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Measuring and Managing Credit Risk – Trends and Developments
Dave WrightDirectorMoody’s [email protected]
Agenda
1. The Trend Towards Superior credit performance
2. Why manage credit risk?
3. How to manage Credit Risk?
111 Introduction
MOODY’S KMV COMPANY. ALL RIGHTS RESERVED.4 COPYRIGHT © 2005
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
Data & Infrastructure
Stage 1
ActivePortfolio
Management
Stage 4
CounterpartyRisk
Management
Stage 2
PortfolioRisk
Measurement
Stage 3
- 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
MOODY’S KMV COMPANY. ALL RIGHTS RESERVED.5 COPYRIGHT © 2005
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
Data & Infrastructure
Stage 1
ActivePortfolio
Management
Stage 4
CounterpartyRisk
Management
Stage 2
PortfolioRisk
Measurement
Stage 3
- 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
MOODY’S KMV COMPANY. ALL RIGHTS RESERVED.6 COPYRIGHT © 2005
Credit Risky Assets
Treasury assets
Credit insurance
Receivables
Lending portfolios
Investment portfolio
Financial Institutions – reinsurance
222 Why mange credit risk?
MOODY’S KMV COMPANY. ALL RIGHTS RESERVED.8 COPYRIGHT © 2005
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………………..
MOODY’S KMV COMPANY. ALL RIGHTS RESERVED.9 COPYRIGHT © 2005
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
MOODY’S KMV COMPANY. ALL RIGHTS RESERVED.10 COPYRIGHT © 2005
Investment Grade Rating Prior To Default 2002
MOODY’S KMV COMPANY. ALL RIGHTS RESERVED.11 COPYRIGHT © 2005
Investment Grade Rating Prior To Default 2003-2006
MOODY’S KMV COMPANY. ALL RIGHTS RESERVED.12 COPYRIGHT © 2005
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
MOODY’S KMV COMPANY. ALL RIGHTS RESERVED.13 COPYRIGHT © 2005
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)
333 How manage Credit Risk?
MOODY’S KMV COMPANY. ALL RIGHTS RESERVED.15 COPYRIGHT © 2005
MOODY’S KMV COMPANY. ALL RIGHTS RESERVED.16 COPYRIGHT © 2005
Counterparty Credit Risk Rating
Market data
Portfolio Mgmt.
Credit Review
Risk Rating Framework
Data Infrastructure
Qualitative
Quantitative
Other data
Ratings and Models Output Data Capture
• Data drives models• Data sources?
• Internal models• External models• Statistical• Expert• Ratings
• Enhanced risk• management
CONSISTENT PROCESS ACROSS THE ORGANISATION
Lending: Treasury: Investment
Reinsurance: Credit Insurance
Development of Sophisticated Credit Risk Models
MOODY’S KMV COMPANY. ALL RIGHTS RESERVED.17 COPYRIGHT © 2005
.02
.05
.10
.15
.20
.50
1
2
5
7
10
15
20
Aaa
Aa
A
Baa
Ba
B
Caa Ca C
AAA
AA
A
BBB
BB
B
CCC CC
08/99 01/00 07/00 01/01 07/01 01/02 07/02 01/03 07/03 01/04 07/04
FIBERMARK INC
1 Year EDF Moody's Rating S&P Rating
1-year EDF
Moody’s Rating
S&P’s Rating
Market Measures Have Proven to Provide Months of Early Warning
• 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%.
• 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%.
Source: Credit Monitor
MOODY’S KMV COMPANY. ALL RIGHTS RESERVED.18 COPYRIGHT © 2005
Fibermark’s 10.750% 04/15/11
spread to Treasury
1-year EDF
Fibermark Inc. : EDF vs. Spread to Treasury
• Fibermark’s EDF anticipates the change in the cash market by 6-months
• Fibermark’s EDF anticipates the change in the cash market by 6-months
Source: CreditEdge
MOODY’S KMV COMPANY. ALL RIGHTS RESERVED.19 COPYRIGHT © 2005
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
MOODY’S KMV COMPANY. ALL RIGHTS RESERVED.20 COPYRIGHT © 2005
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
MOODY’S KMV COMPANY. ALL RIGHTS RESERVED.21 COPYRIGHT © 2005
Economic Capital Drivers
Portfolio Credit Risk
Amount Held
Correlation in Exposure Values
Exposure Credit Risk
Default and Asset Correlation
Default Probability
• 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
LGD
Maturity
EaD
Country
Industry
Size
MOODY’S KMV COMPANY. ALL RIGHTS RESERVED.22 COPYRIGHT © 2005
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
MOODY’S KMV COMPANY. ALL RIGHTS RESERVED.23 COPYRIGHT © 2005
-5
-4
-3
-2
-1
0
1
2
3
4
5
-6 -4 -2 0 2 4 6
Com
pany
A
Company BBadYear
Great Year
Great Year
Correlation = 0.95
MOODY’S KMV COMPANY. ALL RIGHTS RESERVED.24 COPYRIGHT © 2005
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
MOODY’S KMV COMPANY. ALL RIGHTS RESERVED.25 COPYRIGHT © 2005
0.00%
0.20%
0.40%
0.60%
0.80%
1.00%
1.20%
1.40%
1.60%
1.80%
2.00%
Year
Actu
al P
ort
folio
Loss
Tail Risk measures the likelihood of extreme losses
Expected Loss, Unexpected Loss, and Tail Risk
Expected Loss is the average loss
Portfolio 2
Portfolio 1
Unexpected Loss measures the variability around the Expected Loss
(one standard deviation)
MOODY’S KMV COMPANY. ALL RIGHTS RESERVED.26 COPYRIGHT © 2005
Portfolio Loss Distribution
0.00%
0.20%
0.40%
0.60%
0.80%
1.00%
1.20%
1.40%
1.60%
1.80%
2.00%
Year
Act
ual P
ortf
olio
Los
s
Rarely, the portfolio has very large losses
Most of the time, the portfolio has smaller than the Expected Loss
Sometimes, the portfolio has losses equivalent to the Expected Loss
$0
Pro
bab
ility
EL Loss
MOODY’S KMV COMPANY. ALL RIGHTS RESERVED.27 COPYRIGHT © 2005
Portfolio Required Economic Capital
• 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
AaaAaA
Economic Capital
Probability
MOODY’S KMV COMPANY. ALL RIGHTS RESERVED.28 COPYRIGHT © 2005
Diversified away by the Portfolio
Risk Contribution(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)
• Systematic risk
- Undiversifiable
MOODY’S KMV COMPANY. ALL RIGHTS RESERVED.29 COPYRIGHT © 2005
DEUTSCHE TELEKOM
.02
.05
.10
.15 .20
.5
1.0
2
5 7 10
15 20
AAA
AA
A
BBB
BB
B
CCC CC
08/9708/9708/9708/9708/97 01/9808/9708/9708/9708/9708/97 07/9808/9708/9708/9708/9708/97 01/9908/9708/9708/9708/9708/97 07/9908/9708/9708/9708/9708/97 01/0008/9708/9708/9708/9708/97 07/0008/9708/9708/9708/9708/97 01/0108/9708/9708/9708/9708/97 07/0108/9708/9708/9708/9708/97 01/0208/9708/9708/9708/9708/97 07/02
Credit Monitor ®
EDF S&P
0
100
200
300
400
500
Mar 00 Sep 00 Mar 01 Sep 01 Jul 02
Jul 02Mar 00 Sep 00 Mar 01 Sep 01
Impact on Portfolio Risk Contribution
bps
MOODY’S KMV COMPANY. ALL RIGHTS RESERVED.30 COPYRIGHT © 2005
DEUTSCHE TELEKOM
.02
.05
.10
.15 .20
.5
1.0
2
5 7 10
15 20
AAA
AA
A
BBB
BB
B
CCC CC
08/9708/9708/9708/9708/97 01/9808/9708/9708/9708/9708/97 07/9808/9708/9708/9708/9708/97 01/9908/9708/9708/9708/9708/97 07/9908/9708/9708/9708/9708/97 01/0008/9708/9708/9708/9708/97 07/0008/9708/9708/9708/9708/97 01/0108/9708/9708/9708/9708/97 07/0108/9708/9708/9708/9708/97 01/0208/9708/9708/9708/9708/97 07/02
Credit Monitor ®
EDF S&P
-1.00
1.00
3.00
5.00
7.00
9.00
11.00
13.00
15.00
17.00
Mar 00 Sep 00 Mar 01 Sep 01 Jul 02Jul 02Mar 00 Sep 00 Mar 01 Sep 01
02
Impact on Return/Risk Ratio
MOODY’S KMV COMPANY. ALL RIGHTS RESERVED.31 COPYRIGHT © 2005
Mispricing: <= -0.002 Mispricing: -0.002 .. -0.001Mispricing: -0.001 .. 0.001Mispricing: 0.001 .. 0.020Mispricing: > 0.020
Mispricing (Monte Carlo) to Portfolio using Expected Spread & Risk Contribution
Risk Contribution
0.04
000
0.03
500
0.03
000
0.02
500
0.02
000
0.01
500
0.01
000
0.00
500
0.00
000
Exp
ecte
d S
pre
ad (
Mar
ket)
0.06500
0.06000
0.05500
0.05000
0.04500
0.04000
0.03500
0.03000
0.02500
0.02000
0.01500
0.01000
0.00500
0.00000
-0.00500
-0.01000
-0.01500
-0.02000
MOODY’S KMV COMPANY. ALL RIGHTS RESERVED.32 COPYRIGHT © 2005
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
Measuring and Managing Credit Risk – Trends and Developments
Dave WrightDirectorMoody’s [email protected]