Collateral Management expert speaks

Collateral Management expert speaks

Professional collateral management (CM) is an efficient tool for reducing credit risk. The fundamental role of any collateral is to mitigate the loss which may occur if the obligor or counterparty defaults on its obligation (in whole or part).

The diversity of collateral types is extremely wide, just to mention a few types: cash, bond, equity, real estate, mutual fund, physical asset, receivable, credit derivative, insurance, guarantee.

The complete description of these types is quite complex and requires different approaches (and data), but there is one particular characteristic which is crucial from risk management point of view: the eligibility. The separate definition of eligibility for each of the different collateral types is given by the Basel II regulation as well in great details. On high level in order to be eligible the collateral should be legally enforceable and sufficiently liquid with a relatively stable value over time for funded protection and sufficiently reliable in case of unfunded credit protections (e.g. guarantees or credit derivatives). The recognition of collaterals is also conditional on specific operational requirements like proper documentation of the collateralized deals, clear and stable procedures for the liquidation of the collaterals, effective processes for the risk management, regular evaluation of the collaterals.

The current financial crisis painfully underlined the importance of one specific component of the eligibility: the requirement of low level correlation between the creditworthiness of the obligor and collateral value. The failure of conventional credit risk models (incl. the Basel II IRB model as well) is also partly connected to the fact that under stress circumstances a significant portion of collaterals turn out to be uneligible.

The previous subprime crisis could be seen as a multiple misfortune as the loss given default (LGD) and the probability of default (PD) parameters of the deals significantly increased at the same time. LGD – the expected loss ratio of exposure after the realization of the collaterals and other recoveries – increased because of several effects like the lower market value of the collaterals (esp. real estate), the longer liquidation period, the deteriorating guarantors or other unprecedented operational and legal risks.

Loxon’s CM system supports the continuous control of the eligibility through handling risk management (monitoring, control) workflows, monitoring the low correlation criteria and the valuation and regular revaluation of all collaterals. As a unique functionality of the system it optimizes the allocation of collaterals onto the deals in order to safe capital. As a rule of thumb a 10-20% reduction in capital requirement could be achieved using the provided sophisticated allocation instead of the intuitive greedy algorithm (where the worst risk weighted deal is covered first by the collateral with the highest value). By the achieved capital savings the Bank results in higher profitability.

The system is based on an integrated database with all the deals and the linked collaterals of the Bank. CM could be integrated with related IT systems supporting other risk management functionalities as the collection system or the Basel II systems (data warehouse or capital calculation engine). The LGD parameter of the deals could be used in risk based pricing and loan approval process. Even the state of art LGD scorecards could be implemented in the CM system by the use of flexible algorithm editor. CM generates fancy reports to reveal concentration risk for cases when a client is an obligor and a protection provider at a same time, or when a specific collateral type (e.g. mortgages) is generating systematic risk on portfolio level.

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