Credit Portfolio Management

1. Credit Portfolio Management Solvay Business School December 15, 2003

2. 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

3. I.Introduction

4. Introduction • A Bank’s 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 => there is a need to optimise the capital • In a word, Credit Portfolio Management’s 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

5. II.Driving forces for CPM

6. 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

7. Diversified … … Concentrated AAA ... … BB Sovereign Light Light Regulatory Regulatory Light Heavy Economic Economic Bank Heavy Heavy Regulatory Regulatory Light Heavy Economic Economic Corporate 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

8. 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

9. 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

10. III.The CPM function

11. 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’ OriginalPortfolio OriginalPortfolio Original Portfolio: Risk hedged / sold BalancedPortfolio New risk acquired With or without CPM Without CPM With CPM • 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

12. CPM’s 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

13. Expected loss (EL) Frequency Unexpected loss (UL) Economic capital σ EL Lα L99.95% Losses 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+ (S&P) - Aa3(Moody’s)) III. The CPM function

14. Economic Capital Unexpected Loss Expected Loss A. Manage Economic Capital Evolution of Losses Distribution of Losses Losses Time III. The CPM function

15. Initial Economic Capital New Economic Capital Expected Loss (EL) A. Manage Economic Capital • 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 Losses Time III. The CPM function

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

17. €20 million hedge brings exposure down to 80 New relationship deal brings it back to 100 € million 120 Max Limit 100 Company ABC - Final O/S Company ABC - Current O/S 80 Company ABC O/S After €20 million hedge 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

18. 1. Disinvestment 2. Re-investment • CPM reduces exposure to single names, industries or geographies to minimise the risk that any one event can have a significant impact on the Bank’s cash P&L • Note that these hedges do not damage the relationships since they remain silent • CPM acts to ensure that ING is not ‘placing all its eggs in one basket’, thus giving ING Bank revenues for less volatility in earnings • This involves re-investment of Capital released in CPM proprietary diversification transactions and in ING proprietary Investment portfolios OriginalPortfolio Original Portfolio: Risk hedged / sold 3. Support Business growth New risk acquired • Business strategy can dictate that ING should increase investment in an existing concentration • In such cases, CPM supports business growth by ensuring that the existing (valuable) concentrations do not exceed the limit for the name, asset class, industry or geography In practice 1 2 3 III. The CPM function

19. 1. Disinvestment 2. Re-investment • Single Name Hedges: Exposure to any one name is reduced via ‘Golden Rules’ at origination, limit management (IRCC) and in extremis via risk transfer by CPM • Securitisations: Exposure to illiquid names in industries and geographies is reduced via disinvestments e.g.: synthetic CDOs for wholesale concentrations • Re-investment opportunities: Identified and executed in areas where the risk does not overlap with exposures from its customer relationships (i.e. its existing concentrations). Instruments include single names CDS, CDOs... 3. Support Business growth • Single Name Hedges: Protection bought for single name concentrations (via GLCC intervention of in regular course of business) Instruments at our disposal Out of, and into CPM’s own Budget Out of Businesses’ Budget III. The CPM function

20. IV.Credit derivatives

21. + 60% per year Today’s fastest growing derivatives market +20.7% +23.5% Source: British Bankers’ Association (2002) IV. Credit Derivatives

22. Instruments Source: British Bankers’ Association (2002) IV. Credit Derivatives

23. 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

24. Credit Risk on underlying Periodic Fee ING Counterparty Zero No Credit Event Credit Event Contingent Payment Underlying Asset 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

25. Credit Risk on Underlying Periodic Fee ING Counterparty Zero No Credit Event Credit Event Contingent Payment Underlying Asset 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

26. 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

27. Delivery of the Obligation Buyer of Protection Seller of Protection Buyer of Protection Seller of Protection Loss Given Default Cash Transfer Remaining value of the Obligation Par Cash Value of Obligation 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

28. 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

29. True Sale of Assets Issuance of Notes or Bonds Coupon payments and remaining par value at maturity Super Senior Investor 90% Transfer of Assets SPV Holds all the assets of originating bank ING Risk Assets € 1 billion Senior Tranche AAA Tranche Investor 2% Portfolio of Credit risks (Bonds, Loans,…) AA Tranche Investor 1.5% Par value cash payment Payment of par value of assets Mezzanine Tranches A Tranche Investor 1% BBB Tranche Investor 0.5% 1st Loss Piece (Equity) 2.5% 1st Loss Piece retained by originator of the underlying Credits ING’s Balance Sheet Thecash securitisation IV. Credit Derivatives

30. Credit Default Swap Credit Default Swaps or Credit Linked Notes Super Senior Investor 90% Periodic Fee Periodic Fee SPV 97.5% ING Credit Risk Credit Risk € 1 billion Senior Tranche AAA Tranche Investor 2% Portfolio of Credit risks (Bonds, Loans,…) AA Tranche Investor 1.5% Contingent payment after lower tranche is eroded Contingent payment above 1st loss piece Mezzanine Tranches A Tranche Investor 1% BBB Tranche Investor 0.5% 1st Loss Piece (Equity) 2.5% 1st Loss Piece retained by originator of the underlying Credits ING’s Balance Sheet The synthetic securitisation IV. Credit Derivatives

31. 55 bps ING Counterparty Zero No Credit Event Credit Event Contingent Payment Renault SA €20 mln Examples of CPM transactionsDisinvestment - Single name hedge • Suppose that Renault SA represents a big concentration in ING’s 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

32. Examples of CPM transactionsDisinvestment - Synthetic securitisation Asset Backed Commercial Paper Credit Default Swap 2 Credit Default Swaps Conduit Assets Liabilities ING €1,5 bln Reference Portfolio of 100% weighted assets Reference Portfolio of 100% weighted assets 0% weighted assets ABCP ABCP Investors ABCP (A-1+/P-1) Super Senior Credit Default Swap (0% Risk Weighted) Invested ABCP proceeds SPV Assets Liabilities 0% weighted assets Notes Note Principaland Interest Bonds A1 Invested Notes proceeds Rated Notes A2 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

33. Premium of x bps p.a. ING sells protection on the Mezzanine Tranche Contingent payment in case of Credit Event, after first loss piece is fully breached 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

34. Appendix The Credit Derivatives Market Evolution

35. + 60% per year Today’s fastest growing derivatives market +20.7% +23.5% Source: British Bankers’ Association (2002) Appendix

36. Credit Derivatives Market Evolution Source: British Bankers’ Association (2002) Appendix

37. Credit Derivatives Market Evolution Risk Transfer Insurance Co’s Banks Source: British Bankers’ Association (2002) Appendix

38. Credit Derivatives Market Evolution Source: British Bankers’ Association (2002) Appendix

39. 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

40. 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

41. Less sovereign, more corporate Credit Derivatives Market Evolution Source: British Bankers’ Association (2002) Appendix

42. Quality of reference entities is deteriorating Credit Derivatives Market Evolution Source: British Bankers’ Association (2000) Appendix

43. Credit Portfolio Management Solvay Business School December 15, 2003