Risk Management for the Collateral Portfolio

Risk Management for the Collateral Portfolio Presentation to the GARP UK Meeting July 18, 2001 Penny Davenport

Agenda • How collateralisation is used today • Collateral as a risk transformation technique • Risk management techniques • Crisis management in a collateralised scenario • The current market environment

Collateral is a technique for managing credit risk • Credit risk arises because one party who owes money to a second party might not pay. • It’s a risk while we are waiting for it to happen. When it does, it’s a loss! • Good metrics for credit risk take into account the size of the potential loss, the probability of the loss event occurring, and the value of any recourse, such as collateral. • Collateral (normally) reduces credit risk.

Party A owes $10 to Party B… what happens next? $10 Party A Party B Normal performance Case 1 Case 2 Case 3 A defaults - B has a credit loss of $10 Party A Party B A defaults - B has a credit loss of $10, but has recourse to $10 value of collateral. Party A Party B Securities worth $10

What is Collateral? Collateral “Assets of quantifiable value, delivered by one party for the benefit of a second party, pursuant to a formal legal agreement between the two, with the intention of providing the second party with recourse to those assets in the event of the default of the first party, in the expectation that the liquidated value of the assets will defray any loss suffered by the second party.”

Why else might you take collateral? • To protect against credit default loss • To facilitate access to… • More credit transactions • Longer maturity transactions • Larger size transactions • Higher volatility transactions • To manage the cost of credit / economic capital • To comply with counterparty policy requirements • To expand revenue opportunities

ISDA surveys in 1999, 2000 and (soon-to-be-released) 2001. Collateral programmes have mainly developed since 1990. Considerable pace of expansion since 1994. Growth expectations for average >40% across firms surveyed. Market growth has beendramatic, and continues Collateral programmes commenced 50% 1990-94 1994-98 Number of Agreements Example: US Investment Bank 1992 94 96 98

Collateral is a mutual risk reduction technique Percent of total collateralized clients 50 40 30 20 10 0 N/R AAA AA A BBB BB B

The Credit Enhancement Spectrum Transaction Direct Credit Third Party Credit Risk Support Credit Support Exposure Reduction Transfer Elective Single Cash Securities Letters Credit Credit Termination Swap Guarantees Insurance Derivatives Collateral Collateral of Credit Rights Reset But remember… collateralis just one alternative

Agreement structure risk Monitoring control risk Market risk on collateral value Operating risks Concentration risk Correlation risk Third party and settlement risk Collateral Credit risk “Murphy risk” Procedural risk Perfection risk Legal risks Priority risk Recharacterization risk Enforcement risk Local risk factors The risks of collateralization

Risk management in a collateral programme Risk management for the Collateral Portfolio Collateralisation is a risk transformation technique… Credit risk is exchanged for operating and legal risk... A strong risk management culture needs to surround the entire collateral management process.

Specific risk management techniques 1 • Documentation risk • Obtain qualified advice on what documents to use for each client. • Define standard document templates and standard electives and variables for your organisation. • Define rules around who can change terms, for what reasons, and with what approvals. • Record the content of documents fully in appropriate systems, and ensure original documents are protected and controlled.

Specific risk management techniques 2 • Legal risk • Obtain qualified advice on legal issues related to collateralisation in each jurisdiction in which your counterparties are located. • Disseminate the advice you receive to your credit, collateral, operations and trading staff - and understand they understand it (it is not much use gathering dust on a shelf!). • Structure your collateral agreements optimally for each client and jurisdiction combination. Templates may help here, but oversight by qualified collateral risk managers is recommended. • Proactively take legal risks you like and can manage. Avoid those you cannot. Measure your legal risk and hold economic capital against it (irrespective of what bank supervisors might or might not say about it).

Specific risk management techniques 3 • Operating and people risk • Start from the base of a strong collateral policy that governs all aspects of your firm’s use of collateral in a consistent manner. • Buy and use technology appropriately. • Remember that technology is not the whole solution! • Develop comprehensive operational procedures and use them. • Rehearse unusual situations and crisis plans from time to time. • Segregate critical duties and functions; require appropriate approval procedures. • Hire qualified collateral staff and compensate them appropriately to retain and motivate them.

Specific risk management techniques 4 • Portfolio level risks • Recognize that you have a “collateral portfolio” - the combination of all your collateral agreements across all your collateralised clients and all their trades that are collateralised, offset by all the collateral you have taken in and given out. • Measure concentrations of particular collateral types received from multiple counterparties. • Detect correlation between particular collateral assets and the counterparties from which they were received - e.g. the “wrong way” diagonal. • Set limits for concentration and correlation risk. Measure risk against these limits and report accordingly to management. Adjust capital reserves and transaction availability accordingly.

Risk Mitigation Technique Risk Documentation Legal Operationssssssssssssssssssss Portfolio Low Cost GMRA, ISDA Industry Opinions High threshold, Infrequent calls Cash, Govt Bonds High Cost Client Driven Bespoke Zero threshold, daily calls Hedging, limit management Summary

Crisis management planning • The worst time to develop a crisis plan is during a crisis. • The word “crisis” itself is unhelpful and may paralyse the organisation… “Emergency Management Plan” “Emergency Action Plan” “Special Circumstances Procedure” “High Risk Situation Procedures” • What is a “crisis” anyway? A crisis is any situation that differs materially from normal operating conditions or presents the organisation with a higher-than-normal risk profile. Organisational response in a crisis should be appropriate to the specific circumstances and graduated according to severity.

Key elements of a crisis plan • Identification and declaration of a crisis; initiation of special procedures. • Gathering of information, but avoidance of analysis paralysis. • Prompt risk / damage assessment based on available information. • Immediate triage action. • Consideration of complete solutions. • Action. • Review and react. • And later… determine/assign damages, mop up outstanding issues, identify and act on lessons learned.

Positioning the crisis plan • Collateral will most commonly be a factor in a crisis if it is triggered by (a) a specific name credit concern, or (b) a sharp discontinuity in the markets which affect either a geographic region or a class of similar counterparties (e.g. those in a particular industry). • We recommend you write and rehearse a specific collateral crisis plan, but…. • …. NOT in isolation. Make it an integral part of your firm’s credit crisis procedures and market credit procedures. • Rehearse the plan at least once per year, and ideally more often.

Practical questions / steps 1 • Scope of the Crisis • Who is affected? Client (which one?), internal systems, market infrastructure. • Cause? Technology, communications, human error, credit problem, natural disaster. • Does the affected party know there is a problem? • Is the problem contagious? If so, by what route? To whom? • Is the problem going to initiate other problems? Where? • Gathering relevant information • Counterparty details, including branches, subsidiaries, etc. • Portfolio details - value of positions at risk. • Recourse details - collateral, guarantees, letters of credit. • Hedges - credit derivatives that may be triggered. • Size of current losses? Imminent losses? Future potential losses?

Practical questions / steps 2 • Legal analysis • What documents do you have? • Where are they? (Get them!) • Are there any non-standard provisions that may have a beneficial or detrimental impact to resolving the situation? • What are your common law rights? • Is there anything you must do immediately to preserve your legal position, or to improve your chances of future success enforcing netting, collateral or other documents? • Information dissemination • Sift information and communicate relevant facts and opinions to senior management. Obtain any necessary approvals for action. • Keep your counterparty appropriately informed. • Keep information flowing internally at an appropriate level.

Practical questions / steps 3 • Valuation of losses • What do the documents say? • Is market practice in accord with the documents? • Compute the loss number. • Collateral enforcement • Where is the collateral? Do you control it absolutely? • What is the value of the collateral? • Identify the market(s) and mechanism(s) by which you will liquidate it, if forced to do so. • Will market liquidity be impaired - either before your liquidation of the collateral or as a result of your liquidation of the collateral? • Identify and execute all necessary legal steps in the liquidation (e.g. do you need to obtain multiple tenders for the assets?) • Liquidate promptly upon the decision to do so.

Risk Legallllllllllllllllllllll Documentationnn Operationsssssss Portfolio Low Cost EU Collateral Directive, Hague Convention ISDA Margin Provisions 2001, GMRA 2000 Continued investment in systems and people, ISDA surveys Wider collateral acceptance The current market place Changes in the Market Environment

Wrap Up • Collateralisation is a highly effective credit risk management technique but remember that is also a risk transformation technique • The new risks should be measured and managed • There are a wide variety of available techniques for doing this • And remember, collateral is of ultimate use in a crisis scenario so have an action plan ready.

Risk Management for the Collateral Portfolio