Chapter 7: Credit Risk Transfer and Mitigation

Abstract

Financial institutions have throughout time developed several different methods to mitigate and transfer credit risk. These include letters of credit and guarantees, covenants, marking to market, netting central counterparty clearing, collateralization and over-collateralization, syndication, early transaction termination, credit derivatives and securitization. Credit derivatives and securitization are the most sophisticated, flexible and can separate and redistribute credit risk to a very broad class of financial institutions. Securitization and credit derivatives have received a lot of criticism following the 2007 financial crisis. However, these are very powerful tools for credit risk transfer and mitigation. They should be understood before they are used, and used not in excess but with care and caution. If they are used appropriately they can effectively assist in credit risk transfer, mitigation and management, but if they are abused and their dynamics not understood they can have a devastating impact on the economy.