Credit Risk: From Transaction to Portfolio Management (Securities Institute Global Capital Markets)

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But what precisely are the capital markets? And why do lawyers get involved in transactions?

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The Student Guide thought it would be helpful for you to better understand the current state of this important area of the economy. What are capital markets? Investors, meanwhile, are on the lookout for profitable businesses in which they can grow their investment. There are many ways in which this investor-lender relationship can be organised, and many ways to make money out of the process. The equity capital markets are the easiest to understand. Private companies raise money by listing themselves on a stock market and then selling shares in their domestic market and often internationally as well.

An IPO is a transformational event for a company — it changes from a private affair, run by a small group of shareholders to a public company, subject to significant regulation and to the will of its shareholders. For the investor, the profit on shares consists of any dividends they receive and any increase in market value of the shares. Shares pay dividends when the company is profitable — the level of the dividend being determined by directors and shareholders.

Share values are not repayable by the company unless it is being wound up or operating a buyback of shares, but investors can realise their asset by selling in the market. These are called bonds and the investor becomes the owner of the bond. At predetermined intervals, the owner of the bond receives interest payments from the company, which can be at a fixed or floating rate, depending on the terms of the bond.

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The perceived credit risk of the bond which is based broadly on the credit of the issuer, the maturity of the bond, the currency of the bond and any particular features of the bond determines the interest rate. For the investor, the profit on bonds consists of the interest payments they receive and any increase in market value of the bond.

Unless the issuer of the bond has defaulted, or there are specified events in the terms of the bonds, bonds are not usually payable before maturity. However, an investor can realise his asset by selling in the market provided of course there are purchasers interested in buying the bond!

Investment Risks

Unlike shares, bonds therefore have a secure yield. Furthermore, bonds guarantee to pay back the initial value of the loan unless the company or government runs out of money. On an insolvency of the issuer, bondholders are paid with other creditors. Shareholders only receive their share of what if anything is left after all other creditors are paid. With shares there is everything to play for — much to gain, but also much to lose.

In normal markets, bonds are less volatile — this was not the case for many bonds during the credit crisis. Bonds and stocks both carry with them an element of uncertainty. Capital markets have created numerous instruments that allow investors and borrowers to protect and insure themselves against uncertain developments.

Two of the most noteworthy developments on the debt capital markets since the s are the use of collateralised debt obligations and the rise of the derivatives market. Bonds and shares are both types of securities. However, the term securitisation is most often used for the process by which loans are bundled up into a collateralised debt obligation. The most commonly securitised types of loans are mortgages. Essentially, bundles of mortgage loans were sold on to other players on the capital market.

The sale of these bundles of loans provided liquidity to lenders, since they received money for loans that had not yet been repaid by the original borrowers of the money. In addition, the sale of the loans freed up capital for banks.

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  4. This capital is expensive for banks — traditionally they make money by taking deposits and then lending this money at a higher interest rate, not by keeping money on their books. By selling the loans they were able to free up capital. Why would an investor buy an interest in a bundle of mortgages?

    Because it allows them to invest in mortgage loans, which many institutional investors could not previously do because they did not have the relevant licences or did not want the hassle of dealing with individual lenders. In addition, the loans were repackaged in a way that makes them more attractive to institutional investors. Assets range from potatoes to gold to currencies. Derivatives provide businesses with opportunities to protect hedge themselves against future market developments.

    Futures, forwards, options and swaps are all types of derivates. Lawyers also get involved in creating the product: the packaging of loans and selling of the interests in them. Lawyers are key players in the transactional processes which permeate the world of capital markets. They advise debt and equity issuers and the investment banks which structures and sells the financial instruments. The role of lawyers includes advising on legal and regulatory matters, drafting documents, negotiating contracts, and working with bankers to obtain approval from various external parties such as regulators, listing agencies and rating agencies.

    Some transactions are bespoke and more complex.

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    Junior lawyers cut their teeth on cookie-cutter deals, but as lawyers gain more experience they hopefully work on more specialised deals. Legal and regulatory advice: we looked at equity capital markets above and noted that an IPO is transformatory for a company. A first-time borrower in the debt capital markets also requires a lot of lawyer time to prepare it for the new transaction. Much of this type of activity is cross-border, which means considerable time needs to be spent working out how various regulations fit together and liaising with local lawyers.

    When it comes to drafting documents , there are key clauses to get right, and in many cases huge volumes of documents to prepare and amend. While swap confirmations and other derivatives contracts are often short although complex , the majority of capital markets transactions are just the opposite. The selling document for securities a prospectus can range from 15 pages to more than , and the contractual documents are not far behind.

    Securitisation probably tops the charts for most documentation — and therefore worst hours! At university, the longer the essay the more likely you were to stay up all night — nothing much changes when you get to a law firm. Negotiating contracts is a big part of the job. There are a lot of contracts which need to be signed off by a lot of parties — and every contract is of great importance to every party. As such, negotiations can be protracted. Issuers want the best terms; investment banks need the clauses to be acceptable to their internal credit committees, and in the case of securities, they want terms that make the product optimal for selling.

    Regulatory and other approvals are a necessary step.

    Principles for the Management of Credit Risk

    They range from simple listing approvals for frequent bond issuers, to more time-consuming activities like a first listing approval of a securitisation of Russian credit card loans on the London Stock Exchange. The opportunity to work with a client on a huge transaction; the sense of teamwork involved when grafting alongside people from banks, client companies and other law firms; the fun of negotiation and the buzz of finally creating a transaction that complies with all the different laws and regulations and which an investor will still want to buy. It is generally accepted that the credit crunch that precipitated the global economic slowdown was caused by the huge market for repacking collaterisatising American sub-prime mortgages.

    These bundles of mortgages were sold between banks. Because they were easy to repackage and sell, lenders could keep selling more and more of them — they seemed not to care whether the original home-owner borrowers could actually meet their monthly mortgage repayments. Banks were less able and willing to lend money as the asset side of their balance sheets had shrunk, thus leading to a liquidity crisis.

    Although the crisis originates in the US, capital markets are such a global phenomenon that what followed was a true domino effect. Increasing use of stress tests. Regulators are increasingly relying on stress tests to assess capital adequacy, and respondents said stress testing plays a variety of roles in their institutions, including e nables forward-looking assessments of risk 86 percent , feeds into capital and liquidity planning procedures 85 percent , and informs setting of risk tolerance 82 percent.

    Low effectiveness ratings on managing operational risk types. Fewer respondents felt their institution was extremely or very effective when it came to other operational risk types such as third party 44 percent , cybersecurity 42 percent , data integrity 40 percent , and model 37 percent. More attention needed on conduct risk and risk culture.

    There has been increased focus on the steps that institutions can take to manage conduct risk and to create a risk culture that encourages employees to follow ethical practices and assume an appropriate level of risk, but more work appears to be needed in this area.

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    Increasing importance and cost of regulatory requirements. The most important impact of regulatory reform was noticing an increased cost of compliance , cited by 87 percent of respondents. Risk data and technology systems continue to pose challenges. Again in , the survey results indicated a need for continued improvement to risk data and information systems.

    Sixty-two percent of respondents said that risk information systems and technology infrastructure were extremely or very challenging, and 46 percent said the same about risk data. Issues related to data quality and information systems were also considered by many respondents to be extremely or very challenging in complying with Basel III 56 percent and Solvency II 77 percent , and in managing investment management risk 55 percent.

    Going forward, 48 percent of respondents were extremely or very concerned about the ability of the technology systems at their institution to be able to respond flexibly to ongoing regulatory change. Emerging markets, especially China, are also growing more slowly than in the past. The strength of the US dollar is having major but unpredictable impacts on many economies. By March , the US dollar had increased in value by 25 percent compared to a basket of commonly used international currencies since the US Federal Reserve announced in that it would phase out quantitative easing.

    Another important trend has been the dramatic fall in energy prices. Lower energy prices are expected to benefit many economies, but will have adverse effects on certain oil-producing countries, such as Russia, and on financial institutions with exposures to these countries or to companies in or dependent on the energy sector. The UK recovery has continued, with growth of 2. The outlook is darker in other regions. Although the Eurozone economies are no longer contracting, GDP grew by only 0.

    The economy in Japan was stagnant, with no growth in and growth of only 1. Emerging markets, especially China, are not growing at the blistering pace they once were, due to weaker demand from developed countries that has not been replaced by demand from their internal markets. Growth in the Chinese economy slowed to 7. The focus of regulators on such issues as capital adequacy, liquidity, operational risk, governance, and culture is driving change throughout the financial industry.

    The impacts have been widespread as new requirements continue to be proposed by regulators around the world, even as the final rules to implement existing laws are still being written. Complying with multiple, sometimes conflicting, regulatory requirements implemented by different regulatory authorities poses a significant challenge for global financial institutions.

    Regulators have extended the scope of CCAR to cover all the dimensions that could potentially impact capital adequacy.

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    These standards codify regulatory requirements on risk management topics including capital, debt-to-equity ratio, liquidity, counterparty limits, risk governance, stress testing, and early remediation. Many financial institutions will need to enhance their capabilities to meet these requirements. Some foreign banks are building up their US operations to comply, while others are evaluating which of their businesses should remain in the United States. There have also been significant changes in the European regulatory environment.