[Part 1] : SA-CCR (EAD, RC and PFE): Introduction

About a year or more ago, I had written a series of articles on FRTB (SA and IMA) under BCBS 352, in an oversimplified language. This series of articles, is an attempt to lay out Basel requirements for Counterparty Credit Risk (under BCBS 279).

We'll get to details, but first some basics.

What's Counterparty Credit Risk?

Counterparty Credit Risk (CCR) is the risk that the other party in a financial contract (like a derivative or loan) will default before the final settlement of the contract's cash flows. In simple words, it is the risk that counterparty won't fulfil contract's obligation by not paying one or more scheduled payments/cashflows.

Why is measuring Counterparty Credit Risk important?

Banks need to measure CCR to ensure they hold enough capital to cover potential losses from these defaults. Regulators expect banks to have an umbrella in case it rains OR a boat in case it floods. The Basel recommendations provide a standardised method to calculate this, promoting consistency and stability in the financial system.

What happens in this standardised approach of counterparty credit risk calculation?

• Exposure at Default (EAD): The first step is to determine the Exposure at Default i.e. EAD. It is the total potential loss, a bank might face, if the counterparty defaults. SA-CCR calculates EAD by considering both (i) current exposure and (ii) the potential future exposure (PFE).
• Add-On Factors: These are percentages applied to the notional amount (the face value) of the derivative contract to estimate the potential future exposure (PFE). The add-on factors vary by asset class (e.g., interest rates, foreign exchange, commodities etc.).
• Adjusting for Collateral: If the bank holds collateral from the counterparty, this can obviously reduce the exposure because you retain the collateral when the counterparty defaults. SA-CCR allows for the adjustment of EAD by considering the collateral held.
• Netting: If the bank has multiple contracts with the same counterparty, it can net these exposures, which means combining them to reflect the overall risk more accurately.

Calculation Steps:

• Replacement Cost (RC): This is the current cost of replacing the derivative contract if the counterparty defaults today.
• Potential Future Exposure (PFE): This is an estimate of how much the exposure might increase in the future, calculated using add-on factors.
• EAD Calculation: EAD = alpha * (RC + PFE), where alpha is a scaling factor set by regulators (typically 1.4).

• Capital Requirement: Once EAD is determined, the bank uses it to calculate the capital requirement, which is the amount of capital the bank needs to hold to cover the risk. This is done by multiplying the EAD by the risk weight assigned to the counterparty, as specified by Basel guidelines.

That Simple?

Well, no. It's just an introduction. Articles that follow, will describe nuances in RC, PFE, EAD.

Summary:

• SA-CCR provides a standardised way to measure the credit risk of derivatives and similar contracts.
• It involves calculating the current and potential future exposure, adjusting for collateral and netting.
• The result helps determine how much capital a bank needs to hold to protect against potential losses from counterparty defaults.

By using SA-CCR, banks can more accurately and consistently measure their counterparty credit risk, ensuring they remain stable and can absorb potential losses.

#CCR #BASEL #EAD #PFE #RC #RiskManagement