Читать книгу The xVA Challenge - Gregory Jon - Страница 9

Counterparty risk first gained prominence in the late 1990s when the Asian crisis (1997) and default of Russia (1998) highlighted some of the potential problems of major defaults in relation to derivatives contracts. However, it was the failure of Long-Term Capital Management (LTCM) (1998) that had the most significant impact. LTCM was a hedge fund founded by colleagues from Salomon Brothers’ famous bond arbitrage desk, together with two Nobel Prize winners Robert Merton and Myron Scholes. LTCM made stellar profits for several years and then became insolvent in 1998. LTCM was a very significant counterparty for all the large banks and the fear of a chain reaction driven by counterparty risk led the Federal Reserve Bank of New York to organise a bailout whereby a consortium of 14 banks essentially took over LTCM. This failure was a lesson on the perils of derivatives; LTCM has been running at a very significant leverage, much of which was achieved using OTC derivatives together with aspects such as favourable collateral terms. This in turn exposed banks to counterparty risk and raised the prospect of a knock-on impact, causing a cascade of defaults. It was the possibility of this chain reaction that led to the rescue of LTCM because of a perceived threat to the entire financial system.

One of the responses to the above was the Counterparty Risk Management Policy Group (CRMPG) report in June 1999. CRMPG is a group of 12 major international banks with the objective of promoting strong counterparty credit risk and market risk management. Further major defaults such as Enron (2001), WorldCom (2002) and Parmalat (2003) were not as significant as LTCM, but provided a continued lesson on the dangers of counterparty risk. Many banks (typically the largest) devoted significant time and resources into quantifying and managing this. The CRMPG issued a report in January 2005, stating that:

Credit risk, and in particular counterparty credit risk, is probably the single most important variable in determining whether and with what speed financial disturbances become financial shocks with potential systemic traits.

Meanwhile, efforts to ensure that banks were properly capitalised were being initiated. The Basel Committee on Banking Supervision (BCBS) was established by the Group of Ten (G10) countries in 1974. The Basel Committee does not possess any formal authority and simply formulates broad supervisory standards. However, supervisory authorities in the relevant countries generally follow the BCBS guidelines when they develop their national regulation rules. In 1988, the BCBS introduced a capital measurement framework now known as Basel I that was more or less adopted universally. A more risk-sensitive framework, Basel II, started in 1999. The Basel II framework, now covering the G20 group of countries, is described in the Basel Committee’s document entitled International Convergence of Capital Measurement and Capital Standards (BCBS, 2006). It consists of three “pillars”:

• Pillar 1, minimum capital requirements. Banks compute regulatory capital charges according to a set of specified rules.

• Pillar 2, supervisory review. Supervisors evaluate the activities and risk profiles of banks to determine whether they should hold higher levels of capital than the minimum requirements in Pillar 1.

• Pillar 3, market discipline. This specifies public disclosures that banks must make. They provide greater insight into the adequacy of banks” capitalisation (including disclosure about methods used to determine capital levels required).

Requirements for counterparty risk capital were introduced in Basel I and were clearly set out under Pillar 1 of Basel II.

Meanwhile, the growth of the derivatives markets and the default of some significant clients, such as Enron and WorldCom, led banks to better quantify and allocate such losses. Banks started to price in counterparty risk into transactions, generally focusing on the more risky trades and counterparties. Traders and salespeople were charged for this risk, which was often then managed centrally. This was the birth of the CVA desk. Initially, most banks would not actively manage counterparty risk but adopted some sort of income deferral, charging a CVA to the profit of a transaction. Calculations were typically based on historic probabilities of default and the CVA amounted to an expected loss that built up a collective reserve to offset against counterparty defaults. A CVA desk generally acted as an insurer of counterparty risk and there was not active management of CVA risk.

The above approach to counterparty risk started to change around 2005 as accounting standards developed the concept of “fair value” through IAS 39 (“Financial Instruments: Recognition and Measurement”) and FAS 157 (“Financial Accounting Standard 157: Fair Value Measurement”). This required derivatives to be held at their fair value associated with the concept of “exit price”,defined as:

The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.

This implied that CVA was a requirement since the price of a derivative should be adjusted to reflect the value at which another market participant would price in the underlying counterparty risk. FAS 157 accounting standards (applicable to US banks, for example) were more prescriptive, requiring:

A fair value measurement should include a risk premium reflecting the amount market participants would demand because of the risk (uncertainty) in the cashflows.

This suggests that credit spreads, and not historical default probabilities, should be used when computing CVA. Furthermore, FAS 157 states:

The reporting entity shall consider the effect of its credit risk (credit standing) on the fair value of the liability in all periods in which the liability is measured at fair value.

This suggests that a party’s own credit risk should also be considered as part of the exit price. This is generally known as debt value adjustment (DVA).

None of the aforementioned focus on counterparty risk seen in regulation, market practice or accounting rules prevented what happened in 2007. Banks made dramatic errors in their assessment of counterparty risk (e.g. monoline insurers, discussed below), undertook regulatory arbitrage to limit their regulatory capital requirements, were selective about reporting CVA in financial statements and did not routinely hedge CVA risk. These aspects contributed to a major financial crisis.