Managing credit risk: underwriting and administration

Managing credit risk: underwriting and administration
For banks selling credit protection (buying risk) through a credit derivative, management
should complete a financial analysis of both reference obligor(s) and the
counterparty (in both default swaps and TRSs), establish separate credit limits for
each, and assign appropriate risk ratings. The analysis of the reference obligor
should include the same level of scrutiny that a traditional commercial borrower
would receive. Documentation in the credit file should support the purpose of the
transaction and creditworthiness of the reference obligor. Documentation should be
sufficient to support the reference obligor’s risk rating. It is especially important for
banks to use rigorous due diligence procedures in originating credit exposure via
credit derivatives. Banks should not allow the ease with which they can originate
credit exposure in the capital markets via derivatives to lead to lax underwriting
standards, or to assume exposures indirectly that they would not originate directly.
For banks purchasing credit protection through a credit derivative, management
should review the creditworthiness of the counterparty, establish a credit limit, and
assign a risk rating. The credit analysis of the counterparty should be consistent
with that conducted for other borrowers or trading counterparties. Management
should continue to monitor the credit quality of the underlying credits hedged.
Although the credit derivative may provide default protection, in many instances (e.g.
contracts involving cash settlement) the bank will retain the underlying credit(s)
after settlement or maturity of the credit derivative. In the event the credit quality
deteriorates, as legal owner of the asset, management must take actions necessary
to improve the credit.
Banks should measure credit exposures arising from credit derivative transactions
and aggregate with other credit exposures to reference entities and counterparties.
These transactions can create highly customized exposures and the level of risk/
protection can vary significantly between transactions. Management should document
and support their exposure measurement methodology and underlying
assumptions.