Glossary term
Credit Risk Mitigation (CRM)
Subject: Risk Management, Financial Risk (Credit, Market, Liquidity)
Also known as: CRM, Credit protection
Credit risk mitigation covers the techniques a lender uses to reduce the loss it would suffer if a borrower defaults, such as collateral, guarantees, netting and credit derivatives.
Explanation
Mitigation does not remove the chance of default. It reduces how much is lost when default happens, or transfers the loss to someone else. Collateral gives the lender an asset to sell. Guarantees and standby letters of credit bring in a third party who must pay if the borrower does not. Netting sets off what two parties owe each other so only the difference is at risk, and credit derivatives or insurance pass the risk to a protection seller. Under Basel rules a bank may reduce its capital requirement for an exposure if the mitigant meets conditions: it must be legally enforceable, valued prudently, and not closely tied to the borrower. Common problems are falling collateral values, weak legal documents and the guarantor failing at the same time as the borrower. A guarantee or pledge that fails in court gives no relief, so lawyers check enforceability before credit is granted.
Example
A property company borrows 10 million from a bank, secured by a building valued at 14 million. The bank applies a 30% haircut to the value, giving 9.8 million of credit for the loan, and takes a guarantee from the parent company for the rest. Before relying on either, the bank's legal team checks that the charge on the building is registered and enforceable.
Not to be confused with
- Risk Transfer
- Risk transfer moves a risk to another party, as insurance does. Credit risk mitigation includes transfer but also collateral and netting that reduce exposure directly.