COUNTERPARTY CONCENTRATION RISK

Counterparties may also be under concentration risk where a single event is expected to cause significant disturbance at the very same time to many counterparties of the financial system.

The analysis of concentration risk is based on the following concentrated interlinkages and interdependencies:

1. Counterparties are concentrated around a particular exposure or cluster of exposures

2. Credit exposures are concentrated around a particular counterparty and/or cluster¹⁰ of counterparties

3. Counterparties are concentrated around a particular central counterparty and/or clusters of counterparties

4. Counterparties are concentrated around a particular market

In the previous paragraphs we have already discussed the first two. In the case of point 3, counterparties are linked to a central counterparty (single or cluster) in a sense that if the central counterparty defaults or downgrades it will immediately impact the interlinked counterparties (see Figure 11.6a). For instance, most banks have a strong correlation to governmental rating status; also several companies may act as suppliers to a big corporate. Where a government and/or a big corporate defaults it will directly impact the rating status of the correlated counterparties.

Finally, as illustrated in Figure 11.6b, counterparties may be exposed to a common market, e.g., business sector of telecoms. As discussed in Chapter 7 (7.6 Link of Coun­terparties via Markets) several counterparties can be allocated to a single market. Any event in the concentrated sector may cause an immediate impact in surrounding linked counterparties.

Counterparty concentration risk can be minimized by allocating the exposures of the coun­terparties that have different credit and descriptive characteristics and operate in uncorrelated markets.

FIGURE 11.6 An event to a central counterparty (a) e.g. CP_bb, or (b) to a common market risk factor (MRF), may impact the interlinked surrounding n number of counterparties {CP₁, CP₂,... CP_n}

11.5