Leveraged Counterparties After the Crisis

The stress testing programmes should explicitly cover complex and bespoke products such as securitised exposures. According to the Bank of International Settlements, stress tests for securitised assets should consider the underlying assets, their exposure to systematic market factors, relevant contractual arrangements and embedded triggers, and the impact of leverage, particularly as it relates to the subordination level in the issue structure.

Banks have mistakenly assessed the risk of test bank products (eg CDOs of ABS) by relying on external credit ratings or historically observed credit spreads related to (seemingly) similar products like corporate bonds with the same external rating. Such approaches can not capture relevant risk characteristics of complex, structured products under severely stressed conditions.

A bank, therefore, should include in its stress tests all relevant information related to the underlying asset pools, their dependence on market conditions, complicated contractual arrangements as well as effects related to the subordination level of the specific tranches.

The stress testing programme should cover pipeline and warehousing risks. A bank should include such exposures in its stress tests regardless of their probability of being securitised.

Stress testing is particularly important in the management of warehouse and pipeline risk.

Many of the risks associated with pipeline and warehoused exposures emerge when a bank is unable to access the securitisation market due to either bank specific or market stresses.

A bank should therefore include such exposures in its regular stress tests regardless of the probability of the pipeline exposures being securitised.

A bank should enhance its stress testing methodologies to capture the effect of reputational risk. The bank should integrate risks arising from off-balance sheet vehicles and other related entities in its stress testing programme.

To mitigate reputational spill-over effects and maintain market confidence, a bank should develop methodologies to measure the effect of reputational risk on other risk types, with a particular focus on credit, liquidity and market risks. For instance, a bank should include noncontractual off-balance sheet exposures in its stress tests to determine the effect on its credit, liquidity and market risk profiles.

A bank should carefully assess the risks associated with commitments to off-balance sheet vehicles related to structured credit securities and the possibility that assets will need to be taken on balance sheet for reputational reasons.

Therefore, in its stress testing programme, a bank should include scenarios assessing the size and soundness of such vehicles relative to its own financial, liquidity and regulatory capital positions. This analysis should include structural, solvency, liquidity and other risk issues, including the effects of covenants and triggers.

A bank should enhance its stress testing approaches for highly leveraged counterparties in considering its vulnerability to specific asset categories or market movements and in assessing potential wrong-way risk related to risk mitigating techniques.

A bank may have large gross exposures to leveraged counterparties including hedge funds, financial guarantors, investment banks and derivatives counterparties that may be particularly exposed to specific asset types and market movements.

Under normal conditions, these exposures are typically completely secured by posted collateral and

continuous re-margining agreements yielding zero or very small net exposures.

In case of severe market shocks, however, these exposures may increase abruptly and potential crosscorrelation of the creditworthiness of such counterparties with the risks of assets being

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