CAIIB-ABM-MOD-B-Credit Risk Mitigates Credit Risk Mitigates It is a process through which credit Risk is reduced or transferred to counter party. CRM techniques are adopted at Transaction level as well as at Portfolio level as under: At Transaction level: • Obtaining Cash Collaterals • Obtaining guarantees At portfolio level • Securitization • Collateral Loan Obligations and Collateral Loan Notes • Credit Derivatives
1. Securitization It is process/transactions in which financial securities are issued against cash flow generated from pool of assets. Cash flow arising from receipt of Interest and Principal of loans are used to pay interest and repayment of securities.
SPV (Special Purpose Vehicle) is created for the said purpose. Originating bank transfers assets to SPV and it issues financial securities.
2. Collateral Loan Obligations (CLO) and Credit Linked Notes (CLN) It is also a form of securitization. Through CLO, bank removes assets from Balance Sheet and issues tradable securities. They become free from Regulatory Capital. CLO differs from CLN : • CLO provide credit Exposure to diverse pool of credit where CLN relates to single credit. • CLO result in transfer of ownership whereas CLN do not provide such transfer. • CLO may enjoy higher credit rating than that of originating bank.
3. Credit Derivatives It is managing risks without affecting portfolio size. Risk is transferred without transfer of assets from the Balance Sheet though OTC bilateral contract. These are Off Balance Sheet Financial Instruments. Credit Insurance and LC are similar to Credit derivatives. Under a Credit Derivative PB (Prospective buyer) enter into an agreement with PS (Prospective seller) for transfer of risks at notional value by making of Premium payments. In case of delinquencies, default, Foreclosure, prepayments, PS compensates PB for the losses. Settlement can be Physical or Cash. Under physical settlement, asset is transferred whereas under Cash settlement, only loss is compensated. Credit Derivatives are generally OTC instruments. ISDA (International Swaps and Derivatives Association) has come out with documentation evidencing such transaction. Credit Derivatives are: 1. Credit Default Swaps 2. Total Return Swaps 3. Credit Linked Notes 4. Credit Spread Options