measuring and managing credit risk – trends and developments dave wright director moody’s kmv...

Measuring and Managing Credit Risk – Trends and Developments

Dave WrightDirectorMoody’s [email protected]

Agenda

1. The Trend Towards Superior credit performance

2. Why manage credit risk?

3. How to manage Credit Risk?

111 Introduction

MOODY’S KMV COMPANY. ALL RIGHTS RESERVED.4 COPYRIGHT © 2005

The Trend Towards Superior Credit Portfolio Performance: 4 Stages

- Reduce concentrations

- Improve returns on risk & capital

- Measure portfolio risk- Calculate & allocate economic capital- Optimize credit limits

Data & Infrastructure

Stage 1

ActivePortfolio

Management

Stage 4

CounterpartyRisk

Management

Stage 2

PortfolioRisk

Measurement

Stage 3

- Implement & validate internal rating models- Measure PDs, LGDs & EADs- Take early action for high-risk exposures

- Collect, organize & store customer data- Implement internal rating framework


The Trend Towards Superior Credit Portfolio Performance: 4 Stages

- Reduce concentrations

- Improve returns on risk & capital

- Measure portfolio risk- Calculate & allocate economic capital- Optimize credit limits

Data & Infrastructure

Stage 1

ActivePortfolio

Management

Stage 4

CounterpartyRisk

Management

Stage 2

PortfolioRisk

Measurement

Stage 3

- Implement & validate internal rating models- Measure PDs, LGDs & EADs- Take early action for high-risk exposures

- Collect, organize & store customer data- Implement internal rating framework


Credit Risky Assets

Treasury assets

Credit insurance

Receivables

Lending portfolios

Investment portfolio

Financial Institutions – reinsurance

222 Why mange credit risk?


Is credit risk management………

For some, managing credit risk is a defensive skill - trying to stop bad things happening, or reduce the impact of bad things.

However its not quite that simple………………..


and that is because…..….

The major concern in credit risk is seldom from large numbers of small – even risky – borrowers but from

excellent risks that collapse without much warning inadvertent concentrations of creditors that turn out to be highly correlated…

….of which more later


Investment Grade Rating Prior To Default 2002


Investment Grade Rating Prior To Default 2003-2006


What do we mean by managing the credit portfolio?Understanding the component parts of the portfolio and how they interact together

This then enables us to measure the risk in the portfolio – the commonly accepted way of doing this is through measuring Economic Capital.

Economic capital loss the Language if risk in the portfolio

Once we can measure Economic capital we can also measure risk and return of the credit assets – either at the institution, business line or individual asset level


Why manage the credit portfolio - Benefits

Reduces the potential for volatility in profits Better external communication

Better customer profitability analysis

Improve strategic planning – better more cohesive

Improved risk based performance measurement

Enables concentration management and industry exposure capacity creation Opens opportunities for new business lines / profit generating activity (e.g where no appetite currently exists)

333 How manage Credit Risk?


Counterparty Credit Risk Rating

Market data

Portfolio Mgmt.

Credit Review

Risk Rating Framework

Data Infrastructure

Qualitative

Quantitative

Other data

Ratings and Models Output Data Capture

• Data drives models• Data sources?

• Internal models• External models• Statistical• Expert• Ratings

• Enhanced risk• management

CONSISTENT PROCESS ACROSS THE ORGANISATION

Lending: Treasury: Investment

Reinsurance: Credit Insurance

Development of Sophisticated Credit Risk Models


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Baa

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Caa Ca C

AAA

AA

A

BBB

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CCC CC

08/99 01/00 07/00 01/01 07/01 01/02 07/02 01/03 07/03 01/04 07/04

FIBERMARK INC

1 Year EDF Moody's Rating S&P Rating

1-year EDF

Moody’s Rating

S&P’s Rating

Market Measures Have Proven to Provide Months of Early Warning

• Fibermark is based in Vermont, USA and has facilities in both USA and Europe. Fibermark produces specialty paper and nonwoven materials that are used, for example, in vacuum cleaner bags, insulating panels, and specialty tapes.

• After reporting a loss of $7.69 per share at the end of March 2004, the company filed for Chapter 11 protection.

• The company failed to recover from declining income margins that started in 2001 and was not able to take advantage of a July 2003 reorganization that lead to a reduction of its workforce by 9%.

• Fibermark is based in Vermont, USA and has facilities in both USA and Europe. Fibermark produces specialty paper and nonwoven materials that are used, for example, in vacuum cleaner bags, insulating panels, and specialty tapes.

• After reporting a loss of $7.69 per share at the end of March 2004, the company filed for Chapter 11 protection.

• The company failed to recover from declining income margins that started in 2001 and was not able to take advantage of a July 2003 reorganization that lead to a reduction of its workforce by 9%.

Source: Credit Monitor


Fibermark’s 10.750% 04/15/11

spread to Treasury

1-year EDF

Fibermark Inc. : EDF vs. Spread to Treasury

• Fibermark’s EDF anticipates the change in the cash market by 6-months

• Fibermark’s EDF anticipates the change in the cash market by 6-months

Source: CreditEdge


Differentiating Credit Models point-in-Time PDs from Traditional Ratings

Models of Credit Quality

Quantitative components

Quantitative Output

EDF = 0.02% (An actual probability of default)

Absolute (Cardinal)

Precise and continuous, providing full granularity (high resolution)

Specific time horizon

No credit cycle view

Dynamic, updated daily or monthly

Reflects issuer’s default probability (PD), and not issue-specific LGD

Traditional Ratings

Qualitative Method

Qualitative Output

AAA = “Obligor’s capacity to meet its financial commitment on the obligation is extremely strong.”

Relative (Ordinal)

Distinct risk buckets without specifying or targeting a specific default rate

No specific time horizon (“long term”)

Supposed to be through the cycle

Stable (low ratings volatility)

Opinion on Expected Loss – combines the effect of PD and LGD (Loss Given Default)b


What is Economic Capital?

The aggregate amount of equity capital required as a cushion for Unexpected Losses due to credit risks, given the institution’s target financial strength

Risk is measured objectively in terms of economic reality using modeling techniques

Provides a common yardstick to measure, evaluate, manage, and price a wide range of risks

Required economic capital has become the language of risk at leading Financial Institutions

An accurate, granular credit portfolio model is essential for making good credit origination, pricing, and portfolio decisions


Economic Capital Drivers

Portfolio Credit Risk

Amount Held

Correlation in Exposure Values

Exposure Credit Risk

Default and Asset Correlation

Default Probability

• Individual Exposure Risk Drivers are PD, LGD, EAD and Maturity• Portfolio Risk Drivers are Exposure Concentration and Size Exposure Correlation

•The degree to which a customer is sensitive to the business cycle and will change credit quality together with other customers•Key determinants - industry, geography and size•Small firms tend to have less systematic risk and more firm specific risk

LGD

Maturity

EaD

Country

Industry

Size


What is Credit Correlation?

Financial Institutions don’t fail from the occasional default, they fail when simultaneous defaults occur

Correlation is the degree to which a customer is sensitive to the business cycle

Key determinants of correlation include the industry, geography and size.

Greater correlation within a portfolio leads to higher economic capital requirements


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Com

pany

A

Company BBadYear

Great Year

Great Year

Correlation = 0.95


Importance of Concentration and Portfolio Credit Correlation

Ignoring single-name, country and industry concentration and specific measures of systematic risk will not produce the correct signals to manage the portfolio well

Regulatory capital does not measure the degree to which concentration and portfolio credit correlation affect portfolio credit risk and required economic capital

Portfolio credit correlation is not intuitive – there are too many moving parts that affect the measure

For example even in a simple case of hedging large or deteriorating credit exposures, without a portfolio model it is impossible to know the right amount of hedging


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1.60%

1.80%

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Year

Actu

al P

ort

folio

Loss

Tail Risk measures the likelihood of extreme losses

Expected Loss, Unexpected Loss, and Tail Risk

Expected Loss is the average loss

Portfolio 2

Portfolio 1

Unexpected Loss measures the variability around the Expected Loss

(one standard deviation)


Portfolio Loss Distribution

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0.20%

0.40%

0.60%

0.80%

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1.20%

1.40%

1.60%

1.80%

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Year

Act

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Rarely, the portfolio has very large losses

Most of the time, the portfolio has smaller than the Expected Loss

Sometimes, the portfolio has losses equivalent to the Expected Loss

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Pro

bab

ility

EL Loss


Portfolio Required Economic Capital

• The level of economic capital implies a probability of capital exhaustion and an associated debt rating

• Given the portfolio loss distribution and a target debt rating, the required economic capital may be inferred

AaaAaA

Economic Capital

Probability


Diversified away by the Portfolio

Risk Contribution(Risk retained in the Portfolio)

What is the right way of thinking about portfolio risk? How do we allocate risk?Portfolio Capital needs to be allocated to exposures to facilitate decision making.

How should we allocate Portfolio Capital?

A simulation-based portfolio model is the only way to measure Risk Contribution accurately

Total Stand-alone Risk

Unexpected Loss (UL)

• Systematic risk

- Undiversifiable


DEUTSCHE TELEKOM

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AA

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CCC CC

08/9708/9708/9708/9708/97 01/9808/9708/9708/9708/9708/97 07/9808/9708/9708/9708/9708/97 01/9908/9708/9708/9708/9708/97 07/9908/9708/9708/9708/9708/97 01/0008/9708/9708/9708/9708/97 07/0008/9708/9708/9708/9708/97 01/0108/9708/9708/9708/9708/97 07/0108/9708/9708/9708/9708/97 01/0208/9708/9708/9708/9708/97 07/02

Credit Monitor ®

EDF S&P

0

100

200

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400

500

Mar 00 Sep 00 Mar 01 Sep 01 Jul 02

Jul 02Mar 00 Sep 00 Mar 01 Sep 01

Impact on Portfolio Risk Contribution

bps


DEUTSCHE TELEKOM

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5 7 10

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AAA

AA

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BBB

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CCC CC

08/9708/9708/9708/9708/97 01/9808/9708/9708/9708/9708/97 07/9808/9708/9708/9708/9708/97 01/9908/9708/9708/9708/9708/97 07/9908/9708/9708/9708/9708/97 01/0008/9708/9708/9708/9708/97 07/0008/9708/9708/9708/9708/97 01/0108/9708/9708/9708/9708/97 07/0108/9708/9708/9708/9708/97 01/0208/9708/9708/9708/9708/97 07/02

Credit Monitor ®

EDF S&P

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1.00

3.00

5.00

7.00

9.00

11.00

13.00

15.00

17.00

Mar 00 Sep 00 Mar 01 Sep 01 Jul 02Jul 02Mar 00 Sep 00 Mar 01 Sep 01

02

Impact on Return/Risk Ratio


Mispricing: <= -0.002 Mispricing: -0.002 .. -0.001Mispricing: -0.001 .. 0.001Mispricing: 0.001 .. 0.020Mispricing: > 0.020

Mispricing (Monte Carlo) to Portfolio using Expected Spread & Risk Contribution

Risk Contribution

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0.02500

0.02000

0.01500

0.01000

0.00500

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-0.00500

-0.01000

-0.01500

-0.02000


Major Trend Toward Credit Portfolio Management

Actively managing the credit portfolio began among a few leading edge institutions in the late 1990s, mainly to: Reduce concentrations and unexpected losses Increase capital velocity Improve returns on risk and capital

Especially since 2003, there has been an acceleration in adoption and use of active credit portfolio management among other institutions

What convinced senior management at these institutions to pursue active credit portfolio management? Large credit losses in 2000 – 2002 Better liquidity in credit instruments, including CDS and CDOs Success stories among their leading-edge peers in reducing

concentrations and improving returns on risk and economic capital

Measuring and Managing Credit Risk – Trends and Developments

Dave WrightDirectorMoody’s [email protected]

measuring and managing credit risk – trends and developments dave wright director moody’s kmv...

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