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Category: Risk Management in Banking

Credit derivatives have an obvious potential for portfolio management because they are new tools helping to reshape the risk-return profile of portfolios without cash sales of assets or to extend exposure beyond limits by transferring excess risks to others. They also create an inter-bank market for credit risk, allowing banks to rebalance their specific portfolios by exchanging risk concentrations.

The Rationale for Portfolio Management and Credit Risk Protection

The rationale for portfolio management is to resolve the well-known conflict between relationship banking and diversification. This is the credit paradox of relationship banking versus credit exposure.

Banks rely on lending first and services after. Hence, lending is a prerequisite to further relationship development. The relationship manager wants new deals with big customers, but the credit officer gets worried because a large customer failure gets the bank into serious trouble. Developing business requires diversification, but the credit business creates concentration and specialization instead. The focus on client relationship creates a conflict between origination and diversification requirements. Hence, there is a need to off-load loan concentrations in the market. Trading the credit risk resulting from origination would help the bank to stay within risk limits while maintaining relationship banking.

This is one of the emerging roles of active portfolio management. However, cash portfolio management is not easy, because clients might be reluctant to let banks sell their loans and because loans have a poor liquidity. The usage of credit derivatives eliminates these major obstacles, because they do not require any prior agreement from customers and because the liquidity of the credit derivatives market might be higher than that of loans. Credit derivatives appear as a new way of reconciling these two conflicting sides of relationship banking since they allow the excess exposures to be traded while continuing to develop business with the same customers.

As a result, origination does not imply a buy and hold management philosophy. Portfolio management consists of trading exposures in cash or trading credit risk through credit derivatives. It appears as a natural complement to origination and to the basic lending business. The function helps origination by selling excess exposures and creating diversification through purchases of bonds or loans or using credit derivatives.

Portfolio management gets banks closer to the trading philosophy, since it implies changing the structure of portfolios to optimize the risk-return profile. The portfolio management unit becomes a profit centre and lives with its own goals, tools and techniques to achieve optimization. Credit derivatives facilitate this task and add new degrees of freedom for doing so.

Hedging a Portfolio with a First-to-Default Basket Derivative

If the bank holds a concentration in an industry, it has a number of choices: capping exposures, originating commitments in other industries or hedging the risk of some of the assets held in the industry with credit derivatives.

Credit derivatives offers additional options. Buying direct protection for a number of assets held is a simple but costly solution. Buying protection for a first-to-default basket derivative is more attractive. The contract is simple. The first default is an early warning signal of later defaults. This is a powerful rationale for entering into first-to-default baskets. It allows holders of credit risk to get protection for the first-to-default, thereby neutralizing the risk on subsequent defaults.

When correlation varies, the portfolio risk and the first-to-default basket risk vary inversely. The risk of a basket derivative is higher when correlation decreases, because the joint survival probability decreases, and vice versa. The first-to-default risk behaves as a mirror image of the increasing risk of the portfolio when correlation increases. This makes entering into a credit hedge against correlation attractive to both parties. When correlation increases, the portfolio risk increases, making hedging more necessary. Simultaneously, the first-to-default derivative risk decreases, making it less costly for the seller of protection. Similar hedges can use first-to-downgrade baskets.

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