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Multilateral Development Banks (MDBs) face significant concentration risk due to their lending patterns, often focused on a small number of sovereign borrowers. To mitigate this risk, MDBs have implemented Exposure Exchange Agreements (EEAs), a powerful tool for managing single name and geographical concentration. These bilateral agreements, first introduced in 2015, involve MDBs compensating each other in case of defaults on matched subsets of their portfolios. Initially, participating banks with identical credit ratings exchanged portfolios with matched Exposure at Default (EAD) and expected losses, disregarding counterparty risk.
However, the landscape is evolving as MDBs explore EEAs with differently rated counterparties, ranging from AAA to AA-. This shift raises crucial questions about how varying counterparty credit qualities impact deal participants’ risks. The challenge lies in determining appropriate EAD scaling for lower-rated MDBs relative to higher-rated ones, considering the dual risk of borrower default and counterparty failure.
To address this, a novel approach equalizes Expected Losses (EL) for both parties, accounting for counterparty risk. This method yields a simple closed-form equation for scaling factors, applicable in both provisioning and fair pricing approaches. The provisioning approach uses actual Probabilities of Default (PDs) and Loss Given Default (LGD) rates, while the fair pricing approach employs market-implied PDs.
Analysis reveals that scaling factors vary significantly between approaches and are influenced by the Weighted Average Life (WAL) of the EEA. For a 12.5-year WAL EEA, fair pricing approach scaling factors range from 10% to 50%, while provisioning approach factors are much lower at 1% to 3%. These findings provide crucial guidance for MDBs in structuring EEAs with differently rated counterparties, enabling more effective risk management and portfolio diversification.
