Business — Banking — Management — Marketing & Sales

There are many contractual exposures since term loans represent a large fraction of outstanding loans. Most other products raise exposure measurement issues because the amount at risk is unknown in advance. For banking credit exposures, relevant distinctions are on-balance sheet versus off-balance sheet transactions. In most cases, there are always hard data that bound exposures in time and amount. In addition, exposures are at book values or mark-to-model.

The hard data for banking exposures are:

• The amount and maturity of committed lines.

• The amortization schedule for term loans.

• The maturity of the authorizations.

• The dates of reviewing the authorizations.

• The current usage of committed lines.

Because of economic measures of exposures, there is a mismatch issue between these and the basis for calculating revenues addressed in the last subsection.

On-balance Sheet

In general, exposure differs from current usage because the amount at risk at future dates is uncertain. Exposure risk appears when we do not know the future usage of a banking line. The notable exception is term loans. Their amortization profile is a good proxy for the future exposures. Still, contractual repayments are subject to prepayments, and the effective maturity is a substitute. Effective maturity results from experience or models for mortgages. For many other credit lines, there is a commitment of the bank to let the borrower increase the usage by drawing on a credit line up to a certain amount left at the initiative of the borrower. Overdrafts, consumer loans and credit card balances are subject to renewal, and borrowers can make new drawings at their initiative. Rollover lines generate a long-term exposure, beyond the rollover dates. Committed lines of credit are on-balance sheet for the used fraction and off-balance sheet for the unused portion of the line. Borrowers draw a committed line whenever they need to, up to the maximum amount authorized. Project financing is subject to exposure uncertainty both for the construction phase and for the subsequent operation phase when the repayments occur. Uncertain exposures are the rule more than the exception.

In all cases, the current usage of the line might differ from the future usage. It is necessary to define what are the expected exposures at future horizons and the exposure under default, which might increase when credit risk deteriorates. The New Basel Accord stipulates that EAD is a key input to the risk assessment process.

A facility has only two characteristics bounding the exposure set from inception: maturity and authorization. For non-committed lines of credit, the current and expected usages are acceptable measures, although choosing which one is relevant is judgmental. The next date for reviewing the authorization is a good candidate for maturity, since the bank does not need to extend credit beyond this. The authorization remains a cap to all measures. The case of committed lines of credit differs from the above, even when the current usage differs from the authorization. The undrawn portion of the line is off-balance sheet, and the subsequent section addresses this special case.

Off-balance Sheet

The basic issue with off-balance sheet exposures is that it is never certain, and sometimes highly unlikely, that such contingencies given will move up to being on-balance sheet. Because of this uncertainty, the common rule is to assign weights lower than 1 to offbalance sheet contingencies to differentiate them from on-balance sheet exposures. This is similar to defining loan equivalents of smaller exposures. This is the regulatory treatment of off-balance sheet exposures, with the 50% factor.

Because of the diversity of off-balance sheet commitments, it makes sense to differentiate their economic treatment. For committed lines of credit, the economic exposure is 100% of the commitment since the bank is contractually at risk for this total amount, even if there is no current usage. Regulations allow us to use a lower percentage because the likelihood of maximum usage remains remote in many cases. However, a borrower getting close to default is likely to fully draw the line.

Third-party guarantees given have only a remote possibility of exercise, since only the default of the borrower triggers exercise. However, they are similar to direct exposures since the borrowers default triggers the guarantee as if there was a direct exposure. The regulatory view on guarantees given to a third party is that the risk is equivalent to a direct exposure. However, there is a wide spectrum of third-party guarantees, ranging from simple letters of comfort to first recourse full guarantees. The former does not carry any real risk because there is no legal commitment. Legal commitments are equivalent to lending directly. Because of these wide variations of the legal strength of bank commitments, there is a case for differentiating the risks.

Other commitments, such as backup lines of liquidity for issuing commercial paper, look more like financial services than true exposures. What triggers drawing is not the default of the client but a need to draw liquidity triggered by unlikely events. Hence, there is a case for differentiating them from other guarantees, but assessing the likelihood of materialization of the risk remains judgmental.

Revenues and Exposure Mismatches in Projections

Since exposure to credit risk is not the usage of lines, there is a mismatch between projected revenues and exposures considered for assessing credit risk. There is a contractual link between the effective exposure and the revenues. In the example of committed lines of credit, the undrawn portion receives a low fee while the drawn fraction receives full interest rate payment. If 100% of the line is at risk, the revenues no longer match the exposure because the calculation uses the effective amount drawn. In general, exposures at default might differ from projected exposures for calculating revenues. The mismatch between projected revenues and exposures alters the risk-return profile of all transactions and of the entire portfolio. However, it is a consequence of the prudent rules applying to risk measures and to revenue measures.

TRADABLE INSTRUMENTS

When dealing with tradable market instruments, the exposure is the price. Exposure uncertainty results from market-driven prices. The major differences with the banking portfolio are:

• For tradable market instruments, the hold to maturity view is irrelevant. Traders make money from taking positions, not holding them. They can sell them at any time, notably when they fear adverse credit conditions. If they do not, the loss from default is the difference between the pre-default price and the post-default price. The loss from an adverse rating migration is also the difference between the pre-migration price and the post-migration price.

• Market risk is not credit risk, even though both result from variations of market values. Market risk is the potential loss resulting from adverse market movements over the liquidation period. Credit risk is the potential loss resulting only from a change in credit standing over the holding period.

The hold to maturity view does not hold because it is possible to get rid of the exposure whenever a warning light turns on. The exposure is the current price.

Note that the credit risk is not the exposure. It is the fluctuation of the price over the holding period relating to credit risk events only. Chapter 43 expands the discussion and the case for measuring credit risk by the specific risk of such instruments, that is the component of price risk unrelated to general market movements.