As Liability Driven Investment (LDI) strategies become more popular, I thought it would be useful to highlight the process and methods by which investment banks look at credit risk and credit lines. I have put together a series of 4 shorter pieces which should hopefully answer quite a lot of questions.
Part 1: Putting Credit Lines In Place
The initial decision on whether to extend credit, a process bankers regularly refer to as "putting lines in place" is usually, perhaps surprisingly, based more on revenue projections than on credit considerations.
This means a bank will almost always be prepared to consider extending derivative based credit exposure to smaller and less credit worthy entities if they are introduced by means of an existing large counterpart with a strong derivative relationship (e.g. a large LDI house). This is because the bank risks alienating the entire underlying client base if the credit department rejects the new proposed client. Nonetheless the bank will want a number of initial facts about the underlying client in order to gauge whether it will proceed to put lines in place. As well as an estimated revenue figure (normally provided by the client’s internal sponsor at the bank) the credit department will want to know relatively simple facts like the total Assets under Management, the type of assets being managed, how much leverage is proposed to be taken – that is to say whether the client envisages trading a larger notional of derivatives than the notional of assets held with that client. This is obviously quite likely in the UK where many pension funds have liabilities exceeding their asset base and liability managers are often given responsibility for all the liabilities but only a share of the asset base of a pension fund.
When the decision has been taken on whether to put lines in place, the (often lengthy) document negotiation process can start, via the agreement of mutually binding "ISDA" and "CSA" documents. An ISDA (or, more accurately, the schedule to the ISDA Master Agreement) is a largely standardised document which sets out the general terms of engagement under which the bank and the client will conduct derivative business.
The other important document at this stage is the CSA, or “Credit Support Annexe.” This lays out the terms under which client and bank will exchange margin, or collateral, in order to cover the changing mark-to-market on derivative positions. Before the credit crunch, CSAs were widely used but not necessarily vital to transacting derivative business. Nowadays, with the moves towards central clearing, I think it is safe to say that CSAs have become a cornerstone of good derivative practice.
To come back to the first document, the main debate over an ISDA schedule with a potential new counterparty will be the applicability of the various standardised events of default – the usual ones being "cross-default", "credit event upon merger", and various "alternative termination events" (ATE) which one or more counterparties may seek.
For example many counterparties will want to eliminate or reduce the possibility for "cross-default" – that is the extent to which the counterparty could be forced into technical default on various outstanding contracts via a failure to make payments to one particular counterparty.
At the same time banks will also frequently seek to remove the "credit event upon merger" clause, as they would not want to risk the possibility of a large-scale derivative portfolio wind-down in the event of a takeover or merger.
In the case of a pension fund, a bank might potentially look for an ATE that would consider the winding-up of the pension fund sponsor to be an event of default for the pension fund itself. In the case of rated counterparts, ATEs may well contain some reference to official ratings agency ratings – for example, a credit event may be triggered by a downgrade below investment grade level.
It is obviously up to the individual pension scheme and its lawyers to consider these requests, but it is at this stage that the credit department will start to make a decision on how much potential credit to extend to the counterparty – that is, to start to frame a number in their mind to encompass the maximum potential exposure the bank is comfortable taking to this underlying entity.
The size of the credit line ultimately extended will depend upon the favourability of the terms in the CSA and ISDA, as well as the creditworthiness of the underlying client.
In Part 2, I'll delve deeper into the CSA process.