The federal banking regulators have issued guidance on effective counterparty credit risk management, including supervisory expectations for an effective counterparty credit risk management framework. The June 29 guidance, issued by the Federal Reserve, the FDIC, the OCC and the OTS, is intended for use by all banking organizations, but particularly those with large derivatives portfolios, in setting their risk management practices, as well as by examiners as they assess institutions’ management of counterparty credit risk. The agencies advise institutions that do not have large derivatives portfolios to apply the guidance as appropriate for the size, nature and complexity of each institution’s counterparty credit risk profile. Counterparty credit risk is described in the guidance as the risk that the counterparty to a transaction defaults or deteriorates in creditworthiness before the final settlement of the transaction. The guidance emphasizes that banking organizations should use appropriate reporting metrics and exposure limits systems, have well-developed and comprehensive stress testing, and maintain systems that facilitate measurement and aggregation of counterparty credit risk across the organization. The guidance also includes sound practices for risk control functions including, but not limited to, validating models and systems, ensuring independent risk management and internal audit processes, and managing legal and operational risks.

Nutter Notes: The guidance suggests that examiners expect the board of directors, or a designated board-level committee, to clearly articulate an institution’s risk tolerance for counterparty credit risk by approving relevant policies, including a framework for establishing limits on individual counterparty exposures and concentrations of exposures. The guidance recommends that senior management establish and implement a comprehensive risk measurement and management framework consistent with the risk tolerance articulated by the board that provides for the ongoing monitoring, reporting, and control of counterparty credit risk exposures. According to the guidance, counterparty exposures should be reported to the board and senior management at a frequency commensurate with the materiality of exposures and the complexity of transactions. Such reports should include concentration analysis and counterparty credit risk stress testing results that address exposures and potential losses under severe market conditions. The reports should also include an explanation of any measurement weaknesses or limitations that may influence the accuracy and reliability of the counterparty credit risk measures, according to the guidance. The guidance includes an appendix detailing model validation and systems evaluation considerations.