Credit limit principles

The point of credit risk limits is to set an upper bound to the loss that can be suffered by a bank at any one time.

The basic principles of credit limit setting are universal for every bank and follow the essential requirements of prudence and concentration. An element of diversification in the loan portfolio is necessary, although at all times the bank should practise the basic principle of “know your risk”. In other words, diversity as an end in itself is not recommended good practice; a bank should diversify only into sectors that it thoroughly understands and in which it has some competitive advantage or valuable skill base.

In standard textbooks on finance and banking, we read that it is the capital base that drives the limit‐setting process. Essentially, what this is saying in practice is that we take the amount of capital available and allocate it as per credit limit buckets for each of the businesses. Actually, the proper and intellectually robust way to do this is the other way around: the bank should determine its strategy and business model, as well as preparing budgets based on the risk exposure that it considers it has the expertise to manage. This process then drives the level of capital and regulatory capital that the bank should then set up. Once this amount is known and achieved, it can then be allocated to specific business lines as lower level credit limits by geography, industry, product, and so on.

The essential principles governing limit setting include the following:

• All single exposures should be sufficiently contained such that a complete default, running the risk of 0% recovery, can be contained within the existing capital base and does not endanger the bank as a going concern. In other words, after the loss the bank should still be within its regulatory capital limits;
• The loan portfolio should be diversified by industrial sector, geography, and product line, within the knowledge base and expertise of the bank;
• Set minimum internal (and, if desired, external) rating criteria below which the bank will not lend. For example, this may be “investment grade rated only” or “no lending to entities with an internal rating equivalent to BB/Ba2”;
• Do not lend to obligors any amount that as a result overextends them and creates a situation in which repayment is put at risk. This requires that the “know your risk” dictum be applied equally to understanding the customer's risks. This should be assessed via an analysis of the borrower's financial indicators, including leverage ratio, debt service coverage ratio, and so on;
• Set limit categories to avoid concentration, and also by borrower rating.

As part of a transaction origination process, reviewers must consider what “ancillary business” can be generated from the same borrower. The bank must set a policy that dictates how much this ancillary business drives the origination process, whether the lending business can be a “loss leader” to an extent or can create sufficient shareholder value added in its own right.

Credit limit setting

The process of setting credit limits is very important to all banks – vanilla commercial banks, in particular – insofar as credit risk exposure generates the highest losses for such institutions. The process should follow prudent and robust policy and be run according to cycle‐proof principles to avoid getting overextended during a bull market, when loan origination standards are relaxed. Credit limits are set for a range of criteria, which are deliberately set as overlapping so as to ensure that all the various different categories of risk exposure are captured.

Macro‐level credit limits are set per individual obligor, originated within the business lines but approved by the Executive Credit Committee and secondarily approved by the asset and liability committee (ALCO).¹ When necessary, if the size of a transaction dictates it, further approval may be needed by the Executive Management Committee (ExCo) and the Board itself. The level of capital allocation required for a particular limit application determines how far up the governance structure it needs to go. Formal limits on capital allocation are therefore set at ExCo approval level.

The limit‐setting process is designed to produce overlapping limits. Limits will be set in the following categories:

• Individual obligor – This is further split into limit by product class, limit globally and limit locally. Sub‐limits do not necessarily aggregate to the overall obligor limit: this is to prevent excess exposure in one product class or geographical region. Sub‐limits are also set per currency. At all times, the obligor's exposure cannot exceed its overall limit;
• Geographical region – This is further split into country limits and individual regions within a country;
• Industrial sector – As no individual limit can be breached, any new capital‐using transaction must fit into the capacity allowed by all three limit categories.

Limit excess is a serious breach of management governance and must be reported to ALCO (and, if necessary, ExCo) for corrective action. This can be effected by one or more of the following: (i) cease further business with the specific obligor; (ii) transfer some of the exposure, either by secondary market sale, securitisation, or hedging with credit derivatives; (iii) increase the limit; or (iv) transfer some capacity from another part of the business and/or another obligor.

Non‐retail

Traditional banking was very much an “expert system”, where bankers allocated credit in their sectors using subjective judgements. A popular framework was the “five Cs” – character, capital, capacity, collateral, and cycle – weighted as deemed appropriate. Without rigorous analytics, credit was sometimes extended to clients sponsored by the relationship banker who shouted loudest. But, again, soft factors are important and two broad areas for consideration are management and business.

Retail

For many years, retail credit decisions were made by local bank relationship managers based on qualitative factors. Models used to analyse wholesale loans could not be applied to small, unrated borrowers. Data has been expensive to collect and verify, with the cost amplified given small potential profit. Often, sound retail credit decision frameworks have been developed by smaller banks with dedicated resources, local knowledge, and relationships. Part of the decision should be based only on a borrower's ability to pay, but also on their sense of obligation to pay. Borrowers may have a local business and range of other debts (credit cards, mortgages, loans) to consider.

Strictly subjective retail credit decisions allow for inconsistency, and sometimes bias on the basis of race, religion, national origin, gender, or marital status. Perceptions as to the most favourable types of employment could also lead to less rational decisions.

Pricing, provisioning, and capital management

The Basel Committee defines a rating as a “summary indicator of the risk inherent in an individual credit”. Ratings “typically embody an assessment of the risk of loss due to failure by a given borrower to pay as promised”. A rating system is defined as “the conceptual methodology, management processes, and systems that play a role in the assignment of a rating”. Ratings have two dimensions: (i) borrower propensity to default; and (ii) transaction characteristics (for example, product, terms, seniority, and collateral).

Under the Basel “Standardised Approach”, banks use ratings developed by external rating agencies. The starting point for capital required against assets is 8% of the nominal, against which a risk weighting is applied according to a matrix of ratings and types (sovereign, bank, or corporate). An AAA‐rated sovereign asset with a 0% risk weight requires no capital. A $100 million A‐rated bank asset with a 20% risk weight requires 1.6% or $1.6 million of capital ($100 million × 8% × 20%).

A bank loan pricing model is based on the capital required and the target return on that capital. The model considers funding, default probability, recovery rate, and taxes as costs against the interest rate charged in calculating a net gain to weigh against the capital required. If loan rates in the marketplace are below the rate needed to meet the target return, the bank needs to decide whether it will accept a lower return to maintain market share or the client relationship.

Since Basel II, banks meeting strict criteria are permitted to use internal ratings to calculate regulatory capital for credit risk. The rationale is that “internal ratings can prove to be more sensitive to the level of risk in a bank's portfolio”. Internal ratings may incorporate supplementary customer information, which is usually out of the reach of external credit assessment institutions. Banks will (have incentives to) further refine internal credit risk management and measurement techniques.

Internal ratings must satisfy the “use test” and serve as the basis of risk, limits, pricing, provisioning, and capital management decisions, and not be simply for regulatory risk capital calculations.

Both Basel I and Basel II were designed to ensure that banks maintain an adequate capital buffer based on an expected loss methodology. The standard credit loss profile, illustrated in Figure 3.1, lies behind the capital calculation.

Figure 3.2 shows how this general credit losses distribution drives the minimum capital level. Expected losses are covered in the loan asset pricing, typically via the target rate of return (given by the cost of capital). Unexpected losses are covered by the capital reserves, shown in Figure 3.2 as economic capital. Of course, regulatory capital rules assign risk weightings based on the type of loan asset counterparty, and these risk weightings drive the regulatory capital minimum. In the Basel II regime, credit ratings are used to determine risk weightings for banks that use the standardised approach.

Where losses exceed the unexpected losses used to derive the capital calculation, the shortfall results in cessation of the bank as a going concern.

In theory (and in practice if one was putting together a bank's capital structure from scratch today), the expected loss profile effectively drives the capital structure. As Figure 3.3 shows, if the UL is 10%, then this is the minimum equity base requirement.

Critics of Basel II believed that while giving banks more responsibility to measure risk creates greater focus and better analysis, it opened up possibilities for opportunistic behaviour and regulatory arbitrage.

Retail, non‐retail, and specialised lending exposures

The dominant practice of banks is to use ratings to manage corporate credit risk as described. Ratings remain relatively constant, and are often linked to a schedule of average default probabilities. Rating mobility is a function of a bank's philosophy, which can be either Through‐the‐Cycle (TtC – more active migration) or Point‐in‐Time (PIT – less migration).

The quality of the portfolio shifts as the distribution of ratings evolves.

Retail exposures are not generally managed using ratings on an individual borrower basis. Exposures are grouped into segments with similar risk characteristics. Often, the distinction between borrower and product is limited or eliminated. Borrower characteristics (for example, population segment, income, credit history) and those of the facility (for example, product type, credit limit, collateral) are blended in formulating segments. To demonstrate homogeneity of risk, genuine segmentation requires all borrowers within a segment to be treated the same.

Retail exposures include loans (for example, personal finance, education loans, auto loans, or leasing), revolving credits (for example, overdrafts, revolving credit plans, or home equity lines), credit cards, residential mortgages, and small business facilities. Typically (and from a BIS regulatory stand point) retail exposures are managed on a product (facility) basis as opposed to an obligor basis.

There are four tests for characterisation as retail exposure:

• Product;
• Credit to individuals;
• Manageable as a pool of exposures;
• Low value.

For retail exposures, delinquent exposures are managed separately.

In specialised lending, both the source of repayment of a loan and prospects for recovery in an event of default are based on the cash flow from a project or property rather than on the ongoing, open‐ended operations of the borrower. Assets pledged as collateral serve to mitigate risk and as a secondary source of repayment. Types of specialised lending include project finance, income producing real estate, high volatility commercial real estate, object finance, and commodities finance.

Specialised lending possesses unique loss distribution and risk characteristics. Given the source of repayment, the exposures exhibit greater risk volatility, with both high default rates and high loss rates in times of distress. Banks use different internal risk rating criteria. Historical data is often not as readily available or comparable and relevant to the current special financing exposures being assessed.

A special risk management focus for specialised lending includes financial strength and flexibility, collateral control, project phase, and marketability.

Consistency: internal ratings and external credit rating agencies

As described earlier, the largest rating agencies have been performing analyses and collecting data for well over a century. Rating agencies have large teams and resources, and regular contact with the entities they rate. However, while external ratings are undoubtedly useful, they are no more than opinions, and are not a substitute for analysis and informed decision‐making. Banks with borrower relationships may have insights that lead them to assign different ratings from those of the agencies.

Rating agencies serve a wide range of constituencies that use ratings for differing purposes. As such, there are a range of opinions on their process. Some want ratings to be adjusted quickly to give signals of possible deterioration, while others want them to be more stable and uninfluenced by short‐term developments. The role of the economic cycle in ratings is often debated.

Rating agencies rely on the accuracy and completeness of information supplied by borrowers, and do not search for or expose fraud. Analysts concluding that available data raises some questions can assign more conservative ratings or fail to assign or withdraw ratings, but users cannot rely on rating agencies for more.

Some are of the opinion that ratings are biased to the upside, given that borrowers pay for their ratings.

Counterparty risk parameters for non‐defaulted assets

After assigning ratings, banks estimate risk parameters for key exposures including probability of default (PD), loss given default (LGD), and exposure at default (EAD). Exposures are risk weighted by Basel‐mandated asset class (corporate, sovereign, bank, retail, and equity) to arrive at total risk weighted assets (RWA) to determine capital requirements.

Probability of default (PD) describes the likelihood of default over a particular time horizon. PD estimates are derived from internal default experience, mapping to external data, and statistical default models. Except for pooled retail exposures, PD for a particular grade must be a long‐run average of 1‐year default rates. Retail PD estimates must be derived primarily from internal data.

Expected loss given default (ELGD or LGD) is defined as the “economic” loss for non‐defaulted assets, accounting for inflows (via sale of supporting collateral, unsecured recoveries, and guarantor payments) and outflows (via additional post‐default drawdowns on the credit facility, internal administrative costs, and external legal and valuation fees) measured relative to the exposure at default.

An “economic” loss (unlike an accounting loss) takes into account all relevant factors including material discount effect, and material direct and indirect costs associated with holding and collecting the defaulted facilities.

Methods used to estimate ELGD for credit facilities fall into one of two categories. Subjective methods are primarily driven by expert judgement and used mainly on portfolios with few defaults and/or by banks in the early stage of internal model development. Objective methods largely rely on formal mathematical procedures, and can be further divided into explicit methods (i.e. market LGD approach and workout LGD approach) and implicit methods (i.e. implied market LGD approach). The decision to select one of these objective methods is largely driven by the nature of the portfolio in question, exposure type (loan vs bond), and the availability of data.

Estimates are based on historical recoveries (including collateral) in economic downturn conditions and used in calculating regulatory capital. LGD is economic rather than accounting loss, which includes direct and indirect costs discounted back to the point of default. Interpretations of key parameters differ by bank and are not always comparable. Definitions of downturn vary, with some banks using two consecutive quarters of negative GDP growth, while others emphasise product downturn rather than overall economic conditions. The relative financial condition and capabilities by bank are important, as funding levels affect discount rates, stronger banks negotiate better collateral terms, and more capable and well‐staffed teams work through defaults more quickly and efficiently. While PD is largely the same across all types of exposures to a borrower, LGD is likely to vary significantly by product. Banks are expected to be conservative, and auditors and external supervisors must be able to validate the model. Repurchase Value Estimators are used when banks need to take possession of and sell property and goods.

Expected exposure at default (EAD) is the gross exposure upon default. For fixed credit facilities (such as term loans), EAD is simply the amount outstanding (although EADs slightly above 100% are not uncommon given interest accrual). For revolving facilities (such as lines of credit, liquidity facilities, and overdrafts), EAD is the drawn amount plus an estimate of the amount of the remainder of the commitment likely to be drawn at the time of default. These estimates are often referred to as either the Credit Conversion Factor (CCF) or Loan Equivalent.

LGD and EAD for corporate, sovereign, and bank exposures are based on a BIS required period of no shorter than 7 years. Estimates for retail exposures are based on at least 5 years of data unless the bank demonstrates that recent data is a better predictor.

If a supervisor agrees that a bank's total expected loss is less than its provisions, the difference can be included in Tier 2 capital. This can occur in practice as the assumptions used in modelling the provisions required do not necessarily align with those for the capital calculations (for example, a point in time LGD is often used for provisioning, while a downturn LGD is used as a basis for capital calculations).

Counterparty risk parameters for defaulted assets

When exposures default, actual losses can exceed LGD estimates. At this stage, banks need to make a Best Estimate of Expected Losses (BEEL) for each defaulted asset considering the current economic climate, so as to cover the possibility of additional losses. Again, historical data from a full economic cycle should be used as a basis, with losses consistent with any provisions or charge‐offs taken.

Impaired assets

Treatment of assets with a reduced likelihood of performing in full was a source of controversy in the financial crisis, as with hindsight it is clear that often problems should have been identified and loss provisions taken earlier. Under the IAS 39 “incurred loss” model, recognition of credit losses was delayed until there was evidence of a trigger event. While designed to limit the ability to build hidden reserves that could be used to boost earnings in future difficult periods, the model enabled earnings management, which postponed losses.

Under IFRS 9, banks are required to recognise expected credit losses at all times and to update the amount of expected credit losses recognised at each reporting date. IFRS 9 broadens the information that banks are required to consider when determining expected credit losses (for example, reasonable and supportable historical, current, and forecast information). To reduce complexity, the same impairment accounting will now be applied to all financial assets.

This forward‐looking approach is much more transparent for central banks, regulators, creditors, and shareholders. The model eliminates thresholds and triggers for loss reporting, which should reduce “cliff effects”. Disclosure is enhanced, with banks required to explain the basis for their expected credit loss calculations, to explain how they measure expected credit losses, and to explain how they assess changes in credit risk.

Defaults events and measures: specialised lending

The cash waterfall is the priority of payments by which classes of lenders receive interest and principal. Senior lenders are paid first, followed by junior (also called subordinated or mezzanine) lenders. On loan initiation or bond purchase, senior lenders receive lower returns in exchange for lower credit risk. In a default, equity holders receive what (if anything) remains after assets are distributed to debt holders.

Lenders analyse the size of the company or project assets and collateral relative to debt to assess the value of seniority. If the loan is a general obligation of a large company to finance a small project, seniority may be less important. If repayment is secured only on the asset financed and the cash flow it can generate, a higher priority of payment may be more important.

Loan covenants require borrowers to meet certain conditions over the period of a loan. Breaches of covenants may trigger default, higher pricing, penalties, or termination (“call” or “acceleration”) of the loan. Covenants can relate to reporting standards, financial performance, ownership, or business activities.

Common financial covenants include:

• Debt Service Coverage Ratio (DSCR) is the ratio of income less expenses to interest and principal payments. DSCR is the main measure to determine whether cash flow is sufficient to service debt. It can be applied to all types of transactions and used as a covenant set at the minimum level acceptable to the lender;
• Loan Life Coverage Ratio (LLCR) is the net present value of cash flow available for debt servicing to total debt. LLCR is like DSCR but is a useful standard in project finance as the analysis covers the term of the transaction. LLCR is more difficult to monitor if project cash flows are likely to be inconsistent;
• Loan to Value Ratio is central to residential mortgage lending. LTV allows banks to gauge how far prices can fall before loss is incurred should they need to foreclose on the loan and liquidate the property.

Covenants may be waived, and only serve to ensure early alerts and constructive dialogue when conditions become more difficult. However, covenants do cede some control to banks, and management can be forced to take actions not believed by them to be in the best interests of the company.

Defaults events and measures: cross‐border lending

Currency convertibility and transfer risk is the loss that can occur if local currency cannot be converted to another currency and/or transferred abroad. The situation can arise when a country is experiencing capital outflows in a time of political and economic crisis. Governments may impose currency controls, or there may be simply no market for the currency. The risk is different from devaluation or appropriation of assets.

Risk assessment must include analysis of economic conditions, political situation, and legal framework. To the extent the country is integrated into the global economy through trade and capital markets activity, currency restrictions would be more likely to be avoided given the severe repercussions.

Risk can be mitigated by the use of cash collateral and letters of credit with banks in other jurisdictions, or increases in interest rates linked to currency disruption.

Impairment vs default

As discussed earlier, definitions of default vary. Impairment can be described generally as when an exposure is judged by management to have deteriorated so there is no longer a reasonable expectation as to the collection of the full amount as scheduled.

Banks can analyse a number of triggers for borrower deterioration to determine whether an asset is impaired:

• Macroeconomic deterioration:
  • National or local economic conditions relevant to the asset class;
  • Unemployment rate;
  • Property prices for mortgages;
  • Industry (or sector).
• Company:
  • Borrower requests for forbearance;
  • Breach of contract or covenants;
  • Credit rating;
  • Debt service capacity;
  • Financial performance;
  • Cash flow;
  • Net worth;
  • Decrease in turnover;
  • Loss of customers or market share;
  • Diversion of cash flows from earning assets to support non‐earning assets;
  • Prospects of the guarantors;
  • Collateral;
  • Country risks.
• Mortgage portfolio:
  • Decrease in rents received;
  • Absence of refinancing options.
• Retail portfolio:
  • Early delinquency (for example, one payment in arrears);
  • Continual high utilisation of facilities;
  • Steady increase in total debt for the client;
  • Income less than total debt repayments.

Banks should disclose impairment triggers to supervisors.

Loans generally appear on bank balance sheets as assets using nominal principal values. Once a loan is identified as impaired, the current probability of default and loss given default is applied and discounted to establish the new value. Both the loan and capital (shareholders' equity) are marked down on the balance sheet. Impairment provisions appear on the income statement as an expense. Debate as to the optimal balance accounting for loans is ongoing, with some arguing that constant marking‐to‐market is needed.

Lending exposure (legal entity)

As a first step, lenders must know exactly to whom they are lending. The legal entity and type (individual, partnership, trust, or corporation) and its powers to conduct business and engage in borrowing must be fully understood. The structure can be simple or highly complex, involving organisational charts and legal shells.

Group entity (obligor)

Banks must analyse exposure to all entities in a legal or economic group when setting limits, and take a view on the group's industry sector to manage concentration. Given support and cross‐support arrangements, the performance of non‐borrowing entities can either improve or hinder the ability of the borrowing entities to pay. Covenants and default events can be negotiated to apply to the entire group. The bank must be confident that controls are in place so that intragroup loans and transactions are conducted at fair market terms and on an arm's length basis.

On some transactions, co‐borrowers are jointly and severally liable, meaning that if one borrower can no longer repay debt, the other is responsible for full payment.

The Basel Committee recognises that banks have complex global businesses across regions and tax regimes, necessitating multiple entities across the group. However, banks' own intragroup support arrangements and dependencies must be fully understood with risks well managed.

Facilities/accounts (transactions): drawdown profile

Credit agreements include the terms of drawing down the amounts of a facility and types of accounts (for example, revolving credit account, term loan account). A schedule of drawdown amounts and dates can be specified, particularly in project finance. Drawdowns are subject to meeting the conditions precedent, which can involve providing these documents:

• Articles of incorporation demonstrating that the company can enter into the transaction;
• Financial statements;
• Project agreements, licences, consents;
• Rating agency confirmations;
• Legal opinions;
• Corporate authorisations or Board approvals for the transaction, which confirm execution by specified individuals.

Often, the provision of collateral is the precedent for another condition.

The timing and likelihood of drawdown are necessary to estimate exposure and risk.

Collateral

Collateral is (an) asset(s) pledged by the borrower to the lender to secure a loan. In the event of default, and where the bank decides not to restructure the transaction (and the counterparty cannot refinance externally), the bank will take possession of the collateral in order to offset their loss exposure. It is essential that the lender “perfect a security interest” in the collateral, so that it can easily take control and sell without dispute should the borrower fail to meet the terms of the loan.

Collateral ranges from cash, securities as well as property, to the asset being financed. The lender is best protected if the collateral is marketable in all economic conditions, characterised by low price volatility and denominated in the same currency. Banks can choose to lend up to a percentage of the value of the asset to protect against a decline in value. This is called taking a “haircut”, and the concept behind fixing loan‐to‐value percentages in the residential mortgage market. Some loans are “overcollateralised”, meaning the bank receives collateral worth more than the loan. Collateral value must be monitored regularly, with additional collateral (“margin”) required if the value declines.

Taking collateral must not be seen as risk‐free lending. Banks must only lend to clients they believe have the ability to repay from their operations. Reputation risk, collateral value volatility, and the process of taking and liquidating collateral must be considered.

Guarantees

Guarantees take many forms and are issued by all types of entities including banks, corporations, and sovereigns, as well as individuals. Banks issue direct guarantees and indirect or counter‐guarantees (where non‐performance of a second party's guarantee is guaranteed).

Guarantees include:

• A payment guarantee, which assures the seller that the purchase price will be paid on the agreed date if all contractual obligations are met;
• An advance payment guarantee, which assures the buyer that the advanced payment will be reimbursed if the seller does not meet contractual delivery obligations in full;
• A performance bond, which serves as collateral for costs incurred by the buyer due to failure of the seller to provide goods and services promptly and as contractually agreed;
• A bid bond (tender bond), which secures the organiser's expenses in tenders by requiring participants to pay if their bid is accepted but withdrawn;
• A warranty obligations guarantee, which secures any claims by the buyer for defects appearing after delivery;
• A letter of indemnity, which secures the shipping company against any claims if goods are delivered prior to receipt of the original bill of lading;
• A credit security bond, which serves as collateral for loan repayment.

Sovereign guarantees back projects deemed in the public interest, and support development and promotion of infrastructure, new industries, regions, and exports. Many sovereigns have state‐owned development and export/import banks.

On‐balance‐sheet netting

Banks offset client loans against deposits to reduce risk and capital requirements through netting. This is possible when:

• A bank has a well‐founded legal basis for concluding that netting is enforceable in each relevant jurisdiction in all conditions, supported by documents such as legal opinions and netting agreements;
• The maturity of the deposit is at least as long as the loan;
• A bank has adequate reporting and monitoring systems in place so it can always identify the relevant assets and liabilities as well as rollovers.

Netting allows a bank to do more business with its clients.

Netting is key to non‐balance‐sheet activities and businesses including securities clearing, payment systems, and derivatives.

Derivatives and hedging

Derivatives are financial contracts with a value derived from the performance of securities, interest rates, currencies, commodities, indices, credit, and other assets. Derivatives can have set terms (contract size, dates, underlying) and be exchange‐traded and highly liquid, or bilateral tailored contracts.

Banks hedge by taking derivative positions designed to perform in a manner opposite to their actual exposures. For example, a bank with a large credit exposure to a corporation can take a position in a credit derivative that would pay out if the corporation defaulted. “Basis risk” is the risk that the derivative does not perform in the direction expected or in the same magnitude as the position being hedged.

The most common types of derivatives are:

• Futures: a commitment to buy or sell at a fixed price at a fixed date in the future;
• Options: the buyer pays a premium for the right to buy (call) or sell (put) at a fixed price within a fixed time period;
• Swaps: parties agree to exchange a fixed payment against a floating payment.

Derivatives do not require the actual purchase and sale of the underlying. Most positions are closed out by buying or selling prior to or at maturity, with the gain or loss exchanged in cash. Derivatives are generally margined throughout the term of the trade.

Probability of default

Probability of Default is estimated from a range of sources. The simplest and most widely used throughout the world is rating agency ratings. Banks also use their own historical default databases or purchase those compiled by third parties. For some sectors, decades of default data is available. PD can also be estimated by monitoring bond and credit default prices.

Statistical methods to estimate PDs include:

• Linear regression;
• Discriminant analysis;
• Logit and Probit models;
• Panel models;
• Cox proportional hazards model;
• Neural networks.

Banks must make careful judgements as to how data is used. While default is rare (roughly 2% on average globally), consequences for debt portfolios are severe given small earnings margins and no upside as in equities. While modelling monthly or quarterly data from portfolio segments is common, defaults observed may not be a good indicator for forward‐looking analysis if a portfolio is growing or the market is new. The risk of PD being understated is significant.

An important concept in PD is “distance to default”. PD increases as the market value of the assets of a company decreases towards the book value of the liabilities. Issues considered are:

• The current asset value;
• The distribution of asset values at time horizon;
• The volatility of the future assets value at time horizon;
• The level of the default point, the book value of the liabilities;
• The expected rate of growth in the asset value over the horizon;
• The length of time horizon.

The default point is sometimes when the two values converge, although companies may continue to trade if the liabilities are longer term and creditors believe in the business.

Models must provide PD in both unstressed and stressed economic scenarios. Higher interest rates, which make debt more costly, can be integral to stress scenarios. “Point‐in‐time” PDs are estimated for unstressed conditions while “through‐the‐cycle” PDs estimate the trough. Both are fixed for 1 year, but PIT PDs will be volatile as the economy evolves, while TTC PDs will be more stable. Obligors must be classified as to how they are likely to respond to the economic cycle at both peaks and troughs.

Loss given default

The most common loss given default (LGD) measure is “Gross” (total losses are divided by EAD) because it is simple to calculate and requires the least data. Another LGD measure is “Blanco” (losses divided by the unsecured portion of a credit line), which is important when a bank has significant collateralisation. As a conservative measure, collateral is “haircut” in the calculation to allow for a fall in value, thereby decreasing LGD. Banks calculate “Downturn” LGD.

LGD can be difficult to calculate as bank recovery rates vary and workouts take different lengths of time, so peer data is not always useful. Formulas have been developed to best achieve comparability. Models “time weight” LGD, meaning historical data is not analysed simply by averaging loss severity of each default, but also considers the time periods in the economic cycle when they are likely to occur.

There are three objective LGD estimation methods:

• Market LGD, which is observed from market prices of defaulted bonds and marketable loans soon after default events. The main benefit is that actual prices can be used. This is the methodology used most by the rating agencies;
• Workout LGD, which is estimated cash flows from the workout process, based on estimated exposure and a discount rate. Users must monitor the timing of payments received and consider the riskiness of any restructured debt;
• Implied Market LGD, which is derived from prices of bonds deemed to be high risk. This is the least developed of the methods, but has the benefit of a large pool of market data.

Given the challenges involved in calibrating LGD models, banks reference external data sources, such as Pan European Credit Data Consortia (PECDC), S&P LossStat, and Paris Club restructure data.

Exposure at default

Exposure at Default is the gross total of extended credit plus estimated additional drawings for 1 year or until maturity. The greatest analytical challenge in setting Credit Conversion Factors (or Loan Equivalents) is estimating additional drawings. Globally, unused commitments are huge and it is logical that a corporation would seek to drawn down in stress scenarios. Examples of products where modelling is needed include committed loan and liquidity facilities and credit cards.

Strong information management systems are vital in assessing EAD, as the bank must ensure that troubled entities draw only under the terms permitted by the facility and up to the limit. Collateral must be monitored, priced, and margined. The bank must deal efficiently and quickly in default situations.

Risk appetite statement

Risk appetite is the quantum of risk a bank is prepared to assume in pursuit of its strategy, and is established, integrated into business plans, and monitored by the Board. The risk appetite statement sets out the risk profile by identifying risks and boundaries. The statement should be actionable and include quantitative measures. High level limit and target measures can be set against earnings at risk, probability of insolvency, and the chance of experiencing an annual loss. Best‐practice discipline dictates that the bank's Board sign off on the risk appetite statement. By being a Board‐issued document, it ensures that adherence to risk tolerance is taken seriously as a requirement of senior management.

Implementation requires proper policies, procedures, and controls. Regulators will monitor the level of Board involvement, adherence to policies, breach of limits, and policy changes. Crucially, the risk appetite statement must be used to identify excessive risk taking, which can threaten a bank.

Swaps and exotics exposures

Exchange traded derivatives are margined and guaranteed by exchanges, minimising credit risk. Over‐the‐Counter (OTC) derivatives are bi‐lateral contracts with substantial Counterparty Credit Risk (CCR), which must be carefully measured and managed.

Swap counterparties agree to exchange fixed‐rate for floating‐rate payments. If one counterparty defaults, the other has a loss if the trade has a mark‐to‐market gain. Assuming no recovery, the loss is the present value of the net payments remaining (replacement cost). Non‐defaulting counterparties with a negative mark‐to‐market position are not released from the position and will likely make a single cash payment to the receiver. There may also be some transaction cost in replacing the position in the market.

Buyers of options have similar CCR risk.

Potential future exposures and regulatory add‐ons

Swaps, foreign exchange and interest rate forwards, options, other derivatives, and securities finance transactions (repo) are subject to fluctuations in value over the life of the contract. Besides replacement value, credit risk measurement must include Potential Future Exposure (PFE), defined as the maximum expected credit exposure. PFE is important because some transactions have longer maturities where losses may emerge over time. Also, positions with large downsides in extreme markets (for example, options sold) are more fully captured.

CCR “add‐ons” are determined by multiplying the notional principal amount by Credit Conversion Factors set by type (interest rate, commodities, credit, currency, and equities), features, position, and term.

Netting

Netting agreements allow parties to net the mark‐to‐market values of their trades so that in the event of default the credit exposure is limited to the net positive value of the total. Netting is generally effected under an International Swap Dealer Association (ISDA) Master Agreement signed between the parties, which specifies methods for calculating a single settlement amount in the termination currency. ISDA has obtained legal opinions from major jurisdictions confirming the enforceability of netting. “The ISDA” also specifies margining arrangements and collateral terms so that CCR in the normal course of business is further reduced with less capital required.

Securities finance transactions have similar netting and are generally executed under the ICMA Global Master Repo Agreement.

Market implied probability of default and survival curves

Bond and credit default swap (CDS) prices can be used to extract the market view on probability of default and guide the pricing of loans and securities.

Closed form analytical approximations vs Monte Carlo simulation

With the rapid growth and complexity of derivatives markets since the 1980s, credit risk models have advanced in sophistication. Early systems of managing risk were closed form approximations, with limited and static credit categories, default probabilities, recovery rates, term structure, potential future exposure, and netting measures. Little focus was directed to correlation, diversification, and credit migration. With limited historical data and less computing power, more elaborate models were not possible.

Given the complexity, number of dimensions, and uncertainty of the CCR of a bank's derivatives portfolio, Monte Carlo simulations are now the norm. While it is data and IT system intensive, Monte Carlo can incorporate the multiple sources of risk, correlations, and mitigants (including netting). Modelling therefore shifts from the deterministic setting to the probabilistic setting.

Large numbers of joint scenarios are generated based on numerous risk‐based factors pertaining to market conditions, defaults, credit migration, correlations, and recovery over the term of the portfolio. This is especially necessary as credit events and in particular defaults are rare, yet have huge impacts. Besides estimating risk, the simulations provide many insights into profit maximisation and hedging.

The exposure at default value (EAD) is based on the specific asset drawn amount plus the expectation that the facility usage will increase, up to and beyond limit, as the obligor approaches default. Historical data and observation of sector in default is used to drive this. The EAD is, therefore, invariably above the drawn amount and up to the facility limit and beyond (includes some “costs” in certain cases.)

The risk weighting percentage (RW%) is driven by the credit model. In this case, the RW% for retail is based on IRB (uses firm‐specific PD and LGD), while the RW% for commercial real estate (CRE) has been calculated via the regulatory authority's “slotting” technique (whereby the regulator applies its own risk‐weight value because it does not deem the bank's internal model and/or data analytics to be robust enough for this asset class). The RW% for non‐CRE is the standardised approach (no model is needed, and it uses internal rating, which will be model derived).

Note that the 150% RW level is used if there are any non‐performing assets on the balance sheet.

Figure 3.4 is an illustration of the summary of the RWA calculation using the input parameters described here.

Credit risk organisational structures

As made clear in previous chapters, the Board of Directors has overall responsibility for all risks of the bank and sets strategy, policy, and limits. The Board must have a Risk Management subcommittee, which includes the CEO and the heads of the management level Credit, Market, Asset Liability, and Liquidity as well as the Operational Risk Management Committees. The Board subcommittee must take a coordinated and integrated approach to the range of risks. It is vital that its integrity and independence are maintained, with a system in place to report to internal and external auditors, for when and reasons why the full Board does not accept recommendations.

Given the critical importance of credit risk, the Credit Policy Committee (also called the Credit Risk Management Committee) should be chaired by the CEO and include the Chief Risk Officer, Heads of Credit, Credit Risk Management, Treasury, and the Chief Economist. This committee is responsible for implementing Board‐level credit strategy and policy as well as the following:

Credit approval:

• Formulating standards for credit proposals:
  • Credit analysis;
  • Ratings;
  • Loan structures, covenants, and collateral.
• Setting credit pricing policy;
• Delegating credit approval authority;
• Monitoring, risk management, and reporting;
• Measuring and monitoring credit risk with precision and consistency across the bank;
• Maintaining credit risk within approved limits;
• Managing the credit portfolio;
• Establishing a review mechanism for loans;
• Setting policy for provisioning;
• Devising a process for loan workout;
• Ensuring compliance with all regulatory requirements.

The Board and Credit Committee policies and strategies must be communicated effectively throughout the bank and permeate to each level and function. Delegation of authority and responsibility with clear reporting lines and accountability are paramount. Credit risk functions must be staffed and resourced sufficiently.

On an operating level, banks need to have separate Banking and Credit Risk Management Departments. The Banking Department (often organised by industry specialisation) manages customer relationships and takes a commercial approach in identifying business opportunities, pitching for deals, and negotiating and closing transactions. The Credit Risk Management Department measures risk and enforces limits and standards, with constant overseeing of the entire portfolio. Subdepartments of the Credit Risk Management Department include Credit Portfolio, Credit Modelling, Monitoring and Collection, Collateral Management, and Restructuring.

While separate, all departments and functions must rely on each other for credit risk management to be effective. Credit Modelling must receive timely and accurate data to provide useful risk measures to the Credit Department and Credit Portfolio for action.

Asset writing strategy consistent with risk appetite statement

Approvals and cut‐offs

Credit scores have a number of benefits:

• Speed: the input of credit bureau data into a model allows for some decisions to be made within minutes;
• Objectivity: they focus on the relevant facts only, with no inappropriate negative (or positive) bias from individual bankers;
• Accuracy: the factors/variables used that are based directly on behavioural information (based on bank internal/bureau data) cannot be gained easily by either the applicant or the sales staff involved with the deal;
• Forward looking: credit issues in the distant past are not necessarily a factor; recent credit behaviour tends to carry more weight in the credit scoring;
• Better differentiation: more risk assessment means better segmentation of borrowers such that interest rates can be charged, terms set, and products offered according to risk;
• Heightened competition: banks are able to assess more loan requests and can therefore attempt to compete for more consumer business.

Lenders will generally not rely on the credit score only. Potential borrowers complete an application where income and employment are generally considered. While larger banks generally use “black box” approaches that allow little autonomy on decision‐making for their local managers, smaller banks may often rely on their knowledge of community, customers, businesses, and relationships in approving credit. This makes them, in theory, superior SME lenders compared to the larger banks, although in practice small banks' level of loan losses are generally not markedly superior. There is nevertheless a genuine element of positive customer service perception associated with the ability to apply local knowledge and expertise in the loan origination process.

Some lenders utilise “cut‐off scores”. Loan applicants with scores below a set level are rejected unless the bank chooses to make an exemption (referred to as overrides). Cut‐offs generally are more stringent for home loans than for high interest debt such as credit cards or personal loans.

Limits and risk appetite

As discussed elsewhere, the Board uses the risk appetite statement to set the quantity and type of risk the bank will tolerate within its total capacity to pursue its business objectives. Highest level limits for broad exposure groupings are set after considering the impact of the potential transaction on the regulatory and/or economic capital required to support the credit position. This includes using probabilities of default to estimate expected losses under different scenarios (from normal to recession or to major disruption and with consideration of frequency). These may be expressed in absolute amounts for the riskiest exposures or as a percentage of total exposure. An internal economic capital framework considering correlation, concentration, and large single exposures is integral to setting limits. Risk is then allocated on an operating level across business lines, products, industries, and regions, as well as individual borrowers in the form of further limits.

Limits are incorporated in Pillar II of Basel II as part of the supervisory review process. Limits must not be merely a “rubber stamp” of business requests leading to the approval of further increases when requested only. Forward thinking credit management involves consideration of reasonable exposure levels in anticipation of new business opportunities and the potential medium‐term movements of the credit cycle. For instance, when there is an expectation of a downturn in the credit cycle, risk limits may be tightened to alleviate future volatility in the credit outcome (bad debt charge or default rates).

Business lines can work to stay within limits by extending credit only to borrowers with increasingly higher internal ratings (corporates) and credit scores (retail). However, tightening lending standards cannot be relied upon solely to reduce credit risk.

Limits serve varying purposes. In some instances, limits are a firm form of policing against taking on risks not deemed tolerable. In other instances, limits are essentially a form of an early warning system, where credit officers and management are alerted to an increase in risk that merits further discussion and analysis. Sometimes a client is involved in multiple products (including trading) and the bank may not be able to ensure that the total intra‐day exposure limits are not breached, in which case limits should be set conservatively low. As credit risk is constantly changing due to portfolio effects and new data, limits need regular adjustment whether nominal exposures change or remain the same.

Credit risk assessment

In extending credit to a corporation, banks will consider attributes such as market share, quality of products and services, innovation, brand, and operating efficiency. However, a company's performance and ability to meet debt obligations are strongly linked to macroeconomic and industry factors.

Key factors include the phase of the economic cycle, interest, inflation, and exchange rates. Sensitivity to these factors varies by industry. While the durable goods, auto, transportation, and informational technology industries tend to perform in line with the economy (cyclical), the household goods, food, and utilities industries are more constant (non‐cyclical). Historically, the performance of the financial and homebuilding industries has been highly interest rate sensitive.

Industry characteristics to consider include:

• Size and growth prospects;
• Competition;
• Profit margins;
• Supplier power;
• Buyer power;
• Labour supply and relations;
• Barriers to entry for new entrants;
• Innovation;
• New markets;
• Threat of substitute products;
• Research and development costs;
• Regulatory environment;
• Political risks.

With a broader understanding of the industry, it is then possible to analyse a company's competitive advantages, positioning, and its prospects in the future.

Loan facilities

Once the credit strength of a potential borrower is analysed, a bank can consider the structure and risks of the proposed facility. The bank must understand the purpose, amount, and duration of the borrowing. The loan must be for an activity within a company's business remit or an individual's financial goals. It is acceptable to finance the repayment of existing debts, providing the new loan terms can accommodate the client's needs better and can be serviced.

By understanding a borrower's requirements, the bank can offer the most suitable facilities, which include the following:

• Line of credit:
  • Credit availability is established but approval is needed for each drawdown;
  • Drawings to be repaid in fixed, short periods of time;
  • Attractive to companies with short‐term borrowing needs such as seasonable inventory build‐up prior to sales.
• Revolving line of credit:
  • Allows for continuous borrowing up to a limit;
  • Repayments allow for automatic borrowing back up to the limit;
  • Credit cards are a popular form of revolving credit;
  • These are typically subject to a regular (for example, annual) review process.
• Asset based:
  • Attractive to companies with less free cash flow due to rapid growth or difficult markets that are less able to obtain unsecured credit;
  • Funds advanced against collateral:
    • Working capital (accounts receivable, inventories);
    • The assets financed;
  • Factoring is when accounts receivable are sold outright to the bank at a discount that reflects the cost of credit.
• Term loan:
  • Finances longer term assets:
    • Factory and equipment for companies;
    • For individuals, this could include home loans and vehicle finance; as funds are advanced against assets, the bank's assessment of potential losses would be more favourable, resulting in more favourable lending parameters (for example, interest rates) to the customer, compared to, say, personal loans;
  • Ensures funding;
  • Fixed and regular repayment schedule;
    • Bullet: single repayment of principal at maturity;
    • Amortising: principal paid in multiple payments on a schedule (for example, mortgage);
  • Fixed‐rate or floating‐rate interest;
  • Larger company loans may be syndicated across a number of banks:
    • Sale of the loan position is often possible.

Further detail on this asset classification is given in Chapter 4.

In analysing the risk of a facility, bankers must always ask the question “Just how am I going to be repaid?” The bank must identify the primary source of repayment and consider whether there are secondary sources of repayment. For example, in a revolving line of credit to a company, the bank is looking to the successful conversion of the working capital into cash. Should that fail (decline in sales, receivables not collected), secondary sources could be other cash flow from operations, new business, fees, the sale of other assets, and divestitures.

Figure 3.5 illustrates the nature of outstanding loan balances of different facilities. As the revolver is on demand, usage is unknown and will vary. The bullet payment means principal risk remains for the life of the loan. Amortising loans generally require regular payments combining principal and interest, with the proportion for interest declining as principal is reduced.

Risk‐adjusted loan pricing

Risk‐adjusted return on capital (RARoC) is the profitability of capital after considering all costs. This profitability measure expresses expected profit (net of all costs including expected losses) as a percentage of economic capital, or worse case loss. RARoC is preferred to risk‐adjusted return on equity (RARoE) as it includes all capital rather than purely core Tier 1 equity. The relationship to economic capital needs to be understood, although it is regulatory capital that ultimately should drive the overall target and strategy, given that the regulatory capital level is required by legislative fiat.

The RARoC (or RARoE) model expresses facility and connection level income net of expected losses (i.e. it is risk adjusted) as a return on regulatory capital. It should be a key component of principal front book asset pricing calculators. By applying a RARoC target the bank is able to:

• Facilitate comparative analysis of investments of differing risk profiles;
• Understand the cost of risk undertaken and reward received for the process;
• Improve MI and decision making.

The formula is given by:

The element “capital benefit” is contentious and is not an input that is applied at every bank. This is certainly not agreed with by the author of this chapter. Capital benefit is included by some banks who argue that because the business line is charged the cost of capital held against it, it should also benefit from income received when the capital liabilities are “hedged”. That this leads to inconsistencies should be evident when one realises that a business line can start the year with “profit” on the books simply because of this capital benefit, before having undertaken any genuine shareholder value‐added work of any kind. Nevertheless, it is not uncommon to see this element on the numerator line. The better‐managed banks will dispense with this element, and it is a true test of a bank CFO's genuine understanding of the principles of corporate finance to witness whether this element is included in the bank's RARoC analysis.

RARoC enables a bank to compare opportunities more consistently by ensuring that relative risks are considered. Capital can be better allocated to business areas and products, right down to individual loans. RARoC is useful in evaluating ongoing performance as well as deal flow.

Banks set target or “hurdle” RARoCs for the use of capital. Opportunities that do not meet the required RARoC should be rejected or escalated to senior management for additional consideration. Business decisions to proceed can be made because a product is a “loss leader” valued by clients or a new line of business where profitability takes time to develop.

EVA (Economic Value Added) is net profit less the cost of use of economic capital (also known as NIACC – net income after capital charge). The cost is usually calculated as a weighted average cost of the bank's sources of capital. Unlike RARoC, EVA is an absolute measure. EVA is sometimes described as “excess return”. This “economic profit” is different from simple accounting profit because it considers implicit costs as well as tangible costs.

A comparison of RARoC and EVA is summarised in Table 3.2.

RoE: in principle the methodology is:
RoE =		–  Costs are driven by the transaction
		–  A hurdle RoE % is set to determine the income required
		–  The RoE hurdle can be adjusted as appropriate to market/sector/product
		–  Income required to meet RoE hurdle % less costs drives the price
RoE is return on capital employed, which is usually adjusted for risk purposes as RARoE
EVA: in principle the methodolgy is:		–  Costs are driven by the transaction
		–  Profit (EVA) is calculated as a % of costs
EVA =	Income – Costs – Cost of capital	–  The EVA can be varied as appropriate to market/sector/product
		–  Total of costs + EVA drives the required price
EVA is the value created (i.e. economic profit) through undertaking the deal

The basics of loan pricing

A conventional vanilla pricing approach for a corporate bank relationship manager would use these inputs:

1. Set the target margin for the asset (a function of the cost of capital of the bank. Ignoring equity, the cost of which is realistically and notoriously difficult to ascertain with any real accuracy, the cost of debt capital should drive the minimum expected target rate of return);
2. Factor in margin (spread) for default probability and loss‐given‐default of the obligor, so in effect its risk weighting, together with any adjustment for size of loan;
3. Factor in margin reduction arising from extent of collateral (so unsecured highest margin, lowest to zero margin for fully collateralised or overcollateralised lending);
4. Factor in term liquidity premium.

Input (4) is the Treasury‐applied “term liquidity premium”, which is mainly, though not wholly, a function of the tenor of the lending and the liquidity of the asset once originated.

Figure 3.6 shows what the pricing screen might look like.

Asset Pricing Calculator
Product type	Loan		Customer	ANO & Sons
Utilisation	100%
Interest rate basis	LIBOR		Asset costs illustration
Amount	£1,000,000		Tier 1 capital	£12,640		Cost of capital	£2,100
Term (months)	60		TLP bps	236		TLP	£8,325
PD	0.064%		Expected loss rate	0.06%		Expected loss	£480
LGD	5%		Undrawn liquidity buffer	0.00%		Liquidity buffer	£0
						Total costs
Recommended pricing			RM proposed pricing
Margin bps		431	Proposed margin bps		325
Target margin bps		331	Proposed fee		£0
Minimum margin bps		306	Proposed non‐util fee		£0

Credit authorisation process

Beyond risk appetite and measurement, the Credit Policy Committee establishes and monitors the credit authorisation process. This includes:

• Minimum requirements for information and analysis:
  • Client identity verification (may be a regulatory requirement);
  • Financial data (for example, payslip for individual, audited financials for SME/corporate);
• Minimum underwriting standards:
  • Terms;
  • Documentation (for example, sufficient detail on the contract);
  • Collateral, covenants, and guarantees.

Larger and more complicated loans are generally approved by credit committees. The client officer sponsors the loan proposal memorandum and is responsible for completeness. The committee scrutinises the proposal to ensure underwriting standards are met and uses their experience and knowledge of similar customers as well as their own facilities to evaluate risk and reward in making a decision. Smaller and less complicated loans are approved through delegation of authority.

Monitoring the credit authorisation process is an important control function and can yield business insights. This includes tracking:

• Processing time and cost per approval;
• Approval rates (rising or falling);
• Acceptance rates (and NTU – not taken up – rates);
• Volume of policy exceptions.

Breaking data down by client, product, and facility can demonstrate where underwriting standards are falling in line with the market.

The Credit Policy Committee should ensure that minutes of Credit Committee Meetings are complete and include the justification for their decisions.

Collateral management

Banking and collateral are synonymous with each other, as evidenced by the numerous references in this and other chapters. Collateral is an excellent risk mitigant and is recognised in the Basel Accord's loss given default methodology. However – and while banks would almost always prefer to receive collateral – credit should only be extended when it is deemed that the borrower is likely to be able to repay without it. The liquidation of collateral can involve legal, market, and reputational risk, as well as time and resources.

The lending bank must have clear legal rights over the collateral, and must be able to liquidate or take possession in a timely manner in the event of default, insolvency, bankruptcy, or defined credit event. This is called “perfecting” an interest in the collateral. Collateral rights vary by jurisdiction, therefore business collateral transactions with multinational corporations will require focused legal advice.

The amounts and types of collateral are negotiated and depend on:

• Client risk;
• Facility risk and maturity;
• Available collateral;
• Volatility of collateral value;
• Liquidity of collateral;
• Legal terms.

Collateral for loans is most commonly real estate (mortgages), equipment, inventory, cash, or securities. The borrower must prove it holds the deed to the collateral, and certify that it is not already pledged to another creditor (unless the bank is willing to take a second charge).

Where possible, banks should use historical data to project liquidation value. Banks consider potential links between borrower default and declines in collateral value. For example, if a company fails because of lack of sales, buyers for equipment for the manufacture of its products may be limited.

Collateral management is often the responsibility of a dedicated department whose responsibilities include:

• Monitoring collateral amounts and value;
• Collecting additional collateral when collateral value declines, as per facility terms (margining);
• Monitoring and limiting collateral concentrations.

In most jurisdictions, a lien refers to a transaction where the bank does not hold the collateral. Banks will ideally hold securities collateral in their own custody department. However, only clear terms in lending documentation ensure the ability to sell the collateral and keep the proceeds in the event of default.

Demand for securities collateral is growing because banks are required increasingly to post collateral for their own financing, derivatives, and clearing businesses. Central bank trades with banks designed to provide liquidity and effect monetary policy are collateralised. Banks seek to rehypothecate (use collateral received for its own collateral pledges) whenever possible.

Credit portfolio monitoring and control

When new loans are booked and the economy, industries, and companies change, the risk and profitability of the overall credit portfolio also change. Credit policy adapts to rebalance the portfolio by adjusting limits, pricing, maturities, and requirements (for example, collateral, guarantees, and covenants) for new business. However, the credit portfolio management team has the tools to control risk and optimise the profitability of the portfolio, which can then complement lending policy and be quicker and more efficient. This is particularly important should concentrations build and credit concerns develop rapidly. Furthermore, portfolio management techniques can reduce risk and maximise the lending capacity for banks to offer competitive market pricing for important clients and products as often as possible.

The effectiveness of credit portfolio management depends on accurate, uniform, aggregated, and timely data.

Strategies include:

• Sell loans;
• Securitise assets (for example, mortgages, loans, trade receivables, credit cards) for sale;
• Hedge using Credit Default Swaps (CDS):
  • Single name;
  • Index;
  • Options on CDS (swaptions).

Selling and securitising loans frees capacity and can improve profitability if returns are low. While basis risk and liquidity are factors, the global credit default swap (CDS) market has grown massively with gross notional CDS amount reported by the Depository Trust Clearing Corporation to have exceeded $25.5 trillion at year end 2010 alone (http://www.isdacdsmarketplace.com/market_statistics). However, it must be noted that the CDS market is not available for the majority of credit risk reference names.

Traditionally, loan profit and loss were attributed to the responsible lending officer from start date through to maturity. Now, many banks credit the lending officer with the EVA or excess return of the loan (spread between expected return and economic capital) at inception, and then transfer the loan and P&L to the credit portfolio team to manage. Regardless, the relationship banker must remain engaged with the loan throughout its duration in working through any issues with the client and keeping management informed.

Banks need to have a periodic, objective, and comprehensive loan review function, which includes audit and is ultimately responsible to the Board. Smaller banks may outsource loan review. Key functions include:

• Identify loans with potential weaknesses;
• Regrade loans and create a watch list;
• Develop a watch list strategy for monitoring and potential action;
• Assess risk trends and underwriting standards in segments of the portfolio;
• Review loan documentation;
• Confirm adherence to credit policy;
• Evaluate data and reporting.

Behavioural scoring is an additional means of assessing credit risk made possible once a credit facility is extended. Banks can observe the patterns of activity and gain insights into how a customer manages their financial affairs. Exceeding credit limits, missed payments, and returned cheques are negative behaviours. Excessive utilisation of overdrafts or numerous credit card advances can be indicators of financial difficulties. Behavioural scores are generated by weighting recent trends, and are used in evaluating renewals or requests for new or larger borrowings.

Vintage analysis is another means of using existing business to better understand risk. Loan underwriting characteristics and standards vary over different periods of time. Similar loans from time periods are grouped together to create vintage pools, which are further segmented by borrower rating. Pools are tracked to assess how performance is linked to changes in the economy, interest rates, and other variables. Vintage analysis is particularly useful for longer term mortgages in forecasting repayment rates, delinquencies, and charge‐offs. Newer loans can be compared to earlier vintages at similar points in their lifecycle to test the impact of risk credit policy changes, for instance a decision to cut back on risk.

Workout process

The definition of default is when a borrower fails to meet the conditions of a loan. Default can be a failure to make a payment as scheduled or technical, involving a breach of covenants. Default must be distinguished from the legal terms insolvency (borrower without means to pay) and bankruptcy (borrower under court supervision due to default or insolvency).

Corporations, individuals, banks, and even countries default. Difficult economic conditions, financial mismanagement, poor strategy and investment, excess leverage, and fraud all contribute to default. In almost all instances, it is preferable to work with the borrower to try to maximise value in the future than to become enmeshed in lengthy legal proceedings where lawyers and administrators rank first in order of payments.

Corporate debt restructuring

Banks attempt first to refinance debt, which involves extending the maturity and thus reducing and rescheduling payments. If a realistic assessment of the company's finances and business outlook shows the debt burden is still too great, a debt restructuring is necessary. This will include a distressed situation if the company has defaulted on payments or moved into bankruptcy. Banks have restructuring departments to review businesses and work with the company and other creditors to create a workout plan.

Beyond refinancing, a workout can involve exchanging debt for equity and reduction of debt. Before agreeing to concessions, creditors need to agree that the new business plan will rehabilitate the company and make debt levels serviceable. Parties involved will have different incentives and interests, consequently, agreement is not straightforward.

• Creditors: senior, collateralised creditors have less incentive to keep the company going and continue their exposure relative to junior, unsecured creditors;
• Shareholders: do not want the company wound down with their investment lost;
• Management: do not want the company wound down with their jobs lost.

If parties cannot agree that the company continuing as an ongoing concern is worth more than the assets, the parties should then work towards an orderly liquidation.

Consumer default and debt counselling

Consumer debt problems are often the result of loss of employment, decrease in income (less overtime, for instance), or financial mismanagement/illiteracy. The National Credit Act of 2007 established a debt counselling process for consistent debt restructuring, enforcement, and judgement.

A consumer may apply to a debt counsellor to:

• Provide budget advice and basic information;
• Negotiate with credit providers to:
  • Restructure debt;
  • Lower instalments;
  • Reduce debts to manageable levels.

Provision is made for basic living expenses before setting a new repayment schedule, but the consumer loses access to new credit.

Before applying for court permission to institute repossession, a creditor must first send the customer a written notice of options to repay or seek debt counselling.

All credit providers, credit bureaus, and debt counsellors must register with the NCR.

To be effective, debt counselling must ensure that borrowers (i) pay manageable levels of principal and interest; (ii) incur reasonable debt counselling fees; (iii) are given fair expectations of what can be achieved; and (iv) receive education and help with budgeting to avoid future problems.