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Outline why collateral is managed.

FRM® Part II · Credit Risk Measurement and Management · Margin (Collateral) and Settlement · FRM2.CR.17.a

The idea

Collateral is managed because it is the main practical tool for cutting counterparty credit exposure in derivatives and repo. If a counterparty defaults, the secured party can liquidate the assets it holds and apply the proceeds to the net amount owed, so loss given default falls. Lower expected exposure also reduces credit valuation adjustment, frees credit-limit and regulatory capital, and lets a bank trade with counterparties whose unsecured credit standing would not otherwise support the business. Collateral does not remove risk. Exposure can still grow during the margin period of risk, which is the time from the last successful margin call to close-out. Thresholds and minimum transfer amounts leave small gaps, and collateral can lose value or be correlated with the counterparty (wrong-way risk). The exam point is that collateral reduces and transforms credit risk, but does not eliminate it.

A practice question

From the question bank, with the reason each wrong option is wrong.

Which of the following is a direct benefit to a bank of holding collateral against a counterparty exposure?

  1. A guaranteed elimination of the credit valuation adjustment on the tradesWhy not: CVA falls but does not vanish: the margin period of risk, thresholds and minimum transfer amounts leave residual exposure.
  2. Lower net credit exposure, which uses less of its credit limit and regulatory capital - correct
  3. Higher exposure at default, because the collateral is an additional asset on its balance sheetWhy not: Confuses gross balance-sheet recognition with credit exposure; recognised collateral reduces exposure at default.
  4. No market risk on the collateral, because posted assets are always cashWhy not: Collateral can be securities with price and FX risk, which is why haircuts exist.

Exposure net of collateral is smaller, so credit-limit usage and capital fall. The reduction is partial because residual gaps remain.

A harder one

A bank has a credit limit of USD 40 million to a counterparty, measured on exposure net of collateral. The current mark-to-market exposure is USD 55 million and the bank holds collateral worth USD 20 million after haircuts. What is the most accurate conclusion?

  1. Net exposure is USD 55 million, so the limit is breached because collateral does not count toward limitsWhy not: Ignores that the limit is stated net of collateral, which is the point of collateralising.
  2. Net exposure is USD 35 million, inside the limit, so collateral lets the bank do more business within the same limit - correct
  3. Net exposure is USD 75 million, because the collateral held is added to the exposureWhy not: Adds the collateral to the exposure instead of subtracting it.
  4. Net exposure is USD 20 million, which equals the collateral held, and is within the limitWhy not: Confuses the value of collateral held with the net exposure; net exposure is 55 less 20.

Net exposure = 55 - 20 = USD 35 million, below the USD 40 million limit. Gross exposure of 55 would exceed the limit, so collateral expands capacity.

The hardest tier

A bank accepts shares issued by the counterparty, a single-industry airline, as collateral on a fuel swap. Which weakness most directly undermines the purpose of the collateral?

  1. Wrong-way risk: the shares are likely to lose value just when the airline defaults - correct
  2. Equity collateral always carries a 100% haircut, so it is worthless as collateralWhy not: Equities are eligible in many CSAs with a large but not total haircut; this misstates how haircuts work.
  3. Under a pledge the airline keeps title to the shares, so the bank can never sell them even after the airline defaultsWhy not: A secured party can realise pledged collateral on default; ownership by the pledgor does not block this.
  4. The margin period of risk is zero for listed equities because they trade on an exchangeWhy not: The margin period of risk reflects call, dispute and close-out timing; an exchange listing does not remove it.

Collateral is meant to be uncorrelated with the counterparty's default. Its own shares fall as its credit deteriorates, which is classic wrong-way risk.

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