25. The Committees recognise that the notional amount of OTC derivative contracts does not reflect the actual counterparty risk. Credit risk for an OTC contract is best broken into two components, current credit exposure to the counterparty and the potential credit exposure that may result from changes in the market value underlying the derivative contract.

26. To the extent possible, credit risk from derivatives should be considered as part of an institution's overall credit risk exposure. This should include exposure from other off-balance-sheet credit instruments such as standby letters of credit as well as the credit risk from on-balance-sheet positions. Moreover, since organisations are increasingly using credit derivatives to adjust their credit risk exposures, supervisors should be aware of the involvement of institutions with credit derivatives and their impact on institutions' overall credit risk exposure.

(a) Current credit exposure

27. Current credit exposure is measured as the cost of replacing the cash flow of contracts with positive mark-to-market value (replacement cost) if the counterparty defaults. Legally enforceable bilateral netting agreements can significantly reduce the amount of an institution's credit risk to each of its counterparties. These netting agreements can extend across different product types such as foreign exchange, interest rate, equity-linked and commodity contracts. Therefore, an institution's current credit exposure from derivative contracts is best measured as the positive mark-to-market replacement cost of all derivative products on a counterparty by counterparty basis, taking account of any legally enforceable bilateral netting agreements.

28. For individual institutions, breaking out the gross positive and negative market values of contracts may have supervisory value by providing an indication of the extent to which legally enforceable bilateral netting agreements reduce an institution's credit exposure.

(b) Potential credit exposure

29. In light of the potential volatility of replacement costs over time, prudential analysis should not only focus on replacement cost at a given point in time but also on its potential to change. Potential credit exposure can be defined as the exposure of the contract that may be realised over its remaining life due to movements in the rates or prices underlying the contract. Since legally enforceable bilateral netting agreements can significantly reduce the amount of an institution's credit risk to each of its counterparties, measures of potential credit exposure can take account of these agreements. For banks, under the requirements of the 1988 Basle Capital Accord, potential exposure is captured through a so-called "add-on", which is calculated by multiplying the contract's gross or effective ¹⁰ notional principal by a conversion factor that is based on the price volatility of the underlying contract. Bank supervisors should therefore evaluate information on the add-ons that banks must already compile for their risk-based capital calculations. Such information could include notional amounts by product category (i.e. interest rate, foreign exchange, equities, precious metals and other commodities) and by remaining maturity (i.e. one year or less, over one year to five years and more than five years). The Basle Accord defines remaining maturity as the maturity of the derivative contract. However, supervisors could also take into account information on the instrument underlying the derivative contract.

30. Some banks and securities firms have developed sophisticated simulation models that may produce more precise estimates of their potential credit exposures than under the add-ons approach, and supervisors may wish to take account of the results of these models. These models are generally based on probability analysis and techniques modelling the volatility of the underlying variables (exchange rates, interest rates, equity prices, etc.) and the expected effect of movements of these variables on the contract value over time. Estimates of potential credit exposure by simulations are heavily influenced by the parameters used (a discussion of the major parameters that can influence simulation results is included in the market risk section below). Supervisors and firms should discuss the parameters and other aspects of the models to ensure an appropriate level of understanding and confidence in the use of such models.

(c) Credit enhancements

31. Information on credit enhancements used in connection with OTC derivative transactions is important to an effective supervisory assessment of the credit risk inherent in an institution's derivatives positions. Collateral can be required by an institution to reduce both its current and potential credit risk exposure. Collateral held against the current exposure of derivative contracts with a counterparty effectively reduces credit risk and, therefore, merits supervisory attention. However, supervisors need to consider the legal enforceability of netting agreements and the quality and marketability of collateral ¹¹. For supervisory analysis purposes, collateral held by an institution in excess of its netted credit exposure to a counterparty would not reduce current credit exposure below zero but could reduce potential credit exposure. Supervisors could obtain a better understanding of how collateral reduces credit risk by collecting information separately on collateral with a market value less than or equal to the netted current exposure to the counterparty and collateral with market values in excess of the netted current exposure and of the nature of that collateral.

32. OTC contract provisions that require a counterparty to post initial collateral (or additional collateral as netted current exposure increases) may be used to reduce potential credit exposure. An OTC contract that is subject to a collateral or margin agreement may have lower potential exposure, since collateral would be required in the future to offset any increase in credit exposure. Accordingly, information about the notional amount and market value of OTC contracts subject to collateral agreements could enhance supervisory understanding of an institution's potential credit risk.

(d) Concentration of credit risk

33. As with loans, an identification of significant counterparty OTC credit exposures relative to an institution's capital is important for an evaluation of credit risk. This information should be evaluated together with qualitative information on an institution's credit risk controls. To identify significant exposures and limit reporting burden, supervisors could focus on those counterparties presenting netted current and potential credit exposure above a certain threshold. As a minimum, supervisors could identify the ten largest counterparties to which an institution is exposed, subject to the minimum threshold used.

34. Since counterparty exposure may stem from different instruments, overall risk concentrations with single counterparties or groups of counterparties cannot be measured accurately if the analysis is limited to single instruments (e.g., swaps) or classes of instruments (e.g., OTC derivatives). For this reason, institutions should aim to monitor counterparty exposures on an integrated basis, taking into consideration both cash instruments and off-balance-sheet relationships. Supervisors could also consider information on exposure to counterparties in specific business sectors or to counterparties within a certain country or region. Since credit derivatives may be used to adjust a company's credit risk concentration, supervisors should consider how the institution reflects the impact of credit derivatives when evaluating exposures to counterparties, including those in specific business sectors, countries or regions.

35. Supervisors could also analyse information on aggregate exposures to various exchanges, both on- and off-balance-sheet, and on exposures to certain types of collateral supporting derivative instruments. Overexposure to specific issues or markets can lead to additional credit concerns, particularly in the case of banks and securities firms with significant activity in securities markets. Some securities supervisors address this concentration risk by deducting from capital all positions above a certain level of market turnover or by applying some other suitable benchmarks. Supervisors without such provisions should ensure that they are at least informed about these concentrations, whether in the form of holdings of the underlying security itself or in the form of OTC derivatives positions which require the firm to deliver or receive such concentrated positions.

36. Many financial institutions are developing or purchasing credit risk models. These models, once validated and fully integrated into the risk management process of the financial institution, can be used to conduct stress testing or scenario analysis. Scenarios can reflect past historical credit cycles, periods of market distress, or forward-looking analysis of current vulnerabilities, especially those which could impact the financial institution. The results of such stress testing/scenario analysis, especially when based on a thoughtful assessment of the model's underlying assumptions, could be helpful in identifying concentrations, especially complex concentrations involving multiple sectors or risk factors.

(e) Counterparty credit quality

37. Credit risk is jointly dependent upon credit exposure to the counterparty and the probability of the counterparty's default. Information on the current and potential credit exposure to counterparties of various credit quality would increase supervisory insights into the probability of credit loss. Information indicative of counterparty credit quality includes total current and potential credit exposure - taking into account legally enforceable bilateral netting agreements - to counterparties with various characteristics, e.g., Basle Capital Accord risk weights (for banks), credit ratings assigned by rating agencies, or the institution's internal credit rating system. Information on guarantees, standby letters of credit, or other credit enhancements may also enhance supervisory understanding of credit quality. Aggregate information on past-due status and past-due information by major counterparties, together with information on actual credit losses, may be of particular interest for identifying pending counterparty credit quality problems in the OTC derivatives markets.

38. As financial institutions employ credit risk models, measures of credit risk and analyses of credit derived from these models may be useful to supervisors (together with other information on the credit risk of the institution's positions and activities), such as analyses of the relationship of risk and return in the overall credit portfolio, the marginal contribution to overall risk of business lines or credit portfolios, and other measures.

Footnotes:

9. Credit risk is of most concern in the case of OTC derivative contracts since exchange clearing houses for derivatives employ risk management systems that substantially mitigate credit risks to their members. Both futures and options exchanges typically mark exposures to market each day. In the case of futures exchanges, members' exposures to the clearing house are eliminated each day, and often intra-day, through variation margin payments. In the case of options exchanges, clearing house exposures to written options are fully collateralised.

10. Effective notional principal is obtained by adjusting the notional amount to reflect the true exposure of contracts that are leveraged or otherwise affected by the structure of the transaction.

11. For example, supervisors could obtain additional insights through information on OTC contracts with collateral recognised under the Basle Capital Accord (for banks) and OTC contracts with other readily marketable, high quality securities as collateral.