Measuring and Managing Credit Risk – Trends and Developments

1. Measuring and Managing Credit Risk – Trends and Developments Dave Wright Director Moody’s KMV dave.wright@mkmv.com

2. The Trend Towards Superior credit performance • Why manage credit risk? • How to manage Credit Risk?  

3. 1 Introduction

4. Stage 4 Active Portfolio Management Stage 3 Portfolio Risk Measurement Stage 2 Counterparty Risk Management Stage 1 Data & Infrastructure 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 • 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

5. Stage 4 Active Portfolio Management Stage 3 Portfolio Risk Measurement Stage 2 Counterparty Risk Management Stage 1 Data & Infrastructure 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 • 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

6. Credit Risky Assets • Treasury assets • Credit insurance • Receivables • Lending portfolios • Investment portfolio • Financial Institutions – reinsurance

7. 2 Why mange credit risk?

8. 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………………..

9. 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

10. Investment Grade Rating Prior To Default 2002

11. Investment Grade Rating Prior To Default 2003-2006

12. 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

13. 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)

14. 3 How manage Credit Risk?  

16. Risk Rating Framework Credit Review Quantitative Other data Market data Portfolio Mgmt. Qualitative Counterparty Credit Risk Rating Output Ratings and Models Data Capture Data Infrastructure Lending: Treasury: Investment Reinsurance: Credit Insurance Development of Sophisticated Credit Risk Models Internal models External models Statistical Expert Ratings Data drives models Data sources? Enhanced risk management CONSISTENT PROCESS ACROSS THE ORGANISATION

17. 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%. Market Measures Have Proven to Provide Months of Early Warning 1-year EDF Moody’s Rating S&P’s Rating Source: Credit Monitor

18. Fibermark Inc. : EDF vs. Spread to Treasury 1-year EDF • Fibermark’s EDF anticipates the change in the cash market by 6-months Fibermark’s 10.750% 04/15/11 spread to Treasury Source: CreditEdge

19. 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

20. 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

21. Country Industry Size Economic Capital Drivers Portfolio Credit Risk Correlation in Exposure Values Exposure Credit Risk Default Probability Default and Asset Correlation LGD Maturity EaD Amount Held • 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

22. 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

23. Correlation = 0.95 Great Year Company A Bad Year Company B Great Year

24. 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

25. Tail Risk measures the likelihood of extreme losses Expected Loss is the average loss Unexpected Loss measures the variability around the Expected Loss (one standard deviation) Expected Loss, Unexpected Loss, and Tail Risk Portfolio 1 Portfolio 2

26. Most of the time, the portfolio has smaller than the Expected Loss Rarely, the portfolio has very large losses Sometimes, the portfolio has losses equivalent to the Expected Loss Portfolio Loss Distribution Probability $0 EL Loss

27. Portfolio Required Economic Capital Probability 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 Aa Aaa A Economic Capital

28. RiskContribution(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) Diversified away by the Portfolio • Systematic risk - Undiversifiable

29. Impact on Portfolio Risk Contribution bps

30. Impact on Return/Risk Ratio

32. 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

33. Measuring and Managing Credit Risk – Trends and Developments Dave Wright Director Moody’s KMV dave.wright@mkmv.com