Credit Risk Management Framework (Collateral (Types of collateral (…
Credit Risk Management Framework
Issues relating to counterparty credit risk
Due Diligence of various counter parties
Checking public information about the counterparty including all aspects of their financial position
Checking the strategic objectives of the client or counterparty and their attitude to risk
Knowing the quality of management of the counterparty
Assessing the experience and degree of profitability of the previous trading of the counterparty
Making some assessment or check on the counterparty’s standing amongst its business creditors
Checking the size of the exposure by way of the counterparty positions compared with other market users of a similar scale
Checking current account and reserve account balances
Checking currency reserves
Analysis of sovereign credit reports from credit ratings agencies
Analysis of past and projected tax receipts
Analysis of government monetary and fiscal policy
Analysis of key government policies
Using credit reference agencies
Analysis of recent bank statements
References from other banks
Source of wealth checks
Ongoing Reviews of the creditors are required - especially in changing economic situations
Overlap between risks
Overlap between products
Guarantees will always have a legal edge to them with respect to:
The triggers under which the guarantee will be invoked
The degree of benefit that the guarantee provides and whether there will be any capping or conditionality about this
The form of guarantee and the evidence presented in writing signed by the guarantor
Any special legal defences
The right of the guarantor to seek indemnity and reimbursement
Whether the guarantee is full or only partial – the guarantee of part of a debt might apply to a second tranche of a debt rather like an excess on an insurance policy
Issues w/ guarantees
We will only ever know the real value of a guarantee when we call it up.
the guarantee itself is yet another form of credit risk that may not deliver and hence the legal aspects of guarantees are so vital to get right in their drafting and in the enforceability of the documents.
Types of collateral
Charges or mortgages – a transfer of title ownership to the collateral taker. Charges can be floating or fixed. Floating charges are over a class of assets and are distinguished from a fixed charge in that the collateral provider is permitted to deal with the collateral. The collateral taker cannot keep the collateral after an enforcement event but must sell it to satisfy his claim.
Lien – the right to retain possession of the collateral, sometimes known as charges.
Pledge – whereby security interest is provided to another party. In this case the collateral taker cannot keep the collateral after an enforcement event but must sell it to satisfy his claim.
Transfer and set-off – under which the collateral ownership absolutely is transferred to the collateral taker.
Typically collateral arrangements between firms can be unilateral, bilateral or netted:
A unilateral agreement means that one party gives collateral to the other.
A bilateral agreement allows for double-sided obligations (for example with swaps or foreign exchange transactions) to be catered for. Under such an arrangement, both parties must post collateral for the value of their total obligation to the other.
Netted – this is an arrangement whereby the net obligations between two parties may be collateralised so that at any point in time the party who is the net obligor posts collateral to the other for the value of the net obligation outstanding.
Collateral will normally be marked to market and re-valued. It is important to know what the present value is at all times and therefore the exercise will be conducted on a daily basis. Should the collateral reduce in value, it will be necessary for the obligor to present additional collateral and the reverse will be true when the collateral is surplus to requirements. .
Examples of collateral
House under a mortgage, a cash payment against a margin requirement, a parent company guarantee to cover a loan to a subsidiary company from a lending institution, a negotiable security to cover a short options position or a bond taken in a stock lending transaction.
What is Collateral
The objective of taking collateral from another party is to convert credit risk (the concern about the right to receive money) into market risk (the right to sell property).
Why discount collateral?
To build a cushion for potential falls in the market value of the asset
To allow for the expenses of realisation
To build in a cushion for debit interest and charges to be applied to the loan
Risks should be diversified and it has its application therefore in the realms of credit risk; for example lenders will diversify credit risk by taking guarantees and taking collateral.
Another level of diversification is the manner to which it is used to offset risk across a portfolio by spreading it across borrowers or across investments. This has the effect of creating a different set of non-correlating risks and avoids unwanted concentrations of credit risk.
Central Counterparties - Do second part
Listed futures and options markets have always had central clearing houses whereby all the members of an exchange would trade happily with each other knowing that every trade that was conducted between them would be transferred by a legal process known as novation. The process of novation involves a central counterparty clearing house becoming the buyer to every seller and the seller to every buyer.In this way the central counterparty presented a single point of relationship and a single credit risk to every individual member of the exchange rather than the exchange members having risks with each other.
As indicated above, the central counterparties (CCPs) themselves present a credit risk to the firms with whom they have a relationship and in most cases these firms are larger financial entities than the central counterparties themselves. Hence the financial backing and management strength of the central counterparties is vitally important. Typically, this is provided not only by shareholder funds but also a sizeable fund in cash provided by the clearing members of the CCP and possibly by other resources.
Probability of default (PD)
This is the likelihood that a specific asset will go into default. It is a percentage. This is based on the
historic loss experience of the institution.
Loss given default (LGD)
This is the loss that actually occurs when the default event occurs. As such it does take account collatera the degree of subordination.
Exposure at default (EAD)
The loss is contingent upon the amount to which the bank was exposed to the borrower at the time of default, commonly expressed as exposure at default (EAD).
These three components (PD, LGD, EAD) combine to provide a measure of expected intrinsic, or
is the financial term used to describe a general default event related to a legal entity's previously agreed financial obligation.
Failure to pay
The weighted average cost of capital (WACC) is the rate (expressed as a percentage, as with interest) that a company is expected to pay to bondholders (cost of debt) and shareholders (cost of equity) to finance its assets.
WACC is the minimum return that a company must earn on its existing asset base to satisfy its creditors, owners, and other providers of capital.
Different securities are expected to generate different returns. WACC is calculated taking into account the relative weights of each component of the capital structure – debt and equity, and is used to see if the investment is worthwhile to undertake.