Credit risk mitigation
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Regulatory Capital Anatomy™
The JC’s untutored thoughts on how bank capital works.
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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:
- Bankruptcy: The party goes insolvent (or gets close to it)
- Credit impairment: The party’s credit ratings 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 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:
- Key person events: if named individual investment managers cease to be associated with the fund;
- NAV triggers: if NAV triggers granting close-out rights related to significant decreases in the net asset value of the fund.
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:
- 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.
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.