CREDIT RISK MANAGEMENT

THE COMMODITISATION OF CREDIT RISK

TRENDS IN CREDIT RISK MANAGEMENT

KEY PROPOSITION

• THE ADVENT OF ACTIVE AND LIQUID CREDIT TRADING WILL REQUIRE

– COMPLETE RE-ENGINEERING OF THE CREDIT FUNCTION & PROCESS

– ALTER THE NATURE OF BANKING FUNDAMENTALLY

AGENDA

• KEY DRIVERS OF CHANGE

• CREDIT RISK MANAGEMENT PARADIGMS

– CLASSICAL

– MODERN

• CREDIT RISK MANAGEMENT ARCHITECTURE

• IMPLICATIONS FOR FINANCIAL SERVICES

KEY DRIVERS OF CHANGE

• KEY FEATURE OF CREDIT RISK

– CENTRAL TO ALL FINANCIAL TRANSACTIONS

• TRADITIONAL VIEW OF CREDIT

– ILLIQUID

• CURRENT VIEW OF CREDIT

– LIQUID & TRADEABLE

• SHIFT FROM STATIC MANAGEMENT OF CREDIT TO DYNAMIC MANAGEMENT OF CREDIT RISK

KEY DRIVERS OF CHANGE

• SHAREHOLDER VALUE ISSUES

– RETURN ON CREDIT CAPITAL

– OPTIMISATION OF RETURN ON CREDIT CAPITAL

• CHANGES IN FINANCIAL SERVICES

– VALUE CHAIN IN FINANCIAL SERVICES

– TREND TO UNBUNDLING THE MICROSTRUCTURE

PRODUCT MANUFACTURE

ORIGINATION/ DISTRIBUTION

RISK

PROCESSING/ ADMINISTRATION

CAPITAL MANAGEMENT

PRODUCT/ KNOWLEDGE

MANAGEMENT

TECHNOLOGY MANAGEMENT

PRODUCT FOCUS CLIENT FOCUS

RISK MANAGEMENT

KEY DRIVERS OF CHANGE

• CREDIT RISK MANAGEMENT PERFORMANCE

– CONTROL FAILURES

– QUANTIFICATION OF CREDIT RISK

– INTERACTION OF MARKET AND CREDIT RISK

• CREDIT RISK PRICING

– INABILITY TO PRICE CREDITR ISK “CORRECTLY”

– INCONSISTENCY OF PRICING

KEY DRIVERS OF CHANGE

• COSTS OF CREDIT RISK MANAGEMENT INFRASTRUCTURE

• LIQUEFACTION OF CREDIT RISK

– SYNDICATION & ASSET SALES

– SECURITISATION

– CREDIT DERIVATIVES & CREDIT LINKED NOTES

• DEVELOPMENTS IN CREDIT ENHANCEMENT TECHNIQUES

– BI-LATERAL

– MULTILATERAL

• ADVANCES IN CREDIT/ DEFAULT RISK THEORY

• INFRASTRUCTURE DEVELOPMENTS

– SYSTEMS CAPABILITIES

KEY DRIVERS OF CHANGE

KEY DRIVERS OF CHANGE

• CHANGE IN REGULATORY FRAMEWORK

– SHIFT TO CAPITAL BASED REGULATION

– REGULATORY ARBITRAGE

– (POSSIBILITY) OF MODEL BASED CREDIT RISK CAPITAL

KEY DRIVERS OF CHANGE

• KEY NEAR TERM FACTORS

– CREDIT CAPITAL MANAGEMENT

– CREDIT PRICING

– CREDIT RISK MANAGEMENT

– REGULATORY DEVELOPMENTS

– SHIFTS IN BANKING STRATEGY

CREDIT RISK PARADIGMS

• TYPES

– CLASSICAL

– MODERN

• KEY ISSUE

– APPLICABILITY TO DIFFERENT MARKET SEGMENTS

CREDIT RISK BY MARKET SEGMENT

• SEGMENTS

– RETAIL

– MID-MARKET

– WHOLESALE/ CORPORATES

• DIMENSIONS

– RISK

– PRICING

– CREDIT METHODOLOGY

– LIQUIDITY AND TRADEABILITY

SIZE OF INDIVIDUAL EXPOSUREHIGHLOW

NU

MB

ER

OF

CO

UN

TE

RP

AR

TIE

S

SMALL

LARGE

RETAIL

MID-MARKET

WHOLESALE

CLASSICAL PARADIGM

• CONCEPT

– ASSESS RISK AND MATCH WITH CAPITAL

– RISK MANAGEMENT TECHNIQUES• DIVERSIFICATION

• COLLATERAL

• SCHEMATIC

CREDIT REQUEST

CREDIT LIMIT

CREDIT FUNCTION

ORIGINATION CLIENT

TRANSACTION

•CREDIT ASSESSMENT

•MONITORING CREDIT LIMIT & CREDIT ADMINISTRATION

•TRANSACTION ORIGINATION

•PREPARATION OF CREDIT REQUEST

•PRICING/ STRUCTURING

•ADMINISTRATION

CREDIT RISK MANAGEMENT

•CAPITAL

•PROVISIONING

•RISK SYNDICATION

CLASSICAL PARADIGM

• KEY ELEMENTS

• CREDIT ANALYSIS AND ASSESSMENT PROCESS

IMPLICATIONS OF CLASSICAL PARADIGM

• CREDIT RISK ASSUMPTION

• CREDIT PRICING

• CREDIT CAPITAL MANAGEMENT

• CREDIT RISK FOCUS

• CHANGES IN CREDIT QUALITY

• PERFORMANCE ATTRIBUTION OF ORIGINATORS

• PERFORMANCE OF CREDIT FUNCTION

MODERN PARADIGM

• CONCEPT

– CREDIT RISK AS A SEPARATE TRADEABLE ASSET CLASS

– RISK MANAGED DYNAMICALLY THROUGH HEDGING AND TRADING TOOLS

• SCHEMATIC

ORIGINATION

CREDIT FUNCTION

CREDIT PORTFOLIO

CREDIT TRADING

CAPITAL MARKET

CREDIT CAPITAL

CLIENT

TRANSACTION

CREDIT REQUEST

CREDIT LIMIT & CREDIT CHARGE

•TRANSACTION ORIGINATION

•STRUCTURING/ PRICING

•ADMINISTRATION

•SYNDICATION/ ASSET SALES

•SECURITISATION

•CREDIT DERIVATIVES

•CREDIT ASSESSMENT

•CREDIT PORTFOLIO

ANALYSIS

•CREDIT CAPITAL

MANAGEMENT

CREDIT PORTFOLIO MANAGEMENT & POSITIONING

TRANSACTION

RETURN

TRANSACTION CREDIT RISK

ORIGINATOR

INTERNAL CREDIT DEFAULT SWAP

CREDIT RISK

CREDIT RISK CHARGE

CREDIT PORTFOLIO

CREDIT CAPITAL

CREDIT HEDGES

CREDIT RISK TRADED & HEDGED

CREDIT RISK ASSUMED & MANAGED

MODERN PARADIGM

• KEY ELEMENTS

• CREDIT ANALYSIS AND ASSESSMENT PROCESS

IMPLICATIONS OF MODERN PARADIGM

• CREDIT RISK ASSUMPTION

• CREDIT PRICING

• CREDIT CAPITAL MANAGEMENT

• CREDIT RISK FOCUS

• CHANGES IN CREDIT QUALITY

• PERFORMANCE ATTRIBUTION OF ORIGINATORS

• PERFORMANCE OF CREDIT FUNCTION

IMPLICATIONS OF MODERN PARADIGM

• CLIENT MANAGEMENT

– CORE VERSUS NON CORE CLIENTS

– HOME VERSUS FOREIGN MARKETS

CREDIT RISK MANAGEMENT ARCHITECTURE

• CONCEPT

– RISK MANAGEMENT SYSTEMS COMPONENTS

– INFORMATION SYSTEMS

• SCHEMATICS

C R E D IT R IS K M A N A G E M E N T A R C H ITE C TU R E

C R E D IT A N A L Y S IS

C R E D IT E N H A N C E M E N T C R E D IT A D M IN IS TR A TIO N C R E D IT S Y S TE M S /IT IN F R A S TR U C TU R E

C R E D IT C A P ITA L M A N A G E M E N TE C O N O M IC C A P ITA L

R E G U L A TO R Y C A P ITA L

C R E D IT P O R TF O L IO M O D E L L IN G /C R E D IT P R IC IN G

C R E D IT TR A D IN G

CREDIT DATA

TRANSACTION DATA

CREDIT ANALYSIS

RISK DATA CREDIT MODELS

CREDIT ENHANCEMENT

REPORTING

CREDIT CAPITAL

MANAGEMENT

LIMIT ADMINISTRATION

OBLIGOR/ COUNTERPARTY

DATA

RATING MODELS

•INTERNAL

•EXTERNAL

•CREDIT EXPOSURE - STATIC & DYNAMIC (PFCE MODEL)

•DEFAULT PROBABILITY/ RATINGS MIGRATION

•RECOVERY RATES

•DEFAULT CORRELATIONS

•PORTFOLIO MODELS

•PRICING MODELS

•COLLATERAL

•NETTING

•CLEARING HOUSE

•ECONOMIC CAPITAL

•REGULATORY CAPITAL

•PROVISIONING

•SETTLEMENT LIMITS

•RISK LIMITS

IMPLICATIONS FOR FINANCIAL SERVICES

• TYPES

– MICRO(OPERATIONAL)• REDEFINITION OF CREDIT PROCESS WITHIN

ORGANISATIONS

– MACRO(STRATEGIC)• REDEFINITION OF BUSINESS FOCUS

OPERATIONAL CHANGES

• RE-ENGINEERING THE CREDIT PROCESS

• ALTERATION OF CREDIT RISK ARCHITECTURE/ INFRASTRUCTURE

STRATEGIC CHANGES

• THEME

– SHIFT FOCUS OF BANKS FROM HOLDER OF RISK TO ORIGINATORS AND DISTRIBUTORS OF RISK

• MODELS OF BANKING PRACTICE

BORROWER BANKDEPOSITOR

MODEL 1 - CLASSICAL BANKING MODEL

LOAN TRANSACTION DEPOSIT TRANSACTION

BANK ORIGINATES, FUNDS, ADMINISTERS AND RETAINS CREDIT RISK OF BORROWER

BORROWER BANKINVESTOR

MODEL 2 - INVESTMENT BANKING/ SECURITIES MODEL

ISSUE OF SECURITIES DISTRIBUTION OF SECURITIES

BANK ORIGINATES TRANSACTION AND MAY ADMINISTER IT AS PAYMENT AGENT. FUNDING AND CREDIT RISK OF BORROWER IS TRANSFERRED TO INVESTOR. PRIMARY RISK IS UNDERWRITING

WHICH IS SYNDICATED TO REDUCE RISK LEVEL,

OTHER BANKS

UNDERWRITING OF PLACEMENT OF SECURITIES AND SYNDICATION OF UNDERWRITING RISK

BORROWER BANK INVESTOR

MODEL 3 - SECURITISATION MODEL

LOAN TRANSACTIONSALE OF LOAN BACKED

SECURITIES

BANK ORIGINATES AND ADMINISTERS THE LOAN. BANK SELLS LOAN TO SECURITISATION VEHICLE WHICH ISSUES LOAN ASSET BACKED SECURTIES. FUNDING

AND CREDIT RISK OF BORROWER IS BORNE BY INVESTOR. BANK RISK IS CONFINED TO CREDIT RISK PRE-SALE TO SECURITISATION VEHICLE AND ANY UNDERWRITING

RISK ON THE PLACEMENT OF THE LOAN ASSET BACKED SECURITIES

SECURITISATION VEHICLE

SALE OF LOAN TO SECURITISATION VEHICLE

BORROWER BANKINVESTOR/

OTHER BANK

MODEL 4 - ECONOMIC RISK TRANSFER MODEL

LOAN TRANSACTION CREDIT DEFAULT SWAP OR CREDIT LINKED NOTE

BANK ORIGINATES, FUNDS AND ADMINISTERS THE LOAN. CREDIT RISK OF BORROWER IS TRANSFERRED TO INVESTORS OR OTHER BANKS. BANK CREDIT RISK IS PRE ECONOMIC HEDGE ONLY. WHERE A CREDIT LINKED

NOTE IS ISSUED THE INVESTOR/ OTHER BANK ALSO PROVIDES FUNDING.

KEY CHALLENGES

• CREDIT RISK MODELLING PROBLEMS

• DEVELOPMENT OF CREDIT TRADING

• CREDIT ENHANCEMENT PROBLEMS

• CHANGES IN CREDIT INFRASTRUCTURE

• CHANGE MANAGEMENT

CONCLUSIONS

• THE ADVENT OF ACTIVE AND LIQUID CREDIT TRADING WILL REQUIRE

– COMPLETE RE-ENGINEERING OF THE CREDIT FUNCTION & PROCESS

– ALTER THE NATURE OF BANKING FUNDAMENTALLY