Regarding Santosh’s question on counterparty credit risk (CCR), this is clearly a growing problem. The Basel Committee was very late to the table in addressing the issue. I even argue that the prolonged delay in allowing anything beyond mark-to-market plus add-ons as the method for calculating regulatory capital for CCR was an obstacle to banks trying to improve their systems for this important and growing source of risk. It was too easy to take the attitude that “If MTM plus add-ons is good enough for the banking regulators is should be good enough for us.”

While regulators need to push for as extensive transaction coverage as possible and for sophisticated simulation, I think it is a mistake to place too high a threshhold on the share of transactions that must be included to qualify for the expected positive exposure (EPE) approach to calculating regulatory capital for CCR. This runs the risk of discouraging banks from moving in this direction in the first place, especially if the main motivation is reducing the level of regulatory capital rather than improving risk management information and decision making. (See my July 2006 Risk magazine column Dangerous Perfection at: http://www3.sungard.com/SunGardFinancial/menus/documents/risk_managers/200607%20dangerous%20perfection.pdf )

A better approach would be to demand that transactions not included in the simulation analysis be modeled with conservative overrides and aggregated without the benefit of diversification effects.

Basel should be actively promoting a sophisticated simulation-based approach to CCR measurement rather than appearing to resist such an approach, which has often seemed to be the attitude in the past. Frankly, I think such an approach should be mandatory for major derivative trading houses and for others where CCR is a significant part of total credit risk.