Credit Risk Mitigation In The Standardized Approach-Credit and Risk Managment-Lecture Notes, Study notes of Credit and Risk Management

Download Credit Risk Mitigation In The Standardized Approach-Credit and Risk Managment-Lecture Notes and more Study notes Credit and Risk Management in PDF only on Docsity! LECTURE – 24 CREDIT RISK MITIGATION IN THE STANDARDIZED APPROACH Credit risk mitigation (CRM) relates to the reduction of by, for example, collateral, obtaining credit derivatives or guarantees, or taking an offsetting position subject to a netting agreement. The 1988 Accord recognizes only collateral instruments and guarantees deemed to be reliably/identifiably of the very highest quality. The Accord takes an all-or-nothing approach to credit risk mitigates: some forms are recognized while others are not. Since 1988, the markets for the transfer of credit risk have become more liquid and more complex. The number of suppliers of credit protection has increased, and new products such as credit derivatives have allowed banks to un-bundle their credit risks and to sell those risks that they do not wish to retain. The Committee welcomes these innovations: greater liquidity in itself reduces the transaction costs of intermediating between borrowers and lenders, and it also encourages a more efficient allocation of risks in the financial system. In designing the new framework for credit risk mitigation, the Committee has pursued three aims: improving the incentives for banks to manage credit risk in a prudent and effective manner; 1. continuing to offer a prudent and simple approach that may be adopted by a wide range of banks; and 2. relating capital treatments to the economic effects of different (CRM) Credit Risk Mitigation techniques, delivering greater consistency and flexibility in the treatment of different forms of CRM techniques. The new framework for credit risk mitigation offers a choice of approaches that allow different banks to strike different balances between simplicity and risk-sensitivity. There are three broad treatments to CRM: in the standardized approach, the foundation IRB approach and the advanced IRB approach. The treatments of CRM in the standardized and foundation IRB approaches are very similar. In the advanced IRB approach, banks are permitted to estimate a greater number of risk parameters, but the concepts on which the framework is based are the same. The approach to CRM techniques is designed to focus on economic effect. However, collateral, netting and guarantees/credit derivatives typically have different risk characteristics. For example, collateral represents .funded. Protection whereas guarantees and most credit derivatives is unfunded. Furthermore, whereas collateral instruments are subject to market risk, guarantees are not. Finally, credit derivatives are more likely than collateral to be subject to maturity or asset mismatches. Hence, although the treatments of collateral, netting and credit derivatives and guarantees are based on similar concepts, the risk weighting schemes are different. While CRM techniques generally reduce credit risk, they do not fully eliminate it. In such transactions, banks - often for good business reasons - leave some residual risks un-hedged. Three forms of residual risk are explicitly addressed in the new proposed framework: asset mismatch, maturity mismatch and currency mismatch. The Committee’s approach to maturity and currency mismatch is the same across all CRM techniques. The treatment for asset mismatch is provided in the area of credit derivatives. The June 1999 Consultative Paper set out the Committee’s intention to focus on the economic risks, and this intention received broad support among commentators. This document explains the proposed treatments of credit risk mitigate in much greater detail. Also in the context of CRM, given the operational and capital requirements of the first pillar in BASEL Accord, the second pillar will be used to ensure that banks are sufficiently well equipped, ex ante, to control and manage the risks inherent in each business in which they are involved. Furthermore, Pillar 2 supervisory responses will have a role to play should it become apparent, ex post, that banks systems and controls are not adequate to capture and manage the risks of their business. Some rated debt issues may contain credit risk mitigates. Where those mitigates are taken into account in the external credit assessment, they may not be granted regulatory capital relief under the framework set out in this part of the supporting document. If other risk mitigates are applied, then they may be recognized. In other words, no double counting of credit risk mitigation will be allowed docsity.com Collateral This section covers collateralized transactions. A collateralized transaction is one in which 1. A bank has an credit exposure or potential credit exposure to another party by virtue of cash or financial instruments lent or posted as collateral, or an OTC derivatives contract; and 2. The exposure or potential exposure is hedged in whole or in part by collateral posted by the counterparty. As a general rule, no secured claim should receive a higher capital requirement than an otherwise identical claim on which there is no collateral. Well-documented collateral agreements reduce credit risk to the lender. However, the near-collapse of LTCM “Long-Term Capital Management” in 1998 demonstrated that even a fully collateralized position is not without risk. i Minimum Conditions Before capital relief will be granted to any form of collateral, the standards set out in this section must be met. Supervisors will monitor the extent to which banks satisfy these conditions, both at the outset of a collateralized transaction and on an on-going basis. Legal certainty a. Collateral is effective only if the legal mechanism by which collateral is given is robust and ensures that the lender has clear rights over the collateral, and may liquidate or retain it in the event of the default, insolvency or bankruptcy (or otherwise-defined credit event set out in the transaction documentation) of the obligor and, where applicable, the custodian holding the collateral. b. A bank must take all steps necessary to fulfill local contractual requirements in respect of the enforceability of security interest, e.g. by registering a security interest with a registrar. Where the collateral is held by a custodian, the bank must seek to ensure that the custodian ensures adequate segregation of the collateral instruments and the custodian’s own assets. c. A bank must obtain legal opinions confirming the enforceability of the collateral arrangements in all relevant jurisdictions. Legal opinions should be updated at appropriate intervals (e.g. annually). d. The collateral arrangements must be properly documented, with a clear and robust procedure for the timely liquidation of collateral. A bank’s procedures should ensure that any legal conditions required for declaring the default of the customer and liquidating the collateral are observed. Low correlation w th exposure In order for collateral to provide protection, the credit quality of the obligor and the value of the collateral must not have a material positive correlation. For example, securities issued by the collateral provider - or by any related group entity - would provide little protection and so would be ineligible. Robust risk management process While collateral reduces credit risk, it simultaneously increases other risks to which a bank is exposed, such as legal, operational, liquidity and market risks. Therefore, it is imperative that a bank employ robust procedures and processes to control these risks. The following is a list of sound practices relating to collateral management. Collateral Valuation Collateral should be revalued frequently, and the unsecured exposure should also be monitored frequently. More frequent revaluation is more prudent, and the revaluation of marketable securities should preferably occur on (at least) a daily basis. Furthermore, stressed and unstressed measures of the potential unsecured exposure under collateralized transactions should be calculated. One such measure would take account of the time and cost involved if the borrower or counterparty was to default and the collateral had to be liquidated. Furthermore, the setting of limits for collateralized counterparties should take account of the potential unsecured exposure. Stress tests and scenario analysis should be conducted to enable the bank to understand the performance of its portfolio of docsity.com