What is Counterparty Credit Risk
Counterparty Credit Risk is all about risk of dealing with banks. This risk primarily deals with an event under which a banking institution (aka counterparty) fails to meet its obligations to return the money that it borrowed from another bank (aka counterparty).
Banks usually need a lot of cash to do trading, to run their operations, payroll etc... due to their gigantic size. Since they don't have all the cash handy, they usually go to another bank and borrow. Under good economic conditions, banks usually have no problems in lending each other money but they want some sort of assets in the escrow account to make sure they get their money back. The asset that is put as a guarantee in escrow account is called "Collateral". Once the borrower bank returns the money back, the lending bank returns the collateral.
Now consider, economic conditions start worsening and banks still need money to run their operations. The same original banks are now reluctant to lend each other because they are doubting whether the other bank will be able to pay the money back. In case, the borrowing bank doesn't return money, lending bank might have a problem with its operations as well. To signal other bank about its creditworthiness during bad economic conditions, borrowing banks are willing to put even more collateral to get the money. However, even after more collateral deposits, banks are still unwilling to lend each other due to counterparty risk. The rationale here is banks usually put Bonds as a collateral to borrow money and lending banks are not willing to keep those bonds as collateral because they are not even sure whether they would be able to recover 100% of the lent money by selling those bonds in case counterparty defaults on its obligation. Also, under bad economic conditions prices usually fall and hence it makes it even more difficult to price those bonds accurately. Seeing so much volatility in markets, banks usually decline to lend regardless of collateral being posted.
As one can see, when banks stop lending each other because of the creditworthiness of the borrowing bank, it can cause huge liquidity crisis in the financial sector. In fact, this was the primary reason why two famous banks in America, "Lehman Brothers" and "Bear Stearns" collapsed as no other bank was willing to give them cash to keep them functioning. Finally, without much cash in hands to run the operations, banks were left with no choice but to file bankruptcy.
Finally, Remember that Banks are institutions who will give you the umbrella on a perfect sunny day and would want it back on a Rainy day.
This is what counterparty risk is all about.
Nitin
Counterparty Credit Risk is all about risk of dealing with banks. This risk primarily deals with an event under which a banking institution (aka counterparty) fails to meet its obligations to return the money that it borrowed from another bank (aka counterparty).
Banks usually need a lot of cash to do trading, to run their operations, payroll etc... due to their gigantic size. Since they don't have all the cash handy, they usually go to another bank and borrow. Under good economic conditions, banks usually have no problems in lending each other money but they want some sort of assets in the escrow account to make sure they get their money back. The asset that is put as a guarantee in escrow account is called "Collateral". Once the borrower bank returns the money back, the lending bank returns the collateral.
Now consider, economic conditions start worsening and banks still need money to run their operations. The same original banks are now reluctant to lend each other because they are doubting whether the other bank will be able to pay the money back. In case, the borrowing bank doesn't return money, lending bank might have a problem with its operations as well. To signal other bank about its creditworthiness during bad economic conditions, borrowing banks are willing to put even more collateral to get the money. However, even after more collateral deposits, banks are still unwilling to lend each other due to counterparty risk. The rationale here is banks usually put Bonds as a collateral to borrow money and lending banks are not willing to keep those bonds as collateral because they are not even sure whether they would be able to recover 100% of the lent money by selling those bonds in case counterparty defaults on its obligation. Also, under bad economic conditions prices usually fall and hence it makes it even more difficult to price those bonds accurately. Seeing so much volatility in markets, banks usually decline to lend regardless of collateral being posted.
As one can see, when banks stop lending each other because of the creditworthiness of the borrowing bank, it can cause huge liquidity crisis in the financial sector. In fact, this was the primary reason why two famous banks in America, "Lehman Brothers" and "Bear Stearns" collapsed as no other bank was willing to give them cash to keep them functioning. Finally, without much cash in hands to run the operations, banks were left with no choice but to file bankruptcy.
Finally, Remember that Banks are institutions who will give you the umbrella on a perfect sunny day and would want it back on a Rainy day.
This is what counterparty risk is all about.
Nitin
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