UK: Collateral Management & Credit Mitigation - Reducing Risk Exposure

Last Updated: 10 November 2010
Article by Deloitte Financial Services Group

Most Read Contributor in UK, August 2017

Introduction

Credit risk certainly stands as a cornerstone of the banking system. Concerns that counterparties will default on their repayment obligations has become a growing concern over years. In the past, reality sometimes superseded the most pessimistic scenarios that were prevailing. Since then, lessons have been learnt: there is, today, no such thing as any form of qualitative insurance as to the creditworthiness of a private individual, an institution or even a financial system.

In this context, risk management virtues are obvious, in its capacity to restore confidence and transparency as well as to protect the banking sector. Credit institutions have subsequently been actively looking for innovative solutions in risk mitigation. In particular, credit risk can be moderated by enhancing the loan structure. Either at loan inception or throughout the credit's life, banks may require the counterparts to provide mitigants such as collateral, guarantees or pledging relationships. Simultaneously, use of credit derivatives or subscriptions to insurance contracts have constantly increased.

The Basel committee has also steadily recognised the foundations of risk mitigation techniques: collateral, on-balance sheet netting, guarantees and credit derivatives, to quote. Collateral is certainly the most common form of credit risk mitigation. It refers to the process of pledging, hypothecating or giving assets to a credit institution, by the borrower or a third party on behalf of the borrower. In technical terms, collateral gives the possibility to transform, at least partly, credit risk into other forms of risks, namely the ones proper to the collateral (e.g. market risk or liquidity risk). When enforceability of the collateral is ensured through appropriate legal documents, banks can act proactively in monitoring the creditworthiness of the portfolio by means of specific controls at collateral level.

Use of collateral also ultimately impacts the very fundamentals of banks' resiliency: reduction of capital requirement, together with the enhancement of the large exposure risk reporting.

Recognition of financial collateral: Capital requirements reductions

Capital requirements reductions

Under Basel II regulation, Pillar I, when certain conditions are fulfilled, institutions are given the possibility to mitigate their credit risk exposures. To reflect the real risks held in portfolio, collateralised credit exposures may have a risk-weighted exposure lower than the same credit exposure without credit protection, as a defined range of credit protections can be taken into account for reducing capital requirements.

According to the Capital Requirement Directive (Directive 2006/48/CE or 'CRD', amended by Directive 2009/83/EC, and transposed into Luxembourg National Law with the CSSF Circular 06/273, wich has recently been amended by CSSF Circular 10/475 to consider the modifications at European level) there are two approaches to Credit Risk Mitigation ('CRM'): a simple approach, easy to use and a Financial Collateral Comprehensive Method (FCCM).

The simple approach is a substitution method. The risk weight of the collateral is substituted for the risk weight of the counterparty. This method may only be used under the standardised approach for non-trading book credit risk.

Under the comprehensive approach, the collateral adjusted value is deducted from the risk exposure (before assigning the risk weight). Collateral value adjustments ('haircuts') are applied because collaterals are submitted to risk, which could reduce the realisation value of the collateral when liquidated.

Credit institutions can use haircuts pre-defined by the regulator ('prudential' approach) or estimated by the credit institution itself (own-estimates methodology).

A new large exposure regime

New opportunities to consider financial collaterals

In the aftermath of the 2007-2008 market turmoil and the subsequent work by the European Commission to address shortcomings revealed by the financial crisis, the CRD, translating Basel II into European legislation, has been amended in November 2009 with regards to: banks affiliated to central institutions, certain own funds items, large exposures, supervisory arrangements, and crisis management (Directive 2009/111/EC).

The amendments contained in the new CRD are to be transposed and enforced in national law by the end of 2010 (CSSF Circular 10/450 and 10/475).

With the forthcoming new regime, the 'excess value' rule is no longer permitted:

How to treat financial collateral under FCCM?

Regulatory requirements

Under the comprehensive approach, haircuts are applied because the realisation value of the collateral may be reduced when liquidated. An accurate collateral valuation is thus important from the agreement to the end of the contract.

However, the level of loss protection is not only a function of the assets value and liquidity. Collaterals are submitted to a wider range of risk drivers, such as relevant risk management policy, contracts enforceability and collateral portfolio diversification. The CRD has consequently stated rules to include collateral into the capital requirements calculations for each collateral, but also at the portfolio level:

Methodology

Comprehensive prudential approach The risk weight of the exposure remains the same but the exposure is reduced by the collateral value, which has been decreased by applying 3 haircuts:

Volatility haircuts are pre-determined by the regulator depending on the collateral type, the issuer's creditworthiness, the maturity, etc.

The prudential approach could be seen as a good trade-off between the heavy requirements of the own estimates approach and the benefits in the capital requirements calculations (which are however dependent on the portfolio's composition).

Its implementation requires yet resources, adequate tools, as well as definition of policies and procedures. Its use is submitted to an agreement by the regulator.

Own estimates methodology

The effect of collateral as a risk-mitigant under the own estimates method operates through the Loss Given Default risk parameter. This means that under this method, the risk reducing effect of collateral will be reflected in the bank's own estimates of Loss Given Default, and needs to be done consistently. This approach produces more accurate results, fitting your portfolio at best but includes developing internal models, which requires resources, tools and relevant methodologies.

Our assistance

Our approach aims at accompanying you towards an effective management of credit risk, encompassing but superseding regulatory requirements. To remain pragmatic, and ensure a proportional and scalable service offer, we declined it into a spectrum of independent modules hereby listed:

Module I: knowledge transfer

Deloitte can assist you in enhancing your understanding of the regulatory requirements related to the use and implementation of FCCM methodology. The objective is to give you the opportunity to benefit from our experience to let you know each criteria on the basis which the regulator grants the agreement for financial collateral inclusion into Basel II capital charge calculations.

Moreover, we offer specific training sessions, allowing you to leverage on our privileged position towards regulatory authorities and to let you anticipate the forthcoming regulatory changes in credit risk matters. Amendments of the CSSF Circular 06/273 and new large exposures regime are typical examples of topics which might be of interest for you.

Module II: situation assessment

Deloitte can assist you in determining which method will bring the greatest advantage to your institution in making a diagnostic of your credit and collateral portfolios, of your risk management processes and tools, and thus assessing the costs/benefits of migrating towards more-advanced approaches.

Indeed, the success of the project in terms of ratio 'benefits vs costs' will depend on the choice of the appropriate method for your business, based on the analysis of the following factors:

1. Risk management: monitoring functions, client acceptance process, effective controls, etc.

2. Stability of the business_: stability of clients'risk profile, stability of collateral portfolio, dynamic controls/improvement of the processes

3. Operational infrastructure: risk governance, reliable data/IT systems, staff knowledge, etc.

4. Nature of clients: risk profile, concentration, correlations to collateral, etc.

5. Nature of collateral: portfolio composition, concentration, volatility, etc.

Module III: target setting

We can assist you in the development of an implementation planning:

1. Definition of the resources, tools, processes and methodologies to implement in order to meet regulator's requirements

2. Pragmatic diagnostic of the currently used resources, tools, processes and methodologies

3. List of actions to be carried out by theme, business and entity

4. Description, documentation, prioritisation and schedule of each action

Module IV: risk reporting-outsourcing or internally implemented solution

We can assist you in effectively implementing a collateral risk management system. An internal model approach or an outsourcing solution where we would be given the responsibility to perform the risk reporting can equally be contemplated. Irrespective of the chosen vehicle, the following features shall be found:

1. Collateral adjusted values/capital requirements calculations: development of appropriate data, systems and calculations methodology under the regulatory requirements

2. Operational collateral management: development of a solution for breaches control, automation of margin calls, monitoring of securities values, simulation of liquidation strategies of portfolios, etc.

3. Risk reporting/quantitative analyses: production of a range of risk reporting for collateral portfolio, including the dimensions of market, liquidity correlations and concentrations. Probabilities of default, credit VaR and Loss-Given-Default approaches, together with the construction of dynamic credit scores, are proposed

4. Stress test program: systematic simulations of adverse conditions, analogous to ' what-if' scenarios, can be proposed, such as a drop in the market value, a liquidity crisis, a tightening of correlations between the issuer of securities and the debtor, etc.

Module V: follow-up

We can assist you to ensure the efficiency of the CRM techniques implementation and use by performing testing of the models and calculations, gap analysis of systems, data,tools and methodologies with regulatory requirements, etc.

Conclusion

In a constant effort, the European Commission has been steadily promoting an alignment of regulatory requirements more closely with real exposures to underlying risks. This has been achieved by means of increasing the risk sensitivity and adapting the regulatory capital calculations to evolving market practices and products, hence reducing the gap between regulatory capital and economic capital.

The role played by risk mitigation techniques in this endeavour turns out to be fundamental; in particular, this holds true in the context of regulatory capital calculations and new large exposures regime, promoting the comprehensive method.

While the foundations of this method are clear, its implementaiton is, in general, not. Resources, tools, methodologies and processes are needed along the way. A broad variety of benefits nonetheless makes the way worth being taken:

  • Implementation of a stronger risk management
  • Reduction of the number of large exposure breaches, especially in the context of a tighter regulatory framework
  • Capturing real risks
  • Reduction of the regulatory capital requirements related to credit risk (Pillar I)

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
 
In association with
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Check to state you have read and
agree to our Terms and Conditions

Terms & Conditions and Privacy Statement

Mondaq.com (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

Use of www.mondaq.com

You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these terms & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about Mondaq.com’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.

Disclaimer

Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from this server.

The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.

Registration

Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.

Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

If you do not want us to provide your name and email address you may opt out by clicking here .

If you do not wish to receive any future announcements of products and services offered by Mondaq by clicking here .

Information Collection and Use

We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to unsubscribe@mondaq.com with “no disclosure” in the subject heading

Mondaq News Alerts

In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.

Cookies

A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

Log Files

We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.

Links

This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

Surveys & Contests

From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.

Mail-A-Friend

If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.

Security

This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to webmaster@mondaq.com.

Correcting/Updating Personal Information

If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to EditorialAdvisor@mondaq.com.

Notification of Changes

If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

How to contact Mondaq

You can contact us with comments or queries at enquiries@mondaq.com.

If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at problems@mondaq.com and we will use commercially reasonable efforts to determine and correct the problem promptly.