Counterparty credit risk arises in connection with over-the-counter (OTC) derivatives and securities financing transactions (SFT). OTC derivatives are ‘tailor-made’ derivatives created in the context of bilateral negotiations. SFTs consist for the most of repo transactions and securities lending transactions. Exchange traded derivatives are less susceptible to counterparty credit risk, because the intermediary role of the clearing house takes away the bilateral nature of the transaction. The counterparty risk vis-à-vis recognised clearing houses is considered to be nil in a regulatory context [Rsvhk Section 5:5].
A firm must hold regulatory capital in respect of counterparty credit risk, pursuant to Chapter 5 of the Regeling Solvabiliteitseisen voor het kredietrisico or Rsvhk [Regulation providing Solvency Requirements for Credit Risk]. Pivotal to the calculation of the solvency requirement is the determination of the Exposure At Default (EAD). The EAD may be determined by any of four different methods, one of which is the current exposure method. The current exposure method may be used only for OTC derivatives.
Current exposure method
Under the current exposure method, the EAD is determined on the basis of the positive market value (‘current exposure’) of the contract, with a mark-up added for potential credit risk. The mark-up thus serves as a proxy for the potential exposure. The mark-up depends on the type and the time to maturity of the transaction, as is shown by Table 1 below [Rsvhk Section 5:6, Annex 5A].
Tabel 1: Proxy voor potentiële exposure (%)
|Time to maturity||Interest rate contracts||Foreign exchange contracts and contracts concerning gold||Equities contracts||Contracts concerning precious metals except gold|
Contracts concerning commodities other than precious metals / Other contracts*
|< 1 year||0,0%||1,0%||6,0%||7,0%||10,0%|
|> 5 year||1,5%||7,5%||10,0%||8,0%||15,0%|
* Following prior permission by DNB, a financial undertaking apply a more detailed breakdown by commodities (precious metals except gold; base metals; agricultural products (softs); and other products including energy products.
Suppose that Bank X has entered into an interest rate swap (fixed for floating) with a counterparty. The swap has a time to maturity of 10 years and an underlying value of €1 million. Furthermore, the fixed and variable interest rates are equal at the time the EAD is determined, which indicates that the market value of the swap is nil. Under the current exposure method, the EAD is then equal to:
EAD = current exposure + proxy potential exposure
= €0 + [1.5% x € 1,000,000)]= € 15,000
A difference compared to the original exposure method is that in the determination of the EAD the positive market value of the contract is taken into account. However, if the market value of the interest rate swap is negative (that value becomes negative for Bank X if interest rates decreases), it is not taken into account in determining the EAD, since the market value is set at nil. Thus in determining the EAD under the current exposure method, it is important which position you take in the transaction (long in the fixed leg or long in the floating leg), in contrast to the original exposure method, where the EAD is assumed to be equal for both parties to a contract.
Capital requirement under the current exposure method
The capital requirement in respect of counterparty credit risk is determined by filling in the EAD in one of the following formulas:
- Standardised approach (SA):
Capital Requirement = EAD *RW *0,08
- Internal Rating Based approach (IRB):
Risk weighted asset = EAD*RW*12,5*1,06
EAD: Exposure At Default
RW: Risk weight
PD: Probability of Default
LGD: Loss Given Default
b: Maturity Adjustment
N(x): cumulative probability distribution of a standard normal distribution of a random variable with mean = 0 and variance = 1, of which a random draw is equal or smaller than x.
G(z): inverse cumulative probability distribution of a standard normal distribution of a random variable, where x takes a value such that N(x)=z.