Santosh,

Lest my mild criticism of the Basel Committee for being late to the table on the CCR modeling issue be misinterpreted, I fully support the Committee’s move. I also think they have done a sensible job of fitting the dynamic modeling approach to CCR measurement into the larger regulatory capital scheme. My main point is that such measurement techniques should not be just a regulatory exercise. Indeed, the Basel use-test requires that the methods applied to calculating regulatory capital are rooted in the analysis used for internal risk measurement.

Beyond that, I feel the biggest benefit of the Committee’s proposal will not be to reduce minimum regulatory capital, as much as this is likely to be one effect. The core benefit is to discriminate much more accurately among various counterparty exposure amounts regardless of how simple or complex the bilateral portfolios may be. If a proper simulation approach is used for internal limit setting and exposure control, it is optimal for this to be the metric used on the trading desk to determine credit limit availability for a new trade. If it is applied globally, it has the further benefit of providing a sensible basis for a credit risk charge that affects traders’ price quotes.

For such a system to work effectively, certain analytic shortcuts are not just possible but essential. Only then will it be feasible to return metrics to traders in a timely fashion consistent with the necessary speed of decisions in many derivative markets. That said, the ever growing complexity of transactions makes exclusive reliance on analytic methods virtually impossible. Threshold changes in payments for such trades as range floaters and the complexity of modeling exposure to physically settled options beyond their exercise date make Monte Carlo simulation the ultimate benchmark against which purely analytic or hybrid results need to be measured.