A discussion based upon the FSA’s recent paper entitled “ Management of credit risks within a trading environment ”

1. A discussion based upon the FSA’s recent paper entitled“Management of credit risks within atrading environment” Craig MacDougall

2. Introduction • Presentation and discussion of key points - FSA Survey, April 2004 • Full paper available at :http://www.fsa.gov.uk/pubs/other/credit_risk.pdf

3. Reasons? The survey was triggered by concerns about possible deteriorations in counterparty credit quality, higher market volatility and the increasing use of electronic trading platforms. It was also based on previous findings of lower standards of credit risk management at investment firms compared with banks.

4. Participants Twenty-four firms, including five banks, in a variety of trading activities within the sector. Type of firm / Number Major UK banks 2 Investment banks 3 Investment & security firms 4 Security broker-dealers 4 Inter-dealer brokers 3 Spreadbetters 2 Financial futures & options brokers 2 Commodity futures & options brokers 4 Total 24

5. Key Discussion Points • Data integrity problems • Collateralisation • Credit assessment • Portfolio management information • Credit risk exclusions • Electronic futures and options trading • Potential future exposure (PFE) • Other findings • FX settlements • Credit management in groups • Active portfolio management • Potential conflicts of interests • Counterparty risk concentrations

6. Major Points Of Concern

7. Data Integrity Too many separate systems (equity, fixed income, repos etc.) create integrity issues which directly impact risk reports and MIS. • Missed trades • Wrong collateral info • Wrong groupings • Wrong PFEs/Exposure • Wrong internal & external reporting

8. Collateralisation • Nearly all participants are using CSAs for daily margining. CSAs deliver major benefits in reducing risk, capital usage and the exposure window… • …meaning bigger volumes of trades are possible and therefore increased operational and legal risk. • This can present a dichotomy for the market of using Ratings Triggers versus less precisely defined credit-weakening terms to reduce Thresholds. • The potential ‘house of cards’ affect of margin calls triggered by ratings downgrades creating a cashflow squeeze… leading to further downgrades… leading to… default? • Can the client meet margin calls? - the need to monitor gross positions and the pre-collateral risk position. • The decision of when and whether to close out? Can close out be achieved?

9. Credit Assessment • There is a heavy reliance on ratings agencies, especially for Banks, FIs etc., contrasted by the delay of their reaction in cases such as Enron, Parmalat etc. There is still a degree of independent assessment by most firms. • The ‘standardised approach’ to credit risk capital within the Basel 2 Capital Accord may strengthen this further. Will this lead to regulation of ratings agencies? • There is a wide variation in the technicality of internal ratings systems; e.g. an inability to adapt for unusual clients such as hedge funds. • The capability for the credit person to add their own interpretation, leading to a different assumption of risk adjusted credit measures - LGD and RAROC/ROEC?

10. Portfolio Management Information Again, wide variations in approach and result. Types of information distributed:- • breakdown by internal rating, sector, country, product and maturity bands; • aggregate view of total risks, separate analyses of trading exposures (expressed in both current and potential exposure) and on-balance sheet exposures; • indication of key trends in the portfolio; • indication of the largest individual users of economic capital; and • indication of the main vulnerabilities in the portfolio, in terms of events and of individual credits, based on stress analysis.

11. Portfolio Management Information Key observations • Major firms rely heavily on local middle management - senior execs receive little MIS. Can control procedures catch key risks? • Very little information is provided to management about large settlement risks, despite the fact that these are often very substantial; • Insufficient or nonexistent stress testing or sensitivity analysis of counterparty credit risk.

12. Credit risk exclusions • DVP matched-principal activity. Most participants do now measure and monitor these credit risks. Larger firms’ systems struggle with the daunting number of counterparties and the difficulty and time involved in performing a credit assessment on all of them. So, few firms do more than basic due diligence checks and most use monitoring thresholds rather than limits. • Most firms focus more on the riskier jurisdictions and longer than normal settlements. • Issuer risk in credit trading (Bonds and Credit Default Swaps) – common practise is for limits to be set by Market Risk staff without reference to Credit. This can lead to a conflicting strategy across the firm.

13. Electronic futures and options trading • STP and Cross-Product margining are becoming more prevalent. • For the ‘Clearer’ of a counterparty, this means they could be liable to very substantial exposures. Intra-day information is available from most exchanges, but most clearers’ systems can only monitor margin requirements the following day. Given the vast volumes traded on exchanges each day, substantial risks can be built up and go undetected – e.g. Griffin Trading. • Limits on transactions can be set by the clearer with the ‘execution only’ brokers, but these may still fail to prevent losses.

14. Potential Future Exposure (PFE) • Some firms still use MTM without any PFE add-on, but PFE is now so widely accepted that it is the norm to have some form of PFE measure. • It can be as simple as a percentage of notional, or as complex as a Monte Carlo system. • Firms tend to use simple models for short-term products like repos and use more complex models for derivatives and long-term trades such as Interest Rate Swaps. • It can be very difficult to get credit committees to appreciate the risks and understand the complexities of models. • ‘Garbage In, Garbage Out’ – the assumptions used as inputs to the model can produce wide variations in the PFE estimate!

15. Potential Future Exposure (PFE)What Holding Period??? • Firms can close out if the counterparty fails a margin call. • Many firms now estimate the following – 24 hours to confirm receipt (longer for emerging markets); time spent chasing for non-receipt (another 24 hours); time to decide to close out (another 24 hours); actual close out – sometimes hundreds of trades... • Many firms therefore conservatively estimate PFE over an extended period of 5 to 10 days. • Loan Equivalents – some firms now use this instead of PFE. It uses the notion of average instead of peak potential exposure adjusted by a multiple which includes probability of default (PD) and results in dramatically lower exposure estimates, perhaps 50% lower! • If firms do not adjust credit limits accordingly, much greater volumes may be traded without fully assessing the risk. The FSA report says it is therefore investigating these practices currently.

16. Other Issues & Observations • F/X Settlement Risk – Firms rely on managing the settlement process and do not take account of any building cumulative settlement risk arising on one day as a result of various forward trades. • Credit management in groups - “We accept that some important risk management functions, including credit analysis and monitoring, may be delegated by a UK-regulated subsidiary to a global function located in head office. However, local management remains accountable to us for the performance of the outsourced functions and the risk controls surrounding local operations. We also noted that, in some cases, it was not easy to extract from a global institution’s systems and controls the credit limits and exposures which apply to its UK-regulated entity. We are concerned that as a result, the local senior management and/or Board members of that entity, though accountable to us, may not be in a position to control the aggregate credit risks carried by that entity to the extent we normally require.”

17. Other Issues & Observations • Active portfolio management – there is little written guidance on criteria to follow or the balance to be maintained between credit risk and P&L considerations. This could lead to portfolio management adding to, rather than mitigating, a firm’s overall credit risk burden. • Potential conflicts of interests – in some firms the credit person can access advisory related information which they then use to downgrade the internal rating and/or reduce limits, thereby going against the intention of the confidentiality agreement re advisory work. • Counterparty risk concentrations - high concentration of trades with a few market counterparties – there should be concentration limits on these and not just normal counterparties.

18. Conclusions? The good points:- • Wider use of collateral; active portfolio management; refinements in internal ratings and exposure measurement; • No material increase in credit granted, generally sound counterparty credit risk management. The Bad points: • Systems constraints leading to problems with data integrity, risk aggregation and intraday monitoring; • Increased legal, operating and liquidity risks resulting form collateral usage; • Lack of risk-focused, forward looking portfolio information received at senior level; • Problems with PFE measurement.