The Credit Risk Paradox

In this month's issue of Treasury & Risk Magazine, the dramatic increase in credit risk at financial and non-financial companies is examined.  As strategies to mitigate credit risk become more sophisticated, a paradox ensues.  Rather than lowering the amount of credit risk, the strategies can have the opposite effect because they provide a false sense of security.  Here is what the article concludes.

On a macroeconomic level, the dramatic rise in credit risk is partly a result of the very success of credit risk mitigation tools and strategies, argues Jerry Flum, CEO of CreditRiskMonitor in Valley Cottage, N.Y. “We’ve done a lot to promote stability and off-load risk, but the more risk companies transfer, the more they leverage up. When you hedge credit risk with derivatives, you feel confident in taking on more debt.”

The illusion of safety achieved by theoretically reducing risk has encouraged companies to take steps that increase the consequences of negative developments. “Because the foundation seems stable, you build a skyscraper,” Flum says. “It’s rewarding but catastrophic when it falls.” Whether and how the skyscraper will be rebuilt will be a big issue for treasuries of the future.

The big question is how many skyscrapers with weak foundations are looming out there?  Periodic credit stress tests can help provide a better view of the skyscraper and how their foundations can be strengthened.