In 1973, when the Basel Accord was in its early gestation period, global derivatives markets were primarily comprised of exchange-traded commodity derivatives. Four decades later, the derivatives markets total about $632 trillion and are overwhelmingly over the counter.

The Basel Committee on Banking Supervision has had quite a challenge keeping up with bankers' incredible ability to create new derivatives products at a break-neck pace and to make recommendations on how banks should properly calculate for risks arising from derivatives transactions, especially those that are OTC.  

A few weeks ago, the committee published a consultative paper on capitalizing derivatives' counterparty risk exposures. I view the recommendations as an important step in requiring banks to better measure and monitor their derivatives counterparties' credit quality. While the proposal with its numerous, detailed formulae is unlikely to be on anyone's summer beach reading list, it is very important for those wanting to understand how globally systemically important banks should calculate for this subset of credit risk in their trillion dollar derivatives portfolios.

Before the financial crisis, participants clearly failed to focus adequately on the fact that their derivatives' counterparty credit quality might deteriorate or might even fail before their underlying asset does. If you ignore your counterparty's credit quality and only focus on the underlying reference asset, you are essentially assessing greater value to your derivatives' contracts than they are really worth. When the counterparty fails, especially if unexpectedly, you are stuck with positions worth less than you had thought, and importantly you run a significant risk of not having enough capital to sustain unexpected losses. Think of those banks that had any type of derivatives with Lehman Brothers or AIG in September 2008.

The Basel Committee has issued prior guidance on counterparty charges, but this guidance has had significant shortcomings. These shortcomings, which the new consultative paper proposes to address, include:  

  • Existing framework does not differentiate between margined and unmargined transactions.
  • The supervisory credit conversion factors do not sufficiently capture the level of volatilities as observed over stress periods within the last five years.
  • The supervisory add-on factors do not sufficiently capture the level of volatilities as observed over the recent stress periods.
  • Recognition of hedging and netting benefits is too simplistic and does not reflect economically meaningful relationships between derivative positions.
  • The relationship between current exposure and potential future exposure (PFE) is misrepresented in the standardized method because only current exposure or PFE is capitalized.

The proposal has calculations that would address the abovementioned deficiencies, but also tries to balance risk sensitivity with not making the derivatives counterparty charges overly complex. Another positive is that the proposal minimizes discretion used by local regulators and banks while helping both national authorities and banks to better understand banks' risk profiles relating to derivatives exposures. The proposal would apply to all five derivatives classes: interest rate (the largest volume globally), credit, foreign exchange, equity and commodities.
There are quite a number of allowable credit risk mitigants such as collateral, insurance, credit derivatives, netting, offsets and guarantees that influence credit conversion factors and enable banks to convert notional amounts into much lower on-balance-sheet equivalent credit exposures. However, I would argue that banks globally have significantly been underestimating important credit risk drivers about their derivatives counterparties. The new Basel proposal would compel banks to spend more time taking into account those key credit risk drivers.

Given that OTC derivatives account for the vast majority of all derivatives traded, how banks calculate counterparty charges in those transactions is where investor and supervisory focus should be. While there are risks in exchange-traded derivatives markets, there are a lot more credit, liquidity and operational risks, not to mention opacity in the OTC markets.

Derivatives markets are changing due to Dodd-Frank in the U.S. and European Market Infrastructure Regulation overseas, but the derivatives reforms in both of those regulatory frameworks are still evolving. As long as OTC markets continue to dwarf exchange-traded ones, bank observers need to pay close attention to whether banks have sufficient capital for their derivatives portfolios. Just because they are off-balance-sheet transactions does not mean that a bank's profit, not to mention its capital, cannot be eroded shockingly quickly when counterparty risk is measured inaccurately.

Given the interconnectedness of the top four banks (Bank of America, Citigroup, Goldman Sachs and JPMorgan Chase) that transact 90% of OTC derivatives in the U.S., not measuring counterparty risk in derivatives portfolios is not just a problem for a bank, but in times of stress, can quickly become a problem for all banks and the global economy.

Next: A look at capital charges for derivatives transacted through Central Clearing Parties.

Mayra Rodríguez Valladares is Managing Principal at MRV Associates, a New York based capital markets and financial regulatory consulting and training firm. She is also a faculty member at the New York Institute of Finance.