative discussion of key risk drivers of exposures or conditions or factors that would
fundamentally change the risk profile of CCR. An example would be assessment of changes in
credit underwriting terms and whether they remain prudent.
3.
Risk Management Function and Internal Audit
A banking organization’s board and senior management should clearly delineate the respective
roles of business lines versus risk management, both in terms of initiating transactions that have CCR,
and of ongoing CCR management. The board and senior management should ensure that the risk
management functions have adequate resources, are fully independent from CCR related trading
operations (in both activity and reporting), and have sufficient authority to enforce policies and to
escalate issues to senior management and the board (independent of the business line).
The board should direct internal audit to regularly assess the adequacy of the CCR management
framework as part of the regular audit plan. Such assessments should include credit line approval
processes, credit ratings, and credit monitoring. Such an assessment should opine on the adequacy of
the CCR infrastructure and processes, drawing where appropriate from individual business line reviews
or other internal and external audit work
o regularly assess the adequacy of the CCR management
framework as part of the regular audit plan. Such assessments should include credit line approval
processes, credit ratings, and credit monitoring. Such an assessment should opine on the adequacy of
the CCR infrastructure and processes, drawing where appropriate from individual business line reviews
or other internal and external audit work. Please see the relevant section of this guidance regarding the
role of CCR model validation or review. The board should review annual reports from internal audit
and model validation or review, assessing the findings and confirming that management has taken
appropriate corrective actions.
III.
Risk Measurement
1.
CCR Metrics
Given the complexity of CCR exposures (particularly regarding OTC derivatives), banking
organizations should employ a range of risk measurement metrics to promote a comprehensive
5
understanding of CCR and how it changes in varying environments. Metrics should be commensurate
with the size, complexity, liquidity, and risk profile of the CCR portfolio. Banking organizations
typically rely on certain metrics as a primary means of monitoring, with secondary metrics used to
create a more robust view of CCR exposures. Banking organizations should apply these metrics to
single counterparty exposures, groups of counterparties (for example, by internal rating, industry,
geographical region), and the consolidated CCR portfolio. Banking organizations should assess their
largest exposures, for instance their top 20 exposures, using each primary metric.
Major dealers and large, sophisticated banking organizations with substantial CCR exposure
should measure and assess:
• Current exposure (both gross and net of collateral).
• Forward-looking exposure (that is, potential exposure).
• Stressed exposure (broken out by market risk factors, and/or by scenario).
• Aggregate and stressed credit valuation adjustment (CVA) as well as CVA factor sensitivities
ealers and large, sophisticated banking organizations with substantial CCR exposure
should measure and assess:
• Current exposure (both gross and net of collateral).
• Forward-looking exposure (that is, potential exposure).
• Stressed exposure (broken out by market risk factors, and/or by scenario).
• Aggregate and stressed credit valuation adjustment (CVA) as well as CVA factor sensitivities.
• Additional relevant risk measures, such as (for credit derivatives) jump-to-default risk on the
reference obligor, and economic capital usage.
• The largest exposures by individual business line and product types.
• Correlation risks, such as wrong-way risk, as well as the credit quality of collateral.
Refer to Appendix A for definitions of basic metrics and descriptions of their purposes.
2.
Aggregation of Exposures
Banking organizations should have the capacity to measure their exposure at various levels of
aggregation (for example, by business line, legal entity, or consolidated by industry). Systems should be
sufficiently flexible to allow for timely aggregation of all CCR exposures (that is, OTC derivatives,
securities financing transactions (SFTs), and other pre-settlement exposures), as well as aggregation of
other forms of credit risk to the same counterparty (for example, loans, bonds, and other credit risks).
The following are sound CCR aggregation principles:
• Counterparty-level current exposure and potential exposure should be calculated daily, based on the
previous day’s position data and any exchange of collateral.
• For each organizational level of aggregation, all trades should be included.
• There should be sufficient flexibility to aggregate exposure at varying levels of granularity,
including industries, regions, families of products (for example, OTC derivatives, SFTs), or other
groupings to identify concentrations
ed daily, based on the
previous day’s position data and any exchange of collateral.
• For each organizational level of aggregation, all trades should be included.
• There should be sufficient flexibility to aggregate exposure at varying levels of granularity,
including industries, regions, families of products (for example, OTC derivatives, SFTs), or other
groupings to identify concentrations.
• While banking organizations are not required to express all forms of risk in a common metric or
basis, management should be able to view the various forms of exposures to a given counterparty in
a single report and/or system. Specifically, this could include current outstanding exposure across
different categories (e.g., current exposure for OTC derivatives and drawn-down lines of
commitment for loans). Exposure reports should also include the size of settlement and clearing
lines.
6
• Banking organizations should be consistent in their choice of currency and exchange rate, and take
into account the validity and legal enforceability of any netting agreements they may have with a
counterparty.
• Management should understand the specific approach used to aggregate exposures for any given risk
measure, in order to properly assess the results. For instance, some measures of risk (such as current
exposure) may be readily added together, while others (such as potential exposure) are less
meaningful when they are added to form an aggregate view of risk.
• Internal capital adequacy models should incorporate CCR.
3.
Concentrations
Concentrated exposures are a significant concern, as CCR can contribute to sudden increases in
credit exposure, which in turn can result in unexpectedly large losses in the event of counterparty
default. Accordingly, banking organizations should have enterprise-wide processes to effectively
identify, measure, monitor, and control concentrated exposures on both a legal entity and
enterprise-wide basis
rated exposures are a significant concern, as CCR can contribute to sudden increases in
credit exposure, which in turn can result in unexpectedly large losses in the event of counterparty
default. Accordingly, banking organizations should have enterprise-wide processes to effectively
identify, measure, monitor, and control concentrated exposures on both a legal entity and
enterprise-wide basis.
Concentrations should be identified using both quantitative and qualitative means. An exposure
or group of related exposures (for example, firms in the same industry), should be considered a
concentration in the following circumstances: exposures (individually or collectively) exceed risk
tolerance levels established to ensure appropriate diversification; or deterioration of the exposure could
result in material loss. All credit exposures should be considered as part of concentration management,
including loans, OTC derivatives, names in bespoke and index CDO credit tranches, securities
settlements, and money market transactions such as fed funds sold. Total credit exposures should
include the size of settlement and clearing lines, or other committed lines.
CCR concentration management should identify, quantify, and monitor:
• Individual counterparties with large potential exposures, when those exposures are driven by a single
market factor or transaction type. In these circumstances, banking organizations should supplement
statistical measures of potential exposure with other measures, such as stress tests, that identify such
concentrations and provide an alternative view of risks associated with close-outs.
• Concentrations of exposures to individual legal entities, as well as concentrations across affiliated
legal entities at the parent entity level, or in the aggregate for all related entities.
• Concentrations of exposures to industries or other obligor groupings.
• Concentrations of exposures to geographic regions or country-specific groupings sensitive to similar
macroeconomic shocks
-outs.
• Concentrations of exposures to individual legal entities, as well as concentrations across affiliated
legal entities at the parent entity level, or in the aggregate for all related entities.
• Concentrations of exposures to industries or other obligor groupings.
• Concentrations of exposures to geographic regions or country-specific groupings sensitive to similar
macroeconomic shocks.
• Concentrations across counterparties when potential exposure is driven by the same or similar risk
factors. For both derivatives and SFTs, banking organizations should understand the risks associated
with crowded trades,7 where close-out risk may be heightened under stressed market conditions.
7 For purposes of this guidance, a “crowded trade” is a large balance of open trading positions in a given asset or group of assets
relative to its daily trading volume, when other market participants have similar positions that would need to be liquidated should any
adverse price change occur. Coincident sale of these assets by a large number of market participants could lead to significant price
declines and dramatic increases in uncollateralized exposures.
7
• Collateral concentrations, including both risk concentrations with a single counterparty, and risks
associated with portfolios of counterparties. Banking organizations should consider concentrations
of non-cash collateral for all product lines covered by collateral agreements;8 including collateral
that covers a single counterparty exposure and portfolios of counterparties.9
• Collateral concentrations involving special purpose entities (SPEs). Collateral concentration risk is
particularly important for SPEs, because the collateral typically represents an SPE’s paying capacity
centrations
of non-cash collateral for all product lines covered by collateral agreements;8 including collateral
that covers a single counterparty exposure and portfolios of counterparties.9
• Collateral concentrations involving special purpose entities (SPEs). Collateral concentration risk is
particularly important for SPEs, because the collateral typically represents an SPE’s paying capacity.
• Banking organizations should consider the full range of credit risks in combination with CCR to
manage concentration risk, including; risks from on- and -off-balance-sheet activities, contractual
and non-contractual risks, contingent and non-contingent risks, as well as underwriting and pipeline
risks.
4.
Stress Testing
Banking organizations with significant CCR exposures should maintain a comprehensive stress
testing framework, which is integrated into the banking organization’s CCR management. The
framework should inform the banking organization’s day-to-day exposure and concentration
management, and it should identify extreme market conditions that could excessively strain the financial
resources of the banking organization. Regularly, but no less than quarterly, senior management should
evaluate stress test results for evidence of potentially excessive risk, and take risk reduction strategies as
appropriate.
The severity of factor shocks should be consistent with the purpose of the stress test. When
evaluating solvency under stress, factor shocks should be severe enough to capture historical extreme
market environments and/or extreme but plausible stressed market conditions. The impact of such
shocks on capital resources and earnings should be evaluated. For day-to-day portfolio monitoring,
hedging, and management of concentrations, banking organizations should also consider scenarios of
lesser severity and higher probability
or shocks should be severe enough to capture historical extreme
market environments and/or extreme but plausible stressed market conditions. The impact of such
shocks on capital resources and earnings should be evaluated. For day-to-day portfolio monitoring,
hedging, and management of concentrations, banking organizations should also consider scenarios of
lesser severity and higher probability. When conducting stress testing, risk managers should challenge
the strength of assumptions made about the legal enforceability of netting and the ability to collect and
liquidate collateral.
A sound stress-testing framework should include:
• Measurement of the largest counterparty-level impacts across portfolios, material concentrations
within segments of a portfolio (such as industries or regions), and relevant portfolio- and
counterparty-specific trends.
• Complete trade capture and exposure aggregation across all forms of trading (not just OTC
derivatives) at the counterparty-specific level, including transactions that fall outside of the main
credit system. The time frame selected for trade capture should be commensurate with the frequency
with which stress tests are conducted.
• Stress tests, at least quarterly, of principal market risk factors on an individual basis (for example,
interest rates, foreign exchange, equities, credit spreads, and commodity prices) for all material
counterparties. Banking organizations should be aware that some counterparties may be material on
a consolidated basis, even though they may not be material on an individual legal entity basis.
8 Banking organizations should also track concentrations in volatile currencies.
9 This analysis is particularly important with repo-style transactions and other forms of SFTs for which the ability of market
participants to liquidate large collateral positions may be difficult during periods of market turbulence.
asis, even though they may not be material on an individual legal entity basis.
8 Banking organizations should also track concentrations in volatile currencies.
9 This analysis is particularly important with repo-style transactions and other forms of SFTs for which the ability of market
participants to liquidate large collateral positions may be difficult during periods of market turbulence.
8
• Assessment of non-directional risks (for example, yield curve exposures and basis risks) from multi-
factor stress testing scenarios. Multi-factor stress tests should, at a minimum, aim to address
separate scenarios: severe economic or market events; significant decrease in broad market liquidity;
and the liquidation of a large financial intermediary of the banking organization, factoring in direct
and indirect consequences.
• Consideration, at least quarterly, of stressed exposures resulting from the joint movement of
exposures and related counterparty creditworthiness. This should be done at the counterparty-
specific and counterparty-group (for example, industry and region) level, and in aggregate for the
banking organization. When CVA methodologies are used, banking organizations should ensure
that stress testing sufficiently captures additional losses from potential defaults. 10
• Basic stress testing of CVA to assess performance under adverse scenarios, incorporating any
hedging mismatches.
• Concurrent stress testing of exposure and non-cash collateral for assessing wrong-way risk.
• Identification and assessment of exposure levels for certain counterparties (for example, sovereigns
and municipalities), above which the banking organization may be concerned about willingness to
pay.
• Integration of CCR stress tests into firm-wide stress tests.11
5.
Credit Valuation Adjustments (CVA)
CVA refers to adjustments to transaction valuation to reflect the counterparty’s credit quality.
CVA is the fair value adjustment to reflect CCR in valuation of derivatives
le, sovereigns
and municipalities), above which the banking organization may be concerned about willingness to
pay.
• Integration of CCR stress tests into firm-wide stress tests.11
5.
Credit Valuation Adjustments (CVA)
CVA refers to adjustments to transaction valuation to reflect the counterparty’s credit quality.
CVA is the fair value adjustment to reflect CCR in valuation of derivatives. As such, CVA is the market
value of CCR and provides a market-based framework for understanding and valuing the counterparty
credit risk embedded in derivative contracts. CVA may include only the adjustment to reflect the
counterparty’s credit quality (a one-sided CVA or just CVA), or it may include an adjustment to reflect
the banking organization’s own credit quality. The latter is a two-sided CVA, or CVA plus a debt
valuation adjustment (DVA). For the evaluation of the credit risk due to probability of default of
counterparties, a one sided CVA is typically used. For the evaluation of the value of derivatives
transactions with a counterparty or the market risk of derivatives transactions, a two-sided CVA should
be used.
Although CVA is not a new concept, its importance has grown over the last few years, partly
because of a change in accounting rules that requires banking organizations to recognize the earnings
impact of changes in CVA.12 During the 2007-2009 financial crisis, a large portion of CCR losses were
because of CVA losses rather than actual counterparty defaults.13 As such, CVA has become more
important in risk management, as a mechanism to value, manage, and make appropriate hedging
10 Exposure testing should include single-factor, multi-factor and material non-directional risks.
11 CCR stress testing should be consistent with overall banking organization-wide stress testing and follow the principles set forth in
the “Principles for Sound Stress Testing Practices and Supervision” issued by the Risk Management and Modeling Group of the Basel
Committee in May 2009
ing
10 Exposure testing should include single-factor, multi-factor and material non-directional risks.
11 CCR stress testing should be consistent with overall banking organization-wide stress testing and follow the principles set forth in
the “Principles for Sound Stress Testing Practices and Supervision” issued by the Risk Management and Modeling Group of the Basel
Committee in May 2009.
12 Accounting literature pertinent to CVA includes FAS Statement 157, and Accounting Standards Codification (ASC) Topic 820. In
addition, other transaction fair value adjustments should be conducted. For example, those involving a banking organization’s own
credit risk, or differences in funding costs based on whether transactions are collateralized or not.
13 Basel Committee on Banking Supervision, “Strengthening the resilience of the banking sector – consultative document,” December
2009. http://bis.org/publ/bcbs164.htm
9
decisions, to mitigate banking organizations’ exposure to the mark-to-market (MTM) impact of CCR.14
The following are general standards for CVA measurement and use of CVA for risk management
purposes:
• CVA calculations should include all products and counterparties, including margined counterparties.
• The method for incorporating counterparty credit quality into CVA should be reasonable and subject
to ongoing evaluation. CVA should reflect the fair value of the counterparty credit risk for OTC
derivatives, and inputs should be based on current market prices when possible.
o Credit spreads should be reflected in the calculation where available, and banking organizations
should not overly rely on non-market-based probability of default estimates when calculating
CVA.
o Banking organizations should attempt to map credit quality to name-specific spreads rather than
spreads associated with broad credit categories.
o Any proxy spreads should reasonably capture the idiosyncratic nature of the counterparty and the
liquidity profile
lable, and banking organizations
should not overly rely on non-market-based probability of default estimates when calculating
CVA.
o Banking organizations should attempt to map credit quality to name-specific spreads rather than
spreads associated with broad credit categories.
o Any proxy spreads should reasonably capture the idiosyncratic nature of the counterparty and the
liquidity profile.
o The term structure of credit spreads should be reflected in the CVA calculation
• The CVA calculation should incorporate counterparty-specific master netting agreements and
margin terms; for example, the CVA calculation should reflect margin thresholds or minimum
transfer amounts stated in legal documents.
• Banking organizations should identify the correlation between a counterparty’s credit-worthiness
and its exposure to the counterparty, and seek to incorporate the correlation into their respective
CVA calculation.
Management of CVA
CVA management should be consistent with sound risk management practices for other material mark-
to-market risks. These practices should include the following:
• Business units engaged in trades related to CVA management should have independent risk
management functions overseeing their activities.
• Systems that produce CVA risk metrics should be subject to the same controls as used for other
MTM risks, including independent validation or review of all risk models, including alternative
methodologies.15
• Upon transaction execution, CVA costs should be allocated to the business unit that originates the
transaction.
o As a sound practice, the risk of CVA should be incorporated into the risk-adjusted return
calculation of a given business.
14 An accurate measure of CVA is critical to prudent risk-taking, as part of effectively understanding the risk-reward tradeoff in a given
derivatives transaction. The more comprehensively CVA is measured, the more transparent the economics of a given transaction
tion.
o As a sound practice, the risk of CVA should be incorporated into the risk-adjusted return
calculation of a given business.
14 An accurate measure of CVA is critical to prudent risk-taking, as part of effectively understanding the risk-reward tradeoff in a given
derivatives transaction. The more comprehensively CVA is measured, the more transparent the economics of a given transaction.
15 Liquidity in credit markets has varied significantly over time. As liquidity conditions change, banking organizations should
calculate CVA using methodologies appropriate to the market pricing information available for each counterparty and transaction type.
10
o CVA cost allocation provides incentive for certain parties to make prudent risk-taking decisions,
and motivates risk-takers to support risk mitigation, such as requiring strong collateral terms.
• Banking organizations should measure sensitivities to changes in credit and market risk factors to
determine the material drivers of MTM changes. On a regular basis, but no less frequently than
quarterly, banking organizations should ensure that CVA MTM changes are sufficiently explained
by these risk factors (for example, through profit and loss attribution for sensitivities, and
backtesting for value at risk (VaR)).
• Banking organizations hedging CVA MTM should gauge the effectiveness of hedges through
measurements of basis risk or other types of mismatches. In this regard, it is particularly important
to capture non-linearities, such as the correlation between market and credit risk, and other residual
risks that may not be fully offset by hedging.
CVA VaR
Banking organizations with material CVA should measure the risk of associated loss on an ongoing
basis. In addition to stress tests of the CVA, banking organizations may develop VaR models that
include CVA to measure potential losses. While these models are currently in the early stages of
development, they may prove to be effective tools for risk management purposes
set by hedging.
CVA VaR
Banking organizations with material CVA should measure the risk of associated loss on an ongoing
basis. In addition to stress tests of the CVA, banking organizations may develop VaR models that
include CVA to measure potential losses. While these models are currently in the early stages of
development, they may prove to be effective tools for risk management purposes. An advantage of
CVA VaR over more traditional CCR risk measures is that it captures the variability of the CCR
exposure, the variability of the counterparty’s credit spread, and the dependency between them.
Developing VaR models for CVA is significantly more complicated than developing VaR
models for a banking organization’s market risk positions. In developing a CVA VaR model, a banking
organization should match the percentile and time horizon for the VaR model to those appropriate for
the management of this risk, and include all significant risks associated with changes in the CVA. For
example, banking organizations may use the same percentile for CVA VaR as they use for market risk
VaR (for example, the 95th or 99th percentile). However, the time horizon for CVA VaR may need to be
longer than for market risk (for example, one quarter or one year) because of the potentially illiquid
nature of CVA. The following are important considerations in developing a CVA VaR model:
• All material counterparties covered by CVA valuation should be included in the VaR model.
• A CVA VaR calculation that keeps the exposure or the counterparty probability of default static is
not adequate. It will not only omit the dependence between the two variables, but also the risk
arising from the uncertainty of the fixed variable.
• CVA VaR should incorporate all forms of CVA hedging. Banking organizations and examiners
should assess the ability of the VaR measure to accurately capture the types of hedging used by the
banking organization.
6
bability of default static is
not adequate. It will not only omit the dependence between the two variables, but also the risk
arising from the uncertainty of the fixed variable.
• CVA VaR should incorporate all forms of CVA hedging. Banking organizations and examiners
should assess the ability of the VaR measure to accurately capture the types of hedging used by the
banking organization.
6.
Wrong-Way Risk
Wrong-way risk occurs when the exposure to a particular counterparty is positively correlated with the
probability of default of the counterparty itself. Specific wrong-way risk arises when the exposure to a
particular counterparty is positively correlated with the probability of default of the counterparty itself
because of the nature of the transactions with the counterparty. General wrong-way risk arises when the
probability of default of counterparties is positively correlated with general market risk factors. Wrong-
way risk is an important aspect of CCR that has caused major losses at banking organizations.
11
Accordingly, a banking organization should have a process to systematically identify, quantify, and
control both specific and general wrong-way risk across its OTC derivative and SFT portfolios.16 To
prudently manage wrong-way risk, banking organizations should:
• Maintain policies that formally articulate tolerance limits for both specific and general wrong-way
risk, an ongoing wrong-way risk identification process, and the requirements for escalation of
wrong-way risk analysis to senior management.
• Maintain policies for identifying, approving, and otherwise managing situations when there is a legal
connection between the counterparty and the underlying exposure or the associated collateral.17
Banking organizations should generally avoid such transactions because of their increased risk.
• Perform wrong-way risk analysis for OTC derivatives, at least at the industry and regional levels
• Maintain policies for identifying, approving, and otherwise managing situations when there is a legal
connection between the counterparty and the underlying exposure or the associated collateral.17
Banking organizations should generally avoid such transactions because of their increased risk.
• Perform wrong-way risk analysis for OTC derivatives, at least at the industry and regional levels.
• Conduct wrong-way risk analysis for SFTs on broad asset classes of securities (for example,
government bonds, and corporate bonds).
IV.
Systems Infrastructure Considerations
Banking organizations should ensure that systems infrastructure keeps up with changes in the
size and complexity of their CCR exposures, and the OTC derivatives market in general. Systems
should capture and measure the risk of transactions that may be subject to CCR as a fundamental part of
the CCR management framework.
Banking organizations should have strong operational processes across all derivatives markets,
consistent with supervisory and industry recommendations.18 Management should strive for a single
comprehensive CCR exposure measurement platform.19 If not currently possible, banking organizations
should minimize the number of system platforms and methodologies, as well as manual adjustments to
exposure calculations. When using multiple exposure measurement systems, management should
ensure that transactions whose future values are measured by different systems are aggregated
conservatively.
To maintain a systems infrastructure that supports adequate CCR management, banking
organizations should:
Data Integrity and Reconciliation
• Deploy adequate operational resources to support reconciliations and related analytical and
remediation processes
ystems, management should
ensure that transactions whose future values are measured by different systems are aggregated
conservatively.
To maintain a systems infrastructure that supports adequate CCR management, banking
organizations should:
Data Integrity and Reconciliation
• Deploy adequate operational resources to support reconciliations and related analytical and
remediation processes.
16 A standard way of quantifying general wrong-way risk is to design and apply stress scenarios that detect wrong-way risk in the
portfolio, record counterparty exposures most affected by the scenarios, and assess whether the creditworthiness of such counterparties
is also negatively affected by the scenario.
17 Examples of this situation are single-name credit derivatives when there is a legal relationship between the counterparty and the
reference entity underlying the transaction, and financing transactions when the counterparty pledges an affiliate’s security as
collateral.
18 Examples are recommendations made by the Senior Supervisors Group (SSG) and the Counterparty Risk Management Policy Group
(CRMPG).
19 A single platform may in practice contain a number of separate systems and models. These would be considered a cohesive
framework if they are operationally stable and accurate in risk estimation, particularly with regard to proper reflection of collateral and
netting. A common programming language for these systems facilitates an effective measurement framework.
ement Policy Group
(CRMPG).
19 A single platform may in practice contain a number of separate systems and models. These would be considered a cohesive
framework if they are operationally stable and accurate in risk estimation, particularly with regard to proper reflection of collateral and
netting. A common programming language for these systems facilitates an effective measurement framework.
12
• Reconcile positions and valuations with counterparties.
o Large counterparties should perform frequent reconciliations of positions and valuations (daily if
appropriate).20
o For smaller portfolios with non-dealer counterparties where there are infrequent trades, large
dealers should ensure the data integrity of trade and collateral information on a regular (but not
necessarily daily) basis, reconciling their portfolios according to prevailing industry standards.
• Reconcile exposure data in CCR systems with the official books and records of the financial
institution.
• Maintain controls around obligor names at the point of trade entry, as well as reviews of warehoused
credit data, to ensure that all exposures to an obligor are captured under the proper name and can be
aggregated accordingly.
• Maintain quality control over transfer of transaction information between trade capture systems and
exposure measurement systems.
• Harmonize netting and collateral data across systems to ensure accurate collateral calls and
reflection of collateral in all internal systems. Banking organizations should maintain a robust
reconciliation process, to ensure that internal systems have terms that are consistent with those
formally documented in agreements and credit files.
• Remediate promptly any systems weaknesses that raise questions about the appropriateness of the
limits structure. If there are a significant number of limit excesses, this may be a symptom of system
weaknesses, which should be identified and promptly remediated.
• Eliminate or minimize backlogs of unconfirmed trades
e consistent with those
formally documented in agreements and credit files.
• Remediate promptly any systems weaknesses that raise questions about the appropriateness of the
limits structure. If there are a significant number of limit excesses, this may be a symptom of system
weaknesses, which should be identified and promptly remediated.
• Eliminate or minimize backlogs of unconfirmed trades.
Automation and Tracking
• Automate legal and operational information, such as netting and collateral terms. Banking
organizations should be able to adjust exposure measurements, taking into account the enforceability
of legal agreements.
• Automate processes to track and manage legal documentation, especially when there is a large
volume of legal agreements.
• Increase automation of margin processes21 and continue efforts to expand automation of OTC
derivatives post-trade processing. This should include automation of trade confirmations, to reduce
the lag between trade execution and legal execution.
• Maintain systems that track and monitor changes in credit terms and have triggers for relevant
factors, such as net asset value, credit rating, and cross-default.
• Maintain default monitoring processes and systems.
20 Large dealer counterparties should perform portfolio reconciliation on a daily basis, as set forth in relevant industry standards, such
as the ISDA “Collateralised Portfolio Reconciliation Best Operational Practices” (January, 2010).
21 Banking organizations should consider the recommendations in the “Standards of Electronic Exchange of OTC Derivative Margin
Calls,” issued by ISDA Collateral Committee on November 12, 2009.
ould perform portfolio reconciliation on a daily basis, as set forth in relevant industry standards, such
as the ISDA “Collateralised Portfolio Reconciliation Best Operational Practices” (January, 2010).
21 Banking organizations should consider the recommendations in the “Standards of Electronic Exchange of OTC Derivative Margin
Calls,” issued by ISDA Collateral Committee on November 12, 2009.
13
Add-Ons
For large derivatives market participants, certain trades may be difficult to capture in exposure
measurement systems, and are therefore modeled outside of the main measurement system(s). The
resulting exposures, commonly referred to as add-ons, are then added to the portfolio potential exposure
measure. In limited cases, the use of conservative add-on methodologies may be suitable, if the central
system cannot reflect the risk of complex financial products. However, overreliance on add-on
methodologies may distort exposure measures. To mitigate measurement distortions, banking
organizations should:
• Review the use of add-on methodologies at least annually. Current or planned significant trading
activity should trigger efforts to develop appropriate modeling and systems, prior to or concurrent
with these growth plans.
• Establish growth limits for products with material activities that continue to rely on add-ons. Once
systems are improved to meet a generally accepted industry standard of trade capture, these limits
can be removed.
V. Risk Management
1.
Counterparty Limits
Meaningful limits on exposures are an integral part of a CCR management framework, and these
limits should be formalized in CCR policies and procedures. For limits to be effective, a banking
organization should incorporate these limits into an exposure monitoring system independent of relevant
business lines. It should perform ongoing monitoring of exposures against such limits, to ascertain
conformance with these limits, and have adequate risk controls that require action to mitigate limit
exceptions
formalized in CCR policies and procedures. For limits to be effective, a banking
organization should incorporate these limits into an exposure monitoring system independent of relevant
business lines. It should perform ongoing monitoring of exposures against such limits, to ascertain
conformance with these limits, and have adequate risk controls that require action to mitigate limit
exceptions. Review of exceptions should include escalation to a managerial level that is commensurate
with the size of the excess or nature of mitigation required. A sound limit system should include:
• Establishment and regular review of counterparty limits by a designated committee. Further, a
banking organization should have a process to escalate limit approvals to higher levels of authority,
depending on the size of counterparty exposures, credit quality, and tenor.
• Establishment of potential future exposure limits, as well as limits based on other metrics. It is a
sound practice to limit the market risk arising through CVA, with a limit on CVA or CVA VaR.
However, such limits do not eliminate the need to limit counterparty credit exposure with a measure
of potential future exposure.
• Individual CCR limits should be based on peak exposures rather than expected exposures.
o Peak exposures are appropriate for individual counterparty limit monitoring purposes because
they represent the risk tolerance for exposure to a single counterparty.
o Expected exposure is an appropriate measure for aggregating exposures across counterparties in
a portfolio credit model, or for use within CVA.
• Consideration of risk factors such as the credit quality of the counterparty, tenor of the transactions,
and the liquidity of the positions or hedges.
• Sufficiently automated monitoring processes to provide updated exposure measures at least daily.
Expected exposure is an appropriate measure for aggregating exposures across counterparties in
a portfolio credit model, or for use within CVA.
• Consideration of risk factors such as the credit quality of the counterparty, tenor of the transactions,
and the liquidity of the positions or hedges.
• Sufficiently automated monitoring processes to provide updated exposure measures at least daily.
14
• Monitoring of intra-day trading activity for conformance with exposure limits and exception
policies. Such controls and procedures can include intra-day limit monitoring, trade procedures and
systems that assess a trade’s impact on limit utilization prior to execution, limit warning triggers at
specific utilization levels, and restrictions by credit risk management on allocation of full limits to
the business lines.
2.
Margin Policies and Practices
Collateral is a fundamental CCR mitigant. Indeed, significant stress events have highlighted the
importance of sound margining practices. With this in mind, banking organizations should ensure that
they have adequate margin and collateral “haircut” 22 guidelines for all products with CCR.23
Accordingly, banking organizations should:
• Maintain CCR policies that address margin practices and collateral terms, including, but not limited
to:
o Processes to establish and periodically review minimum haircuts.
o Processes to evaluate the volatility and liquidity of the underlying collateral. Banks should strive
to ensure that haircuts on collateral do not decline during periods of low volatility.
o Controls to mitigate the potential for a weakening of credit standards from competitive pressure.
• Set guidelines for cross-product margining. Banking organizations offer cross-product margining
arrangements to clients to reduce required margin amounts. Guidelines to control risks associated
with cross-product margining would include limiting the set of eligible transactions to liquid
exposures, and having procedures to resolve margin disputes
f credit standards from competitive pressure.
• Set guidelines for cross-product margining. Banking organizations offer cross-product margining
arrangements to clients to reduce required margin amounts. Guidelines to control risks associated
with cross-product margining would include limiting the set of eligible transactions to liquid
exposures, and having procedures to resolve margin disputes.
• Maintain collateral management policies and procedures to control, monitor and report:
o The extent to which collateral agreements expose a banking organization to collateral risks, such
as the volatility and liquidity of the securities held as collateral.
o Concentrations of less liquid or less marketable collateral asset classes.
o The risks of re-hypothecation or other reinvestment of collateral (both cash and noncash)
received from counterparties, including the potential liquidity shortfalls resulting from the re-use
of such collateral.
o The CCR associated with the decision whether to require posted margin to be segregated.
Organizations should perform a legal analysis concerning the risks of agreeing to allow cash to
be commingled with a counterparty’s own cash and of allowing a counterparty to re-hypothecate
securities pledged as margin.
• Maintain policies and processes for monitoring margin agreements involving third-party custodians.
As with bilateral counterparties, banking organizations should:
o Identify the location of the account to which collateral is posted, or from which it is received.
22 A haircut is the difference between the market value of an asset being used as collateral for a loan and the amount of money that a
lender will advance against the asset.
23 See guidelines issued by ISDA, SIFMA and MFA, including the “Market Review of OTC Derivative Bilateral Collateralization
Practices (Release 2.0),” March 2010, and “Best Practices for Collateral Management,” June 30, 2010.
A haircut is the difference between the market value of an asset being used as collateral for a loan and the amount of money that a
lender will advance against the asset.
23 See guidelines issued by ISDA, SIFMA and MFA, including the “Market Review of OTC Derivative Bilateral Collateralization
Practices (Release 2.0),” March 2010, and “Best Practices for Collateral Management,” June 30, 2010.
15
o Obtain periodic account statements or other assurances that confirm the custodian is holding the
collateral in conformance with the agreement.
o Understand the characteristics of the account where the collateral is held (for example, whether it
is in a segregated account), and the legal rights of the counterparty or any third-party custodian
regarding this collateral.
3.
Validation of Models and Systems:
A banking organization should validate its CCR models initially and on an ongoing basis.
Validation of models should include: an evaluation of the conceptual soundness and developmental
evidence supporting a given model; an ongoing monitoring process that includes verification of
processes and benchmarking; and an outcomes-analysis process that includes backtesting. Validation
should identify key assumptions and potential limitations, and it should assess their possible impact on
risk metrics. All components of models should be subject to validation along with their combination in
the CCR system.
Evaluating the conceptual soundness involves assessing the quality of the design and
construction of the CCR models and systems, including documentation and empirical evidence that
supports the theory, data, and methods used.
Ongoing monitoring confirms that CCR systems continue to perform as intended. This generally
involves process verification, an assessment of model data integrity and systems operation, and
benchmarking to assess the quality of a given model. Benchmarking is a valuable diagnostic tool in
identifying potential weaknesses
n and empirical evidence that
supports the theory, data, and methods used.
Ongoing monitoring confirms that CCR systems continue to perform as intended. This generally
involves process verification, an assessment of model data integrity and systems operation, and
benchmarking to assess the quality of a given model. Benchmarking is a valuable diagnostic tool in
identifying potential weaknesses. Specifically, it is the comparison of a banking organization’s CCR
model estimates with those derived using alternative data, methods, or techniques. Benchmarking can
also be applied to particular CCR model components, such as parameter estimation methods or pricing
models. Management should investigate the source of any differences in output, and determine whether
benchmarking gaps indicate weakness in the banking organization’s models.
Outcomes analysis compares model outputs to actual results during a sample period not used in
model development. This is generally accomplished using backtesting. It should be applied to
components of CCR models (for example the risk factor distribution and pricing model), the risk
measures, and projected exposures. While there are limitations to backtesting, especially for testing the
longer time horizon predictions of a given CCR model, it is an essential component of model validation.
Banking organizations should have a process for the resolution of observed model deficiencies detected
by backtesting. This should include further investigation to determine the problem, and appropriate
course of action, including changing a given CCR model.
If the validation of CCR models and infrastructure systems is not performed by staff that is
independent from the developers of the models, then an independent review should be conducted by
technically competent personnel to ensure the adequacy and effectiveness of the validation
her investigation to determine the problem, and appropriate
course of action, including changing a given CCR model.
If the validation of CCR models and infrastructure systems is not performed by staff that is
independent from the developers of the models, then an independent review should be conducted by
technically competent personnel to ensure the adequacy and effectiveness of the validation. The scope
of the independent review should include: validation procedures for all components, the role of relevant
parties, and documentation of the model and validation processes. This review should document its
results, what action was taken to resolve findings, and its relative timeliness.
Senior management should be notified of validation and review results and should take
appropriate and timely corrective actions to address deficiencies. The board should be apprised of
summary results, especially unresolved deficiencies. In support of validation activities, internal audit
should review and test models and systems validation, and overall systems infrastructure as part of their
regular audit cycle.
16
For more details on validation, please see Appendix B.
4.
Close-Out Policies and Practices
Banking organizations should have the ability to effectively manage counterparties in distress,
including execution of a close-out. Policies and procedures outlining sound practices for managing a
close-out should include:
• Requirements for hypothetical close-out simulations at least once every two years for one of the
banking organization’s most complex counterparties.
• Standards for the speed and accuracy with which the banking organization can compile
comprehensive counterparty exposure data and net cash outflows. Operational capacity to aggregate
exposures within four hours is a reasonable standard.
• The sequence of critical tasks, and decision-making responsibilities, needed to execute a close-out
he
banking organization’s most complex counterparties.
• Standards for the speed and accuracy with which the banking organization can compile
comprehensive counterparty exposure data and net cash outflows. Operational capacity to aggregate
exposures within four hours is a reasonable standard.
• The sequence of critical tasks, and decision-making responsibilities, needed to execute a close-out.
• Requirements for periodic review of documentation related to counterparty terminations, and
confirmation that appropriate and current agreements that specify the definition of events of default
and the termination methodology that will be used are in place.
o Banking organizations should take corrective action if documents are not current, active and
enforceable.
o Management should document their decision to trade with counterparties that are either
unwilling or unable to maintain appropriate and current documentation.
• Established closeout methodologies that are practical to implement, particularly with large and
potentially illiquid portfolios. Dealers should consider using the “close-out amount” approach for
early termination upon default in inter-dealer relationships.24
• A requirement that the banking organization transmit immediate instructions to its appropriate
transfer agent(s) to deactivate collateral transfers, contractual payments, or other automated transfers
contained in “standard settlement instructions” for counterparties or prime brokers that have
defaulted on the contract or for counterparties or prime brokers that have declared bankruptcy.
VI.
Managing Central Counterparty Exposures
A central credit counterparty (CCP) facilitates trades between counterparties in one or more
financial markets by either guaranteeing trades or novating contracts, and typically requires all
participants to be fully collateralized on a daily basis
have
defaulted on the contract or for counterparties or prime brokers that have declared bankruptcy.
VI.
Managing Central Counterparty Exposures
A central credit counterparty (CCP) facilitates trades between counterparties in one or more
financial markets by either guaranteeing trades or novating contracts, and typically requires all
participants to be fully collateralized on a daily basis. The CCP thus effectively bears most of the
counterparty credit risk in transactions, becoming the buyer for every seller and the seller to every buyer.
Well-regulated and soundly-managed CCPs can be an important means of reducing bilateral
counterparty exposure in the OTC derivatives market. However, CCPs also concentrate risk within a
single entity. Therefore, it is important that banking organizations centrally clear through regulated
CCPs with sound risk management processes, and strong financial resources sufficient to meet their
obligations under extreme stress conditions.
24 The close-out amount approach is defined in CRMPG III, Containing Systemic Risk: Road to Reform (August 6, 2008),
pp. 122-125. Also, ISDA has published a closeout amount protocol to aid in the adoption of the close-out amount approach.
17
To manage CCP exposures, banking organizations should regularly, but no less frequently than
annually, review the individual CCPs to which they have exposures. This review should include
performing and documenting due diligence on each CCP, applying current supervisory or industry
standards25 (and any subsequent standards) as a baseline to assess the CCP’s risk management practices.
• For each CCP, an evaluation of its risk management framework should at a minimum include
membership requirements, guarantee fund contributions, margining practices, default-sharing
protocols, and limits of liability
enting due diligence on each CCP, applying current supervisory or industry
standards25 (and any subsequent standards) as a baseline to assess the CCP’s risk management practices.
• For each CCP, an evaluation of its risk management framework should at a minimum include
membership requirements, guarantee fund contributions, margining practices, default-sharing
protocols, and limits of liability.
• Banking organizations should also consider the soundness of the CCP’s policies and procedures,
including procedures for handling the default of a clearing member, obligations at post-default
auctions, and post-default assignment of positions.
• Banking organizations should also maintain compliance with applicable regulatory requirements,
such as ensuring contingent loss exposure remains within a banking organization’s legal lending
limit.
VII. Legal and Operational Risk Management
Banking organizations should ensure proper control of, and access to, legal documentation and
agreements. In addition, it is important that systems used to measure CCR incorporate accurate legal
terms and provisions. The accessibility and accuracy of legal terms is particularly critical in close-outs,
when there is limited time to review the collateral and netting agreements. Accordingly, banking
organizations should:
• Have a formal process for negotiating legal agreements. As a best practice, the process would
include approval steps and responsibilities of applicable departments.
• At least annually, conduct a review of the legal enforceability of collateral and netting agreements
for all relevant jurisdictions.
• Maintain policies on when it is acceptable to trade without a master agreement,26 using metrics such
as trading volume or the counterparty’s risk profile.
o Trading without a master agreement may be acceptable in cases of minimal volume or when
trading in jurisdictions where master agreements are unenforceable
forceability of collateral and netting agreements
for all relevant jurisdictions.
• Maintain policies on when it is acceptable to trade without a master agreement,26 using metrics such
as trading volume or the counterparty’s risk profile.
o Trading without a master agreement may be acceptable in cases of minimal volume or when
trading in jurisdictions where master agreements are unenforceable. As applicable, policies
should outline required actions, to undertake and monitor transactions without an executed
master agreement.
• Use commonly recognized dispute resolution procedures.27
25 For instance, “Recommendations for Central Counterparties,” a consultative report issued by the Committee on Payment and
Settlement Systems and the Technical Committee of the International Organization of Securities Commissions under the auspices of
the Bank for International Settlements (March 2004).
26 The capital rules in the United States refer to master agreements. These include: The Federal Reserve’s “Risk-Based Capital
Standards: Advanced Capital Adequacy Framework — Basel II”, 12 CFR 208; Appendix F, and 12 CFR 225; Appendix G.” For
the FDIC, it is 12 CFR 325, Appendix D. For the OCC, it is 12 CFR Part 3, Appendix C. For the OTS, it is 12 CFR Parts 559,
560, 563, and 567.
27An example of such procedures would be the ISDA “2009 Dispute Resolution Protocol” (September 2009).
18
o Banking organizations should seek to resolve collateral disputes within recommended
timeframes.
o Senior management should receive reports listing material and aged disputes, as these pose
significant risk.
• Include netting of positions in risk management systems, only if there is a written legal review
(either internally or externally) that expresses a high level of confidence that netting agreements are
legally enforceable.
• Maintain ongoing participation in both bilateral and multilateral portfolio compression efforts
ports listing material and aged disputes, as these pose
significant risk.
• Include netting of positions in risk management systems, only if there is a written legal review
(either internally or externally) that expresses a high level of confidence that netting agreements are
legally enforceable.
• Maintain ongoing participation in both bilateral and multilateral portfolio compression efforts.
Where feasible, banking organizations are encouraged to elect compression tolerances (such as post-
termination factor sensitivity changes and cash payments) that allow the widest possible portfolio of
trades to be terminated.
• Adopt and implement appropriate novation protocols.28
1.
Legal Risk Arising from Counterparty Appropriateness29
While a counterparty’s ability to pay should be evaluated when assessing credit risk, credit losses
can also occur when a counterparty is unwilling to pay, which most commonly occurs when a
counterparty questions the appropriateness of a contract. These types of disputes pose not only risk of a
direct credit loss, but also risk of litigation costs. Banking organizations should maintain policies and
procedures to assess client and deal appropriateness. In addition, banking organizations should:
• Conduct initial and ongoing due diligence, evaluating whether a client is able to understand and
utilize transactions with CCR as part of assessing the client’s sophistication, investment objectives,
and financial condition.
o For example, although some clients may be sophisticated enough to enter into a standardized
swap, they may lack the sophistication to fully analyze the risks of a complex OTC deal.
o Banking organizations should be particularly careful to assess appropriateness of complex, long-
dated, off-market, illiquid, or other transactions.
• Include appropriateness assessments in the new product approval process
le, although some clients may be sophisticated enough to enter into a standardized
swap, they may lack the sophistication to fully analyze the risks of a complex OTC deal.
o Banking organizations should be particularly careful to assess appropriateness of complex, long-
dated, off-market, illiquid, or other transactions.
• Include appropriateness assessments in the new product approval process. Such assessments should
determine the types of counterparties acceptable for a new product, and what level of counterparty
sophistication is required for any given product.
• Maintain disclosure policies for OTC derivative and other complex transactions, to ensure that risks
are accurately and completely communicated to counterparties.
• Maintain guidelines for determination of acceptable counterparties for complex derivatives
transactions.
28 An example would be the ISDA novation protocol.
29 For guidance on counterparty appropriateness, see the Federal Reserve’s “Trading and Capital Markets Activity Manual,” section
2070, pp. 6-7, and the “Interagency Statement on Sound Practices Concerning Elevated Risk Complex Structured Finance Activities”
(January 11, 2007).
19
VIII. Conclusion
For relevant banking organizations, CCR management should be an integral component of the
risk management framework. When considering the applicability of specific guidelines and best
practices set forth in this guidance, a banking organization’s senior management and supervisors should
consider the size and complexity of its securities and trading activities. Banking organizations should
comprehensively evaluate existing practices against the standards in this guidance and implement
remedial action as appropriate. A banking organization’s CCR exposure levels and the effectiveness of
its CCR management are important factors for a supervisor to consider when evaluating a banking
organization’s overall management, risk management and credit and market risk profile.
ations should
comprehensively evaluate existing practices against the standards in this guidance and implement
remedial action as appropriate. A banking organization’s CCR exposure levels and the effectiveness of
its CCR management are important factors for a supervisor to consider when evaluating a banking
organization’s overall management, risk management and credit and market risk profile.
20
Appendix A
GLOSSARY
This glossary describes commonly used CCR metrics. As discussed above, banking
organizations should employ a suite of metrics commensurate with the size, complexity, liquidity, and
risk profile of the organization’s CCR portfolio. Major broker - dealer banking organizations should
employ the full range of risk measurement metrics to enable a comprehensive understanding of CCR
and how it changes in varying environments. Banking organizations of lesser size and complexity
should carefully consider which of these metrics they need to track as part of their exposure risk
management processes. At a minimum, all banking organizations should calculate current exposure and
stress test their CCR exposures. Definitions marked with an asterisk are from the Bank for International
Settlements.
Exposure Metrics:
Current Exposure
Definition: Current exposure is the larger of zero, or the market value of a transaction or a portfolio of
transactions within a netting set with a counterparty that would be lost upon the default of the
counterparty, assuming no recovery on the value of those transactions in bankruptcy. Current exposure
is often also called replacement cost. Current exposure may be reported gross or net of collateral.
Purpose: Allows banking organizations to assess their CCR exposure at any given time, that is, the
amount currently at risk.
Jump-to-Default (JTD) Exposure
Definition: JTD exposure is the change in the value of counterparty transactions upon the default of a
reference name in CDS positions
ure
is often also called replacement cost. Current exposure may be reported gross or net of collateral.
Purpose: Allows banking organizations to assess their CCR exposure at any given time, that is, the
amount currently at risk.
Jump-to-Default (JTD) Exposure
Definition: JTD exposure is the change in the value of counterparty transactions upon the default of a
reference name in CDS positions.
Purpose: Allows banking organizations to assess the risk of a sudden, unanticipated default before the
market can adjust.
Expected Exposure
Definition: Expected exposure is calculated as average exposure to a counterparty at a date in the future.
Purpose: This is often an intermediate calculation for expected positive exposure or CVA. It can also
be used as a measure of exposure at a common time in the future.
Expected Positive Exposure (EPE)
Definition: EPE is the weighted average over time of expected exposures when the weights are the
proportion that an individual expected exposure represents of the entire time interval.*
Purpose: Expected positive exposure is an appropriate measure of CCR exposure when measured in a
portfolio credit risk model.
Peak Exposure
Definition: Peak exposure is a high percentile (typically 95 percent or 99 percent) of the distribution of
exposures at any particular future date before the maturity date of the longest transaction in the netting
set. A peak exposure value is typically generated for many future dates up until the longest maturity
date of transactions in the netting set.*
lio credit risk model.
Peak Exposure
Definition: Peak exposure is a high percentile (typically 95 percent or 99 percent) of the distribution of
exposures at any particular future date before the maturity date of the longest transaction in the netting
set. A peak exposure value is typically generated for many future dates up until the longest maturity
date of transactions in the netting set.*
21
Purpose: Allows banking organizations to estimate their maximum potential exposure at a specified
future date, or over a given time horizon, with a high level of confidence. For collateralized
counterparties, this metric should be based on a realistic close-out period, considering both the size and
liquidity of the portfolio. Banking organizations should consider peak potential exposure when setting
counterparty credit limits.
Expected Shortfall Exposure
Definition: Expected shortfall exposure is similar to peak exposure, but is the expected exposure
conditional on the exposure being greater than some specified peak percentile.
Purpose: For transactions with very low probability of high exposure, the expected shortfall accounts
for large losses that may be associated with transactions with high tail risk.
Sensitivity to Market Risk Factors
Definition: Sensitivity to market risk factors, is the change in exposure because of a given market risk
factor change (for example, DV01).
Purpose: Provides information on the key drivers of exposure to specific counterparties and on hedging.
Stressed Exposure
Definition: Stressed exposure is a forward-looking measure of exposure based on pre-defined market
factor movements (non-statistically generated). These can include single-factor market shocks,
historical scenarios, and hypothetical scenarios.
Purpose: Allows banking organizations to consider their counterparty exposure under a severe or
stressed scenario. This serves as a supplemental view of potential exposure, and provides banking
organizations with additional information on risk drivers
factor movements (non-statistically generated). These can include single-factor market shocks,
historical scenarios, and hypothetical scenarios.
Purpose: Allows banking organizations to consider their counterparty exposure under a severe or
stressed scenario. This serves as a supplemental view of potential exposure, and provides banking
organizations with additional information on risk drivers. It is best practice to compare stressed
exposure to counterparty credit limits.
CVA Related Metrics:
Credit Valuation Adjustment (CVA)
Definition: The credit valuation adjustment is an adjustment to the mid-market valuation (average of the
bid and asked price) of the portfolio of trades with a counterparty. This adjustment reflects the market
value of the credit risk resulting from any failure to perform on contractual agreements with a
counterparty. This adjustment may reflect the market value of the credit risk of the counterparty or the
market value of the credit risk of both the banking organization and the counterparty.*
Purpose: CVA is a measure of the market value of CCR, incorporating both counterparty
creditworthiness and the variability of exposure.
CVA VaR
Definition: CVA VaR is a measure of the variability of the CVA mark-to-market value and is based on
the projected distributions of both exposures and counterparty creditworthiness.
Purpose: Provides banking organizations with an estimate of the potential CVA mark-to-market loss, at
a certain confidence interval and over a given time horizon.
CVA Factor Sensitivities
ity of exposure.
CVA VaR
Definition: CVA VaR is a measure of the variability of the CVA mark-to-market value and is based on
the projected distributions of both exposures and counterparty creditworthiness.
Purpose: Provides banking organizations with an estimate of the potential CVA mark-to-market loss, at
a certain confidence interval and over a given time horizon.
CVA Factor Sensitivities
22
Definition: CVA factor sensitivities is the mark-to-market change in CVA resulting from a given market
risk factor change (for example, CR01).
Purpose: Allows banking organizations to assess and hedge the market value of the credit or market
risks to single names and portfolios and permits banking organizations to monitor excessive buildups in
counterparty concentrations.
Stressed CVA
Definition: Stressed CVA is a forward-looking measure of CVA mark-to-market value based on pre-
defined credit or market factor movements (non-statistically generated). These can include single
market factor shocks, historical scenarios, and hypothetical scenarios.
Purpose: Serves as an informational tool, and allows banking organizations to assess the sensitivity of
their CVA to a potential mark-to-market loss under defined scenarios.
23
Appendix B:
DETAIL ON MODEL VALIDATION AND SYSTEMS EVALUATION
A banking organization should validate its CCR models, initially and on an ongoing basis.
Validation should include three components: an evaluation of the conceptual soundness of relevant
models (including developmental evidence); an ongoing monitoring process that includes verification of
processes and benchmarking; and an outcomes-analysis process that includes backtesting. The
validation should either be independent, or subject to independent review.
Validation is the set of activities designed to give the greatest possible assurances of CCR
models’ accuracy and systems’ integrity
including developmental evidence); an ongoing monitoring process that includes verification of
processes and benchmarking; and an outcomes-analysis process that includes backtesting. The
validation should either be independent, or subject to independent review.
Validation is the set of activities designed to give the greatest possible assurances of CCR
models’ accuracy and systems’ integrity. Validation should also identify key assumptions and potential
limitations, and assess their possible impact on risk metrics. CCR models have several components:
• Statistical models to estimate parameters, including the volatility of risk factors and their
correlations;
• Simulation models to convert those parameters into future distributions of risk factors;
• Pricing models that estimate value in simulated scenarios; and
• Calculations that summarize the simulation results into various risk metrics.
All components of each model should be subject to validation, along with analysis of their interaction in
the CCR system. Validation should be performed initially as a model first goes into production.
Ongoing validation is a means of addressing situations where models have known weaknesses and
ensuring that changes in markets, products, or counterparties do not create new weaknesses. Senior
management should be notified of the validation results and should take corrective actions in a timely
manner when appropriate.
A banking organization’s validation process should be independent of the CCR model and
systems development, implementation, and operation. Alternately, the validation should be subject to
independent review, whereby the individuals who perform the review are not biased in their assessment
because of involvement in the development, implementation, or operation of the processes or products.
Individuals performing the reviews should possess the requisite technical skills and expertise to provide
critical analysis, effective challenge, and appropriate recommendations
be subject to
independent review, whereby the individuals who perform the review are not biased in their assessment
because of involvement in the development, implementation, or operation of the processes or products.
Individuals performing the reviews should possess the requisite technical skills and expertise to provide
critical analysis, effective challenge, and appropriate recommendations. The extent of such reviews
should be fully documented, sufficiently thorough to cover all significant model elements, and include
additional testing of models or systems as appropriate. In addition, reviewers should have the authority
to effectively challenge developers and model users, elevate concerns or findings as necessary, and
either have issues addressed in a prompt and substantial manner or reject a model for use by the banking
organization.
Conceptual Soundness and Developmental Evidence
The first component of validation is evaluating conceptual soundness, which involves assessing
the quality of the design and construction of CCR models. The evaluation of conceptual soundness
includes documentation and empirical evidence supporting the theory, data, and methods used. The
documentation should also identify key assumptions and potential limitations and assess their possible
impact. A comparison to industry practice should be done to identify areas where substantial and
warranted improvements can be made. All model components are subject to evaluation, including
simplifying assumptions, parameter calibrations, risk-factor diffusion processes, pricing models, and risk
metrics. Developmental evidence should be reviewed whenever the banking organization makes
material changes in CCR models. Evaluating conceptual soundness includes independent evaluation of
and
warranted improvements can be made. All model components are subject to evaluation, including
simplifying assumptions, parameter calibrations, risk-factor diffusion processes, pricing models, and risk
metrics. Developmental evidence should be reviewed whenever the banking organization makes
material changes in CCR models. Evaluating conceptual soundness includes independent evaluation of
24
whether a model is appropriate for its purpose, and whether all underlying assumptions, limitations, and
shortcomings have been identified and their potential impact assessed.
Ongoing Monitoring, Process Verification and Benchmarking
The second component of model validation is ongoing monitoring to confirm that the models
were implemented appropriately and continue to perform as intended. This involves process
verification, an assessment of models, and benchmarking to assess the quality of the model.
Deficiencies uncovered through these activities should be remediated promptly.
Process verification includes evaluating data integrity and operational performance of the
systems supporting CCR measurement and reporting. This should be performed on an ongoing basis
and includes:
• The completeness and accuracy of the transaction and counterparty data flowing through the
counterparty exposure systems.
• Reliance on up-to-date reviews of the legal enforceability of contracts and master netting agreements
that govern the use of netting and collateral in systems measuring net exposures, and the accuracy of
their representations in the banking organization’s systems.
• The integrity of the market data used within the banking organization’s models, both as current
values for risk factors and as sources for parameter calibrations
f the legal enforceability of contracts and master netting agreements
that govern the use of netting and collateral in systems measuring net exposures, and the accuracy of
their representations in the banking organization’s systems.
• The integrity of the market data used within the banking organization’s models, both as current
values for risk factors and as sources for parameter calibrations.
• The operational performance of the banking organization’s counterparty exposure calculation
systems, including the timeliness of the batch-run calculations, the consistent integration of data
coming from different internal or external sources, and the synchronization of exposure, collateral
management and finance systems.
“Benchmarking” means comparing a banking organization’s CCR measures with those derived
using alternative data, methods, or techniques. It can also be applied to particular model components,
such as parameter estimation methods or pricing models. It is an important complement to backtesting
and is a valuable diagnostic tool in identifying potential weaknesses. Differences between the model
and the benchmark do not necessarily indicate that the model is in error because the benchmark itself is
an alternative prediction. It is important that a banking organization use appropriate benchmarks, or the
exercise will be compromised. As part of the benchmarking exercise, the banking organization should
investigate the source of the differences and whether the extent of the differences is appropriate.
Outcomes Analysis Including Backtesting
The third component of validation is outcomes analysis, which is the comparison of model
outputs to actual results during a sample period not used in model development. Backtesting is one form
of out-of-sample testing. Backtesting should be applied to components of a CCR model, for example
the risk factor distribution and pricing model, as well as the risk measures and projected exposures
ting
The third component of validation is outcomes analysis, which is the comparison of model
outputs to actual results during a sample period not used in model development. Backtesting is one form
of out-of-sample testing. Backtesting should be applied to components of a CCR model, for example
the risk factor distribution and pricing model, as well as the risk measures and projected exposures.
Outcomes analysis includes an independent evaluation of the design and results of backtesting to
determine whether all material risk factors are captured and to assess the accuracy of the diffusion of
risk factors and the projection of exposures. While there are limitations to backtesting, especially for
testing the longer horizon predictions of a CCR model, banking organizations should incorporate it as an
essential component of model validation.
25
Typical examples of CCR models that require backtesting are expected exposure, peak exposure,
and CVA VaR models. Backtesting of models used for measurement of CCR is substantially different
than backtesting VaR models for market risk. Notably, CCR models are applied to each counterparty
facing the banking organization, rather than an aggregate portfolio. Furthermore, CCR models should
project the distribution over multiple dates and over long time horizons for each counterparty. These
complications make the interpretation of CCR backtesting results more difficult than that for market
risk. Because backtesting is critical to providing feedback on the accuracy of CCR models, it is
particularly important that banking organizations exert considerable effort to ensure that backtesting
provides effective feedback on the accuracy of these models.
Key elements of backtesting include the following activities:
• Back-testing programs should be designed to evaluate the effectiveness of the models for typical
counterparties, key risk factors, key correlations and pricing models
particularly important that banking organizations exert considerable effort to ensure that backtesting
provides effective feedback on the accuracy of these models.
Key elements of backtesting include the following activities:
• Back-testing programs should be designed to evaluate the effectiveness of the models for typical
counterparties, key risk factors, key correlations and pricing models. Backtesting results should be
evaluated for reasonableness as well as for statistical significance. This may serve as a useful check
for programming errors, or cases in which models have been incorrectly calibrated.
• Backtesting should be performed over different time horizons. For instance, the inclusion of mean
reversion parameters or similar time varying features of a model can cause a model to perform
adequately over one time horizon, but perform very differently over a different time horizon. A
typical large dealer should, at a minimum, perform backtesting over one day, one week, two weeks,
one month and every quarter out to a year. Shorter time periods may be appropriate for transactions
under a collateral agreement when variation margin is exchanged frequently, even daily, or for
portfolios that contain transactions that expire or mature in a short timeframe.
• Backtesting should be conducted on both real counterparty portfolios and hypothetical portfolios.
Backtesting on fixed hypothetical portfolios provides the opportunity to tailor backtesting portfolios
to identify whether particular risk factors or correlations are modeled correctly. In addition, the use
of hypothetical portfolios is an effective way to meaningfully test the predictive abilities of the
counterparty exposure models over long time horizons. Banking organizations should have criteria
for their hypothetical portfolios. The use of real counterparty portfolios evaluates whether the
models perform on actual counterparty exposures, taking into account portfolio changes over time
e use
of hypothetical portfolios is an effective way to meaningfully test the predictive abilities of the
counterparty exposure models over long time horizons. Banking organizations should have criteria
for their hypothetical portfolios. The use of real counterparty portfolios evaluates whether the
models perform on actual counterparty exposures, taking into account portfolio changes over time.
It may be appropriate to use back-testing methods that compare forecast distributions of
exposures with actual distributions. Some CCR measures depend on the whole distribution of future
exposures rather than a single exposure percentile (for example, EE and EPE). For this reason, sole
reliance on backtesting methods that count the number of times an exposure exceeds a unique percentile
threshold may not be appropriate.
Exception counting remains useful, especially for evaluating peak or percentile measures of
CCR, but these measures will not provide sufficient insight for expected exposure measures. Hence,
banking organizations should test the entire distribution of future exposure estimates and not just a
single percentile prediction.
Banking organizations should have policies and procedures in place that describe when back-
testing results will generate an investigation into the source of observed backtesting deficiencies, and
when model changes should be initiated as a result of backtesting.
26
Documentation
Adequate validation and review are contingent on complete documentation of all material
aspects of CCR models and systems. This should include all model components and parameter
estimation or calibration processes. Documentation should also include the rationale for all material
assumptions underpinning its chosen analytical frameworks, including the choice of inputs;
distributional assumptions; and weighting of quantitative and qualitative elements. Any subsequent
changes to these assumptions should also be documented and justified
all model components and parameter
estimation or calibration processes. Documentation should also include the rationale for all material
assumptions underpinning its chosen analytical frameworks, including the choice of inputs;
distributional assumptions; and weighting of quantitative and qualitative elements. Any subsequent
changes to these assumptions should also be documented and justified.
The validation or independent review should be fully documented. Specifically, this would
include results, the scope of work, conclusions and recommendations, and responses to those
recommendations. This includes documentation of each of the three components of model validation,
discussed above. Complete documentation should be done initially and updated over time to reflect
ongoing changes and model performance. Ability of the validation (or review) to provide effective
challenge should also be documented.
Internal Audit
A banking organization should have an internal audit function, independent of business-line
management, which assesses the effectiveness of the model validation process. This assessment should
ensure the following: proper validation procedures were followed for all components of the CCR model
and infrastructure systems; required independence was maintained by validators or reviewers;
documentation was adequate for the model and validation processes; and results of validation
procedures are elevated, with timely responses to findings. Internal audit should also evaluate systems
and operations that support CCR. While internal audit may not have the same level of expertise as
quantitative experts involved in the development and validation of the model, they are particularly well
suited to evaluate process verification procedures. If any validation or review work is out-sourced,
internal audit should evaluate whether that work meets the standards discussed in this section.
This is a copy of a public record, reproduced as it was published. It is not legal advice, and it may not be the version a court would rely on. Check the official source before you cite it.