ECO 469: MONEY AND BANKNG
CREDIT DERIVATIVES AS FINANCIAL INSTRUMENTS FOR CONTROLLING CREDIT RISK
Bame Sandra Kooganne
As it is a norm in the financial system, financial institutions extend credit as main part of their business operation and in every financial transaction that includes credit extension credit risk is present. Due to this risks, banks and investors often suffers losses on their investments due to defaulters. This study analyses the emergence of financial instruments that aim at reducing or mitigating the losses banks and investors suffer on their investments. Its purpose is to explain how these financial instruments work, their effectiveness and shortcomings in controlling credit risk. The goal of this research is to increase the amount of knowledge regarding credit mitigating financial instruments and their importance to financial institutions.
According to Mark C Freeman the credit derivatives market is at present dominated by large banks and insurance companies who trade credit exposure among themselves and the question arising from these is that should corporate treasures consider using credit derivatives to manage credit exposure as credit derivatives become more transparent and liquid. While on the issue of liquidity and transparency, economist Jose A. Lopez says that even though credit derivatives has much promise challenges like liquidity, documentation, issues of contract transparency and systemic risk must be addressed to reduce regulators’ concerns about the widespread use of credit mitigating financial instruments.
Today the economy is dominated by the use of money rather than the barter system which was used in the old days because transactions that make up our daily economic activity are conducted using money. Money is the center of economic activity hence making it inevitable to overdraw our financial resources to finance our investment projects for example we often acquire loans from banks and financial companies for mortgages, startup capital for businesses and also for personal reasons. These loans bear risks that affect banks, investors and financial companies and one of the risks is known as credit risk which is risk of default by the borrower and this causes banks, investors and financial companies to suffer losses on their investments. As a way of responding to these risks, new financial instruments were developed known as credit derivatives. This new financial instruments allowed credit risk or exposure to be transferred from the owner of the risk to another party known as the guarantor or counterparty in a way being beneficial to banks and investors as they reduced the losses they suffered on their investments due to defaulters.
This discussion will be more focused on credit derivatives in terms of their definition, types and how they operate. Furthermore it will look on credit risk i.e. how it can be measured, its effects to financial institutions and how it can be managed with the use of credit mitigating derivatives.
Credit derivatives are a very useful tool for risk management and it is different among the categories of user; banks, financial institutions, other investors (Roxana Angela Calistru, 2012). In order to assess the credit risk, it is necessary to take a close look at the borrower’s economic and legal situation as well as the relevant environment e.g. industry, economic growth rate and employment rate (Seyfried, 2001). Derivatives manage credit risk by insuring against adverse movements in the credit quality of the borrower, thus if used properly they can reduce an investor’s overall credit risk (Robert S Neal, 1996).
Credit derivatives are a form of derivatives (a financial instrument which its value is derived from the price of an underlying asset, index rate). They are said to be a class of privately negotiated contracts designed with the express purpose of transferring credit risk from one party to another and there are two major categories that makeup credit derivatives which include; collateralized debt obligation (CDOs) and credit default swaps (CDs)(Roxana Angela Calistru, 2012). They allow bankers to manage concentration of risk hence improving the management of their credit portfolios. (Das, 1998). Credit derivatives serve several economic functions such as reducing business risks, expanding product offerings to customers and trade for profit e.t.c and although they are legitimate and valuable tools for banks and corporations, like all financial instruments they contain risks that must be managed. The risks associated with derivatives include; credit risk, operational risk, cash flow risk, basis risk, and legal and documentation risk, market risk and in our discussion we are going to focus on management of credit risk with the use of derivatives. (Elvis Mujacevic, 2004). Before we could discuss credit risk and its management we will look at the two major categories of credit derivatives that banks, investors and financial companies use to manage or control credit risk of their investment.
COLLATERALIZED DEBT OBLIGATION (CDOs); they are referred to as a pool of debt contracts housed within a special purpose entity whose capital structure is sliced and resold based on differences in credit quality.
CREDIT DERIVATIVES SWAPS (CDs); they are defined as private contracts in which parties bet on a debt issuers bankruptcy, default or restructuring.
These two are sometimes referred to as securitization transactions and banks use these transactions to transfer the credit risk of a portfolio of exposure to investors and they use CDs to get rid of the credit risk of issuers to whom they make a large exposure. (Roxana Angela Calistru, 2012).
Credit risk is the probability that a borrower will default on a commitment to repay debt or bank loans. Default occurs when the borrower cannot fulfill key financial obligations such as making interest payments to bondholder or repaying banks loans. In case of a default the lender suffers a loss because they will not receive all the payment promised to them. (Robert S Neal, 1996). There are two types of credit risks which include;
Unsystematic credit risk which covers the probability of a borrower’s default caused by circumstances that are essentially unique to the individual
Systematic credit risk which is the probability of a borrower’s default caused by more general economic fundamentals (Milivoje Davidovich, 2011).
Credit risk increases during economic contractions because earnings deteriorate making it more difficult to repay loans or make bonds payments. A firm’s credit risk can be measured using credit rating and credit risk premium which is the difference between the interest rate a firm pays when it borrows and the interest rate on a default security. The premium is the extra compensation the bond market or commercial bank requires for lending to a company that might default. Credit risks affect any party making or receiving a loan or a debt payment e.g. bond issuers, bond investors and commercial banks, (Robert S Neal, 1996).
MANAGING /CONTROLLING CREDIT RISK
We have traditional methods of managing credit risks which include;
Underwriting standards and diversification whereby banks examine one’s financial statements and ability to pay back the loan and they would manage the credit risk exposure by controlling the terms of the loan i.e. set limits on the size of the loan establish a repayment schedule and require additional collateral for higher risk loans. Even though this method is necessary, it ability to reduce credit risk is limited by scarcity of diversification opportunities.
Securitization and loans sale; of recent banks have been selling loans directly with credit risk to outside investors and this reduced credit risk as it transferred credit exposure to new owners. Binds and loans with the credit risk are pooled together and sold to an outsider investor. Even though this method was promising to some extent it only suited loans that have standardized payment schedules and similar credit risk characteristics such as home mortgages and automobile loans but did not suit those that had diverse credit risks like commercial or industrial loans.(Robert S Neal, 1996)
Due to the shortcomings of these two methods, it led to the emergence of the use of credit derivatives as a way of managing credit risk. Credit derivatives provided insurance against credit related losses and they gave investors , debt issuers and banks new techniques for managing credit risk through;
Credit linked notes
CREDIT DEFAULT SWAPS
They are similar to insurance contracts and its main purpose is to protect the investment portfolio in case of decrease in market value. It is used by banks to protect portfolios of their bonds in case of value depreciation. (Milivoje Davidovich, 2011). This type of derivative reduces credit risk through diversification and instead of diversifying credit risk by lending outside or by selling loans; a bank can swap the payments from some of its loans for payments from a different institution. This kind of swap is known as the loan swap portfolio which is a swap of payments from loans between two banks and another bank play the role of an intermediary. (Robert S Neal, 1996)
Assume Barclays bank gave out a home mortgage loan and Standard Chartered bank gave out a commercial loan to an individual. If these two banks use the credit swap derivative to manage the credit risk of their loans then they would use First National Bank as an intermediary to execute the transactions between the two banks. Barclays would send the loan payments they receive say P10million to First National Bank and First National Bank would also receive P10million of loan payments from Standard Chartered Bank then it would swap the loan payments between the two banks. This will allow each bank to diversify away some of its credit risk and First National Bank receives a small fee for arranging the transaction.
The example above shows how the loan swaps portfolio work in controlling credit risk.
The second form of credit swaps is the total return swap which allows banks to diversify credit risk while maintaining confidentiality of their client’s financial records and the administrative costs of the swap transaction can be lower than for a loan sale transaction.
Still using the Barclays bank and First National Bank example, in this type of transaction, Barclays will send its loan payments to FNB which in turn sends the payments to a hypothetical insurance company. In exchange for the loan payments the insurance company sends an adjustable-rate interest payment to First National Bank which sends the payment to Barclays Bank. Assume there is a P10 million investment, the insurance company might send Barclays Bank a return of 2 percent greater than a 3-month Treasury bill rate. The effect of this swap for Barclays Bank is to trade the return from its loan portfolio for a guaranteed return that is 2 percent above the short term default free rate. Because the return is guaranteed, Barclays Bank has eliminated the credit risk on P10million of its loan portfolio.
Credit options provide a similar hedging function as car insurances as they allow investors to buy insurance to protect themselves against adverse moves in the credit quality of financial assets. They key features of credit options are identical to options on stocks. For example a bond investor may buy insurance policy to hedge against credit risk and in case of default the payoff from the insurance policy would offset the loss from the bond hence the investor will not suffer any loss.( Robert S Neal, 1996).
A second type of option is a put option. In general put options are similar to insurance policies because they protect investors from declines in the value of the underlying asset. Example in terms of selling and buying of stocks, a put option gives an investor or stockholder the right to sell the stock at a predetermined strike price and when the market price falls below the strike price the owner of the option can earn profit by purchasing the share at market price and selling it at the share at strike price. Therefore a put option provides insurance against decline in stock prices. Options are also available where the payoff is linked to an interest rate. For example, fixed-rate mortgages typically provide a 30-day interest rate lock. Following approval of the loan, the prospective homeowner’s mortgage rate is protected against rate increases for 30 days. This interest rate protection is actually a call option on the rate because the homeowner implicitly receives a payment if mortgage rates rise following the loan approval. In a similar manner, bond issuers can use credit options to hedge against a rise in the average credit risk premium. (Alan D. Morrison, 2001)
The credit linked note is a combination of a regular bond and a credit option. It promises to make periodic payments just like a regular bond and a large lump sum payment at maturity and the credit option on the note allows the issuer to reduce the note’s payments if a key financial variable specified by the note deteriorates. It is mostly used by credit card companies as they issue credit linked notes as it reduces the company’s credit risk exposure and a high default rates reduce the company’s earnings but the company will only pay 4 percent coupon therefore the company is purchasing credit insurance from the investors.(Alan D. Morrison, 2001)
Even though credit derivatives are a valuable tool in managing credit risk they can also expose the user to new risks financial risks and regulatory costs. One of the risks that credit derivatives expose users to is operational risk which is defined as the risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems or from external events(Elvis Mujacevic, 2004).
The other risks include;
The counterparty risk which is a risk that the counterparty of the transaction will default
Liquidity risk which is the uncertainty about being able to sell or offset a previously established position
Legal risk which is a risk that in event of a default the company may be unable to enforce or rely on rights arising under contractual arrangement with its broker or counterparty. (Elvis Mujacevic, 2004).
Credit derivatives market is growing as most organizations are adopting their use as a way of hedging risks associated with credit extensions. They have proven to reduce credit risk by a significantly large margin or rate than traditional methods that were used before their emergence. Even though these new financial instruments are promising there are issues that have remained unaddressed such as liquidity, transparency of contracts, documentation and legality of these financial instruments hindering them to be as effective and efficient as they can be.
Credit derivatives; new financial instruments for controlling credit risk,(Robert S Neal 1996
Credit derivatives in the function of credit risk management, Milivoje Davidovich 2011
Credit securitization and credit derivatives; financial instruments and the credit risk management of middle market commercial loan portfolios, Sabine hence, January 1998
Credit derivatives in banking; useful tools for managing risk? Gregory R Duffee , Chonshen Zhou, 2001
Risk management of financial derivatives ,Elvis Mujacevic, vol.no 3-4 pp107-126, 2004
Credit derivatives, disintermediation and investment decision, Alan D Morrison, 2001
The credit derivatives market-a threat to financial stability? ,Roxana Angela Calistru, 2012
Financial instruments for mitigating credit risk ,Jose A Lopez, November 23 2001
Credit risk management; the use of credit derivatives by nonfinancial corporations ,Mark C Freeman
A survey of credit risk management techniques used by microfinance institutions in Kenya ,Sifunjo Kisaka, 2014