Know Risk: Enterprise Credit Risk Management Framework For Economic & Regulatory Capital

Enterprise Credit Risk
Management Framework
for Economic &
Regulatory Capital
RiskLab Madrid
Madrid, November 14 2002
Dr. Dan Rosen

VP Marketing, Algorithmics Inc.
Know Your Risk drosen@algorithmics.com
Company Confidential ©2001 Algorithmics Inc.
Last Year’s Talk…..

• Enterprise credit risk framework
Enterprise Portfolio • integrate credit risk
Credit Risk • integrate market and credit
Modelling • valuation and MtM

• portfolio credit risk management
RiskLab International • Modelling exposures/LGD accurately

Conference, is key for accurate PCR measurement
Madrid, October 18 2001
• ECR Framework à solid basis for
• managing and reconciling
regulatory and economic capital
• pillar II
• providing transparency (Pillar III)
11
Last Year - Case Study
• Standard portfolio credit risk models assume deterministic exposures (LGDs)
• If stochastic, they are generally assumed independent
• Case study: demonstrates impact of stochastic & correlated exposures on

credit capital (results generally extend to LGDs & collateral)
• Substantial effect of vols., credit & market-credit correlations, granularity
• Results have important implications for both economic and regulatory capital
• Substantial benefits from
• A flexible, integrated market and credit-simulation model – analytical
approximations generally show strong limitations
• Accurate models for exposures, LGDs, collateral and other mitigation techniques
Summary – today’s talk

Business Requirement:
Enterprise Risk Framework à evolving BIS II requirements
• Risk architecture - scalable

• Measure and manage market, credit, operational risk (ALM, & collateral)
• Enterprise coverage: consistent treatment of banking and trading books
• Risk engine
• Compute and reconcile economic and regulatory credit capital
• Analyze risk along multiple dimensions: consolidate disparate exposure across
multiple business lines, portfolios and products
• Reporting infrastructure: comprehensive enterprise risk reporting
• Flexible drill-down analysis and reporting in many dimensions
• Accommodate users at every level of the firm, and multiple regulators
• Integration of global market & credit risk information into business processes
22
• Introduction
• Enterprise Credit Risk
Outline
Management
• BIS II and Enterprise Credit Risk
• Enterprise Framework for Regulatory
& Economic Capital
• Data Architecture
• Risk Engine
• Reconciling Regulatory &
Economic Capital
• Reporting Infrastructure
Enterprise Credit Risk
Financial Institution
Banking Book Trading Book
Retail Commercial Commercial

Commercial
Retail Commercial
medium/small Large
Large
medium/small Derivatives
Derivatives
Counterparties
Counterparties
mortgages Credit
Credit Lines
Linesofof
mortgages
cards credit
credit Sovereign
Sovereign
cards Bond
BondIssuers
Issuers
Private
Private
Firms Corporates
Corporates
Firms (Public
(Publicand
and Corporate
Corporate
Private)
Private) Bond
BondIssuers
Issuers
Sectors
Sectors
Sectors Sectors
Sectors Sectors
Sectors Sectors
Credit
Credit
Derivatives
Derivatives
33
Enterprise Credit Risk Functions
Portfolio
Management
Counterparty
Exposures
Measurement & Control
Instrument Valuation
Transaction Management
Obligor Creditworthiness Analysis

Portfolio
Management
Sovereign
Counterparty Public firms
Exposures
Measurement & Control Private: large & medium
Small businesses
Transaction Management Retail consumers

44
Derivatives
Credit Derivatives
Portfolio
Bonds
Management
Syndicated loans
Large corporate loans
Counterparty
Exposures Middle & small market
Measurement & Control Retail
Instrument Valuation - collateral

Transaction Management management

Measurement and limits
Aggregation of positions by
Portfolio
- obligor/counterparty
Management
- sector
Counterparty - country, etc.
Exposures
Measurement & Control Derivatives:
- actual & potential exposures

Transaction Management Mitigation
- netting, collateral, etc.

55
Exposure Profiles & Limits
Counter Party Exposure Limits
TURQUOISE
TURQUOISE -- AA
AA SAPPHIRE
SAPPHIRE -- AA
AA
80.0
80.0 90.0
90.0
(Millions)
Exposure (Millions)
(Millions)
Exposure (Millions)
60.0
60.0
60.0
60.0
Credit Exposure
Credit Exposure
40.0
40.0
30.0
30.0
20.0
20.0
Credit
Credit
0.0
0.0 0.0
0.0
6/4/97
6/4/97 6/4/01
6/4/01 6/4/05
6/4/05 6/4/09
6/4/09 6/4/13
6/4/13 6/4/17
6/4/17 6/4/97
6/4/97 6/4/01
6/4/01 6/4/05
6/4/05 6/4/09
6/4/09 6/4/13
6/4/13 6/4/17
6/4/17
Time
Time Time
Time
Portfolio credit risk capital
- economic & regulatory

Portfolio
Portfolio Management tools
Management
- risk contributions
-marginal risk
Counterparty
Exposures -capital allocation
Measurement & Control -performance
-optimization & efficient frontiers
Transaction Management

66
Portfolio Credit Risk Reports
Expected losses
Unexpected losses (99.5%)
BIS II Proposal for new capital

adequacy framework
Three pillars:
• Minimum capital requirements
• gives the explicit rules that define the minimum ratio of capital to risk
weighted assets
• Supervisory review process
• requires supervisors to undertake a qualitative assessment of capital
allocation techniques and compliance with standards actually in place in
an institution
• Market discipline
• high disclosure standards & adequate capital which facilitate market
discipline
77
BIS II
• BIS II: proposal for new Capital Accord
• Foster a strong emphasis on risk management practices
• Encourage ongoing improvements in banks risk assessment capabilities
• Regulatory framework covers
• Credit Risk, Market Risk of trading activities, and Operational Risk (Pillar I -
minimum capital requirements)
• Interest rate management (ALM) and liquidity risk, Collateral Management
(supervisory reviews)
• Implementation currently scheduled for end of 2006
• Requires substantial resource commitments on the part of banks and
supervisors
Minimum Capital Under BIS II
Summary of minimum capital requirements
• Three approaches to calculation of risk-weighted assets:

• (Revised) standardized approach
• Foundation internal ratings-based (IRB) approach
• Advanced Internal ratings-based (IRB) approach
• Explicit capital charge for operational risk
• Market risk capital as defined in the 1996 Amendment to remain

largely unchanged
88
Portfolio Credit Risk & BIS II
Credit risk models for the banking book
- Although portfolio credit risk models are not allowed for the
calculation of minimum capital requirements,
- The functional form and coefficients of the BRW and GA already embed
portfolio credit risk model
- Satisfying Pillar II will likely require that institution on the advanced IRB
approach have implemented in practice a portfolio credit risk
management system
BIS II Advanced IRB Approach

 n 
Regulatory Capital = 
 ∑E j ⋅ RW j  × 8% + GA

 j 
GA = Granularity Adjustment
RWj = Risk Weight for asset/obligor j
E j = Exposure at default for asset/obligor j
• RW x E x 8% represents the capital for a “perfectly” diversified

portfolio (asymptotically fine grained; with only systemic risk)
• The“granularity adjustment” adjusts the capital for the level of

diversification of the actual portfolio
• now likely to be out of Pillar I
99
For example, the RW for an exposure to a corporate obligor :
[ 0.5
RW(PD,LGD,M) = 12.5 x LGD x N G(PD) + R x0.5G(0.999) x
(1 - R) ]
[1 + (M - 2.5) x b(PD)]
[1 - 1.5 x b(PD)]
where
PD = obligor’s probability of default
LGD = loss in event of default
M = maturity of transaction
b(PD) = sensitivity of the maturity adjustment to M (from a calibration)
N(x) = cdf for standard normal random variable
G(x) = inverse cdf for standard normal random variable
Expected & unexpected default losses of a

hypothetical, asymptotically fine-grained, portfolio
Adjustment for LGD of one-year loans (from one-factor credit portfolio
model)
[ 0.5
(1 - R) ]
[1 + (M - 2.5) x b(PD)]
[1 - 1.5 x b(PD)]
Used to offset 8% capital charge Maturity adjustment to reflect a

portfolio of maturity 2.5 years
10
10
Enterprise Credit Solution:
Architecture
Financial Engines
Exposure/
BIS PCR MtM Limits
Bonds:
Prices/ External Systems
spreads Data Staging, Results Management Database Positions
Loans:
Transaction Data
Terms &
Internal Systems
Mapping Interface
Input DB Report DB
Mapping Interface
Prices/
spreads Conditions
Market Data
Obligor
Credit Standard Exposures
Transaction
Derivs. Regulatory
Collateral
Internal Systems
IRs. FX, Market Capital

Collateral
EQ., etc. Guarantees
Mitigation
Credit
Drivers Mapping Interface (extract, map, load)
(factors)
Internal Systems External Systems
Ratings LGD Obligor Credit Collateral
PD/TM relationships correlations Management
Obligor Creditworthiness Data Company Confidential ©2001 Algorithmics Inc.
Credit Data Architecture

• BIS II à advanced data infrastructure: collect, aggregate, validate and
reconcile enterprise-wide credit data - one common data architecture.
• Comprehensive product coverage of trading and banking book exposures
• Default/migration and LGD data
• Credit mitigation including netting, collateral and guarantees
• Advanced counterparty and own bank data structures
• Credit information must fundamentally be integrated into business processes
• Limits management, capital allocation, pricing & origination, performance
• Execution: development of a comprehensive solution in a timely manner
• Must start data collecting efforts before architecture is completed
• Leverage: substantial cost savings through the development of common

infrastructure for global limits management and economic capital.
11
11
Enterprise Credit Solution: Economic
and Regulatory (BIS-II) Capital
Mapping Interface (extract, map, load)
Internal Bank Systems External Bank Systems

Ratings Obligor Credit Ratings Credit
LGDs LGD
PD/TM relationships correlations PD/TM correlations
Estimation/Calibration Obligor
relationships
Retail Corporates Financial Sovereigns


Bond
External Systems
Prices/spreads
Data Selection and Calibration
Loan
Prices/spreads
Market Data
CD
Prices
(e.g. Default Swaps)
Internal Bank Systems
IRs. FX,
EQ., etc.
Credit
Drivers
(e.g. Macrofactors)
12
12

Positions
Internal Bank Systems
Data consolidation
Transaction Data
Terms &
Conditions
Exposures
Collateral
Guarantees
Mitigation
BIS II IRB & Portfolio Credit

Building blocks
The minimum capital calculation requires
• Probabilities of default for each obligor (PD)
• Maturity of each transaction (M)
• Exposure at default for each transaction (EAD)
• Loss given default for each transaction (LGD)
• Credit Mitigant information
Full portfolio credit risk modeling further requires

• Obligor correlation model
• Full MtM for each transaction (for MtM models)
13
13
Regulatory & Economic Capital
Engine
Requirement: comprehensive capital engine
• Flexible (evolving BIS II requirements & multiple regulatory environments)
• BIS I, BIS II (standard, foundation IRB and advanced IRB)
• smooth transition to advanced IRB à consolidated reporting of BIS I and
multiple BIS II approaches for two years
• Integrated - regulatory, economic capital and Credit MtM

• Coverage - enterprise coverage of trading, corporate and retail exposures
• Comprehensive treatment of CP structures, credit mitigation & collateral
• Trading CP exposures: advanced internal models using full simula tion
• Risk management tools:
• scenario analysis and stress testing
• robust risk decomposition, Hot Spots and optimization analytics
Credit Risk Pricing: banking loans
Example: syndicated deal (14/04/00): $115 M to fund acquisition of PlayCore

Holdings Inc. (unrated holding company: interests in sporting and games)
• $30 million revolver, $25 million term loan A, $60 million term loan B.
• Secured credit: 85% of eligible accounts receivable, 60% of elig ible
inventories, plus $3,000 monthly from November through March
• Covenants require hedging of IR risk, minimum fixed-charge coverage
ratios, limitations on dividends, etc.
• Pricing tied to: Funded debt / EBITDA
• In default, pricing increases by 200 bps
• Prepayment without penalty at any repricing date.
14
14
Credit Risk Pricing: banking loans
Term-loan B component (marketed to loan funds):
• Maturity July 1, 2006 (87 months term)
• 20 quarterly payments of $150,000, starting on October 1, 2000
• Followed by eight quarterly payments of $7,125
• Loan amortization over several quarters
• Initially, facility priced at
PRIME + 225bps (LIBOR + 400bps)
• Pricing grid determines pricing
Modeling a Bank Credit Facility

• Choice of credit from among a set
instrument types:
• a term loan
• a funded revolving line
• a letter of credit
• banker’s acceptance.
• Vital to model cash flows accurately
15
15
Modeling a Bank Credit Facility
Modeling Embedded Options

• Default option: in default, borrower may not pay an obligation in full
• affects CFs explicitly through the probability of default
• Prepayment option: right to prepay or cancel the contract before maturity

• affects CFs explicitly through the probability of prepayment
• function of obligor credit state, risk-free interest rates and spreads
• contingent on credit events other than default (e.g. credit downgrades)
• Credit line utilization option: right to choose the usage level of a commitment
• affects implicitly several CFs and outstanding amounts - as obligor’s
creditworthiness diminishes, draw on credit line increases
• embedded option on credit events other than default (e.g. downgrades)
16
16
Credit Valuation Framework
In summary:
• The cash flows from credit facilities are a function of: borrower
creditworthiness (e.g., risk rating), interest rates and credit spreads.
• e.g. a decrease in interest rates or credit spreads or an improvement in
borrower risk rating may trigger prepayment
• credit facilities include pricing grids, graduated utilization fees and
amortization schedules
• Underlying credit risk model must describe each state of the world by
• obligor creditworthiness (e.g. a ratings and default probabilities)
• the term structure of default-free interest rates
• the term structures of credit spreads for non-defaulted securities.
Large Corporate Example: $10 Million

Primary Participation in Playcore
Playcore 7-Year Term Loan B Tranche: B- Counterparty
NPV Duration*
• Base Case Valuation -$267k 2.31 years
• No Prepayment: -$126k 4.87 years
• Prepayment Option $141k
• No Pricing Grid -$270k
• No Amortization (NPV) -$286k
• Key point: substantial impact on value of loan structure components

(NOTE* Duration is risk and option-adjusted)
17
17
Evolution of Credit Exposure
Measurement
• First level (Common practice): Exposure = Notional
• simple, easy
• traditional loan products
• handles derivatives as loans
• does not consider “potential exposures”
• Second level: Exposure = MtM + Add On (potential exposure) (BIS)
• easy to implement
• better for derivatives
• may not capture properly offsets, netting, mitigation
• Third level: Exposure profile over time - Simulation
• accurate for derivatives... but computationally intensive
• multiple time limits
Counterparty Exposures through

Mark-to-Future
aggregation, netting, collateral,

credit mitigation, etc.
Securities Counterparties
Scenarios
Scenarios
Mark-to- Future Mark-to-

Mark-to-Future Future
Instruments
Values Counterparty
Portfolios
18
18
Exposure: Importance of Netting
Exposure: Importance of Collateral

A “Simple” Netting
Example:
• Daily collateral calls
• Instantaneous collection
(payment) of collateral
• Static CSA variables
Result:
Exposure to CP is capped at
$35M Threshold level
Daily Margin Calls flow

directly through to Collateral
Balance
19
19
Exposure: Importance of Collateral
Reality is not so
“Simple”:
30%
23% • 3 day lag for receiving
collateral but must post
collateral immediately (CP
Exposure drifts beyond Threshold
as you wait for collateral)
• Thresholds are only checked

weekly (CP Exposure drifts around
Threshold between call dates)
32% • CP downgraded during horizon

(CP Exposure reduced due to lower
acceptable threshold)
Mark-to-Future Framework for

Portfolio Credit Risk
1. Scenarios: 2. Conditional obligor 3. Obligor scenario 4. Conditional
• market factors losses portfolio losses
default probabilities
..... .....
• credit drivers (exposures X LGD)
+
..... .....
+
..... ..... _________
5. Unconditional Portfolio
loss distribution
20
20
Systemic and idiosyncratic
Portfolio Losses
2. Conditional 3. Obligor 4. Conditional 4a. Conditional
1. Scenarios
probabilities losses l(X) (total) portfolio Systemic losses
p(X) losses P(L= l|X) E{L|X}
E{L | X = x1} =
X=x 1 p j(X=x 1) lj (X=x 1) n
j=1,…,n j=1,…,n ∑l j ⋅ p j{x1}

+ j =1
E{ L | X = x 2} =
X=x 2 p j(X=x 2) lj (X=x 2) n
j=1,…,n j=1,…,n ∑l j ⋅ p j {x2 }

+ j =1
E{ L | X = x3 } =
X=x 3 p j(X=x 3) lj (X=x 3) n
j=1,…,n j=1,…,n ∑l
j =1
j ⋅ p j {x3}
5. Unconditional Portfolio
loss distribution
Portfolio Credit Risk:

Regulatory Capital Breakdown
BIS II formulae provide a transparent way to break down regulatory capital calculations.
Systemic Default
Regulatory Capital
Idiosyncratic (GA) MtM/Migration
 n 
where Reg Capital =  ∑ E j ⋅ RWj  × 8% + GA
 j 
[ 0.5
(1 - R) ]
[1 + (M - 2.5) x b(PD)]
[1 - 1.5 x b(PD)]
GA = (TE / n*) x (0.6 + 1.8 x LGDAG) x (9.5 + 13.75 x PDAG / F AG)

21
21
Portfolio Credit Risk: Economic
& Regulatory Capital
Regulatory Capital Economic Capital
Systemic Idiosyncratic (GA) Systemic Idiosyncratic
Default MtM/Migration Default MtM/Migration
Integrated market-
Regulatory Model (best) Single- Standard credit
single factor Factor, X Multi-Factor, X Multi-Factor, X
Comprehensive enterprise
Reporting Infrastructure
Integrated -supports all enterprise aspects of an organization’s credit risk
• Global limits and exposures; economic and regulatory capital; MtM
• Consolidation model and data management tools (support definition of complex CP
data and hierarchies; management of current and future exposures)
• Historical analysis and auditing
Enterprise Business support
• Desk level (limits & Analytics), Middle-office risk management (Enterprise analysis &
drilldown), senior Management (exec dashboards, capital allocation, Raroc)
Costumizable: analyze risk along multiple dimensions
• Flexible ‘slice & dice’ functionality (capital, CP information, exposures &, limits) à
user-specified criteria (industry, country, rating, product type)
• Extensive drill-down capabilities
Flexible and extensible framework
• Web-based reporting tools
• Support multiple reporting technologies and user reporting requirements
22
22
Reporting Infrastructure
Enterprise Reporting Infrastructure
Financial Engines
Exposure/
BIS PCR MtM Limits
Bonds:
External Systems
Prices/
spreads Data Staging, Results Management Database Positions
Loans:
Transaction Data
Mapping Interface
Internal Systems
Terms &
Mapping Interface
Prices/ Input DB Report DB
Market Data
spreads Conditions
Obligor
Credit Standard
Transaction Exposures
Derivs. Regulatory
Collateral
Internal Systems
IRs. FX, Market Capital Collateral

EQ., etc. Guarantees
Credit Mitigation
Drivers Mapping Interface (extract, map, load)
(factors)
Internal Systems External Systems
Ratings Obligor Credit Collateral
LGD
PD/TM relationships correlations Management
Enterprise Capital Report
23
23
Credit Capital Report
Credit Capital Report
24
24
Credit Reports: Loss Distribution
• 20K MC scenarios
Loss (99%) Expected Loss
Credit VaR
Unexpected Loss (99%)
Marginal Contributions:
HotSpots Report
Risk Contributions: Obligor contributions to portfolio credit risk
By Industry
By Industry
ByBy
Credit
Credit
State
State
25
25
HotSpots Report
Concentrations in B2
and Ba3
Concentrations in Marine, Real

Estate and Retail
HotSpots Report
Removing Caa rated

Counterparties
26
26
Marginal Portfolio Credit Risk
Risk contribution ~ Marginal risk (additional risk/unit) X size of exposure
Outliers
CP 28
CP 14
CP 11

Risk contribution ~ Marginal risk (additional risk/unit) X size of exposure
Marginal Risk influenced

by: Rating, Credit Drivers
and Risk Sensitivity
CP12 & CP16: Exposure

CP63 & CP62: Credit Driver
CP69 & CP72: Rating
CP55 & CP48: Duration
27
27
Taking into account Credit Derivatives
Before CD After CD
CP10 CP10
Global Exposures & Limits Reports
28
28
Real Time Limits Reports
Market Risk Report
29
29
OpRisk Reports
OpRisk Reports
30
30
Summary – today’s talk
Business Requirement:
Enterprise Risk Framework à evolving BIS II requirements
• Risk architecture - scalable

• Measure and manage market, credit, operational risk (ALM, & collateral)
• Enterprise coverage: consistent treatment of banking and trading books
• Risk engine
• Compute and reconcile economic and regulatory credit capital
• Analyze risk along multiple dimensions: consolidate disparate exposure across
multiple business lines, portfolios and products
• Reporting infrastructure: comprehensive enterprise risk reporting
• Flexible drill-down analysis and reporting in many dimensions
• Accommodate users at every level of the firm, and multiple regulators
• Integration of global market & credit risk information into business processes
www.algorithmics.com
See
•Enterprise Credit Risk with
Mark-to-Future
•Algo Research Quarterly
drosen@algorithmics.com
31
31

Know Risk: Enterprise Credit Risk Management Framework For Economic & Regulatory Capital

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Enterprise Credit Risk

Dr. Dan Rosen

Last Year’s Talk…..

Modelling • valuation and MtM

RiskLab International • Modelling exposures/LGD accurately

Company Confidential ©2001 Algorithmics Inc.

• Case study: demonstrates impact of stochastic & correlated exposures on

Company Confidential ©2001 Algorithmics Inc.

Summary – today’s talk

• Risk architecture - scalable

Enterprise Credit Risk

Banking Book Trading Book

Retail Commercial Commercial

Obligor Creditworthiness Analysis

Enterprise Credit Risk Functions

Obligor Creditworthiness Analysis

Instrument Valuation - collateral

Obligor Creditworthiness Analysis

Enterprise Credit Risk Functions

Measurement and limits

- actual & potential exposures

- netting, collateral, etc.

Obligor Creditworthiness Analysis

Company Confidential ©2001 Algorithmics Inc.

Enterprise Credit Risk Functions

Portfolio credit risk capital

- economic & regulatory

Obligor Creditworthiness Analysis

Unexpected losses (99.5%)

Company Confidential ©2001 Algorithmics Inc.

BIS II Proposal for new capital

Company Confidential ©2001 Algorithmics Inc.

Company Confidential ©2001 Algorithmics Inc.

Minimum Capital Under BIS II

Summary of minimum capital requirements

• Three approaches to calculation of risk-weighted assets:

• Explicit capital charge for operational risk

• Market risk capital as defined in the 1996 Amendment to remain

Company Confidential ©2001 Algorithmics Inc.

Credit risk models for the banking book

Company Confidential ©2001 Algorithmics Inc.

BIS II Advanced IRB Approach

• RW x E x 8% represents the capital for a “perfectly” diversified

• The“granularity adjustment” adjusts the capital for the level of

Company Confidential ©2001 Algorithmics Inc.

For example, the RW for an exposure to a corporate obligor :

Company Confidential ©2001 Algorithmics Inc.

BIS II Advanced IRB Approach

Expected & unexpected default losses of a

Used to offset 8% capital charge Maturity adjustment to reflect a

Company Confidential ©2001 Algorithmics Inc.

IRs. FX, Market Capital

Credit Data Architecture

• Leverage: substantial cost savings through the development of common

Mapping Interface (extract, map, load)

Internal Bank Systems External Bank Systems

Retail Corporates Financial Sovereigns

Enterprise Credit Solution: Economic

Mapping Interface (extract, map, load)

Company Confidential ©2001 Algorithmics Inc.

Mapping Interface (extract, map, load)

Internal Bank Systems