Credit Risk Mitigation and Transfer: Techniques Explained

Understand Credit Risk Mitigation and Transfer

Key rules to remember

Net exposure after collateral (comprehensive approach)

E* = max{0, E × (1 + He) − C × (1 − Hc − Hfx)}

E = exposure, He = haircut on exposure, C = collateral value, Hc = haircut on collateral, Hfx = currency mismatch haircut. Capital is then computed on E*.

Simple netting of loans and deposits

Net exposure = Loan outstanding − Eligible deposit set off

Applies only when there is a legally enforceable netting right. Floor at zero.

Guarantee substitution

Covered portion takes the guarantor's risk weight; uncovered portion keeps the borrower's risk weight

Applies for eligible guarantees. Risk-weighted assets = covered × guarantor RW + uncovered × borrower RW.

Risk-weighted assets and capital

RWA = Exposure × Risk weight; Capital required = RWA × minimum capital ratio

Use the ratio given in the question. Do not assume a figure.

Credit default swap payout

Payout = Notional × (1 − Recovery rate)

Applies on a credit event under cash settlement. Annual premium = Spread × Notional.

Expected loss

EL = PD × LGD × EAD

Collateral and guarantees reduce LGD or EAD, and so reduce EL.

How to solve Credit Risk Mitigation and Transfer questions

1. 1Read the question and name the exposure: borrower, amount, maturity and current risk weight.
2. 2Classify each protection as funded (collateral, netting) or unfunded (guarantee, credit derivative), or as transfer (securitisation) or diversification.
3. 3Check eligibility: legal certainty, enforceability, and whether the protection provider or collateral qualifies.
4. 4Apply adjustments: haircuts on collateral, currency mismatch, and maturity mismatch if given.
5. 5Compute the net exposure, or split into covered and uncovered portions for a guarantee.
6. 6Apply the risk weight and the capital ratio given, or compute EL or CDS payout as asked.
7. 7State the residual risks: guarantor default, collateral price fall, basis risk, legal risk.
8. 8Close with a clear conclusion on how much the risk fell and what remains.

Quickest way: Three-line scan for MCQs and short numericals

Common mistakes in Credit Risk Mitigation and Transfer

• Treating collateral and guarantee as the same thing.

  Both are called security for the loan.

  Fix: Collateral is a claim on an asset; a guarantee is a claim on a person. Judge collateral by value and enforceability, a guarantee by the guarantor's credit standing.

• Ignoring haircuts and subtracting full collateral value.

  Students want a quick answer.

  Fix: Reduce collateral by the haircut (and currency haircut) before subtracting. Increase the exposure by its own haircut if given.

• Saying a CDS removes all risk.

  It is described as insurance.

  Fix: Mention counterparty risk of the seller, basis risk, and the need for a defined credit event.

• Claiming securitisation always transfers risk fully.

  The loans leave the balance sheet.

  Fix: Say transfer is real only if the bank gives up control and keeps no significant risk, for example through credit enhancements.

• Applying the guarantor's risk weight to the whole loan when only part is guaranteed.

  Students skip the split.

  Fix: Split into covered and uncovered parts and weight each separately.

• Forgetting that diversification lowers only specific risk.

  It is treated as a complete cure.

  Fix: State that concentration limits reduce single-name risk but a general downturn still hits all borrowers.

Worked examples