Saturday Brain Storming Thought (126) 14/08/2021
COMPILED BY ER. AVINASH KULKARNI
COLLATERAL RISK MANAGEMENT (CRM)
It is the process of two parties exchanging assets in order to reduce credit risk associated with any unsecured financial transactions between them
Such counterparties include banks, broker-dealers, insurance companies, hedge funds, pension funds, asset managers, and large corporations
Collateral Risk
The risk of loss arising from errors in the nature, quantity, pricing or characteristics of collateral securing a transaction with credit risk
The collateral risk scale/matrix is an escalating scale that focuses on risk to mission considerations
Collateral management responsibility
1) managing the collateral
2) exposure
3) valuations
4) regulatory commitments
5) minimize credit
6) market risks
7) operational risks
This role will be responsible for building and implementing the collateral management function in the bank
Collateral and margin management
It is the process of managing assets pledged by one party to another to mitigate risk between the parties and to minimize the effect of potential default
Collateral
Collateral is an asset or property that an individual or entity offers to a lender as security for a loan
It acts as a protection against potential loss for the lender in case payments defaults by borrowers
In such an event, the collateral becomes the property of the lender to compensate for the unreturned borrowed money
Types of Collateral
1) Real estate
2) cash secured loan
3) inventory financing
4) invoice collateral
5) blanket liens
Key components of a Collateral Management System
1) collateral agreement and documentation (collation)
2) collateral allocation
3) daily mark to markets (MTM) and collateral calculations (calculations and evolutions)
4) reconciliation
5) collateral optimization
6) Counterparty communications
7) extensive reporting
8) integration with trading and risk management (interfaces)
9) support for compliance (interfaces)
New risks for collateral management
1) Operational risks
Introduction of new processes, inexperienced staff, lack of controlled and automated technology
2) Settlement risk
Failure to deliver collateral
3) Market and liquidity risk
Insufficient haircuts versus eligible collateral, extreme market events
4) Concentration and correlation risk
Lack of variety in collateral, wrong-way exposure
5) Legal risk
Different perfection of interest governing laws, inappropriate rights to collateral in the events of default
Benefits of the collateral management system
1) improved credit risk mitigation
2) reduced credit line utilization
3) comprehensive regulatory capital savings (fewer reserves required)
4) increased the number of trading counterparties
5) increased the array of acceptable instruments type
6) strategic global reporting for front, middle and back offices
7) easy integration with in-house and legacy systems
Collateral Risk Event (CRE)
1) identify, define potentially explanatory risk variables
2) assessment/initial risk buffering strategy
3) assessment/initial collateral risk buffering strategy
4) refined assessment risk and collateral risks buffering strategy
5) effect of buffering strategy on organizational goal and objectives
Collateral Arrangement forms
1) Pledge
a) the giver posts collateral to the taker
b) the giver still owns the collateral
c) if the giver defaults, the taker can take the cash or sell the securities
d) it is widely used
2) Title Transfer
a) the taker owns the collateral
b) the giver is only entitled to the return of fungible securities and/or repayment of cash
c) it is widely used in the stock-lending and report market
Collateral for lender
1) encourage willingness of payment to reduce personal loss
2) substitute the repayments to reduce loss given default
3) protects against borrowers over-borrowing
Collateral for Borrower
1) access to credit
2) cost of credit – potentially reduce funding costs for the lower expected loss
3) overcoming asymmetric information problems – access to funds even in a financially difficult time, or even without audited financial reports
Collateral Law
It is a system that is constituted by several relevant laws and regulations
Extent of collateral
1) after-acquired property
2) proceeds
3) supporting obligation
Collateral Evaluation
1) to find a price and logic which are realistic, practical, and acceptable by ordinary market participants
2) evaluate collateral on the basis of market value rather than book value
3) apply the most conservative evaluation method
4) if possible, the collateral property should be located within s distance bank officers can take frequent visits
5) watch the market price, if it’s rising fast – a price bubble may be developing
Elements to create a valid security interest in collateral
1) the debtor has rights in collateral
2) a security agreement must be authenticated by the debtor
3) a security agreement must contain a description of the collateral
4) a security interest cannot attach unless the value is given
Attributes of a good collateral
1) highly liquid and easy marketability
2) ascertain the ability
3) stability of value
4) transferability
Liquid securities, government securities, gift edged securities, stock exchange securities, blue-chip securities
Compiled by:-
Avinash Kulkarni
Chartered Engineer
Govt Regd Valuer
IBBI Regd Valuer
