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[[Credit risk mitigation]] is a concept of great interest to those concerned with the capital position of financial institutions. Things like the [[leverage ratio]] and its fabled [[leverage ratio denominator|denominator]], as percolated by that splendid assembly of prudent Schweizers, the [[Basel Committee on Banking Supervision]].
{{a|glossary|}}{{a|crr|}}
[[Credit risk mitigation]] is a concept of great interest to those concerned with the capital position of financial institutions. Things like the [[leverage ratio]] and its fabled [[leverage ratio denominator|denominator]], as percolated by that splendid assembly of prudent bankers, the [[Basel Committee on Banking Supervision]], and [[risk-weighted assets]] are meant as a bulwark against the nightmarish scenes we all witnessed in 2008.


===[[Credit risk mitigation techniques]]===
===[[Credit risk mitigation techniques]]===
Banks may use [[credit risk mitigation technique]]s (jauntily known as “[[CRM technique]]s” or even “[[CRM tool|tool]]s”) to reduce the impact on their capital calculations of counterparty [[credit exposure]] in their trading businesses.
Banks may use [[credit risk mitigation technique]]s (jauntily known as “[[CRM technique]]s” or even “[[CRM tool|tool]]s”) to reduce the impact on their capital calculations of counterparty [[credit exposure]] in their trading businesses.


[[CRM technique]]s are broken down as follows:
===Bedtime reading===
*'''[[Title transfer collateral arrangement|Collateralised transactions]]''': A bank has a [[credit exposure]] which it hedges<ref>This is what it says, and I suppose it is true, even though this is a curious way of describing it</ref> [[in whole or in part]] by {{csaprov|collateral}} posted by a counterparty or a [[credit support provider]].
*[http://www.bis.org/bcbs/publ/d347.pdf Second consultative document on revisions to the Standardised Approach to Credit Risk] HEY! WAKE UP!


*'''On-[[balance sheet]] {{tag|netting}}''': Legally enforceable [[close-out netting]] arrangements covering multiple transactions with offsetting [[mark-to-market]] values.
===In derivative master trading documentation===
The controversial protections in master trading agreements are there for one reason: To stop you losing money. They’re “''[[credit mitigant|credit mitigants]]''”:
====[[Event of default|Events of default]]====
*'''Direct [[Failure to pay]]''': If a party [[failure to pay|fails to pay]] or deliver things it owes under the agreement. This is the cleanest of all default events. If you could precipitate a [[failure to pay]] on any day, you wouldn’t really need the other events of default - each other event has associated anxieties, and will generally take longer to activate. Most master agreements date from an era where there were ''not''  regular payments: a fixed rate interest swap may only require quarterly payments.
*'''Indirect credit issues''': Things that increase the likelihood that the party will be unable to do so in the future:
**'''[[Bankruptcy]]''': The party goes [[insolvent]] (or gets close to it)
**'''Credit impairment''': The party’s [[credit rating]]s are prejudiced (via a merger)
**'''[[Cross default]]''': The party breaches important obligations owed to other counterparties
*'''[[Misrepresentation]]''': Things that tend to undermine the comfort you took as to the party’s creditworthiness at the outset of the arrangement, such as representations and warranties no longer being true.
*'''[[Credit support provider]] issues''': similar things happening to  the counterparty’s named guarantors or [[credit support provider]]s.
These [[events of default]] live in the pre-printed the agreement, and tend not to be negotiated (except perhaps [[cross-default]], and that's a whole different story).
====[[Additional termination events]]====
Brokers will usually also require customised “[[additional termination event|additional termination events]]” tailored to the idiosyncrasies of their clients. For example, they will require of [[hedge fund]]s the right to terminate:
*'''[[Key person]] events''': if named individual investment managers cease to be associated with the fund;
*'''[[NAV trigger]]s''': if [[NAV trigger]]s granting close-out rights related to significant decreases in the [[net asset value]] of the fund.  


*'''{{tag|Guarantee}}s and [[credit derivative]]s''': {{tag|Guarantees}} provided by third parties (whose [[credit risk]] isn't materially correlated to the counterparty’s) or {{tag|credit derivative}} transactions.
These customised events tend to be more controversial, harder to articulate and more complicated: [[NAV trigger]]s may be set at different thresholds over different periods. Additionally, having such events represent termination events potentially cause the counterparty issues with its own market counterparties, who conceivably could use them to trigger [[cross default]]s.


{{Box|
====[[Netting]] and [[margin]]====
===An Important point ===
There are less invasive credit mitigation techniques.  
Note the difference between [[CRM technique|techniques]] which mitigate a credit risk that you nonetheless have — as above — and those which negate the [[credit exposure]] in the first place. So, ''par example'', a [[title-transfer collateral arrangement]] whereby a bank transfers outright {{tag|collateral}} to a counterparty may, as part of  a valid netting agreement, mitigate that collateral but will leave you with an exposure to any [[excess collateral]] or [[haircut]]; however transfer under a [[pledged collateral arrangement]] — at least [[to the exent]] that you don't surrender legal title to the collateral at all — will leave you with no counterparty {{tag|credit exposure}} at all to the haircut or excess, seeing as it is yours, and if the counterparty goes [[bust]], you will be entitled to have it returned in full.
*'''[[Netting]]''': Rights to offset positive and negative transaction values under the same agreement upon [[close out]];
}}
*'''[[Margin]]''': The obligation:
**'''[[Variation margin]]''': To regularly transfer cash or assets representing the present net [[mark-to-market]] value of transactions under the agreement;
**'''[[Initial margin]]''':  To transfer assets representing the worst-case market movements in transactions values between [[variation margin]] payments.
So here’s the thing: As long as margin can be regularly collected and is paid when due, and as long as you’ve generously calculated the initial margin so that it covers any “[[gap loss]]” if your counterparty goes bust — you’re covered. The moment the counterparty misses a margin call, you have a [[failure to pay]]. It’s the cleanest event there is. You may have to wait out a grace period of a day or two — but you took initial margin to look after that.  


===Bedtime reading===
These days, [[regulatory margin]] must be calculated and collected daily. True, at the time your counterparty is struggling, the market positions may not move in your favour, so there may be no payments to fail (but by definition you will be structurally over-collateralised in this case). If you had a means of forcing a payment on any day — if you were entitled to raise [[initial margin]], for example — then even this reservation falls away.
*[http://www.bis.org/bcbs/publ/d347.pdf Second consultative document on revisions to the Standardised Approach to Credit Risk] HEY! WAKE UP!


{{sa}}
*{{isdaprov|Events of Default}} — {{isdama}}
*{{gmslaprov|Events of Default}} — {{gmsla}}


{{ref}}
{{ref}}
{{anat|crr}}

Latest revision as of 11:36, 18 January 2020

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Credit risk mitigation is a concept of great interest to those concerned with the capital position of financial institutions. Things like the leverage ratio and its fabled denominator, as percolated by that splendid assembly of prudent bankers, the Basel Committee on Banking Supervision, and risk-weighted assets are meant as a bulwark against the nightmarish scenes we all witnessed in 2008.

Credit risk mitigation techniques

Banks may use credit risk mitigation techniques (jauntily known as “CRM techniques” or even “tools”) to reduce the impact on their capital calculations of counterparty credit exposure in their trading businesses.

Bedtime reading

In derivative master trading documentation

The controversial protections in master trading agreements are there for one reason: To stop you losing money. They’re “credit mitigants”:

Events of default

  • Direct Failure to pay: If a party fails to pay or deliver things it owes under the agreement. This is the cleanest of all default events. If you could precipitate a failure to pay on any day, you wouldn’t really need the other events of default - each other event has associated anxieties, and will generally take longer to activate. Most master agreements date from an era where there were not regular payments: a fixed rate interest swap may only require quarterly payments.
  • Indirect credit issues: Things that increase the likelihood that the party will be unable to do so in the future:
  • Misrepresentation: Things that tend to undermine the comfort you took as to the party’s creditworthiness at the outset of the arrangement, such as representations and warranties no longer being true.
  • Credit support provider issues: similar things happening to the counterparty’s named guarantors or credit support providers.

These events of default live in the pre-printed the agreement, and tend not to be negotiated (except perhaps cross-default, and that's a whole different story).

Additional termination events

Brokers will usually also require customised “additional termination events” tailored to the idiosyncrasies of their clients. For example, they will require of hedge funds the right to terminate:

These customised events tend to be more controversial, harder to articulate and more complicated: NAV triggers may be set at different thresholds over different periods. Additionally, having such events represent termination events potentially cause the counterparty issues with its own market counterparties, who conceivably could use them to trigger cross defaults.

Netting and margin

There are less invasive credit mitigation techniques.

  • Netting: Rights to offset positive and negative transaction values under the same agreement upon close out;
  • Margin: The obligation:

So here’s the thing: As long as margin can be regularly collected and is paid when due, and as long as you’ve generously calculated the initial margin so that it covers any “gap loss” if your counterparty goes bust — you’re covered. The moment the counterparty misses a margin call, you have a failure to pay. It’s the cleanest event there is. You may have to wait out a grace period of a day or two — but you took initial margin to look after that.

These days, regulatory margin must be calculated and collected daily. True, at the time your counterparty is struggling, the market positions may not move in your favour, so there may be no payments to fail (but by definition you will be structurally over-collateralised in this case). If you had a means of forcing a payment on any day — if you were entitled to raise initial margin, for example — then even this reservation falls away.

See also

References