Credit Protection: Risk or Return, What Matters More?

Credit officers are sometimes tempted to allow traders to trade with counterparties despite their credit lines being full. What are his options then? He could increase the credit limit. Alternatively he could reduce exposure by repackaging short-term exposure to long-term exposure by using custom swaps in order to utilize the entire term structure of the credit lines.

A mechanism that would allow for the risk to be transferred to counterparties that have unfilled credit lines would be desirable in such cases. This can be done by using credit derivatives. There are some issues that must be taken into account in such cases. The right kind of credit derivative at the right price is needed. It is difficult to estimate the exact amount of protection required for the future. True the instrument has a certain expected protection, but will it be enough for a future point of time, is the question. The criteria on the basis of which the expected cover has been calculated such as default probability, exposures or loss given default tend to change and may require readjustment.

A viable option in such a situation is to bundle all counterparty exposure within one portfolio and then securitize them. This allows for large diversification and significant reduction of credit lines. This bundling and securitization process must take into account the bank’s credit risk framework. It must also fit the global risk strategy and must take into account the limit management and reporting risks.

This process makes ‘active’ the link between trading and risk management. The roles of the trader and credit officer are intertwined and not two separate functions. Previously traders may have considered credit officers as gate keepers who allow or disallow further trading based on credit limits. Now by implementing such an option they become enablers. In this way returns and risks are linked making good business and good risk management both possible.

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