Credit exposure is defined as the amount that would be lost if the borrower or counterparty were to default, with no recovery from the subsequent liquidation. This exposure is traditionally measured independently from the quality or nature of the counterparty. A given transaction or portfolio of transactions will generate the same level of exposure no matter who the counterparty is. This view stems from the lending world, where exposure is a known quantity, such as the outstanding loan balance or a contractually committed credit extension by the lender.
In the trading world, however, exposure fluctuates markedly with changes in market factors; as we have seen all too clearly in recent months. Counterparty exposure is an uncertain amount, so the simplest approach is to measure exposure at default as the expected exposure taken over a large number of simulated market conditions.
The assumption of independence between potential exposure and potential default may be pervasive and convenient, but it is questionable as to whether it provides the best reflection of the bank's credit exposure and risk managers should consider what alternative options are available.
The shortcomings of the above approach can be seen when applied to sample transactions. If a reverse repo is entered into where the counterparty pledges its own stock as collateral, it is clear that the collateral will be worthless if the counterparty were to default.
A diligent credit manager would therefore not assign any value to the collateral and would treat this reverse repo as an unsecured loan (exposure = 100% of notional). A similar conclusion may be reached if the collateral were issued by an entity closely related to the counterparty, such as a subsidiary. The prudent course of action would be to ignore the value of the collateral in the measurement.