Risk management of credit derivatives

Credit risk is the largest single risk in banking. To enhance credit risk management,
banks actively evaluate strategies to identify, measure, and control credit concentrations.
Credit derivatives, a market that has grown from virtually zero in 1993 to an
estimated $350 billion at year end 1998,1 have emerged as an increasingly popular
tool. Initially, banks used credit derivatives to generate revenue; more recently, bank
usage has evolved to using them as a capital and credit risk management tool. This
chapter discusses the types of credit derivative products, market growth, and risks.
It also highlights risk management practices that market participants should adopt
to ensure that they use credit derivatives in a safe and sound manner. It concludes
with a discussion of a portfolio approach to credit risk management.

Credit derivatives can allow banks to manage credit risk more effectively and
improve portfolio diversification. Banks can use credit derivatives to reduce undesired
risk concentrations, which historically have proven to be a major source of bank
financial problems. Similarly, banks can assume risk, in a diversification context, by
targeting exposures having a low correlation with existing portfolio risks. Credit
derivatives allow institutions to customize credit exposures, creating risk profiles
unavailable in the cash markets. They also enable creditors to take risk-reducing
actions without adversely impacting the underlying credit relationship.

Users of credit derivatives must recognize and manage a number of associated
risks. The market is new and therefore largely untested. Participants will undoubtedly
discover unanticipated risks as the market evolves. Legal risks, in particular, can be
much higher than in other derivative products. Similar to poorly developed lending
strategies, the improper use of credit derivatives can result in an imprudent credit
risk profile. Institutions should avoid material participation in the nascent credit
derivatives market until they have fully explored, and developed a comfort level with,
the risks involved. Originally developed for trading opportunities, these instruments
recently have begun to serve as credit risk management tools. This chapter primarily
deals with the credit risk management aspects of banks’ use of credit derivatives.
Credit derivatives have become a common element in two emerging trends in how
banks assess their large corporate credit portfolios. First, larger banks increasingly
devote human and capital resources to measure and model credit portfolio risks
more quantitatively, embracing the tenets of modern portfolio theory (MPT). Banks have pursued these efforts to increase the efficiency of their credit portfolios and look
to increase returns for a given level of risk or, conversely, to reduce risks for a given
level of returns. Institutions adopting more advanced credit portfolio measurement
techniques expect that increased portfolio diversification and greater insight into
portfolio risks will result in superior relative performance over the economic cycle.
The second trend involves tactical bank efforts to reduce regulatory capital requirements
on high-quality corporate credit exposures. The current Basel Committee on
Bank Supervision Accord (‘Basel’) requirements of 8% for all corporate credits,
regardless of underlying quality, reduce banks’ incentives to make higher quality
loans. Banks have used various securitization alternatives to reconcile regulatory
and economic capital requirements for large corporate exposures. Initially, these
securitizations took the form of collateralized loan obligations (CLOs). More recently,
however, banks have explored ways to reduce the high costs of CLOs, and have
begun to consider synthetic securitization structures.

The synthetic securitization structures banks employ to reduce regulatory capital
requirements for higher-grade loan exposures use credit derivatives to purchase
credit protection against a pool of credit exposures. As credit risk modeling efforts
evolve, and banks increasingly embrace a MPT approach to credit risk management,
banks increasingly may use credit derivatives to adjust portfolio risk profiles.