Legal and cultural issues

Unlike most financial derivatives, credit derivative transactions require extensive
legal review. Banks that engage in credit derivatives face a variety of legal issues,
such as:
1 Interpreting the meaning of terms not clearly defined in contracts and
confirmations when unanticipated situations arise
2 The capacity of counterparties to contract and
3 Risks that reviewing courts will not uphold contractual arrangements.
Although contracts have become more standardized, market participants continue
to report that transactions often require extensive legal review, and that many
situations require negotiation and amendments to the standardized documents.
Until recently, very few default swap contracts were triggered because of the relative
absence of default events. The recent increase in defaults has led to more credit
events, and protection sellers generally have met their obligations without threat of
litigation. Nevertheless, because the possibility for litigation remains a significant
concern, legal risks and costs associated with legal transactional review remain
obstacles to greater participation and market growth.
Cultural issues also have constrained the use of credit derivatives. The traditional
separation within banks between the credit and treasury functions has made it
difficult for many banks to evaluate credit derivatives as a strategic risk management
tool. Credit officers in many institutions are skeptical that the use of a portfolio
model, which attempts to identify risk concentrations, can lead to more effective
risk/reward decision making. Many resist credit derivatives because of a negative
view of derivatives generally.
Over time, bank treasury and credit functions likely will become more integrated,
with each function contributing its comparative advantages to more effective risk management decisions. As more banks use credit portfolio models and credit derivatives,
credit portfolio management may become more ‘equity-like’. As portfolio managers
buy and sell credit risk in a portfolio context, to increase diversification and to
make the portfolio more efficient, however, banks increasingly may originate exposure
without maintaining direct borrower relationships. As portfolio management evolves
toward this model, banks will face significant cultural challenges. Most banks report
at least some friction between credit portfolio managers and line lenders, particularly
with respect to loan pricing. Credit portfolio managers face an important challenge.
They will attempt to capture the diversification and efficiency benefits offered by the
use of more quantitative techniques and credit derivatives. At the same time, these
risk managers will try to avoid diminution in their qualitative understanding of
portfolio risks, which less direct contact with obligors may imply.