Counterparty Credit Risk (Pillar 1 and 2)

SUMMARY

The client, a major banking group specialised in the provision of online banking and trading services, was in the process of launching new derivative products for its retail clients and required assistance for the counterparty credit risk calculations and regulatory reporting of these products.

The project had three major areas of focus:

• Assessment of the Pillar 1 Counterparty Credit Risk (CCR) capital requirements for the new products;
• Development of the stress testing for the Pillar 2 (i.e. ICAAP) to incorporate the new products;
• Assessment of the additional reporting requirements for new products.

CUSTOMER GOALS

The bank wanted to conduct a comprehensive risk management assessment of the derivative products to understand the following:

1. How should the bank calculate the capital requirements for the Counterparty Credit Risk under a Mark-to-Market Approach?
2. How should the bank capture these products in its Internal Capital Adequacy Assessment Process (ICAAP)?
3. What stress testing scenarios should the bank implement in the ICAAP?
4. What are the relevant reporting requirements the bank will have to fulfil regarding these new products?

CHALLENGES

Avantage Reply’s team was well prepared for the engagement and received all the necessary support from the client. However, a number of challenges became evident over time such as:

• The bank’s dependence on the decision making processes within the Group, which significantly slowed down the project;
• The client had no prior experience with derivatives, which required additional time for the client to understand all the activities involved;
• Since the products had not been finalised at the time of the engagement, a number of assumptions had to be made regarding the final product and processes to be conducted by the bank.

SOLUTION

In order to deliver on the objectives outlined in the customer goals section, Avantage Reply put together a team of CRR (i.e. Capital Requirements Regulation), ICAAP and derivatives experts, which conducted the following tasks:

• Review of the scope for the derivative products, current processes, systems and data to be used;
• Definition of the methodology to calculate the CCR capital requirements;
• Building an excel tool showcasing the calculation for a variety of derivative contract types (i.e. FX, equity, commodity);
• Developing a dedicated stress test for the new products to be included in the ICAAP report;
• Definition of the scope of new reporting requirements and assembling all these new reporting requirements for derivatives in a comprehensive list.