Credit risk limits are part of a well-designed limit system. They should be established for all counterparties with whom an institution conducts business, and no dealings can begin before the counterparty’s credit limit is approved. The credit limits for each counterparty must be aggregated globally and across all products (i.e. loans, securities, derivatives) so that a firm is aware of its aggregate exposure to each counterparty. Procedures for authorising credit limit excesses must be established and serious breaches reported to the supervisory board. These limits should be reviewed and revised regularly. Credit officers should also monitor the usage of credit risk by each counterparty against its limits. Researching the identity and legal status of a new client should be part and parcel of any credit assessment of new counterparties. Staff should be encouraged to put a face to all counterparties and should not be overwhelmed or seduced by a client’s reputation into authorising unjustified credit lines.

Box 6

Counterparty credit risk - a snapshot

General Electric uses the criteria set out below whenever it enters into an interest rate or currency swap. Once a counterparty exceeds the credit exposure limits shown in the table below, no additional deals are allowed until the exposure with that counterparty is reduced to an amount within the established limit. Open contracts remain in force. Table 1: Counterparty credit criteria Credit Rating Moody's Standard & Poor's Term of transaction Between one and five years Aa3 AA- Greater than five years Aaa AAA Credit exposure limits Up to $50 million Aa3 AA- Up to $75 million Aaa AAA Source: GE Annual Report 1995

Senior managers should try to reduce counterparty risks by putting in place master netting as well as collateral agreements. Under a master netting agreement, losses associated with one transaction with a counterparty are offset against gains associated with another transaction so that the exposure is limited to the net of all gains and losses related to the transactions covered by the agreement. The Basle Committee for Banking Supervision estimates that netting reduces current (gross) replacement value on average by 50% per counterparty. However, board members, senior management and line personnel must be aware that netting agreements are not yet legally enforceable in several European and Asian countries; a factor which they must take into consideration in their daily dealings with counterparties in these countries; not to do so will engender a false sense of security. The forms of collateral generally accepted are cash and government bonds.

Box 7

Halving credit risk

The following table, which appeared in Bankers Trust’s 1995 annual report shows how much the credit risk of the firm’s derivatives-related transactions was reduced by netting and collateral. The New York-based bank disclosed the institution’s credit risk at the end of 1995 by breaking its client base into three groups along the lines of its internal rating system. Ratings 1-4 is equivalent to investment grade-ratings (triple-B and higher); rating 5 about equal to double-B and ratings 6 to 8 equivalent to single B and below. Shareholders were given the impact of netting and collateral for every category. Table 2 ($ in millions) December 31,1995 Internal Rating for Customer 1 to 4 5 6 to 8 TOTAL Remplacement costs (gross) 25,461 2,259 186 27,906 Impact of netting agreements (17,082) (1,371) (11) (18,464) Remplacement costs (after netting) 8,379 888 175 9,442 Collateral held and applied (433) (282) (44) (759) Remplacement costs after netting and collateral 7,946 606 131 8,683 Extracted from: Bankers Trust 1995 annual report It is clear that the bank has more netting agreements in place with investment grade counterparties than with those rated single-B or less. Consequently, the credit risk of investment grade counterparties is reduced by about 67%, compared with 60% for double-B and only 6% for single-B clients. But as expected, the bank demanded more collateral for transactions with single-B counterparties than with investment grade customers, in percentage terms. Only 2% of the gross replacement value of investment-grade deals were collateralised, 12% for double-B and 24% for single-B and below. The value of collateral held as a percentage of net replacement costs was 5% for triple-B and above, 32% for double-B and 25% for single-B and below.