The fourth seminar of the risk salon program was about the credit risk management in capital markets. We were honored to have Guillaume Dechambre, Vice President, Cross Business Risk Trading, at BMO Capital Markets, sharing his remarkable professional experience and knowledge with us. Other speakers include Dmitri Rubisov, Edmond Choi, Xuping Zhang and Devin Luo.
Guillaume started with introducing the differences in managing credit risk by risk management teams and by front office teams. A front office team’s focus is on expected losses because they are supposed to price and hedge the capital market credit risk exposure. Risk management team’s responsibility is calculating unexpected losses. They also monitor credit exposure and ensure it stays within risk limits; and calculate capital associated with credit exposures. For credit purposes, banks aggregate all their transactions with each of their counter-parties. Risk managers measure their exposure to these counter-parties in a conservative way. Based on the exposure, credit risk is calculated in a very similar way to that of loans. After that introduction, Guillaume walked us through the history of approaches to credit risk in the international regulatory frameworks. He mentioned that Basel I first introduced credit risk based capital in 1988, but that capital was based on a constant fraction (8%) of the exposure. Subsequent Basel accords (II and II.V) added a series of new concepts such as revised risk weights, and the use of internal models. Operational risk was also added at that time. After the 2008 financial crisis, regulators realized the weakness of the previous Basel accord and introduced quick changes known as Basel II.V. Among other new requirements, it demanded that CVA volatility became part of VaR calculations.
Guillaume said that CVA (Credit Valuation Adjustment) is a very important concept in today’s regulatory framework and the main focus of the front office credit risk teams. It can be considered the price that must be paid for the expected credit loss arising from the banks’ transactions with different counter-parties. By definition, CVA is the difference between the price that includes the probability of defaults and the price calculated with no default consideration. CVA depends on many variables such as market conditions, credit spread and recovery rate. Calculation methods depend on whether the deals are collateralized and whether there is a netting agreement with counter-party. Correct correlations are very important in calculating CVA to be able to account for the wrong way risk. After that Guillaume talked about parties in the front office involved in trading derivative transactions. He introduced the three parties dealing in this area: sales team, trading team and CVA desk. CVA desk prices the cost of doing a trade from a counter-party risk perspective and sends the price to the sales team, which will also receive a risk-free price from traders. The final price of the trade is the combined price of the two. The sales team has to ensure that after the transaction the credit exposure stays within the limits. The bank hedges its CVA exposure by trading CDS and baskets of bonds.
Guillaume ended his exciting presentation by sharing his insight on the differences between working in risk management and front office teams. Generally credit risk management teams like people with a quant background for model development. There is more time for research and innovations in risk management teams than in the front office.