Fed Gov Kroszner Views Enhanced Counterparty Credit Risk Management as Key to Securitization Reform

In the coming reform of securitization, noted Federal Reserve Board Governor Randall S. Kroszner, financial institutions must strengthen their counterparty credit risk management, mainly through more extensive stress testing. In remarks at a seminar in Geneva, he said that in the current crisis risk managers did not fully contemplate the possibility that many participants would need to unwind their positions at the same time, that such actions might present substantial losses for several key counterparties, and that collateral posted as protection for positions would fall in value at the same time.

This goes back to a failure to do adequate stress testing. Also, even when risk managers at financial institutions had some understanding of these issues, they found it difficult to demand more collateral or guarantees during good times because no risk manager wanted to be the first to do so.

Financial markets have developed mechanisms that are specific to the control of counterparty risk. The simplest of these is the posting of collateral against counterparty exposures. Ensuring the efficacy of collateral is challenging even under ordinary circumstances, said the official, and may leave counterparties especially vulnerable to large sudden changes in market prices, also called gap risk

The Fed governor observed that a central counterparty or clearinghouse is a sophisticated convention for mitigating counterparty credit risk. The NY Fed is currently vetting a process to create a central counterparty in the credit derivatives market. In markets with a clearinghouse, all trades are intermediated through a central counterparty. This arrangement can vastly reduce counterparty risk, enthused the governor. The central counterparty runs a balanced book, he pointed out, so generally has no direct market exposure. In the case of a member's default, the central counterparty can draw upon the proprietary margin of the defaulting member, its own reserve fund, and the assessment of members for share purchase.

According to Gov. Kroszner, counterparty credit risk management should be focused on its effectiveness in different market situations and its implications for financial stability, which in turn underscore the importance of stress testing and scenario analysis focused on market-wide events. Such stress tests would include the potential for key counterparties to fail or suffer difficulty at the same time, he noted, or market liquidity to erode and remain low for some time, and for market participants to view the financial institution itself as an impaired counterparty.

In his view, properly designed stress tests can provide information that typical statistical models may leave out, such as abnormally large jumps or market moves, evaporation of liquidity, prolonged periods of market distress, or structural changes in markets. Stress tests are most useful when they aim to include potential secondary or knock-on effects, he emphasized, which are often difficult to model with standard techniques. In these ways, stress tests can serve as a complementary tool to other risk measures. It is also important for banks to conduct stress tests across several markets, Mr. Kroszner said, since some counterparties are key players across many financial markets and their inability to repay could cascade across those markets.

Many good events flow from effective stress testing. For example, based on the results of their stress tests, banks may reassess their participation in certain markets and exercise greater caution to account for potential tail risks and better protect themselves in times of market wide stress. One of the first things they may do is increase their internal assessments of capital needs for these activities, given the added risks that stress tests reveal. They may wish to restructure contracts or alter terms.

Financial institutions also might ask for higher initial margin, given that subsequent calls may not provide as much risk mitigation during distress. They may wish to ask for more collateral, or ensure that the collateral is less linked to the counterparty's condition or broader market distress. Or they might look for other ways to enhance their assessment of counterparties, and, perhaps more importantly, the potential for counterparties to encounter difficulties during market wide stresses. Moreover, they may wish to conduct more of their trading and hedging on more organized exchanges or with clearinghouses, to benefit from their safeguards.

In addition, banks acting collectively may decide to take action to improve the quality assurance performance of markets during future times of stress. For their part, trade associations in the banking industry may consider additional safeguards to reduce the impact of systematic risks among counterparties. For example, banks may collectively act to remove uncertainty associated with back-office inefficiencies and related risks in the credit default swaps market. Another example is an attempt to enhance mortgage markets so that there is greater standardization of data and simpler, more homogeneous provisions in the securitizations, and less reliance on third-party monitoring.