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II. Credit Risk Management
Ongoing Monitoring and Credit
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Four documentary tools are available to monitor and reduce counterparty credit risk:
- Reporting
Agreements frequently provide for periodic delivery of financial information, required notice of defaults and material financial events, or an obligation to respond to "reasonable" requests for information. The product of the reporting obligations then is employed pursuant to internal credit policies.
- Covenants
Financial covenants can be imposed, but rarely are, to limit credit exposure to a counterparty.
- Netting or Novation
Bilateral netting is intended to reduce counterparty exposure by automatically offsetting the concurrent payment obligations that each party has to the other. Bilateral netting agreements typically provide for both payment netting and close-out netting. Payment netting provides that if payments in the same currency are due on the same day from the same designated offices of both parties, those payment obligations will be netted so that the party with the larger payment obligation will pay to the party with the smaller payment obligation an amount equal to the excess of the larger payment over the smaller payment. Close-out netting applies in the event one or both of the counterparties defaults under the agreement or another event triggering close-out occurs, such as a termination event. Under close-out netting, all outstanding transactions under the agreement are terminated and are valued based on their replacement cost. These termination values are then netted or set off with the result that only a single amount is due by one counterparty to the other in respect of all of the terminated transactions. The recent Consultative Paper by the Basle Committee of the BIS (April 1993) includes a proposal for the recognition of the effectiveness of close-out netting as an important credit risk reduction technique. Several netting variations exist, including:
- Cross-Currency and Cross-Product Netting Cross-currency netting provides for netting of payments as described above, whether or not such payments are denominated in the same currency. To net different currency payment obligations, the payments are, to the extent necessary, converted into a base currency at the then prevailing spot rate. Cross-currency netting is common only with respect to close-outs. Cross-product netting permits netting of payments across derivative categories or between derivatives and non-derivatives.
- Designated Offices In some cases, payment obligations between counterparties are netted as described above, whether or not the payment obligations are between the same designated offices of the counterparties. Such would be the case where, for example, a counterparty is permitted to book a transaction in a different office for accounting or regulatory reasons. This type of multibranch netting is discussed in the Working Paper of the Enforceability Subcommittee.
- Novation A variation of payment netting exists whereby two or more transactions in the same currency, between the same designated offices, and with common payment dates are deemed terminated and replaced by a single transaction requiring a payment equal to the difference of the payments of the novated transactions. Novation does not operate as simply where the transactions involve a series of payments as opposed to a single payment. Transactions may be novated as of the trade date of the second transaction or as of the day immediately preceding the common payment date. The latter may have the adverse effect of changing the character of the novated transactions into a single spot contract.
- Payment Deferral
A party may suspend payments to its counterparty if a default exists with respect to the counterparty. Often, the deferral can last only a specified period before the party must declare a default or release the deferred payment. Sometimes, one party will be given the right at any time to defer a payment to the other (with interest at a market rate accruing during the deferral).
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II. Credit Risk Management
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