Freeing capital: swaps versus CLOs
The collapse of Japan's tenth largest bank is a timely reminder that credit risk is the largest and most pervasive of all those which financial institutions face but the least rationally priced and least scientifically managed. New approaches to credit-risk modelling, applying modern mathematical, computational and database techniques, could revolutionize the way banks allocate economic capital and make provisions and could also create a new discipline of credit portfolio management.
Banks need to aggregate their credit exposures into portfolios, work out the possible losses then allocate capital to cover them. The large commercial banks, particularly Bank of America, Citibank and SBC Warburg Dillon Read, have spent heavily to develop proprietary systems. Two have gone public: JP Morgan has published its CreditMetrics data model, and its Credit Manager software is available for about $25,000 a year; Credit Suisse Financial Products has released CreditRisk+, which is free and can be downloaded from the Internet.
These are not pricing models though their results usually will modify banks' demands for particular types of risk and so affect their price at that institution.