Results from joint Credit/FitchSolutions survey shows most buy-side firms do not hedge counterparty risk.
Those surveyed cited hedging as too expensive.
The presentation suggest using CDS as early market systems of increasing risk from counterparties.
2. Fitch Solutions Representatives
Presenter
● Jonathan DiGiambattista, Managing Director, Global Head of Risk and
Performance Analytics
The Panel
● Damiano Brigo, Managing Director, Quantitative Analytics
● Diana Allmendinger, Director, Research
● Catherine Downhill, Director, Integrated Data Services
● Jesse Waters, Director, Risk and Performance Platform
www.fitchsolutions.com January 28, 2010 1
3. Fitch Solutions is a leading provider of credit related analytics
and data services
● Products & Services include:
– Risk & Performance Platform for monitoring market-based credit risk signals and CDS
price movements
– Integrated Data Services providing CDS & ABCDS pricing, fundamental financials,
Fitch Ratings and market-based risk data
– FitchResearch.com credit research portal
● Market leading Quantitative Analytics team
● Commentaries and Publications:
– Weekly Risk and Performance Monitor providing overview of credit-related market
movements of sectors and regions
– Bi-weekly Liquidity commentaries highlighting liquidity in the CDS market
– Available on www.FitchSolutions.com
www.fitchsolutions.com January 28, 2010 2
4. Agenda
● Results of Counterparty Risk survey
● Meeting the challenges posed throughout the credit risk monitoring
workflow
● Benefits, shortcomings and options for using the CDS market for risk
signals
● A real-world example of counterparty risk management in a post-
Lehman world
● Question and Answer
www.fitchsolutions.com January 28, 2010 3
6. Counterparty Risk Management Survey 2009
● 85 Counterparty Risk Manager interviews during October 2009
● 11 broad questions were asked re: current practices and changes since
the Lehman default
Do you actively hedge counterparty risk? Are you set up to use central counterparties?
What other measures do you have in place to How many banks do you regularly deal with now?
manage counterparty risk? Pre-Lehman?
What measures do you have in place to monitor What factors influence your decisions not to trade
counterparty risk? with the best priced dealer?
How common are break clauses? Which dealers include their own credit risk as a
discount?
Are you in favor of segregated margin accounts? How have your counterparty risk practices
changed over the past year?
What is the impact of central counterparties on
your business?
● Results published in December issue of CREDIT
● Full results of the report and related articles available for download on
www.FitchSolutions.com
www.fitchsolutions.com January 28, 2010 5
7. Counterparty Risk Survey Results
● Results from joint Credit/FitchSolutions survey shows
most buy-side firms do not hedge counterparty risk
● Those surveyed cited hedging as too expensive
– ‘manage’ counterparty risk
– Limits and collateral
– Calculating exposure
– Monitoring for ‘early warning’
Source: credit/FitchSolutions Counterparty Risk Survey
● >75% of respondents are not set-up to trade on
CCPs
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8. Survey shows increased efforts on monitoring CP
credit quality
● 63% of respondents deal with fewer counterparties today than before
Lehman defaulted
– Respondents did not see benefit of counterparty diversification due to
nature of derivatives, correlation of derivatives and FI credit risks
– Fewer counterparties allows for better monitoring and enforcement of credit
quality standards
● Market participants were least satisfied with counterparty credit risk
monitoring and Market Liquidity
Source: credit/FitchSolutions Counterparty Risk Survey
www.fitchsolutions.com January 28, 2010 7
9. Survey respondents cited internal workflows pose
challenges for monitoring CP credit risk
66% of CRMs depend upon risk Counterparty selection: >60% of
assessments from a centralized CRMs deem credit risk the leading
Credit Risk function for an official reason to NOT trade with an
risk assessment; 33% do not use a ‘approved’ counterparty; 40% cited
formal credit risk assessment liquidity
5-10 Active
Counterparties
CRMs adjust limits and collateral
requirements according to
perceived likelihood of
downgrades or credit events.
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10. 5-10 Active
Counterparties
Central Risk Assessments form ‘short-list’ of approved
counterparties; also used for allocating capital
● Assessments made by credit analyst and guided by formal credit policy
– Factors include:
Financial Performance Agency Ratings
Capital Adequacy Sovereign Support
Market Signals Sovereign Risks / Ratings
Industry Standing Management Quality
– Central risk assessments are ‘official’ views of entity credit risk often using
rigid methodologies, particularly among BIS-II compliant firms
● Internal assessments impact P&Ls as enterprise capital requirements
are based on internal-risk-weighted exposures
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11. 5-10 Active
Counterparties
Counterparty Risk Manager challenges: Avoiding adverse counterparty
selection & optimize exposure to existing counterparties
● Imperative for CRMs to select counterparties on short-list with least likelihood of future downgrade or credit
event within contract horizon
● CRMs take action on limits, collateral and hedging based on continuous monitoring of counterparties for risk
migration relative to existing exposure
Additional Capital Charge
Future Increase Exposure
Possible forced ‘sale’ for Economic Loss
Downgrade
economic loss
Maintain limits &
collateral Req’s
Reduce limits
Stable
Stable Capital Charge Economic Loss Increase Collateral Req’s
Rating
Aggressively reduce limits
Increase collateral req’s
Hedge to eliminate exposure
Future Reduced Capital Charge
Upgrade Economic Loss
No Future Credit Event Future Credit Event
www.fitchsolutions.com January 28, 2010 10
12. Meeting the challenges for monitoring counterparty credit risk
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13. CRMs are dissatisfied with their ability to access and
integrate CP credit risk signals
● CRMs have significant informational needs around current risk levels
and potential for credit risk migration
– Anticipating changes to internal risk assessments
– Full transparency into central risk methodologies and policies, and
access to relevant data:
Fundamental Financials Agency Ratings
Capital Adequacy Sovereign Support
Market Signals Sovereign Risks / Ratings
Industry Standing Management Quality
– Anticipating future credit events
– External credit risk assessments
– Early warning, benchmark and relative risk indicators
– “News flow”
www.fitchsolutions.com January 28, 2010 12
14. CDS market and derived metrics are best early warning
signals available
● Cardinal and ordinal levels observed
in the CDS market have most direct
implications for credit risk managers
● From the CDS market we can derive:
– PDs for individual entities
– Relative risk levels by region/sector
– Historical cycle comparisons
– Sector performance
– Aggregate expectations for future
default rates
www.fitchsolutions.com January 28, 2010 13
15. But Cardinal values are difficult to rationalize
Implied PD for
FI’s = 9.1%
(40% recovery)
Source: FitchSolutions
www.fitchsolutions.com January 28, 2010 14
18. CDS liquidity signals uncertainty
Citigroup Inc. Lehman Brothers Holdings Inc. Royal Bank of Scotland Plc
(Liquidity Score)
12
RBS
percentile
Rk = 72 11
RBS
10 nationalization
RBS
Citigroup
percentile percentile
Rk = 63 9 Rk = 7
8
Lehman
percentile
Rk = 8 7
Citigroup
6 percentile
Citigroup Rk = 2
Lehman bankruptcy
capital injection
5
Jan 07 Jun 07 Nov 07 May 08 Oct 08 Mar 09 Sep 09
Source: Fitch Solutions
www.fitchsolutions.com January 28, 2010 17
19. CDS early warning proved valuable through the crisis
www.fitchsolutions.com January 28, 2010 18
20. A return to uncertainty for Financials, Sovereigns
Liquidity for 25 Most Liquid Financials vs Sovereigns
6
6.5
FS Liquidity Score
7
7.5
8
8.5
9
6/1/07
8/1/07
10/1/07
12/1/07
2/1/08
4/1/08
6/1/08
8/1/08
10/1/08
12/1/08
2/1/09
4/1/09
6/1/09
8/1/09
10/1/09
12/1/09
Financials Sovereigns
21. Using Fitch Solutions content to monitor Counterparty Credit Risk
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22. A counterparty risk manager requires timely and
accurate data to meet 3 key needs:
www.fitchsolutions.com January 28, 2010 21
23. Fitch client counterparty risk monitoring practices
● Mid-sized buy-side firm transacts with financial institutions for interest
rate, foreign exchange hedging, and utilizes banks for cash
management
– Short-list determined by screening the Fitch international bank universe for
firms with individual rating of ‘B’ or better, at least $100bn in assets and a
maximum leverage ratio.
– Per internal credit policy, maximum exposure limit scales with the Fitch
individual rating.
– The CRM has the ability to further limit exposure depending on perceived
risk migration. To do so, the CRM monitors the following on his portfolio of
counterparties :
– CDS Implied Ratings (and ‘gap’ with Agency ratings), CDS spot-
spreads and CDS benchmarks
– Fitch Ratings status (outlooks, watches) and research and
announcements
– Financial results
www.fitchsolutions.com January 28, 2010 22
24. Counterparty Risk Management Post-Lehman
● Increased focus on counterparty selection and credit risk monitoring
● CRMs have taken on additional responsibilities for anticipating future
credit events
● Information challenges persist in anticipating future movements in
credit risk assessments and potential credit events
● Integration of fundamental financial data, market data, agency ratings,
and fundamental research is essential for the contemporary
counterparty risk manager
www.fitchsolutions.com January 28, 2010 23
25. Fitch Solutions Research, Commentaries and Related Information
● All our research and commentaries can be found on www.fitchsolutions.com and include:
– Risk and Performance Monitor
– Weekly monitor assessing geographical CDS spread movements and market indicators of credit
risk
– Fitch Solutions/Credit 2009 Counterparty Risk Survey
– A write up of the survey we undertook with Credit into Counterparty Risk
– Fitch Solutions' Global CDS Liquidity Scores Commentaries
– Bi-weekly commentaries on the liquidity in the CDS market
– Quantitative Research
• Articles include: “Counterparty Risk for Credit Default Swaps”
● If you’d like to learn more about our products or research please contact the Fitch Solutions team:
– Jonathan.DiGiambattista@fitchsolutions.com – Catherine.Downhill@fitchsolutions.com
– Damiano.Brigo@fitchsolutions.com – Jesse.Waters@fitchsolutions.com
– Diana.Allmendinger@fitchsolutions.com
www.fitchsolutions.com January 28, 2010 24
26. Fitch Solutions New York London
www.fitchsolutions.com One State Street Plaza 101 Finsbury Pavement
New York, NY 10004 London
+1 212 908 0500 EC2A 1RS
+1 800 75 FITCH +44 20 7417 4222
Fitch Group Fitch Ratings Fitch Solutions Algorithmics
www.fitchsolutions.com January 28, 2010 25
