The use of derivative products

- The paradox of credit :
• Overexposure to sectors/ names on which banks have a comparative advantage in term of originality.
• Overconcentration
• Incentive to use this comparative advantage.

- Macro management of the credit risk
- Portfolio of the receivables of commercial banks:
• Geographical / Sectoriel bias
• Possibility to diversify
o Exchanges of Portfolio
o Sale of protection on underexposed names.

- Disassociation of the claims of limitation of authorisation between country limit and counterparty limit.
• Purchase of protection on the subjacent country.

Advantage of credit derivative:

o The physical transfer of a credit risk is not always possible
o In the case of a banking loan, it is necessary to get the agreement of the credit subscriber:
- He can be opposed to it
- Problem of the service provided by the bank and the commercial
o It is often complex to sell a credit

Reduction of the financing cost:

According to the quality of a bank, its financing cost can vary, the more the quality of a bank deteriorates, the more its cost increases. It reflects a deterioration of the signature quality.

Application for firms:

o Margin of the commercial risk
o Margin of sovereign risks
o Applications for debts issuers on funds markets

1- Banks:

The main function of a commercial bank is to serve as a financial intermediary between borrowers and lenders.
- It bears therefore three major risks:
o The rate risk
o The exchange risk
o The credit risk

- The most important is the credit risk which is the least managed because it is difficult to manage.
- Moreover, the management of a bank is a restrained activity:
o Regulatory equities have to be tied up opposite to most of the operations.
o The born risks have to be diversified and balanced to minimize the risks of loss or insolvency.
o Equities have to, under the pressure of the shareholders, offer the best profitability possible.

- One of the credit derivative goals is to make the management of risks easier while responding to the major constraints.

1.1 What does the use of credit derivatives represent for banks?

- A powerful management tool of the credit risk : by-products of credits first aim at making the credit market more flexible, more liquid and larger.

- To optimize the regulatory constraints: credit activities of banks are closely watched by authorities’ regulation to avoid any risk of insolvency of banks which might lead to a major systemic risk.

- To optimize the regulatory constraints. So, they have to:
o Immobilize equities in the eyes of their credit operations.
o Buying some protection on a credit asset by means of a derived credit generally enables to reduce the needs in regulatory equities for a bank.
o To do so, the bank must respect a certain number of conditions imposed by the Banking Commission.

1.2 Improving the profitability of equities

- Nowadays, more and more banks are interested in the profitability of credit operations in the eyes of the immobilization of their equities.
- Equities are, indeed, a limited resource transmitted by the shareholders that want to optimize the yield.
- Credit derivatives allow a bank to optimize its economic risks and its regulatory constraints.

2- The management of the portfolio:

One way to use credit derivatives in the management of portfolios is to sell the credit risk of a portfolio when it is not possible to sell the cash position.
This kind of situation is quiet frequent when:
• The market is not liquid enough.
• The prices offered are not satisfying enough.
• We try to avoid concretizing the results of the cash operations for fiscal or countable reasons.