Default Risk and Derivatives: An Empirical Analysis of Bilateral Netting

Abstract

This paper discusses the determination of a capital charge to cover default risk on a netted derivatives portfolio. Different methods of setting a capital charge are investigated. Their ability to track a more sophisticated measure of credit risk is tested for Australian banks’ portfolios. The effect on the level of credit risk of moving from an environment without bilateral netting, to one where netting has firm legal basis, is examined. We find that, while there are theoretical grounds for arguing that more sophisticated measures would track exposures more closely than the approach currently used in capital adequacy requirements, as an empirical matter, no single formulation clearly outranked any other.