Credit risk in reserves: anticipating issuer deterioration

Why a credit loss is harder to explain than a market loss and how to detect the signals in time.

Interview summary

Andrés Granados Ruiz explains why it is easier to present to a board losses from market movements than a marginal loss from a credit default: the former tend to be temporary, can reverse and, if the portfolio is held to maturity, the mark-to-market loss is not necessarily the real one. A default, on the other hand, means losing part of the capital. What matters, he says, is being able to explain the rationale of the decision, with criteria that make sense, with all areas of the investment process involved and with what was approved well documented.

He recommends governance, with approval levels and communication between risk and investments: separate areas but a close relationship, because the job of the risk manager is to accompany and contribute to profitability, not to slow things down. Although the deterioration of an issuer cannot be predicted, due diligence does reveal signals, as seen in cases such as Silicon Valley Bank or Credit Suisse, and it is preferable to accept the type one error, that is, to exit issuers that may not default. On rating agencies, he advises not relying on them alone: complement them with market metrics, which give earlier information, with one-year probabilities of default and with fundamental analysis of financial statements.

Topics covered

• Market losses versus credit default losses
• How to explain the investment decision to the board: criteria and documentation
• Governance: approvals and the relationship between risk and investments
• Signals of issuer deterioration and the cost of acting in time
• The limits of relying only on rating agencies
• Market metrics, probabilities of default and fundamental analysis