The risk of a trading partner not fulfilling his obligations in full on due date or at any time thereafter is a risk that affects all aspects of business. Among the risks that face financial institutions, credit risk is the one with which we are most familiar. It is also the risk to which supervisors of financial institutions pay the closest attention because it has been the risk most likely to cause a bank to fail.

With traditional instruments such as loans, bonds or currency trading, the amount which the counterparty is obliged to repay is the full or principal amount of the instrument. For these instruments, the amount at risk equals the principal amount. Derivatives are different - because they derive their value from an underlying asset or index, their credit risk is not equal to the principal amount of the trade, but rather to the cost of replacing the contract if the counterparty defaults. This replacement value fluctuates over time and is made up of current replacement and potential replacement costs.

It is relatively straightforward to measure current replacement cost. The Basle Committee for Banking Supervision recommends using the current mark-to-market value of the contract. Potential replacement value is harder to estimate because it is a function of the remaining maturity (which is given), as well as the expected volatility and price of the underlying asset, both of which can fluctuate considerably. The Basle Committee recommends multiplying the notional principal of a transaction by an appropriate percentage, which it calls the 'add-on', to arrive at a potential replacement value.

The derivative industry, however, feels that potential replacement cost is best measured by either Monte Carlo or historical simulation, probability analysis and option valuation models. Their analysis generally involves modelling the volatility of the underlying variables and the effect of movements on these variables on the value of the derivatives contract. These techniques are often used to generate two measures of potential exposure: average or "expected" exposure and maximum or "worst case" exposure.

In a "Framework for Voluntary Oversight"(1995), the Derivatives Policy Group, representing some of the largest American securities houses, explains their recommended method. The OTC derivatives portfolio of each counterparty (regardless of whether the net replacement value is positive or negative) would be subject to the capital at risk calculation used for estimating portfolio market risk. Thus, for each counterparty, a firm would calculate, as a proxy for potential credit exposure to the counterparty, the maximum loss over a two-week period, likely to be exceeded with a probability of one percent, ignoring for these purposes any legally enforceable right of the firm to call for the transfer of collateral on a prospective basis. This number would then be multiplied by the counterparty's applicable default ratio, based on the firm's internal credit rating for the relevant counterparty, to arrive at an estimate of the potential credit risk. The total potential credit risk for the firm would be the sum of all the individual counterparty calculations of potential credit risk.

But VaR is not recognised by supervisors as a measure of credit risk because data on both defaults and recovery rates are not extensive and credit returns are highly-skewed and fat-tailed. In "Methodologies for Determining Minimum Capital Standards for Internationally Active Securities Firms Which Permit the Use of Models Under Prescribed Conditions" (1998), the Technical Committee of IOSCO outlines these reasons. IOSCO's reservations were further amplified by the Basle Committee on Banking Supervision in April 1999.

The Basle Committee notes that credit risk models are not a simple extension of their market risk counterparts for two key reasons - data limitations and model validation. In a comprehensive and most up-to-date analysis of the state of credit risk modelling, the Committee notes that the above two factors are the main hurdles to credit risk models being the basis for regulatory capital. "Credit Risk Modelling: Current Practices and Applications" (1999) is the perfect introduction to the types, conceptual issues and limitations of credit risk models being used by the world's largest banks. The Task Force which wrote the report used material culled from public and private conferences by market practitioners and a survey of modelling practices at 20 large international banks located in 10 countries.

The Committee notes that data limitations are a key impediment to the design and implementation of credit risk models. Most credit instruments are not marked to market, and the predictive nature of a credit risk model does not derive from a statistical projection of future prices based on a comprehensive record of historical prices. The scarcity of the data required to estimate credit risk models also stems from the infrequent nature of default events and the longer-term time horizons used in measuring credit risk. The longer time horizons also make validating credit risk models much more difficult than backtesting market risk models. Where the latter typically employ a horizon of a few days, credit risk models generally rely on a time frame of one year or more. The longer holding period, coupled with higher confidence intervals used in credit risk models, presents problems to model-builders in assessing the accuracy of their models. By the same token, a quantitative validation standard similar to that in the Market Risk Amendment would require an impractical number of years of data, spanning multiple credit cycles.

In its evaluation of models for setting regulatory capital , the Task Force separated the issues it identified into three categories:

1. conceptual methodology. Under this category are topics such as the conceptual definition of credit loss (the default-mode paradigm or the mark-to-model paradigm), different techniques to measure the interdependence of factors that contribute to credit losses, the aggregation of credit risk and unconditional and conditional models.

2. Parameter specification and estimation. For example, the specification of the process of default and rating migration is severely constrained by a lack of data on the historical performance of loans and other modelled variables. Such data limitation encourage the use of various simplifying assumptions which affect the model's accuracy.

3. Validation. At present there is no commonly accepted framework for periodically verifying the accuracy of credit risk models. Banks have indicated the use of higher confidence intervals in the measurement of credit risk than those used for market risk. It is unclear whether such high confidence intervals can be estimated reasonably accurately, and it is not yet well understood what the effect of modelling assumptions is on the extreme tails of distributions, and hence on the amount of capital needed to support risk-taking. Furthermore, there is still an issue as to whether the use of high confidence intervals would produce capital requirements that are highly model-dependent, or are not comparable across institutions. The Committee is seeking comments on the report by October 1, 1999.

The measurement of credit risk is clearly explained in a "Working paper of the Credit Risk Measurement and Management Subcommittee", part of appendix 1 which accompanied the G-30 report on derivatives (1993). This document is a good introduction to credit risk because it covers all the main aspects of credit risk - aggregation, probability of default and expected loss measurements, credit risk management and controls, netting, and credit enhancement - in understandable, technical language. The full appendix is available from the G-30.

Financial institutions' management of credit risk has been the focus of regulatory initiatives in the first half of 1999. This is because exposure to credit risk continues to be the leading source of problems in banks worldwide. As a result the Basle Committee on Banking Supervision released three related reports on credit risk management and disclosure, while the Joint Forum on Financial Conglomerates released one on credit concentrations.

"Principles for the Management of Credit Risk" (1999) sets out 17 principle to address five main areas: establishing an appropriate credit risk environment, operating under a sound credit granting process, maintaining an appropriate credit administration, measurement and monitoring process, ensuring adequate controls over credit risk and the role of supervisors. The board of directors of a bank should for example, should be responsible for the bank's credit strategy - which should include a statement of the bank's willingness to grant credit based on type, economic sector, geographical location, currency, maturity and anticipated profitability. This would include the identification of target markets and the overall characteristics that the bank would want in its credit portfolio, including levels of diversification and concentration tolerances. In a direct reference to the United Bank of Switzerland/Long Term Capital Management debacle (for full story, See Introduction to Risk - Lessons from the collapse of LTCM) , the Committee stipulates that board members and senior management should not override the credit-granting and monitoring processes of the bank. Another lesson which regulators drew from their post-mortems over LTCM was the fact that collateral cannot be a substitute for a comprehensive assessment of a counterparty. The Committee recommends that transactions should be entered into primarily on the strength of the borrower's repayment capacity.

Banks are also urged to consider the results of stress testing in the overall limit setting and monitoring process. Banks' credit limits should recognise and reflect the risks associated with the near-term liquidation of positions in the event of a counterparty default. Where a bank has several transactions with a counterparty, its potential exposure to that counterparty is likely to vary significantly and discontinuously over the maturity over which it is calculated. Potential future exposures should therefore be calculated over multiple time horizons. Limits should also factor in any unsecured exposure in a liquidation scenario.

The Basle Committee notes that a "a continuing source of credit-related problems in banks is concentrations within the credit portfolio." So banks are urged to have management information systems to identify concentrations of risk and particular sensitivities to such risks because a bank with significant concentrations in certain areas will be exposed to adverse changes in the area in which the credits are concentrated.

The Joint Forum of banking, securities and insurance regulators has echoed similar concerns in its issuance of "Risk Concentration Principles" (1999). The forum defines a risk concentration as an exposure with the potential to produce losses large enough to threaten a financial institution's health or ability to maintain its core operations. The paper outlines five principles which supervisors should use when dealing with concentration risk of financial conglomerates. These include reinforcing firm-level processes with supervisory limits and promoting public disclosure of risk concentrations at the group-wide level.

Accompanying the credit risk management principles consultative paper is the "Best Practices for Credit Risk Disclosure" (1999). Information disclosed should be relevant and timely; reliable, comparable and material and cover five broad areas - accounting policies and practices; credit risk management; credit exposures; credit quality and earnings. In July 1999, the Basle Committee released "Sound Practices for Loan Accounting and Disclosure" . Supervisors have four main concerns regarding loan accounting: (a) the adequacy of an institution's process for determining allowances, (b) the adequacy of the total allowance, (c) the timely recognition of identified losses through either specific allowances or charge-offs and (d) timely and accurate credit risk disclosures. Thus the paper offers guidance on key loan accounting issues, such as the initial recognition and measurement of loans, subsequent measurement of impaired loans, the establishment of loan loss allowances, and income recognition. There are 26 principles enunciated.

Better control of counterparty risk management is one of the main recommendations resulting from the President’s Working Group on Financial Markets’ analysis of the lessons to be learnt from the Long-Term Capital Management debacle. In its report on "Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management (1999)" , the working group recommends that the private sector should address, amongst others, the following areas in counterparty risk management:

• Procedures for estimating potential future credit exposures, including stress testing to gauge exposures in volatile and illiquid markets, and model validation procedures including back-testing.
• Approaches to setting limits on counterparty credit exposures
• Approaches to limit concentration of credit exposures and concentration of exposures to particular markets
• Policies regarding the use of collateral to mitigate counterparty credit risks
• Valuation practices for derivatives and collateral.

Because most OTC derivatives are settled bilaterally, counterparty credit risk is the most significant risk facing derivative dealers. Dealers use close-out netting agreements to help reduce this risk. A master agreement typically provides that, in the event of a counterparty's default, the non-defaulting counterpary can accelerate and terminate all outstanding transactions and net the transactions' market values so that a single sum will be owed by, or owed to, the non-defaulting counterparty. In recent years, dealers have expanded the use of collateral to mitigate counterparty credit risk. "OTC Derivatives: Settlement Procedures and Counterparty Risk Management" (1998), a report issued by the central banks of the G-10 countries, estimates that dealers with the most advanced programmes collateralise transactions with between 10 to 30% of their counterparties. Collateral is used most widely by dealers located in the United States and the United Kingdom.

The most widely used collateral agreement is the International Swap and Derivatives Association (ISDA) credit support annex (CSA.) But the use of collateral brings with it attendant legal, liquidity and operational risks. (See Key risk concepts - other risks.) For example, the administration of collateral agreements requires complex information systems and a variety of internal controls. If, as a result of systems deficiencies, transactions or collateral are being valued inaccurately or the terms of collateral agreements are inaccurately recorded, insufficient collateral may be called. Collateral holdings must be monitored to ensure that collateral is received when called. The Committee on Payment and Settlement Systems and the Euro-Currency Standing Committee who wrote the report recommend that supervisors should consider developing supervisory guidance on the use of collateral and that all interested parties should encourage governments to take action to reduce unnecessary legal uncertainty.

The collateral issue figured prominently in the Basle Committee's analysis of the relationship between highly leveraged institutions (HLIs) and banks. In a paper prompted by the near collapse of Long Term Capital Management, the Committee said that "there had not been an appropriate balance among the key elements of the credit risk management process, with an over reliance in collateralisation of mark-to-market procedures." "Sound Practices for Banks' Interactions with Highly Leveraged Institutions" (1999) thus sets out recommendations on how banks should align collateral, early termination and other contractual provisions with the credit quality of HLIs, taking into account the particular characteristics of these institutions such as their ability to rapidly change trading strategies, risk profiles and leverage. The committee recommends that if a bank does not receive meaningful financial information on a sufficiently frequent basis, then it should require the HLI to post excess collateral even when the bank has no current exposure. In accepting collateral from HLIs, banks must assess and take into account the correlation between the probability of counterparty default and the likelihood of collateral being impaired owing to market, credit or liquidity developments. It noted, "Experience has shown that in stressed -market conditions, all but the most liquid securities issued by the best credits worldwide may be downgraded owing to a broad-based flight to quality, during or preceding the default of a major HLI."

The Committee also recommended that banks focus their efforts on developing meaningful measures of potential credit exposure to give an accurate picture of a bank's credit risk. Banks are also asked to develop more effective measures for assessing the unsecured risks inherent in collateralised derivatives positions. At the moment, many banks calculate just one measure of potential future exposure, typically over the life of the contract which do not provide a meaningful measure of unsecured credit risk . Shorter horizons would be necessary to capture the exposure arising over the time needed to liquidate and rebalance positions and to realise the value of collateral if a margin call is not met. Banks are also asked to develop and implement timely and plausible stress tests for counterparty credit exposures. These tests should consider the liquidity impacts on underlying markets and positions and the effect on the value of any pledged collateral.

On a more general level, the committee recommends that banks assess whether dealings with HLIs are consistent with the bank's own credit risk strategy and appetite. If so, the bank must establish procedures to effectively monitor and control these relationships; procedures which should not be overridden by competitive pressures. The paper recommends that HLIs which do not provide meaningful credit information should face tougher credit conditions, including for instance, a higher margin level, no loss threshold and a narrower range of assets which are deemed acceptable for collateral.

Because credit risk can be the undoing of a financial institution, banks are required to set aside capital to cover the risk of defaulting customers. The most important regulatory document on credit risk is thus the "International Convergence of Capital Measurement and Capital Standards"which sets out the framework for credit risk capital. Released by the Basle Committee in 1988, the document outlines how different asset classes (both on and off-balance sheet) are weighted according to their riskiness. OECD-government debt, for example, has a zero or low weight while loans fully secured by mortgages on residential property are weighted at 50% and unsecured loans to corporations carry a weight of 100%. The Basle Committee has issued a consultative document to supercede the 1988 weightings. The "Consultative Paper on a New Capital Adequacy Framework" (1999) proposes a risk-weighting system based on external credit ratings rather than just whether a loan is sovereign or non-sovereign debt. So the debt of an OECD country rated single A will have a risk weighting of 20% while that of a triple-A will still enjoy the zero weighting. Corporate debt will also enjoy the graduated weightings so that a double-A rated corporate loan will be risk-weighted at 20% while a single-A 100%. The committee has also introduced a higher-than-100% risk weight for certain low quality exposures.

The report also advocates providing the proper capital incentives for credit risk mitigation techniques. For example, under the 1988 Accord, there is only minimal capital relief for collateral. In some cases the Accord's structure may not have favoured the development of specific forms of credit risk mitigation techniques by placing restrictions on both the type of hedges acceptable for achieving capital reduction and the amount of capital relief. The types of collateral and third party guarantees were restricted to securities issued by OECD central government and public sector entities and some multilateral development banks. The Committee is now proposing to expand eligible guarantors to those that attract lower risk weights than the underlying exposure. It is also considering expanding eligible collateral to include all financial assets, not just marketable securities, that attract a risk weighting lower than the underlying exposure. Eligible collateral could include accounts receivable from AAA/AA companies, or cash flows from derivatives contracts.

Off-balance sheet assets are converted to credit risk equivalents by multiplying the notional principal amounts by a credit conversion factor, the resulting amounts then being weighted according to the nature of the counterparty. For example, standby letters of credit serving as financial guarantees for loans carry a 100% credit risk conversion factor while revolving underwriting facilities require 50%. Two methods were originally suggested for calculating the credit risk of derivatives. The first was to use the current replacement cost plus an add-on to account for potential exposure. The add-ons are based on the notional principal of each contract and vary depending on the volatility of the underlying asset and the contract's maturity. The second, known as the original maturity/exposure method, does not take into account current value, but is expressed solely as a fraction of notional principal, the fraction being determined according to asset type and contract maturity. This second method is discontinued now that there are market risk capital requirements.

Banks are now allowed to set aside less capital for credit risks. This was because the Basle Committee released a new add-on formula in 1995, which recognised the risk reduction effects of netting. The formula and all the Basle percentage factors for different underlying assets and maturities are contained in "The Treatment of Potential Exposure for Off-Balance Sheet Items (1995)".

The Capital Accord makes a distinction between exchange-traded and over-the-counter derivatives; only the latter need credit risk capital because the daily payment and receipt of margin at an exchange's clearing house covers the credit risk of exchange-traded instruments. A "Report on Margin (1996)" written by the Technical Committee of IOSCO explains how margins are set, collected and monitored. It also contains details of margin requirements and default procedures of all major exchanges worldwide.

Regulators do not just use capital to guard against the downside of credit risk. The Basle Committee has also issued some supervisory guidelines which are enshrined in the "Core Principles for Effective Banking Supervision"(1997). Principles 7 to 11 deal with credit-granting standards and the credit monitoring process; the assessment of asset quality and adequacy of loan loss provisions and reserves; the concentrations of risk and large exposures; connected lending and country and transfer risk.

Supervisors require banks to review regularly the bank's individual credits, asset classification and provisioning. They must also set prudential limits to restrict bank exposures to single borrowers, groups of related borrowers and other significant risk concentrations. These limits are usually expressed in terms of a percentage of bank capital and, although they vary, 25% of capital is a typical limit. Anything below 10% would not seem realistic bearing in mind the present portfolios of many banks. To prevent abuses from arising from connected lending, banking supervisors must ensure that such lending is conducted only on an arm's-length basis and that the amount of credit extended is monitored.

A guide to appropriate controls on concentrations of credit risk is contained in "Measuring and Controlling Large Credit Exposures"(1991). The paper defines a credit exposure as the amount of credit risk arising from both actual claims (including participations, equities and bonds) and potential claims of all kinds (e.g. future claims which the bank is committed to provide), as well as contingent liabilities. One of the main problems of controlling large credit exposures is the accurate identification of potential linkages between exposures to single debtors (who appear independent but are legally or economically interrelated.) The paper suggests supervisors look at common ownership, common directors, common managers, cross-guarantees and direct commercial interdependency, which cannot be substituted in the short-term as a means of identifying related counterparties. Whatever the maximum limits for large exposures, the Basle Committee recommends a reporting threshold somewhat below the maximum. The supervisor can then devote particular attention to those exposures above the threshold and if it judges it desirable, require banks to take preventative action before the exposure becomes too risky.

Regulatory documentation on default so far has concentrated on default procedures, and mainly from an exchanges' viewpoint. None have addressed the question of how to calculate the probability of default or how to incorporate it into an expected loss measurement. Of the documents on-line on this service, a "Framework for Voluntary Oversight" urges firms to multiply the potential credit exposure by the counterparty's applicable default ratio derived from credit rating agencies. (see paragraph 5 above).

In a "Report on Co-operation between Market Authorities and Default Procedures (1996)" the IOSCO Technical Committee identifies the procedures for identifying the relevant circumstances which may prompt an exchange to take action against a market participant. Exchanges are also encouraged to clarify how they treat both customer and proprietary positions, the mechanisms they have in place to address a defaulting member's and/or clearinghouse's obligations to other counterparties, and how they communicate with other participants when a default happens.

See overviews on capital adequacy, market integrity and systemic safety

• Measuring and Controlling Large Credit Exposures (1991)
• International Convergence of Capital Measurement and Capital Standards (1993)
• Working paper of the Credit Risk Measurement and Management Subcommittee (1993)
• The Treatment of Potential Exposure for Off-Balance Sheet Items (1995)
• Report on Margin (1996)
• Report on Co-operation between Market Authorities and Default Procedures (1996)
• Framework for Voluntary Oversight (1995)
• Core Principles for Effective Banking Supervision (1997)
• Sound Practives for Banks' Interactions with Highly Leveraged Institutions (1999)
• Credit Risk Modelling: Current Practices and Applications (1999)
• Consultative Paper on a New Capital Adequacy Framework (1999)
• Principles for the Management of Credit Risk (1999)
• Risk Concentration Principles (1999)
• Best Practices for Credit Risk Disclosure (1999)
• Sound Practices for Loan Accounting and Disclosure (1999)

Latest Update February 2000