Calibrating the Single-Counterparty Credit Limit between Systemically Important Financial Institutions
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This paper explains the rationale for a more stringent single-counterparty credit limit as well as the calibration of the proposed tighter 15 percent limit for the largest and most systemically risky institutions. The analysis concludes that the more stringent credit limit would mitigate systemic risks posed by credit extensions between systemically important financial institutions (SIFIs).
Inter-SIFI credit extensions are characterized by a heightened degree of credit risk that is appropriately addressed by a single-counterparty credit limit that differentiates between SIFI and non-SIFI counterparties. SIFIs are engaged in a similar mix of global business lines that are subject to related risks so that a shock that impairs a credit-receiving SIFI could well be expected to also impair the credit-granting SIFI. These commonalities would likely be less salient in the event that a non-SIFI borrower, such as a non-financial corporate, came under stress and defaulted on a credit extension made by a SIFI. Accordingly, the heightened degree of correlation between a SIFI lender and SIFI borrower results in a greater degree of total credit risk on inter-SIFI credit extensions that must be reflected in single-counterparty credit limits to appropriately mitigate financial stability risks.
Single-counterparty credit limits are explicitly designed to limit the threat that a default by a large counterparty could pose to the viability of the creditor. In designing such limits, the potential effects of simultaneous defaults by both borrower and lender should be considered. The threat to financial stability that would be created by multiple SIFI defaults is likely many times larger than the financial stability risk posed by the default of a single SIFI and a single non-SIFI borrower. Accordingly, it is appropriate to set the limit on inter-SIFI credit exposures at a stringent enough level to ensure that the risk of multiple SIFI defaults is significantly lower than the risk of a SIFI default paired with a non-SIFI counterparty default.
The above considerations provide an important qualitative rationale for a more stringent credit limit on inter-SIFI credit extensions. This paper presents a quantitative credit risk model and calibrates that model with data to arrive at a range of inter-SIFI single-counterparty credit limits. A range of data-based model calibrations are considered and presented in recognition of the considerable and inherent uncertainties that exist in using any single model calibration for policy analysis. Credit default swap (CDS) data are analyzed and indicate that the correlation between SIFIs is larger than the correlation between a SIFI and non-SIFI. The heightened correlation between SIFIs is then used as an input to the quantitative credit risk model and results in more stringent single-counterparty credit limits on inter-SIFI credit exposures. The presented model and analysis indicate that a single-counterparty credit limit of 15 percent on inter-SIFI credit exposures is appropriate and mitigates systemic risk.
