Evolving view of counterparty risk

15 September 2011

By Alberto Corvo,
managing principal,
Financial Services,

Although the issue of risk management has been around for a long time in the financial services industry, current volatile market conditions, coupled with the lingering effects of the 2008 financial crisis, have brought risk management into sharper focus. Risk managers know they need to have a consolidated view of their counterparties in order to have a complete picture of their exposure. However, gaining one holistic view of all the outstanding risks has proven a tough task for financial institutions to date. New regulatory mandates, increased pressure from investors and a demand for greater transparency, in a framework of tightening budgets, are driving financial services firms to look for solutions that meet the new counterparty risk requirements.

Impediments to overcome

One of the reasons why it has been notoriously difficult to obtain a combined view of counterparty risk is that banks have by and large adopted a silo-based IT infrastructure - using multiple systems for various pieces of their business, including over-the-counter (OTC) derivatives, listed derivatives, loans, cash, repos, securities and so on. These systems may have different client IDs, security IDs, data structures, formalisms and workflows, making collating the data a non-straightforward exercise.

Another reason why a consolidated view is difficult to achieve is the fact that some firms have outdated know your customer (KYC) information, particularly relating to the counterparties’ corporate parent/child relationships, making it increasingly difficult for the risk manager to grasp an accurate consolidated view of all counterparties. In addition, collateral agreements that have not been updated and may not be correctly captured in the bank’s collateral systems can create significant confusion in the organisation when it comes to issuing margin calls. With better information coming from a full relationship view, it is possible to make better collateral decisions, and be quicker to react to under-collateralisation issues that may not be observable unless a full snapshot of the exposure is taken. Also, by considering all factors, it is possible to offer better service to the client, possibly reducing the number of margin calls and improving capital utilisation.

Driving forces

After the global economic events of 2008, and a heightened sensitivity brought about by the financial regulators, it has become more important for all the players in the financial world to monitor the exposure to their counterparties as far as possible on a real time basis. In addition, the push towards centralised clearing for derivatives, and the daily margin call process that participants will be required to enforce, will demand substantially more visibility on the counterparty risk. Lastly, the need to more efficiently allocate risk capital internally within financial institutions and capital markets firms becomes tougher and more expensive, particularly in light of Basel III.

In addition to external pressures from regulators, there is a need to have a better handle on the client exposure coming from within the organisations. Margins are shrinking and banks will be in a position to rely less and less on their prop trading desks, forcing them to offer more services to clients, and make the relationships with such clients more efficient and less risky.

Streamlined solution

A consolidated view via a fully automated solution will take substantial time to build, if it can be built at all. Some vendors exist today that can help banks consolidate this information in a flexible and cost-effective manner by combining technology and people to effectively clean, consolidate and process the data, resulting in a risk view spanning all client relationships. Because of the flexibility of these vendors, with their ability to deploy resources in relatively short order these solutions are also quick to deploy.

In order for the counterparty risk computation to be correctly and effectively carried out, several operating parts of a bank will be impacted: the KYC function, which will need to have up to date creditworthiness and taxonomy data of each counterparty. A review of the consistency between CSAs and collateral systems will be required to implement and manage a timely and accurate margin call process. The risk management process will also be affected, as the banks will need to be able to centralise the information from multiple sources and see the client relationship as a single one. On the other hand, a centralised view of the client relationship will allow for the bank to offer better services and devise additional revenue streams.

Looking ahead

As technology continues to evolve, so do KYC and counterparty risk management processes. Over the next several years, the industry will see a demand for shorter review times for KYC, with a view to reduce exposure. In addition, centralised counterparty risk will be managed more tightly and monitored on a more real-time basis. As investors and regulators continue to place pressures on risk managers, the need to assess counterparty risk at faster speeds will grow.

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