Insolvency Practice and the Credit Process

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

2. 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

3. 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)

4. 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

5. Credit Policy & Port-folio Management Portfolio Maintenance Portfolio Acquisition Credit Application Credit Approval Documentation & Disbursement Marketing Monitoring Workout Credit Organization and Culture 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

6. The Credit Equation Ties Closely to the Credit Process • Feedback • Process • Credit Specifics

7. Capital Is Allocated Against “Unexpected” Losses

8. 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

9. Low Facility Rating, e.g. High LGD Manage Risk, Monitor client, Collateral High EL - Avoid Manage Risk, Monitor client, collateral Low EL -– Manage returns High facility Rating, e.g. Low LGD High Risk Rating, i.e., Low PD Low Risk Rating, i.e. High PD 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:

10. 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

11. . . . 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

12. 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).

13. 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.

14. S & P Has Developed “Loss Stats” Date General recovery data unsurprising, but 2003 a bad year Recovery heavily correlated to structural financing factors

15. Fitch Produces Similar General Results, but Clarifies a Skewed Distribution

16. Moody’s Results Are Congruent but Lower Rating Agency LGD Models • S & P Loss Stats • Moody’s LossCalc • Fitch’s DART

17. Other Studies • Edward Altman of NYU’s 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 NPL’s • 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

18. An RMA Paper Digs into Causes Define: LGD = (Charge-off - charge-off recovery) / Outstanding balance at default α: The beta distribution’s center parameter and can be derived from equations below β: The beta distribution’s shape parameter and can be derived from equations belowMin: Minimum of all casesMax: Maximum of all cases α and β are then derived from the following equations: where μ, δ2 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 α and β as calculated above.

19. 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 • Cash flow information • Expense information • Resolution 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)

20. Asia Begins to Implement Basel

21. RoC’s JCIC Pioneers Data Collection Singapore banks work with S & P, results not in yet

22. 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

23. Asia’s NPL Estimates Appear Too Low Source: S & P Asia-Pacific Banking Outlook 2004

24. Asian LGD’s Vary A Lot by Country, but Are High Relative to the U. S. Source: S & P Asia-Pacific Banking Outlook 2004

25. 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

26. An Informal “Expert Panel” Generally Confirms the List

27. 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

28. Philip D. Sherman Senior Adviser in Asia The Risk Management Association psherman@dc.com or phil63772@hotmail.com Telephone: 65-6836-1297 Mobile: 65-9788-5001