Exposure Monitoring is a key component of risk management for banks and lending institutions. At an enterprise level a bank will decide its risk appetite / risk tolerance. There are various ways in which the risk appetite is inculcated in every action that the bank takes — be it pertaining to the approach it follows while lending to new businesses, techniques it adopts for credit assessment of new borrowers or the way it designs it’s risk management framework. From risk management perspective, its vital to have a quantitative measure for monitoring the counterparty credit risk in real-time. Such a quantitative measure is defined by the Limits Framework of the bank. Limits framework defines the maximum exposure limits that are in-line with the risk appetite of the bank. Limits are defined for every counterparty with which the bank mainly does the below transactions:
Calculation of a Trade Exposure:
Trade exposure can be computed by the following formula:
Trade Exposure = Positive MTM + Potential Future Exposure
Positive MTM: is defined as the current credit exposure, and
PFE: is the part that captures the potential future exposure
Approach to calculate the above two components:
a. MTM is calculated via pricing models OR traded market prices (if available)
b. PFE is calculated either via Basel’s regulatory guidelines OR via simulation models
The above calculation for trade exposure will be adjusted for collateral that has been posted by the counterparty. Collateral posted by the counterparty reduces the total amount of exposure. Collateral is generally in the form of cash or cash-like products. Daily collateral exchange is governed by the Credit Support Annex (CSA) between banks.
Typically, in banks, there are two types of limits that are defined in their risk policies. These are namely:
a. Treasury Limits
b. Trade Limits
These limits are defined in the board approved risk policy of the bank. These limits are plugged into the bank’s systems and are monitored in real-time.
These limits are set for monitoring trading activities that are done by the Front Office i.e., the trading desks. These are further divided into a: pre-settlement limit and settlement limit. The aforesaid two limits are popular when it comes to Interbank Exposure monitoring. For various trades including swaps, options, fixed income, FX etc. these two limits are calculated on a daily basis and monitored by risk management. Generally,
Treasury Limit for a counterparty = Pre-settlement Limit + Settlement Limit
The treasury exposure for a counterparty is compared against the above defined treasury limit for that counterparty. Any breaches are reported to the concerned traders in the front office so that they may take the necessary corrective action to bring down the exposure to respective counterparty. Many banks report a limit breach when the Treasury Limit OR settlement limit gets breached. Generally, pre-settlement limit breaches may not be reported.
We can make out from the names, pre-settlement limits are applicable when the trade has a longer time to expiry (i.e., generally greater than T+2 days to maturity). An approach to calculate the pre-settlement exposure for example say a plain vanilla interest rate swap is to look up the maximum amount of cash flow to be exchanged during the life of the swap.
Whereas, settlement limit is something which is applicable within the settlement period for a trade. Generally, treasury limits are tracked for the bank’s trades with other banks / financial institutions
Trade limits are monitored generally for counterparties that are non-banks / non-financial in nature. For example, say the monitoring of exposure limits for a certain counterparty that is into manufacturing may be monitored under trade limits.
Are Trade Limits and Treasury Limits interchangeable?
The bank’s Financial Institutions Group (FIG) is the owner of the Trade and Treasury Limits. These limits are interchangeable if the business teams expect potential new business to come to the bank. Finally, growth of the bank’s business is important, so whenever required tweaks can be made to these limits that have been set in the board approved policies.
Total Limit for a counterparty = Treasury Limit + Trade Limit
Lets understand the interchangeability of these limits through a simple example. We are given the following for a certain counterparty XYZ:
Assume the current treasury limit consumption is $450. Whereas, assume that trade limit consumption is NIL. Say that the Front Office believes that there are going to be some potentially profitable trading opportunities with XYZ Ltd over the next 1 month, and for pursuing the same they need an additional limit of $200. Now they only have $50 available before they breach the treasury limit set at $500. Therefore, in this case the Front Office will approach the FIG group to allow temporary transfer of $200 limits from trade to treasury for a period of 1 month. If the FIG approves, the limit transfer can happen such that the new limits would look like below:
Note, that in no case are they exceeding the board approved Total Limit of $800.
Generally, most banks / lending institutions have a limits module as a part of their enterprise risk management system. These limits are monitored in real time. To ensure integrity of the limits module, the business functions are given a Read access, whereas, Risk Management is given a Read + Write access to the limits module. The management, auditors & regulators also periodically review the reports on limit breaches and the corrective actions taken. Exposure monitoring plays an important role in the overall risk management, also the exposure calculations done in the bank’s systems get used in computation of one of the components of the regulatory capital requirement for banks.