Managing credit risk is an inherent part of the banking business. Traditionally, credit exposures were assessed and managed at an individual level as the activity in a banking book was limited to addition, maturity, or closure of credit exposures. With limited avenues to offload risks and lack of strong regulatory incentives to actively manage risks, exposures were at best managed reactively.
However, the banking business has witnessed significant transformations over the past decade. The increasing complexity of the banking business, the dynamic composition of banking book, intense competition at global level, regulatory compliance requirements such as Basel II, the emergence of credit risk transfer markets and advances in risk technology have incentivised banks to change their credit risk measurement and management strategy from an ‘originate, hold, fold’ approach to an ‘originate, manage, distribute’ approach.
These changes have happened at two levels: risk measurement and risk management. The first level change represents a move from standalone risk measurement to portfolio risk measurement. The second level change focuses on transforming passive risk management into active risk management. Passive management involves mitigating risk during credit origination and structuring, but in a reactive manner. ACPM facilitates proactive management of risks and explicitly attempts to maximize the risk adjusted return and shareholder value by rebalancing credit portfolios.
Business Case for ACPM
Banks that invest in technology and capabilities for ACPM implementation gain from substantial competitive advantages compared to banks that remain less sophisticated in managing credit risks. The ‘economic capital’ metrics underlying ACPM provide a holistic picture of standalone and inter-related credit risks within a bank and thereby encourages the conscious pursuit of diversification strategies to manage sector and name concentration risks. Simulations of the credit portfolio model help in decision-making regarding which credits to add or sell, which exposures to securitize and which to hedge so that the risk-return profile of the enterprise wide credit portfolio is optimized. The net result of implementing ACPM is higher risk adjusted returns per unit of economic capital (RAROC) and higher shareholder value.
ACPM enables ‘relative’ pricing of a new exposure as opposed to ‘silo’ based pricing. Thus, if a new credit reduces the portfolio’s credit risk for the bank, it can be priced more competitively compared to pricing it in isolation, or relative to its portfolios. This gives the bank a competitive pricing edge over its peers.
Further, the churning of the credit portfolio due to pursuit of ACPM allows the bank to leverage existing capital for new business origination and revenue growth.
At a macro level, ACPM facilitates the creation of liquid and efficiently priced credit markets through active participation in securitization, secondary loans and credit derivatives markets.
Portfolio Credit Risk Measurement Models
The most commonly used vendor portfolio risk measurement models arePortfolio Manager by Moody’s KMV, Credit Metrics by JPMorgan, Credit Portfolio View by McKinsey and Credit Risk+ by Credit Suisse First Boston. These models can handle not just the plain vanilla credit products such as loans and bonds but also complex products such as credit default swaps, basket default swaps and other credit derivative and securitization products as they are getting more sophisticated.
Data Requirements
Credit portfolio management implementation is data intensive like Basel II. It needs granular level transaction data and reference data for estimating risk measures, performance measures and for conducting scenario analyses.
Since accuracy of results depends on the input data it is important to have good quality input data. Though the data requirements would vary as per the selected portfolio credit model, the key data requirements1 for ACPM are given in Figure 1. The majority of the data is readily available for banks that have adopted the Advanced Internal Ratings Based (AIRB) approach for Basel II implementation. Thus the groundwork done for Basel II can be leveraged substantially for ACPM.
Implementation Challenges in ACPM
Typically banks face the following challenges while implementing ACPM:
Model selection and customization
- Selecting portfolio credit risk measurement model and analytic tools that will be suitable for bank’s existing and future portfolios spread across multiple asset classes. The model should support various analyses and reporting required by the bank.
- Customization of selected portfolio credit risk measurement model so that internally available data and estimated parameters such as ratings, probability of default, loss given default can be used without much modifications.
- Finding a suitable solution for portfolios that cannot be supported by the selected model such as illiquid portfolios or complex structured products portfolio. Such portfolios need to be incorporated into enterprise wide credit portfolio management.
Data availability, standardization and system integration
- Estimating asset and default correlations is the critical and also the most difficult part of ACPM. Banks may appreciate correlations but may not have the necessary data or the sophisticated models or the infrastructure required for estimating correlations.
- Extracting required data from various business units and bringing it to a standardized level for running the chosen portfolio analytic tools may get tedious as the data may not be available or may be available in silos or may need processing to make it consistent.
- Integrating the existing risk management systems and databases (which are spread across various business units and are at varying levels of readiness in terms of standardization and completeness) with the analytics and reporting engine requires building multiple interfaces.
Acting on ACPM outputs
- Taking decisions based on portfolio analysis outputs and acting on them may not be a smooth process. If a bank cannot act upon the outputs of portfolio analyses in conjunction with the judgment of its portfolio managers and rebalance the portfolio, then the real benefits of ACPM will not accrue.
A bank may face these challenges in varying degrees based on its existing level of preparation in terms of data and systems, support of senior management and acceptance of an independent ACPM unit. Though implementing ACPM is a challenge, its rewards outweigh the efforts.
Conclusion
With adoption of Basel II across the globe, banks have been prompted to improve their risk measurement and management processes and systems. However, the Basel II framework undermines the importance of default correlations in a portfolio approach to credit risk. Thus, banks for which the frontiers of credit risk management end at Basel II implementation will fail to take advantage of active diversification afforded by portfolio models. On the other hand, banks that are moving to ACPM will improve their competitiveness and value of franchise. ACPM implementation has its challenges but by leveraging Basel II implementation efforts, banks can expedite the ACPM implementation process and reap its rewards.
1The data element list is indicative and not exhaustive.