The effective management of credit risk is vital to the success of a bank. By allowing banks and other financial institutions to transfer credit risk from one party to another, credit derivatives have helped to enhance the efficiency and flexibility of credit risk management in these institutions.
The advent of credit derivatives has also allowed participants such as banks and investors to isolate credit risk as a key component, thus separating the risk from the intrinsic influences of the underlying lending relationship. In so doing, participants can now view credit as a tradable commodity, resulting in an increased focus on active credit portfolio management.
On the other side of the equation, there is also tremendous scope for corporates and institutional investors such as investment funds and insurance companies to use credit derivatives as a bridging tool to manage sovereign risk and portfolio credit risk, and take advantage of yield enhancement opportunities. In fact, credit derivatives are now playing a key role in all facets of the credit business spectrum - from loan portfolio management to secondary loan and debt trading, asset swaps, asset securitisation and structured credit products.
A credit derivative can take a number of forms, the most common being credit default swaps, total return swaps and credit-linked notes. The nature of a credit derivative is best illustrated with a credit default swap in the digram shown: Bank A has an underlying loan whose default risk it wishes to hedge. Bank A is the protection buyer and Bank B is the protection seller. Bank A pays 30 basis points to Bank B over the period of the credit derivative. Upon a 'credit event' such as a default of the loan, Bank B makes a 'credit event payment' to Bank A.
In this example, Bank A is able to hedge its credit risk without informing the loan customer with whom it has a banking relationship, while Bank B is able to take on the credit exposure without funding costs or to diversify its own portfolio by taking on a further specific credit risk.
Making an impact
Credit derivatives have the potential to transform the fundamental lending model of many commercial banks. It will require re-assessing the operating model for the lending product, including how loans should be made; how services should be developed, priced and targeted; how risks should be assessed, priced and selected, and how risk-oriented processes should be developed and implemented.
Banks participating in the commercial lending market have traditionally sought to contain within their operations all aspects of the processes for lending from origination to administration, monitoring and collection. Credit risk decision-making under such a model is binary in nature - the credit risk is either acceptable or unacceptable to the institution. Once accepted, the risk is invariably held to maturity.
In the evolving model, all loan transactions will be originated with a view to possible ultimate distribution. This distribution could occur either in the form of the asset itself (by way of an outright sale or asset securitisation) or laying off the underlying credit risks (by way of a credit derivative).
Credit managers will no longer make simple binary credit decisions but will be able to accept a loan based on an Originate Manage and Distribute (OMD) model. A lending institution will never have to make an outright rejection for any deal provided it remains economically possible to lay off the risks to the market. The credit management function then assumes the responsibility for managing the portfolio risks of the institution, taking decisions at the margin for new transactions and changing the portfolio by way of secondary market sales, securitisation and credit derivative activities as warranted.
MAS guidelines
In Singapore, credit derivatives have also become increasingly common especially in the last two years. In fact, while New York and London are hailed as the biggest markets in credit derivatives, Singapore has the potential to become the Asian hub for credit trading. It is not surprising, therefore, that the Monetary Authority of Singapore (MAS) has issued a guideline, MAS Notice 627, in September 2000, on the capital treatment of certain credit derivative products.
The use of credit derivatives transfers the credit risk from the protection buyer to the protection seller. The MAS Notice requires the protection seller to maintain regulatory capital against the credit exposure and allows some capital relief to the protection buyer. Under the MAS rules, credit derivatives are assigned to the banking book as opposed to the trading book of a bank unless it can be demonstrated that the credit derivative is traded and marked to market.
Under such rules, a protection buyer may replace the risk weighting of the underlying assets hedged with that of the protection seller when no funding is received.
When funding is received, the protection buyer may reduce the dollar amount of its exposure to the underlying asset by the amount of funding received. On the part of a protection seller, which acquires credit exposure to the underlying assets, it is necessary to risk weigh this exposure based on the weight of the reference credit.
Where a protection seller also provides funding, a capital charge would be levied on the sum of the risk weighted exposures of both the reference credit and protection buyer, subject to the maximum possible payout under the credit derivative contract. For both the protection buyer and seller, where there are asset, currency or maturity mismatches, MAS has established some rules on the extent of the capital relief available to the protection buyer under various scenarios.
Obstacles to growth
While credit derivatives are certainly grabbing headlines over the past few years with year-on-year volume statistics illustrating the exponential growth of this market, there is also an air of frustration. There are rumblings that the market has been hampered by various factors that deterred credit derivatives from reaching their full potential. These include:
Lack of effective infrastructure
Banks need to develop a more sophisticated and integrated infrastructure capable of responding to the expanding volumes and increasing complexity of credit products.
Failure to develop the necessary capabilities could impair growth and heighten operational risks within the financial institution. Existing configurations generally fail to provide portfolio-wide data views required for active portfolio management and are inherently weak in their aggregation ability across applications due to poor data interface capabilities and weak controls over data capacity. Banks need an integrated business generation model capable of providing end-to-end support aligned to the paradigm shift of new credit products.
Lack of liquidity
There is still a dearth of liquidity in the interbank market on credit derivatives, especially in Asia. The market still caters to relatively well-known and preferably rated debt issues. In many situations, only a few institutions are selling protection for the credits that other institutions seek to hedge. It is also said that the lack of standardisation has deterred banks from participating due to their lack of confidence in dealing with the larger banks and prohibitive costs involved in documentation.
While the nature and function of credit derivatives beyond the basic type do not always lend themselves to documentary standardisation, considerable effort is now made to develop agreed definitions across a range of areas on credit derivative contracts. Standardisation will help to take some 'noise' out of negotiation, and will complement moves towards common IT platforms for trading and settlement purposes.
Lack of transparency
The shortage of liquidity leads to inadequate data, hence creating transparency issues. There is also a problem of accessing objective data across different countries as each jurisdiction uses different yardsticks to measure key criteria such as credit delinquency. Many traders face a dearth of information about non-rated names and sub-investment grade credits in Europe and Asia. But this issue is increasingly being addressed by e-business initiatives like Creditex and CreditTrade which will help improve data dissemination and lead to greater price transparency, which will hopefully boost market liquidity.
The introduction of JP Morgan Chase's new online credit derivative trading platform, morgancredit.com, and in particular, Orbit, is aimed at ensuring that a price is always visible during the US, European or Asia-Pacific trading hours. This site also provides previously unavailable data on spot and historical swap spreads for individual credits and credits sorted by industry and geographical sector. Despite these hitches, participants are upbeat about the credit derivatives market.
The development of synthetic securitisation, particularly in the US, is seen to hold great potential. Banks in Europe and Asia are now engaged in secondary loan trading to a greater extent, and this can only boost the credit derivatives market. The winners will be the banks which seize the opportunities in an emerging market and develop an infrastructure responsive to this fast-evolving market to create value to shareholders.
Lian Wee Cheow and Chua Kim Chiu are partners of PricewaterhouseCoopers' Financial Services Industry practice in Singapore.
