Magazine article The Journal of Lending & Credit Risk Management

Organizational Issues and Transactional Capabilities for Credit Portfolio Management

Magazine article The Journal of Lending & Credit Risk Management

Organizational Issues and Transactional Capabilities for Credit Portfolio Management

Article excerpt

The need to better manage credit risk was underscored by the credit cycles of the 1980s and early 1990s. Furthermore, the emergence of a secondary market for commercial loans, the successful securitization of selected types of loans, and the development of credit derivatives have created opportunities to apply modern portfolio techniques to the management of credit exposures.

While the ultimate goal of portfolio management is widely recognized, market limitations, as well as internal organizational and cultural issues, have led institutions to develop quite different approaches to this practice. In time, today's varied techniques and procedures will become increasingly standardized; however, the process of establishing a portfolio management practice is likely to remain a unique experience for each institution that ventures down this path.

Methodologies, Models, and Procedures

A strong credit portfolio is a prerequisite for success in banking. Decisions about the portfolio's composition have traditionally been made at the level of the individual counterparty (borrower). Paramount to this analysis is an assessment of the counterparty's historical performance, the quality of its management, the purpose of the transaction, and the counterparty's ability to meet its future financial obligations.

In this traditional credit process, portfolio management emphasizes the protection of underwriting standards for new counterparties and new transactions. Credit analysis is done under the assumption that the asset or exposure will be held until maturity, and little consideration is given to the risk characteristics of other assets held in the portfolio when the origination decision is made. Once a new counterparty or transaction is on the books, the responsibilities of the traditional portfolio manager are largely passive. They include:

* Monitoring the portfolio's structural characteristics as they relate to credit quality, tenor, and industry/geographic/name exposures.

* Reporting significant changes in these structural characteristics or in the performance of individual assets.

* Recommending corrective actions.

In contrast to traditional portfolio management, a number of banks are developing a more active approach to portfolio management, which includes:

* Recognizing the need to consider each asset, or prospective asset, as part of an overall investment plan or strategy.

* Committing to manage portfolio returns as well as risks.

* Measuring portfolio performance in a manner that facilitates comparison with other asset classes.

* Using transactional capabilities to affect the risk/return structure of the portfolio.

In their efforts to develop active portfolio practices, banks have attempted to adapt the methodologies and models first applied in managing market risk (equity and fixed-income) portfolios. However, progress in modeling portfolio risk in credit portfolios has been slow.

* First, the typical distribution of credit returns is very different from the "bell-shaped" distribution of market returns. In a credit portfolio, the remote probability of large losses produces skewed-return distributions with "fat" downside tails. To describe these distributions analytically requires much more information than simple summary statistics such as the mean and standard deviation.

* Second, a distinguishing characteristic of all portfolio models is the recognition of correlations among asset returns in the portfolio. In market portfolios, the data necessary to compute historical correlations are readily available; however, such data are not readily available for credit portfolios. Typically, correlations of credit returns must be inferred either through equity prices or through simulation models that relate credit returns to underlying economic variables. In most cases, it is the treatment, or handling, of correlations that distinguishes alternative portfolio models. …

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