Optimal credit risk mitigation methodology

Uncollateralized exposures receive far less beneficiary regulatory treatment in comparison to collateralized ones, forcing banks to set aside much more capital for holding such exposures. Notwithstanding the need for collateral, as an important credit risk mitigation technique, we have recognized the significance of a frequently neglected possibility for lowering capital charges via efficient collateral management, without jeopardizing banks’ sound risk management practices or regulatory compliance. Using state of the art techniques for global constrained optimization of linear and nonlinear functions, we developed a methodology for optimal allocation of collateral to competing exposures in order to minimize capital requirement for credit risk via two mutually reinforcing channels – RWA and required reserve. The methodology was successfully implemented in several banks, leading to a decrease in RWA of as much as 5-10%.