Risk mitigation

Past version: effective from 21/10/2015 - 20/10/2015
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56. Various methods can be used to mitigate Credit Risk, such as taking security or Collateral, obtaining a guarantee from a third party, purchasing insurance or Credit Derivatives. Authorised Persons should view these as complementary to, rather than a replacement for, thorough credit analysis and procedures.
57. In controlling Credit Risk, an Authorised Person may utilise certain mitigation techniques.

Normally, they include:
a. accepting Collateral, standby letters of credit and guarantees;
b. entering into Netting arrangements;
c. setting strict loan covenants; and
d. using Credit Derivatives and other hedging instruments.
58. In determining which types of credit mitigation techniques should be used, firms should also consider:
a. their own knowledge and experience in using such techniques;
b. cost-effectiveness;
c. type and financial strength of the Counterparties or Issuers;
d. correlation with the underlying credits;
e. availability, liquidity and realisability of the credit mitigation instruments;
f. the extent to which legally recognised documentation, e.g. ISDA Master Agreement, can be adopted; and
g. the degree of supervisory recognition of the mitigation technique.
59. While mitigation through Collateral and guarantees is usually dealt with at the time of granting of credits, Credit Derivatives and Netting are often employed after the credit is in place, or used to manage the overall portfolio risk. When the mitigation arrangements are in place they should then be controlled. Authorised Persons should have written policies, procedures and controls for the use of credit mitigation techniques. They should also ensure adequate systems are in place to manage these activities.
60. Authorised Persons should revalue their Collateral and mitigation instruments on a regular basis.

The method and frequency of revaluation depends on the nature of the hedge and the products involved.
61. If an Authorised Person takes security or Collateral, on credit facilities, appropriate policies and procedures should be documented covering:
a. the types of security or Collateral considered;
b. procedures governing the valuation and revaluation of security or Collateral including the basis of valuation;
c. policies governing the taking of security or Collateral, including obtaining appropriate legal title; and
d. policies governing possession of security or Collateral.
62. The value of security and Collateral should be monitored at an appropriate frequency. For example, commercial property might be revalued annually, whereas Securities provided as Collateral should be marked to market usually on a daily basis. Residential property may not need to be revalued annually, but information should be sought as to general market conditions.
63. When taking Collateral in support of an Exposure, an Authorised Person should ensure that legal procedures have been followed, to ensure the Collateral can be enforced if required.
64. An Authorised Person should consider the legal and financial ability of a guarantor to fulfil the guarantee were it called upon to perform its obligations as guarantor.
65. An Authorised Person should analyse carefully the protection afforded by risk mitigants such as Netting agreements or Credit Derivatives, to ensure that any residual Credit Risk is identified, measured, monitored and controlled.
66. An Authorised Person providing mortgages at high loan-to-value ratios should consider the need for alternative forms of protection against the risks of such lending, including mortgage indemnity insurance, to protect against the risk of a fall in the value of the property.