European markets. In the event that accounts receivable cycles in these markets lengthen further, or larger resellers in these regions fail, the manufacturer is adversely affected. Hence the wisdom of credit limits.
The board, CEO and senior management are responsible for determining the appro- priate credit limit structure. Some financial analysts suggest that the best way to proceed is to first establish the risk appetite of the firm, then follow with the overall framework within which the system of counterparty risk limit operates.
Whether this or a different approach is adopted, it is important to remember that setting limits is a dynamic, ongoing process that relies for its effectiveness on input from many areas of operations. The imposition of institution-wide credit risk (and market risk) limits is a strategic decision affecting business units, loans offices, desks and traders across the organization.
Both for loans and for trading, a framework of institution-wide limits gives senior management a clear goal for the amount of credit exposure as a whole.
Unbundling that risk along divisional and departmental lines provides their managers with a measure of the risks that can be assumed. Another interesting unbundling is according to product lines and geographic operations area. The best way to proceed is by means of an interactive limit management procedure, which includes simulation and experimentation. Among important decision elem- ents for a portfolio of debt instruments are:
● Weighted average risk rating
● Variances from limits
● Target exposures experienced in the short, medium and long term, and
● Special considerations to be given to factors such as country risk.
A sound practice requires that the counterparty risk premium is separated from product-related income, so that it can be addressed on a default-oriented basis, even if further down the line credit risks and market risks are combined. Risk pre- miums connected to counterparty exposure must cover the default probability of the debtor and a contribution to a possible increase in market uncertainty because of default.
Credit lines must not only be set up, but also monitored. They need to be spe- cified for each counterparty–product combination whose credit limits must be classified by tenor, and set up in all currencies used in transactions. All transac- tions should be tracked in real time against these credit lines.
Hierarchies of lines and sublines must also be established, with separate credit limits for each. As section 5 underlined, the collateral for limits being awarded must be steadily monitored. Clauses conditioning credit availability can be of two types depending on the characteristics of the line:
● With revolving lines, a repayment increases the availability of funds against the line
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● With non-revolving lines (special transaction lines), a repayment does not alter line availability.
In either case, liabilities must be tracked against the customer’s individual credit lines, as well as together with the counterparty’s parent company’s set of credit lines (if any). This is important in as much as credit facilities awarded to a parent com- pany can be utilized by its subsidiaries and branches. If the transaction creates an overdraft situation, an override should be required with full identification of the authorizer.
Banks operating in the global market have the intention of providing them- selves with automatic currency conversion facilities. If the currency of the book- ing differs from that of the line, the system should convert the amount from the booking currency to the line currency, before checking for availability of funds.
Additionally, an interest and charges function should handle the interest-related input and processing requirements for balance-type accounts, providing flexibility in defining all necessary aspects involved in calculating debit interest, credit interest, charges and credit allowances. This function should be fully parameter- ized with the system, creating a whole range of exception reports brought to man- agement’s attention.
Feedback control is recommended because commercial credits are rapidly grow- ing and this increases the need for a more accurate and up-to-date limit disposition and monitoring system. The adopted solution should target position risk calcula- tion (Chapter 8), and include risk premium computing, a steady watch over risk premium limits, country risk assessment and counterparty default risk. The method to be chosen should satisfy two objectives:
● Quantifying counterparty exposure, and
● Assisting in evaluation of the current capital at risk.
An example is the computation of present value of a financial transaction. Present value (PV) represents the present cost of replacing this transaction in the event of default. Net present value (NPV) is calculated as the sum of present value plus add-ons or, in the case of forward contracts, of future cash flows.
While the choice of method is in itself a challenge, institutions must also pay enough attention to other challenges, such as timeliness and effective visualiza- tion, to improve end-user perception of computational results. Not only should reporting be online, interactive and in 3-D colour graphics, but it must also visual- ize the output in a way that leads to efficient management decisions.
Last but not least, good management practice must see to it that the chief credit officer responsible for counterparty risk is also responsible for analysis, evaluation
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and reporting on prudent limits. While in centralized counterparty risk manage- ment the final decision regarding the allocation of credit limits will be taken at headquarters, a well-run credit division will always appreciate critical input from the field.