Credit Risk Mitigation

Credit risk mitigation is the set of techniques a lender uses to reduce the loss it would bear if a borrower or trading counterparty failed to pay. Instead of relying only on the borrower's ability to repay, the lender obtains a second way out: assets it can sell, another party it can claim against, or amounts it owes the borrower that can be set off. The term is used both in everyday credit practice and, more narrowly, in bank capital rules, where it is often shortened to CRM.

Mitigation does not remove credit risk. It changes its shape, replacing part of the exposure to the borrower with exposure to the value of collateral or to the strength of a guarantor, and it adds legal and operational risks of its own. The international capital framework set by the Basel Committee on Banking Supervision allows banks to hold less capital against mitigated exposures, but only if strict conditions are met.

• Funded protection. The lender holds collateral such as cash, securities, property, receivables or equipment that it can realise on default. A collateral haircut is applied to allow for falls in value.
• Unfunded protection. A third party promises to pay if the borrower does not, through a guarantee, a standby letter of credit, trade credit insurance or a credit default swap.
• Netting. Mutual obligations are offset so that only a net amount is at risk. This includes on-balance-sheet netting of loans and deposits and close-out netting of derivatives under a master agreement.
• Structural protection. Covenants, seniority, shorter maturities and exposure limits reduce the chance or size of loss, although they are not treated as mitigation for capital purposes.

Under the standardised approach for credit risk, eligible financial collateral can be recognised in one of two ways. The simple approach substitutes the risk weight of the collateral for that of the borrower on the covered portion. The comprehensive approach reduces the exposure amount by the collateral value after supervisory haircuts for price volatility and currency mismatch. Guarantees and credit derivatives are recognised by substitution: the protected part of the exposure takes the risk weight of the protection provider if that is lower.

Banks using the internal ratings-based approach reflect mitigation mainly through a lower loss given default, and may recognise a wider range of collateral, including receivables, real estate and other physical assets, subject to conditions. In each approach the result is a lower figure for risk-weighted assets. Residential and commercial mortgages are handled through their own exposure classes rather than as collateral in this sense.

Supervisors recognise mitigation only where the bank can rely on it in practice. The main conditions are:

• Legal certainty. The arrangement must be binding and enforceable in every relevant jurisdiction, including in the insolvency of the borrower, supported where needed by legal opinions.
• Direct and unconditional protection. A guarantee must be explicit, irrevocable and payable without the bank first having to pursue the borrower.
• Low correlation. The collateral or guarantor must not be closely linked to the borrower, so that both do not fail together.
• Operational capability. The bank must be able to value collateral regularly, call for more when needed and liquidate it promptly, as described under collateral management.
• Maturity matching. Protection that expires before the exposure is recognised only partly, and not at all if its remaining term is very short.

Each technique leaves risks behind. Collateral may fall in value just when the borrower defaults, be hard to sell, or prove to be pledged elsewhere. A guarantor may dispute a claim or fail itself; when protection is bought from a party whose health is tied to the borrower, the bank faces wrong-way risk. Documentation errors can make security unenforceable. Heavy reliance on one type of collateral or one protection provider creates concentration risk. The Basel framework asks banks to assess these residual risks under Pillar 2.

Non-bank firms apply the same ideas. Exporters use letters of credit and credit insurance, suppliers take retention of title over goods, and derivatives users exchange margin under a credit support annex. Central clearing through a central counterparty is also a form of mitigation, replacing bilateral exposure with exposure to a well-collateralised clearing house.

• Bank for International Settlements: Basel Framework