Introduction

Talking to numerous practitioners on a daily basis, Lepus often hears about wrong way risk and the fact that it is one of the main focus points at the moment.  Examining the association between the financial strength of a counterparty (credit worthiness), or set of counterparties, against the respective exposure is categorised as one of the more pertinent priorities. In the past, banks were perhaps more focused on default rates, considering them in isolation, but this has certainly changed of late. Measuring credit exposure has gradually evolved and become more sophisticated.

Key findings

• Background and Overview – The vast majority of banks affirmed that they do, in fact, give recognition to expected correlation between default probability and exposure for OTC trades, at least to a certain extent.

• Monitoring Wrong Way Risk – The response from the banks interviewed suggests that wrong way risk is being monitored actively. The majority of the respondents also commented that approaches are a mixture of proactive and reactive measures.

• Specific vs. General Risk – Although distinctions are not always clear, the vast majority of institutions interviewed for the research differentiate between specific and general wrong way risk.

• Stakeholders and Responsibility – The key stakeholders of wrong way risk at the majority of banks include both risk department personnel and those in the front office

• Qualitative vs. Quantitative Analysis – There does not appear to be a definitive way to distinguish between different types of wrong way risk. However, the greater the number of information sources and types considered, the better the identification of wrong way risk will be.

Conclusion

The research shows that wrong way risk is becoming more actively recognised, monitored and reported. A number of institutions are either increasing the sophistication of their wrong way risk monitoring techniques or rolling out new capabilities. There is still much to consider in this space, and as a greater number of financial institutions become more focused on distinguishing and monitoring different types of wrong way risk, the more established solutions and methodologies will become.

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Tagged with: 2010, risk management, Risk Research Report