Wrong-way Risk
March 17, 2025
What is Wrong-way Risk?
Wrong-way risk (WWR) occurs when the probability of a default by a counterparty is correlated with the size of exposure to that counterparty. In other words, the more money owed by the counterparty, the greater the chance the counterparty will default. This is an issue that has come to the fore following the Financial Crisis in 2007/8 as banks and regulators look to improve counterparty credit risk.
Key Learning Points
- Wrong-way risk is an element of counterparty risk
- It occurs when the probability of defaults by a counterparty is correlated with the size of exposure to that counterparty
- Specific wrong-way risk (SWWR) is driven by the specific risk profile of the counterparty or the transaction
- General wrong-way risk (GWWR) occurs when the change in creditworthiness of the counterparty and the exposure are both driven by general macroeconomic conditions
- Collateral is an important tool to manage counterparty risk in general and wrong way risk specifically
The Risks of Counterparties
In its simplest form, counterparty risk is the likelihood that a transaction will fail as one side of the deal has been unable to meet its obligations. Counterparty risk is a significant concern for investment banks, particularly when it comes to wrong-way risk. If the likelihood of default grows along with the size of the obligation, this can be termed wrong-way risk.
Counterparty risk can be difficult to predict as it depends on the market conditions and is usually associated with derivative contracts. These types of contracts can be exposed to significant potential losses in the future, and due to being OTC contracts, there is no central clearing house to protect the two counterparties.
Defining Right and Wrong Way Risk
Wrong way risk can significantly impact the extent of counterparty credit risk. It occurs when the probability of defaults by a counterparty is correlated with the size of exposure to that counterparty. The higher the credit exposure (to a counterparty), the lower the credit quality (of the counterparty).
Right-Way Risk
Right way risk is the opposite of wrong way risk. It occurs when, as the credit quality of the counterparty improves and the probability of default decreases, the size of the exposure increases. This is a positive correlation as the risk of default shrinks as the exposure to credit risk rises. Risk exposure decreases as the counterparty’s credit quality worsens.
This is clearly preferred by financial institutions as there is a positive relationship between the size of the deal and the risk associated. As the size of the exposure rises (e.g. from US$1m to USD1.8m), the risk of default would lessen (e.g. 10% to 7%).
Wrong-way Risk vs. Right-way Risk
Wrong-way risk is contrasted with right-way risk, where the exposure to a counterparty decreases as the counterparty’s credit quality deteriorates. In right-way risk scenarios, the potential losses are mitigated as the counterparty’s financial condition worsens.
Specific Wrong-Way Risk (SWWR)
Specific wrong-way risk is driven by the specific risk profile of the counterparty or the transaction. Let’s look at an example of when a bank enters into an interest rate swap with a company where the company is receiving fixed interest and paying the floating interest leg. An increase in interest rates would increase amounts owed from the company to the bank. However, if the company also has many other significant variable rate interest loans to pay, they will also have higher interest payments on those loans. This increases the likelihood of the company defaulting on all of their loans, including the one owed to the bank.
General Wrong-Way Risk (GWWR)
General wrong-way risk occurs when the change in creditworthiness of the counterparty and the exposure are both driven by general macroeconomic conditions. For example, a short equity swap position, which wins if equity markets fall, might face general wrong way risk. If there is a general economic downturn leading to a stock market crash, the winning position from the trade would increase at the same time as the counterparty may be suffering a decrease in its creditworthiness.
General vs. Specific Wrong-way Risk
General wrong-way risk refers to situations where there is a broad, market-wide correlation between exposure and credit quality. Specific wrong-way risk, on the other hand, involves a direct relationship between the exposure and the counterparty’s credit quality.
Examples of Wrong-way Risk
Examples of wrong-way risk include situations where a bank has lent money to a company and also holds the company’s bonds. If the company’s financial condition worsens, the value of the bonds will decrease, and the likelihood of default on the loan will increase.
Specific Wrong-way Risk under Basel III
Basel III regulations require banks to identify and manage specific wrong-way risk. This involves assessing the correlation between exposure and counterparty credit quality and implementing measures to mitigate potential losses within the bank. It will also help regulate systemic risk within financial markets.
Conclusion
Understanding and managing wrong way risk is crucial for investment banks to mitigate counterparty credit risk effectively. By implementing strategies such as collateralization, banks can reduce potential losses and ensure a more stable financial environment.
Download the cheat sheet to learn more about Wrong-way Risk and how to mitigate it.