GARP UK Meeting July 18, 2001 Page 1 Risk Management for the Collateral Portfolio Presentation to the GARP UK Meeting July 18, 2001 Penny Davenport

Page 1GARP UK Meeting July 18, 2001

Risk Management for the Collateral Portfolio

Presentation to the GARP UK Meeting

July 18, 2001

Penny Davenport


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


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.


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


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


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


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


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


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


Agenda







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


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.


Agenda







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.



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).



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.



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.


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


Agenda







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.


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.


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.


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?



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.



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.


Agenda







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


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.

Documents

GARP UK Meeting July 18, 2001 Page 1 Risk Management for the Collateral Portfolio Presentation to the GARP UK Meeting July 18, 2001 Penny Davenport