If anything, the financial crisis reminded us that counterparty risk is a critical consideration in risk management, and even more acute for corporations that also hold large cash balances deposited across many global banks. But what’s the best way to measure counterparty risk?
One suggestion from meeting sponsor PIMCO was that in thinking about measuring counterparty risk, it’s important to think about the direct and indirect risks. PIMCO advised members to set limits to percent held in each individual portfolio and think about correlated risk. It also outlined the three key factors in managing risk:
Consistency – ensure risk exposures are consistent with outlook and investment strategy and the intended risk-return profile.
Multiple approaches – combine insights from a variety of methodologies and models. Look to continually enhance models to adapt to changing market environments. Make sure the process measures counterparty, collateral, liquidity, and regulatory risks
Avoid surprises – use forward looking risk measures including stress testing.
Also, look at exposure daily and separate out direct exposure. The key is doing this daily so that with inflows and outflows, portfolio managers can rebalance. Everything about indirect exposure changes every day. But perhaps the best way to mitigate counterparty risk is to trade with the best counterparties and have the proper documentation. Have a policy of reviewing approved counterparties at least quarterly. Also look to trade with the best documentation possible.
One member related to the group that a scorecard process has been effective for his company. The member outlined for members the scorecard process the company uses to monitor counterparty risk. The scorecard includes data from Bloomberg, including daily stock and CDS price. He estimates that the company is able to capture 95% of its exposure and it factors this into the analysis. Also part of the process is incorporating exposure through money funds and SMA’s.
In the final analysis, critical to any risk management process is having the ability to aggregate exposure and monitor daily. Also important is staying current and adapting quickly to changes in the market.