03 · Exposure value, CRM & counterparty risk

Before the weight comes the amount

Risk weights get the attention; the exposure value quietly decides half the answer. For balance-sheet items EAD is carrying value net of provisions; for commitments it is a credit-conversion question — how much of the undrawn line will be drawn by the time trouble arrives (empirically: most of it, which is why the unconditionally-cancellable 0% became 10%); for derivatives it is a distribution question — what could this be worth when the counterparty fails.

The derivatives answer has its own history. The Current Exposure Method (1988) — MtM plus a notional add-on — survived twenty-five years because it was simple, and misfired throughout because the add-ons knew nothing of netting quality, margining or moneyness. SA-CCR (BCBS 2014, EU since 2021) rebuilt it: replacement cost that respects margin terms, PFE add-ons per asset class with supervisory factors, a multiplier rewarding over-collateralisation, and the α = 1.4 scalar carried over from IMM as a conservatism buffer — much criticised, still standing.

CRM philosophy: collateral and guarantees reduce loss only if legally enforceable, valued with haircuts for market and FX risk, and monitored. CRR3's notable turn: own-estimate haircuts abolished — one more model surface closed.