RBS 2009 Annual Report Download - page 131

Business review
Risk, capital and liquidity management
Exposure at default (EAD)
Facility usage models estimate the expected level of utilisation of a
credit facility at the time of a borrower’s default. For revolving and
variable draw down type products which are not fully drawn, the EAD
will typically be higher than the current utilisation. The methodologies
used in EAD modelling provide an estimate of potential exposure and
recognise that customers may make more use of their existing credit
facilities as they approach default.
Counterparty credit risk exposure measurement models calculate the
market driven credit risk exposure for products where the exposure is
not based solely upon principal and interest due. These models are
most commonly used for derivative and other traded instruments where
the amount of credit risk exposure may be dependent upon one or more
underlying market variables such as interest or foreign exchange rates.
These models drive internal credit risk activities such as limit and
excess management.
Loss given default (LGD)
These models estimate the economic loss that may be experienced –
the amount that cannot be recovered – by the Group on a credit facility
in the event of default. The Group’s LGD models take into account both
borrower and facility characteristics for unsecured or partially
unsecured facilities, as well as the quality of any risk mitigation that may
be in place for secured facilities, plus the cost of collections and a time
discount factor for the delay in cash recovery.
Credit risk mitigation
The Group employs a number of structures and techniques to mitigate
credit risk:
•Netting of debtor and creditor balances is utilised in accordance
with relevant regulatory and internal policies and requires a formal
agreement with the customer to net the balances and a legal right of
set-off;
•Under market standard documentation net exposure on over-the-
counter (OTC) derivative and secured financing transactions is
further mitigated by the exchange of financial collateral;
•The Group enhances its position as a lender in a range of transactions,
from retail mortgage lending to large wholesale financing, by
structuring a security interest in a physical or financial asset;
•Credit derivatives, including credit default swaps, credit linked debt
instruments, and securitisation structures are used to mitigate credit
risk; and
•Guarantees and similar instruments (for example, credit insurance)
from related and third parties are used in the management of credit
portfolios, typically to mitigate credit concentrations in relation to an
individual obligor, a borrower group or a collection of related
borrowers.
The use and approach to credit risk mitigation varies by product type,
customer and business strategy. Minimum standards applied across the
Group cover:
•General requirements, including acceptable credit risk mitigation
types and any conditions or restrictions applicable to those mitigants;
•The maximum loan-to-value (LTV) percentages, minimum haircuts or
other volatility adjustments applicable to each type of mitigant
including, where appropriate, adjustments for currency mismatch,
obsolescence and any time sensitivities on asset values;
•The means by which legal certainty is to be established, including
required documentation and all necessary steps required to
establish legal rights;
•Acceptable methodologies for the initial and any subsequent
valuations of collateral and the frequency with which they are to be
revalued (for example, daily in the trading book);
•Actions to be taken in the event the current value of mitigation falls
below required levels;
•Management of the risk of correlation between changes in the credit
risk of the customer and the value of credit risk mitigation, for
example, any situations where customer default materially impacts
the value of a mitigant and applying a haircut or recovery value
adjustment which reflects the potential correlation risk;
•Management of concentration risks, for example, setting thresholds
and controls on the acceptability of credit risk mitigants and on lines
of business that are characterised by a specific collateral type or
structure; and
•Collateral management to ensure that credit risk mitigation is legally
effective and enforceable.
129RBS Group Annual Report and Accounts 2009