3
Strategic Customer Management for SME Portfolios
Stephen Gildert
Nick Vanstone
Calculating Probability of Default for Basel
II Compliance in Financial Institutions
Eduardo Borges da Silva
Armando Chinelatto Neto
Managing for the Financial Self-sustainability
of Microfinance Institutions
Cristiano G. Colozzi
Challenges and solutions in Counterparty
Credit Risk (CCR) treatment
Carlos Antonio Campos Nogueira
The article explores the management of Small and
Medium Enterprise (SME) customers and the ben-
efits that can be derived from the introduction of
a strategic approach. It provides practical insights
into how increased use of automated customer
management tools has been allowing retail banks
to reduce the cost of extending credit and improve
customer service.
25
The purpose of the paper is to develop a risk rating
system for legal entities in the Wholesale and Small
and Medium Enterprises (SME) segments. It also ad-
dresses the calculation of Probability of Default (PD)
according to the guidelines of the new capital accord
International Convergence of Capital Measurement
and Capital Standards: A Revised Framework, also
known as Basel II.
41
Brazil, a country that is home to one of the worlds
largest underground economies, has a latent de-
mand for productive credit. Millions of micro-entre-
preneurs are unable to carry out productive activities
due to lack of access to credit, mainly because they
are not formally established and lack the guarantees
the traditional financial system requires.
53
The article addresses the main concepts and funda-
mentals of the treatment necessary to calculate the
risk metrics and regulatory capital associated with
Counterparty Credit Risk (CCR). The piece takes ac-
count of the original text of Basel II and its updates,
and of the best practices. It focuses on the Internal
Model Method (IMM), but also mentions alternatives
where applicable.
 53

Challenges and
Solutions in
Counterparty Credit
Risk (CCR) Treatment

Carlos Antonio Campos Nogueira

 54

Abstract
The crisis that rocked the financial markets and, con-
sequently, the entire global economy has its roots set largely
in inaccurate assessment of counterparty default risk. Those
counterparties were regarded as sound and solvent in mas-
sive volumes of derivatives markets exposures. The risks were
grossly underestimated and, as a consequence, OTC deriva-
tives (e.g.: CDSs and CLNs) issued by Institutions such as Leh-
man Brothers and AIG were treated by financial institutions
as basically risk free, based on their ratings and the belief in
too big to fail, or too big to be allowed to fail.
The need to contain additional complications through
realistic measurement of those risks and appropriate allocation
of regulatory and economic capital led the Basel Committee
for Banking Supervision (BCBS) to make adjustments to Ba-
sel II, adding new requirements and control parameters. This
took place mainly in documents published in late 2009 (see the
References).

Keywords: CCR, OTC derivatives, Internal Model

Method.

This paper addresses the main their use in calculating regulatory

concepts and fundamentals of the
treatment needed to calculate risk
metrics and regulatory capital as con-
cerns CCR, taking account of the origi-
nal contents of Basel II and its updates,
as well as best practices. Its main fo-
cus lies on the Internal Model Method
(IMM), although alternatives are men-
tioned as well, where applicable.
There was no intention of pro-
ducing a definitive paper, given the
subjects complexity and immaturi-
ty (its methods and fundamentals are
still being defined), even among its
references of excellence. Our goal, in-
stead, was to introduce the main pa-
rameters for CCR measurement and
capital. Also in connection with cal-
culating capital, only the references
documentation was used, given that
the Central Bank of Brazil is yet to set
its standards on this front.
1. Initial Definitions
Before discussing the meth-
ods, it is worth establishing the main
concepts and terminology of CCR.
Counterparty Credit
Risk (CCR), Defined
Directly defined, it is the risk
associated with the possibility of the
default of a counterparty involved in
a market transaction (or a set thereof)

before all of the transactions sched-
uled cash flows are completed.
CCR differs from operational
risk in loans and financings because of
two basic factors:
Since many of the transactions
involved carry mutual payment obliga-
tions, the risk of default is bilateral.
The amount of the contract
varies based on the market fluctu-
ations of the prices of commodities,
securities and indices, all of which
affect the counterparties cash flows.
At the end of the contract, the net
amount of receipts and payments
may be positive or negative for each
of the parties involved.
These differences complicate
the calculation of the basic parame-
ters that serve as inputs to determine
regulatory capital, in particular maturi-
ty M and the predicted exposure at de-
fault (EAD). This requires application
of more complex metrics than those
used to calculate M and EAD for con-
ventional credit exposures.
The market transactions that
typically involve CCR include:
SFTs (Securities Financing
Transactions), which translate into com-
promissadas operations in Brazil Repur-
chase Agreements - Repos - and similar).
Assets-backed (securities
and shares) and margin loans.
OTC derivatives.
Derivatives negotiated with
central counterparties
Exposure Metrics
Arriving at the Me and EAD pa-
rameters demands first defining cer-
55
tain exposure metrics to reflect the
characteristics of operations subject
to CCR. They include:
Expected exposure (EE): The
mean distribution of exposures on a fu-
ture date previous to the effective term
of the lengthiest deal in a set of nettable
exposures. EE only takes positive mar-
ket value predictions into account and is,
therefore, always greater than the aver-
age of market exposures when negative
exposures are also considered.
Potential future exposure
(PFE): The high percentile of the dis-
tribution of exposures on a future date
previous to the effective term of the
lengthiest in a set of nettable expo-
sures. It is a GiP (Gain in Potential)
rather than a VaR, (Value at Risk), as it
uses the same confidence interval cri-
terion (99%, for example) to determine
that highest possible exposure on a fu-
ture date (usually far more distant than
in VaR) within this confidence interval.
Effective Expected Expo-
sure (EEE): The maximum amount of
the expected exposure (EE) until a cer-
tain date.
Expected Positive Exposure
(EPE): Expected positive exposure EPE
is the mean expected exposure EE.
Effective expected positive
exposure (effective EPE): Effective
EPE is the average over time of effec-
tive expected exposures (EEE).
Netting
Usually, two counterparties
group their operations into netting sets
(sets of mutually netting exposures, or
groups of nettable exposures).

Netting (the creation of netting
sets) is a means to reciprocally offset
exposures between two counterparties
over the course of the combined matu-
rity of the operations involved.
Close-out netting rules are
set by contract in a concomitant
and interactive manner, with con-
tract termination clauses the so-
called close-out clauses that deter-
mine the closure of all operations be-
tween two counterparties when one
of them defaults.
Chart 1
Payment
Operation
from a to B
Swap I 25
Swap II 30
Non-netted
exposure
Netter
exposure
In addition, as the example shows,
netting reduces the amount of the expo-
sure for each of the counterparties.
Close-out netting, in its turn, is
a process that takes place in the event
of a default by one of the parties, and
must be seated on a netting agreement
defining the make-up of the netting set
and the applicable netting rules. It fa-
cilitates the settling of accounts, serv-
56
Payments-flow Netting
and Close-out Netting
Payments-flow netting is a normal
and routine operation between two coun-
terparties with several contracts subject
to CCR. Its purpose is to reduce the pay-
ments flow, simplifying and reducing the
cost of operations for both parties. Chart
1 illustrates the netting of two swaps be-
tween parties A and B (MtM is the marked-
to-marked value of As exposures to B and
vice-versa on the date of cash-flow deter-
mination and realization).
Payment
As MtM Bs MtM
from B to A
20 -5 5
45 15 -15
15 5
10 0
ing as a hedge, or automatic opera-
tions cancellation.
Two counterparties may enter into
bilateral netting agreements for various
netting sets and/or a global netting agree-
ment (Master Agreement) that replaces
and/or supersedes individual agreements
in the event of doubt concerning the rules
(e.g.: the International Swaps and Deriva-
tives Association ISDA model).

The netting sets covered by net-
ting agreements must involve careful cri-
teria for:
Maturities matching
Number of exposures: the
greater the number of exposures (for a
given average correlation), the greater
the effect of netting
Diversication and correlation
of the assets involved.
Inclusion of exposures with
negative MtM and maturities similar
to those with positive MtM (providing a
safety cushion).
Although not yet standardized in
Brazil, netting may theoretically be done
cross-product, involving several deriva-
tive products, which may help find a bet-
ter match of maturities and lead to more
appropriate hedging.
Netting agreements involving
more than two parties also lack regulato-
ry support, but are theoretically possible.
Margins, Margin Agreements
and Collateralization
It is common practice for the
counterparties involved in operations
subject to CCR to post collateral as a
means to mitigate risk in the event of ear-
ly close-out due to a default by the party
posting the collateral. The amounts, lim-
its and form of the collateral (margins) are
usually established in the so-called Mar-
gin Agreements. Margin Agreements
determine that one, both, or more (where
more than two) counterparties must post
collateral at operation start and periodi-
cally add to (adjust) their margins.
The starting collateral is re-
ferred to as initial margin (IM) and mar-
57
gin calls are posted when the differ-
ence between the portfolios net worth
and the amount of the posted collateral
exceeds a certain threshold. The mar-
gin agreement between the parties de-
fines the initial margin, the threshold,
and the minimum collateral amount to
be posted at each margin call.
Therefore, when the thresh-
old is broken, a margin call is required
and the counterparty potentially in
debt must post an amount equal to or
greater than the minimum margin call.
There is, however, a response time for
the call to be made. During this period,
the potential creditor counterparty has
a non-collateralized position. Should
the potential debtor counterparty de-
fault, there will be no mitigation ef-
fect for the outstanding balance. This
lapse of time is called margin risk pe-
riod (MRP). In December 2009 (BCBS
Document 164 Strengthening the re-
silience of the banking sector), the
Basel Committee determined mini-
mum MRP values:
Five business days for netting
sets made up of repo and reverse repo
operations with daily margin calls and
marked to marked daily. As an addi-
tional requirement, these nettings sets
must contain a maximum of 5000 op-
erations within a period of one quarter
and must not include illiquid assets.
Ten business days for net-
ting sets with other operations (not
repo and reverse repo). As an addi-
tional requirement, these nettings sets
must contain a maximum of 5000 op-
erations within a period of one quarter
and must not include illiquid assets.
 58

Twenty business days for any net- If the period of margin calls (ad-
ting sets with more than 5000 operations at justments) is greater than one day, or,
any point during a quarter or containing an say, N days, the MRP in business days is
operation involving at least one illiquid asset. calculated as follows:

MRP = (F - 1) + N

Where: N is the margin adjustment pe-

F is the minimum margin ad- riod in days.
justment period as defined above (5, 10, Chart 2 summarizes the situa-
or 20 business days). tions above.

Chart 2

Any deal
Repo & similar OTC Derivatives involving illiquid
assets
N of operations
Up to 5000 > 5000 Up to 5000 > 5000 Any
per quarter
F 5 20 10 20 20
Prmg 4+N 19+N 9+N 19+N 19+N

3. Calculating Exposure bust models for calculating the metrics,

Metrics, Effective
Maturity, and EAD
Having presented the main con-
cepts, we address the calculation of the
main exposure metrics and then move
on to determining EAD (expected expo-
sure at default).
3.1. Obtaining Effective
EPE from Models
We begin with the method that
assumes the availability of sufficiently ro-
and effective EPE in particular.
3.1.1. Calculating
Expected Exposure
Let us assume that the finan-
cial institution that is calculating its
CCR has statistical models capable
of predictive calculation, at any fu-
ture moment within the modeling ho-
rizon, of the distribution of market val-
ues (predicted MtM) of the operations
in a given netting set.
 59

Based on these market value dis-
tributions, value zero is assigned to all neg-
ative value predictions, producing the expo-
sure distributions (negative values are not ex-
posures for the counterparty calculating the
CCR). The model then averages the expo-
sure distributions, based on the several pos-
sible values of the relevant risk factors (inter-
est rates, foreign exchange rates, commodi-
ty prices, stock prices, etc.). The resulting av-
erage is called Expected Exposure (EE).
3.1.2. Calculating
Effective Expected Exposure
(Effective EE, or EEE)
Effective expected exposure is
the maximum expected exposure (EE)
until a certain date, or, more formally:

Effective EE t = max (Effective EE t ,EE t )

k k-1 k

It is calculated recursively, as- evant variations of the risk factors used

suming t 0 as the current moment and in the statistical model.
effective EE at t 0 as the current ex-
posure. From this point onwards, the 3.1.3. Calculating Effective
highest value of effective EE is pre- Expected Positive Exposure
served and becomes the value of ef- (Effective EPE)
fective EE. Effective EPE is the average over
Future moments tk (t 1, t 2 , t 3) time of the effective expected exposures
must be selected according to the rel- (EEE) or, more formally:

min (1 year,
maturity)

Effective EPE = Effective EE

k=1
tk
Effective EE t x tk
k

Where tk = tk - tk-1 are the time tions ( tk) relative to the maturity of the
intervals between the dates of estimation netting set.
of future exposures.
We calculate effective EE (EEE) 3.1.4. Calculating
for k relevant future moments from the Effective Maturity (M)
perspective of risk factors (interest rates, The effective maturity of a portfo-
foreign exchange rates, inflation, com- lio of conventional credit operations (loans
modity prices, etc.). We then weight the and financings) is the result, in years, of the
EEEs obtained by their relative dura- weighted average:

t * FC
t
M=
FC
t
t

That is, an average of the periods
of the several operations weighted by the
value of cash flow events, which is rather
simple in the case of operations of this kind.
tk1 year
Effective EE x t x df + EE
k=1
k k
M= tk1 year
Effective EE x t x df
k=1
Where df k is the discount fac-
tor based on the risk-free rate used
to discount EE, and t k = t k - t k-1 rep-
resent the time intervals between the
dates (k) of estimation of the future ex-
posures.
M is limited to a maximum of
five years. In the absence of maturi-
EAD = x Effective EPE
Alpha is a weight used to com-
pensate for the uncertainties inher-
ent to the calculation of effective EPE,
equating it to the EAD of typical cred-
it operations.
Financial institutions that are
calculating CCR may model , as long
as they abide by the minimum and max-
imum regulatory limits (regulators may
even set a fixed value).
Alpha models developed by sev-
eral financial institutions and regulators
have been generating values that lie typ-
ically between 1.05 and 2.25. Alpha is
smaller (closer to 1.0):
The more numerous (more
counterparties) the portfolio;
60
For exposures subject to CCR,
the uncertainty surrounding pay-
ment amounts leads to a more com-
plex formula.
maturity
k
tk>1 year
k
x tk x dfk
k k k
ties in excess of one year, the simpli-
fied formula for conventional credit op-
erations applies.
3.1.5. Calculating Expected
Exposure at Default EAD
EAD is the effective EPE multi-
plied by (alpha).
The higher the average proba-
bility of default;
The greater the correlation
across assets; and
The greater the confidence
level used to produce the estimates.
3.2. Obtaining Effective EPE
where Models are Insufficient
The approach introduced in 3.1 as-
sumes that the models supporting the de-
termination of effective EPE take account
of the mitigating effects o the collateral (in-
itial margins and subsequent adjustments)
posted for the operations in the netting set.
This may be complex and even impossi-
ble, depending on the data available from

the database used by the Institution. In this
case, the Accord and BCBS Document 164
(Strengthening) offer two alternatives:
a) Using effective EPE with-
out considering the effects of collat-
eral (margins). This may be inconven-
ient, as it increases EAD and therefore
Effective EPE = max (T + MTA, MtM - VM) + add-on (IM)
Where:
add-on(IM) = E {Max[(MtM(t=Prmg)
(MtM(t=0) + IM), 0] }
T = Exposure threshold for
margin calls
MtM: Current marked-to-market
value of the contents of the netting set
IM: Initial margin (to cover an
eventual close-out).
VM: Margin change (daily ad-
justment to the initial margin to prevent
operation close-out).
MTA: Minimum margin transfer value
Prmg: Margin risk period.
N: periodicity of the margin
calls, as defined earlier.
Pepr (IMM) = f x EPR
Where EPR (risk-weighted expo-
sure) = 12.5 x K x EAD
The factor f, as defined in Circu-
lar No. 3.360 of the Central Bank of Brazil,
is currently set at 0.11 (or 11%), although it
can be modified by the regulator.
N-1 (PD) + R x N-1 (0,9999)
K= {LGD x N [ 1-R
61
overestimates the share of regulatory
capital associated with CCR.
b) Application of the formula sug-
gested in Paragraph 155 of BCBS Docu-
ment 164, which replaces and updates the
approach mentioned in paragraph 41 of
Annex 4 of the Basel Accord, as follows:
The E in the add-on expres-
sion stands for the expected value of the
sub-expression in brackets.
Calculation of effective maturity
M and EAD proceed as discussed in 3.1.3
and 3.1.4 above.
4. Calculating the
Factor K and the Share of
Regulatory Capital for
the IMM
Having determined EAD and ef-
fective maturity M, we can proceed to
calculate the share of regulatory capital
(Pepr) for CCR, Internal Model Method
(IMM), using the formula:
For factor K (risk weight), we
use the Basel II formula as applicable
to the wholesale and financial institu-
tions class as provided by the Central
Bank of Brazil in its Public Hearing
Document No. 37 (EAP 37):
1 + (M - 2,5) x b
] - PD x LGD} * (1 - 1,5 x b)
 62

N = normal distribution func- LGD = Loss Given Default pa-

tion;
N-1 = reverse normal distribu-
tion function;
PD = Probability of Default pa-
rameter for the relevant counterparty;
rameter;
M = effective maturity (or effec-
tive term) as calculated in 3.1.3 above;
b = adjustment coefficient for ef-
fective maturity M, calculated as:

b = (0,11852 - 0,05478 x In(PD))2

R = asset correlation factor, de-

termined as follows :

(1 - e (-50 x PD)) (1 - e (-50 x PD))

R = 0,12 x
(1 - e (-50))
+ 0,24 x [ 1- (1 - e (-50)) ]
Bear in mind that substitut- February 2011. The early version includes
ing Pepr (IMM) for the treatment dis- required application articles, particularly
cussed in Circular No. 3.360 for oper- when financial collateral is used as mar-
ations subject to CCR must abide by a gin in derivatives deals.
transition period similar to that appli- These standards are summa-
cable to exposures arising from con- rized below:
ventional credit operations (loans and Circular No. 3.360:
financings). This will probably imply Amount of the exposure in-
applying a transition or progression stead of EAD.
factor S, to be defined by the Central Articles 2-5 define CCR calcu-
Bank of Brazil according to the guide- lation.
lines discussed in EAP 37, article 166. Resoluo No. 3.263:
Addresses bilateral netting agree-
5. Regulatory Aspects ments governing the netting sets
Although the Central Bank EAP No. 37:
of Brazil has not yet published spe- Credit risk mitigation section (arti-
cific standards for treating CCR un- cles 75-96).
der the IMM (which is expected to oc- Rules for use: article 76.
cur before the application period for In- Acknowledgement of financial
ternal Ratings Based IRB models, on collateral.
Dec/28/2012, according to Comunica- Use of personal security.
do No. 19.028), some non-specific stand- Non-financial collateral.
ards do address the topic. In addition, an Application of haircuts.
early version of the generic standard for Article 89 addresses the bilat-
migration to IRB has been disclosed in eral netting agreements that govern
Public Hearing Document 37 (EAP 37) in the netting sets.
 63

Article 172 (Pillar III) discussed here. A few, non-exhaustive

Description of the allocation meth- examples of additional topics that must
odology for the economic capital relative to be addressed are:
these exposures. Wrong-way risk (generic and
Description of policies applicable specific) observation and treatment;
to the risks associated with the presence of CCR management (based on the
an adverse positive correlation between: exposure metrics discussed here and with
PD and the amount of the expo- proven use thereof)
sure to the same counterparty. Modeling techniques that take
PD and market variables. collateral (margins) into consideration;
Pricing (including the calculation
6. Final Remarks of unilateral or bilateral Credit Value Ad-
The purpose of this article is to justment CVA);
introduce the definitions and basic met- Stress testing (scenarios and
rics of Counterparty Credit Risk, in ad- methods);
dition to providing guidance for the cal- Validation.
culation of the regulatory capital re- The Central Bank of Brazil is still in
quired for operations subject to CCR. the process of defining the applicable reg-
Of course, a comprehensive CCR imple- ulatory guidelines, and specific standards
mentation in full compliance with Basel are not yet available (at the time of the draft-
II and III requires far more than can be ing of this article, in November 2011).
Author

Carlos Antonio Campos Nogueira

Has a degree in Physics (PUC - RJ) and a Masters Degree in Astrophysics and Elementary Particles (Centro Brasileiro de

Pesquisas Fsicas - CBPF/CNPQ). A practice leader in IT consulting, Mr. Nogueira has 27 years experience of service to

more than 40 companies in close to 70 projects. Managing Partner and founder of IntelliSearch.

E-mail can@intellisearch.com.br
References

Acordo de Basileia II, verso de junho de 2006 (principalmente o Anexo 4).

Strengthening the Resilience of the Banking Sector do BCBS (Documento 164 de dezembro de 2009).
Circulares e resolues publicadas pelo Banco Central do Brasil, especialmente a Circular 3.360 e a Resoluo 3.263.
Edital de audincia pblica n 37 (EAP 37) publicado pelo Banco Central do Brasil em fevereiro de 2011.
CESARI Giovanni, AQUILINA John, CHARPILLON Niels, FILIPOVIC Zlatko, LEE Gordon, MANDA Ion Modelling, Pri-
cing, and Hedging Conterparty Credit Exposure a technical guide Springer (2009).
GREGORY Jon Counterparty Credit Risk: The new challenge for global financial markets Wiley (2010).
The calculation of counterparty risk exposure values for financial derivatives, securities financing transactions and long
settlement transactions (FSA Handbook, release 115 de julho de 2011).
Publicaes de suporte do BCBS.