Dear SAP Banking Community members.
Yesterday I had a very interesting conversation with a friend, specialist on Credit Derivatives Contracts in Energy markets, about how the increasing requirements of Disclosure and Solvency are rising the prices of Credit Derivative Products.
In my opinion, those higher prices are a direct consequence of the higher cost of the main and necessary resource for offering those hedging Financial Instruments, “Solvency”.
A classical method for Risk Mitigation (solvency improvement), recognized by all the Basel agreements and most of solvency regulations, is collateralization. Consequently, from some perspective, collateral rights are a component of the very critical resource that we call Solvency.
On collaterals management we can follow two approaches.
• Static Collateral Management. The Bank has an exposure (receivable or asset) and requires a collateral right for hedging the Default Risk of the exposure. Normally, the higher the exposure, the higher the collateral that the Bank will require. The collateralization degree will be determined by the difference between the amount of the Exposure and the value of the collateral.
• Dynamic Collateral Management. On the other hand; according to the Basel agreement, Capital consumption (solvency) does not depend directly on the Bank’s exposure, but on the Bank’s exposures “weighted” but the exposures’ risk. Consequently collateralization degree depends on the risk of the exposure, and it changes (dynamically) with it.
The difference on the above approaches has relevant consequences for Capital Management.
In the first case, collateralization does not depend on the exposure’s risk (rating), but only on its size (the risk of the collateral value is somehow considered if we update the collateral value regularly), while in the second approach the risk of the exposure is integrated on the Risk Weighted Assets Calculation and consequently on the collateralization degree.
The second approach is more sensitive on risk and permits a more efficient management of the Collateral, and consequently, the Solvency and Capital.
By the way, as the solvency becomes a more expensive resource, the work of the Counterparty Valuation Adjustment (CVA) desks becomes a more critical activity.
Looking forward to read your opinions.
Kindest Regards.
Ferran.
Yesterday I had a very interesting conversation with a friend, specialist on Credit Derivatives Contracts in Energy markets, about how the increasing requirements of Disclosure and Solvency are rising the prices of Credit Derivative Products.
In my opinion, those higher prices are a direct consequence of the higher cost of the main and necessary resource for offering those hedging Financial Instruments, “Solvency”.
A classical method for Risk Mitigation (solvency improvement), recognized by all the Basel agreements and most of solvency regulations, is collateralization. Consequently, from some perspective, collateral rights are a component of the very critical resource that we call Solvency.
On collaterals management we can follow two approaches.
• Static Collateral Management. The Bank has an exposure (receivable or asset) and requires a collateral right for hedging the Default Risk of the exposure. Normally, the higher the exposure, the higher the collateral that the Bank will require. The collateralization degree will be determined by the difference between the amount of the Exposure and the value of the collateral.
• Dynamic Collateral Management. On the other hand; according to the Basel agreement, Capital consumption (solvency) does not depend directly on the Bank’s exposure, but on the Bank’s exposures “weighted” but the exposures’ risk. Consequently collateralization degree depends on the risk of the exposure, and it changes (dynamically) with it.
The difference on the above approaches has relevant consequences for Capital Management.
In the first case, collateralization does not depend on the exposure’s risk (rating), but only on its size (the risk of the collateral value is somehow considered if we update the collateral value regularly), while in the second approach the risk of the exposure is integrated on the Risk Weighted Assets Calculation and consequently on the collateralization degree.
The second approach is more sensitive on risk and permits a more efficient management of the Collateral, and consequently, the Solvency and Capital.
By the way, as the solvency becomes a more expensive resource, the work of the Counterparty Valuation Adjustment (CVA) desks becomes a more critical activity.
Looking forward to read your opinions.
Kindest Regards.
Ferran.
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