Counterparty prestige risk remains a multi-faceted problem and over the past few years institutions have had to advent it in stages. Since it is such a complicated issue to address institutions are increasingly seeing to vendors for solutions. The issues of gigantic data management, scalable technology infrastructure and industrialized prestige analytics have been looked at ad infinitum, however the modern accident has brought a renewed focus to the field and increasingly vendors are foremost the way with innovation and best practice.
If you roll back the calendar a few years, you would return to an era where the retail/commercial banks addressed the problem from one angle and investment banks looked at it from a derivatives perspective. As the necessity to free up capital grew within the strongest of these institutions as a effect of an increase in consolidation, the business was introduced to innovative processes and increasingly the onus of responsibility was shifted onto senior management.
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With this rise in capital requirements came changes to course and normal procedures for analysing counterparty risk management. As it matured, the management of counterparty risk moved towards a much more active role that included hedging. As responses to the accident in terms of dramatically increased capital requirements and needful responsibility for prestige value shifted, newly formed internal groups or third parties, all charged with the responsibility of pricing and managing counterparty risk for an organisation started to take greater control.
This increased need to free up capital coupled with the increase in capacity resulted in the hedging and pricing of counterparty prestige risk along with the hedging of hereafter exposure levels and capital reserves. This is turn allowed for an extensive increase in trading capacity with counterparties.
The hedging and pricing of counterparty prestige risk appealed to many, as it collapsed prestige risk management into the more mature and better understood market risk institution and it quickly became a very standard formula for incorporating the prestige variable into pricing models. Counterparties that had enough excellent debt to set-off against derivative exposures were specially selected. Instances where the bank owed the counterparty were particularly attractive, as those bonds yielded a higher return and could be marked up to face value in the event of default. The banks gained a distinct contentious advantage when they priced derivatives in this manner since the Cva reduced the unlikeness between what they saw as "risky" versus those that were deemed to be "risk-free", with minimal capital charge due to the hedge being replicated.
A few institutions determined transitioning as much of their prestige folder as potential into this market model, using bilateral set off wherever potential and the unilateral option model for all things else. The idea seemed uncostly at the time - but was it...?
With over 90% of corporate derivatives being simple interest rate and cross-currency swaps, using risky discounting for each stock type was for real credible at the time. Trades that were actively managed in this way were simply tagged and diverted from the support model. The extreme undoing for this model was that, under the close scrutiny of today, you would have the marginal price under the unilateral model being consistently higher than under the simulation model.
The other huge feebleness in this model was in the practicality of having each trading desk administrate prestige risk or be willing to exchange it to a central desk. The traders needed prestige expertise in increasing to knowledge of the markets they traded. As well as all of that, the systems being used had to be substantially upgraded. This raised flags of a dissimilar nature for firms, as they tried to make sense about exactly where prestige risk management responsibility should lie.
When the financial accident struck with all its vengeance, you could quickly see that firms that had an integrated advent to prestige risk management survived while those that had a fragmented advent struggled. Improving counterparty risk management processes is a global priority and the gap is ordinarily shrinking. For some banks the new accounting requirements have caused them to revisit the front-office market model with its known deficiencies, as a stop-gap measure. However, those firms are still struggling and increasingly they are turning to vendors to aid them in the implementation of complicated real-time Cva simulation.
But with many banks still trying to implement simulation models over all products, there are some who are flourishing. Holding portfolios where 80% of their counterparty risk falls into 20% of their business, they are regarding themselves with other items. Increased legislation such as Basel Iii are pushing these institutions on elements such as clearing but again, these will evolve as we move forward. And as they do move forward, those large dealers will need to more actively administrate their capital. Vendors are increasingly providing solutions that are transparent and cost-effective. Addressing the ever-changing landscape of counterparty range with solutions that meet security and responsibility levels for all parties is why today's vendors are uniquely positioned to impact everyone's future.
Counterparty Collections - Which Way Will They Go Next?
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