Core Focus: The identification, measurement, and management of credit and counterparty risk in reserve portfolios, including the use of rating-based limits, concentration thresholds, counterparty assessment, and collateral and legal frameworks.

In-Depth Notes:
Reserve management entities are exposed to credit risk on all deposits, investments, and off-balance sheet transactions . Credit risk is the risk of loss arising from the failure of a borrower or counterparty to meet its financial obligations. For reserve portfolios, credit risk arises from investments in bonds, deposits with banks, and repurchase agreements . The adoption of credit risk management strategies, including the establishment of counterparty limits and minimum acceptable credit ratings, is a common practice .

Credit Ratings and Counterparty Assessment:
Credit ratings assigned by external rating agencies provide an assessment of the creditworthiness of issuers of debt instruments and of counterparties. Reserve managers typically set minimum credit rating requirements for investments and counterparties. The determination of risk parameters that include the minimum acceptable credit ratings for the counterparties to deal with is a core recommendation for reserve managers . The risk management framework should seek to identify the possible risks that may impact on portfolio values and to manage these risks through the measurement of exposures, and where necessary, supporting internal control procedures to mitigate effects of these risks .

Credit Limits:
Credit limits are established to limit the exposure to any single counterparty or issuer. Limits are typically based on the credit rating of the counterparty or issuer, with higher-rated entities receiving higher limits. The ECB follows a uniform approach, based essentially on two sets of criteria: the assessment of the creditworthiness of the counterparties, and efficiency considerations . All operations are conducted using standard legal documentation, including master agreements for repurchase transactions and over-the-counter derivatives, to protect the central bank’s interests .

The Federal Reserve’s Guidance on Foreign Exchange Settlement Risks:
The Federal Reserve has issued guidance on managing foreign exchange settlement risks, which includes several principles or “guidelines” for credit and counterparty risk management . A bank should use financial market infrastructures that provide payment-versus-payment settlement to eliminate principal risk when settling foreign exchange transactions. Where payment-versus-payment settlement is not practicable, a bank should properly identify, measure, control, and reduce the size and duration of its remaining principal risk . A bank should employ prudent risk mitigation regimes to properly identify, measure, monitor, and control replacement cost risk for foreign exchange transactions until settlement has been confirmed and reconciled . A bank should ensure that agreements and contracts are legally enforceable for each aspect of its activities in all relevant jurisdictions .

Settlement Risk Management:
A bank should properly identify, measure, monitor, and control its liquidity needs and risks in each currency when settling foreign exchange transactions . A bank should properly identify, assess, monitor, and control its operational risks. A bank should ensure that its systems support appropriate risk management controls, and have sufficient capacity, scalability, and resiliency to handle foreign exchange volumes under normal and stressed conditions .

Collateral Frameworks:
Reserve management entities are increasingly implementing collateral frameworks to reduce credit risk. Some reserve managers undertake repurchase agreements and have put in place collateral frameworks for cross-currency swap programs and collateralized repos to manage credit risk. A primary motivation for executing such contractual documentation is to protect the interests of the reserve management entity in the event of a counterparty insolvency, and, in particular, to activate the close-out netting provisions in these agreements. The ECB’s legal documentation requirements ensure that all operations are conducted using standard agreements with close-out netting provisions .