Credit risk management

The majority of countries use models to monitor credit risk, with most of the models developed internally. Few models were purchased from external providers. Market value is the most commonly used measure to monitor credit risk, far more common than either book value or notional value. Most countries using market value as a measure of credit risk employ internal models to value positions. A majority of countries monitor potential exposure as well. Credit risk exposures are generally updated on at least a weekly basis, with the largest number of countries calculating exposure on a daily basis.

Credit exposure limits for individual counterparties are set almost universally as a single limit on a consolidated basis across all business lines.

Some countries have additional separate limits by type of security (e.g.swaps), and for actual versus potential exposure. The counterparty’s credit rating is the most common factor used in setting exposure limits, with almost all countries relying on external rating agencies. Several countries use internally developed ratings in combination with external ratings. While credit rating is the most common factor, many countries also use the counterparty’s size (generally, capital) in setting exposure limits. Quite a number of countries look also to the type of entity in setting limits. Among those which do, several make a distinction between sovereigns, banks and corporates.

Before countries will transact with counterparties, there are eligibility criteria which must be satisfied. Given the factors involved in setting exposure limits, eligibility criteria include, not surprisingly, minimum credit ratings and size requirements. For swaps, countries require that the counterparty sign the ISDA master swap agreement and, in several cases, a collateral agreement must be in place as well. Circumstances which can trigger a review of exposure limits to counterparties include: change in credit rating; a merger/

acquisition; change in capital size; concerns for the counterparty’s financial strength which are not taken into account in the entity’s rating; and, change in the counterparty’s business strategy.

Most countries employ some form of credit mitigation. Netting agreements are the most common, followed closely by early termination clauses. Collateral is used by roughly half of respondents which use credit mitigation. Several countries indicated that they accept only cash as collateral;

collateral in the form of securities typically involves government bonds.

A recent survey by the OECD Working Party on Public Debt Management highlighted the following credit risk policy issues.²

● What is the scope of credit risk? A distinction can be made between sovereigns who limit credit risk to non-compliance with timely and full payments of interest and redemption, and those sovereigns who also include loss of market value due to creditworthiness problems, irrespective of whether the loss has been realised. Some sovereigns consider counterparts’ credit rating downgrades in themselves to be a credit risk, irrespective of whether a direct loss or loss of market value has occurred.

Exposure to a downgraded entity, even if no direct or market value loss has occurred, may result in substantial internal resources being devoted to the issue. In addition, a non-materialized credit risk could already lead to some reputational risk.

● Is it desirable to avoid credit risk? Taking credit risk is intrinsically linked to managing a portfolio and therefore to government debt management.

Trying to avoid all credit risk would create distortions of its own. On the other hand, taking credit risk should comply with strict internal rules on risk management.

● Does the trade in interest rate risk instruments with counterparts of lower ratings send signals to markets about acceptable spread levels? Debt managers provide different answers to this question. Some note that every transaction, whether it be borrowing, lending, or involving a derivative, will send market signals, but that this is of no policy concern. Other sovereigns note that it is their explicit aim to limit this impact on the market; these concerns influence, among other things, the use of instruments. However, many debt managers note with regard to the interest rate swap market that it has developed to such an extent that it has no relevance (any longer) as an indicator of credit risk. Instead, swap spreads reflect supply and demand for paying and receiving interest.

● How to limit taking credit risk in money market transactions? Sovereigns use various strategies to limit taking credit risk in money market transactions. Quite a few sovereigns minimise the use of uncollateralised deposits in private banks. A number of countries prefer repos or other forms of collateralised lending to limit risk on their money market lending. A significant part of these countries have moved (or are planning to do so) from uncollateralised lending to collateralised transactions. A number of sovereigns does not limit lending or use collateral. With regard to money market lending, different approaches are being followed. Some sovereigns choose to avoid lending money, simply by being as much as possible on the borrowing side of the money market by not running a positive balance with the Central Bank. Some other sovereigns always carry a positive cash

balance, either by law or as a policy choice. Depending on the arrangement with their respective Central Banks, the money is either kept at the Central Bank, or lent on a short-term basis to other financial institutions.

Sovereigns implicitly or explicitly consider exposure to their own Central Bank to be free of credit risk. On-lending to private sector parties creates of course exposure to credit risk. Credit rating thresholds, repos, and other forms of collateralisation are used to limit that source of credit risk.

● How to limit credit risk exposure related to derivatives? In the case of interest rate swaps, a number of approaches can be distinguished. Some sovereigns limit the use of derivative instruments to what they consider the bare minimum. Many sovereigns make use of derivative contracts that require posting collateral if certain market value thresholds are exceeded.

In addition, most sovereigns use maximum exposure levels per counterparty. Some debt managers also use overall limits for certain categories of counterparties.

● Who has the responsibility to set credit risk limits? Risk limits are mainly the responsibility of middle offices, risk units or risk committees. In most OECD jurisdictions, the debt management office is organised in such a way that staff responsible for overall risk management issues also formulates credit risk guidelines.³ In a number of cases, setting credit risk limits is subject to pre-established external (to the debt office) general guidelines.

For example, some debt management offices work within general guidelines set by other divisions of the ministry of Finance or the Central Bank. Against this backdrop, a clear distinction can be made between a majority of countries in which the head of the debt management office approves general credit risk guidelines and individual limits and countries in which the minister of finance ultimately reviews and approves proposals put forward by the debt manager.

● What is the impact of counterparty ratings on setting credit risk limits?

Sovereigns that restrict their transactions to highly creditworthy institutions (AA) may have a tendency to set less clearly defined quantitative limits than sovereigns that also deal with lower rated counterparties (below AA). Most sovereigns set limits on exposure to individual counterparts, while they also have product limits in place. Very few sovereigns deduce these individual limits from a pre-set total maximum limit or from a total maximum acceptable loss. In most cases, adding a counterparty will, in theory, raise the overall potential limit. Some sovereigns determine their maximum overall limit on the basis of their need to invest in assets. Many sovereigns use 95% or 99% confidence intervals to measure maximum losses. Very few use worst case scenarios as a risk management tool. As a result, scenarios simulating systemic breakdowns are not taken into account. Many sovereigns report that they

restrict transactions to very creditworthy counterparties (measured by credit ratings). In some cases this gives the impression that this creditworthiness criterion is the single most important one, making quantitative limits less relevant. In contrast, debt managers that transact with counterparties with a wider variety of ratings, seem to have very precise quantitative limits for each creditworthiness category. But also in these cases the exact size of limits is always somewhat arbitrary as some sovereigns note that data on past defaults and rating records are to various degrees inadequate or even absent.

● How many counterparties? The number of counterparties varies considerably. A number of issuers limit their exposure to a very restricted number of institutions, typically their primary dealers. This makes it easier of course to maintain updated information on each counterparty. A possible downside of this could be the smaller diversification potential, although one could argue that 20 counterparties provide a sufficient degree of diversification for money market transactions and swaps. Debt managers that also manage longer-term asset portfolios usually will have much wider range of diversification possibilities.

● How much disclosure on credit risk? Information on credit risk is usually not made public and a public discussion is rare. Only a few sovereigns publish their exposure to credit risk. Most sovereigns are of the opinion that the topic is too technical for public consumption and that it is sufficient to provide a general assurance that strict guidelines are being followed.