IMPROVING COUNTERPARTY RISK MANAGEMENT PRACTICES

IMPROVINGCOUNTERPARTY RISK MANAGEMENTPRACTICESCounterparty Risk Management Policy GroupJune 1999

iiCOUNTERPARTY RISK MANAGEMENT POLICY GROUPE. Gerald Corrigan, Co-ChairmanManaging DirectorGoldman, Sachs & Co.Stephen G. Thieke, Co-ChairmanManaging DirectorJ.P. Morgan & Co. IncorporatedPolicy Group MembersMichael J. AlixSenior Managing DirectorGlobal CreditBear StearnsThomas L. KalarisChief Executive, AmericasBarclays Capital, Inc.Dr. Hugo BanzigerHead of Credit Risk ManagementGlobal Corporates & Institutes DivisionDeutsche BankRobert O’BrienManaging DirectorChief Credit OfficerCredit Suisse First BostonGary W. BrownManaging DirectorChief Credit Officer, AmericasWarburg Dillon Read (UBS AG)Stan O’NealExecutive Vice PresidentChief Financial OfficerMerrill Lynch & Co., Inc.Patrick de Saint-AignanAdvisory DirectorMorgan Stanley Dean WitterThomas A. RussoManaging DirectorChief Legal OfficerLehman BrothersAnn GoodbodyExecutive Vice President, Citicorp andChairman, Credit Policy, CitigroupEric S. SchwartzManaging DirectorEquity Derivatives and ConvertiblesGoldman, Sachs & Co.Peter D. HancockChief Financial OfficerChairman of Capital Committee and Chairman ofRisk Management CommitteeJ.P. Morgan & Co. IncorporatedRobert StrongExecutive Vice President and Chief Credit OfficerChase Manhattan Corp.Of CounselEdward J. Rosen, Esq.PartnerCleary, Gottlieb, Steen & HamiltonSecretariatAdam GilbertVice PresidentJ.P. Morgan & Co. IncorporatedDavid MengleVice PresidentJ.P. Morgan & Co. IncorporatedAllison MorhaimAnalystGoldman, Sachs & Co.

iiiCOUNTERPARTY RISK MANAGEMENT PROJECTWorking GroupsIRisk Management PracticesCo-ChairmenAnn GoodbodyExecutive Vice President,Citicorp andChairman, Credit Policy,CitigroupIIInformation Sharing and ReportingCo-ChairmenPatrick de Saint-AignanAdvisory DirectorMorgan Stanley Dean WitterIIIMarket Practices and ConventionsCo-ChairmenThomas A. RussoManaging DirectorChief Legal OfficerLehman BrothersStan O’NealExecutive Vice PresidentChief Financial OfficerMerrill Lynch & Co., Inc.Robert StrongExecutive Vice President and Chief CreditOfficerChase Manhattan Corp.Gary W. BrownManaging DirectorChief Credit Officer, AmericasWarburg Dillon Read (UBS AG)MembersMichael J. AlixSenior Managing DirectorGlobal CreditBear StearnsMembersRobert ClemmensHead of Credit Risk Management for theAmericas and Global Head of Credit forLeveraged CounterpartiesBarclays Capital Inc.MembersMark SteglitzGlobal Credit Risk ManagementCredit Suisse First BostonDennis OakleyManaging DirectorGlobal Credit Capital and AssetManagementChase Manhattan BankMarshall LevinsonSenior Managing Director and ControllerBear StearnsJane CarlinManaging DirectorMorgan Stanley Dean WitterBarry L. ZubrowChief Administrative OfficerManaging DirectorGoldman, Sachs & Co.John EmertVice President & Legal CounselCitibank, NAMark BrickellManaging DirectorJ.P. Morgan & Co. IncorporatedJay HelveyManaging DirectorCredit PortfolioJ.P. Morgan & Co. IncorporatedFrank AccettaDirector, Portfolio ManagementCredit Suisse First BostonJeffrey KronthalManaging DirectorHead of Fixed Income DebtDerivativesMerrill Lynch & Co., Inc.Anne BinstockManaging DirectorGlobal Head,Credit Risk Management SecuritizationDeutsche BankC. Douglas FugeManaging DirectorControllerGoldman, Sachs & Co.Ernest T. PatrikisGeneral CounselAmerican International GroupRobert GumerlockIndependent Risk ConsultantWarburg Dillon Read (UBSAG)Maureen MiskovicManaging DirectorHead of Global Risk ManagementLehman Brothers Inc.Daniel CunninghamPartnerCravath, Swaine & Moore

ivCOUNTERPARTY RISK MANAGEMENT PROJECTWorking Groups - ContinuedIRisk Management PracticesIIInformation Sharing and ReportingIIIMarket Practices and ConventionsMembersKevin HeerdtDirector Quantative StrategiesMoore Capital ManagementMembersRobert FinkSenior Managing DirectorTiger Management LLCMembersWilliam P. Bowden Jr.Managing Director and General CounselSociete GeneraleS. Waite RawlsChief Operating OfficerFerrell Capital ManagementCarol SimonHead of Credit Risk Financial Markets- New YorkParibasPeggy EisenManaging DirectorNorth American EquitiesGeneral Motors Investment ManagementCorp.Mark BalfanSenior Vice PresidentIndependent Risk ManagementBank of Tokyo MitsubishiDoug ReidDirector of Banking and FinanceSoros Fund Management LLCRichard A. DunnSenior Vice PresidentHead of Global Risk and CreditManagementMerrill Lynch & Co., Inc.SecretariatCarlos MoralesSenior Vice President &General Counsel of CICG LegalMerrill Lynch & Co., Inc.SecretariatMarjorie E. GrossSenior Vice PresidentLegal DivisionChase Manhattan BankSecretariatAdam GilbertVice PresidentJ.P. Morgan & Co. IncorporatedTim WilsonPrincipalFirm Risk ManagementMorgan Stanley Dean WitterDavid MengleVice PresidentJ.P. Morgan & Co. IncorporatedMarlisa VinciguerraSenior Vice President and CounselLehman Brothers

TABLE OF CONTENTSSummary and Recommendations .2Improving Transparency and Counterparty Credit Assessments 12Improving Risk Measurement, Management and Reporting .24Improving Market Practices and Conventions 37Improving Regulatory Reporting 50Implementation .D.Market Risk, Leverage and Liquidity Risk EstimationCounterparty Credit Exposure and Risk EstimationModel Regulatory Report Formats and DefinitionsGlossary of Terms

2Summary and RecommendationsIn January 1999, a group of 12 major, internationally active commercial and investment banksannounced the formation of a Counterparty Risk Management Policy Group (CRMPG). The objective ofthe Policy Group, whose formation was endorsed by Chairman Greenspan, Chairman Levitt andSecretary Rubin, has been to promote enhanced strong practices in counterparty credit and market riskmanagement. This was to be achieved by building on the self-improvement efforts being undertaken byindividual firms in the immediate aftermath of last year’s severe market disruptions, by extending thoseefforts through collective evaluation of potential new strong practices, by evaluating and proposingimprovements in market-wide practices and conventions, and by compiling information on new strongpractices and, where appropriate, sharing such information with regulators. This report sets forth thePolicy Group’s review of key risk management issues, its evaluation of emerging strong practices, and itsrecommendations for action.The Policy Group approached its work as an initiative by market practitioners mainly targeted atimproving internal counterparty credit and market risk management practices. It did so with appreciationfor several important principles. First, those practices must not be thought of as either static or "one sizefits all". Rather, they must be adapted to the circumstances and practices of individual firms and themarkets in which they operate. They also require continuous adaptation and enhancement. As such, thePolicy Group views many of its recommendations as suggestions for improvements best evaluated by thesenior managers of each firm -- not as an all or none proposition, but rather in the context of theirevolving policies, practices and risk profile. Second, the Policy Group’s recommendations should not beviewed as a roadmap for new regulation or even as a mandated checklist for supervision. It would be amistake to attempt to codify risk management practices in that fashion. Third, the Policy Group’srecommendations are not in any way intended to standardize credit terms and conditions, as creditdecision making must remain the domain of reasoned, professional credit risk managers at individualfirms. Finally, since the intent is for this initiative to have a broad reach across many disciplines andtypes of firms, the Policy Group has reached out to involve directly in its various working groups seniorpractitioners from a broader cross section of U.S. and foreign financial institutions, including banks,investment banks, investment managers, insurance companies and hedge funds. The Policy Groupappreciates the involvement and contribution of these people and firms. The Policy Group, of course, isresponsible for this report and its recommendations.This report is organized in four sections. The first explores initiatives to improve the effectiveness,transparency and quality of counterparty credit assessments. The second part evaluates techniques forimproving important elements of internal risk measurement, management and information flows aimed

3at improved risk awareness and decision making within individual firms. The third section focuses onaspects of common market practices and conventions which, if improved, would facilitate themanagement of counterparty credit risk, including as it relates to dealings with distressed counterparties.The final section explores a limited range of initiatives for improving the quality, timeliness andrelevance of information flows between major market participants and their primary regulators. Theappendices provide more detailed analysis of the key risk estimation and reporting issues.The package of recommendations of the Policy Group represents a comprehensive set of proposals, manyof which build upon improvements to risk management practices already initiated by individual firms.As such, many of the specific recommended practices may already be in place, to one degree or another,in different firms, even if no one firm presently utilizes all these practices. They also reflect new ideasfor further enhancements, growing out of the creative interaction of the many skilled professionals whoparticipated in our various working groups.Overall, the Policy Group believes that its recommendations represent the basis for a significant furtherenhancement of risk management practices which will, in turn, help strengthen the market disciplinesrelated to counterparty and market risk management. While each of the recommendations will contributeto meeting this objective, the Group wishes to emphasize a contextual framework that ties the keyelements of the individual recommendations together. There are six significant building blocks to thatframework. They are:First, implementation of the significant enhancements to information sharing betweencounterparties, as better knowledge of one’s counterparty (recommendation 1) represents thefoundation upon which the other pillars of risk management rest;Second, applying an integrated analytical framework to the evaluation of market risk, liquidityrisk and leverage -- one that treats leverage not as an independent source of risk, but as a factorthat can accentuate market and liquidity risk (recommendation 3);Third, a systematic evaluation of the integrated elements of market, liquidity and credit riskfactors to develop liquidation based estimates of potential counterparty credit exposures, as wellas integrated efforts at market and credit risk stress testing (recommendations 5 and 6);