Collateral Management Practice
Collateral Management Practice
Collateral Management Practice
Category: Capital
No: A-1 Date: January 2006
I. Introduction
This document outlines principles around Collateral Management Systems (CMS) for the purposes
of approving internal risk rating systems (rating systems) for the internal ratings-based (IRB)
methodology and minimum regulatory capital calculation under Chapters 4 and 5 of OSFI’s Capital
Adequacy Requirements (CAR) Guideline A-1. An institution’s1 adherence to the broad principles
outlined in this implementation note will be an important consideration in OSFI’s initial approval for
IRB and ongoing use of the IRB approach.
This document is used to set out OSFI expectations relative to the minimum standards for IRB with
respect to collateral management. It articulates principles for collateral management on the
understanding that risk-based assessments will underpin each institution’s approach to collateral
management. The document was written primarily with wholesale exposures in mind; changes in
emphasis or content may be needed for other exposure classes and their associated risk mitigants.
1
Banks and bank holding companies to which the Bank Act applies and federally regulated trust or loan companies
to which the Trust and Loan Companies Act applies are collectively referred to as “institutions”.
www.osfi-bsif.gc.ca
Table of Contents
I. Introduction......................................................................................................................... 1
1. Purpose........................................................................................................................ 3
2. Risk Management Policies and Documentation ......................................................... 4
3. Consistency of Collateral Definitions......................................................................... 4
4. Legal Certainty and Timeliness .................................................................................. 4
5. Comprehensive Assessment of Risks ......................................................................... 5
6. Valuations, Inspections and Verifications .................................................................. 5
7. Operational Requirements .......................................................................................... 5
8. Internal Reporting and Analysis ................................................................................. 6
9. Disclosure ................................................................................................................... 6
Sound management and effective control of the techniques and collateral used for credit risk
mitigation is a fundamental component of effective risk management. Institutions will use
various systems and processes to manage collateral and will need to demonstrate that they have
established effective collateral management policies, procedures and methodologies for the
purposes of IRB approval and ongoing use of the IRB approach. In particular, institutions will
need to demonstrate that the policies and procedures are appropriate for the level of capital relief
they receive from the risk mitigation techniques employed.
III. Principles
Institutions use different techniques to mitigate credit risk. However, all institutions need to
establish collateral management systems and operational procedures and processes throughout
the organization that observe principles of purpose, documentation, consistency, legal certainty
and timeliness, risk identification, valuation, inspection, verification, operations, and reporting.
The principles governing the collateral management policies and practices should be interpreted
and applied consistently throughout the organization, but the implementation processes can vary
within and among institutions. OSFI’s supervisory processes to approve and monitor the
ongoing use of the IRB method for the calculation of regulatory capital under CAR will include
a review of adherence to the principles outlined below.
The term collateral management systems (CMS) refers to all the systems, methods, processes,
controls, data collection and IT systems that are used in the taking, management, valuation,
maintenance and realization of collateral held for credit risk mitigation purposes.
1. Purpose
In order for collateral to be recognised for regulatory capital purposes, institutions must meet all
of the requirements with respect to IRB minimum standards and other qualifying criteria outlined
in CAR and demonstrate adherence to the under-noted CMS principles. At a minimum,
individual institutions will adopt practices appropriate to their circumstances, risk profiles and
their risk assessment and business strategies.
Institutions should establish and maintain fully documented practices and procedures
surrounding the scope, purpose, and use of the CMS, such that they can be readily understood by
and be available to users and parties reviewing the material.
Appropriate documentation will help ensure that users understand the objectives of the system
and how well these objectives are met, thereby reducing the possibility that the system will be
used inconsistently.
Institutions will need to ensure consistency of definitions used throughout the organization for
all collateral types to ensure that data systems capture consistent recovery rates for validation of
internal loss estimates.
Institutions’ collateral management systems should ensure that all necessary steps have been
taken to fulfill legal requirements to secure an institution’s interest in the collateral, so that it
has and maintains an enforceable security interest.
All documentation used in collateralizing a transaction should be binding on all parties and
legally enforceable in all relevant jurisdictions. Institutions should have conducted sufficient
legal review to verify this conclusion, should have a well-founded legal basis for this conclusion,
and should re-conduct such a review, as necessary, to ensure continuing legal enforceability. For
example, such a review may include an institution’s current practices, including reviews of
standardized forms. An institution’s documentation and policies should ensure that it has the
right to legally take control, liquidate or otherwise deal with the collateral in a timely fashion.
Institutions will need to have policies and procedures to manage relevant and material risks that
may arise from the use of collateral to mitigate credit risk.
Institutions should have clear definitions of the types of risks that arise in respect of collateral
management and the associated processes and procedures used to manage these risks.
Institutions’ policies should explicitly define how and when to value, re-value, inspect, and verify
collateral.
Collateral valuation estimates should be conservative to allow for the imprecision inherent in
most collateral value estimates, particularly where there is no readily available market value.
Different asset types, collateral types and borrowers’ risk profiles may require different
processes and procedures for valuation, frequency of evaluation (and re-evaluation), and
inspection and verification. Institutions’ policies should explicitly document and define the
requirements for each process and the rationale for the approach adopted. Mark-to-market
policies and procedures for financial collateral must be explicit and incorporate suitable control
mechanisms.
Certain collateral types may require periodic verification and/or physical examination.
Consequently, institutions should establish policies and procedures around these activities and
track the application of these requirements to ensure consistency of application and control.
Institutions should document appropriate early warning indicators for various collateral types,
where they find such indicators appropriate and provide the action requirements to be followed
as a result of material changes to collateral value. Institutions should document their processes
around the design and review of what they consider appropriate early warning indicators for
various collateral types. In addition, institutions should document the associated action
requirements that should be followed as a result of material changes to these early warning
signals.
7. Operational Requirements
Institutions should examine all relevant and material data to ensure a complete collateral data
set for the purposes of assessing the risk-mitigation benefits of collateral and developing internal
loss estimates.
The examination of relevant and material data should include a review of a variety of data such
as the collateral type, the loan to value parameters, the historical collateral values by obligor, the
valuation and revaluation criteria, the collection costs tied to loans, the physical location of
collateral (where applicable), and the associated recovery rates.
Institutions will need to ensure that the internal reporting and analysis capability of the CMS
supports key risk identification and mitigation and can therefore be used to inform risk
management.
In addition to analysis of loss and recovery experience, the system must include internal
reporting and analysis capabilities in order to provide ongoing support to the risk management
process (see Appendix I.9).
9. Disclosure
Institutions will need to comply with all the disclosure requirements under Part 4: The Third
Pillar – Market Discipline – of the new Basel framework as they relate to credit risk mitigation,
including general credit risk exposures, disclosures specific to portfolios subject to IRB
approaches, and credit risk mitigation-specific disclosures.
The Third Pillar of the new Basel framework sets out the disclosure requirements for IRB
institutions in respect of the credit risk mitigation techniques they employ. Institutions should
therefore ensure their CMS support such disclosure requirements.
There are numerous policies and procedures that institutions will likely be required to undertake
to ensure their CMS are appropriate. Institutions should perform activities that are appropriate
for their credit risk portfolios and support the credit risk mitigation techniques employed.
Risk management policies should be comprehensive and clear as they relate to collateral
management. Collateral management principles should be established for an institution,
including any principles that are specific to business units. Policies and procedures should be
reflected in the collateral management processes and systems that have been (or will be)
implemented. The impact of compliance and non-compliance with these principles should be
well understood by those responsible for implementing, maintaining and monitoring the system.
An institution’s policies should be consistent across the institution for collateral definitions and
data collection. Institutions’ policies should give clear direction as to what constitutes relevant
and material risks as they relate to collateral for credit risk mitigation. CMS should be
sufficiently robust to assess relevant and material risks on an ongoing basis.
While it is recognized that business units within an institution will have different types of
collateral classes that are prevalent and used for credit risk mitigation purposes, the definitions of
these collateral classes need to be consistent across the enterprise. Definitions need to provide
sufficient clarity to avoid interpretive differences that might arise from different practices and
treatments across different business units within an institution.
Policies and procedures should address what constitutes material changes to collateral risks and
what, if any, additional procedures are to be followed and actions taken as a result of these
changes.
Data collection has to be sufficient for estimating PD or LGD and calculating capital under
CAR. Institutions’ policies should clearly define how collateral values would be captured and
used for purposes of collateral management, and exceptions to an established treatment should
be tracked to provide evidence of the validity and impact of such exceptions.
3. Documentation of CMS
Financial institutions should establish and maintain fully documented policies and procedures
surrounding the scope, purpose and use of CMS, such that they can be readily understood by
and be available to users across the institution.
Institutions should have established procedures and practices that explicitly define how to value
each collateral type and establish clear practices for the frequency of re-valuations, and should
explicitly define how and when to inspect each collateral type.
Institutions should have systems in place for requesting and ensuring prompt receipt of
additional collateral for transactions whose terms require maintenance of collateral values at
specified thresholds.
Requirements for inspection for the same collateral type may differ across business lines.
Policies should delineate these differences, which should be reasonable and based on sound
principles.
Institutions’ collateral policies should clearly articulate and define permissible prior charges or
liens on the specific collateral. There should be processes in place to ensure that only such
permissible prior charges or liens exist for security taken.
Institutions should have CMS that ensure all steps necessary have been taken to fulfil legal
requirements to secure the organization’s interest in the collateral.
Institutions should have operational procedures and risk management processes in place that
ensure relevant and material documentation used in collateralizing a transaction is binding on all
parties and legally enforceable in all relevant jurisdictions. Institutions should have conducted
sufficient legal reviews to verify this conclusion, should have well-founded legal bases for the
conclusion, and should re-conduct such reviews as necessary to ensure continuing enforceability.
The legal mechanism under which the collateral is pledged or transferred must ensure that
institutions have the right to liquidate or take legal possession (in accordance with the terms of
the documentation and the requirements of the jurisdiction) of the collateral in a timely manner
in the event of the default, insolvency, or bankruptcy (or other defined credit event) of the
obligor and, where applicable, the custodian holding the collateral. The ability to act in a timely
Institutions’ policies and procedures should define responsibility for obtaining, monitoring and
maintaining enforceable security interests.
Institutions should have clear and robust procedures for the timely liquidation of collateral to
ensure observation of any legal conditions required for declaring the default of the borrower and
prompt liquidation of the collateral in the event of default.
CMS should be sufficiently robust to track collateral liquidation dates, proceeds from disposition
of collateral, where appropriate, and costs incurred and paid.
Institutions’ collateral valuation practices should take into account the interdependence (or not)
of borrower and collateral.
Risk management policies at each institution will define what constitutes interdependencies
between borrower and collateral. In particular, institutions should address, in a conservative
manner, cases where the credit quality of the counterparty and the value of the collateral have a
material positive correlation.
In reflecting collateral loss estimates, institutions will need to consider the extent of any
interdependence between the risk of the borrower and that of the collateral or collateral provider.
An institution’s assessment would have to conservatively address any significant degree of
dependence, as well as any currency mismatch between the underlying obligation and the
collateral. The associated internal estimates (e.g., LGDs) would have to be grounded in
historical recovery rates on the collateral and should not be based solely upon the collateral’s
estimated market value. Use of third party data, where relevant and material, could be used to
supplement internal data.
Institutions should be able to demonstrate that the capital benefit claims are appropriate
considering the robustness of credit risk mitigation policies.
Institutions should test their collateral management policies and procedures to ensure that
systems are robust and reliable and appropriate for capital benefits of credit risk mitigants.
Internal reporting and analysis will likely need to consider many areas. Some illustrative
examples of those areas include:
Institutions should develop measures appropriate to their respective CMS in respect of internal
reporting and analysis. These measures need not include all of the above examples in every
instance.