Podcast: Kenyon and Berrahoui on the pitfalls of PFE

Quants propose replacement to existing credit risk measure

Nazneen Sherif and Mauro Cesa

Photo: Monika Ghose

Chris Kenyon, head of XVA quant modelling at MUFG Securities for Europe, the Middle East and Africa, and Mourad Berrahoui, head of counterparty credit risk modelling at Lloyds Banking Group, visited our offices in London on January 17 to talk about their new paper published in Risk.net, co-authored by Benjamin Poncet, a senior manager in Berrahoui’s team.

The quants argued that potential future exposure (PFE), which is widely used to set credit risk limits at banks, has many inconsistencies that make it an insufficient risk measure.

One of their key criticisms was that PFE, being defined as a maximum expected loss over a period at a given confidence level, does not account for tail losses or loss given default (LGD). This makes comparisons across different counterparties – and even across different seniorities of the same counterparty – difficult.

“The basic thing you need to be able to do to compare risk limits is, if you have two numbers, you want to know which is bigger. So, if you have a PFE number for one counterparty and a PFE number for another counterparty, you don’t really know which represents bigger risk, because the actual loss that will happen on default is the exposure multiplied by the LGD, and PFE only looks at the exposure,” said Kenyon.

Because of this inherent drawback, risks are compared by credit officers using their expert judgement on the recovery rates and how they relate to the setting of the PFE-based risk limits.

As a solution, the quants propose a new measure in their paper called potential future loss (PFL), which can be expressed as a product of a portfolio’s expected shortfall multiplied by its LGD. Since it includes the LGD, risks can be compared across different counterparties and seniorities.

“The first thing it gives you is comparability, so you can actually now build a dashboard for an executive and they can see their risks in a way they can compare different numbers on the same dashboard,” said Kenyon.

The pair argued that from a system perspective, the transition would be easy for most banks. One challenge though is changing the mindset of risk managers who are used to PFE.

“How to translate the risk appetite, which is basically [going] from a PFE mindset to a PFL mindset, this is one challenge. The second challenge is training the credit officer…so basically pushing them to think about PFL, that can be a challenge in the application,” argued Berrahoui.

As for future research, Berrahoui said he will be focusing more on regulation. Along with Kenyon, he will be looking at the outstanding issues around the standardised approach to counterparty credit risk. He will also be working on Basel’s revised credit valuation adjustment risk framework.

Kenyon, on the other hand, will be continuing his research on valuation adjustments and exploring newer avenues such as artificial intelligence. 

Index

0:00 Introduction

1:40 PFE’s role in the industry

3:27 Drawbacks of PFE

4:14 Dealing with PFE in practice

5:50 Introduction of potential future loss (PFL)

12:50 Advantages of PFL

16:00 CVA and PFE

17:00 Challenges with moving away from PFE

20:43 Future research

To hear the full interview, listen in the player above, or download. Future podcasts in our Quantcast series will be uploaded to Risk.net. You can also visit the main page here to access all tracks, or go to the iTunes store or Google Podcasts to listen and subscribe.