CREDIT RISK MANAGEMENT

THE COMMODITISATION OF CREDIT RISK TRENDS IN CREDIT RISK MANAGEMENT

KEY PROPOSITION
‡ THE ADVENT OF ACTIVE AND LIQUID CREDIT TRADING WILL REQUIRE ± COMPLETE RE-ENGINEERING OF THE CREDIT FUNCTION & PROCESS ± ALTER THE NATURE OF BANKING FUNDAMENTALLY

AGENDA
‡ KEY DRIVERS OF CHANGE ‡ CREDIT RISK MANAGEMENT PARADIGMS ± CLASSICAL ± MODERN ‡ CREDIT RISK MANAGEMENT ARCHITECTURE ‡ IMPLICATIONS FOR FINANCIAL SERVICES

KEY DRIVERS OF CHANGE
‡ KEY FEATURE OF CREDIT RISK ± CENTRAL TO ALL FINANCIAL TRANSACTIONS ‡ TRADITIONAL VIEW OF CREDIT ± ILLIQUID ‡ CURRENT VIEW OF CREDIT ± LIQUID & TRADEABLE ‡ SHIFT FROM STATIC MANAGEMENT OF CREDIT TO DYNAMIC MANAGEMENT OF CREDIT RISK

KEY DRIVERS OF CHANGE
‡ SHAREHOLDER VALUE ISSUES ± RETURN ON CREDIT CAPITAL ± OPTIMISATION OF RETURN ON CREDIT CAPITAL ‡ CHANGES IN FINANCIAL SERVICES ± VALUE CHAIN IN FINANCIAL SERVICES ± TREND TO UNBUNDLING THE MICROSTRUCTURE

CAPITAL MANAGEMENT

RISK MANAGEMENT

PRODUCT/ KNOWLEDGE MANAGEMENT

TECHNOLOGY MANAGEMENT

RISK

PRODUCT MANUFACTURE

ORIGINATION/ DISTRIBUTION

PROCESSING/ ADMINISTRATION

PRODUCT FOCUS

CLIENT FOCUS

KEY DRIVERS OF CHANGE
‡ CREDIT RISK MANAGEMENT PERFORMANCE ± CONTROL FAILURES ± QUANTIFICATION OF CREDIT RISK ± INTERACTION OF MARKET AND CREDIT RISK ‡ CREDIT RISK PRICING ± INABILITY TO PRICE CREDITR ISK ³CORRECTLY´ ± INCONSISTENCY OF PRICING

KEY DRIVERS OF CHANGE
‡ COSTS OF CREDIT RISK MANAGEMENT INFRASTRUCTURE ‡ LIQUEFACTION OF CREDIT RISK ± SYNDICATION & ASSET SALES ± SECURITISATION ± CREDIT DERIVATIVES & CREDIT LINKED NOTES

KEY DRIVERS OF CHANGE
‡ DEVELOPMENTS IN CREDIT ENHANCEMENT TECHNIQUES ± BI-LATERAL ± MULTILATERAL ‡ ADVANCES IN CREDIT/ DEFAULT RISK THEORY ‡ INFRASTRUCTURE DEVELOPMENTS ± SYSTEMS CAPABILITIES

KEY DRIVERS OF CHANGE
‡ CHANGE IN REGULATORY FRAMEWORK ± SHIFT TO CAPITAL BASED REGULATION ± REGULATORY ARBITRAGE ± (POSSIBILITY) OF MODEL BASED CREDIT RISK CAPITAL

KEY DRIVERS OF CHANGE
‡ KEY NEAR TERM FACTORS ± CREDIT CAPITAL MANAGEMENT ± CREDIT PRICING ± CREDIT RISK MANAGEMENT ± REGULATORY DEVELOPMENTS ± SHIFTS IN BANKING STRATEGY

CREDIT RISK PARADIGMS
‡ TYPES ± CLASSICAL ± MODERN ‡ KEY ISSUE ± APPLICABILITY TO DIFFERENT MARKET SEGMENTS

CREDIT RISK BY MARKET SEGMENT
‡ SEGMENTS ± RETAIL ± MID-MARKET ± WHOLESALE/ CORPORATES ‡ DIMENSIONS ± RISK ± PRICING ± CREDIT METHODOLOGY ± LIQUIDITY AND TRADEABILITY

LARGE RETAIL

MID-MARKET

WHOLESALE

SMALL LOW HIGH

SIZE OF INDIVIDUAL EXPOSURE

CLASSICAL PARADIGM
‡ CONCEPT ± ASSESS RISK AND MATCH WITH CAPITAL ± RISK MANAGEMENT TECHNIQUES
‡ DIVERSIFICATION ‡ COLLATERAL

‡ SCHEMATIC

‡CAPITAL ‡PROVISIONING ‡RISK SYNDICATION CREDIT RISK MANAGEMENT

CREDIT REQUEST

TRANSACTION CREDIT FUNCTION ORIGINATION CLIENT

CREDIT LIMIT ‡CREDIT ASSESSMENT ‡MONITORING CREDIT LIMIT & CREDIT ADMINISTRATION ‡TRANSACTION ORIGINATION ‡PREPARATION OF CREDIT REQUEST ‡PRICING/ STRUCTURING ‡ADMINISTRATION

CLASSICAL PARADIGM
‡ KEY ELEMENTS ‡ CREDIT ANALYSIS AND ASSESSMENT PROCESS

IMPLICATIONS OF CLASSICAL PARADIGM
‡ ‡ ‡ ‡ ‡ ‡ ‡ CREDIT RISK ASSUMPTION CREDIT PRICING CREDIT CAPITAL MANAGEMENT CREDIT RISK FOCUS CHANGES IN CREDIT QUALITY PERFORMANCE ATTRIBUTION OF ORIGINATORS PERFORMANCE OF CREDIT FUNCTION

MODERN PARADIGM
‡ CONCEPT ± CREDIT RISK AS A SEPARATE TRADEABLE ASSET CLASS ± RISK MANAGED DYNAMICALLY THROUGH HEDGING AND TRADING TOOLS ‡ SCHEMATIC

TRANSACTION ‡TRANSACTION ORIGINATION ‡STRUCTURING/ PRICING ‡ADMINISTRATION ORIGINATION CLIENT

CREDIT REQUEST

CREDIT LIMIT & CREDIT CHARGE

CREDIT FUNCTION

‡CREDIT ASSESSMENT ‡CREDIT PORTFOLIO ANALYSIS ‡CREDIT CAPITAL MANAGEMENT CREDIT PORTFOLIO CREDIT TRADING CREDIT PORTFOLIO MANAGEMENT & POSITIONING

‡SYNDICATION/ ASSET SALES ‡SECURITISATION ‡CREDIT DERIVATIVES

CREDIT CAPITAL

CAPITAL MARKET

CREDIT RISK ASSUMED & MANAGED CREDIT CAPITAL TRANSACTION CREDIT RISK INTERNAL CREDIT DEFAULT SWAP CREDIT RISK TRANSACTION RETURN CREDIT RISK CHARGE ORIGINATOR CREDIT PORTFOLIO

CREDIT HEDGES CREDIT RISK TRADED & HEDGED

MODERN PARADIGM
‡ KEY ELEMENTS ‡ CREDIT ANALYSIS AND ASSESSMENT PROCESS

IMPLICATIONS OF MODERN PARADIGM
‡ ‡ ‡ ‡ ‡ ‡ ‡ CREDIT RISK ASSUMPTION CREDIT PRICING CREDIT CAPITAL MANAGEMENT CREDIT RISK FOCUS CHANGES IN CREDIT QUALITY PERFORMANCE ATTRIBUTION OF ORIGINATORS PERFORMANCE OF CREDIT FUNCTION

IMPLICATIONS OF MODERN PARADIGM
‡ CLIENT MANAGEMENT ± CORE VERSUS NON CORE CLIENTS ± HOME VERSUS FOREIGN MARKETS

CREDIT RISK MANAGEMENT ARCHITECTURE
‡ CONCEPT ± RISK MANAGEMENT SYSTEMS COMPONENTS ± INFORMATION SYSTEMS ‡ SCHEMATICS

CREDIT RISK MANAGEMENT ARCHITECTURE

CREDIT ANALYSIS

CREDIT PORTFOLIO MODELLING/ CREDIT PRICING

CREDIT TRADING

CREDIT CAPITAL MANAGEMENT ECONOMIC CAPITAL REGULATORY CAPITAL

CREDIT ENHANCEMENT

CREDIT ADMINISTRATION

CREDIT SYSTEMS/ IT INFRASTRUCTURE

‡CREDIT EXPOSURE - STATIC & DYNAMIC (PFCE MODEL) ‡DEFAULT PROBABILITY/ RATINGS MIGRATION ‡RECOVERY RATES ‡DEFAULT CORRELATIONS RATING MODELS ‡INTERNAL ‡EXTERNAL CREDIT ANALYSIS RISK DATA CREDIT MODELS ‡PORTFOLIO MODELS ‡PRICING MODELS

TRANSACTION DATA OBLIGOR/ COUNTERPARTY DATA CREDIT DATA ‡COLLATERAL CREDIT ENHANCEMENT ‡NETTING ‡CLEARING HOUSE

‡ECONOMIC CAPITAL ‡REGULATORY CAPITAL ‡PROVISIONING

CREDIT CAPITAL MANAGEMENT

LIMIT ADMINISTRATION REPORTING ‡SETTLEMENT LIMITS ‡RISK LIMITS

IMPLICATIONS FOR FINANCIAL SERVICES
‡ TYPES ± MICRO(OPERATIONAL)
‡ REDEFINITION OF CREDIT PROCESS WITHIN ORGANISATIONS

± MACRO(STRATEGIC)
‡ REDEFINITION OF BUSINESS FOCUS

OPERATIONAL CHANGES
‡ RE-ENGINEERING THE CREDIT PROCESS ‡ ALTERATION OF CREDIT RISK ARCHITECTURE/ INFRASTRUCTURE

STRATEGIC CHANGES
‡ THEME ± SHIFT FOCUS OF BANKS FROM HOLDER OF RISK TO ORIGINATORS AND DISTRIBUTORS OF RISK ‡ MODELS OF BANKING PRACTICE

MODEL 1 -

LASSI AL BANKING MODEL

LOAN TRANSACTION

DEPOSIT TRANSACTION

BORROWER

BANK

DEPOSITOR

BANK ORIGINATES, NDS, ADMINISTERS AND RETAINS CREDIT RISK OF BORROWER

MODEL 2 - INVESTMENT BANKING/ SECURITIES MODEL

ISSUE OF SECURITIES

DISTRIBUTION OF SECURITIES

BORROWER

BANK

INVESTOR

UNDERWRITING OF PLACEMENT OF SECURITIES AND SYNDICATION OF UNDERWRITING RISK

OTHER BANKS

BANK ORIGINATES TRANSACTION AND MAY ADMINISTER IT AS PAYMENT AGENT. FUNDING AND CREDIT RISK OF BORROWER IS TRANSFERRED TO INVESTOR. PRIMARY RISK IS UNDERWRITING WHICH IS SYNDICATED TO REDUCE RISK LEVEL,

MODEL 3 - SECURITISATION MODEL

LOAN TRANSACTION

SALE OF LOAN BACKED SECURITIES

BORROWER

BANK

SECURITISATION VEHICLE

INVESTOR

SALE OF LOAN TO SECURITISATION VEHICLE

BANK ORIGINATES AND ADMINISTERS THE LOAN. BANK SELLS LOAN TO SECURITISATION VEHICLE WHICH ISSUES LOAN ASSET BACKED SECURTIES. FUNDING AND CREDIT RISK OF BORROWER IS BORNE BY INVESTOR. BANK RISK IS CONFINED TO CREDIT RISK PRE-SALE TO SECURITISATION VEHICLE AND ANY UNDERWRITING RISK ON THE PLACEMENT OF THE LOAN ASSET BACKED SECURITIES

MODEL 4 - ECONOMIC RISK TRANSFER MODEL

LOAN TRANSACTION

CREDIT DEFAULT SWAP OR CREDIT LINKED NOTE

BORROWER

BANK

INVESTOR/ OTHER BANK

BANK ORIGINATES, FUNDS AND ADMINISTERS THE LOAN. CREDIT RISK OF BORROWER IS TRANSFERRED TO INVESTORS OR OTHER BANKS. BANK CREDIT RISK IS PRE ECONOMIC HEDGE ONLY. WHERE A CREDIT LINKED NOTE IS ISSUED THE INVESTOR/ OTHER BANK ALSO PROVIDES FUNDING.

KEY CHALLENGES
‡ ‡ ‡ ‡ ‡ CREDIT RISK MODELLING PROBLEMS DEVELOPMENT OF CREDIT TRADING CREDIT ENHANCEMENT PROBLEMS CHANGES IN CREDIT INFRASTRUCTURE CHANGE MANAGEMENT

CONCLUSIONS
‡ THE ADVENT OF ACTIVE AND LIQUID CREDIT TRADING WILL REQUIRE ± COMPLETE RE-ENGINEERING OF THE CREDIT FUNCTION & PROCESS ± ALTER THE NATURE OF BANKING FUNDAMENTALLY

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