Credit risk mitigation: Difference between revisions
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*'''On-[[balance sheet]] {{tag|netting}}''': Legally enforceable [[close-out netting]] arrangements covering multiple transactions with offsetting [[mark-to-market]] values. | *'''On-[[balance sheet]] {{tag|netting}}''': Legally enforceable [[close-out netting]] arrangements covering multiple transactions with offsetting [[mark-to-market]] values. | ||
*'''{{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. | |||
{{tag|Guarantees}} provided by third parties (whose [[credit risk]] isn't materially correlated to the counterparty’s) or {{tag|credit derivative}} transactions. | |||
{{Box| | {{Box| | ||
Revision as of 18:15, 8 November 2016
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 Schweizers, the Basel Committee on Banking Supervision.
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.
CRM techniques are broken down as follows:
- Collateralised transactions: A bank has a credit exposure which it hedges[1] in whole or in part by collateral posted by a counterparty or a credit support provider.
- 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.
An Important point
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 outright 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 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.
Bedtime reading
References
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Regulatory Capital Anatomy™
The JC’s untutored thoughts on how bank capital works. {{{2}}}
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- ↑ This is what it says, and I suppose it is true, even though this is a curious way of describing it