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Credit Risk Management Framework- Collateral/Credit assessment (Collateral…
Credit Risk Management Framework- Collateral/Credit assessment
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 allow for the expenses of realisation
To build in a cushion for debit interest and charges to be applied to the loan
To build a cushion for potential falls in the market value of the asset
Types of collateral
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.
Lien – the right to retain possession of the collateral, sometimes known as charges.
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.
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.
Typically collateral arrangements between firms can be unilateral, bilateral or netted:
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.
A unilateral agreement means that one party gives collateral to the other.
Monitoring
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. .
Due Diligence of various counter parties
Governments
Analysis of sovereign credit reports from credit ratings agencies
Analysis of past and projected tax receipts
Checking currency reserves
Analysis of government monetary and fiscal policy
Checking current account and reserve account balances
Analysis of key government policies
Ongoing Reviews of the creditors are required - especially in changing economic situations
Companies
Knowing the quality of management of the counterparty
Assessing the experience and degree of profitability of the previous trading of the counterparty
Checking the strategic objectives of the client or counterparty and their attitude to risk
Checking public information about the counterparty including all aspects of their financial position
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
Retail
Credit scoring
Using credit reference agencies
Liquidity checks
Analysis of recent bank statements
Source of Wealth Checks
Security
References from other banks
Boundary issues
Overlap between products
Overlap between risks