Credit Portfolio Management

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Credit Portfolio Management

• Solvay Business School
• December 15, 2003

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Content
I. Introduction II. Driving forces for
developing Credit Portfolio Management
(CPM) III. The CPM function IV. Credit
derivatives - The most broadly used instruments
by CPM Appendix The Credit Derivatives Market
Evolution
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I. Introduction
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Introduction

• A Banks capital is used as a cushion to insure
  depositors against massive losses on the asset
  side that would hit not only the equity but also
  the depositors
• A minimum capital level is required to avoid bank
  runs where all the depositors ask to withdraw
  their money
• At the same time, shareholders would like to
  minimise the capital size in order to increase
  their return gt there is a need to optimise the
  capital
• In a word, Credit Portfolio Managements mission
  is to manage the risk capital in the credit
  (loans) portfolio while increasing the return,
  thereby improving the return/risk profile of the
  Bank

Assets
Liabilities
Cash and Government Bonds
Capital
Loans
Deposits
I. Introduction
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II. Driving forces for CPM
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External forces

• Credit downturn
• Recent precipitous declines in the Corporate
  world are a serious threat to commercial banks
  and uncertainty over future still reigns
• Advances in the measurement and management of
  credit risks
• Revolution in the science of credit risk
  measurement (widespread adoption of risk rating,
  expected loss, economic capital methodologies)
  and development of sophisticated credit portfolio
  models
• Increasing liquidity in the credit markets
• The take-off of credit derivatives has been
  creating new possibilities for risk
  transformation through innovative structures

II. Driving forces for CPM
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External forces

• Divergence of economic capital and regulatory
  capital
• In current BIS capital rules, risk weighting is
  still a function of the nature of the issuer and
  not a function of the credit quality of the
  issuer.
• This divergence between economic and regulatory
  capital creates real economic costs for
  commercial Banks and have an adverse impact on
  shareholder value and competitiveness as banks
• Avoid economic transactions that use regulatory
  capital inefficiently (A)
• Enter uneconomic transactions that use regulatory
  capital efficiently (B)

B
A
II. Driving forces for CPM
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Internal forces

• Creation of shareholder value
• Across the whole European banking industry, the
  return required by shareholders is increasing.
  ROE targets increasingly difficult to meet with a
   buy-and-hold  credit portfolio
• Need for active management of the credit
  portfolio
• Passively managed loan portfolios naturally
  deteriorate (a bank loan never trades above par
  value, unlike bonds)
• Dynamics of credit quality
• Wrong to believe that a rigorous credit approval
  process when a loan is first granted can hold
  good through the life of that loan credit
  quality is dynamic

II. Driving forces for CPM
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Effects

• Banks should be ready to act much quicker when
  the quality of a borrower starts to deteriorate
• Portfolio management tools such as selling,
  hedging or securitising should be used to reduce
  exposures before there is a significant fall in
  the secondary market price
• In recent years, many leading banks have
  appointed specialist portfolio managers to take
  responsibility for their loan books
• Empowerment of portfolio managers to enforce the
  discipline is the key success factor

II. Driving forces for CPM
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III. The CPM function
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With or without CPM
Without CPM
With CPM

• A Bank can only originate assets where it has
  client relationships
• Without management of the portfolio this leads to
  concentrations (either at a name, asset class,
  industry or geography level), leaving ING with
  all its eggs in one basket

• ING actively manages the portfolio, reducing risk
  in certain areas where it has (valuable) client
  business
• The risks ING takes are now less concentrated and
  as spread out as possible
• CPM achieves this through concrete steps
  described below, in line with its mandate

III. The CPM function
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CPMs objectives

• Manage credit risk economic capital
• Maintain economic capital constant across
  business cycles by managing volatility of losses
  and concentration
• Improve return/risk profile (Sharpe ratio, ROE,
  ) of the reference credit portfolio
• Support business growth (by releasing limits on
  key commercial relationships) transfer pricing
  involved

III. The CPM function
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A. Manage Economic Capital

• Economic Capital is a function of the Unexpected
  Loss (Standard Deviation of Losses) and of
  Retained Risk EC RR x UL x 7
• Economic Capital allows to cover the losses in
  99.95 of the cases, which is the minimum
  required to obtain a Aa Credit Rating for the
  Bank (currently A (SP) - Aa3(Moodys))

III. The CPM function
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A. Manage Economic Capital
Evolution of Losses
Distribution of Losses
Losses
Time
III. The CPM function
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A. Manage Economic Capital
Losses
Time

• The objective is to maintain economic capital
  constant across business cycles
• The key word is DIVERSIFICATION - diversification
  of the underlying portfolio reduces the
  volatility of the losses and, thereby, economic
  capital

III. The CPM function
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B. Improve Return/ Risk Profile
Return
Assets performing above average
Efficient Frontier
Assets performing below average
Risk

• The objective is to increase the return/risk
  profile of the credit portfolio
• This can be achieved by increasing the return or
  reducing the risk of underperforming assets

III. The CPM function
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C. Support Business growth

• The objective is to help the Business to grow
  even if limits on the best clients are fully
  used.
• This can be done via hedging excesses of limits
• The cost of hedging has to be compensated by
  returns on the loan and non-credit incomes
  (return on assets)

III. The CPM function
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In practice
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2
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III. The CPM function
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Instruments at our disposal
Out of, and into CPMs own Budget
Out of Businesses Budget
III. The CPM function
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IV. Credit derivatives
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Todays fastest growing derivatives market
20.7
23.5
Source British Bankers Association (2002)
IV. Credit Derivatives
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Instruments
Source British Bankers Association (2002)
IV. Credit Derivatives
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Instruments

• Various instruments are used by Credit Portfolio
  Managers, mainly in unfunded format
• The most commonly used are
• The Credit Default Swap (CDS)
• The synthetic securitisation (CDO and the like)

IV. Credit Derivatives
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The Credit Default Swap

• A Credit Default Swap synthetically transfers the
  credit risk of a reference asset between two
  counterparties
• The protection buyer (ING in this case) pays a
  fixed perdiodic fee (usually expressed in basis
  points per annum on the notional amount) to the
  counterparty
• The protection seller makes no payment unless
  some specified credit event relating to the
  reference entity (underlying asset) occurs during
  the life of the transaction, in which case the
  protection seller is obligated to make a payment
  via the settlement process

IV. Credit Derivatives
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The Credit Default Swap

• ING can also sell protection to a counterparty
  through a CDS
• ING receives the periodic fee payments
• In case of Credit Event, ING would have to pay
  the contingent payment through the settlement
  process
• Same as the previous situation but ING takes an
  opposite position

IV. Credit Derivatives
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The Credit Default Swap

• A Credit Event triggers the Credit Default Swap
  and leads to the settlement of the transaction
• Three Credit Events are currently the market
  standard
• Bankruptcy the Reference Entity has filed for
  protection under Chapter 11 or an equivalent
  bankruptcy legislation
• Failure to Pay the Reference Entity has failed
  to pay any interest or principal of one of its
  obligation (loan, bond,)
• Restructuring One or more obligations of the
  Reference Entity have been restructured (maturity
  extension, coupon reduction, change in ranking,)
  after a deterioration of its creditworthiness

IV. Credit Derivatives
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The Credit Default Swap
Cash Settlement
Physical Settlement

• The Physical Settlement is the most commonly used
• The Buyer of Protection delivers to the Seller an
  Obligation of the Reference Entity
• The Seller pays to the Buyer the par Value of the
  Obligation
• The Seller has then received an asset paid at
  100 with a value lower than 100

• The Cash Settlement is less commonly used by the
  market
• The Buyer of Protection calculates the remaining
  (market) price of an Obligation of the Reference
  Entity
• (100 - remaining price) is considered as the
  loss given default on the Reference Entity. It
  has to be paid by the Seller (taking into account
  the notional of the transaction) to the Buyer

IV. Credit Derivatives
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The securitisation

• What is a securitisation?
• Process of transferring risks associated with a
  pool of assets from one party to another
• Risks are capped at the level of first loss and
  other enhancements
• Risk can be tranched to meet investor appetite
• Risk can be physically transferred or
  synthetically transferred

IV. Credit Derivatives
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The cash securitisation
IV. Credit Derivatives
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The synthetic securitisation
IV. Credit Derivatives
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Examples of CPM transactionsDisinvestment -
Single name hedge

• Suppose that Renault SA represents a big
  concentration in INGs credit portfolio and,
  therefore, is a good candidate for disinvestment
• CPM buys protection on Renault SA for an amount
  of say, 20 mln, with a maturity of 3 years
• CPM pays 55 bps (0.55) per annum to its
  counterparty in exchange for the protection
• The risk on Renault SA (up to 20 mln) is
  effectively transferred to the counterparty
• In terms of risk, Renault SA has been disinvested
  (even though it remains on the Balance Sheet)

Credit Risk on Renault SA
IV. Credit Derivatives
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Examples of CPM transactionsDisinvestment -
Synthetic securitisation
Asset Backed Commercial Paper
Credit Default Swap
2 Credit Default Swaps
Conduit
Liabilities
Assets
Reference Portfolio of 100 weighted assets
ING 1,5 bln Reference Portfolio of 100
weighted assets
ABCP Investors
0 weighted assets
ABCP
ABCP (A-1/P-1)
Super Senior
Credit Default Swap (0 Risk Weighted)
Invested ABCP proceeds
SPV
Liabilities
Assets
0 weighted assets
Notes
Note Principaland Interest
Bonds A1
Invested Notes proceeds
A2
Rated Notes
Junior Credit Default Swap (0 Risk Weighted)
A3
A4
Collateral
Retained First Loss
Not rated
Deposit/Repo Arrangements
IV. Credit Derivatives
Long Term Credit Linked Notes
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Examples of CPM transactionsRe-investment -
Synthetic securitisation

• Synthetic CDO transactions are composed of 70/80
  underlying companies rated at least Baa2/BBB
• The usual average rating of the underlying
  companies is A2/A
• The Aa3/AA- rated Apple transactions represent a
  good way to re-invest into diversification while
  minimising Event Risk
• Recent Variations
• Index of Credits (900 names, industry hedging on
  ING concentrations, fixed recovery rate,)
• Management allowing for substitutions (subject to
  specific constraints)
• CDO made of tranches of underlying CDOs

Super Senior Tranche
Senior Tranche
AA/AA- implied rated Mezzanine Tranche
Equity
Pool of 70/80 companies originated by counterparty
IV. Credit Derivatives
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Appendix The Credit Derivatives Market Evolution
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Todays fastest growing derivatives market
20.7
23.5
Source British Bankers Association (2002)
Appendix
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Credit Derivatives Market Evolution
Source British Bankers Association (2002)
Appendix
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Credit Derivatives Market Evolution
Risk Transfer
Insurance Cos
Banks
Source British Bankers Association (2002)
Appendix
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Credit Derivatives Market Evolution
Source British Bankers Association (2002)
Appendix
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Credit Derivatives Market Evolution

• Growth has, again, surpassed expectations
• Obvious risk transfer from banks to insurance
  companies
• Portfolio transactions popularity has increased
• Reference entities nature has changed

Appendix
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Credit Derivatives Market Evolution

• Credit default swaps
• Market share has actually increased to 45 in
  2001
• 43 expected market share in 2004
• Portfolio transactions
• Not even included in the 1997/1998 Survey
• 22 market share in 2001
• 26 expected market share in 2004
• No other instrument accounts for more than 8 of
  the market in 2001

Appendix
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Credit Derivatives Market Evolution
Source British Bankers Association (2002)
Appendix
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Credit Derivatives Market Evolution
Source British Bankers Association (2000)
Appendix
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Credit Portfolio Management

• Solvay Business School
• December 15, 2003