Credit risk is most simply defined as the potential that a bank borrower or counterparty will fail to meet its obligations in accordance with agreed terms. The goal of credit risk management is to maximise a bank’s risk-adjusted rate of return by maintaining credit risk exposure within acceptable parameters. Banks need to manage the credit risk inherent in the entire portfolio as well as the risk in individual credits or transactions. Banks should also consider the relationships between credit risk and other risks. The effective management of credit risk is a critical component of a comprehensive approach to risk management and essential to the long-term success of any banking organisation.

For most banks, loans are the largest and most obvious source of credit risk; however, other sources of credit risk exist throughout the activities of a bank, including in the banking book and in the trading book, and both on and off the balance sheet. Banks are increasingly facing credit risk (or counterparty risk) in various financial instruments other than loans, including acceptances, interbank transactions, trade financing, foreign exchange transactions, financial futures, swaps, bonds, equities, options, and in the extension of commitments and guarantees, and the settlement of transactions.

Since exposure to credit risk continues to be the leading source of problems in banks world-wide, banks and their supervisors should be able to draw useful lessons from past experiences. Banks should now have a keen awareness of the need to identify, measure, monitor and control credit risk as well as to determine that they hold adequate capital against these risks and that they are adequately compensated for risks incurred.

The Basel Committee has issued this documents in order to encourage banking supervisors globally to promote sound practices for managing credit risk. Although the principles contained in the paper are most clearly applicable to the business of lending, they should be applied to all activities where credit risk is present.

Collateral management is a process which helps to reduce counterparty credit exposures.

It is normally used with over-the-counter derivatives like swaps and options. If two parties agree to enter into collaterisation this is what happens.

1. The two parties negotiate and execute a collateral support document, (CSD), this contains the terms and conditions under which collateralisation will take place.
2. The trades subject to collateral are regularly marked-to-market. Their net valuation is then agreed.
3. The party with the negative MTM on the trade portfolio delivers collateral to the party with the positive MTM.
4. As prices move and new deals are added the valuation of the trade portfolio will change.
5. Depending on what is agreed the valuation is repeated at frequent intervals-typically daily, weekly or monthly.
6. The collateral position is then adjusted to reflect the new valuation. The process continues unless one of the parties defaults.

In simple terms the collateral process is very similar to futures variation margining. The party that has a MTM loss must post collateral.

Suppose your counterparty defaulted and from your perspective the trade portfolio is “in-the-money”, normally you would have an unsecured credit exposure.

But with collateral, provided you serve the appropriate legal notices, you can terminate the trades and use the collateral as repayment. Provided the collateral value is sufficient your MTM profit is protected. Your credit risk has been mitigated.

This all sounds simple. But there is more to collateral than meets the eye. Let’s look at some of the issues.

Will you encounter collateral management?

This market is growing. According to ISDA there were over 70,000 collateral agreements in place covering USD1.017 trillion of collateral in 2005. As derivative markets have grown today’s figure will be higher. If you use OTC derivatives it is likely you have collateral agreements in place. If not it is probable that you will be asked. Agreeing collateral documentation is a process of negotiation you do not have to accept all the terms requested and you can impose some of your own.

Why the growth?

Collateral management has benefits. It can reduce potential credit losses and capital usage, it can increase the number of transactions you do with a party and may also reduce dealing spreads.

What trades are subject to collateral?

Normally OTC derivatives are subject to collateral. Careful consideration should be given to the trades included. If you cannot accurately value the trade you will be reliant on the valuation made by the counterparty. This is why some parties restrict collateral to swaps and exclude complex trades.

What is used as collateral?

The most popular form of collateral is cash. In 2005 ISDA indicated that USD and EUR cash accounted for 73% of collateral assets.

Why is cash so popular? Because cash has big advantages, it is easy to value, transfer and hold.

When you give cash collateral you receive interest. When you take cash collateral you pay interest. In the documentation it is normal to mutually agree the use of an overnight index rate like EONIA.

You can also use other forms of collateral like bonds. Depending on their credit rating and liquidity they may be subject to a valuation percentage or haircut.

Is it straight forward?

You can think of collateral management as a process that exchanges credit risk for operational risk. If you are considering implementing collateral management you may wish to consider the following points:

You still need to assess the creditworthiness of your counterparty.
The reasons why you are using collateral should be documented.
The legal agreements used must be suitable and enforceable.
The regular process of collateral calls and returns will need to be carried out by a responsible individual or team.
Timely and accurate valuation data needs to be used.
They will need to know what type of collateral is applicable, the valuation percentages, independent amounts, thresholds, minimum transfer amounts, rounding amounts and currencies that apply.
They will also need to know what collateral is currently in transit and what events are pending each day.
The reduction in credit risk as a result of collateralisation needs to be captured by credit management systems.
Failure by the counterparty to deliver collateral will need to be swiftly followed up.
There needs to be the appropriate escalation processes for disputes and defaults.
This is why you need to carefully consider the operational risks and costs and compare them with the benefits you hope to achieve before you sign a credit support document.

Do disputes occur?

Yes, trade valuations between parties will always differ. But is the difference significant? It is important to have an escalation process that handles disputes so they are investigated and resolved satisfactorily. To reduce the possibility of disputes practitioners suggest that trade reconciliation is done before collateralisation is commenced.

Disputes can be caused by variations in the data used for valuation. Yield curves captured at different times and from different sources may be the source of the problem.

Sometimes disputes are serious and need to be resolved. For example, the parties may have different trade data or even missing trades. Problems of this nature require the parties to reconcile their portfolios.

Can collateral management make money?

The short answer is “no”. But when properly managed it reduces credit risk. Trade portfolios between counterparties can have MTM values running into tens of millions of dollars. These exposures can become so large that they prevent further trades being done.

It is therefore not surprising that traders can become advocates of using collateral management to facilitate further dealing with counterparties.

Glossary

Some of the terms used are explained in more detail below:

Call & return amounts: The collateral amount that is being requested or given back.

Credit support document (CSD): CSDs are the documents that are agreed between the two parties that are establishing a collateral relationship. Normally the trades are documented under an ISDA Master Agreement, the CSDs then take the form of an annex or supplement to the Master Agreement.

Independent Amounts: The independent amount is an additional credit support amount that is required over and above the market value of the trade portfolio. The main purpose of the independent amount is to cater for changes in the market value of the trades between collateral calls. The independent amount can be a fixed amount or a percentage of the nominal size of the portfolio. There is resistance to providing an independent amount because it can adversely affect a firm’s liquidity.

Mark-to-market (MTM): The current market value of a trade or trade portfolio.

Minimum transfer amount (MTAs): Collateral calls for amounts smaller than the MTA are not permitted. MTAs are designed to prevent the calling of nuisance amounts. This avoids unnecessary costs involved in small transfers. Typically the MTA will lie in the range of $50,000-$1,000,000. Increasingly there is a trend to set the independent amount at zero and use the MTA as a type of threshold.

Netting: Netting permits individual trade values to be added together to provide a single exposure. This is important to collateral management. If netting cannot be enforced you may end up with a gross exposure to the counterparty and insufficient collateral to cover it.

Threshold amounts: The threshold amount is an unsecured credit exposure that the parties are prepared to accept before asking for collateral. Ideally threshold amounts are set at relatively low levels in order to maximise credit risk mitigation.

Trade portfolio: The trades that are subject to the collateral process.

Valuation percentage: This is also called a “haircut”. It is a percentage by which the market value of the collateral will be reduced. For example, collateral with a market value of $10m and a valuation percentage of 98% is only recognised as $9.8m for collateral purposes. Valuation percentages protect the collateral taker against falls in the value of the collateral during the period between collateral calls.

The framework is designed to deliver the appropriate term and structure of funding consistent with the banks Liquidity Risk Appetite and is fully compliant with regulatory requirements.

Liquidity risk is defined as the risk that the bank is unable to meet its obligations as they fall due, leading to an inability to support normal business activity and meet liquidity regulatory requirements.

This framework incorporates a range of ongoing business management tools to monitor, limit and stress-test the Group’s balance sheet and contingent liabilities:

Limit setting and transfer pricing are tools designed to control the level of liquidity risk taken and to drive the appropriate mix of funds, which together reduce the likelihood that a liquidity stress event could lead to an inability to meet the Group’s obligations as they fall due.
The stress tests assess potential contractual and contingent outflows under a range of scenarios, which are then used to determine the size of the liquidity buffer that is immediately available to meet anticipated outflows if a stress of which of which are then used to determine the size of the liquidity buffer that is immediately available to meet anticipated outflows if a stress occurred.

Contingency funding plan
In addition, banks maintain a contingency funding plan that details how liquidity stress events of varying severity would be managed. As the precise nature of any stress event cannot be known in advance, the plans are designed to be flexible to the nature and severity of the stress event, and provide a menu of options that could be used as appropriate at the time. Barclays also maintains recovery plans that consider actions to generate additional liquidity in order to facilitate recovery in a severe stress.

Liquidity Risk Appetite
Under the liquidity framework, some banks have established a Liquidity Risk Appetite (LRA), together with the appropriate limits for the management of the liquidity risk. This is the level of liquidity risk the Group chooses to take in pursuit of its business objectives and in meeting its regulatory obligations. The key expression of the liquidity risk is through internal stress testing. This involves comparing the liquidity pool with anticipated stressed net contractual and contingent outflows under a variety of stress scenarios. These scenarios are aligned to the PRA’s prescribed stresses and cover the following:
A market-wide stress event
A bank-specific stress event
A combination of the two.
Under normal market conditions, the liquidity pool is managed to be in excess of 100% of 90 days of anticipated outflows for a market-wide stress and 30 days of anticipated outflows for each of the bank-specifc and combined stresses.

The latest stress test results are available on Liquidity metrics.

Liquidity pool
Banks maintains a strong and high-quality liquidity pool that consists exclusively of unencumbered assets, representing resources immediately available to meet outflows in a stress. The liquidity pool mainly comprises cash and balances with central banks, government bonds and other highly liquid assets, denominated in multiple currencies and with different maturities.

The size of the liquidity pool is determined by the size of the LRA stress outflows, ensuring that the Group is able to meet its obligations as they fall due even in the event of a sudden and potentially protracted increase in net cash outflows. Details on the size and components of the liquidity pool are available on Liquidity metrics.

Internal pricing and incentives
In order to induce the correct behaviour and decision-making, banks actively manage the composition of their balance sheets and contingent liabilities through the appropriate transfer pricing of liquidity costs. Mechanisms used to do this include funds-transfer pricing, economic funds allocation of behaviouralised assets and liabilities, and contingent liquidity risk charging to the businesses. Such mechanisms are designed to ensure liquidity risk is reflected in product pricing and performance measurement, thereby ensuring that the liquidity framework is integrated into business-level decision-making to drive the appropriate mix of sources and uses of funds.

Effective liquidity risk management requires the establishment of a robust liquidity risk management framework (i.e. strategy, policy and practices) that ensures sufficient liquidity. This includes the maintenance of a cushion of unencumbered, high quality liquid assets in order to withstand stress events, including those involving the loss or impairment of both unsecured and secured funding sources.

Some Risk solution providers offer standard and customized liquidity analysis projections and reporting including:

1. Stress Scenarios for Liquidity Risk
2. Static liquidity gap
3. Marginal liquidity gap
4. Cumulative liquidity gap
5. Residual liquidity gap
6. Contingency gap
7. Marginal liquidity
8. Cumulative liquidity
9. Residual liquidity
10. Dynamic gap
11. Cash management / margining
12. Systemic and concentration risks

The Fundamental Review of the Trading Book (FRTB) is a Basel Committee on Banking Supervision initiative to overhaul trading book capital rules, with the aim of replacing the current crop of measures under Basel 2.5 with a more coherent and consistent framework.

The FRTB is vast in scope and touches upon a number of complex but pivotal issues – from the design of the basic model used to measure risk, to the process for deciding what sits in the banking and trading books. While Basel 2.5 was implemented in the immediate aftermath of the financial crisis as a stop-gap measure to lift trading book capital requirements, the FRTB is primarily aimed at consolidating existing measures and reducing variability in capital levels across banks. ISDA and its members welcome the switch to a more streamlined, consistent market risk framework, and have been working constructively with regulators to help hone the rules.

A huge amount of progress has been made. But given the scale of the overhaul and the complexity of the issues, it’s important all elements are fully tested before the framework is finalised. Without comprehensive assessment, the objectives of a globally consistent and coherent capital framework may be undermined

On January 14th, the Basel Committee on Banking Supervision (BCBS) published its revised capital requirements for market risk. The final standard, also known as the Fundamental Review of the Trading Book (FRTB), is intended to harmonize the treatment of market risk across national jurisdictions and will generally result in higher global capital requirements. BCBS estimates a median capital increase of 22% and a weighted-average capital increase of 40%. However, we believe this impact can be somewhat mitigated by portfolio re-optimization. January 19, 2016, Standardized approaches continue to gain regulatory favor. The final framework allows banks to calculate their capital requirements using a new standardized approach (SA) or, for certain qualifying trading desks, a regulator-approved internal model-based approach. However, the framework’s requirements are clearly designed to push firms toward the new SA, which is consistent with the overall regulatory trend of moving away from internal model-based approaches.1 This is evidenced by the framework’s more stringent requirements applicable to the use of internal models (e.g., around regulatory model approval and desk-level reporting). The new standardized approach is more risk sensitive.

The new SA for capital calculation relies on a bank’s pricing models to capture more granular and complex risk factors across different asset classes in the trading book. It is more risk sensitive than the currently effective Basel II SA and is likely to result in significantly higher capital charges for certain businesses due to its inclusion of residual and basis risks that are not captured by the Basel II SA. The new SA is also likely to increase regulatory capital due to the removal of capital credits for diversification within an asset class.

The new boundary between the trading book and banking book will limit the potential for regulatory arbitrage. The final framework imposes stringent rules for internal transfers between the trading and banking books, defining a new boundary based on a bank’s intent to trade an asset or to hold it to maturity. The framework also introduces a presumptive list of assets that should be placed in the trading book unless a justifiable reason exists not to do so. These provisions are intended to limit an institution’s ability to move illiquid assets from its trading book (where assets must be marked to market) to its banking book, thereby avoiding higher capital charges. It is not clear that the revised boundary will be effective in reducing such positioning in all jurisdictions, as national regulators are given discretion in defining their asset lists.

Internal models attract more regulatory scrutiny. Internal models will be subject to regulatory approval at the trading desk-level,2 supported by granular performance measures. This desk-level approval process will be primarily driven by verification of model accuracy through P&L attribution tests and backtesting using daily model results. In addition, compared to the 2014 proposal, the final framework’s treatment of models that generate inaccurate results is more stringent, as evidenced by the more punitive multiplier which increases regulatory capital requirements after a given number of exceptions are encountered during desk-level backtesting of a model.

The final framework’s daily P&L attribution and backtesting requirements will necessitate substantial technology infrastructure development by many institutions, and further challenge internal model review and governance. A new, costly measure to capture internal models’ tail risk. The final framework replaces Value at Risk (VaR) and Stressed VaR (SVaR) measures for capturing risk with a new Expected Shortfall (ES) measure for the internal model-based approach. As the new ES measure captures tail risk (unlike VaR and SVaR), capital requirements will likely be higher under the final framework.

Furthermore, tail risk capture comes at a significant cost, as data requirements and operational complexities of the ES measure are likely to be extensive. More granular liquidity horizons for the internal model-based approach. The final framework increases the granularity of liquidity horizons (i.e., the time needed to sell or hedge an asset during market stress without adversely affecting prices) by stipulating specific liquidity horizons by asset class.

The overall impact of this change is again likely to be higher capital requirements – many assets will become subjected to longer liquidity horizons and therefore will face higher capital charges. However, the final framework brings some good news for the industry, as liquidity horizons across some asset classes have been reduced from those earlier proposed by approximately 30% to 50%. This change responds to industry comments that the proposed horizons were not representative of historical performance during the financial crisis. Capital requirements likely to also increase due to the introduction of non-modellable risk factors (NMRFs) in the internal model- based approach.

Under the final framework, only risks that meet strict data availability and quality requirements are deemed modellable. All other risks (i.e., NMRFs) must be accounted for by a catch-all capital charge which is calculated for each NMRF based on a risk-specific stress scenario. The results from the BCBS’s 2015 quantitative impact study suggest that this capital charge will not be trivial. Credit migration risk no longer double counted with the introduction of the Default Risk Charge (DRC). The final framework replaces the capital charge for incremental risk (IRC) in the internal model-based approach with the DRC.

This change reflect concerns that credit migration risk (i.e., the risk of credit deterioration over time) was previously double-counted, once as part of credit risk volatility and once as a stand- alone modelled risk. While this is good news for the industry, the mandatory inclusion of equity products in the DRC calculation will bring new challenges due to the large number of issuers and low correlation in performance between various equities. Correlation trading positions (CTPs) no longer allowed to be measured using internal models. Under the final standard, CTPs must be captured using the SA, similar to other securitization positions. This is due to regulatory concerns around the ability of internal models to adequately capture CTPs’ risk. Banks will need more data and stronger data analysis to meet new risk measurement and reporting requirements. The final standard imposes new internal and external reporting requirements, including monitoring market risk on an intraday basis and measuring market risk capital as of the end of the previous day. Furthermore, banks that continue to use internal models face even stricter requirements, as they have to report risk capital under both the SA and internal model- based approach.

These banks will also have to report their key modelling assumptions to regulators in order to facilitate a better understanding of the variations between standardized and internal model-based results. What’s next? BCBS calls for the adoption of FRTB by each jurisdiction before January 2019 and for compliance to begin by December 2019.

We do not expect US regulators to adopt the standard until 2018 because they are likely to wait for any changes to the framework that may result from the impact of other evolving global standards and recalibration by BCBS.