Sunday, July 10, 2011

Active Credit Portfolio Management

ACPM has evolved as a practice among financial institution with a global foot print as to keep a healthy portfolio while sensing and acting ahead of any predicted and unpredicted losses leading to a crisis that leads to the financial instability  of the institution.

Post banking crisis and portfolio concentration

If we do an analysis of past banking crises
we can find one major Common source of bank failures which accounts to too much portfolio concentration in a specific sector, region or country.

This is quite natural that any business, no matter how much diversified it is? Can not do well in all areas.
The earning and concentration improve with rising economy and dawns with the slow down.

Rise in the economy may take place in specific region or sector.Which is based on prevailing conditions derived by several factors.Banking and finance is also a type of business and gets affected with these ups and down.

If a bank develops a strong business in a particular sector or region, and if it's subsidiaries does its job well.
Over a period it will generate concentrated exposure to that area as because of the liqidity which is there and specialization that it develops with its client.

This heavy concentration in a specific sector apparently seems giving a lot of return in short term but may pose  a risk in long term specially when the slow down in economy happens  may or may not leading to the corrections in the market.

In a global market, the correlations may be less apparent,but no less dangerous.
Actively managing a portfolio mitigates this concentration risk to the extent possible.

Portfolio diversification

Despite the advances in managing credit portfolios,Recent subprime crisis in the United States suggests that many institutions still have lot to do in terms of managing their exposure to liquidity risk.
Liquidity risk arises when the confidence between borrower and lender or buyer and seller decreases suddenly.Or May be due to too many market participants end up on the same side of every trade.

This may leads to a major loss suddently or significan number of defaulters which may lead to another difficulty which is  developed from the challenge in managing potentially large losses on the bank’s loan book.

Actual trouble arises when a sizable portion of a bank’s portfolio of loans simultaneously cannot be repaid as promised.In this case the bank, in a sense, becomes the victim of its own success.

Connectig this to retail banking,I still remember a night when each customer was trying to take out money from one of the Bank ATM fearing losses because of negative sentiments in the market.

This is why there is lot of emphasize on portfolio diversification. A variety of financial institutions manage their portfolios using measures of diversification.

In recent years, some of the most sophisticated banks have used portfolio analysis technology to devise transfer pricing mechanisms allowing them to separate the management of the bank’s credit portfolio from the creation of valuable service businesses.

Clearly, today the motivation for trading credit goes beyond avoiding a default and ranges from perceived market inefficiencies to portfolio rebalancing designed to improve the return/risk profile of an institution’s entire credit portfolio.
Banks and financial institution are in a way to separate the management of the bank’s credit portfolio from the creation of valuable service businesses.

Issue with defining risk on the Basis of obligor not on overall portfolio
Many have focused on risk as defined only in terms of the probability of default (i.e., firms with low PDs (high ratings) are safe and those with high PDs are risky).

The trouble with this definition is that a portfolio can store up “time bombs,” in effect, that are not readily appreciated until it is too late when many firms in the same industry or geography default at the same time.

Since the probability of default of one loan is the same regardless of the concentrations in a portfolio, the potential for large losses on a portfolio can change dramatically with portfolio correlation.

Furthermore, the tracking of credit migration or changes in value prior to maturity becomes essential to capturing the true risk of a portfolio through time. Otherwise, the portfolio manager may be surprised by a cluster of sudden defaults.

An approach that considers both the underlying risk and the change in the values of securities within a portfolio is a superior focus for risk assessment than just the risk of defaults within a portfolio.

The  Credit and Market risk Connections:

In the case of credit risk, the change in value derives from the changing probability that the obligor will fulfill
its obligation to pay interest and ultimately repay principal. This is fundamentally different along a number
of dimensions than market risk, which encompasses changes in a security’s value as driven by variables such as interest rates, equity prices, commodity prices, and foreign exchange.

The availability of data and liquid markets in instruments such as interest-rate swaps and other derivatives has made it easier to introduce quantitative hedging and portfolio management techniques in the field of market risk for equity and other instruments, while the absence  of data and the more complicated statistical relationships made it  more difficult historically to do the same for credit risk.
That said, recent advances in both fields have produced a convergence of models and systems. Increasingly, which has encounterd demands to integrate credit and market risk.

An implication of this shift is in managing a bank’s portfolio separately from developing its franchise businesses  (which includes the business of loan origination) is that a bank moves from an originate-and-hold strategy to an originate-to-distribute (also called “originate-and-distribute”) strategy.

This means that loans may be sold or hedged  right after origination and not necessarily held to maturity.
Said differently, the bank now manages its portfolio or credit risk based on portfolio concerns rather than assuming it will hold each originated loan to maturity.

model must still evolve to provide more closely aligned incentives for market participants.

Understanding ACPM buisness
Understanding ACPM business requires understanding of portfolio framework
And Understanding the portfolio framework requires definitions of the key components used for credit portfolio analysis:
Probability of default (PD): The probability that an obligor will not meet a stated obligation. In the case of a loan, the obligor is the borrower and the obligation is to pay a regular coupon and repay the principal at
maturity. A PD will have a time horizon attached to it.
Loss given default (LGD): The amount lost when an obligor fails to meet a stated obligation. Many times the focus is on recovery, or 1-LGD.
Time horizon of analysis (H):
Meaningful credit portfolio analysis requires the specification of a time horizon over which the analytics are calculated. Most analyses begin with the assumption that H is one year. Note that we often denote time with the letter T. we can distinguish time to maturity as T from time horizon of analysis, which is H.

Default correlation: The co-movement into default of two obligors.

Value correlation: The co-movement in the value of the credit-risky securities within a portfolio.
With these definitions, we can sketch out the framework for evaluating a
credit portfolio. Initially, we will determine expected loss, which is a primary
cost of building a credit portfolio.
Expected loss (EL): PD times LGD. This quantity is typically calculated over the time horizon, H. In this definition, we assume that the exposure at default (EAD) is par. This definition can be modified for other
instrument types.
Economic capital: The amount of (value) cushion available to absorb extreme losses—that is, absorb losses after using other sources of reserves such as provisions based on EL and earnings from exposures.
The economic capital amount is calculated based on a target probability associated with an estimated portfolio loss distribution for the time horizon, H. That is, the economic capital corresponds to
the present value (of amounts at time H) of the loss level at which the probability of exceeding that loss level equals the target probability. it may be tempting to interpret EL as a measure
of risk; however, it is better thought of as a measure of the cost of  building credit portfolios. Then when we discuss capital as a cushion for unexpected losses, we have a clean separation of costs and capital.

Following are two preferred measures of portfolio risk:

Unexpected loss (UL): A measure of the volatility or standard deviation for a portfolio loss distribution.
Tail risk (TR): A measure of the likelihood of extreme losses in the portfolio (this is similar to the concept of value-at-risk or VaR; we will also introduce the concept of conditional VaR or CVaR, which is
sometimes referred to as expected shortfall). Tail risk corresponds to the area of the portfolio loss distribution from which we typically calculate economic capital.

Economic capital and Book Capital EC typically differs from book capital, which is an accounting concept.
Book capital is not really the value cushion available to absorb extreme losses; book capital reflects the accumulation of accounting entries that have a backward-looking bias.
Whether the financial institution possesses the resources to absorb loss depends entirely on the current ability of the financial institution to make use of its equity’s market value.
Regulatory capital Another type of capital results from regulations. This is known as regulatory capital.

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