New Developments in Credit Portfolio Management and Basel II: A New Paradigm: Underwrite Distribute Michel Crouhy

1. 1 The Credit Function is Changing: Over the last few years it has been fascinating to follow the mutation of the credit function in major banks. To give you some context: The portfolio of loans and other credit assets held by banks have become increasingly more concentrated in less credit worthy obligors. This situation has made banks more vulnerable in economic downturns such as 2001-2002 where banks experienced huge credit related losses in areas such as telecom, cable and energy. 2001-2002 saw defaults reaching levels not experienced since the early 1990s. In the one year period between the start of Q3 2002 and the end of Q2 2002, 10.7% of speculative grade issuers defaulted, the highest percentage of default since the Q2 1992, when the default rate reached 12.5%. Default volume in 2002 reached the unprecedented peak of $178 bn according to Moody’s compared with approximately $20 bn in 1990 and 1991. At the same time that default rates were high, recovery rates were also abnormally low producing large credit related losses in all major banks. But during this period of stress, the banking system has remained very resilient. No financial institution defaulted while the credit losses reached a level almost 10 times bigger than in 1991-92. Why?... Banks have been more proactive in the way they mange their credit exposure and spreading out their exposure across the financial system through the use of credit derivatives, syndicated loans and securitization. Controlling their credit risk exposure has been facilitated by the use of credit portfolio models which allows to assess concentration risk and measure the risk contribution of individual transactions to the risk of the overall protfolio.The Credit Function is Changing: Over the last few years it has been fascinating to follow the mutation of the credit function in major banks. To give you some context: The portfolio of loans and other credit assets held by banks have become increasingly more concentrated in less credit worthy obligors. This situation has made banks more vulnerable in economic downturns such as 2001-2002 where banks experienced huge credit related losses in areas such as telecom, cable and energy. 2001-2002 saw defaults reaching levels not experienced since the early 1990s. In the one year period between the start of Q3 2002 and the end of Q2 2002, 10.7% of speculative grade issuers defaulted, the highest percentage of default since the Q2 1992, when the default rate reached 12.5%. Default volume in 2002 reached the unprecedented peak of $178 bn according to Moody’s compared with approximately $20 bn in 1990 and 1991. At the same time that default rates were high, recovery rates were also abnormally low producing large credit related losses in all major banks. But during this period of stress, the banking system has remained very resilient. No financial institution defaulted while the credit losses reached a level almost 10 times bigger than in 1991-92. Why?... Banks have been more proactive in the way they mange their credit exposure and spreading out their exposure across the financial system through the use of credit derivatives, syndicated loans and securitization. Controlling their credit risk exposure has been facilitated by the use of credit portfolio models which allows to assess concentration risk and measure the risk contribution of individual transactions to the risk of the overall protfolio.

2. 2 Bank Loan Portfolios Banks originate and hold loan exposures that are a function of their geography and industry expertise. As a result, they hold concentrated credit risk. Credit portfolios have become increasingly more concentrated in less creditworthy obligors. This situation has made banks more vulnerable in economic downturns (2001-2002): Disintermediation of banks that started in the 70s continues today: IG firms are less likely to borrow from banks Regulatory rules induce banks to extend credit to lower-credit quality obligors. Two factors are contributing to credit risk concentration in financial institutions: geography and industry expertise. In Canada, for example, banks are more concentrated in natural resources industries such as lumber, mining and oil & gas. Two forces have combined to lead to low quality credit concentration: Disintermediation Regulatory rules Banks are trying to boost their return by lending to less credit worthy borrowers. The old “originate and hold” business model where bank loans reside where they are originated is not viable anymore. It is too capital intensive and produces too low adjusted return on economic capital. Two factors are contributing to credit risk concentration in financial institutions: geography and industry expertise. In Canada, for example, banks are more concentrated in natural resources industries such as lumber, mining and oil & gas. Two forces have combined to lead to low quality credit concentration: Disintermediation Regulatory rules Banks are trying to boost their return by lending to less credit worthy borrowers. The old “originate and hold” business model where bank loans reside where they are originated is not viable anymore. It is too capital intensive and produces too low adjusted return on economic capital.

3. 3 Banks find it more profitable to concentrate on origination, servicing loans and distribution for two reasons: Economies of scale in operations, The superior access they enjoy to corporations. On the one hand banks have developed a strong expertise in analyzing and structuring credits and have built solid relationships over the years with business clients through lending and other banking services. On the other hand, major banks have a solid distribution network that allows them to dispose financial assets to retail and institutional investors either directly or through structured products. In addition, banks have large complex back-offices that facilitate the servicing of loans. This is this expertise that banks are trying to leverage by moving away from the traditional “originate & hold” business model to the new “underwrite and distribute” business model. Banks find it more profitable to concentrate on origination, servicing loans and distribution for two reasons: Economies of scale in operations, The superior access they enjoy to corporations. On the one hand banks have developed a strong expertise in analyzing and structuring credits and have built solid relationships over the years with business clients through lending and other banking services. On the other hand, major banks have a solid distribution network that allows them to dispose financial assets to retail and institutional investors either directly or through structured products. In addition, banks have large complex back-offices that facilitate the servicing of loans. This is this expertise that banks are trying to leverage by moving away from the traditional “originate & hold” business model to the new “underwrite and distribute” business model.

4. 4 Changes in the Approach to Credit In the traditional model, the business owns and holds the credit assets until they mature or the borrower defaults. The business unit builds over time a credit portfolio that basically remains unmanaged. Exposure is measured in terms of notional value of the loan. Risk is at best characterized by External/internal rating mapped to a PD LGD + EAD EL = PDxEADxLGD Risk management is limited to a binary process at origination. Compensation is largely based on the volume of loans originated rather than pure economic rational. Pricing is grid based and depends on the rating of the facility not on of their risk contribution to the loan portfolio of the bank. In a portfolio-based approach, the economics of the loans is owned by the credit portfolio management group or by a partnership between the credit portfolio management group and the business unit. The residual loans, after origination and distribution, are transfer priced to the portfolio management group. The hold levels for non-investment grade loans that the banks originate is less than 10% Capital is now the key: Capital is allocated to each loan based on its risk contribution to the portfolio. At origination, the spread charged should produce a risk-adjusted return on capital greater than the hurdle rate for the bank.In the traditional model, the business owns and holds the credit assets until they mature or the borrower defaults. The business unit builds over time a credit portfolio that basically remains unmanaged. Exposure is measured in terms of notional value of the loan. Risk is at best characterized by External/internal rating mapped to a PD LGD + EAD EL = PDxEADxLGD Risk management is limited to a binary process at origination. Compensation is largely based on the volume of loans originated rather than pure economic rational. Pricing is grid based and depends on the rating of the facility not on of their risk contribution to the loan portfolio of the bank. In a portfolio-based approach, the economics of the loans is owned by the credit portfolio management group or by a partnership between the credit portfolio management group and the business unit. The residual loans, after origination and distribution, are transfer priced to the portfolio management group. The hold levels for non-investment grade loans that the banks originate is less than 10% Capital is now the key: Capital is allocated to each loan based on its risk contribution to the portfolio. At origination, the spread charged should produce a risk-adjusted return on capital greater than the hurdle rate for the bank.

5. 5 Originate to Sell Model

6. 6 Credit Portfolio Management The Credit Portfolio Group is a utility that manages the retained risks of derivatives and commercial loans.The Credit Portfolio Group is a utility that manages the retained risks of derivatives and commercial loans.

7. 7 Four Primary Portfolio Actions Distribute loans through primary syndication to desired hold level Reduce loan exposures by selling down, securitizing or hedging concentrated loan positions with credit default swaps Focus first on high risk obligors, particularly those that are leveraged in market value terms and experience high volatility of returns Simultaneously, sell or hedge low risk, low return loan assets

8. 8 Adopting Credit Asset Management Strategies Portfolio Strategies that focus on adding credit exposures are Emerging within banks in two ways: Credit Asset Management Designing cash and synthetic portfolios of credit risk purchased and managed on a leveraged and unlevered basis with access to all credit asset classes selecting best relative value investments with a long term investment horizon Credit Trading / Relative Value Acquiring and trading synthetic credit portfolios by selling protection on a leveraged basis with access primarily to investment grade credit default swaps selecting the best relative value trades with a short term trading horizon

9. 9 Credit Asset Management StrategiesInvesting In Credit (cont’d) These are the recent innovations that are shaping the credit risk management function in financial institutions.These are the recent innovations that are shaping the credit risk management function in financial institutions.

10. 10 Basel II Basel II and Active Portfolio Management require the same: Historical data to calibrate key inputs, i.e., PDs, LGDs, EADs. IT infrastructure. But, there are additional, though necessary, costs: Upgrading the rating systems: more granularity, two-tier rating system; Backtesting discipline: Keep the history of not only past ratings and LGDs, but also of all the relevant information to reconstitute them.

11. 11 Basel II Basel II is one step behind what is required for active credit portfolio management: Credit portfolio models (internal models): Which rating philosophy? Point-in-Time (PIT) vs. Through-the-Cycle (TTC) Capture portfolio effects Incorporate risk mitigation techniques and hedging strategies Provide opportunities for capital reduction through a better risk assessment Economic capital attribution: still, regulatory arbitrage opportunities will persist with Basel II Deal analyzer and pricing models

12. 12 Economic Capital EL: Expected Loss (average probability of default X loan amount at default) UL: Unexpected Loss (1 standard deviation in value) Capital: A loss amount determined by the probability of default of the lender