1. Measuring and Managing Credit Risk – Trends and Developments
Dave Wright
Director
Moody’s KMV

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

3. 1
Introduction

4. 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

5. 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

6. Credit Risky Assets Credit insurance Receivables Lending portfolios
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. 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

17. 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

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 % 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. 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

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. 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)

26. 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

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 A Aa
Aaa
Economic Capital

28. 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

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