Credit Risk Mitigation:
- Credit risk refers to the potential loss that a lender may face if a borrower fails to meet their repayment obligations.
- Credit risk mitigation aims to reduce the impact of credit losses through various strategies and techniques.
Methods of Credit Risk Mitigation:
- Collateralization:
- Lenders require borrowers to provide collateral, which can be seized in case of default.
- Collateral serves as a secondary source of repayment and reduces the lender’s exposure to risk.
- Guarantees and Insurance:
- Guarantees involve a third party promising to cover the borrower’s obligations in case of default.
- Insurance products, such as credit default swaps, provide protection against borrower default.
- Loan Covenants:
- Loan agreements include covenants that specify certain conditions borrowers must adhere to.
- Breaching covenants can lead to early repayment demands or other penalties.
- Diversification:
- Lenders spread their lending across various industries, sectors, and borrowers to reduce concentrated risk.
- Credit Derivatives:
- Financial contracts like credit default swaps allow transferring credit risk to other parties.
Securitisation:
- Securitisation involves pooling and repackaging financial assets (such as loans, mortgages, or credit card debt) into securities that can be sold to investors.
- The goal is to transform illiquid assets into tradable securities and transfer risk from the originator to investors.
Process of Securitisation:
- Asset Pooling:
- The originator gathers a pool of assets with similar characteristics, such as residential mortgages.
- Special Purpose Vehicle (SPV):
- The SPV is created to hold the pooled assets and issue securities to investors.
- Securities Issuance:
- The SPV issues different classes of securities (tranches) backed by the cash flows from the pooled assets.
- Tranches have varying levels of risk and return.
- Credit Enhancement:
- Credit enhancements like overcollateralization, subordination, and guarantees are used to enhance the creditworthiness of the securities.
- Investor Purchase:
- Investors purchase the securities based on their risk appetite and return expectations.
- Cash Flows Distribution:
- Cash flows generated by the pooled assets are distributed to the investors according to the terms of the securities.
Benefits of Securitisation:
- Risk Transfer:
- Originators can transfer credit risk to investors, reducing their exposure to defaults.
- Liquidity:
- Illiquid assets become tradable securities, enhancing market liquidity.
- Capital Efficiency:
- Securitisation frees up capital for originators by moving assets off their balance sheets.
- Diversification:
- Investors can access a diverse range of assets and risks.
Multiple Choice Questions (MCQs) with Answers:
- What is the primary goal of credit risk mitigation? a) Maximizing loan interest rates b) Eliminating all lending risks c) Reducing the impact of credit losses d) Expanding the borrower’s credit limit Answer: c) Reducing the impact of credit losses
- What does collateralization involve in credit risk mitigation? a) Transferring credit risk through contracts b) Pooling and repackaging financial assets c) Obtaining insurance against default d) Requiring borrowers to provide security Answer: d) Requiring borrowers to provide security
- What role does a Special Purpose Vehicle (SPV) play in securitisation? a) Originating loans b) Issuing credit derivatives c) Enhancing creditworthiness d) Holding and managing pooled assets Answer: d) Holding and managing pooled assets
- How does securitisation enhance market liquidity? a) By eliminating all financial risks b) By pooling only illiquid assets c) By transforming illiquid assets into tradable securities d) By discouraging investor participation Answer: c) By transforming illiquid assets into tradable securities
- What does a credit default swap provide protection against? a) Interest rate changes b) Borrower default c) Stock market volatility d) Inflation Answer: b) Borrower default