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Derivatives and Credit Risk

Many derivatives are over-the-counter instruments (interest rate swaps, currency swaps, and options), not as liquid as market instruments. Theoretically, banks hold these assets until maturity, and bear credit risk since they exchange flows of funds with counterparties subject to default risk. For derivatives, credit risk interacts with market risk in that the mark-to-market (or liquidation) value depends on market movements.

The regulators consider those as "hold-to-maturity" positions. The principle is to define the exposure to credit risk as the potential positive value that the derivative can reach during its life. If a derivative has a positive value, the counterparty stands to lose this value if the other counterparty defaults. But values vary randomly with markets, and there is a need to define a methodology for finding out potential positive values.

The G30 group, in 1993, defined the framework for monitoring OTC derivative credit risk. The G30 report recommended techniques for better assessing uncertain exposures, and proposed a framework for modeling the potential deviations of portfolios of derivatives over long periods. The principle is to determine the time profile of upper bounds that future values will not exceed in more than is a preset probability, or confidence level6. The final result of this approach is a time profile of potential positive values of the OTC derivatives, updated continuously. Such time-varying exposures are treated as "credit equivalents," that is as if they were loans. The current credit risk exposure is the current liquidation value. There is an additional risk due to the potential upward deviations of liquidation value from the current value.

Regulators defined standard "add-ons," or percentages of notional depending on the underlying parameter and the maturity buckets. Underlying risk factors are interest rate, foreign exchange, equity and commodities. The maturity buckets are up to 1 year, between 1 and 5 years and beyond 5 years. The capital charge is based on current credit exposure plus the add-on for the potential upward drift of the exposure of the derivative. Such add-ons are proxies. In addition, they are added arithmetically, which does not allow capturing dependencies across credit exposures, thereby providing a strong incentive for full-blown modeling of derivative exposures.

Current best-practices rely on such full-blown models of potential credit exposures of derivatives, and those are accepted as exposure inputs under the Basel 2 Accord.

Basel I Drawbacks

The major strength of the Cooke ratio is simplicity. There are several major drawbacks, however, which the new Basel Accord addressed. There is no differentiation between the risks of private corporations of different risks. An 8% ratio applying both for a large Aa corporation and for a small business does not make much sense economically. In other words, the accord is not risk-sensitive enough. In addition, short facilities have zero weights, while long facilities have a full capital load. This unequal treatment leads to artificial arbitrage by banks, such as renewing short loans rather than lending long. There is limited allowance for recoveries if a default occurs, even in a case where recoveries are likely, such as for securities collateral. Diversification effects are embedded in the 8% ratio, but the same ratio applies to all credit risk portfolios, whatever their degree of diversification. The regulatory body recognized these facts and reviewed these issues, leading to the New Basel Accord - detailed in the next chapter.

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