Academic journal article Federal Reserve Bank of New York Economic Policy Review

Portfolio Credit Risk

Academic journal article Federal Reserve Bank of New York Economic Policy Review

Portfolio Credit Risk

Article excerpt

INTRODUCTION AND SUMMARY

Financial institutions are increasingly measuring and managing the risk from credit exposures at the portfolio level, in addition to the transaction level. This change in perspective has occurred for a number of reasons. First is the recognition that the traditional binary classification of credits into "good" credits and "bad" credits is not sufficient--a precondition for managing credit risk at the portfolio level is the recognition that all credits can potentially become "bad" over time given a particular economic scenario. The second reason is the declining profitability of traditional credit products, implying little room for error in terms of the selection and pricing of individual transactions, or for portfolio decisions, where diversification and timing effects increasingly mean the difference between profit and loss. Finally, management has more opportunities to manage exposure proactively after it has been originated, with the increased liquidity in the secondary loan market, the increased importance of syndicated lending, the availability of credit derivatives and third-party guarantees, and so on.

In order to take advantage of credit portfolio management opportunities, however, management must first answer several technical questions: What is the risk of a given portfolio? How do different macroeconomic scenarios, at both the regional and the industry sector level, affect the portfolio's risk profile? What is the effect of changing the portfolio mix? How might risk-based pricing at the individual contract and the portfolio level be influenced by the level of expected losses and credit risk capital?

This paper describes a new and intuitive method for answering these technical questions by tabulating the exact loss distribution arising from correlated credit events for any arbitrary portfolio of counterparty exposures, down to the individual contract level, with the losses measured on a marked-to-market basis that explicitly recognises the potential impact of defaults and credit migrations.(1) The importance of tabulating the exact loss distribution is highlighted by the fact that counterparty defaults and rating migrations cannot be predicted with perfect foresight and are not perfectly correlated, implying that management faces a distribution of potential losses rather than a single potential loss. In order to define credit risk more precisely in the context of loss distributions, the financial industry is converging on risk measures that summarise management-relevant aspects of the entire loss distribution. Two distributional statistics are becoming increasingly relevant for measuring credit risk: expected losses and a critical value of the loss distribution, often defined as the portfolio's credit risk capital (CRC). Each of these serves a distinct and useful role in supporting management decision making and control (Exhibit 1).

[Exhibit 1 ILLUSTRATION OMITTED]

Expected losses illustrated as the mean of the distribution, often serve as the basis for management's reserve policies: the higher the expected losses, the higher the reserves required. As such, expected losses are also an important component in determining whether the pricing of the credit-risky position is adequate: normally, each transaction should be priced with sufficient margin to cover its contribution to the portfolio's expected credit losses, as well as other operating expenses.

Credit risk capital, defined as the maximum loss within a known confidence interval (for example, 99 percent) over an orderly liquidation period, is often interpreted as the additional economic capital that must be held against a given portfolio, above and beyond the level of credit reserves, in order to cover its unexpected credit losses. Since it would be uneconomic to hold capital against all potential losses (this would imply that equity is held against 100 percent of all credit exposures), some level of capital must be chosen to support the portfolio of transactions in most, but not all, cases. …

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