A bank interacting with HLIs should align collateral, early termination and other contractual provisions with the credit quality of HLIs, taking into account the particular characteristics of these institutions such as their ability to rapidly change trading strategies, risk profiles and leverage. In doing so, banks may be able to control credit risk more pre-emptively than is the case when such provisions are driven solely by net asset values.
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Bank policies should determine the contractual provisions that govern HLI counterparty relationships. It is these contractual arrangements, together with the bank’s internal limit structure, that should determine the size of unsecured credit exposure assumed by the bank. In a number of market segments the types of collateral arrangements and covenants offered to a counterparty, rather than pricing, constitute the primary means for compensating for risk differentiation. It is therefore paramount that these contractual conditions closely relate to the credit quality of the counterparty.
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The use of collateral can significantly reduce counterparty credit risks. Banks use collateral provisions in secured loans, repurchase agreements2 and OTC derivatives transactions. This includes transactions for which PFE (Section IV) is highly uncertain and transactions with less creditworthy counterparties. Nonetheless, the use of collateral does not eliminate credit risk and may entail other risks: liquidity, legal, custody and operational risks. Moreover, two-way collateral provisions could give rise to another type of credit risk. A loss could occur, for instance, when the bank has provided collateral owing to a negative exposure and the value of this collateral at the moment of the counterparty's default is larger than the mark-to-market position.
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In establishing collateral provisions vis-à-vis HLIs, banks should bear in mind that HLIs are unregulated financial institutions whose leverage is not restricted by the prudential supervision of risk management practices and the capital requirement regimes that apply to regulated financial intermediaries. If a bank does not receive meaningful financial information on a sufficiently frequent basis to permit effective monitoring of counterparty credit risk, it should consider requiring the institution to post excess collateral even when the bank has no current exposure (i.e. posting of initial margin). At a minimum, banks should design and enforce clear internal guidelines for determining when initial margin will be required from counterparties. Similar prudent policies should be established for setting minimum transfer amounts (amounts of collateral below which a counterparty is not required to transfer collateral) and loss thresholds (exposures below which no collateral is posted). Similarly, the granting of two-way margining and rehypothecation rights should be a function of the credit quality of the counterparty. If banks agree to two-way collateral provisions, they should make sure that the resulting additional credit risk exposure is integrated in the overall risk management process (including measurement of the PFE).
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Contractual provisions should reflect bank credit standards regarding haircuts applied to the securities taken as collateral, by discounting the collateral value relative to the current market value. Banks usually base the size of the valuation adjustments on the price volatility of the securities over the time that would be required to liquidate them on the default of a counterparty (in normal market conditions). In accepting collateral from HLIs, banks should carefully assess and take into account the correlation between the probability of counterparty default and the likelihood of the collateral being impaired owing to market, credit or liquidity developments. Experience has shown that in stressed-market conditions, all but the most liquid securities issued by the best credits worldwide may be downgraded owing to a broad-based flight to quality following, during or preceding the default of a major HLI.
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With respect to OTC derivatives transactions, banks should bear in mind that the effectiveness of collateral provisions established to cover counterparty credit exposures may be significantly reduced if the value of the collateral is negatively correlated with the probability of the counterparty’s default or with the market value of the contracts. In stressed-market conditions, sizable amounts of additional collateral may have to be posted by an HLI with a concentrated portfolio. There should be clear documentation setting forth the actions to be taken in the event that a counterparty fails to meet collateral calls.
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In addition, banks should include covenants which permit termination or other action in the event of a material deterioration in an HLI’s credit quality. The application and design of such early termination or close-out provisions should be a function of the counterparty’s credit quality and the ability of the bank to observe changes in (prospective) creditworthiness and to react swiftly to any negative changes. In the case of HLIs, publicly available information may be insufficiently up-to-date to permit continuous credit monitoring. The bank should set adequate standards for information disclosure during the credit relationship and establish termination provisions in relation to the counterparty’s risk profile so that it can take risk-reducing measures in a timely manner.
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Banks’ standard practice in relation to conventional corporate credits is to set a range of covenants relating to financial strength. For HLIs, verifiable covenants addressing significant changes in strategy, or relating to leverage and risk concentration, appear particularly relevant. Reflecting the difficulties of measuring the absolute levels of some of these variables, covenants should be specified in terms of changes to the levels existing at the start of a credit relationship and based on agreed definitions of risk and capital. They should be designed with a view to tightening credit limits as counterparty risk increases. However, banks should realise that industry-wide use of “sudden death” termination provisions could have systemic implications. If these provisions do not affect the extent of risk-taking by HLIs ex ante, the intended credit risk reduction may not materialise, and all lenders may tighten credit terms at the same time. Covenants should ensure that banks are made aware of adverse financial developments and are able to press for adjustment well before the time when cessation of the relationship is appropriate. This pre-emptive aspect is as important as the ability to require repayment once adverse changes have occurred.
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