How to mitigate Counterparty Risks?

The flows of credit from commercial banks are the major and the most noticeable cause of credit risk. Besides loans there is other type of credit risks in banking operations which is called counterparty risk. Loan has default risk; a derivative has counterparty risk. We are discussing here on Counterparty risks.

What is the meaning of counterparty risk?

We refer the parties involved in a transaction as counter parties, when a transaction of a derivative is traded between two parties (viz. buyer and seller) under prior agreement with set of terms and conditions. The Counterparty risk or default risk arises due to the inability or unwillingness of a customer or counterparty to meet his commitments relating to trading, hedging, settlement and other financial transactions under the agreement. Normally such default arises where there is inappropriate underwriting or credit assessment.

What is the meaning of derivatives?

Derivatives are specific types of instruments that derive their value over the time from the performance of assets like financial futures, swaps, bonds, equities, options (call/put) and forwards.

What is the difference between exchanges traded derivative and OTC?

Derivatives can be traded on or off an exchange. The derivatives which can be traded through an Exchange (clearing house) are known as Exchange –Traded Derivatives (ETs) and the derivatives which are traded without routing through an Exchange (clearing house) are known as Over-the-Counter Derivatives (OTCs).

Exchange traded (ETs) derivatives are listed (trading on exchange) derivatives traded through recognized exchange (clearing house). It indicates a Standardised contracts traded on a recognized exchanges which offer more liquidity, transparency and lower counterparty risks. The contract terms of ETs are non-negotiable and are publicly available. Examples of ETs are Futures, Options and options on future contracts.

The OTCs are bespoke contracts traded off-exchange with specific conditions determined and agreed by the buyer and seller (counterparties).  On the flip side, OTC derivatives are more illiquid as they are traded out of clearing houses or exchange which exposes the transactions in increased credit (default) risk.  Examples of OTC are Interest rate derivative, Credit derivative, Commodity derivative, equity derivative, forward contracts and swaps.

What are the strategies adapted by the banks to mitigate counter party risks?

Banks normally adapt following strategies to mitigate counterparty risks.

1. Hedging: Hedging is the risk management strategies adapted by the banks in making an investment in to eliminate or reduce the risk of adverse price movements in financial instruments (bonds, notes, and shares), foreign exchange derivatives or precious metals. Generally, investors can hedge the price in the international commodity exchange/markets, using hedging products such as futures and options as permitted by RBI from time to time.
2. Trading with selected counter parties: Under this strategy banks trade only with counterparties with excellent credit quality. In this way risk is mitigated as their default is highly improbable in spite of potentially very large exposure. However counterparty transactions cannot fully rely on the above strategy. The concept of ‘too big to fail’ in respect of counterparty risks which was prevailing in international banking turned out to be illusion after big collapse of Lehman Brothers, Icelandic banks, Monoline Insurance company, Fannie Mae and Freddie Mac in spite of all the above had Triple –A status.
3. Closeout netting: Closeout netting is a very standard risk mitigation method for counterparty risk practiced worldwide. Under this method netting allows amounts owed to a counterparty to be offset with those owed by the other counterparty. However, it is possible only in cases of bi-directional transactions between counterparties which rarely happen.
4. Collateralized transactions: A further way to reduce credit exposure is through the use of eligible financial collateral for the transactions.  Only Cash, Deposit, LIC surrender Value and Gold are accepted as eligible collateral security.
5. Prorate sharing of security: In case of consortium/multiple banking/ syndicating agents on behalf of the other member banks, a prorate share of security clause is incorporated in joint deed. This would help a bank to share the risk amongst the other member banks. A letter in this regard will be obtained from the leader bank.
6. Guarantees as a credit protection: Taking of suitable personal as well corporate guarantee is another method of mitigating the risk.
7. Capital Conservation Buffer: The capital conservation buffer (CCB) is planned to safeguard that banks ought to build up capital buffers during normal times which can be utilized during stressed period to wipe out the losses incurred. Basel III norms recommends, capital conservative buffer in the form of common equity will be phased-in over a period of four years in a uniform manner of 0.625% per year, commencing from January 1, 2016.

At present the counterparty credit risk in the trading book covers only the risk of default of the counterparty. However, Basel III norms recommends for enhancing counter party risk coverage. The new norm prescribes additional capital charge for Credit Value Adjustment (CVA) risk which captures risk of mark-to-market losses due to deterioration in the credit worthiness of a counterparty.

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