Credit risk management answers the question "what money could be lost in the event that a client defaults on its obligations".
In most cases, transactions are collateralized. At any point in time, if a party makes a margin call and fails to post collateral, the portfolio and collateral are liquidated. This can still result in substantial credit risk exposure.
The collapse of Archegos Capital Management resulted in $5.5 billion loss for Credit Suisse!
This addresses immediate loss potential if a customer defaults today. While simpler than calculating future exposure, it reveals critical issues.
Accurately measuring current exposure is fundamentally a data management challenge. For example, two $100 transactions — one favoring the client, one against — would net to zero risk under an enforceable netting agreement. Without such protection, the client receives $100 while the company pursues recovery through bankruptcy at reduced value.
Essential elements for accurate measurement include:
Products requiring consolidated management:
Future potential exposure assesses potential loss over time and is more complex to compute. Rather than current market values, this approach uses Value at Risk (VaR) distributions and stress testing to model possible future scenarios and their impact on position values and collateral requirements.