The Credit Risk of Financial Instruments

In the decades preceding the 1970s banking was a relatively ordinary and well understood business. Banks were at the same time intermediaries between suppliers and users of funds and managers (and sometimes takers) of risk. Profitability was good, risks were acceptable, competition, though present, was not especially intense and innovation was generally slow. The clear division in countries such as the US and Japan between commercial banking and investment banking, with no real encroachment on one another’s territory, added to the relatively comfortable worlds of each business. Even in European countries, where the concept of ‘universal banking’ was already widely practised (where an institution could have a presence in retail, institutional and investment banking), a few dominant banks controlled the market and were not under pressure to innovate, change or compete.

Understanding from our previous discussion that increased market volatility and competition have led, among other things, to an increased level of risk for most participants in banking, it is useful to adopt a general risk management framework for treating the subject. Risk management can be defined generally as the management of events that cannot be predicted. Since many of the by-products of increased risk cannot be predicted and are potentially damaging to an institution if not handled properly, an organised and methodical approach to the management of risks is warranted.

As we have seen above, exposure to a given counterparty will not be incurred if an institution elects not to transact business. If, however, a decision to transact is taken, management of the exposure becomes a necessity. In order for a bank to arrive at the decision of whether or not to transact, it must consider a series of factors: counterparty credit quality, risk, return, maturity, motivation and enhancement. In considering these elements, the bank will arrive at a decision; we term this the credit decision. If affirmative, the decision will commit a bank to a given transaction in a certain structure; if negative, it will avoid commitment to the transaction.

As indicated in our risk management framework in Chapter 2, the accurate classification of risk is a vital first step in the entire risk management process. If a bank is unable correctly to identify and classify the risks it is facing, it will be unable to measure risk exposure properly. This chapter is devoted to a description of the different types of risk a bank is likely to face in the normal course of business.

An integral part of the risk management process, as we have seen, is accurate measurement of risks. In order to measure risks precisely, particularly for those instruments we have termed market risk-based, it is vital to comprehend (and to apply) the risk equivalency process.

By now the reader should be aware of the importance of the risk equivalency process in determining product risk and allocating the correct amount of risk exposure to a given transaction; the development of an accurate risk equivalency gauge is an important component in the measurement stage of the risk management process. It is vital at this point to understand thoroughly the basis for the derivation of our risk factor variable RF, discussed in Chapter 5. Remember that the risk equivalency process is applicable only in deriving potential risk equivalent exposure (REE) and is utilised only for those products or transactions which are deemed to add market risk exposure to the bank (inventory and provisional risks require no adjustments).

The first product covered in this section is the repurchase agreement, one of the fundamental instruments in the money markets. A repurchase agreement (or repo, as it is commonly known) is essentially an agreement to sell and repurchase a security. The actual repurchase of the security may come as soon as the next day or as far away as one or two years in the future. Repos can also be booked on an ‘open’ basis; that is, the transaction can be ‘rolled’ (rebooked) daily until one of the two parties involved decides to close it out. In a standard repo transaction the bank will sell its securities (perhaps Treasury notes) to a third party, while at the same time entering into a contract to repurchase them at some point in the future. Both sale and repurchase prices are agreed prior to entering the deal. In return for the securities, the bank will receive cash from the third party; the inflow of cash can be used to fund the balance sheet and a repo transaction is thus often thought of as a financing or a short-term, collateralised borrowing.

A Treasury security (or simply Treasury) is the name given to a debt obligation of the US Federal Government. Without spending any length of time detailing why and how the US Government funds itself, the vital component in this discussion is the end result of the funding process, the Treasury security itself. When the government decides it needs to raise a certain amount of dollars to finance its operations, one of its primary means is through the issuance of bills, notes or bonds. These three instruments make up Treasury securities. The distinction between the three is primarily a question of maturity, issuance frequency and coupon payment.

Mortgage-backed securities (MBSs), or pass-through securities, are instruments backed by ‘pools’ of mortgages, which pay a periodic (generally monthly) coupon of interest and principal. In essence, MBSs represent the securitised and tradeable form of residential and commercial mortgages. The most commonly traded MBSs are based on mortgages packaged by loan originators and guaranteed by one of three US Government agencies: the Government National Mortgage Association (GNMA or Ginnie Mae), the Federal National Mortgage Association (FNMA or Fannie Mae) and the Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac).

In general terms, money market instruments are defined as short- to medium-term, senior, unsecured debt obligations of the company or bank issuing the notes. In most instances the notes are issued in shelf or programme form and are utilised, or drawn down, as required. Use of the notes is typically for general financing purposes (in lieu of, or in addition to, bank financing, equity financing or long-term bond financing). Money market instruments are often used to meet a short-term or seasonal need for funds (while equity financing and long-term bond issuance might be regarded as more ‘permanent’ forms of funding).

Any discussion of bonds and the bond markets will be lengthy and detailed because the market is large and the variations on the standard bond concept are substantial and growing. In the very simplest form a bond is an interest-bearing debt obligation or corporate IOU. It is a security which represents a company’s promise to repay at some time in the future (and to make periodic interest payments to) an investor who has lent it money. The ‘promise’ also includes details of when and how the investor will be fully repaid. When a company needs to raise funds and elects to do so using debt (as opposed to equity) one of the main vehicles available to fulfil the requirement is a bond.

Although the trading of foreign exchange (FX) can be enormously complicated, in its simplest form an underlying transaction involves the exchange of one currency for a second currency, with settlement at some point in the near or medium-term future.

The swap in its simplest form can be described as a periodic exchange (or ‘swap’) of payments between two counterparties for a specified period of time; the exchange is generally based on interest rates, currency rates or commodity prices. The actual exchange of payments is governed by a contractual agreement between the participants and is reflected as an off-balance sheet exposure.