Credit Portfolio Management

Credit Portfolio Management

Credit Portfolio ManagementCredit Portfolio Management

Solvay Business SchoolSolvay Business SchoolDecember 15, 2003December 15, 2003

22


ContentContent

I. Introduction

II. Driving forces for developing Credit Portfolio Management (CPM)

III. The CPM function

IV. Credit derivatives - The most broadly used instruments by CPM

AppendixThe Credit Derivatives Market Evolution

33


I.I. IntroductionIntroduction

44


LoansLoans

IntroductionIntroduction

A Bank’s capital is used as a cushion to insure depositors against massive losses on the asset side that would hit not only the equity but also the depositors

A minimum capital level is required to avoid bank runs where all the depositors ask to withdraw their money

At the same time, shareholders would like to minimise the capital size in order to increase their return => there is a need to optimise the capital

In a word, Credit Portfolio Management’s mission is to manage the risk capital in the credit (loans) portfolio while increasing the return, thereby improving the return/risk profile of the Bank

AssetsAssets LiabilitiesLiabilities

Cash and Cash and Government Government

BondsBondsCapitalCapital

DepositsDeposits

I. IntroductionI. Introduction

55


II.II. Driving forces for CPMDriving forces for CPM

66


External forcesExternal forces

Credit downturnCredit downturnRecent precipitous declines in the Corporate world are a serious threat to commercial banks and uncertainty over future still reigns

Advances in the measurement and management of Advances in the measurement and management of credit riskscredit risks

Revolution in the science of credit risk measurement (widespread adoption of risk rating, expected loss, economic capital methodologies) and development of sophisticated credit portfolio models

Increasing liquidity in the credit marketsIncreasing liquidity in the credit marketsThe take-off of credit derivatives has been creating new possibilities for risk transformation through innovative structures

II. Driving forces for CPMII. Driving forces for CPM

77


Divergence of economic capital and regulatory capital;In current BIS capital rules, risk weighting is still a function of the nature of the issuer and not a function of the credit quality of the issuer.

This divergence between economic and regulatory capital creates real economic costs for commercial Banks and have an adverse impact on shareholder value and competitiveness as banks:

Avoid economic transactions that use regulatory capital inefficiently (A);Enter uneconomic transactions that use regulatory capital efficiently (B);

LightRegulatory

LightEconomic

LightRegulatory

HeavyEconomic

HeavyRegulatory

HeavyEconomic

HeavyRegulatory

LightEconomic

Diversified …

AAA ...

… Concentrated

… BB

Sovereign

Bank

Corporate

External forcesExternal forces


88


Creation of shareholder value Across the whole European banking industry, the return required

by shareholders is increasing. ROE targets increasingly difficult to meet with a ‘ buy-and-hold ’ credit portfolio

Need for active management of the credit portfolio

Passively managed loan portfolios naturally deteriorate (a bank loan never trades above par value, unlike bonds)

Dynamics of credit quality

Wrong to believe that a rigorous credit approval process when a loan is first granted can hold good through the life of that loan: credit quality is dynamic

Internal forcesInternal forces


99


Banks should be ready to act much quicker when the quality of a borrower starts to deteriorate

Portfolio management tools such as selling, hedging or securitising should be used to reduce exposures before there is a significant fall in the secondary market price

In recent years, many leading banks have appointed specialist portfolio managers to take responsibility for their loan books

Empowerment of portfolio managers to enforce the discipline is the key success factor


EffectsEffects

1010


III.III. The CPM functionThe CPM function

1111


A Bank can only originate assets where it A Bank can only originate assets where it has client relationshipshas client relationships

Without management of the portfolio this Without management of the portfolio this leads to concentrations (either at a name, leads to concentrations (either at a name, asset class, industry or geography level), asset class, industry or geography level), leaving ING with ‘all its eggs in one leaving ING with ‘all its eggs in one basket’basket’

ING actively manages the portfolio, ING actively manages the portfolio, reducing risk in certain areas where it has reducing risk in certain areas where it has (valuable) client business(valuable) client business

The risks ING takes are now less The risks ING takes are now less concentrated and as ‘spread out’ as concentrated and as ‘spread out’ as possiblepossible

CPM achieves this through concrete steps CPM achieves this through concrete steps described below, in line with its mandatedescribed below, in line with its mandate

Without CPM With CPM

Balanced Portfolio

Original Portfolio Original Portfolio

New risk acquired

Original Portfolio: Risk hedged / sold

With or without CPMWith or without CPM

III. The CPM functionIII. The CPM function

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CPM’s objectivesCPM’s objectives

Manage credit risk economic capitalMaintain economic capital constant across business cycles by managing volatility of losses and concentration

Improve return/risk profile (Sharpe ratio, ROE, …) of the reference credit portfolio

Support business growth (by releasing limits on key commercial relationships): transfer pricing involved


1313


A.A. Manage Economic Capital Manage Economic Capital

σσ

LossesLosses

FrequencyFrequencyExpected loss (EL)Expected loss (EL)

Unexpected loss (UL)

LLαα LL99.95%99.95%ELEL

Economic capital

Economic Capital is a function of the Unexpected Loss (Standard Deviation Economic Capital is a function of the Unexpected Loss (Standard Deviation of Losses) and of Retained Risk : EC = RR x UL x 7of Losses) and of Retained Risk : EC = RR x UL x 7

Economic Capital allows to cover the losses in 99.95% of the cases, which is Economic Capital allows to cover the losses in 99.95% of the cases, which is the minimum required to obtain a Aa Credit Rating for the Bank (currently: A+ the minimum required to obtain a Aa Credit Rating for the Bank (currently: A+ (S&P) - Aa3(Moody’s))(S&P) - Aa3(Moody’s))


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LossesLosses

TimeTime

Expected Expected LossLoss

Economic Capital

Unexpected Loss

Evolution of Losses Distribution of Losses

A.A. Manage Economic Capital Manage Economic Capital


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LossesLosses

TimeTime

Expected Loss (EL)Expected Loss (EL)

Initial Economic Capital

New Economic Capital

A.A. Manage Economic CapitalManage Economic Capital

The objective is to maintain economic capital constant across business cyclesThe objective is to maintain economic capital constant across business cycles

The key word is DIVERSIFICATION - diversification of the underlying portfolio The key word is DIVERSIFICATION - diversification of the underlying portfolio reduces the volatility of the losses and, thereby, economic capitalreduces the volatility of the losses and, thereby, economic capital


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The objective is to increase the return/risk profile of the credit portfolioThe objective is to increase the return/risk profile of the credit portfolio This can be achieved by increasing the return or reducing the risk of This can be achieved by increasing the return or reducing the risk of

underperforming assetsunderperforming assets

ReturnReturn

RiskRisk

Assets performing Assets performing below averagebelow average

Assets performing Assets performing above averageabove average

B.B. Improve Return/ Risk ProfileImprove Return/ Risk Profile

Efficient FrontierEfficient Frontier


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The objective is to help the Business to grow even if limits on the best clients are fully used.

This can be done via hedging excesses of limits The cost of hedging has to be compensated by returns on the loan and

non-credit incomes (return on assets)

Company Company ABCABCO/SO/S

After €20 After €20 million million hedgehedge

€€20 million hedge 20 million hedge brings exposure down to 80brings exposure down to 80

Company Company ABCABC

--Current Current

O/SO/S

8080

Max LimitMax Limit

120120

€ € millionmillion

100100

Company Company ABCABC

--Final O/SFinal O/S

New relationship deal New relationship deal brings it back to 100brings it back to 100

C.C. Support Business growth Support Business growth


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1. Disinvestment

CPM reduces exposure to single names, industries or CPM reduces exposure to single names, industries or geographies to minimise the risk that any one event can geographies to minimise the risk that any one event can have a significant impact on the Bank’s cash P&Lhave a significant impact on the Bank’s cash P&L

Note that these hedges do not damage the relationships Note that these hedges do not damage the relationships since they remain silentsince they remain silent

2. Re-investment

CPM acts to ensure that ING is CPM acts to ensure that ING is not ‘placing all its eggs in one not ‘placing all its eggs in one basket’, thus giving ING Bank basket’, thus giving ING Bank revenues for less volatility in revenues for less volatility in earningsearnings

This involves re-investment of This involves re-investment of Capital released in CPM Capital released in CPM proprietary diversification proprietary diversification transactions and in ING transactions and in ING proprietary Investment proprietary Investment portfoliosportfolios

3. Support Business growth

Business strategy can dictate Business strategy can dictate that ING should increase that ING should increase investment in an existing investment in an existing concentrationconcentration

In such cases, CPM supports In such cases, CPM supports business growth by ensuring business growth by ensuring that the existing (valuable) that the existing (valuable) concentrations do not exceed concentrations do not exceed the limit for the name, asset the limit for the name, asset class, industry or geographyclass, industry or geography

Original Portfolio

New risk acquired

Original Portfolio: Risk hedged / sold

1

2

3

In practiceIn practice


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2. Re-investment

Re-investment opportunitiesRe-investment opportunities: :

Identified and executed in areas Identified and executed in areas where the risk does not overlap where the risk does not overlap with exposures from its with exposures from its customer relationships (i.e. its customer relationships (i.e. its existing concentrations). existing concentrations). Instruments include single Instruments include single names CDS, CDOs...names CDS, CDOs...

1. Disinvestment

Single Name HedgesSingle Name Hedges: :

Exposure to any one name is reduced via ‘Golden Rules’ at origination, limit management Exposure to any one name is reduced via ‘Golden Rules’ at origination, limit management (IRCC) and (IRCC) and in extremisin extremis via risk transfer by CPM via risk transfer by CPM

SecuritisationsSecuritisations::

Exposure to illiquid names in industries and geographies is reduced via disinvestments Exposure to illiquid names in industries and geographies is reduced via disinvestments

e.g.: synthetic CDOs for wholesale concentrationse.g.: synthetic CDOs for wholesale concentrations

3. Support Business growth

Single Name HedgesSingle Name Hedges: :

Protection bought for single Protection bought for single name concentrations (via name concentrations (via GLCC intervention of in regular GLCC intervention of in regular course of business)course of business)

Out of, and into CPM’s own Budget Out of Businesses’ Budget

Instruments at our disposalInstruments at our disposal


2020


IV.IV. Credit derivativesCredit derivatives

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+ 60% per year

+23.5%

+20.7%

Source: British Bankers’ Association (2002)

Today’s fastest growing derivatives Today’s fastest growing derivatives marketmarket

IV. Credit DerivativesIV. Credit Derivatives

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InstrumentsInstruments



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Various instruments are used by Credit Portfolio Various instruments are used by Credit Portfolio Managers, mainly in unfunded formatManagers, mainly in unfunded format

The most commonly used are:The most commonly used are:

The Credit Default Swap (CDS)The Credit Default Swap (CDS)

The synthetic securitisation (CDO and the like)The synthetic securitisation (CDO and the like)

InstrumentsInstruments


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A Credit Default Swap synthetically transfers the credit risk of a reference asset A Credit Default Swap synthetically transfers the credit risk of a reference asset between two counterparties :between two counterparties :

The protection buyer (ING in this case) pays a fixed perdiodic fee (usually The protection buyer (ING in this case) pays a fixed perdiodic fee (usually expressed in basis points per annum on the notional amount) to the expressed in basis points per annum on the notional amount) to the counterparty;counterparty;

The protection seller makes no payment unless some specified credit event The protection seller makes no payment unless some specified credit event relating to the reference entity (underlying asset) occurs during the life of the relating to the reference entity (underlying asset) occurs during the life of the transaction, in which case the protection seller is obligated to make a payment transaction, in which case the protection seller is obligated to make a payment via the settlement processvia the settlement process

ING Counterparty

Periodic Fee

Zero No Credit Event

Contingent Payment

Credit Event

Credit Risk on underlying

The Credit Default SwapThe Credit Default Swap

Underlying Underlying AssetAsset


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ING Counterparty

Periodic Fee

Credit Risk on Underlying

ZeroNo Credit Event

Contingent Payment

Credit Event

Underlying Underlying AssetAsset

ING can also sell protection to a counterparty through a CDS ING receives the periodic fee payments In case of Credit Event, ING would have to pay the contingent

payment through the settlement process

Same as the previous situation but ING takes an opposite position


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A Credit Event triggers the Credit Default Swap and leads to the settlement of the transaction

Three Credit Events are currently the market standard

Bankruptcy: the Reference Entity has filed for protection under Chapter 11 or an equivalent bankruptcy legislation

Failure to Pay: the Reference Entity has failed to pay any interest or principal of one of its obligation (loan, bond,…)

Restructuring: One or more obligations of the Reference Entity have been restructured (maturity extension, coupon reduction, change in ranking,…) after a deterioration of its creditworthiness


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Buyer of Protection

Seller of Protection

Delivery of the Obligation

Par Cash Value of Obligation

Physical SettlementPhysical Settlement Cash SettlementCash Settlement

The Physical Settlement is the most The Physical Settlement is the most commonly usedcommonly used

The Buyer of Protection delivers to The Buyer of Protection delivers to the Seller an Obligation of the the Seller an Obligation of the Reference EntityReference Entity

The Seller pays to the Buyer the par The Seller pays to the Buyer the par Value of the ObligationValue of the Obligation

The Seller has then received an asset The Seller has then received an asset paid at 100% with a value lower than paid at 100% with a value lower than 100%100%

The Cash Settlement is less commonly The Cash Settlement is less commonly used by the marketused by the market

The Buyer of Protection calculates the The Buyer of Protection calculates the remaining (market) price of an remaining (market) price of an Obligation of the Reference EntityObligation of the Reference Entity

(100% - remaining price) is considered (100% - remaining price) is considered as the loss given default on the as the loss given default on the Reference Entity. It has to be paid by Reference Entity. It has to be paid by the Seller (taking into account the the Seller (taking into account the notional of the transaction) to the Buyernotional of the transaction) to the Buyer

Buyer of Protection

Seller of ProtectionLoss Given

Default Cash TransferRemaining value

of the Obligation


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What is a securitisation?What is a securitisation?

Process of transferring risks associated with a pool of Process of transferring risks associated with a pool of assets from one party to anotherassets from one party to another

Risks are capped at the level of first loss and other Risks are capped at the level of first loss and other enhancementsenhancements

Risk can be tranched to meet investor appetiteRisk can be tranched to meet investor appetite Risk can be physically transferred or synthetically Risk can be physically transferred or synthetically

transferredtransferred

The securitisationThe securitisation


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TheThe cash securitisationcash securitisation

Portfolio of Portfolio of Credit risks Credit risks

(Bonds, Loans,(Bonds, Loans,…)…)

INGING

€ € 1 billion1 billion

Transfer of AssetsTransfer of Assets

Payment of par Payment of par value of assetsvalue of assets

SPVSPV

Holds all the Holds all the assets of assets of

originating bankoriginating bankAssetsAssets

True Sale of Assets True Sale of Assets

ING’s Balance ING’s Balance SheetSheet

1st Loss Piece retained1st Loss Piece retainedby originator of the underlying Creditsby originator of the underlying Credits

1st Loss Piece 1st Loss Piece (Equity)(Equity)

2.5%2.5%

BBB Tranche InvestorBBB Tranche Investor0.5%0.5%

A Tranche InvestorA Tranche Investor1%1%

AA Tranche InvestorAA Tranche Investor1.5%1.5%

AAA TrancheAAA Tranche Investor Investor2%2%

Super Senior Investor Super Senior Investor

90%90%

Coupon payments Coupon payments and remaining par and remaining par value at maturityvalue at maturity

Par value cash Par value cash paymentpayment

RiskRisk

Issuance of Notes or BondsIssuance of Notes or Bonds

Senior Senior TrancheTranche

Mezzanine Mezzanine TranchesTranches


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Portfolio of Portfolio of Credit risks Credit risks

(Bonds, Loans,(Bonds, Loans,…)…)

INGING

€ € 1 billion1 billion

The synthetic securitisationThe synthetic securitisation

SPVSPV

97.5%97.5%

Credit Default SwapCredit Default Swap

Periodic FeePeriodic Fee

Contingent paymentContingent paymentabove 1st loss pieceabove 1st loss piece

1st Loss Piece1st Loss Piece(Equity)(Equity)

2.5%2.5%

Credit Credit RiskRisk

ING’s Balance ING’s Balance SheetSheet

1st Loss Piece retained1st Loss Piece retainedby originator of the underlying Creditsby originator of the underlying Credits

BBB Tranche InvestorBBB Tranche Investor0.5%0.5%

A Tranche InvestorA Tranche Investor1%1%

AA Tranche InvestorAA Tranche Investor1.5%1.5%

AAA TrancheAAA Tranche Investor Investor2%2%

Super Senior Investor Super Senior Investor

90%90% Periodic FeePeriodic Fee

Contingent paymentContingent paymentafter lower tranche is after lower tranche is erodederoded

Credit Default Swaps or Credit Linked NotesCredit Default Swaps or Credit Linked Notes

Credit Credit RiskRisk Senior Senior

TrancheTranche

Mezzanine Mezzanine TranchesTranches


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Suppose that Renault SA represents a big concentration in ING’s credit portfolio and, Suppose that Renault SA represents a big concentration in ING’s credit portfolio and, therefore, is a good candidate for disinvestmenttherefore, is a good candidate for disinvestment

CPM buys protection on Renault SA for an amount of say, €20 mln, with a maturity of CPM buys protection on Renault SA for an amount of say, €20 mln, with a maturity of 3 years3 years

CPM pays 55 bps (0.55%) per annum to its counterparty in exchange for the protectionCPM pays 55 bps (0.55%) per annum to its counterparty in exchange for the protection The risk on Renault SA (up to €20 mln) is effectively transferred to the counterpartyThe risk on Renault SA (up to €20 mln) is effectively transferred to the counterparty In terms of risk, Renault SA has been disinvested (even though it remains on the In terms of risk, Renault SA has been disinvested (even though it remains on the

Balance Sheet)Balance Sheet)

ING Counterparty

55 bps

Zero No Credit Event

Contingent Payment

Credit Event

Credit Risk on Renault SA

Examples of CPM transactionsExamples of CPM transactionsDisinvestment - Single name hedgeDisinvestment - Single name hedge

Renault SARenault SA€€20 mln20 mln


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Credit Default SwapCredit Default Swap 2 Credit Default Swaps2 Credit Default Swaps Asset Backed Commercial PaperAsset Backed Commercial Paper

Long Term Credit Linked NotesLong Term Credit Linked Notes

Reference Portfolio of

100% weighted assets

A4A3

A2

Bonds

A1

Invested Notes

proceeds

Note Principaland Interest0%

weighted assets

Collateral

Junior Credit Default Swap

(0% Risk Weighted)

Credit Default Swap (0% Risk Weighted)

Not rated

Super Senior

Rated Notes

Notes

Deposit/Repo Arrangements

SPVLiabilitiesAssets

Retained First Loss

ABCP Investors

ABCP (A-1+/P-1)0%

weighted assets

ABCP

ConduitLiabilitiesAssets

Invested ABCP

proceeds

INGING€€1,5 bln1,5 bln

Reference Portfolio of

100% weighted assets

Examples of CPM transactionsExamples of CPM transactionsDisinvestment - Synthetic securitisationDisinvestment - Synthetic securitisation


3333


Synthetic CDO transactions areSynthetic CDO transactions are composed of 70/80 underlying composed of 70/80 underlying companies rated at least Baa2/BBBcompanies rated at least Baa2/BBB

The usual average rating of the The usual average rating of the underlying companies is A2/Aunderlying companies is A2/A

The Aa3/AA- rated Apple transactions The Aa3/AA- rated Apple transactions represent a good way to re-invest into represent a good way to re-invest into diversification while minimising Event diversification while minimising Event RiskRisk

Recent VariationsRecent Variations Index of Credits (900 names, industry Index of Credits (900 names, industry

hedging on ING concentrations, fixed hedging on ING concentrations, fixed recovery rate,…)recovery rate,…)

Management allowing for substitutions Management allowing for substitutions (subject to specific constraints)(subject to specific constraints)

CDO made of tranches of underlying CDO made of tranches of underlying CDOsCDOs

Senior TrancheSenior Tranche

Contingent payment in case of Credit Event, after first loss piece is

fully breached

Premium of x bps p.a.

ING sells ING sells protection on the protection on the

Mezzanine Mezzanine TrancheTranche

AA/AA- implied AA/AA- implied rated Mezzanine rated Mezzanine

TrancheTranche

Super Senior Super Senior TrancheTranche

EquityEquity

Pool of 70/80 Pool of 70/80 companies originated companies originated

by counterpartyby counterparty

Examples of CPM transactionsExamples of CPM transactionsRe-investment - Synthetic securitisationRe-investment - Synthetic securitisation


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Appendix Appendix The Credit Derivatives Market EvolutionThe Credit Derivatives Market Evolution

3535


+ 60% per year

+23.5%

+20.7%


Today’s fastest growing derivatives Today’s fastest growing derivatives marketmarket

AppendixAppendix

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Credit Portfolio ManagementCredit Portfolio ManagementCredit Derivatives Market EvolutionCredit Derivatives Market Evolution

Protection Buyers

Banks52%

Securities Houses21%

Hedge Funds12%

Insurance Companies

6%

Corporations4% Mutual Funds

2%Pension Funds

1%

Government/Export Credit Agencies

2%

Protection Sellers

Pension Funds2%

Government/Export Credit Agencies

0%Mutual Funds

3%Corporations2%

Insurance Companies

33%

Hedge Funds5%

Banks39%

Securities Houses16%


AppendixAppendix

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-400

-200

0

200

Net Protection

Net Protection (USD million)

Banks Hedge FundsSecurities Houses CorporationsGovernment/Export Credit Agencies Mutual FundsPension Funds Insurance Companies


Risk TransferBanks

Insurance Co’s

AppendixAppendix

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AppendixAppendix

3939


Growth has, again, surpassed expectations

Obvious risk transfer from banks to insurance companies

Portfolio transactions’ popularity has increased

Reference entities’ nature has changed

AppendixAppendix

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Credit default swapsCredit default swaps Market share has actually Market share has actually increasedincreased to 45% in 2001 to 45% in 2001 43% expected market share in 200443% expected market share in 2004

Portfolio transactions Portfolio transactions Not even included in the 1997/1998 SurveyNot even included in the 1997/1998 Survey 22% market share in 200122% market share in 2001 26% expected market share in 200426% expected market share in 2004

No other instrument accounts for more than 8% of the No other instrument accounts for more than 8% of the market in 2001market in 2001

AppendixAppendix

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0%

10%

20%

30%

40%

50%

60%

1996 1999 2001 2004

Sovereign Corporate Financial InstitutionSource: British Bankers’ Association (2002)

Less sovereign, more corporateAppendixAppendix

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17%25%

0%10%20%30%40%50%60%70%

AAA-AA A-BBB BB-B

1999 2002(est)


Quality of reference entities is deterioratingAppendixAppendix

Credit Portfolio Management


Solvay Business SchoolSolvay Business SchoolDecember 15, 2003December 15, 2003

Credit Portfolio Management

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