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**Credit portfolio management
**

M

odern credit risk management techniques were initiated by the banking industry’s desire to avoid a repeat of its late ‘80s and early ‘90s default experience. The heavy credit losses during this period, driven by a poorly controlled rush to build market share at the expense of asset quality and portfolio diversification, threatened the solvency of even well capitalised institutions. The need to better understand portfolio credit risks was reinforced by the publication of the Bank for International Settlements’ (BIS) capital adequacy guidelines in 1988. These guidelines, whilst specifying minimum regulatory capital requirements, were inadequate to provide an accurate measure of the risk/reward characteristics of a credit portfolio. Banks therefore started to develop more sophisticated credit risk management techniques that recognised both the credit risk of individual exposures and the degree to which

By Thomas Garside, Henry Stott and Anthony Stevens

these risks were diversified. Banks leading the development of credit risk management techniques quickly discovered that credit pricing was highly inefficient. Typically pricing within a loan portfolio would be almost flat across the credit risk spectrum, generating huge skews in customer profitability. Initial efforts focused on mitigating these skews by calculating riskadjusted profitability (eg risk adjusted return on [risk-adjusted] capital) by sub-portfolio and then using these measures to create riskadjusted loan pricing tools. Leading

banks thus started to rationalise pricing in both loan and bond portfolios, and moving under-performing assets off their balance sheets. Consequently banks that had not developed risk-adjusted performance measures started to suffer from negative selection, often accepting significantly underpriced assets from more sophisticated institutions. In parallel to developing aggregate risk-adjusted performance measures, leading banks were also starting to quantify credit risk at finer levels of detail. Credit portfolio models were developed which could differentiate credit risk along multiple dimensions (credit grade, industry, country/region etc) and, for large corporate exposures, on a name-by-name basis. These credit portfolio models have positioned leading institutions to take advantage of the increasing liquidity of the credit markets and to adopt a far more active approach to credit portfolio management than was previously possible. Historically, credit portfolio management had focused on the monitoring of exposure by broad portfolio segment and, if necessary, the imposition of exposure caps. The creation of a stand-alone credit portfolio management function, armed with sophisticated portfolio models and with a controlling mandate over assets held on the balance sheet, now enabled the credit portfolio to be optimised independent of origination activity, (figure 1). Active credit portfolio optimisation has enormous poten-

**1. Optimisation of origination and portfolio management activities
**

Line of business

product and delivery optimisation

‘

Banks leading the development of credit risk management techniques discovered that credit pricing was highly inefficient’

Portfolio management

mark-to-market credit portfolio transfer of Pr (loss) assets

optimisation of syndication/ sales loss distribution

origination opportunities

sales/product teams

approval

loss

asset syndication/ disposals asset purchases asset swaps credit derivatives

ERisk.com

01

Definition of credit loss volatility credit losses credit losses effect on the book value of the obligation. and if it downgrades it is assumed to be worth less than par. The different credit risk profiles generated for the same portfolio using loss-based and NPV-based methods are shown later in this article (figure 8). Under this approach an exposure is assumed to be held to maturity. This seemingly simple statement conceals the complex string of calcula1 December 1999 2 correlation of borrower behaviour systematic risk: driven by correlation size of portfolio 02 . As discussed previously. Credit portfolio methodology I Measuring credit risk correlations. Using this approach credit migration has no 2. for example. For the vast majority of commercial bank exposures. two alternative approaches can be used when valuing the portfolio: G Loss-based method. Credit risk is conventionally defined using the concepts of expected loss (EL) and unexpected loss (UL) (figure 2). It is this volatility that credit portfolio models are designed to quantify. The value of the obligation can be calculated using either using market credit spreads (where applicable) or by marking-to-model using CAPM or similar method. G NPV-based method. Under this approach. Obviously credit losses are not constant across the economic cycle. I Credit risk measurement framework. Correlation describes the sensitivity of the portfolio to changes in underlying macro-economic factors (eg why it is more risky to lend to very cyclical industries such as property development). the embedded value of an exposure is assumed to be realisable. However. NPV-based methods are most applicable to bond portfolios and large corporate portfolios where meaningful markets exist for either the physical assets or credit derivatives.com tial to enhance profitability. When quantifying credit risk. where such markets do not exist a more meaningful risk profile is obtained using a loss-based method. to accurately model portfolio credit risk the correlation between exposures must first be measured. particularly for portfolios where securitisation is possible. Because expected losses can be anticipated. and thus worth the recovery value of any collateral.ERisk. many institutions are starting to run both methods in parallel. In all but the smallest credit portfolios. In general. Using only very basic optimisation techniques a typical institution might expect to reduce the economic capital consumed by its credit portfolio by 25%–30%. NPV-based methods are most applicable to bond portfolios and large corporate portfolios where meaningful markets exist for either the physical assets or credit derivatives’ 3. Volatility of portfolio losses is driven by two factors – concentration and correlation (figure 3). Concentration describes the ‘lumpiness’ of the credit portfolio (eg why it is more risky to lend £10m to 10 companies than to lend £0. EL time (years) frequency ‘ 1 diversification of credit risk In general.000 companies).1m to 1. Effects of concentration and correlation on credit risk credit risk concentration of portfolio specific risk: driven by concentration II. there being substantial volatility (unexpected loss) about the level of expected loss. correlation effects will dominate. The exposure is therefore either repaid at par or defaults. they should be regarded as a cost of doing business and not as a financial risk. is not required) and being simpler to compute. Loss-based calculations have the advantage of requiring less input data (margin and maturity information. If the obligation upgrades then it is assumed to be worth more than par.

Complexity arises as it is extremely difficult to calculate credit risk correlations directly. The Merton model has also been successfully adapted to describe credit risk correlations in financial institution portfolios that contain corporate exposures.9 0.18 0.15 -0. Asset correlations have the benefit of being more easily observable (from equity prices. Secondly. Firstly. In figure 5 the more correlated the movements in the two companies’ assets the greater the ‘twist’ in the joint asset value distribution.economic factor model average factor weight using factor models in the same way that an equity ‘beta’ is estimated.1 1. of enabling intuitive stress testing and scenario analysis of the credit portfolio. Joint probability density function for company asset values 0.00 -1.06 0. balance sheet analysis etc) and their correlations have been shown to be stable over time. as this would require repeated observations over a given time-period during which each company would either default or survive. and then transforms them into a default probability. with insufficient data on underlying credit risk rating. industry and geographic distribution of the portfolio. Clearly such analysis is impossible in practice.3 aggregate time series to infer credit risk correlation. The most widely used model for commercial lending portfolios being the Merton default model (figure 4). fall and ultimately default together. An example of a macro-economic factor model is shown in figure 6.9 3. Indeed.05 0 -0.20 0.10 0. The simplest solution is to use Probability % market value 2. Factor models usually produce better prospective correlation estimates than direct observation and have the additional benefit.5 3 3.04 0. The Merton model assumes that a firm will default if.12 0. aggregate time series are usually available only at a very high level.15 0.5 4 -0.14 0.20 0.5 1 1. This enables asset correlation to be transformed into credit risk correlation (figure 5). Unfortunately this approach is unsuitable except for the most basic of portfolio analysis for two main reasons. Similar difficulties exist when trying to estimate correlation between changes in credit rating or bond spreads.5 2 2.3 -0.5 -1 -0.10 0.20 -0. Illustrative macro. Not only could a credit portfolio manager potentially hedge credit risk via equity or ‘macro-economic’ derivatives.5 0 0. Hence the greater the probability that the credit quality of the two firms will rise.16 0.05 -0. but professional market-makers should ensure that credit. using aggregate time series produces unstable results over time. The ‘connection’ of credit risk to underlying macroeconomic risk factors has significant implications for credit risk management and the future development of credit markets. over a 12month period. A more attractive solution to calculating credit risk correlation is to use a causative default model that takes more observable financial quantities as inputs. if macro-economic factors are chosen.3 2.25 equity index exchange rate index interest rates unemployment property index 1 December 1999 03 .com 4. to measure default correlation (as required for loss-based measures) between two companies is impossible. Credit risk correlation could then be calculated from the number of times both companies defaulted simultaneously. volatility of asset values 1.08 0.02 0.5 0. The correlation of model inputs themselves are best measured 1 year time 5.9 asset value 2 1 defaults asset value 1 2 defaults 6. The Merton default model tions that are actually necessary. current market value of assets 3.5 -1.10 -0. equity and other derivative desks are positioned to take advantage of resulting arbitrage 0. the market value of assets falls below the value of 1 and 2 default 3.ERisk.7 2. callable liabilities expected default frequency probability distribution of future asset value callable liabilities.

These developments are likely to be a major driver of liquidity as these markets develop.98% loss-based 99. •factor weights %change in value. Portfolio model applications Having discussed the inner workings of credit portfolio models we can now illustrate their uses by examining a number of management applications. from which its credit risk profile can be calculated (figure 7). economic capital equivalent to 7. % change in NPV 2% 99.5% probability density change in value loss %change in value. I Simulation methods.com 7. Monte Carlo simulation is the standard method. There are a number of currently available credit portfolio models that are distinguished by their correlation structures and choice of risk measure. In figure 6 a positive factor weight indicates that a positive change in that factor produces an increase in asset value. This is calculated from the tails of the credit risk distribution by determining the probability that a reduction in portfolio value exceeds a critical value. the large number of calculations required mean that for most portfolios it is better to employ a numerical simulation technique.02% default probability). I Credit risk concentrations and portfolio optimisation.98% NPV-based -9% -8% -7% -6% -5% -4% -3% -2% -1% 0% % change in loss.ERisk. Assessment of economic capital requirement loss expected NPV NPV 1% expected loss 99.% losses A.% losses • • • change in value scenario N* DEquity =+15% DFX =+0. Wyman & Co approach (and other proprietary models) Disadvantages complexity in portfolio model calculations G Data availability G Additional of intuitive understanding of underlying factors G Applicability to non-quoted companies/retail segments G Ability of factor structure to describe correlation effects (especially for non-corporate exposures) G Loss-based calculation only G Lack of macro-economic insights G Performance drop-off when specifying multiple portfolio segments G Loss III.00% 1 December 1999 04 . Whilst the risk of small credit portfolios can be calculated analytically. Summary of credit portfolio models Risk measure Advantages G Intuitive understanding of G NPV-based underlying factors G Applicable to all portfolio segments Macro-economic factor models G Links to economic forecasting models and provisioning G Ease of stress testing/ scenario analysis KMV Portfolio Model G Loss-based G Simplified portfolio G NPV-based model calculations Orthogonal factor sets based on G Data availability for equity prices quotedcompanies JP Morgan CreditMetrics/ G NPV-based G Data availability CreditManager G Easy to understand factors Equity indices CSFP CreditRisk+ G Loss-based G Simplicity G Speed of calculation “Market risk” volatility approach – no factor structure G Loss-based Model/factor Oliver. I Solvency analysis.5% • • DUnemp=–0.00% 99. a negative factor weight indicates that a positive change in that factor produces a decrease in asset value. These models are summarised in table A. with a corresponding rise in credit quality and reduction in default rate. The most obvious application of a credit portfolio model is to calculate economic capital.% losses loss factor-to-factor correlations 10% 5% –5% 0% %change in value.8% of total exposure is required. I Summary of credit portfolio models. A lossbased example of such an analysis is shown in figure 8 where. with a corresponding fall in credit quality and increase in default rate. and can be thought of as a ‘state-of-the-world generator’ that generates all possible states of the economy and the resulting impact on the value of the credit portfolio. Breaking 8. to achieve a Aa1/AA+ credit rating (equivalent to a 0. In this way a distribution of all possible portfolio values is built up. Conversely. Monte Carlo simulation Monte Carlo simulation input datasets borrower/cluster details • exposure •collateral •margin •rating simulated portfolio loss and value distribution probability density scenario 1 DEquity = –20% DFX =+5% • • DUnemp=+2% scenario 2 scenario 3 • • portfolio response to scenario probability density change in value loss opportunities.

7% 1.90% 1. Credit risk concentrations 10. 1 December 1999 ‘ Banks must ensure that they understand the economic value of their portfolios and how this can be maximised through effective management’ 05 .98%) solvency standard Property Crash Scenario Probability that losses exceed 7. In order to benefit from these new opportunities. the possibility of active credit portfolio management will increase dramatically and result in a fundamental shift in the way banks both originate and hold credit assets. Conclusion This article has described the underlying theory of credit portfolio models and illustrated their value in making more effective management decisions.6bn concentration correlation specific risk 4% systematic risk £4. I Sensitivity analysis and stress testing.0bn 2% 0% existing portfolio diversified portfolio 11. An extension of this application is to use the models for ‘stress-testing’ to estimate possible changes in portfolio value conditional on extreme macro-economic scenarios. simple optimisation techniques will substantially reduce economic capital requirements – typically reductions of 30% are achievable equivalent to annual savings of £288m (assuming a capital charge of 18%) for a portfolio of £100bn (figure 10). For most credit portfolios.05%* down the aggregate credit risk distribution to show the credit risk of each portfolio element allows risk concentrations and hence diversification opportunities to be identified (figure 9). An example of portfolio behav- iour under stress-test scenarios is shown in figure 12. With the rapidly growing market in credit derivatives and portfolio securitisations.com 9. Stress testing credit portfolios Assessment of capital adequacy under property crash scenario Base Case: Economic capital AA+ (99. Portfolio models can be used to calculate expected loss rates under different economic scenarios and thus drive dynamic provisioning estimates or loan loss reserving methodologies such as the SBC ACRA reserve. Loan loss sensitivity 12. banks must ensure that they understand the economic value of their portfolios and how this value can be maximised through efficient credit portfolio management.7% of outstandings implied probability of scenario consistent with desired solvency standard * = 0. The sensitivity of portfolio credit losses to changes in the underlying macro-economic risk factors can also be examined to determine whether a hedging strategy might be possible (figure 11).ERisk. IV.90% 7. Potential diversification benefits in a typical bank portfolio economic capital (£bn) 6% exposure by counterparty 10m economic capital 50m economic capital Economic capital as % of exposure 70 60 50 40 30 20 10 0 0 100 200 300 400 500 600 Exposure (millions) 700 800 reduction in reduction in name £5.02% ∏1.

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