The new Basel III capital accord, a global regulatory standard for bank capital adequacy which kicks in from January 1, presents daunting challenges in the form of managing counterparty default risk.

While banks are moving toward active management of counterparty risk, there is limited or no liquidity in credit default swaps contracts needed to hedge a significant number of counterparties.

“Institutions will therefore continue to manage a substantial portion of counterparty credit risk through traditional reserves and exposure limits,” said Rohan Douglas, chief executive of risk analytics provider Quantifi.

“The residual counterparty risk portfolio is essentially a pool of loans, and therefore fraught with the complexities of CDO [collateralized debt obligation] structures,” Douglas said.

These complexities include model specification and configuration, manipulating large and diverse sets of position and market data, and managing unhedgeable correlation and basis risks.

The upshot: counterparty risk portfolios will continue to be susceptible to large unexpected losses.

The Basel III proposals for counterparty credit risk contain significant enhancements related to CVA (credit valuation adjustment) and in particular the needs to account for variation in CVA with a regulatory CVA VaR computation.

This computation, disclosed in the Basel III annex, takes into account variations of credit spreads that in turns affect CVA.

“This CVA VaR calculation shares with CVA the same computational challenge,” said Eric Benhamou, chief executive of Pricing Partners, in a statement.

To address this, Pricing Partners has upgraded its CVA engine to be able to compute at the portfolio level the CVA VaR for any generic trade, using its powerful American Monte Carlo.

“The CVA VaR engine that works for any Price-it trade and can aggregate at the portfolio per counterparty the corresponding CVA VaR,” said Benhamou.

Banks are making significant changes to internal counterparty risk management practices.

One of the drivers for CVA desks was the need to reduce credit risk, i.e., free capacity and release reserves, so banks could do more business.

“Given the complexity of CVA pricing and hedging, these responsibilities have increasingly been consolidated within specialized CVA desks,” said Douglas. “Now, with the increased capital charges for counterparty default risk under Basel III and the new CVA VaR charges, there is even more incentive to implement CVA desks.”

Another structural issue is related to clearing.

“While the near zero risk weight encourages dealers to clear CDS and other hedge transactions, not all products will be cleared, which means a critical mass of bilateral counterparty risk will likely remain in the system,” Douglas said. “Clearinghouses may also specialise in specific products, potentially increasing net counterparty risk.”

Also, said Douglas, “a clearinghouse could conceivably fail, and there is no evidence that the 1%-3% risk weighting will provide an adequate capital cushion to contain the systemic fallout”.