Credit risk management

1. Managing Credit Risk Under The Basel III Framework 73
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Credit Risk Controls
6
KEY CONCEPTS
• Bilateral netting
• Collateral
• Credit guarantee
• Downgrade trigger
• Diversification
• Credit limit
6 Credit risk controls
6.1 Credit risk mitigation
In order to gain an excess return over the risk-free rate, a lender takes credit risk
consciously to originate a debt investment. Through credit risk mitigation, the credit risk
is reduced with an effect of reducing the excess return. At a first glance, credit risk
mitigation seems to act against the initiative of a lending business.
However, along the horizon of a debt investment, a lender may desire to lock in the
unrealized profit when his debts have registered a significant reduction in the EL and/or
XCL. Conversely, a lender must limit the unrealized loss when his debts have recorded a
significant increase in the EL and/or XCL. Moreover, due to the deterioration on a
systematic or specific basis, the credit risk of the debts may have increased beyond the
tolerance level of a lender. Finally, a lender may become conservative and prefer to take
less credit risk. All these reasons drive a lender to hedge his credit risk through credit
risk mitigation.
Credit risk mitigation is triggered by credit risk monitoring through which a lender
detects that the credit risk of a single debt or debt portfolio has exceeded his tolerance
level.
In most cases, a lender cannot terminate unilaterally a debt during the middle of the
lending period, i.e., he must hold the debt until maturity. Therefore, credit risk controls,
which are tools for mitigating credit risk, serve as indirect substitutions. With the EL and
XCL as the credit risk measures of a single debt and debt portfolio respectively, credit
risk is an increasing function of the EAD, LGD, PD, RM, concentration of debts and
default dependency. Therefore, by implementing adequate controls to alter these six
credit risk factors, the credit risk to a lender can be well mitigated.
The following sections illustrate some common controls to mitigate credit risk through
the reduction of these six credit risk factors. Most credit risk controls have to be
implemented at the origination as pre-lending contractual controls, except credit default
swap and credit securitization.

2. 74 Managing Credit Risk Under The Basel III Framework
Copyright 2018 CapitaLogic Limited
6.2 EAD reduction
6.2.1 Bilateral netting ★★★★★★★★★★★★
It is a common situation in a real business operation that two lenders are also borrowers
to each other. For example: (i) bank A and bank B lend to each other on different loan
products; and (ii) corporation A and corporation B purchase different goods from each
other on a credit basis. In such case, if party A defaults, upon the liquidation process,
party B must first surrender the EAD, including principal and interest owed by party B to
party A, before party B can start the debt collection process to claim the EAD owned by
party A to party B. The process is reversed in case party B defaults. This results in a
paradox that a lender must first pay a borrower upon the default of the borrower.
To rectify this paradox, the two parties may enter a bilateral netting agreement to offset
the EAD common to each other upon the default of either party. Under a bilateral netting
agreement, if party A defaults, before the liquidation process, party B is allowed to use
the EAD owed by party B to party A to offset fully or partially the EAD owed by party A
to party B. In case the EAD owed by party B to party A is less than the EAD owed by
party A to party B, party B continues the debt collection process to claim the residual
EAD owned by party A to party B. In case the EAD owed by party B to party A is more
than the EAD owed by party A to party B, party B must surrender the residual EAD to
the liquidator of party A upon liquidation. As such, the bilateral netting agreement
reduces effectively the EAD to the larger of: (i) the difference between the lending EAD
and borrowing EAD; and (ii) zero, i.e.:
Net EAD = Max[Lending EAD - Borrowing EAD, 0]
6.2.2 Principal amortization
For a debt with a very long lending period, it is difficult for a lender to forecast accurately
the credit quality of a borrower throughout the entire lending period. To compensate for
the risk arising from this long initial RM, the borrower is required to return on a regular
basis a small part of the principal. This process of principal amortization allows the
potential deterioration in credit quality of a borrower over a long period of time to be
offset by the scheduled reduction in the EAD of a debt.
Principal amortization is often applied to a residential mortgage with a longer initial RM,
from five up to thirty years. Each month a fixed amount comprising the interest and part
of the principal is paid to the lender.