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Transcript of GARP UK Meeting July 18, 2001 Page 1 Risk Management for the Collateral Portfolio Presentation to...
Page 1GARP UK Meeting July 18, 2001
Risk Management for the Collateral Portfolio
Presentation to the GARP UK Meeting
July 18, 2001
Penny Davenport
Page 2GARP UK Meeting July 18, 2001
Agenda
How collateralisation is used today
Collateral as a risk transformation technique
Risk management techniques
Crisis management in a collateralised scenario
The current market environment
Page 3GARP UK Meeting July 18, 2001
Collateral is a technique for managing credit risk
Credit risk arises because one party who owes money to a second party might not pay.
It’s a risk while we are waiting for it to happen. When it does, it’s a loss!
Good metrics for credit risk take into account the size of the potential loss, the probability of the loss event occurring, and the value of any recourse, such as collateral.
Collateral (normally) reduces credit risk.
Page 4GARP UK Meeting July 18, 2001
Party A owes $10 toParty B… what happens next?
Party BParty A A defaults - B has a credit loss of $10
Case 1
Case 2
Case 3
Normal performanceParty A Party B$10
Party BParty A
$
A defaults - B has a credit loss of $10, but has recourse to $10value of collateral.
Securities worth $10
Page 5GARP UK Meeting July 18, 2001
What is Collateral?
“Assets of quantifiable value, delivered by one
party for the benefit of a second party, pursuant
to a formal legal agreement between the two,
with the intention of providing the second party
with recourse to those assets in the event of the
default of the first party, in the expectation that
the liquidated value of the assets will defray any
loss suffered by the second party.”
Collateral
Page 6GARP UK Meeting July 18, 2001
Why else might you take collateral? To protect against credit default loss
To facilitate access to… More credit transactions Longer maturity transactions Larger size transactions Higher volatility transactions
To manage the cost of credit / economic capital
To comply with counterparty policy requirements
To expand revenue opportunities
Page 7GARP UK Meeting July 18, 2001
Market growth has beendramatic, and continues
• ISDA surveys in 1999, 2000 and (soon-to-be-released) 2001.
• Collateral programmes have mainly developed since 1990.
• Considerable pace of expansion since 1994.
• Growth expectations for average >40% across firms surveyed.
50%
1990-94 1994-98
1992 94 96 98
Number ofAgreements Example: US Investment Bank
Collateral programmes commenced
Page 8GARP UK Meeting July 18, 2001
Collateral is a mutual risk reduction technique
0
10
20
30
40
50
AAA AA A BBB BB B N/R
Percent of totalcollateralized clients
Page 9GARP UK Meeting July 18, 2001
But remember… collateralis just one alternative
The Credit Enhancement Spectrum
CashCollateral
Single Swap Reset
Elective Termination
Rights
Lettersof Credit
GuaranteesCredit
InsuranceCredit
Derivatives
Credit RiskTransfer
Third Party Credit Support
Direct Credit Support
TransactionExposure Reduction
SecuritiesCollateral
Page 10GARP UK Meeting July 18, 2001
Agenda
How collateralisation is used today
Collateral as a risk transformation technique
Risk management techniques
Crisis management in a collateralised scenario
The current market environment
Page 11GARP UK Meeting July 18, 2001
Agreement structure riskMonitoring control risk
Concentration riskMarket risk on collateral value
Correlation riskThird party and settlement risk
Procedural riskPerfection risk
Recharacterization riskPriority risk
Enforcement riskLocal risk factors
“Murphy risk”
Legalrisks
Operatingrisks
CollateralCredit
risk
The risks of collateralization
Page 12GARP UK Meeting July 18, 2001
Risk management in a collateral programme
“ A s s e t s o f q u a n t ifi a b le v a lu e , d e liv e r e d b y o n e
p a r t y f o r t h e b e n e fi t o f a s e c o n d p a r t y , p u r s u a n t
t o a f o r m a l le g a l a g r e e m e n t b e t w e e n t h e t w o ,
w it h t h e in t e n t io n o f p r o v id in g t h e s e c o n d p a r t y
w it h r e c o u r s e t o t h o s e a s s e t s in t h e e v e n t o f t h e
d e f a u lt o f t h e fi r s t p a r t y , in t h e e x p e c t a t io n t h a t
t h e l iq u id a t e d v a lu e o f t h e a s s e t s w il l d e f r a y a n y
lo s s s u ff e r e d b y t h e s e c o n d p a r t y . ”
A n y ta n g ib le o rin ta n g ib le a s s e t s , e gfi n a n c ia l in s t r u m e n t s ,p h y s ic a l p r o p e r t y , r ig h t s ,e t c .
W e n e e d t o b e a b le tov a lu e th e a s s e t s r e l ia b ly( a t le a s t p e r io d ic a l ly )
D e l iv e r y m a y b ep h y s ic a l , b u t m o r e o f t e ne le c t r o n ic t r a n s f e r isu s e d in p r a c t ic e
D e l iv e r y n e e d n o t b e“ t o ” th e c o l la t e r a lr e c e iv e r - m a y b ein d ir e c t ly h e ld f o r t h eb e n e fi t o f t h e r e c e iv e r .
T h e r e n e e d s t o b e a na p p r o p r ia t e le g a l d o c u m e n tt h a t s e t s o u t t h e r ig h t s a n do b l ig a t io n s o f th e p a r t ie s ,a n d m o s t im p o r t a n t lye s t a b l is h e s th e le g a l n a t u r eo f t h e “ c o l la te r a l” c la imo v e r a s s e t s - p le d g e ,c h a r g e , s e c u r i t y in t e r e s t ,m o r tg a g e , t i t le t r a n s f e r ,e t c )
I n t e n t t o p r o v id ep r o t e c t io n , b u t n og u a r a n t e e .
R e c o u r s e t o t h e a s s e t s ,b u t n o d ir e c t r e d u c t io no f c r e d it e x p o s u r e o rd e f a u lt p r o b a b i l i t y
N e e d t o e s ta b l is h in t h eg o v e r n in g d o c u m e n t a t io nw h a t th e t r ig g e r f o r ac la im a g a in s t th ec o l la t e r a l w i l l b e .
W h e th e r o r n o t t h e c o l la te r a lc a n b e e x p e c te d t o c o v e r t h elo s s o n d e f a u lt is a q u e s t io nf o r th e c o l la t e r a l r e c e iv e r t od e t e r m in e - p r e s u m p t iv e lyt h e r e m u s t b e a r e a s o n a b lee x p e c ta t io n th a t th ec o l la t e r a l w i l l p r o v id e s o m ev a lu e , o t h e r w is e th ec o l la t e r a l a g r e e m e n t w o u ldn o t b e w o r th w h i le
T h e v a lu e o f t h e c o l la te r a lin p r a c t ic e ( r e g a r d le s s o fa n y e x - a n t e v a lu a t io n s )w i l l b e t h e l iq u id a t io np r o c e e d s r e s u lt in g f r o m as a le o f t h e a s s e t s in t h e c ir c u m s ta n c e sim m e d ia t e ly a f t e r t h e t im e o f d e f a u lt - i . e .p o t e n t ia l ly a f o r c e d s a le in a d is t r e s s e d m a r k e t .
T h e l iq u id a t e d v a lu e o f t h ea s s e t s m a y o ff s e t t h e lo s ss u ff e r e d o n d e f a u lt f u l ly , o rp a r t ia l ly . I f t h e r e is a n ye x c e s s o f l iq u id a t e d v a lu eo v e r lo s s a m o u n t t h e n t h ism u s t n o r m a l ly b e r e tu r n e d tot h e d e f a u lt in g p a r t y .
C o l l a t e r a l
L e g a la g r e e m e n t s
C l ie n t s
P o l ic y
O p e r a t in gp r o c e d u r e s
P e o p le
C o l la t e r a la s s e t
m a n a g e m e n t
L e g a l r is kr e s e a r c h
P o r t f o l ior is k
a n a ly s is
Risk management for the Collateral PortfolioCollateralisatio
n is a risk transformation technique…
Credit risk isexchanged for operatingand legal risk... A strong risk
managementculture needs
to surround theentire collateral
management process.
Page 13GARP UK Meeting July 18, 2001
Agenda
How collateralisation is used today
Collateral as a risk transformation technique
Risk management techniques
Crisis management in a collateralised scenario
The current market environment
Page 14GARP UK Meeting July 18, 2001
Specific risk management techniques 1
Documentation risk Obtain qualified advice on what documents to use for
each client.
Define standard document templates and standard electives and variables for your organisation.
Define rules around who can change terms, for what reasons, and with what approvals.
Record the content of documents fully in appropriate systems, and ensure original documents are protected and controlled.
Page 15GARP UK Meeting July 18, 2001
Specific risk management techniques 2
Legal risk Obtain qualified advice on legal issues related to
collateralisation in each jurisdiction in which your counterparties are located.
Disseminate the advice you receive to your credit, collateral, operations and trading staff - and understand they understand it (it is not much use gathering dust on a shelf!).
Structure your collateral agreements optimally for each client and jurisdiction combination. Templates may help here, but oversight by qualified collateral risk managers is recommended.
Proactively take legal risks you like and can manage. Avoid those you cannot. Measure your legal risk and hold economic capital against it (irrespective of what bank supervisors might or might not say about it).
Page 16GARP UK Meeting July 18, 2001
Specific risk management techniques 3
Operating and people risk Start from the base of a strong collateral policy that
governs all aspects of your firm’s use of collateral in a consistent manner.
Buy and use technology appropriately.
Remember that technology is not the whole solution!
Develop comprehensive operational procedures and use them.
Rehearse unusual situations and crisis plans from time to time.
Segregate critical duties and functions; require appropriate approval procedures.
Hire qualified collateral staff and compensate them appropriately to retain and motivate them.
Page 17GARP UK Meeting July 18, 2001
Specific risk management techniques 4
Portfolio level risks Recognize that you have a “collateral portfolio” - the
combination of all your collateral agreements across all your collateralised clients and all their trades that are collateralised, offset by all the collateral you have taken in and given out.
Measure concentrations of particular collateral types received from multiple counterparties.
Detect correlation between particular collateral assets and the counterparties from which they were received - e.g. the “wrong way” diagonal.
Set limits for concentration and correlation risk. Measure risk against these limits and report accordingly to management. Adjust capital reserves and transaction availability accordingly.
Page 18GARP UK Meeting July 18, 2001
Summary
Risk
Documentation
Legal
Operationssssssssssssssssssss
Portfolio
Risk Mitigation Technique
Low Cost
GMRA, ISDA
Industry Opinions
High threshold, Infrequent calls
Cash, Govt Bonds
High Cost
Client Driven
Bespoke
Zero threshold, daily calls
Hedging, limit management
Page 19GARP UK Meeting July 18, 2001
Agenda
How collateralisation is used today
Collateral as a risk transformation technique
Risk management techniques
Crisis management in a collateralised scenario
The current market environment
Page 20GARP UK Meeting July 18, 2001
Crisis management planning
The worst time to develop a crisis plan is during a crisis.
The word “crisis” itself is unhelpful and may paralyse the organisation…
“Emergency Management Plan”“Emergency Action Plan”“Special Circumstances Procedure”“High Risk Situation Procedures”
What is a “crisis” anyway?A crisis is any situation that differs materially from normal operating conditions or presents the organisation with a higher-than-normal risk profile. Organisational response in a crisis should be appropriate to the specific circumstances and graduated according to severity.
Page 21GARP UK Meeting July 18, 2001
Key elements of a crisis plan
Identification and declaration of a crisis; initiation of special procedures.
Gathering of information, but avoidance of analysis paralysis.
Prompt risk / damage assessment based on available information.
Immediate triage action. Consideration of complete solutions. Action. Review and react. And later… determine/assign damages, mop up
outstanding issues, identify and act on lessons learned.
Page 22GARP UK Meeting July 18, 2001
Positioning the crisis plan
Collateral will most commonly be a factor in a crisis if it is triggered by (a) a specific name credit concern, or (b) a sharp discontinuity in the markets which affect either a geographic region or a class of similar counterparties (e.g. those in a particular industry).
We recommend you write and rehearse a specific collateral crisis plan, but….
…. NOT in isolation. Make it an integral part of your firm’s credit crisis procedures and market credit procedures.
Rehearse the plan at least once per year, and ideally more often.
Page 23GARP UK Meeting July 18, 2001
Practical questions / steps 1
Scope of the Crisis Who is affected? Client (which one?), internal systems,
market infrastructure. Cause? Technology, communications, human error, credit
problem, natural disaster. Does the affected party know there is a problem? Is the problem contagious? If so, by what route? To whom? Is the problem going to initiate other problems? Where?
Gathering relevant information Counterparty details, including branches, subsidiaries, etc. Portfolio details - value of positions at risk. Recourse details - collateral, guarantees, letters of credit. Hedges - credit derivatives that may be triggered. Size of current losses? Imminent losses? Future potential
losses?
Page 24GARP UK Meeting July 18, 2001
Practical questions / steps 2
Legal analysis What documents do you have? Where are they? (Get them!) Are there any non-standard provisions that may have a
beneficial or detrimental impact to resolving the situation? What are your common law rights? Is there anything you must do immediately to preserve your
legal position, or to improve your chances of future success enforcing netting, collateral or other documents?
Information dissemination Sift information and communicate relevant facts and
opinions to senior management. Obtain any necessary approvals for action.
Keep your counterparty appropriately informed. Keep information flowing internally at an appropriate level.
Page 25GARP UK Meeting July 18, 2001
Practical questions / steps 3
Valuation of losses What do the documents say? Is market practice in accord with the documents? Compute the loss number.
Collateral enforcement Where is the collateral? Do you control it absolutely? What is the value of the collateral? Identify the market(s) and mechanism(s) by which you will
liquidate it, if forced to do so. Will market liquidity be impaired - either before your
liquidation of the collateral or as a result of your liquidation of the collateral?
Identify and execute all necessary legal steps in the liquidation (e.g. do you need to obtain multiple tenders for the assets?)
Liquidate promptly upon the decision to do so.
Page 26GARP UK Meeting July 18, 2001
Agenda
How collateralisation is used today
Collateral as a risk transformation technique
Risk management techniques
Crisis management in a collateralised scenario
The current market environment
Page 27GARP UK Meeting July 18, 2001
The current market place
Risk
Legallllllllllllllllllllll
Documentationnn
Operationsssssss
Portfolio
Changes in the Market Environment
Low Cost
EU Collateral Directive, Hague Convention
ISDA Margin Provisions 2001, GMRA 2000
Continued investment in systems and people, ISDA surveys
Wider collateral acceptance
Page 28GARP UK Meeting July 18, 2001
Wrap Up
Collateralisation is a highly effective credit risk management technique but remember that is also a risk transformation technique
The new risks should be measured and managed
There are a wide variety of available techniques for doing this
And remember, collateral is of ultimate use in a crisis scenario so have an action plan ready.