Following common practices, Basel 2 considers two dimensions to credit risk: The borrower's credit standing and the transaction-specific features that "mitigate" borrower's credit risk.

Credit risk in lending activities is primarily driven by the credit standing of the borrower. Credit standing varies across counterparties and is qualified primarily by credit ratings. Under Basel 2, credit ratings are assigned to all borrowers from the bank, corporates, individuals in retail banking, and sovereign. Note that Basel credit ratings are distinct from credit ratings of rating agencies, which are defined for debt issues rather than by borrower (or "issuer").

Credit Risk Mitigants

Most transactions include some specific features which influence their credit risk. Transaction risk is differentiated by techniques that "mitigate" credit risk. There are many common credit risk mitigants, including "debt seniority," collateral pledged to the lender, third-party guarantees, covenants or contractual clauses binding the borrower's obligations.

Seniority is the priority ranking of loans or "claims" of the bank. Senior loans are paid first, while subordinated debt is paid only once senior claims have been repaid in full. Loans can be secured or unsecured. For secured debt, collateral is pledged to the lender. Collateral is used here as a generic term for designating cash, securities, commodities, some other assets (gold...), or physical assets such as residential real estate property. In the event of default, the lender becomes the owner of the collateral, can sell it and use the proceeds as (partial) repayment of its claim on the borrower. Third-party guarantees are provided by "guarantors" who commit to repay debts of borrowers if the latter default.

Covenants are contractual clauses imposed by lenders on various borrowers' debts. They specify lender's obligation with respect to a transaction. Covenants are legal or financial. Legal covenants stipulate the obligations of the borrowers, such as "Do this," "don't do this." Financial covenants are quantitative constraints imposed on borrowers. Some covenants are economic. They impose a minimum diversification of portfolio posted as collateral, or are triggered by credit events such as downgrades. Other financial covenants are the leverage of the borrower, the ratio of debt to equity, or the debt cover ratio (DCR), which is the ratio of cash flows generated by the borrowing entity to the amount due over the same period. DCRs have to be higher than one.

A covenant breach occurs when the borrower does not comply with the constraint. A breach triggers prompt repayment in theory. In practice, a breach provides an opportunity for lenders to restructure the transaction and impose additional restrictions intended to mitigate the risk (more equity from sponsors, etc.). Waivers can be granted by lenders in the event of a breach, allowing the borrower to continue operations.

Collateral-based transactions include all transactions backed by collateralized assets. In the financial system, all players hold a portfolio of securities, which can be eligible for collateral. Such transactions are subject to a minimum ratio of collateral value to the amount of borrowing. The value of collateral is higher than the amount lent. The difference serves as a buffer against the fluctuations of values of securities posted as collateral. The gap between collateral value and loan amount is called the "haircut." It represents the safety cushion required by lenders for lending. Repurchase/reverse repurchases and securities lending/borrowing, or "repo-style transactions," use securities as collateral of the debt and are widely used. Under Basel 2, such transactions are generically designated as securities lending and borrowing, since such securities are exchanged for serving as collateral gain the cash lent or borrowed.

Because such features are transaction-specific, credit risk mitigation is relevant only at the transaction level. Various loans to the same borrowers differ in terms of credit risk because they benefits from different credit mitigants.

Credit Risk Mitigation under Basel 2

Credit risk mitigation in Basel 2 is characterized by loss given default (LGD) equal to amount due, inclusive of interest accrued, minus recoveries from guarantees in the event of default and minus work-out costs. LGD is defined at the transaction level. The LGD is expressed as percentage of the total amount due, principal and interests accrued. The recoveries are 100% minus the LGD in percentage. Loss under default and recoveries cannot be defined at the level of the borrower because various loans have different loss rates. Some debts are more senior than others, some are secured and others are not, etc. The LGD quantifies the transaction-specific risk, the fraction of credit risk that depends on the transaction rather than on the borrower's credit standing.

Agency ratings address investors in debt issues. Accordingly, they are issue-specific, unlike issuers' ratings which characterize the borrowers' credit standings. Note that Basel credit ratings differ from agencies' credit ratings to the extent that they specify the credit standing of the borrower. Issuers' ratings are similar to unsecured debt ratings because such debts are only secured by the credit standing of the borrower. The LGD serves for characterizing the transaction-specific risk.

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