Among the risks borne by banks, credit risk easily ranks first.

Not surprisingly, extensive systems have been developed during the past 30 years to support loans and the extension of credit to corporate and retail customers.

Only more recently, however, have banks recognized the enormous credit risk associated with their trading portfolios.

Consider a dealer who buys a security from a corporate client and then sells it back into the market. If the counterparty doesn't deliver on the trade as expected, the dealer will have to replace the security, possibly at a higher price, causing a loss. Managing counterparty credit risk is distinct both in practice and in theory from that associated with loan products.

In the past, banks managed credit risk for their corporate trading counterparties by using approximations, such as notional values, or the face value of the transaction. Credit lines were set up in much the same way as they were for loan products, and notional values outstanding were tracked against these limits.

But these practices frequently led institutions to overestimate credit risk. That's because, generally, the notional value is never actually exchanged.

Many traded products, such as interest rate swaps, require the exchange of cash flows based on a small percentage of notional value. Since banks are required to hold capital against potential credit losses, overstating these exposures could have a detrimental effect on the institution's profitability.

Banks are actively investigating new theories and practices to rectify these inaccuracies.

They are beginning to develop applications drawing on both market risk valuation techniques, such as default and recovery, to create a hybrid credit risk system that tries to measure exposure accurately and to predict maximum potential losses correctly. These systems will likely become the industry standard within seven years.

Today, counterparty credit is managed primarily through the use of limits. The limit is the maximum exposure allowed per customer. Limits are typically created annually and reviewed quarterly.

Most major institutions use these limits to compare current exposures based on a transaction's market value, plus something additional for future potential exposure (often a straight percentage of the notional amount, based on the type of transaction). These calculations are fairly simple and do not require sophisticated technology.

The most difficult part of estimating credit exposure in this manner is obtaining accurate data on which to perform the analysis. The Bank for International Settlements requires capital adequacy to be based on an exposure calculation done in this way.

More advanced institutions simulate future market conditions. In order to run a Monte Carlo simulation for credit purposes, however, it must take into account possible market conditions over the entire life of the transaction, which is often as long as 10 to 15 years.

These calculations are often intensive, require sophisticated algorithms, and can run for hours for a large portfolio.

An easier middle ground for calculating potential exposures is to multiply current exposure (that is, mark-to-market value) by a factor derived from the deal type and maturity. This factor, in effect, allows the institution to risk-weight its exposures.

Longer-dated, riskier transactions are weighted more heavily. These formulas also let banks accommodate their own views about the future in a proprietary and unique manner without requiring the extra time and power for Monte Carlo simulations. Many banks use this technique (or another, similar short cut) during the day to manage trading activities and then run more sophisticated simulations overnight for more accurate exposure calculations.

After calculating the current exposure and the potential exposure, an institution should be able to take into account any factor that might reduce credit exposure. This would include any netting agreement - typically, a bilateral agreement between counterparties that allows them to exchange net cash flows rather than gross amounts.

In addition, the transaction might be covered by multilateral netting schemes, such as Echo for foreign exchange, which let members settle only net cash flows for all foreign exchange trades with other members. Including netting in a credit exposure calculation is extremely complex due to the many different entities included both within the financial organization and within the counterparty.

For example, would a netting agreement between Chase London and Barclays Bank London cover a deal between Chase New York and Barclays London? What about a deal between Barclays Tokyo and Chase Hong Kong? The answers are unclear.

Beyond understanding the legal agreement between the entities and what it covers, an institution must know whether there is a legal foundation for netting in the country in which the trade will settle and whether netting has been proven legal in the case of default.

Inclusion of netting is becoming more common in credit calculations.

Other mitigating factors to include in the exposure calculation are current valuation of any collateral (for example, Treasury bills) and guarantees. Although both these concepts are fairly standard for commercial credits, neither is widely available for counterparty credit today. We expect that collateral management will, however, become an industry standard for trading institutions within three years.

Overall, we believe few institutions currently undertake adoption of counterparty credit risk systems but that virtually every financial institution in the top 300 globally will be involved in a project of this kind by the year 2000. The impact of this shift will be seen in spending, which is expected nearly to double over the next five years, to $1.2 billion.

Counterparty credit risk management is still very much in its infancy. Of the five major risk categories - market, credit, legal, liquidity, and operational - credit risk is often the largest monetary risk faced by a financial institution. With all the recent attention paid to market risk, however, credit has largely been neglected in the trading room in an effort to control fast-moving market exposures.

This is beginning to change as institutions begin to apply the knowledge gained in their market risk systems to the credit process. The first area of impact is counterparty credit, which, not coincidentally, is the most closely related to market risk in terms of methodology.

We anticipate the widespread adoption of counterparty credit risk management technology, which will necessarily accompany the changes described above. The first steps are being taken today, and most financial services companies worldwide will have begun projects within the next 18 months.

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