Oliver, Wyman & Company 1 December 1999

Credit portfolio
management
M
odern credit risk manage-
ment techniques were
initiated by the banking
industry’s desire to avoid a repeat
of its late ‘80s and early ‘90s default
experience. The heavy credit losses
during this period, driven by a
poorly controlled rush to build mar-
ket share at the expense of asset
quality and portfolio diversification,
threatened the solvency of even
well capitalised institutions.
The need to better understand
portfolio credit risks was reinforced
by the publication of the Bank for
International Settlements’ (BIS) cap-
ital adequacy guidelines in 1988.
These guidelines, whilst specifying
By Thomas
these risks were diversified.
Banks leading the development
Garside, of credit risk management tech-
niques quickly discovered that
Henry Stott credit pricing was highly inefficient.
Typically pricing within a loan port-
and folio would be almost flat across the
credit risk spectrum, generating
Anthony huge skews in customer profitabil-
Stevens ity. Initial efforts focused on mitigat-
ing these skews by calculating risk-
adjusted profitability (eg risk
adjusted return on [risk-adjusted]
capital) by sub-portfolio and then
using these measures to create risk-
adjusted loan pricing tools. Leading
banks thus started to rationalise
pricing in both loan and bond port-
folios, and moving under-perform-
ing assets off their balance sheets.
Consequently banks that had not
developed risk-adjusted perform-
ance measures started to suffer
from negative selection, often
accepting significantly under-
priced assets from more sophisti-
cated institutions.
In parallel to developing aggre-
gate risk-adjusted performance
measures, leading banks were also
starting to quantify credit risk at
finer levels of detail. Credit portfolio
models were developed which
could differentiate credit risk along

minimum regulatory capital
requirements, were inadequate to
provide an accurate measure of
the risk/reward characteristics of a
credit portfolio. Banks therefore
started to develop more sophisti-
cated credit risk management
techniques that recognised both
the credit risk of individual expo-
sures and the degree to which
1. Optimisation of origination and portfolio management activities
Line of business
product and delivery
optimisation
origination sales/product
opportunities teams
‘
Banks leading the multiple dimensions (credit grade,
industry, country/region etc) and,
development of credit for large corporate exposures, on a
risk management name-by-name basis.
These credit portfolio models
techniques discovered have positioned leading institutions
that credit pricing was to take advantage of the increas-
ing liquidity of the credit markets
highly inefficient’ and to adopt a far more active
approach to credit portfolio man-
agement than was previously possi-
ble. Historically, credit portfolio
management had focused on the
Portfolio management monitoring of exposure by broad
portfolio segment and, if necessary,
mark-to-market credit portfolio
transfer of Pr (loss) the imposition of exposure caps.
assets
The creation of a stand-alone
optimisation of
credit portfolio management func-
approval syndication/ loss distribution
sales tion, armed with sophisticated port-
folio models and with a controlling
loss
mandate over assets held on the
balance sheet, now enabled the
asset syndication/
disposals credit portfolio to be optimised
independent of origination activity,
asset purchases (figure 1). Active credit portfolio
asset swaps
credit derivatives optimisation has enormous poten-

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01

tial to enhance profitability. Using
only very basic optimisation tech-
niques a typical institution might
expect to reduce the economic
capital consumed by its credit port-
folio by 25%–30%.
■ Credit risk measurement frame-
work. Credit risk is conventionally
defined using the concepts of
expected loss (EL) and unex-
pected loss (UL) (figure 2).
Because expected losses can be
anticipated, they should be
regarded as a cost of doing busi-
ness and not as a financial risk.
Obviously credit losses are not
constant across the economic
cycle, there being substantial
volatility (unexpected loss) about
the level of expected loss. It is this
volatility that credit portfolio mod-
els are designed to quantify.
Volatility of portfolio losses is
driven by two factors – concentra-
tion and correlation (figure 3).
Concentration describes the ‘lumpi-
ness’ of the credit portfolio (eg why
it is more risky to lend £10m to 10
companies than to lend £0.1m to
1,000 companies). Correlation
describes the sensitivity of the port-
folio to changes in underlying
macro-economic factors (eg why it
is more risky to lend to very cyclical
industries such as property develop-
ment). In all but the smallest credit
portfolios, correlation effects will
dominate.
When quantifying credit risk, two
alternative approaches can be
used when valuing the portfolio:
● Loss-based method. Under this
approach an exposure is assumed
to be held to maturity. The exposure
is therefore either repaid at par or
defaults, and thus worth the recov-
ery value of any collateral. Using this
approach credit migration has no
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effect on the book value of the
2. Definition of credit loss volatility obligation.
● NPV-based method. Under this
credit credit approach, the embedded value of
losses losses
an exposure is assumed to be real-
isable. If the obligation upgrades
then it is assumed to be worth more
than par, and if it downgrades it is
assumed to be worth less than par.
The value of the obligation can be
calculated using either using mar-
EL ket credit spreads (where applica-
ble) or by marking-to-model using
CAPM or similar method.
time (years) frequency In general, NPV-based methods
are most applicable to bond port-
folios and large corporate portfolios
where meaningful markets exist for
‘
In general, NPV-based either the physical assets or credit
derivatives. For the vast majority of
methods are most commercial bank exposures,
applicable to bond portfolios where such markets do not exist a
more meaningful risk profile is
and large corporate obtained using a loss-based
portfolios where meaningful method. Loss-based calculations
have the advantage of requiring
markets exist for either the less input data (margin and matu-
physical assets or credit rity information, for example, is not
required) and being simpler to
derivatives’ compute. However, many institu-
tions are starting to run both meth-
3. Effects of concentration and correlation ods in parallel, particularly for port-
on credit risk folios where securitisation is possi-
ble. The different credit risk profiles
generated for the same portfolio
credit risk using loss-based and NPV-based
1 methods are shown later in this arti-
concentration cle (figure 8).
of portfolio
diversification specific risk: driven II. Credit portfolio
of credit risk by concentration methodology
■ Measuring credit risk correla-
2
correlation of systematic risk: tions. As discussed previously, to
borrower driven by correlation accurately model portfolio credit
behaviour
risk the correlation between expo-
size of portfolio sures must first be measured. This
seemingly simple statement con-
ceals the complex string of calcula-
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4. The Merton default model

tions that are actually necessary.
Complexity arises as it is
extremely difficult to calculate
credit risk correlations directly.
Indeed, to measure default corre-
lation (as required for loss-based
measures) between two compa-
nies is impossible, as this would
require repeated observations over
a given time-period during which
each company would either
default or survive. Credit risk corre-
lation could then be calculated
from the number of times both
companies defaulted simultane-
ously. Clearly such analysis is impos-
sible in practice. Similar difficulties
exist when trying to estimate corre-
lation between changes in credit
rating or bond spreads.
The simplest solution is to use
aggregate time series to infer credit
market
value callable liabilities. This enables asset
2. volatility correlation to be transformed into
of asset
values credit risk correlation (figure 5).
In figure 5 the more correlated
1. current the movements in the two compa-
market
value of nies’ assets the greater the ‘twist’ in
probability distribution
assets
of future asset value the joint asset value distribution.
Hence the greater the probability
3. callable
liabilities that the credit quality of the two
expected
default firms will rise, fall and ultimately
frequency
default together. Asset correlations
1 year time have the benefit of being more
easily observable (from equity
5. Joint probability density function for prices, balance sheet analysis etc)
company asset values and their correlations have been
shown to be stable over time. The
Merton model has also been suc-
cessfully adapted to describe
credit risk correlations in financial
0.20
institution portfolios that contain
0.18
corporate exposures.
0.16
The correlation of model inputs
0.14
Probability %

risk correlation. Unfortunately this themselves are best measured

0.12
approach is unsuitable except for 1 and 2 default using factor models in the same
0.10
3.9
the most basic of portfolio analysis 0.08 3.3 way that an equity ‘beta’ is esti-
2.7
for two main reasons. Firstly, aggre- 0.06 2.1
mated. Factor models usually pro-
gate time series are usually avail- 0.04
1.5 duce better prospective correla-
0.9
able only at a very high level, with 0.02 0.3
asset tion estimates than direct observa-
value 2
insufficient data on underlying 0.00 -0.3 tion and have the additional bene-
-1.5 -1 -0.9
credit risk rating, industry and geo- -0.5 0
0.5 1
fit, if macro-economic factors are
1.5 2 -1.5
2.5 3
graphic distribution of the portfolio. 1 defaults asset value 1
3.5 4
2 defaults
chosen, of enabling intuitive stress
Secondly, using aggregate time testing and scenario analysis of the
series produces unstable results credit portfolio. An example of a
over time. macro-economic factor model is
6. Illustrative macro- economic factor model
A more attractive solution to cal- shown in figure 6. The ‘connection’
culating credit risk correlation is to of credit risk to underlying macro-
average factor
use a causative default model that weight economic risk factors has signifi-
takes more observable financial 0.20 cant implications for credit risk
quantities as inputs, and then trans- 0.15 management and the future
forms them into a default probabil- 0.10 exchange
development of credit markets. Not
ity. The most widely used model for 0.05 rate interest only could a credit portfolio man-
index rates unemployment
commercial lending portfolios 0 ager potentially hedge credit risk
equity property
being the Merton default model -0.05 index index via equity or ‘macro-economic’
(figure 4). -0.10 derivatives, but professional mar-
The Merton model assumes that -0.15 ket-makers should ensure that
a firm will default if, over a 12- -0.20 credit, equity and other derivative
month period, the market value of -0.25 desks are positioned to take
assets falls below the value of advantage of resulting arbitrage

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7. Monte Carlo simulation

Monte Carlo simulation

simulated portfolio loss
input datasets
and value distribution
borrower/cluster portfolio response
details scenario 1 to scenario probability density
• exposure DEquity = –20% probability
•collateral DFX =+5% density
•margin • change
•rating • in value
DUnemp=+2% loss
opportunities. These developments •factor weights
scenario 2
are likely to be a major driver of liq- %change in value,% losses
scenario 3 • change in
uidity as these markets develop. • •
value

In figure 6 a positive factor weight • •

probability loss
indicates that a positive change in scenario N* density
that factor produces an increase in DEquity =+15%
change
asset value, with a corresponding factor-to-factor DFX =+0.5%
in value
correlations • 10% 5% 0% –5%
rise in credit quality and reduction in • loss %change in value,% losses
DUnemp=–0.5%
default rate. Conversely, a negative %change in value,% losses
factor weight indicates that a posi-
tive change in that factor produces
a decrease in asset value, with a
corresponding fall in credit quality A. Summary of credit portfolio models
and increase in default rate. Model/factor Risk measure Advantages Disadvantages
■ Simulation methods. Whilst the risk Oliver, Wyman & Co ● Loss-based ● Intuitive understanding of ● Additional complexity in
of small credit portfolios can be cal- approach (and other ● NPV-based underlying factors portfolio model calculations
culated analytically, the large num- proprietary models) ● Applicable to all portfolio ● Data availability
segments
ber of calculations required mean Macro-economic factor models ● Links to economic
that for most portfolios it is better to forecasting models and
employ a numerical simulation provisioning
● Ease of stress testing/
technique. Monte Carlo simulation is scenario analysis
the standard method, and can be KMV Portfolio Model ● Loss-based ● Simplified portfolio ● Loss of intuitive understanding
thought of as a ‘state-of-the-world ● NPV-based model calculations of underlying factors
generator’ that generates all possi- Orthogonal factor sets based on ● Data availability for ● Applicability to non-quoted
equity prices quotedcompanies companies/retail segments
ble states of the economy and the
JP Morgan CreditMetrics/ ● NPV-based ● Data availability ● Ability of factor structure to
resulting impact on the value of the CreditManager ● Easy to understand describe correlation effects
credit portfolio. In this way a distribu- factors (especially for non-corporate
tion of all possible portfolio values is Equity indices exposures)
built up, from which its credit risk pro- CSFP CreditRisk+ ● Loss-based ● Simplicity ● Loss-based calculation only
● Speed of calculation ● Lack of macro-economic
file can be calculated (figure 7). “Market risk” volatility insights
■ Summary of credit portfolio approach – no factor structure ● Performance drop-off when

models. There are a number of cur- specifying multiple portfolio

rently available credit portfolio
models that are distinguished by
their correlation structures and
choice of risk measure. These mod-
els are summarised in table A.
segments
capital. This is calculated from the
8. Assessment of economic capital
tails of the credit risk distribution by
requirement
determining the probability that a
expected NPV
expected loss

reduction in portfolio value loss

III. Portfolio model exceeds a critical value. A loss-
applications based example of such an analysis
Having discussed the inner workings is shown in figure 8 where, to 99.98% 99.00%
of credit portfolio models we can achieve a Aa1/AA+ credit rating loss-based NPV

now illustrate their uses by examin- (equivalent to a 0.02% default

ing a number of management probability), economic capital
99.98% 99.00%
applications. equivalent to 7.8% of total exposure NPV-based
■ Solvency analysis. The most obvi- is required.
-9% -8% -7% -6% -5% -4% -3% -2% -1% 0% 1% 2%
ous application of a credit portfolio ■ Credit risk concentrations and % change in loss, % change in NPV
model is to calculate economic portfolio optimisation. Breaking

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10. Potential diversification benefits in
9. Credit risk concentrations
a typical bank portfolio
economic
capital
(£bn) reduction in
Economic capital as % of exposure name reduction in
6% £5.6bn concentration correlation
70
exposure by counterparty specific risk
60
10m economic capital
50 £4.0bn
50m economic capital 4%
40
systematic
30 risk
20
2%
10
0
0 100 200 300 400 500 600 700 800
Exposure (millions) 0%
existing diversified
portfolio portfolio

11. Loan loss sensitivity 12. Stress testing credit portfolios

Assessment of capital adequacy under property crash

scenario

Base Case: 7.7%

Economic capital AA+ (99.98%) solvency
standard

Property Crash Scenario 1.90%

Probability that losses exceed 7.7% of
outstandings

implied probability of scenario 1.05%*

consistent with desired solvency standard
* = 0.02% ∏1.90%

down the aggregate credit risk
distribution to show the credit risk of
each portfolio element allows risk
concentrations and hence diversifi-
cation opportunities to be identi-
fied (figure 9). For most credit port-
folios, simple optimisation tech-
niques will substantially reduce
economic capital requirements –
typically reductions of 30% are
achievable equivalent to annual
savings of £288m (assuming a capi-
tal charge of 18%) for a portfolio of
the underlying macro-economic iour under stress-test scenarios is
risk factors can also be examined shown in figure 12.
to determine whether a hedging
strategy might be possible (figure IV. Conclusion
11). This article has described the
An extension of this application is underlying theory of credit portfolio
to use the models for ‘stress-testing’ models and illustrated their value in
to estimate possible changes in making more effective manage-
portfolio value conditional on ment decisions.
extreme macro-economic scenar- With the rapidly growing market
ios. An example of portfolio behav- in credit derivatives and portfolio
securitisations, the possibility of
active credit portfolio manage-

‘
£100bn (figure 10). Banks must ensure that ment will increase dramatically and
■ Sensitivity analysis and stress test- result in a fundamental shift in the
ing. Portfolio models can be used
they understand the way banks both originate and hold
to calculate expected loss rates economic value of their credit assets. In order to benefit
under different economic scenarios from these new opportunities,
and thus drive dynamic provision-
portfolios and how this banks must ensure that they under-
ing estimates or loan loss reserving can be maximised stand the economic value of their
methodologies such as the SBC portfolios and how this value can
ACRA reserve. The sensitivity of
through effective be maximised through efficient
portfolio credit losses to changes in management’ credit portfolio management.

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