What are the main credit risk mitigation techniques and how do they reduce exposure?

Question

AcadiFi · Accepted Answer

Credit risk mitigation (CRM) techniques are mechanisms that reduce a bank's exposure to counterparty default. Under Basel regulations, recognized CRM techniques also reduce regulatory capital requirements.

Major CRM techniques:

**Major CRM techniques:**

```mermaid
flowchart TD
    A["Credit Risk Mitigation"] --> B["Collateral"]
    A --> C["Netting"]
    A --> D["Guarantees &
Credit Derivatives"]
    A --> E["Credit Enhancements"]
    B --> B1["Cash / Government bonds"]
    B --> B2["Margin / Variation margin"]
    C --> C1["Bilateral netting"]
    C --> C2["Multilateral (CCP)"]
    D --> D1["Parent guarantee"]
    D --> D2["CDS protection"]
    E --> E1["Subordination"]
    E --> E2["Overcollateralization"]
```

**1. Collateral:**
The counterparty posts assets that the bank can seize if default occurs.

| Collateral Type | Haircut | Effectiveness |
|---|---|---|
| Cash | 0% | Highest — no market risk |
| Government bonds | 0.5-4% | Very high |
| Corporate bonds | 4-12% | Moderate |
| Equities | 15-25% | Lower — more volatile |

- **Initial margin:** Posted at trade inception as a buffer
- **Variation margin:** Daily adjustments to reflect mark-to-market changes
- **Rehypothecation risk:** If the bank can re-use posted collateral, there's chain risk

**2. Netting (covered in detail in the next Q&A):**
Offsetting positive and negative exposures with the same counterparty.
- Reduces exposure from gross to net
- Can reduce a $100M gross exposure to $15M net exposure

**3. Guarantees and credit derivatives:**
- A third party (guarantor) agrees to pay if the obligor defaults
- **Substitution approach:** The exposure's risk weight changes from the obligor's to the guarantor's (if the guarantor has better credit)
- CDS provides similar protection but in derivative form

**4. Credit enhancements:**
- **Subordination:** Junior tranches absorb losses first, protecting senior tranches
- **Overcollateralization:** Asset pool value exceeds the notes issued
- **Excess spread:** Difference between asset yield and note coupon provides a buffer

**Basel regulatory recognition:**

| Approach | CRM Treatment |
|---|---|
| Standardized | Eligible collateral reduces EAD; guarantees substitute risk weight |
| Foundation IRB | Eligible collateral adjusts LGD; guarantees substitute PD |
| Advanced IRB | Banks model own LGD incorporating collateral |

**Example:** Pinnacle Bank has a $50M loan to Apex Corp (BB rated) secured by $35M in US Treasury bonds.
- Without CRM: Full $50M exposure at BB risk weight
- With CRM (simple approach): Secured portion ($35M) gets the Treasury risk weight (0%); unsecured portion ($15M) keeps BB risk weight
- Capital savings: Significant reduction in required capital

**Exam tip:** FRM Part II tests the types of CRM, Basel recognition criteria, and how each technique affects EAD, PD, or LGD calculations.

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What are the main credit risk mitigation techniques and how do they reduce exposure?

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Practice Questions

Collateral Type	Haircut	Effectiveness
Cash	0%	Highest — no market risk
Government bonds	0.5-4%	Very high
Corporate bonds	4-12%	Moderate
Equities	15-25%	Lower — more volatile

Approach	CRM Treatment
Standardized	Eligible collateral reduces EAD; guarantees substitute risk weight
Foundation IRB	Eligible collateral adjusts LGD; guarantees substitute PD
Advanced IRB	Banks model own LGD incorporating collateral