LO 34.2: Identify and explain the different techniques used to mitigate credit risk,

LO 34.2: Identify and explain the different techniques used to mitigate credit risk, and describe how some o f these techniques are changing the bank credit function.
When conducted properly, the credit risk transfer process can be revolutionary for financial institutions. Proper techniques can include bond insurance, collateralization, termination, reassignment, netting, marking to market, syndication of loan origination, or outright selling of a loan portfolio in the secondary market.
As its name suggests, bond insurance is a formal process of purchasing insurance against the potential default of an issuer. In the corporate debt market, it is the lender who needs to purchase default protection. However, in the municipal bond market, insurance is purchased by the issuer of the municipal obligation. Approximately one third of all municipal bond offerings are covered by insurance. This insurance coverage enables these municipalities to issue debt at reduced rates. Some issuers also need to utilize guarantees and letters of credit, which are both de facto forms of insurance. These tools involve a third party with a higher credit rating than the issuer agreeing to make good on any deficiencies should the issuer default.
The use of collateralization is perhaps the longest running form of credit risk mitigation. The losses sustained by the lender will be offset by the value of the collateral in the event of a default. One issue that needs to be considered is liquidity of the collateral. Liquidity is the ability to turn an asset into cash quickly while retaining reasonable value. In the 20072009 financial crisis, we learned that mortgage lending, while secured with real estate as collateral, is riskier than it sounds because the same risk event that triggered the default of securitized loans also caused the value of the collateral to deteriorate.
.Another risk mitigation option is termination. Using this tool means that the debt obligation is canceled prior to maturity at a mid-market quote. Usually, this means that a certain trigger event, such as a downgrade, has occurred and the issuer was obligated to repay the loan early. An alternative to outright termination is known as reassignment, which gives the right to assign ones position as a counterparty to a third party if a trigger event occurs.
Sometimes a counterparty will enter into numerous derivative transactions with the same financial institution. Some of these derivatives will have a positive replacement value while others will have a negative replacement value. All over-the-counter (OTC) derivatives transactions between common counterparties can be aggregated together so that the net replacement value represents the true credit risk exposure. This process is known as netting.
Marking to market is another option. This tool involves periodically acknowledging the true market value of a transaction. This transparency will result in immediately transferring value from the losing side to the winning side of the trade. This process is extremely efficient, but it does require sophisticated monitoring technology and back-office systems for implementation.
Some financial institutions also utilize loan syndication when an issuer needs to raise a significant amount of capital or perhaps the credit risk is more than a single lender would
2018 Kaplan, Inc.
Page 267
Topic 34 Cross Reference to GARP Assigned Reading – Crouhy, Galai, and Mark, Chapter 12
choose to absorb. The syndication process will involve multiple lenders all working together as a team to provide funding to a given borrower. The lead syndicator will receive a fee from the issuer for arranging the syndicate.
Professors Note: According to the Federal Reserve Bank o f New York, the syndicated loan market grew from $339 billion in 1988 to $2.2 trillion in 2007.
Typically, syndicated loans end up being traded on the secondary markets, and there is an emerging trend for certain entities (e.g., insurance companies) to match the duration of their long-term liabilities with loan pools purchased from banks. These are secondary market transactions. This innovation can mitigate risk for the loan-originating bank and also the insurance company at the same time. The risk reduction is not limited to insurance companies. Secondary market transactions are being used for risk mitigation at all financial institutions.
The traditional model of the bank credit function is changing as a result of these credit risk mitigation techniques. Traditionally, banks would hold credit assets, like loans, until they matured. As such, banks focused on estimating the expected loan losses using the notional value of the loan and the probability of default (PD). These expected losses formed the basis of loan loss reserves held on the banks balance sheet and were explicitly priced into the spread charged on the loan over the banks funding costs. However, the real world has proven that there are many unexpected events that are not captured by normal probability estimates.
Sometimes unexpected events materialize because of credit concentration in loan pools. Many banks become highly concentrated either in their geographic dispersion of loans, their industry exposure, or even in a small number of issuers due to a special relationship with the bank. One of the credit departments key responsibilities is to increase the velocity of capital by using lower cost borrowing to facilitate more profitable opportunities. Credit mitigation techniques enable banks to continue extending credit to riskier borrowers and to more concentrated pools of issuers and then transfer the credit risk to keep overall risk within an acceptable margin.
T h e O r i g i n a t e -t o – D i s t r i b u t e M o d e l o f C r e d i t R i s k