12

Managing CounterpartyRisk in a Financial Institution

”A banker is a fellow who lends you his umbrella when the sun is shining, but wants it back the minute it begins to rain.”

Mark Twain (1835–1910)

12.1 INTRODUCTION

In this chapter we deal with the management of counterparty risk within a financial institution. We make no particular assumptions about the type of institution in question although this practice has been generally pioneered by large banks and there will be a natural bias in this direction. Depending on the risk management sophistication of a particul ar institution and the overall amount of counterparty risk taken, the management approach will differ. Different institutions may have very different approaches towards aspects such as collateralisation, regulatory matters, pricing and hedging of counterparty risks. Here, we aim to discuss the high level issues around an overall strategy towards counterparty risk, the main aim being protection of revenues, balance sheets and general financial integrity in case of default of derivatives counterparties. Whilst we try to keep the discussion as general as possible, it will ultimate ly be biased towards large banks, who have been actively managing counterpart y risk since around the 2000–2001 period. The focus will also be on OTC derivatives although other trades such as repos may also be managed centrally.

12.2 COUNTERPARTY RISK IN FINANCIAL INSTITUTIONS

12.2.1 Components

A basic strategy in managing counterparty risk ...

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