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A Survey by the

Professional Risk

Managers International

Association

NOVEMBER2008

Counterparty Credit Limits and

Exposure Management Survey

Thanks to our sponso


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2 T H E P R O F E S S I O N A L R I S K M A N A G E R S I N T E R N A T I O N A L A S S O C I A T I O N

ABOUT PRMIA

PRMIA is the Professional Risk Managers International Association. Formed in January 2002,

PRMIA sets a higher standard for risk professionals with more than 65 chapters around the

world and over 55,000 members from more than 180 countries. A non-profit, member-led

association, PRMIA is dedicated to defining and implementing the best practices of risk

management through education, certification, events, networking, and online resources.

More information can be found atwww.PRMIA.org.

Contact PRMIA [email protected]

ABOUT SUNGARD ADAPTIV

SunGards Adaptiv provides enterprise-wide credit and market risk management and opera-

tions solutions for financial services institutions. Adaptiv assists institutions of varying size

and complexity to deploy technology to meet both internal and regulatory requirements for

risk management and operational control.

To find out more contact:telephone: +44 (0)208 081 2779

email:[email protected],web:www.sungard.com/adaptiv


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A H I G H E R S T A N D A R D F O R R I S K P R O F E S S I O N A L S

Counterparty Credit Limits and

Exposure Management Survey

I N T R O D U C T I O N

C

ounterparty risk has never been of more importance than now. We are

experiencing a maelstrom in the capital markets the likes of which has not

been seen since the great depression of the 1930s. We have seen recurring

banking disasters as Wall Street and the City of London watched centuries-oldinstitutions fail, be absorbed by others or be bailed out by government support.

The prospect of a bulge-bracket primary dealer being allowed to fail seemed almost

inconceivable as recently as a year ago. Now this remote possibility has become a

reality. Similarly inconceivable was a situation where hedge funds would be more

concerned about the creditworthiness of their prime brokers than vice versa.

The sense of crisis has been massively exacerbated by a lack of timely and reliable

risk information at many institutions that hampered their ability to react effectively.

When it takes weeks to compile a comprehensive report on all your exposures to a

given counterparty you cannot hope to be able to react to daily events.

In the present circumstances, it is hardly surprising to observe such urgency among

banks to reassess their counterparty risk management, methodologies and systems.

It is with this urgency in mind that SunGard, in conjunction with the Professional Risk

Managers International Association (PRMIA), launched the following survey into

counterparty risk. The questions are designed to explore best practices in the areas of

risk policies, exposure measurement and systems. Responses were provided by more

than 450 risk professionals from around the world.


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Please assess the importance of the following features of a credit exposure monitoring system.

Tied for 1st and 2nd in terms of importance were accuracy of exposure estimates and

flexibility of the limit structures the system can handle.

In 3rd place was gaining a consolidated exposure view across derivatives, issuer risk

and banking book.

4th place was tactical decision support such as pre-deal checking and not just afterthe-

fact reporting.

Exposure sensitivity analysis is not widely available in existing systems. The resulting

unfamiliarity with the concept is likely to be the reason that a somewhat smaller share

of respondents rated it as Very important or Somewhat important. Nevertheless,

almost half of all respondents rated it Very important and another 36% rated it

Somewhat important. Recent fears concerning the stability of even major financial

institutions is likely to have boosted the perceived importance of this functionality.

Generally work flow and presentation functionality were viewed as desirable but less

important than the analytical core of the system.

0% 20% 40% 60% 80% 100%

Flexible credit limits framework (global limits, sub-limits, etc).

Real-time exposures updates.

Accuracy of exposure modelling.

Consolidation of exposures arising from theTrading Book (counterpartyriskon OTC derivatives) and the Banking Book (lending activities).

Inclusion of Issuer Exposures.

Ability for risk takers to perform fast pre-deal limit checks.

Single view of all entity-specific exposures.

Calculation of regulatory exposure.

Graphical representation of exposure profiles.

Real-time notification of violations &excesses.

Approval workflow for violations & excesses (post-deal).

Workflowfor pre-dealapprovals.

Approval workflow for credit limits.

Credit grading (scoring) models.

Indication of thesensitivity of portfolioexposures to underlying risk factors.

Reporting ofwrong-way riskpositions.

Very Important

Not Important

Somewhat Important

Somewhat Unimportan

FIGURE 1

S U R V E Y R E S U L T S


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With respect to the real-time aspect, how shouldexposure updates be applied, including thosefrom what-if pre-deal checks?

A significant amount of doubt was evident concerning the

feasibility of real-time what-if limit checks based on simul-

ated PFE. This is likely conditioned by the functionality

and performance of systems with which respondents are

familiar.

Should the credit limits system calculate Exposure

or Risk?

A strong consensus is evident that risk estimation is a

necessary functionality in addition to accurate exposure

profiling.

How should pre-deal limit checks be performed?

Although the responses were relatively mixed with a combi-

nation of the above being the most popular choice, the

most surprising result was the low vote (11%) for checking

against allocated sub-limits versus a central credit system.

These answers may well be influenced by the respondents

perception of the possible alternatives based on their

individual experience. Nevertheless, most of the market has

come to the logical conclusion that risk is a portfolio issueand that counterparty credit risk must be treated accordingly.

In many banks the reality is that risk managers are woefully

short of the information they need to assess counterparty

risk accurately. While this is a regrettable state of affairs, the

upside is that recent events may act as the overdue catalyst

needed to support a portfolio approach to credit risk.


From the relevant front office system, via real-time

interface to the credit limits system.

Within the front office system, against sub-limits

allocated to each front office system.

Via a dedicated credit checking user interface(which may be part of the credit limits system).

A combination of the above.

46%

29%

14%

11%

With some proxy gross exposure,

pending full portfolio recalculation.

With accurate netted portfolio-based exposure.

42%

58%

FIGURE 2


FIGURE 4

It should just calculate portfolio exposures

(Exposure At Default).

It should also calculate portfolio risk (Credit VaR,

economic capital, etc.).

32%

68%

FIGURE 3


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Should pre-deal limit checks also provide anindication of the cost-of-credit (CVA = CreditValuation Adjustment)?

There was a nearly equal distribution across the possible

responses for this question. Almost a quarter (23%) of

respondents believed the addition of cost of credit would

complicate what should be as simple and efficient a

process as possible. The consensus, however, appeared to

be that calculating a sophisticated real-time cost of credit

in some form is highly desirable. Despite this, the surveyreflects considerable doubt regarding the commercial

practicality of achieving this given the perceived complexity

and cost of such a move. Individual comments included:

Ideally, but this is difficult and the value it adds

should be measured against the cost and difficulty of

implementation.

In the development of risk systems there is always a trade-

off between the cost of development and the value of the

system but in this respect there seems to be an underesti-

mation of the technology possibilities. This may be because

many respondents have come from an in-house technologybackground an environment where it is harder to take a

long-term perspective to development due to the budgetary

constraints. Typically systems are developed to fill only the

immediate need. Additionally the amount of consolidation

in the banking sector of late means that many banks

development plans are hampered by the volume of

necessary integration work.

How should cost-of-credit be defined?

As with the previous question, there was a clear consensus

of opinion among respondents that cost-of-credit should

be defined by a combination of loss provisions and cost of

capital for unexpected losses. Again, as with the previous

question, there were doubts about the feasibility and

expense of achieving this aim.

No, this should be kept separate to limit checking.

Ideally, yes, but this is technically not feasible.

Yes, although the CVA indication may be based on a gross

calculation, and may therefore not include all portfolio effects.

Yes, and the calculation should consider incremental

portfolio effects.

30%

23%

20%

27%

FIGURE 5


Provisions required to cover expected losses.

Cost of capital required to cover unexpected losses.

Both provisions for expected losses and cost of

capital for unexpected losses.

14%

16%

70%

FIGURE 6



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With respect to issuer exposures, please assess the following features:

The ability to set (and by implication to track and control) limits on maximum exposure to an issuer

was the overwhelming favourite, although all the options were deemed very important or somewhat

important by an overwhelming majority of respondents. Monitoring concentrations and viewing issuerrisk along side other credit risks were considered to be the next most important features. What these

responses reflect is the importance of flexibility to configure counterparty risk systems to individual

institutional preferences.

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When combining derivative (counterparty) exposures with lending exposures, what is the mostappropriate measure?

Potential Future Exposure at a given

confidence level ( e.g. 95%).

Expected exposure.A hybrid measure in-between EE

and PFE.

Notional Amount.

Current MtM exposure.

9%

16%

39%

30%

6%

0% 20% 40% 60% 80% 100%

The ability to set limits to control the maximum exposure to an issuer.

The monitoring of the maximum holding period for securities.

The monitoring of any concentration risk in certain types of securities.

The monitoring of issuer exposures alongside credit exposures.

The ability to offset issuer exposures via credit derivatives.

Very Important

Not Important

Somewhat Important

Somewhat Unimportant

FIGURE 7



FIGURE 8

A surprising share of respondents (39%) opted for PFE at a

given confidence level (e.g. 95%) although an equal num-

ber opted for either EPE (9%) or a hybrid measure between

EPE and PFE (30%). It is possible that some respondents

did not understand the question in the anticipated manner

that the issue is how to set relationship caps that include

both banking book loan exposures and derivative credit

exposure. The banking book component is usually stated in

terms of outstanding loan exposure and the question is

what measure for derivative credit exposure should count

against the cap.

One aspect of counterparty risk that is difficult to capture

in surveys is that measures for setting individual counter-

party limits may not be equally appropriate for portfolio

analysis. There needs to be a consistent grammarbetween mainstream banking book credit exposures and

trading book counterparty exposures but the best measure

to apply for trading book exposures may differ depending

on the situation.


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How should issuer exposures (arising from hold-ings in securities positions) be monitored?

This question raises the prominent issue of integrating the

market and credit risk disciplines, a point which is also

addressed later in this survey. Over 60% of respondents

opted for a hybrid approach rather than a strictly market risk

or traditional credit risk approach. Presumably the nature of

the hybrid approach would vary depending on the liquidity

of the securities involved; therefore some variation in

respondents answers is to be expected.

How should issuer exposures on securitiesholdings be measured?

Approximately half of the respondents said the method

should differ with the book in which the securities are held.

This is consistent with exposure being the potential for loss

not already recognized through a decline in market value.

Historical cost was chosen by a surprisingly low 2% of

respondents even though this is standard operating

procedure for certain investment accounts.

Within a credit limits framework.

Within a market risk framework.

Under a hybrid framework.

14%

24%

62%

FIGURE 9

Notional amount.

Market value.

Historical cost.

A combination of the above depending

on which book (trading or investment)

the securities are held in.

2%

37%

50%11%

FIGURE 10


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With respect to Banking Book exposures (loans,LCs, etc.), how should one monitor the compli-ance with the terms of individual facilities?

A remarkable lack of consensus prevails here. The majority

response was for a global limits system for customer expo-

sure that also monitors the essential elements of each facility.A significant minority of respondents (31%) indicated a fully

integrated system would be best, although many expressed

significant scepticism about the feasibility of implementing

such an approach. Many observers feel that adopting one

monolithic solution to risk systems is impractical. They

argue that the risk area is so complex that such a system

would never allow risk managers to be agile enough to track

and analyze the full range of risks properly.

Is it mandatory for risk takers to always checkcredit limits before committing to a transaction?

Almost two-thirds said yes, credit limits must always be

checked. Several indicated that it is necessary to recognize

that always executing the actual check may be impractical

but that the risk of being penalized for breaching a limit

falls on the trader.

The global limits system should monitor the overall customer

exposure, but not the terms of each facility; the latter would be

the role of a dedicated Banking Book system, e.g. a loanadministration system or a facility management system.

In addition to the overall customer exposure, the global limits

system should also monitor the essential elements of each

facility, e.g. the facility limit and facility tenor. Other terms

(e.g. the permissible drawdown methods, subfacility limits,

etc.) should be monitored by the loan administration system.

The global limits system should monitor compliance with all

terms and conditions of banking book facilities.

26%

43%

31%

FIGURE 11

Yes, credit limits must always be checked

before entering into any risktaking activity.

Yes, except if the entity is rated at orabove a defined threshold (e.g. AA+).

In theory, yes, but pre-deal limit checking

is not always feasible, due to timing

and system constraints.

Pre-deal checking cannot be enforced

and is hence not mandatory.

24%

63%12%

1%

FIGURE 12


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What best describes your opinion about limitexcesses?

40% opted for True excesses should be pre-approved.

If this is not the case, a disciplinary process will apply.

Slightly fewer respondents chose Excesses should be kept

to a minimum, by ensuring that adequate credit limits are inplace to meet the needs of the business. The remaining

responses were split roughly evenly between Excesses are

a necessary evil that have to be dealt with as efficiently as

possible, and Excesses are intolerable. All risk-taking

activities must take place within approved credit limits.

How should counterparty limits be segregated?

Half of the respondents opted for the safety of A combina-

tion. 31% chose a single global limit per counterparty. One

comment pointed out the need to differentiate by documen-

tation, although this is not necessary as long as netting is

handled properly. In the absence of a proper exposure

simulation methodology, segregation by agreement does

indeed make sense.

Excesses are a necessary evil that have to be

dealt with as efficiently as possible.

Excesses should be kept to a minimum, byensuring that adequate credit limits are in

place to meet the needs of the business.

True excesses should be pre-approved. If this

is not the case, a disciplinary process will apply.

Excesses are intolerable. All risk-taking

activities must take place within approved

credit limits.

11%

37%40%

12%

FIGURE 13

Product groups.

Business areas.

Local branches.

A combination of the above.

None of the above (i.e. global counterparty

limits should be cross-product and crosslocation).

9%

49%

31%

2%9%

FIGURE 14




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1 1 T H E P R O F E S S I O N A L R I S K M A N A G E R S I N T E R N A T I O N A L A S S O C I A T I O N

How should collateralised exposures (under ISDACSA) be measured?

Roughly 40% opted for the most sophisticated approach

of modeling the buffer during the cure period analytically

and another 40% opted for modeling the buffer as a fixed

proportion of the threshold. The latter would probably

prefer modeling the buffer analytically but considered itimpractical. Less than 20% opted for using just the

threshold plus the minimum transfer amount with no

allowance for volatility during the cure period.

How should Banking Book collateralised expo-sures be measured?

Just over 60% chose a combination of approaches based on

the liquidity of the collateral. A quarter opted for full offset

of the exposure for the value of the collateral and 15%

argued that the collateral should be recorded pro memo-

ria and not treated as an offset at all. The comments were

quite varied but no one mentioned an approach that somefind compelling, namely to treat the threshold plus an

appropriate buffer as unsecured risk with the Loss Given

Default (LGD) of the obligor while collateral held is shown

as exposure with a much lower LGD (higher recovery rate)

but the same probability of default of the obligor.

The lending value of the collateral should act

as an offset against the customer exposure.

The lending value of the collateral should be

recorded pro memoria, and should therefore

not reduce the original exposure amount

A combination of the above, depending on

whether the collateral is deemed to be liquid

or illiquid.

24%

15%

61%

FIGURE 16

By capping the exposure profile to the threshold

plus minimum transfer amount.

By capping the exposure profile to the thresholdamount plus a buffer for potential exposure

movements during the 'cure' period. Buffer

represents a fixed percentage of the threshold.

Same as above, but the buffer is modelled

analytically based on the actual portfolio

composition.

41%

42%

17%

FIGURE 15


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How should guaranteed exposures be measured(including exposures protected by creditderivatives)?

25% opted for transferring the exposure to the guarantor

while 75% opted for leaving it with the obligor and recording

indirect exposure to the guarantor. One comment

mentioned using the Basel II double default method. Quite

obviously the problem of how to handle joint responsibility

for an exposure continues to bedevil designers of risk

information systems.

Please rate the importance of having acombined credit risk and market risk system.

A full two-thirds of respondents rated a combined credit

and market risk system as Very important. Another one-

quarter of respondents rated it as Somewhat important.

Clearly the increasing prevalence of traded credit risk has

raised the perceived urgency of a combined risk solution.

Some who argued for separate systems did so for practical

or cost reasons, stating that much of the benefit of more

integrated analysis across these areas can be achieved

without extensive system unification.

By completely transferring the exposure from

the primary obligor to the guarantor.

Continue to record the exposure to the

primary obligor as guaranteed, and record

the exposure to the guarantor as indirect.

75%

25%

FIGURE 17



Very important.

Somewhat important.

Somewhat unimportant.

Not important.

67%

26%

6% 1%

FIGURE 18


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1 3 T H E P R O F E S S I O N A L R I S K M A N A G E R S I N T E R N A T I O N A L A S S O C I A T I O N

How long would you expect the implementation of a global credit exposure & limits system to take?

0% 5% 10% 15% 20% 30%

3 months.

6 months.

9 months.

12 months.

15 months.

18 months.

24 months.

30 months.

More than 30 months.

25%

5.7%

14.9%

9.9%

26.3%

4.7%

12.9%

16.1%

2.5%

6.9% FIGURE 19

Most respondents who commented emphasised the heavy dependence on the size and complexity

of the organisation and its trading activities. In some cases there was also confusion about whether

this was the time to build a system from scratch or to deploy a system already well developed but

requiring some configuration or customisation. One respondent even offered a formula, namely

2 years (Tier * 6 months). This appears to mean 18 months for a Tier 1 organization and as

little as 6 months for a Tier 3 organization. In general, these are not unreasonable figures for

deployment of a fairly well developed system but when applied to the development of a system

from scratch to full deployment seems an overly aggressive timetable.


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C O N C L U S I O N

The current crisis has enhanced awareness of the need for reliable, timely and

sophisticated counterparty credit exposure and credit risk information. There is

a growing recognition that this has to be undertaken at a portfolio level, using

appropriately sophisticated risk measures. Enhanced analysis to identify wrongway risk

and portfolio sensitivities is getting much more attention than even a year ago.

This survey indicates significant recognition of the importance of more detailed, more

comprehensive and more timely information on counterparty credit exposure and credit

risk. There is however disagreement on the exact detail of how best to achieve this. This

highlights the importance that vendors must place on flexibility and the ability of users

to customize counterparty risk systems to accommodate the views of their own

institutions. The task of deploying, maintaining and upgrading effective counterparty

credit systems remains a daunting one. Nevertheless, regulators, investors and the

general public will expect better performance in the future than has been evident in the

recent past.

Without a doubt both financial institutions and vendors will face serious challenges in

coming years to meet the demands for better counterparty credit risk management

information. The good news is that the tools, techniques and systems already existwhich will form the underlying architecture for such solutions. Now is the time for

institutions to invest in updating their risk infrastructures so that, next time around,

they are able to respond to fastchanging market conditions in minutes rather than days.


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