Credit risk complacency and hedging costs

The absence of material domestic loan losses in recent years, the current strength of
the US economy, and competitive pressures have led not only to a slippage in
underwriting standards but also in some cases to complacency regarding asset
quality and the need to reduce credit concentrations. Figure 11.1 illustrates the
‘lumpy’ nature of credit losses on commercial credits over the past 15 years. It plots
charge-offs of commercial and industrial loans as a percentage of such loans.

Over the past few years, banks have experienced very small losses on commercial
credits. However, it is also clear that when the economy weakens, credit losses can
become a major concern. The threat of large losses, which can occur because of
credit concentrations, has led many larger banks to attempt to measure their credit
risks on a more quantitative, ‘portfolio’, basis.
Until recently, credit spreads on lower-rated, non-investment grade credits had contracted sharply. Creditors believe lower credit spreads indicate reduced credit
risk, and therefore less need to hedge.

Even when economic considerations indicate a bank should hedge a credit exposure,
creditors often choose not to buy credit protection when the hedge cost exceeds
the return from carrying the exposure. In addition, competitive factors and a desire
to maintain customer relationships often cause banks to originate credit (funded or
unfunded) at returns that are lower than the cost of hedging such exposures in the
derivatives market. Many banks continue to have a book value, as opposed to an
economic value, focus.