Credit Portfolio Management A practioners’ view Bruno De Cleen Essex, March 19 2008

1. Credit Portfolio ManagementA practioners’ view Bruno De Cleen Essex, March 19 2008

2. Introduction • The purpose of this material is to give some input for a discussion about capital and portfolio management, a domain where theory and practice meet. • The dominant perspective is that of a M, L, XL commercial bank in continental Europe • I would like to demonstrate that things get already complicated before the mathematics become difficult. Therefore I invite you to put one step back. • I have deliberately left out all the more technical and mathematical aspects. • As this is rather a high level overview, things have been considerably simplified and therefore may lack accuracy. • The opinions expressed in this document are solely the author’s and do not necessarily reflect those of my current or previous employers. • Any graphs or tables shown are based on mock data and are for illustrative purposes only.

3. A Commercial Bank (extended) Executive Board • Audit • Finance/Risk • Retail • Private Banking • SME • Publc Sector • Asset Management • RealEstate • Insurance • IT • HR • Operations • Corporate • SpecialisedFinance • CorporateFinance • Private Equity • Financial Markets

4. The simplified balance sheet Bank B/S • ALM Risk • Liquidity Risk • Credit Risk • Market Risk Property Equity • Tier 2 (retained earnings) • Tier 2 (Subordinated Debt) Loans Deposits • Without term • Term • SolvencyRequrirements • Basel 1 – Basel 2 • Target Capital • Rating AgenciesCapital Financial Sector Funding OffBalance Receivable Liability

5. All flavours and formats of Credit Risk Funded Bullet Leverage • Loans • Overdraft facilities • Tranches • Investment • Hedging Unfunded Amortising • CDS • Guarantees • Wide variety of risks • Rental guarantee • Bidbond, • Performance bond etc. Revolving Legal • Format • Jurisdiction • Confirmed vs not confirmed • Immediately cancellable Counterparty risk for Derivatives

6. Very different types of exposures

7. Geographical Concentration as a rule

8. Risk/Solvency Measures Economic Capital VAR (1-x bps) Expected Loss • VAR has some conceptual shortcomings which however in practice don’t cause too much problems • Calculation in the tail is difficult • Small changes in parameters can have large impact Unexpected Loss EconomicCapital Basel 2 • The main perceived shortcomings as to solvency for credit risk are: • Imposed correlations • Structured products • Assumed single name concentration adjustment • Unclear “mild crisis’ calibration • Various imposed caps and floors Transition Regime: • Floor of 90/80% of old Basel 1 regime • Basel 1 regime for credits was fairly arbitrary (100, 50, 20 % weightings) • Basel 2 (pillar 1), Internal Ratings based Approach, calculates solvency requirements in an “economic capital’ way.

9. Risk Tolerance and relevant risk measures Insolvency • Different stakeholders have different focus and different risk tolerance • The same amount of loss can have different impact depending on the fact whether the loss has been realised inside or outside the core business or the strategic business plan communicated to the market • Ex ante loss tolerance tends to be bigger than ex-post loss tolerance • Human beings tend to be bad at handling probabilistic choices. They prefer real dollars to wooden dollars. They tend to have a linear approach. • Rating agencies capital) • Economic Capital Regulator Deposit Holders Going Concern Failure • Solvency insufficiency B1,B2 • Downgrading • Event or series of events hitting the ” the front page’’ • Inquiry by Stakeholders Management Shareholders P&L Volatility

10. Return Calculations Traditional Raroc EconomicProfit + Income • Cost - Losses and provisions + Capital Benefit • Taxation • ------------------------ Risk Adjusted Net Profit / Capital or Assets => percentage + Income • Cost - Expected Loss + Capital Benefit • Taxation ------------------------ Risk Adjusted Net Profit / Economic capital =>Raroc percentage Risk Adjusted Net Profit • Economic capital * Cost of Captital --------------------------- =>Economc Profit amount • Return on Assets • Return on Equity • Return on Capital • Return on Required Equity • B! And B2 • In practice many hybrid concepts are used • Different measures are used simultaneously • Even if called the same, calculations can be very different

11. The Spectrum of Credit Portfolio Approaches Limit Management Economic/ RegulatoryCapital Management Profit Centre/ ‘Credit Treasury’ • Name level notional limit management based on rating grade/ industry • Limits set by board level credit committees • CDS used to hedge excess exposure • Name level notional limit management supplemented by economic capital limits • RAROC based objectives • Hedge names or sectors that breach limits using CDS, indices or baskets/ nth to default • Economic/ regulatory capital driven securitisations • Centralised view of credit risk • RAROC based objectives but recently overlaid by a mark to market view due to IFRS/ fair value acc. • Migrate to the ‘optimal’ portfolio • Overlay macro views on credit, CPPI structures • Credit portfolio models that aggregate and dis-aggregate risk to individual issuers/ sectors • Ability to evaluate the impact of single name and basket hedges • Ability to evaluate the impact of hedging using tranches, proxy-hedges, CPPI • Ability to evaluate the MtoM volatility of the hedge book • Exposure management systems • Credit rating tools • LGD tools MtoM/Total Return view Default view

12. The Building Blocks of Credit Risk Modelling Dependency • Default correlations almost not directly observable • Independency building blocks • If not foreseen by construction, a positive definite matrix is often already quite a performance • What about dependency if things get really sour • Looking for the perfect copula PD Probability of default EaD Exposure at Default LGD Loss Given Default • Limited number of observed defaults for some populations • Lack of consistency • Default definitions • Legacy systems • Calibration issues • Consistency in calibration over different populations • Limited number of years of history • Group effects • Randomness • Amortising loans versus growing portfolios • Revolving exposures • Counterparty risk in derivative transactions • Limited to extremely limited number of observations • Often bimodal distributions • Lose a lot • Lose almost nothing • All types of

13. PD Modelling Rank Ordering • Limited to extremely limited number of observations • A patchwork of different populations • Very different techniques used • Qualitative vs quantitative or expert based • Producing • PDs • Ratings mapped to PDs • Rank ordering is most of the time fairly all right • Estimates from models and experts tend rather to converge Calibration • Randomness is quite an obstacle • A small change on the side of the highest PD’s implies a massive change of the distribution • Events perceived as default triggers can vary over different popoulations • 90 days pas due in consumer finance • 1 day past due on an interest payment in the bond market • Grace period in shipping • ... • Harmonisation across the portfolio is very hard Portfolio Patchwork

14. Dependency structures: (Proxy)n Portfolio Reference Population Geography Geography • Dependency data mainly available for US corporate or for listed corporate. • The Bank’s portfolio is mainly is European, non listed, with lots of retail • Data are bucketed along a few dimensions => does not fit the required dimensions Segment Segment • Information derived not from defaults but from equity or asset values Asset Values+Equity Values

15. When looking at default statistics, drawing conclusions is often less straight forward than one would have hoped • Randomness • Inconsistency in methodology used • Correlation impact

16. LGD Modelling • “Technical’ defaults returning to the healthy portfolio • Often a re-start can be envisagead; • Liquidity/capital injection • Carving out the unhealthy part of the business, • Bank loans often with good collateral as compared to bonds • Independency with PD often questionable e.g. Asset based finance OftenBimodal

17. Credit risk may be fairly complex to assess Group Structures Geography Company A • GreekOwner • LiberianFlag • Sailing all over the globe • The Mainclient is a Russian Company • A Collecting Account in the US • Insurance in the UK Company B Company C Company D SPE Joint venture • Group Structures are often complex • Unclear where a group starts and where it ends • Co-debtorship, Guarantees and Letters of intent of all sorts => what to think about PD and LGD ? • Ring fenced structures • Difficult to tell what economic sector • There is no simple/unique answer to the question what geographical risk the ship financing is exposed to.

18. Credit Risk Modelling = looking for the adequate compromise Criteria • Business Acceptance • Market consistency • Robustness • Methodological integrity Objectives and Use Choices • Trading (bps market consistent) • Solvency (order of magnitude) • Identification of concentration • Hedging Diversification • Strategic choices • Default versus MtoM • Horizon • Point in Time (PIT) versus through the cycle (TTC) • Instruments/Hedges forced in framework or Portfolio expressed in Marketable instruments (replicating portfolio)

19. Accounting Complexity: What you see is what you get? Main regimes for assets with credit risk Fair value through Profit & Loss Assets Balence Sheet P&L Assets Balence Sheet P&L Equity Available for Sale/Fair value through Equity - Impairment Assets Balence Sheet P&L Loans and receivables - Impairment

20. Accounting: The Hedging Trap Economic view Value of the book hedged Economic value of the combined position Value of the book hedged Asymmetrical accounting treatment of the book hedged and the hedging instrument shows increase volatility where it has been economically reduced Accounting view Value of the book hedged P&L Assets Balence Sheet

21. The Main Levers of Portfolio Management Diversification/Overlay • Investments • Derivatives • L/S Beta Overlays • X-Asset class Front Door Back Door • Limits • Pricing • Incentive systems • Acquisitions • Securitisation • Swaps/Pooling • Derivatives

22. Securitisation Notes • The dominant factors in the business case are usually • Funding cost • Liquidity • Regulatory Capital Relief • The rationale behind regulatory capital arbitrage is fairly simple: the purpose of the exercise is to free-up capital at a cost that is lower than the cost of raising new capital in the market • Risk transfer and economic capital savings are often difficult to calculate (CDO2) • No solution for tall trees • Not all types of assets are suitable • Operational complexity / infrasturcture • An extremely wide variety of structures: • Synthetic transactions versus true sales • Synthetic usually partially funded (SPV) • B1 to B2 transition Super Senior Reference orTransferred Portfolio AAA Mezzanine Total Portfolio

23. Main Hedging/Credit Spread Tools Instrument Advantages Disadvantage ECap B 1 B 2 Cost MtoM • Corporate Single-Name Credit Default Swaps • Isolates credit risk and best tool for ‘tall trees’ • Liquidity and transparency • Basis between loan and bond underlying • More efficient hedging/ ideal for ‘tall trees’ • Can be non mark to market • Developing market, lack of liquidity • Non cancellability/ no restructuring • Loan Credit Default Swaps • CDS indices • Highly liquid instruments • Ability to put on large macro hedges • Cost and roll down • No capital relief except where names overlap • Swaptions on CDS indices • Potential for lower cost and mark to market compared to CDS • Single name market is not liquid • Tranches on CDS indices • Ability to pinpoint macro hedges to lower cost • Market well balanced and liquid • Non linear risk • Impacted by market technicals Remark: predominantl y a pre-credit crisis view

24. The Complexity of working with credit derivatives or “Where is Omicron*” Views • The Hedge stand alone versus the combined position • MtoM view and Accounting view (if different) The Greeks and the like Basis Risk Operational aspects • Delta • Gamma • etc. • Jump to default • Cliff risk? • Spread difference Bond-CDS • But more general difference between position hedged and hedging instrument. • Most hedges when looked at properly turn out to be proxy hedges • Timely evaluation based on real market prices • Operational speed and accuracy * Omicron is the undiscovered Greek character feared by all modellers

25. What about the universal or ultimate Credit Portfolio Model? Market Environment Credit Portfolio Environment Market Intstruments Portfolio Patchwork Specific Trading Models Specific Trading Models Overall Portfolio Model Specific Trading Models • Overall view • Low frequency of update • Patchwork • Order of magnitude ambitions • Specific product view • High frequency of update • Focused – Pure • Bps ambitions • How not to get ripped off on the Bps • How not to save Bps while missing the point on the effectiveness of the hedge

26. Important Modelling Choices One Step Approach • Static Hedges ? Portfolio Model Force Market Instruments into Model Logic Hedges Portfolio Patchwork Replicating Portfolio • DynamicHedges? Portfolio Model Market Vaue Express Portfolio in Marketable Instruments Replicating Portfolio Hedges Portfolio Patchwork

27. Assessment of Back-end Transactions is complex Quantitative Qualitativeor Difficult to Quantify Time • Liquidity - diversification • Legal/Documentation • Taxation • Accounting interpretation • Operational Aspects • Reputational Risk • LT effects • ST effects • Transition from one regime to another • EVA-Raroc • The transaction as such • Alternative use of the space liberated • Funding cost • Risk Transfer • Solvency relief • Reduction of P&L vol • Eg. Reduction of concentrationl • Alternative solutions (Back-end – Front End) • Business Perspective – Group Perspective

28. Concluding remarks • Things get already complicated before the mathematics become difficult. Sometimes the stochastic differential equations is the funny part of the exercise. • Although I am a great fan of modelling, I would like to invite you to keep your eyes open for its limitations. • Beware of apparent precision. • Due to lack of data, assumptions (explicit and … implicit) have great impact • Sometimes but fortunately not always, more advanced mathematical techniques don’t make things any better. Sometimes it is even quite the opposite. • Beware of the cookbook approach. The value is to be found not in the formulas but in the rigorous thinking. • Don’t underestimate the importance of regulations, accounting and legal. • Communication with all stakeholders is a crucial but a difficult exercise. • A Master in Common Sense and a PhD in Applied Modesty are great qualifications on top of the necessary degrees in maths, stats, physics, financial engineering or econometrics.

29. Addional Slides

30. Capital Management Activities Credit The simplified ICAAP View Capital Assessment Capital Adequacy and Planning Capital Market Transactions Capital Optimisation Stakeholder Communication • Quantitative Assessment of • Basel I • Basel II • Rating Agencies • Economic Capital • Internal • Senior management • Other departments • External • Local Banks • Investors/analysts • Rating agencies, regulators, • Issuance • Tier 1 • Tier 2 • Monitoring Regulatory, economic and rating agency capital levels • Forecasting and scenario analysis linked to strategic planning • Transactions • Risk transfer • Diversification • Risk taking • Input into strategic planning process to risk taking (within Risk appetite) • Optimisation possibilities • Input • Initiative • Steering CPM Involvement

31. Typical CPM roles/activities at the Group level Centre of Competence Risk Aggregator: Manager of Credit Risk: • Collect, roll out and ensure use of consistent CPM best practices within BU CPM functions • Provide selective CPM functionality for Business Units without dedicated CPM unit • Represent all CPM activities internally and externally (e.g. in IACPM meetings) • Represent Business Unit CPM across the group Develop market transaction competence • Periodically build and report global Group credit exposures • Monitor portfolio developments and report major changes to management • Conduct stress tests on Global level • Develop portfolio optimisation strategies in order to enhance group risk/return profile from a neutral perspective (including limited investments) • Propose actions if alarming concentrations on Group level occur • Propose, design and manage transactions delivered on a group level • Involvement in strategy and budget process (esp. capital management) Controller Enabler Policy Contributor • Highlight significant breaches of group-wide credit risk limits • Propose immediate action when required in order to shield the portfolio from severe value losses • Monitor BU CPM activity • Monitor BU origination policies and initiate improvements if needed • Recommend group-wide exposure limits (name, industry & country level) • Input into policy formulation and review process • Set guidelines for credit risk related stress testing within Bus • Contribute to determination of Rabo’s risk appetite and capital allocation strategy • Keep books on the Group level • Provides operational and administrative support on the group level

32. Growth Profit Capital management activities both to secure and to optimise going concern Limits Contingency Process STOP Hedge Guideline Forecast Policies Capital Budgets Secure Going Concern Optimise Going Concern