Insolvency Practice and the Credit Process

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Insolvency Practice and the Credit Process
Philip D. Sherman Senior Adviser in Asia The Risk
Management Association November 2004
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Outline

• Banks must take risks . . . They need to have a
  process to manage the risks and the inevitable
  losses . . . and a capital cushion
• The insolvency community deals with the risk
  failures, whether of process problems or due to
  the environment or borrower or both
• Banks need to tap insolvency knowledge to improve
  their process and decision-making so that they
  can
• minimize exposure at the time of default
• recover as much as possible of that amount
• We can look at process and capital in terms of
  the modern credit risk equation
• 
  
• 
  . . . with focus on the last two terms

Expected Loss Probability of Default X Exposure
at Default X Loss
Given Default
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The Credit Equation Summarizes the Methodology
for Risk Measurement
Expected Loss (EL) Probability of Default
(PD/ PoD) X Exposure at Default (EAD) X Loss
Given Default (LGD) plus correction factors for
tenor and correlations.
EAD and LGD loom large in the arithmetic
Exposure at Default (EAD)
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LGD Is Particularly Important in Asia

• Problems of client information mean PD is hard to
  estimate . . .
• Collateral . . . which is a focus of LGD . . .
  Is a the center of the process
• LGD must therefore be managed very well

Collateral
Restructuring of Business Management
Refinancing
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Bank Credit Processes Lay Out the Drill for Credit

• The Basel Committee requires
• An Orderly, professional and imaginative process
• The measurement of risk and the use of
  measurement in all credit activities

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The Credit Equation Ties Closely to the Credit
Process

• Feedback
• Process
• Credit Specifics

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Capital Is Allocated Against Unexpected Losses
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The Credit Equation is Used to Determine Credit
Capital by Way of Risk Weights
Standardized Approach Mandates Capital in
Accordance with Rated or Unrelated Risks,
incorporating all equation elements
The Internal Ratings Based Approach (IRB)
produces a range of requirements based on
Expected Loss, with a mandated LGD (Foundation)
or a calculated LGD ( Advanced)
Mandated LGD assumption in Foundation Process
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Banks Build the Equation into Their Credit
Management System

• Some banks already used Expected Loss
• A much larger group uses Risk Ratings and some
  LGD assumption
• Facility Ratings are another way to manage LGD
  and potentially EAD
• Ratings translate into action guidelines in risk
  management

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Basel Sets Requirements for Collateral
Management. . .

• Legal enforceability
• Objective market value
• Frequent revaluation
• First claim
• Clear credit policy for collateral
• Appropriate liquidation analysis in
• credit approvals
• Distinct operational unit to manage
• collateral
• Adequate insurance
• Property monitoring, e.g., to
• ensure taxes paid
• Environmental liability risk
• management

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. . . and LGD Estimation

• Basel LGD Estimate Process
• Estimates have to be used for management
• Track record in using data for at least three
  years.
• Assessment of principal drivers supported by
  analysis
• Adequate time frame
• Historical experience/empirical evidence
• Adequate statistical base and analysis, with
  consistent
• application and with appropriate validation
  procedures
• External comparisons
• Stress testing
• Comprehensive view of loss
• Consistency of default definition
• Key characteristics of borrower/facility/product
• Country and industry factors
• Legal factors including insolvency regime
• Procedure for overrides of grades
• Collateral analysis

• Collateral Analysis
• Dependence between borrower and
• collateral value
• Currency mismatch
• Conservative valuation/estimation of
• workout period
• Conservatism!!!!
• Clear, consistent collateral policy
• keeping in mind creditworthiness of
• obligor
• Robust collateral management systems
• Concentration monitoring/action
• Policies on appropriateness of collateral,
• liquidation potential and revaluation
• procedures

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Basel Defines Default and Loss

• 
  Default
• Per paragraph 272 of the final Accord document, a
  default occurs when one or more
• of the following conditions obtain
• It is determined the obligor is unlikely to pay
  its debt obligations
• (principal, interest, fees) in full
• A credit loss even associated with any obligation
  of the obligor, such as
• charge-off, specific provision, interest or fees
• The obligor is more than 90 days past due on any
  credit obligation
• The obligor has filed for bankruptcy of similar
  protection from creditors

Loss This should include the discount effects,
funding costs and direct and indirect costs
association with collecting on the instrument in
the de termination of loss. Banks should not
simply measure the loss recorded in accounting
records, although they should be able to compare
the two (Basel Accord, Para 339).
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LGD Studies Are Thin and U. S. Orientated

• Shortage of data and focus on bond markets and
  syndicated loans
• Many definitions and calculation algorithms,
  particularly default and loss,
• are far from being agreed or implemented.
• Individual bank universes of defaults are much
  narrower
• Difference between studies of losses when all is
  said and done and losses
• as measured by security prices subsequent to
  default
• Both EAD and LGD are very reflective of the bank
  credit process/willpower
• In Asia, there are wide differences by country.

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S P Has Developed Loss Stats Date
General recovery data unsurprising, but 2003 a
bad year
Recovery heavily correlated to structural
financing factors
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Fitch Produces Similar General Results, but
Clarifies a Skewed Distribution
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Moodys Results Are Congruent but Lower

• Rating Agency LGD Models
• S P Loss Stats
• Moodys LossCalc
• Fitchs DART

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Other Studies

• Edward Altman of NYUs Stern School has delved
  into LGD and collateral management issues.
  papers.stern.nyu/ealtman/
• Altman and colleagues link recovery and default
  rates, which is currently not part of Basel
  thinking.
• A Bank of Italy group produced Italian Banks
  Workout Activity Costs, Timing and Recovery
  Rates, which was presented at third FAIR.
  Principal conclusions
• Private agreements were much more important in
  case settlement than bankruptcy
  proceedings/foreclosure
• Recovery timing ranged from 6-7 years for
  bankruptcy/composition proceedings to around two
  years for private agreements. Foreclosures take
  longer than proceedings based on pledged
  securities. Foreclosure takes longer in southern
  and central Italy (PDS note which have
  environments closer to Asia than the north) than
  in northern Italy.
• Annual recovery cost estimated at 1.2 of NPLs
• Average recovery by 1999 (it was not clear the
  period covered but obviously fairly long since
  the recovery periods were up to 264 months!) was
  37 with considerable dispersion amongst banks.
  (PDS Bank differences would seem to be a key
  element for further study)
• Short recovery periods led to higher recovery
  rates
• Consumer recoveries were better than enterprise
  recovering producer families were above the
  mean

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An RMA Paper Digs into Causes
Define LGD (Charge-off - charge-off recovery)
/ Outstanding balance at default a The beta
distributions center parameter and can be
derived from equations below ß The beta
distributions shape parameter and can be derived
from equations belowMin Minimum of all
casesMax Maximum of all cases a and ß are then
derived from the following equations
where µ, d2 are population mean and variance
respectively. 2. We then transform LGD from a
beta to a normal distribution suitable for use
in OLS regressions, using the definitions of a
and ß as calculated above.
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RMA Conducts Cooperative LGD Studies

• Data Model
• Facility and Customer Number
• Type of Company
• Syndication indicator
• Country
• Facility risk rating
• Obligor risk rating
• Authorized limit
• Amount outstanding at default
• Spread index and per cent
• Industry
• Collateral
• Collateral value and evaluation frequency
• Unfunded risk protection information
• Credit mitigation produce
• Facility type
• Seniority
• Facility purpose
• Credit event

• Loss Calculations
• There are very extensive breakdowns with in
• categories. Methodology to calculate actual
• economic losses is defined in some detail
• as well as is the event of default, which for
• purpose of this study includes
• Past due
• Unlikely to pay
• Non accrual
• Credit loss
• Facility sale
• Distressed restructuring
• Bank-filed bankruptcy
• Obligor-filed bankruptcy
• Unknown (which please minimize)

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Asia Begins to Implement Basel
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RoCs JCIC Pioneers Data Collection
Singapore banks work with S P, results not in
yet
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Specific Asian Issues in LGD Study

• Poor historical data it has been lost, was never
  created,
• is difficult to locate and extract
• Mergers mean data is either lost or
  non-comparable
• Data on paper, not digitized
• Definition difficulties (which however can be
  resolved up to a point)
• Problems in defining what needs to be measured
  some elements,
• e.g., management willpower are more measured
  in results which
• are still hard to compare

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Asias NPL Estimates Appear Too Low
Source S P Asia-Pacific Banking Outlook 2004
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Asian LGDs Vary A Lot by Country, but Are High
Relative to the U. S.
Source S P Asia-Pacific Banking Outlook 2004
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Many Factors Affect LGD Management

• External
• Economic Environment
• Legal Environment
• Financial Markets
• Banking
• Structure of Facilities
• Structure of Borrowers
• Structure of Lenders
• Documentation
• Collateral
• Management
• Monitoring
• Valuation Collateral Management
• Personnel and staffing
• Decision-making and Willpower

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An Informal Expert Panel Generally Confirms the
List
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Recommendations for Action in Asia

• Banks to be required to focus on LGD, data
  gathering
• Regulators to set LGD coefficients
• Regulators should use Basel definitions and
  standards
• Regulatory papers to deal with LGD in depth,
  collateral and recovery process
• FAIR to recommend a Basel Committee treatment of
  recovery
• Asian regulators to develop Asian treatment for
  collateral
• Regulators and banks to collaborate to improved
  legal environment
• FAIR to increase bank involvement in its
  activities

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Philip D. Sherman Senior Adviser in Asia The Risk
Management Association psherman_at_dc.com or
phil63772_at_hotmail.com Telephone
65-6836-1297 Mobile [phone]