Credit Risk Measurement: Understanding Credit Risk

Part 4 in Transforming the Credit Risk Management Process

Credit mitigation techniques are used to reduce credit loss. Credit risk mitigations are of two types:

• Credit risk protection through collaterals provided as a part of the transactions.
• Credit risk transfer techniques provided as a part of the transaction or purchased subsequently.

There are various ways to consider risk mitigation within credit risk measurement. Since credit loss is measured through credit drivers, risk mitigation techniques can be reflected in reduction of credit drivers.

Measuring Risk Reduction due to Collateral

Collateral should be realizable to be effective. Factors affecting realization are:

• Liquidity
• Price volatility

To simplify the liquidity impact, the Accord has recognized liquid financial assets as eligible collaterals for the time being. Going forward, as the markets for other collaterals develop (for example, market for second-hand vehicles is quite liquid, markets in many of the countries have their own indices to measure the price trends), supervisors are likely to accept other liquid collaterals (and those collaterals are not necessarily going to be financial collateral) – the most likely candidates are vehicles, real estate and tradable physical assets titles. After liquidity, the most important thing to consider is the price the collateral is likely to realize. The volatility in the price needs to be considered. Since the Basel Accord recognizes financial assets, only the volatility of the financial assets is considered by the Accord and Basel Bench mark

These benchmarks (practices and models), also called comprehensive approach by the Accord, though prescribed for standard approach, can continue to be utilized for other approaches. This helps in smooth transformation. To further ease the transformation, risk weights of the exposure can be substituted with that of collateral to the extent of collateralization for banking books, provided there are no maturity mismatches.

Properties for eligible collateral – over the period of development of the Basel Accord, many additional types of collateral were recognized as eligible. This trend is likely to continue by the supervisors of various countries if it can be shown that the collateral has the following attributes:

• Reliable revaluation – market prices are available
• Volatility in the value for the same type of assets over a period of time; compare this with valuation of equities, bonds or gold
• Rights of the bank or lessor
• Liquidation of assets
• Legal enforceability

Steps in valuation of assets, which lose value with usage and time (like vehicles, machinery, etc)

• Marking-to-market maybe accomplished with the guidance of market prices
• Depreciation curves
• Inflation adjustment
• Disposal adjustment
• Excess mileage adjustment
• Forward-looking elements

Credit Risk Transfers

It is debatable whether guarantees and insurance are a form of risk protection or risk transfer. There are seven types of instruments used for credit risk transfer categorised as funded or non-funded.

Funded vs. Non-funded

Funding implies upfront funding where funds change hands at the beginning of the transaction. Funding is from the perspective of a risk shedder. Techniques for transferring credit risk, such as financial guarantees and credit insurance, have been a long-standing feature of financial markets. In the past few years, however, the range of credit risk transfer (CRT) instruments and the circumstances in which they are used have widened considerably. This is changing the role of banks as a Lender to Loan Originator to loan servicing.

Changing Role of Banks

CRT instruments typically change the relationship between borrowers and lenders and establish new relationships between lenders and those to whom they may pass on credit risk. Further, due to asymmetric information, principal/agent problems and incomplete contracts create problems of moral hazard and adverse selection.

Single Name Instrument

• Directly observable from market rates
• Credit spread for the given rating
• Structural models

Portfolio Instrument

The following components are modelled:

• Probability of default and how this varies over the life of the transaction
• Expected recovery rates on each credit following a default
• Correlation of defaults within the portfolio

Correlation: The industry presently uses crude methods for incorporating correlation. Modelling techniques used by various Agencies (in addition to the judgmental factors and credit conditions) are:

Actors in Credit Risk Transfer

Actors include: borrower; lender/risk shedder; lender’s creditor, shareholders and regulator; risk taker; and risk taker’s creditors, shareholders and regulator. It is a well-known fact that incentives for various actors in the transaction are different. CRT alters the existing incentives in their relationships and, by creating a new set of relationships amongst borrowers, lenders/risk shedders and risk takers, it potentially gives rise to moral hazard and/or conflicts of interest.

For a credit risk transfer, the following should be considered:

• Cash flow
• Bundled and non-bundled risks
• Funding and non-funding
• Credit events and triggers
• Potential exposure and counterparty risks
• Settlement
• Notification to borrower
• Standardized or tradable contract
• Documentation

Following are the best practices to manage/minimize moral hazards or conflict of interest:

(i) Borrower and risk shedder

• Split-risk shedding from loan administration
• Credit monitoring
• Market price
  • KMV model
  • Credit ratings
  • Credit signalling: Measure the health of a borrower by observing price movements and other developments in the credit risk transfer for the borrower
  • Contract should define the behaviour towards distressed borrower according to built in incentives. Moral hazard from both parties should be considered, including their impacts on event definition

(ii) Borrower and risk taker

• Rights flowing through risk shedder are:
  • Maintaining incentives for the risk shedder to monitor the creditworthiness of the borrower and to take prompt and effective action to collect any arrears of payments
  • First-loss tranches
  • Defining risk events and triggers
  • Avoiding or reducing incomplete contracting
  • Use of standardized documentation
• Direct rights
  • Split risk shedding from loan administration

(iii) Risk shedder and risk taker

• Mechanisms to manage or reduce adverse risk selection problem
• Publicly available information on single names
• Third-party credit opinion
• Randomly selecting exposure from the portfolio (auditors and rating agencies are involved to ensure this)
• Risk shedder to retain first loss position
• Retaining small portion of senior tranches (for losses exceeding equity losses)
• Explicit material disclosures from risk shedder
• Own credit review of each name in the portfolio

(iv) Risk shedder and its creditors, owners and regulators

• Disclosures
• Risk Measurement
• Mark to market or model

• Capital adequacy

The same is applicable for a risk taker or its creditors, owners and regulators.

The instrument used to transfer credit risk may not contain terms or conditions that limit the amount of credit risk transferred, such as those provided below:

• Clauses that materially limit the credit protection or credit risk transference (e.g. significant materiality thresholds below which credit protection is deemed not to be triggered even if a credit event occurs, or those that allow for the termination of the protection due to deterioration in the credit quality of the underlying credit exposures).
• Clauses that require the originating bank to alter the underlying credit exposures such that it can result in improvements to the pool’s weighted average credit quality.
• Clauses that increase the banks’ cost of credit protection in response to deterioration in the pool’s quality.
• Clauses that increase the yield payable to parties other than the originating banks, such as investors and third-party providers of credit enhancements in response to deterioration in the credit quality of the underlying pool.
• Clauses that provide for increases in a retained first loss position or credit enhancement provided by the originating bank after the transaction’s inception.
• An opinion must be obtained from a qualified legal counsel that confirms the enforceability of the contracts in all relevant jurisdictions.

The extent to which credit risk mitigation techniques are used vary with the size, business strategy and level of sophistication of the banking institution. Factors which determines the type of techniques used are

• Accounting standards – whether on balance sheet netting is recognized
• Regulatory treatments – whether counterparties receive the preferential regulatory treatment.
• Legal enforceability
• Price
• Liquidity
• Credit quality
• The availability of product and appropriate counterparties
• Historical recovery data
• Ease of structuring

Managing residual risk arising from imperfect credit mitigation technique:

• Maturity mismatch – hedging instrument expires before the underlying assets. Generally, maturity mismatch does not occur for guarantees and collaterals. It is generally a case for credit derivative.
• Basis – basis risk arises where the exposure and/or hedging instrument are subject to potential changes in market price that could create a shortfall in the value of the hedge.
• Asset mismatches – when an asset is hedged by a credit derivative referenced to an asset with different default characteristics.

Take Note: Transformation Process – Timing is the most important element determining the choice of risk mitigation techniques. Collateral or guarantee is often taken ex-ante, as a part of the overall credit process. Credit derivatives are purchased ex-post, at a somewhat later stage in the life cycle of credit exposure. Risk mitigation instruments are also used for managing portfolio concentration.

Measuring Risk Reduction due to Ineffective Risk Transfer

Credit Risk Transfer evolved due to the arbitrage opportunities created by different regulatory treatments for credit risk for insurance companies. The difference has caught the eyes of regulators and regulation is likely to converge to Basel treatment. This aspect should be taken into account while entering into new contracts. This has a major impact on pricing and therefore on potential exposure.

Securitization is one of the ways to transfer the risk. However, many times, for various reasons, there is no clear break from the exposure or risk. The retained risk from securitization is reflected by investment in the BB or lower tranche. This is investment in the below investment grade bonds or in pure junk and represents a very high quantity of risk. In order to discourage banks from using a securitization mechanism as a means to arbitrage regulatory capital requirements, the amount invested is reduced from the capital (or needs 100 per cent capital). This is not because of the grade of the exposure, but because of the securitization. The following table shows the difference in risks by presenting the capital treatment.

Risk Transfer – Residual risk vs. original risk

The instruments used to transfer credit risk may not contain terms or conditions that limit the amount of credit risks transferred, such as those provided below:

• Clauses that materially limit the credit protection or credit risk transference (e.g. significant materiality thresholds below which credit protection is deemed not to be triggered even if a credit event occurs or those that allow for the termination of the protection due to deterioration in the credit quality of the underlying credit exposures).
• Clauses that require the originating bank to alter the underlying credit exposures such that it can result in improvements to the pool’s weighted average credit quality.
• Clauses that increase the banks’ cost of credit protection in response to deterioration in the pool’s quality.
• Clauses that increase the yield payable to parties other than the originating banks, such as investors and third-party providers of credit enhancements, in response to deterioration in the credit quality of the underlying pool.
• Clauses that provide for increases in a retained first loss position or credit enhancement provided by the originating bank after the transaction’s inception.
• An opinion must be obtained from a qualified legal counsel that confirms the enforceability of the contracts in all relevant jurisdictions.

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