Academic journal article Economic Perspectives

Credit Derivatives: Just-in-Time Provisioning for Loan Losses

Academic journal article Economic Perspectives

Credit Derivatives: Just-in-Time Provisioning for Loan Losses

Article excerpt

Introduction and summary

Risk managers use a "peeling an onion" analogy to illustrate their prioritization of risk management activities. The resulting priorities have produced the contracting innovations needed to manage the outer layers of this risk onion. These tools are derivative contracts whose values are driven by changes in interest rates, equity prices, and foreign exchange rates. Having dealt with these outer layers, today's risk managers are paying increasing attention to the inner layers of the onion, most especially credit risk. Furthermore, globalization of the financial markets is increasing diversification opportunities. To remain competitive in the global marketplace, financial institutions whose borrowers are concentrated in certain business or geographic sectors are seeking methods to improve their diversification of credit exposures.

The efforts of risk managers are proceeding on two fronts. First, they are developing methods to measure credit risk exposures. Three of the better known procedures for measuring credit exposures are the Expected Default Frequency metric developed by KMV,(1) J.P. Morgan's CreditMetrics,(2) and Credit Suisse's CreditRisk+.(3) Second, risk managers are engineering derivative contracts to enable transference of credit risk exposures.(4) This article examines some of these contracts and compares this new risk management route with a traditional route for managing loan loss exposures.

Descriptions of growth prospects for the credit derivatives market in terms such as "the next interest rate swap" stem from a confluence of events. Smithson (1997) points out that the first steps came as over-the-counter (OTC) derivatives dealers began to recognize the need to manage their credit exposures to one another. This recognition led to efforts to quantify and then to create structures controlling credit risk exposures. One such structure is the derivative product company (DPC), in which derivative contracts are booked in a subsidiary that then books an offsetting position with its parent.(5) Such structures shift broad market exposures, most often to interest rates, from the subsidiary to the parent firm while retaining credit exposures to original counterparties at the subsidiary level. These structures are motivated by the need to raise the credit ratings of OTC dealers and improve their ability to compete for business. DPC structures isolate credit risk from other risk sources. This enables institutions to allocate capital directed at credit risk concerns. In addition, DPC structures motivate specialization in credit risk management.

Recently, attention has focused on transferring credit risk from one party to another using credit derivative contracts. Various contracting schemes are now labeled credit derivatives. The common feature of these risk management tools is that they retain assets on the books of originating institutions, while transferring some portion of the credit exposure inherent in these assets to other parties. This accomplishes several objectives. Originating institutions have a vehicle that transfers credit risk without requiring the sale of the asset. When asset sales weaken an institution's relationships with its borrowers, a vehicle transferring only the credit exposure permits the institution to retain its relationship. In addition, the ability to reshape credit exposures through derivatives can be used to improve diversification. For example, an institution with loan concentrations in a problem industry can lessen credit exposures by swapping its exposures in the problem industry for credits from a broader borrowing segment. Thus, following an oil price decline, the credit exposures from loans to oil exploration firms may be regarded as excessive. A credit risk swap reduces the institution's concentration in these firms to achieve a more diversified loan portfolio.

Current regulatory policy toward credit derivatives does not recognize their risk reducing potential. …

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