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Page 1ARP UK Meeting July 18, 2001

Risk Management for theCollateral PortfolioPresentation to the GARP UK MeetingJuly 18, 2001Penny Davenport

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Agenda

x How collateralisation is used today

x Collateral as a risk transformation technique

x Risk management techniques

x Crisis management in a collateralised scenario

x The current market environment

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Collateral is a technique for managingcredit risk

x Credit risk arises because one party who owes money toa second party might not pay.

x Its a risk while we are waiting for it to happen. When it

does, its a loss!x Good metrics for credit risk take into account the size of

the potential loss, the probability of the loss eventoccurring, and the value of any recourse, such as

collateral.

x Collateral (normally) reduces credit risk.

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Party A owes $10 toParty B what happens next?

Party Barty A A defaults - B has acredit loss of $10

Case 1

Case 2

Case 3

Normal performancearty A Party B$10

Party Barty A$

A defaults - B has acredit loss of $10, but hasrecourse to $10value of collateral.

Securities worth $10

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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

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Why else might you take collateral?

x To protect against credit default loss

x To facilitate access toq More credit transactionsq Longer maturity transactionsq Larger size transactionsq Higher volatility transactions

x To manage the cost of credit / economic capital

x To comply with counterparty policy requirementsx To expand revenue opportunities

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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 of

Agreements Example: US Investment Bank

Collateral

programmes

commenced

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Collateral is a mutual risk reductiontechnique

0

10

20

30

40

50

AAA AA A BBB BB B N/R

Percent of total

collateralized clients

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But remember collateralis just one alternative

The Credit Enhancement Spectrum

Cash

Collateral

Single

Swap

Reset

ElectiveTermination

Rights

Letters

of CreditGuarantees

Credit

Insurance

Credit

Derivatives

Credit RiskTransfer

Third PartyCredit Support

Direct CreditSupport

TransactionExposure Reduction

Securities

Collateral

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Agenda






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Agreement structure riskMonitoring control r iskConcentration riskMarket risk on col lateral valueCorrelation riskThird party and settlement risk

Procedural r iskPerfection riskRecharacterization riskPriority riskEnforcement riskLocal risk factors

Murphy risk

L ega lr i s k s

Ope ra t i ngr i sk s

CollateralCreditrisk

The risks ofcollateralization

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Risk management in acollateral programme

Assets of quantifiable value, delivered by oneparty 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.

Anytangible or

intangible assets,egfinancial instruments,physical property,rights,etc.

We needto beable to

value the assetsreliably(atleastperiodically)

Deliverymaybephysical,butmore oftenelectronic transfer isusedin practice

Deliveryneednot beto the collateralrece iver - maybeindirectly heldfor thebenefit ofthe receiver.

There needs to be anappropriate legal documentthat setsout the rights andobligations ofthe parties,and mostimportantlyestablishes the legal natureof the collateral claimover assets -pledge,charge,security interest,mortgage,title transfer,etc)

Intent to provideprotection,but noguarantee.

Recourse to the assets,but no directreductionof credit exposure ordefault probability

Needto establish in thegoverning documentationwhat the trigger for aclaim againstthecollateral will be.

Whether or not the collateralcan be expectedto cover the

loss ondefault is a questionfor the collateral receiver todetermine -presumptivelythere must be a reasonableexpectationthat thecollateral will provide somevalue,otherwise thecollateral agreementwouldnotbe worthwhile

The value of the collateralin practice (regardlessofanyex-ante valuations)will be the liquidationproceeds resulting from asale of the assets in the circumstancesimmediatelyafter the time of default- i.e.potentiallyaforcedsale inadistressedmarket.

The liquidated value of theassets mayoffset the losssufferedon default fully,orpartially.If there is anyexcess ofliquidated valueover lossamount then thismust normallybereturned tothe defaultingparty.

Co l l a t e r a l

Legalagreements

Clients

Policy

Operatingprocedures

People

Collateralasset

management

Legal riskresearch

Portfoliorisk

analysis

Risk managementfor the Collateral Portfolioollateralisationis a risktransformationtechniqueCredit r isk isexchangedfor operatingand legalrisk... A strong riskmanagementculture needsto surround theentire col lateralmanagement process.

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Agenda






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Specific risk management techniques 1

x Documentation risk

x Obtain qualified advice on what documents to use for each client.

x Define standard document templates and standard electives andvariables for your organisation.

x Define rules around who can change terms, for what reasons, andwith what approvals.

x Record the content of documents fully in appropriate systems, andensure original documents are protected and controlled.

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x Legal risk

x Obtain qualified advice on legal issues related to collateralisation ineach jurisdiction in which your counterparties are located.

x 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!).

x Structure your collateral agreements optimally for each client andjurisdiction combination. Templates may help here, but oversightby qualified collateral risk managers is recommended.

x Proactively take legal risks you like and can manage. Avoid thoseyou cannot. Measure your legal risk and hold economic capitalagainst it (irrespective of what bank supervisors might or might notsay about it).

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x Operating and people risk

x Start from the base of a strong collateral policy that governs allaspects of your firms use of collateral in a consistent manner.

x Buy and use technology appropriately.

x Remember that technology is not the whole solution!

x Develop comprehensive operational procedures and use them.

x Rehearse unusual situations and crisis plans from time to time.

x

Segregate critical duties and functions; require appropriateapproval procedures.

x Hire qualified collateral staff and compensate them appropriately toretain and motivate them.

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x Portfolio level risks

x Recognize that you have a collateral portfolio - the combinationof all your collateral agreements across all your collateralisedclients and all their trades that are collateralised, offset by all the

collateral you have taken in and given out.x Measure concentrations of particular collateral types received from

multiple counterparties.

x Detect correlation between particular collateral assets and thecounterparties from which they were received - e.g. the wrong

way diagonal.x Set limits for concentration and correlation risk. Measure risk

against these limits and report accordingly to management. Adjustcapital reserves and transaction availability accordingly.

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Summary

RiskDocumentation

Legal

Operationssssssssssssssssssss

Portfolio

Risk Mitigation TechniqueLow CostGMRA, ISDA

Industry Opinions

High threshold,Infrequent calls

Cash, Govt Bonds

High CostClient Driven

Bespoke

Zero threshold,daily calls

Hedging, limitmanagement

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Agenda






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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

organisationEmergency Management PlanEmergency Action PlanSpecial Circumstances ProcedureHigh Risk Situation Procedures

What is a crisis anyway?

A crisis is any situation that differs materially from normaloperating conditions or presents the organisation with ahigher-than-normal risk profi le. Organisational responsein a crisis should be appropriate to the specificcircumstances and graduated according to severity.

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Key elements of a crisis plan

Identification and declaration of a crisis; initiation ofspecial procedures.

Gathering of information, but avoidance of analysisparalysis.

Prompt risk / damage assessment based on availableinformation.

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.

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Positioning the crisis plan

Collateral will most commonly be a factor in a crisis if it istriggered by (a) a specific name credit concern, or (b) asharp discontinuity in the markets which affect either ageographic 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 firms

credit crisis procedures and market credit procedures. Rehearse the plan at least once per year, and ideally moreoften.

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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?

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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 enforcingnetting, collateral or other documents?

Information dissemination Sift information and communicate relevant facts and opinions tosenior management. Obtain any necessary approvals for action.

Keep your counterparty appropriately informed. Keep information flowing internally at an appropriate level.

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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 ofthe 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.

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Agenda






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The current market place

RiskLegalllllllllllllllllllll

l

Documentationnn

Operationsssssss

Portfolio

Changes in the MarketEnvironmentLow CostEU Collateral Directive, Hague

Convention

ISDA Margin Provisions 2001, GMRA2000

Continued investment in systems andpeople, ISDA surveys

Wider collateral acceptance

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Wrap Up

x Collateralisation is a highly effective credit riskmanagement technique but remember that is also a risktransformation technique

x The new risks should be measured and managed

x There are a wide variety of available techniques fordoing this

x And remember, collateral is of ultimate use in a crisis

scenario so have an action plan ready.

LN 20010718 Davenport

Documents

Transcript of LN 20010718 Davenport