Counterparty Credit Risk

Ahraz Sheikh

7.1 INTRODUCTION

Although it is not apparent from its name, counterparty credit risk is a hybrid of both credit risk and market risk. Conventional credit risk (Chapter 6) covers the bank’s exposure to defaulted banking book products (eg, loans, mortgages or lines of credit). Although market risk (Chapter 5) is focused on the potential loss of portfolio value due to unfavourable economic and financial conditions, market risk regulatory capital also captures issuer default risk for debt products, such as bonds, through the default risk charge (DRC; see Section 6.10), rather than for derivative-based products.

However, the default risk component describes only a limited subset of the default exposure for trade counterparties. In fact, a significant component of the default exposure comes from derivative instruments. According to Investopedia, the global derivatives market is estimated at US$1.2 quadrillion at the time of writing in 2017. The market risk component captures only fluctuations in value. This is continuously at risk of the trade counterparty itself defaulting. In such cases, the bank would lose the value of such trades; these trades might serve a particular purpose