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

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

1 Introduction

The Trend Towards Superior Credit Portfolio Performance: 4 Stages Active Portfolio Management Stage 4 - Reduce concentrations Improve returns on risk & capital Portfolio Risk Measurement Stage 3 Measure portfolio risk Calculate & allocate economic capital Optimize credit limits Counterparty Risk Management Stage 2 Implement & validate internal rating models Measure PDs, LGDs & EADs Take early action for high-risk exposures Data & Infrastructure Stage 1 Collect, organize & store customer data Implement internal rating framework

The Trend Towards Superior Credit Portfolio Performance: 4 Stages Active Portfolio Management Stage 4 - Reduce concentrations Improve returns on risk & capital Portfolio Risk Measurement Stage 3 Measure portfolio risk Calculate & allocate economic capital Optimize credit limits Counterparty Risk Management Stage 2 Implement & validate internal rating models Measure PDs, LGDs & EADs Take early action for high-risk exposures Data & Infrastructure Stage 1 Collect, organize & store customer data Implement internal rating framework

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

2 Why mange credit risk?

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………………..

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

Investment Grade Rating Prior To Default 2002

Investment Grade Rating Prior To Default 2003-2006

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

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)

3 How manage Credit Risk?  

Counterparty Credit Risk Rating Data Capture Data Infrastructure Ratings and Models Output Market data Qualitative Quantitative Risk Rating Framework Portfolio Mgmt. Credit Review Lending: Treasury: Investment Reinsurance: Credit Insurance Other data 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

Market Measures Have Proven to Provide Months of Early Warning 1-year EDF Moody’s Rating S&P’s Rating 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

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

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

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

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

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

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

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

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

Portfolio Loss Distribution 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 Probability $0 EL Loss

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 A Aa Aaa Economic Capital

Total Stand-alone Risk Unexpected Loss (UL) 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 Risk Contribution (Risk retained in the Portfolio) Systematic risk - Undiversifiable

Impact on Portfolio Risk Contribution bps

Impact on Return/Risk Ratio

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 Wright Director Moody’s KMV dave.wright@mkmv.com