Credit risk on derivatives
Credit risk of specific financial instruments
Credit risk management best practice guidelines
INTRODUCTION
When an investment bank enters into a transaction with a client, it is exposed to the risk that the client may default on their obligation. Such risk is called credit risk. The bank may try to reduce the risk of default by only dealing with clients of high creditworthiness, but as history has shown, even large investment banks can go into bankruptcy. Therefore, it is a real and present danger in any transaction a bank undertakes. It is described in more detail in the following sections.
COUNTERPARTY RISK
In a nutshell, this is an estimate of the likelihood that the client would for some reason default and the bank will be exposed to a loss. The size of the loss would depend on whether it was a just a simple borrowing (incurring 100 per cent loss of the face value of a loan plus interest), or a derivative instrument where the loss is limited to the difference between the settlement price and the cost of replacing the security. Counterparty risk depends on a number of factors:
Customer risk: The risk that the counterparty will fail to fulfil their obligations.
Country risk: The risk that the client’s domicile country will enter into financial or political problems that can indirectly affect the transaction between the counterparties.
Transfer risk: The risk that a foreign client will not be able to transfer funds to the bank due to issues with his domestic banking system.
PRODUCT RISK
Product risk determines the level of credit exposure, i.e. the amount of default. Depending on the transacted security, it can incorporate all or just some of the elements below:
Principal exposure applies only to transactions where principal is involved. Such instruments are also called ‘balance sheet instruments’, as they impact on the bank’s balance sheet. It mainly applies to bank loans, but can also arise in swaps, or bank guarantees.
Interest rate exposure is implicit in all products, as all market transactions are subject to the interest rate effect. But it particularly applies to those instruments where interest payments are due at regular intervals (such as swaps) or at maturity (loans).
Replacement risk is associated with products which do not involve exchange of principal (‘off-balance sheet’ instruments). Hence virtually all derivative securities will be exposed to it. The bank may simply accept the loss, as it is only a fraction of the notional amount of the underlying security, or it may have to replace the contract at potentially significant cost.
Settlement risk can occur when the counterparty fails to repay the principal amount at maturity. This can potentially arise in transactions involving a foreign counterparty, as the market operation times may differ. Thus the bank can fulfil its side of the deal earlier than the customer is due, arising in significant exposure.
Collateral risk arises in transactions where the customer, wishing to reduce the cost of borrowing, deposits a security (collateral) with the bank as a guarantee. Should the security depreciate in value, the collateral would provide insufficient cover in case of client default. This situation is akin to a mortgage. If the borrower does not fulfil its obligations, the property is repossessed. However, if the housing market has declined since the purchase, the bank may not recoup the full mortgage value.
CREDIT RISK OF SPECIFIC FINANCIAL INSTRUMENTS
Exchange-traded products
Exchange-traded products are seen as virtually riskless, as they are guaranteed by the Clearing House. The system of margining is the buffer that gives Clearing House protection against default. Hence individual investors are only exposed to their individual risks of failing to make margin payments or deliver the underlying security. This applies to all exchange-traded products, regardless of their specification (contracts for delivery or settlement) and their underlying market.
OTC financial securities
Money market products
Money market products are used for short-term lending and borrowing. Lenders are exposed to the risk equal to the full contract amount in the event of counterparty default. As money market instruments are typically structured so that the interest is also repaid at maturity, the total loss is further amplified. In addition to the customer risks defined above, product risks relevant to money market instruments include: principal and interest rate exposure as well as settlement and replacement risk.
Capital market products
Capital market products are typically used for long-term lending and borrowing. Akin to the above, credit risk that lenders are exposed to in the event of counterparty default is equal to the full contract amount. However, instruments with maturities over one year typically pay interest at regular intervals, thus not increasing the amount of loss. All the risks defined in the previous section are applicable to this product class.
FRAs
The credit risk associated with FRAs contracts is relatively low, as the principal amount is not exchanged. Only the settlement amount (difference between the FRA rate and the prevailing market rate calculated on a notional amount) is at stake. Hence in addition to all customer risks potentially arising, the financial institution is exposed to the relatively low settlement risk (i.e. the probability of default might be substantial, but the amount at stake is low compared to the contract notional amount). However, if the FRA was a part of a structure or a hedging strategy its replacement might have to be done on potentially unfavourable terms, increasing the overall exposure.
Swaps
In most swap trades the investment bank acts as an intermediary between two counterparties, guaranteeing each side of the swap and earning the spread between the quoted rates. By doing so it accepts the credit risk of both counterparties, creating a huge exposure in case of default. This is particularly the case where exchange of principal takes place, different currencies are involved or there is a mismatch of payment dates. Hence, all of the risks defined in the previous section apply. This is particularly the case with more exotic swap structures, including legs with mismatched payment dates and/or frequencies, swaps with legs linked to different underlying markets (e.g. total return swap, equity index swap etc.) or where the interest is deferred until maturity.
Options
Exchange-traded options, just like futures, are margined and guaranteed by the Clearing House, hence virtually riskless. OTC contracts carry significant exposure to counterparty risk for the option buyer, in case the counterparty fails to deliver the security if the option is exercised. In the case of the option seller, as the premium is paid at the outset, default risk is removed. Some options, such as collars, carry a counterparty risk, whether bought or sold, as both sides can exercise depending on market conditions.
Foreign exchange instruments
Any type of financial instrument can be structured to involve foreign currency. Thus the credit risks inherent in the basic product (option, future, swap etc.) are further enhanced by the incorporation of more than one currency in the deal. Within the customer risk umbrella, the most significant exposure arises in country and transfer risks, whereas within the product range the interest rate exposure is the most significant, as the foreign exchange products not only incorporate the exchange rate between different currencies, but implicitly expose the counterparties to the interest rates in different countries. Replacement may also be an issue due to potentially limited access to the foreign currency market.
Bonds
Creditworthiness is implicit in bond pricing. Yield on any given bond is a reflection of the issuer’s credit rating. Government bonds are seen as virtually riskless and consequently offer lower returns to investors compared to corporate bonds, not to mention junk bonds. Any change in the counterparty credit rating has a huge impact on the bond value. Thus credit risk associated with bonds is not limited to default scenarios only, it further extends to any downgrades in credit rating. Other features such as call or put options attached to bonds (as in callable and puttable bonds respectively) and options to convert all or part of a bond into equity (convertible bonds) further increase risk exposure, as the number of parameters affecting the potential loss increases. However, as bonds are typically issued directly in the market, i.e. without banks acting as intermediaries, the credit risk bearer is an investor. Bonds nevertheless feature in investment banks’ portfolios, typically as part of asset-backed securities or other credit derivatives, where their credit risk is further complicated by the structure they are part of. All of the risks listed in the first two sections of this chapter potentially apply. Bond replacement, if required might be virtually impossible.
Equity derivatives
Equity derivatives offer exposure to equity markets without actual market participation. Their benefit to the investor can turn into significant credit risk in the event of counterparty default. As the investor often has no direct access to the equities market, or it is prohibitively expensive or impractical, replacement risk is a significant contributor to the overall credit exposure. Furthermore, inherent in the product structure is the exposure to a single company, industry sector or a market index, all of which carry their associated credit risks, thus exposing the investors to the multifold credit risks they have no means of mitigating. The range of applicable risk components described in the first two sections of this chapter depends on the derivative security type (e.g. option, future, swap etc. – all of which are covered in the previous sections).
Commodity derivatives
Commodity derivatives have over the years moved away from being solely means of guaranteeing the price and delivery, to being securities used mostly for hedging, arbitrage and speculation. Nevertheless, many products are still delivered, which is reflected in their pricing. Hence credit exposure in the event of default, in addition to all previously described risk components, involves the inconvenience (which may not be insignificant) of not acquiring a commodity. Furthermore, contract replacement at spot prices might incur significant losses, due to the pricing mechanisms that incorporate convenience yields (premiums payable for guaranteed access to the commodity), which price shorter-dated contracts higher than the longer-dated ones (an anomaly compared to other derivatives markets).
Credit derivatives
Credit derivatives have credit as their underlying security, thus credit exposure is inherent in all products. However, this exposure relates to the third party or asset default risk rather than the risk associated with the counterparty to the credit derivative contract. Nevertheless both the protection buyer and the protection seller accept a level of counterparty credit exposure, albeit to significantly different degrees. The protection seller receives regular premiums in exchange for accepting the third party credit risk, thus is exposed to a relatively small loss in the event of default. In contrast, the protection buyer’s exposure is equal to the full amount of contingent payment.
CREDIT RATINGS
Credit ratings are introduced to the financial industry to establish a standard measure of creditworthiness of market participants. They are conducted by independent agencies to ensure impartiality. They carry out an evaluation of a borrower’s overall credit history, current assets and liabilities, and based on that information assess their ability to repay a debt. Individuals, corporations and even countries are subject to credit rating. It impacts on their ability to borrow funds and execute financial transactions.
The best known credit agencies are Standard & Poor’s and Moody’s.
The Standard & Poor’s rating scale is from excellent to poor: AAA, AA+, AA, AA–, A+, A, A–, BBB+, BBB, BBB–, BB+, BB, BB–, B+, B, B–, CCC+, CCC, CCC–, CC, C, D. Investment banks tend to transact only with AAA, AA+ and AA clients.
The Moody’s rating system is similar: AAA, Aa1, Aa2, Aa3, A1, A2, A3, Baa1, Baa2, Baa3, Ba1, Ba2, Ba3, B1, B2, B3, Caa1, Caa2, Caa3, Ca, C. Only the top two are typically considered by investment banks.
CREDIT RISK MANAGEMENT
In order to successfully manage credit risk, the existing and potential risks inherent in any traded product or activity firstly have to be identified and estimated. Financial market participants tend to rely on the published credit ratings, as produced by the independent agencies, described above. Furthermore, additional resources and sophisticated models are typically employed to produce proprietary credit assessments that enhance the publicly available information.
Credit scoring models form a part of the framework used by investment banks to establish the level of credit lines extended to their customers. For corporate and commercial borrowers, these qualitative and quantitative models generally include, but are not limited to: independent credit rating, assessment of assets and liabilities, market performance, operating procedures, management expertise, historical credit quality, and leverage and liquidity ratios.
Once the credit risk is established or at least bounded, it is mitigated using several methods, depending on the product type or transaction the client is involved in.
Risk-based pricing
Risk-based pricing is the practice employed by lenders whereby a higher interest rate is charged to borrowers that are more likely to default. This is evident in the financial markets practice, whereby Libor and Libid are typically only applicable to the interbank transactions, whereas other market participants have access to funds at a much higher borrowing rate, or lower investment rate. Within risk-based pricing, the lenders typically consider credit rating, loan purpose and loan-to-value ratio, and credit spread (yield).
Credit limits
Further to employing the risk-based pricing, another significant measure in mitigating the credit risk is the establishment of credit exposure limits to single counterparties or groups of related counterparties. This is typically further extended to setting the credit limits applicable to particular products or product classes for each counterparty.
Covenants
Covenants are stipulations on the borrower’s actions that lenders may require in order to extend the funds; they typically include (but are not limited to):
- Periodical reports of borrower’s financial standing
- Limits to dividend payouts for the duration of the loan
- Further borrowing limits or other financial commitments that might impact on the timely repayment of the loan
- Acceleration of loan repayment upon pre-specified events, e.g. change in credit rating, change in interest coverage ratio or debt-to-equity ratio
- Being subject to regulatory investigation
- Being a target or originator or a merger or acquisition etc.
Diversification
Lenders to a narrow range of borrowers (from the same sector or requiring a similar type of funding with respect to product structure and maturity) are highly exposed to unsystematic credit risk, arising from a high concentration of correlated liabilities. Hence diversification is employed in order to mitigate this type of risk. However, as seen from the credit rating section, most investment banks tend to accept only the counterparties with the highest credit standing, thus only the range of products and their specifications is subject to diversification.
Credit insurance
Bond holders as well as lenders use credit insurance to hedge their credit exposure, thus transferring risk to the insurer in exchange for regular premium payments. Even the insurance issuers can seek further protection in a form of reinsurance, whereby the insurance contracts are pooled together by another counterparty acting as a backer to the insurance contracts.
Credit derivatives
Credit derivatives offer protection from default of an asset rather than an entity (counterparty). Nevertheless they are useful tools in mitigating credit risk exposure. Akin to insurance contracts, they transfer the third party or an asset risk to the protection seller in exchange for regular payments. Another parallel with credit insurance is that credit protection sellers can use securitisation (akin to reinsurance) to diversify their own credit risk exposure.
CREDIT RISK MANAGEMENT BEST PRACTICE GUIDELINES
All financial markets participants, including investment banks, should have a well-defined set of credit risk management principles. Whilst some are imposed by the regulatory structure, others should be followed as a part of prudent business operation. These include, but are not limited to:
- Establishing an appropriate credit risk environment
- Operating under a prudent and conservative credit limit policy
- Maintaining an appropriate credit risk recognition, assessment and management
- Ensuring adequate credit controls and revisions.
Appropriate credit risk environment
Financial institutions should identify, evaluate and manage credit risks inherent in all products and activities (including the counterparties to all transactions). Particular attention should be placed on new activities or counterparties, whereby suitable controls and management procedures need to be put in place, tested and approved. A credit risk management strategy and policy should be developed and periodically reviewed at the highest level of seniority. Furthermore, all staff involved in identifying, measuring, monitoring and controlling credit risks should be aware of and adherent to the policies.
Prudent and conservative credit limit policy
In addition to the use of externally established credit ratings, as provided by Standard & Poor’s and Moody’s (described above), investment banks should employ their proprietary credit evaluation methodology. This should be used when determining credit limits to individual counterparties and groups of related counterparties in conjunction with the assessment of credit purpose, structure and a planned repayment strategy. Particular care should be taken when extending existing credit limits or establishing new credit lines, both to the existing customers entering into new transaction types and to the new clients.
Appropriate credit risk recognition, assessment and management
A well-established, maintained and audited system for ongoing administration of all credit risk-bearing positions should be in place at all financial institutions, investment banks in particular. Furthermore, a system for monitoring the status of individual clients’ credits should be established. Internal reserving and capital provision policies should be regularly revised in line with market moves and credit downgrades. In addition, the information on the overall composition and quality of the credit portfolio must be readily reproducible. In order to achieve this, information systems, applications and analytical models should be developed enabling analysis of present and potential credit exposures by any classification (counterparty, sector, product, or in various hypothetical scenarios).
Ensuring adequate credit controls and revisions
In line with the requirement for the proprietary credit evaluation methodology, investment banks should establish a system of continual independent credit review of all counterparties. Furthermore, internal controls and other monitoring activities should be employed to ensure that internal and external policies, procedures and limits are adhered to and any exceptions reported and addressed in a timely manner. Controls over credit limit extension and establishment of new credit lines should take a key place within the control function. Finally, revision of all existing policies, procedures and the controls themselves should be done periodically to prevent problems and unforeseen losses due to unidentified or unmitigated credit exposure.