Credit Risk Management

Credit Risk Management looks at what money could be lost in the event that a client defaults on its obligations.

Current Credit Exposure

Current credit exposure addresses what the current loss would be if a customer were to default on its obligations today.  It is simpler to compute than future potential exposure, but illustrates many of the important issues.

This is a data problem. Consider a case where one transaction is worth $100 in favor of the client and $100 against the client.  If these are booked in an enforceable netting agreement, the two net out in the case of a default and there is essentially no credit risk. But, if they are not nettable, the client gets the $100 and the $100 owed goes through bankruptcy processing and ultimately paid cents on the dollar.  Clearly, having accurate information about what netting agreement a transaction used - is critical to accurate reporting.  In the absence of a master master agreement netting across agreements, a surplus in one agreement cannot offset a deficit in a different agreement - similarly leading to payments to the customer and receipts that co through bankrupcy processing.

Similarly, collateral held by either party goes into the measurement.  Credit derivative protection and guarantees also have to be taken into account.   

Current transactions, margin arrangements, collateral and current market value are all needed to compute exposure.

Finally, all the products that a customer may trade need to be brought together for the risk management.  There are strategies for centralized vs distributed systems to do the work.  For example, exchange traded options, and OTC swaps do not (normally) share a netting agreement and therefore can be managed separately

However, in general risk management has to consider

  • Exchange Traded - Equities, Equity Derivatives, Fixed Income, Fixed Income Derivatives
  • Exchange Cleared - Fixed Income Derivatives, Credit Derivatives
  • ISDA/OTC - Equity Swaps, Fixed Income Derivatives, Credit Derivatives, Mortgage Backed Derivatives
  • FX, FX Derivatives
  • Repo
  • Stock Borrow Loan
  • Bank Loan

Future Potential Exposure

Future potential exposure looks at the potential loss over time, and is more complex to compute.  There are in-depth write ups of modeling methodology.  The following is only a very brief introduction:

Current credit exposure can use the current value (mark to market) of transactions to compute credit exposure.  In contrast, the value of these positions over time is not known.  Value at Risk (VaR) can be used to compute the a distribution of possible market conditions over time.  For many products, including swaps, the market conditions are inputs to models that ten determine the value of the transaction that goes into the credit exposure management. The same applies to collateral, as collateral held (or pledged) in the future is different from the today's collateral.  Depending on the products, this can involve significant amount of number crunching. 

Alternately stress calculations can be used to compute exposure.  It is less computationally intensive.  Both VaR and Stress attempt to measure the same credit risk.  There are extensive and heated discussions contrasting the merit of the methodologies.  Overall, these are models, and anyone using the models should be aware of the assumptions and limitations of the model.