Six New Elements in Counterparty Credit Risk Analysis

In the on-going global economic crisis, counterparty risk plays one of the most significant roles in the financial analysis of the portfolios and accounts held by the financial industry. Its downstream effect in credit, liquidity, systemic, concentration and valuation risks are causing high uncertainty and losses in the markets globally.

New challenges in methodologies, models and systems have been raised in the assessment, management and mitigation processes of counterparty risk and their corresponding losses. The financial industry is starting to rethink the usage of the new elements referring to counterparty risk where the following six issues must be considered:

1. The mixture of elements defining counterparty credit ratings
The current and future status of the counterparty is among the main factors for identifying credit risks and losses. The term ‘status’ contains qualitative and quantitative characteristics expressed as counterparty credit ratings, including the probability of default.

In the credit rating process, financial institutions attempt to identify the capability of the counterparty fulfilling the agreed obligation, also defined as creditability. They are considering quantitative measurements such as the actual amount and distribution of credit exposure, the correlation among the counterparties and, in case of default, the quality and value of the collaterals. On the other hand, based on qualitative criteria, assessments and hypothetical assumptions are trying to identify the willingness (expected decisions), commonly expressed as seniority, of the counterparty to comply with the credit obligations as they have been agreed and, in the default case, the expected behaviour in recovering the credit losses. 

This mix previously resulted in misleading and sometimes inaccurate estimations of qualitative and quantitative characteristics, reducing the transparency of the rating indicator. Analysts argue that by applying credit exposure, high quality of collaterals does not necessarily improve the counterparty’s creditability. Moreover, the markets know that the willingness of the counterparty for non-default – or in the case of default for providing recoveries – could have nothing to do with the seniority level evaluated at the time of the agreed obligations, but it is rather driven by political and strategic decisions at the time of the event.

2. The link of market credit spreads with the confidence in credit ratings
An important issue is that although there are many rating models they still lack transparency and robustness, especially under volatile market conditions. This has a direct impact in defining the counterparty’s credit spreads. They are derived from the opinion of markets regarding the available, current and expected counterparties’ ratings but also by their own belief in counterparties’ credit quality.

It has been observed in this crisis that markets have been adjusting the credit spreads before the ratings have even been changed. Moreover, when sharp downgrading is applied on high rated counterparties, markets tend to influence the credit spreads to a higher degree. Associating credit spreads with the credit ratings, together with the corresponding markets’ opinion, is a challenging task. In recent times markets have been seeing more volatility on credit ratings confidence, resulting in fluctuation on credit spreads. As a result, higher fluctuation in the value of credit portfolios is impacting market liquidity.

3. The link between the discrete counterparty ratings and the continuous credit spreads
Despite the definition of a credit rating having mixed components of creditability and willingness that could change over time, the resulting rating status of the counterparty is received by the markets as a discrete signal, covering mitigation or default, at a particular time. However, the link between the counterparty ratings is based on their sensitivities to certain market risk factors, as well as the correlations among them. This implies that the identification for volatilities of credit ratings is based upon market volatilities, correlations and counterparty changes.

On the other hand, credit spread is received more as a continuous signal, because it is considered to be driven by the markets in a continuous manner. Having said this, credit spreads more than any other asset class can be also expected to have jumps caused by sudden changes of the discrete credit ratings. Consequently, during the observation of spread volatilities and correlations, the possible impact of the credit ratings must also be considered.

In the valuation and validation process for credit portfolios, elements of both discrete credit rating and continuous credit spreads are considered. It has been observed that treasurers and financial institutions are basing the valuation on counterparty credit ratings, their probability of default and the migration risks. In contrast, the markets are moving towards a valuation process based on the actual market credit spreads. These differences of views in valuation could impact the acceptance of both current and future performance of credit portfolios, especially when high volatilities and changes in correlations have to be considered. 

4. The impact of counterparty credit ratings and spreads on liquidity risk
Credit ratings are more likely to indicate funding liquidity risk as they are referring to idiosyncratic counterparty risk. Counterparties are mainly responsible for the changes and robustness of their ratings, especially under stress markets. On the other hand, counterparty credit spreads are linked to market liquidity risk. Credit spreads normally define the capability of selling assets of credit portfolios. However, there is a catch: assets that can be assumed as perfectly liquid and tradable in less adverse times might not be liquid and tradable under stressed market liquidity conditions. Changes in credit spreads therefore indicate the market’s view on liquidity risk.

Although funding risk and market risk are different types of liquidity risks, they are strongly linked and aligned with the integration between counterparty credit ratings and spreads. For instance, downgrading key institutions results in funding liquidity distress, which generates chain reactions in the market due to systemic risk. Systemic risk losses are defined by analysing the systemic interaction between the risk factors of particular market sectors, counterparty credit ratings, as well as the market sector and its idiosyncratic behaviour characteristics.

The concentration of funding portfolio with a certain credit rating may also impact liquidity. On the other hand, market liquidity risk affects the liquidity position of the entire sector, reducing the value and liquidity of all instruments belonging to that sector.

5. The role of counterparty on valuating loss given default
Having referenced the counterparty credit ratings and spreads, markets can also obtain an estimate of the implied market loss given default (LGD). This is for non-defaulted, but risky, assets such as heavily downgraded bonds that are still traded. High volatility of credit spreads on such products implies fluctuation on the exposures and exposure at default and thus on the implied market LGD. Moreover, in the event of default, market LGD considers recoveries on discounted principal and missed interest payments. The expected recoveries are linked to specific counterparty seniorities, although recovery rates have to be considered from the point of view of a distribution (rather than as known values).

6. The role of counterparty ratings in wrong-way risk
Credit exposures can very much depend on the counterparty credit ratings and/or credit spreads. In other words exposures can be under significant wrong-way risk. Conversely, right-way risk could exist where the dependence between exposure and credit quality is a favorable one; in this case it will reduce counterparty risk.

This dependency can be specific, resulting mainly from poorly structured portfolios; such as when an exposure is collateralized by its own or related party assets. They can also be general where the exposure is affected by other third party counterparty ratings; for example, a loan exposure in euros is also affected by the governmental ratings of a specific market. It would therefore be naive to model the value of the exposures, as well as their adjustments, without considering wrong way risk. The regulatory approach for estimating credit valuation adjustments (CVAs) does not consider the impact of wrong-way risk – see BIS/BCBS: 189.

This creates new challenges in counterparty credit risk analysis, which must be considered in modern risk and profitability analysis programmes and procedures. Reviewing each of them, while bearing in mind that markets, counterparties and their behaviours are fully integrated, are key elements in providing a holistic and complete solution for counterparty and credit risk analysis.