The Basel III Enhancements to Counterparty Risk Capital Charges

David Lynch

The Basel III reforms to the international capital rules included substantial changes to the treatment of counterparty risk.¹¹The term counterparty risk is now used here instead of counterparty credit risk. This is because of the recognition of the market risk component of counterparty risk. Most notably this risk was recognised as being both a market risk and a credit risk. This chapter describes the regulatory concerns that led to the changes in the treatment of counterparty risk and gives the rationale and background for the changes. Despite the improvement in risk capture represented by the Basel III changes, there are significant areas of ongoing work where the framework could be changed to provide better incentives to participants in the derivatives markets and a more risk-sensitive treatment.

Regulatory Concerns Regarding Counterparty Risk

The counterparty risk changes in Basel III came about because of broad concerns with over-the-counter (OTC) derivatives expressed by the official sector. For example, the Financial Crisis Inquiry Commission (FCIC) concluded that OTC derivatives contributed significantly to the 2007–9 crisis (Financial Crisis Inquiry Commission 2011)