Credit risk mitigation techniques

CRM techniques under the Basel Standardised Approach to Credit Risk framework are broken down as follows:

• Collateralised transactions: A bank has a credit exposure which it hedges in whole or in part by collateral posted by a counterparty or a credit support provider. (Often there is no more than a fag paper between a TTCA and an on-balance sheet netting arrangement).
• On-balance sheet netting: Legally enforceable close-out netting arrangements covering multiple transactions with offsetting mark-to-market values.
• Guarantees and credit derivatives: Guarantees provided by third parties (whose credit risk isn't materially correlated to the counterparty’s) or credit derivative transactions.

Now note a fundamental difference between legally enforceable netting arrangements and Guarantees: In a netting arrangement the full value of the offsetting transaction fully and automatically cancels out the corresponding exposure. There are no contingencies. By contrast, collateral arrangements that don’t amount to enforceable netting arrangements, guarantees and CDS transactions all depend for their effectiveness on the solvency of the person providing the credit mitigation – if the credit support provider fails, so does the credit mitigation and the exposure remains.

Credit risk mitigation against exposure negation

Note the difference between 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 collateral to a counterparty outright may, as part of a valid netting agreement, mitigate that collateral but it will leave an exposure for the return of any excess collateral should the MTM move (or any margin haircut); however
• A pledged collateral arrangement — at least to the exent that the bank doesn’t surrender legal title to the collateral at all — will leave the bank with no counterparty credit exposure at all to the haircut or excess, seeing as it remains the bank’s, and if the counterparty goes bust, the bank does not have to claim it from the counterparty’s insolvent estate.