Managing Credit Risk

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F I N A N C I A L S E RV I C E S
Managing Credit Risk

Beyond Basel II
A DV I S O RY
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Contents
Foreword
Delivering on a Promise 1
How to Leverage Basel II Investments to Create
Value for the Credit Business
Laying the Foundations 4

Sound Data Governance and Data Quality as Asset
and Competitive Advantage
In Search of the Right Measure 7

Linking Credit Risk Modeling and Measurement in
Basel II and IFRS
Going to the Limit 11

On the Use of Advanced Credit Risk Measures in a
Credit Risk Limit System
Exploring the Unexpected 14

Developing and Using Credit Risk Stress Testing in
Risk Management
Pricing at all Costs 17

Comments on Credit Pricing Today and its Post-
Basel II Future
Growth Processes 20
Leveraging Basel II Scoring Models and Data to
Improve Credit Processes
An Orchestrated Approach to Value Creation 25

Opportunities and Challenges in Active Credit
Portfolio Management
Calculations with Many Unknowns 29

The Implications of Credit Derivatives for Corporate
Restructurings
The Value in Bad Debt 32

On the Management of Sub- and Non-Performing
Loans in Retail Banking
Managing Credit Risk: Beyond Basel II 5
Foreword
Many banks have invested significantly

in improving their credit risk manage-
ment in the past few years. Specifically,
banks have invested in methods,
resources, processes, and technology
to assess, monitor, manage, and
model their credit risk. Most of the
effort has focused on compliance with
Basel II and other regulatory require-
ments, and some banks continue to
struggle as they work through the
approval process.
Leading banks, however, already have

risk management frameworks in place
and are now seeking to make the
process significantly more relevant to
management decision making.
These banks are evaluating how to

build on lessons learned from Basel II
implementation, regulatory approval
preparations, and regulators’ feedback.
An emerging goal is to leverage their
investments in credit risk management
to make better decisions and enhance
business performance.
In this white paper, KPMG credit risk

personnel from around the world
explore these issues. They review • Leveraging the Basel II methodology to address International Financial
results of the Basel II implementation Reporting Standards (IFRS) requirements
as well as the changes that have • Using internal ratings in credit risk limit management
occurred in the markets for credit risk • Devising stress tests as components of sound credit risk management
transfer and present their perspectives • Addressing pitfalls and challenges in risk-adjusted credit pricing using Basel II
on value creation in the credit business ratings
post–Basel II. • Using Basel II data to create more value from credit processes
• Leveraging opportunities for implementing active credit portfolio management
Specifically, this document addresses
using leading risk measurement practices and risk transfer techniques
key aspects of credit risk management,
• Managing impaired loans in a world of credit derivatives
such as:
• Using customer information and classification systems to improve bad debt
• Coping with the rising amount of management.
credit-related data post–Basel II
through improved data quality We hope you find this document useful, and we look forward to discussing
management and data governance these issues with you.
Jörg Hashagen
Global Head Advisory Financial Services
1 Managing Credit Risk: Beyond Basel II
Delivering on a Promise
How to Leverage Basel II Investments to Create Value for
the Credit Businesses
Institutions that are currently to price more appropriately Following years of planning and devel-
oping systems, tools, and processes to
gaining approval to use the in the market? These ques- meet Basel II requirements, banks will
internal ratings–based (IRB) tions are asked against a be able to apply Basel IRB approaches
approach under Basel II have background of credit risk by 2007 or 2008, subject to supervi-
sory approval. In fact, most medium to
spent millions on their pro- management that, with the large-sized institutions will seek or
jects and now want to see a rise of new products and have already obtained IRB approval.
return on this investment. markets, has changed Whatever practitioners, risk profession-
How and where can the considerably since the incep- als, and industry observers may think
investment in models, infra- tion of the Basel II process. of Basel II, none can deny that it has
led organizations to an unprecedented
structure, and processes Pia Evertsson (Sweden), Steven Hall investment in risk infrastructures. The
pay dividends as economic (United Kingdom), and Jürgen result has been a sizeable change in
conditions evolve? Where Ringschmidt (Germany) explore some the way many banks approach risk
areas for leveraging investments in management (see Figure 1 on page 2).
are the opportunities to Basel II implementation to create
improve processes, to value for the credit businesses.
streamline organization, or
Some of the key benefits are: Figure 1: Going to the Next Level by Leveraging Basel Improvements
• Greater implementation consistency

between adopting banks
• A common risk language—for exam-
ple, “probability of default,” “loss
given default,” and “expected loss
measures”—leading to more accu-
rate comparisons of various outputs
and results
• Greater scrutiny, challenge, and
review of the technical approaches
being adopted, which has stimulated
an evolution of thinking in the quanti-
Source: KPMG in the U.K., 2007
tative areas of risk management
• A focus on the importance of sound
risk governance, systems, and prac-
Figure 2: Global Credit Derivatives Market
tices, and an increased understand-
ing of how such an infrastructure
affects market perceptions, given
the new reporting requirements.
Some institutions are leveraging their

Basel II efforts to drive business bene-
fits and competitive advantage. Others
have limited such activity to piecemeal
initiatives. Indeed, only a few more
advanced and sophisticated banks
have progressed to the next level.
This observation is somewhat contrary

to the business cases presented when
the Basel II initiatives were introduced.
At the time, besides prospects of
reduced regulatory capital require-
ments, improvements in the manage-
ment of credit risk and resulting gains
in value for a bank’s credit business
were cited as equally beneficial reasons Figure 3: Global Securitization Volume
for making the long and costly journey
toward implementing Basel II’s IRB
approaches. While compliance with
regulatory requirements has dominated
efforts so far, now banks want to
deliver on the value creation aspect of
the Basel II business case. This is true
even for those banks that need to work
for a few more years to reach full IRB
compliance.
While banks were focused on Basel II

implementation, the environment of
the credit business has changed. The
significant increase in transaction
volume taking place in credit deriva- Source: Fitch Ratings 2006
tives and securitization markets are
probably the most obvious examples of
change affecting the way credit busi-
ness will be conducted in the future.
Purpose and Scope of This • Limiting credit risk. Then, turning to ment takes this idea several steps
credit risk management proper, this further and explains how the credit
Document document explores a number of processes can be changed and
Against this background, this publica-
issues related to risk management tuned to value creation by using the
tion tries to shed light on a number of
and modeling, beginning with the Basel II data and by combining the
areas expected to play an important
possibilities for introducing more risk results with advanced customer
role in the future of credit business
risk-sensitive credit risk limit value metrics in the retail and small-
and credit risk management. One
systems using the methodology and business segments of the credit
publication cannot cover so complex a
models developed under Basel II. business.
field, but this one attempts to address
• Implementing stress testing. • Managing the credit portfolio. If
some of the key topics in the credit
Reliance on models for credit risk customer value management is an
risk management of the future:
management as under Basel II overriding goal of retail credit, then
• Managing data quality. The imple- necessitates protective measures active credit portfolio management
mentation of Basel II has produced against the pitfalls of model risk and has a similar role in the corporate
an unprecedented amount of data unexpected developments. In this credit sector. The realization of this
on banks’ credit portfolios. Ensuring context, this document then consid- concept requires both the changes in
the quality of this data and managing ers stress testing as an indispensable the markets for the transfer of credit
data ownership appropriately is a ingredient of a sound risk manage- risk and the advances in risk
fundamental prerequisite for sound ment concept from both a regulatory methodology fostered by Basel II.
credit risk management. Thus, the and business point of view. This document explains how active
first section addresses the impor- • Credit pricing. One of the far-reach- credit portfolio management can be
tance of data quality management ing promises related to the introduc- implemented to reap the benefits of
and data governance. tion of Basel II–compliant rating both developments for value-based
• Leveraging Basel II knowledge for systems was that they could provide credit risk management.
IFRS. In addition to complying with the foundation for risk-adjusted pric- • Dealing with non- or sub-perform-
Basel II, banks have also had to cope ing and value-based management in ing loans. The two final sections of
with implementing IFRS. However, the credit business. Inspired by the this publication focus on the
among the topics left largely unsolved development of the markets for management of non- or sub-perform-
in the first wave of the IFRS imple- credit risk transfer, we shed a critical ing loans—first, with a look at the
mentation is the issue of portfolio light on this tenet and consider new intricacies introduced into debt
impairment. As a first example of approaches to credit pricing. restructurings when credit deriva-
how the Basel II work can be lever- • Improving credit processes. An tives are involved and, finally, with a
aged to serve purposes outside the important concept underlying Basel discussion of how Basel II data and
narrow confines of prudential regula- II is the requirement that risk models methodology can be used to imple-
tion, this document considers how used for regulatory purposes should ment a bad-debt management
the Basel methodology can be used also be embedded in the credit risk program that is guided by value-
to cope with the IFRS requirements. management processes. This docu- based objectives.
In retrospect, the implementation of

Basel II, together with the develop-
ments in the markets for credit risk
transfer, will be considered a turning
point in value-based credit risk
management. Investments in systems,
processes, data, and expertise have
resulted in a platform of measurement
infrastructure and understanding that
can now be fully utilized.
Laying the Foundations

Sound Data Governance and Data Quality as Asset and
Competitive Advantage
One of the most important Concerning the group-wide consis- ability. Indeed, such requirements will
tency and degree of detail of data on continue to increase in keeping with
efforts in the implementa- the customer level, the following the performance-driven developments
tion of Basel II was to examples are worth noting. First, in the financial services industry.
increase the amount and before the advent of Basel II, maintain-
The progressive integration of risk and
ing in the system the correct coding of
quality of available data on the group affiliation of a business part- performance management requires
credit exposures. This ner’s foreign subsidiary was of impor- increasing data compatibility within
these two financial function disciplines,
immense investment tance only in the context of
which have until now been largely
concentration risk management, and
should now be leveraged to therefore only for large exposures. separate. Consider the examples of a
serve the business beyond With Basel II, having such a code is a “credit treasury” and a performance-
oriented management of risk capital.
pure regulatory compliance. prerequisite for the rating process of
They both require risk and investment
credit customers, and thus relevant to
Tim Schabert (Germany), Peter Lam all business partners irrespective of return information on credit positions at
(Australia), and Marco Lenhardt exposure size. Second, under Basel II, the same level of granularity. This infor-
(Germany) explain how sound data when processing guaranties received mation is generated in the process of
governance can lay the foundations for as collateral, detailed business-partner origination; thus, the efficiency of an
competitive advantage through high- information on the provider of the institute’s operations on the secondary
quality data. collateral is necessary, whereas in the credit market is closely tied to the avail-
past a bank obtaining a guarantee from ability and quality of data that have their
Data quality refers to correct, another bank had to indicate only that origin in the activities on the primary
complete, and timely information that the latter, as the provider of the collat- credit market. This dual purpose gives
is available for a specific analytical eral, was based in an Organisation rise to new demands on the quality and
use. Data quality is not an end in itself for Economic Co-operation and availability of these data. For example,
nor can it be measured on an absolute Development [OECD] zone A country. by keeping side-letter agreements on
scale; rather, it is subject to continu- paper files only, as is the common prac-
ous change and new challenges. However, compliance with regulations tice for corporate loans, risk-relevant
Implementation of Basel II increased is not the sole driver for increasing information may not be available for
banks’ data quality requirements. requirements on data quality and avail- credit portfolio management.
Data deficiencies increase transaction Figure 4: Integrated Accounting, Performance, and Risk IT Architecture
costs and underscore the importance
of data quality as a factor in achieving
competitive advantage. Whether trig-
gered by regulatory requirements or by
competitive market pressure, data
quality is an asset that influences an
institute’s ability to reach its targets.
Consequently, measures that aim at
improving data quality represent invest-
ments that can be justified by their
contribution to the achievement of
performance goals.
The Case for Data

Governance
Achieving efficient and long-term
improvement in data quality requires
data governance that is adjusted to
identified analytical purposes and qual-
ity goals. Data governance describes Source: KPMG in Germany, 2007
the set of group-wide regulations and
structures referring to the supply and
processing of data. As discussed longer be regarded as a by-product of work to ensure that the bank can
below, data governance encompasses existing data processing routines. achieve high standards of data quality
three mutually interacting dimensions: Without a proper data management must be driven from the top. Senior
IT architecture, organization, and framework, quality assurance meas- management needs to build aware-
processes. ures may easily account for 75 percent ness for the importance of data quality
or more of the time available to gener- in all areas of the organization. A criti-
IT Architecture ate a report. cal step is to develop key performance
A consistently high level of data qual- indicators (KPIs) for data quality and to
ity depends on the support of suitable One option to raise the efficiency of reengineer data ownership to ensure
IT tools. Quality deficits that result decision support processes is to indus- clear accountability among the busi-
from inadvertent inaccuracy of data trialize data supply operations and to ness units for the quality of data they
inputs or automated data processes separate data analysis processes from capture. The KPIs should be linked to
(e.g., migrations) cannot be remedied any quality assurance activity. A central tangible values, such as performance
by organizational and process-related unit would be responsible for ensuring evaluation for year-end bonuses, or
measures alone. a high level of data quality and for penalties, such as ascribing a higher
providing all analytical processes with capital charge to business units where
Beyond a certain data volume, a reliable data. these KPIs have not been met.
systematic detection and correction
Effective KPIs should be specific,
of deficient data, data inconsistencies, An existing IT architecture largely
measurable, business oriented, control-
or double entries can be performed determines the range of potential orga-
lable, and reportable and involve the
efficiently only with the help of auto- nizational structures for data gover-
inspection of data.
mated analysis routines, which require nance. For example, centralized
a centralized data household to responsibility for the functional valida-
tion of input data is possible only with General Principles of Data
operate effectively. Key elements of
an adequate IT architecture include the consolidation of decentralized indi- Governance
separation of analytical data layer from vidual databases in a central data ware- While an explicit definition of data
operational data repository, modulariza- house. Thus the existing IT architecture governance has to be adjusted to the
tion of functions, and elimination of and the road map of its further devel- specific conditions prevailing in a finan-
redundancies (Figure 4). opment determine the scope of cial institution, the following guidelines
options for the definition of a specific are applicable:
Organization data governance model. • Responsibility for data quality should
The complexity of data management be resident in the business unit
processes in a bank increases with the Processes
where the data are introduced into
number of local divisions that produce Efficient and effective processes are
the process and/or where the data
relevant information and the number of the most important ingredients for
(for example, by calculation) are
users requiring reliable data for diverse achieving a high level of sustainable
produced. The responsibility for the
analytical purposes. Beyond a certain data quality. Although data is often
quality of business and customer
level of complexity, data quality can no captured bottom-up, the control frame-
data, for example, should be with The quality gates should be comple-
the respective market divisions. mentary so that at the higher levels the
Accountability for the results data only errors occurring are those that
then rests with the units responsible could not be identified efficiently at any
for the appropriate application of the preceding stage. The process of data
analytical methods and their correct analysis by highly skilled experts to
implementation. Ownership for support business decisions must not be
results data also encompasses constrained by issues that should be
responsibility for their completeness: detected and resolved at earlier stages.
Business or customer information
that was rejected during the Thus, by supporting business decision
processing—due, for example, to making and enhancing the accuracy of
undiscovered quality faults—has to business decisions, efficient data
be corrected and (as a quick fix) be governance becomes a strong compet-
reentered into the processing. The itive advantage.
correction of quality deficiencies of
input data rests, again, with the
respective market divisions.
• Downstream quality assurance
measures, such as data validation
procedures outside the market divi-
sions, should be pooled in an orga-
nizationally separate central unit.
This unit would be responsible for Figure 5: Schematic View on Quality Gates
controlling the completeness,
correctness, and timeliness of data
deliveries from the diverse busi-
ness divisions and for providing
validated data at least to the analyt-
ical processes the results of which
have to be compatible.
• All measures that aim at the provi-
sion of a high level of data quality
should be organized in the form of
quality “gates” that build upon each
other (Figure 5):
– Quality gate 1. Technical process-
ability: Technical assessment of
supplied data and employment of
error-handling routines
– Quality gate 2. Systematic valida-
tion of data content: (1) Data
analysis designed to detect miss-
ing data, duplicates, and so forth
(by a dedicated data quality team)
using “intelligent” routines and
(2) correction of detected quality Source: KPMG in Germany, 2007
deficiencies in source systems

and clearing of database
– Quality gate 3. Data analysis:
(1) Detection of (sporadic) data
quality problems (such as
outliers) in the course of data
analysis for decision support,
(2) correction of detected quality
deficiencies directly in the
respective reports or analyses,
and (3) triggering the data correc-
tion in the source system
In Search of the Right Measure

Linking Credit Risk Modeling and Measurement in Basel II
and IFRS
Basel II and International unsustainable. Fortunately, underly- • Similarities and differences between
ing Basel II models and data also IFRS and Basel II
Accounting Standard (IAS) may be used for IFRS purposes. • Applying Basel II models for IFRS
39 “Financial Instruments: Bridging the gap between the two impairment calculation
Recognition and Measure- sets of rules, however, still requires
ment” both require banks

considerable and costly modifica- IFRS Requirements on
tions and supplementary analyses— Loan-Loss Provisioning
to model and measure the but the costs for implementing IFRS IFRS loan-loss provisioning can occur
risks from their credit loan-loss calculations from scratch on an individual or on a collective (port-
would be considerably higher.
engagements. • Consistency of risk reporting. Bank
folio) basis. Specific analysis of signifi-
cant and impaired assets is necessary
Frank Glormann (Germany) explores management relies increasingly on to calculate the so-called “specific”
how Basel II investments can be lever- an integrated view of the institution’s loan-loss provision. All the other
aged for IFRS purposes, especially on regulatory, accounting, and business assets, such as individually not-signifi-
impairment provisioning. operations. Achieving such integra- cant loans and individually significant
tion requires coherent and consis- but non-impaired loans, are subject to
What is the right way to measure tent reporting across all three a portfolio approach to loan-loss provi-
credit risk? Depending on their respec- perspectives. Consequently, data sioning and thus are potential candi-
tive objectives, regulators and account- and methodologies must be aligned, dates for the application of Basel II
ing standards-setters have come up and the transition between the methodologies (Figure 6 on page 8).
with different answers. But from a different sets of calculations must be
management point of view, arriving at well understood.
Similarities and Differences
an integrated approach is imperative
for at least two reasons: Developing an integrated approach for Between Basel II and IFRS
loan-loss calculations under IFRS and Both Basel II and IFRS agree, in
• Cost savings. Setting up and main- Basel II requires consideration of the essence, in their international focus
taining two methodologies requiring following: and their general goal to provide
distinct data for Basel II and IFRS
• IFRS requirements on loan-loss market participants and supervisory
loan-loss calculations would seem
provisioning authorities with transparent and
Figure 6: Loans and Receivables
NOTE: Above-mentioned are applicable for only on-balance-sheet items
Source: KPMG in Germany, 2007
precise information. Consequently, of a balance-sheet date, Basel II quent potential credit crunches
many of the requirements and sources focuses on expected and unex- during development, Basel II indi-
of data are similar under IFRS and pected losses. According to IFRS, a cated that neither regulators nor
Basel II. financial asset is impaired, and banks wish to see erratic move-
impairment losses are incurred, if ments in capital requirement levels
Supplementary IAS 39.AG92 recog- objective evidence exists indicating due to changes in economic condi-
nizes the considerable synergies impairment as a result of a past tions. A reasonable strategy under
between IFRS and Basel II by acknowl- event that occurred subsequent to Basel II therefore seeks to reduce
edging that, ”formula-based approaches the initial recognition of assets. volatility in the level of capital require-
or statistical methods may be used to Incurred losses are based on ments over the economic cycle.
determine impairment losses in a economic/market events or risk • Loss definition. Technically speak-
group of financial assets” (as illus- circumstances (risk conditions ing, Basel II defines a loss event as
trated in Figure 6). However, there are /impairment trigger) that have occurring when either or both of two
some conceptual differences between occurred after the initial recognition conditions are met: (1) The obligor is
IFRS and Basel that prevent banks of the asset and provide evidence of unlikely to pay its credit obligations
from using unadjusted Basel II data a forthcoming default affecting future or (2) the obligor is 90 days past due
and models for IFRS purposes. cash flows that may be reliably esti- on any material obligation. In other
mated. IAS 39 explicitly states that words, loss in the sense of Basel II
The most important of these differ-
expected losses as a result of future means some form of economic loss
ences are described below:
events, “no matter how likely,” are and the expected loss calculation
• General purpose. The overall Basel II not recognized. refers to the whole asset ledger.
objective is to ensure reliability and • Cycle dependency. IAS 39.59(f)(ii) Under IFRS, an impairment loss is
stability of the financial system. Thus, states that, “an adverse change in defined as occurring when the
it requires banks to hold an adequate national or local economic condi- difference between the present
level of funds against the expected tions…should be used as a basis for value of the expected cash flows,
risks they take plus a buffer against determining that there is a measura- discounted at the effective interest
unexpected risks over the course of ble decrease in their estimated cash rate, and the carrying value of the
the following 12 months. By contrast, flows.” In other words, economic loan becomes negative.
the IFRS perspective is to provide triggers are allowed as an indication
relevant information for decision that impairment may be present in a This difference in loss definitions
making at a defined point in time, group of assets so that, conse- between Basel II and IFRS implies
specifically the balance-sheet date. quently, IFRS seeks to reflect that the starting basis for Basel II
• Incurred loss versus expected loss. economic volatility in provision expected loss (EL) calculations and
Whereas the objective of IFRS is to levels. Although Basel II is not IFRS impairment calculations are
ensure that financial statements explicit on this topic, in the discus- also different—because, for exam-
adequately reflect losses incurred as sions around cyclicality and subse- ple, non-cash transactions such as
indirect costs for the overhead of a Figure 7: Application of Basel II Parameter for IFRS Provisioning
collection department or late
payment charges are considered
under Basel II but not under IFRS.
Also, the Basel II loss given default
(LGD) number requires the inclusion
of capital costs whereas IFRS explic-
itly states that the discount rate to
be used is the same “effective inter-
est rate” used to recognize income
on the asset before it was impaired.
Applying Basel II Models for

IFRS Impairment Calculation
The basic equation for calculating
incurred loss (IL) under IFRS looks
quite similar to the Basel II formulae,
as in Figure 7.
Discussed below are the specific

components of the equation and Source: KPMG in Germany, 2007
related detail on Basel II characteris-
tics, IFRS requirements, and adjust-
parameters since changes in portfo- • IFRS: The methodology of applying
ments required.
lio composition alter the basis for internal rating systems for Basel II
Assignment of Portfolio parameter estimation. purposes is also valid for determin-
• Basel II: Expected Loss is deter- ing IFRS PD, with appropriate
Adjustment concerning the expo- adjustments.
mined with respect to the whole
sure at default (EAD) • Adjustments: Delineate Basel II
asset ledger
• Basel II: Capital requirement calcula- prediction horizon from a one-year
• IFRS: Calculation of loan loss provi-
tions are done using EAD numbers, forward-looking PD toward the
sions required for specific assets; for
i.e., the expected exposure at balance-sheet incurred-loss point of
example:
default, including unused credit view as required by IFRS.
– (i) Financial assets classified as
limits, projected over a one-year Additionally, the need for adjusting
Loans and Receivables (LaR)
horizon. the cyclical behavior of the underly-
carried at amortized costs
• IFRS: The basis for loan loss calcula- ing PD models might be verified
– (ii) Off balance-sheet items
tions under IAS 39 is the IFRS book since Basel II models often use a
according to IAS 37
value, not the Basel II EAD (IFRS hybrid calibration instead of a pure
– (iii) Fixed income assets classified
book value < EAD). Losses expected point-in-time perspective, as favored
as available for sale (AfS)
as a result of future events, no by IFRS (IAS 39.59(f)(ii)).
• Comparison: The Basel II methodol-
matter how likely, are not recog-
ogy can be leveraged in the above
nized. Unused credit limits are not Adjustment concerning loss given
cases (i) and (ii). However, in the
included, and book values are used default
case of fixed income assets classi-
as of the balance-sheet date. • Basel II: LGD numbers are based on
fied as available for sale (AfS), there
• Adjustments: Substitute EAD the definition of economic losses
is an inevitable asymmetry between
number with IFRS book value as of relating to the expected amount of
Basel II and IFRS. These financial
the balance-sheet date for IAS 39 debt at the time of default, for which
instruments, which are held on the
loan loss provisioning. future cash flows are discounted
banking book, are not subject to
using a risk-free market rate.
portfolio or general loan loss provi- Adjustment concerning the proba- • IFRS: The reference figure for deter-
sioning IFRS. Hence, Basel II param- bility of default mining impairment is the IFRS book
eters do not play a role in their IFRS • Basel II: The PD defines the probabil- value as of the balance-sheet date
treatment. They may still-—and typi- ity of a customer (transaction view using the effective interest rate to
cally will be—-subject to the IRB also permitted in the retail segment) discount expected cash flows.
approach under Basel II just like to hit one of the Basel II default • Adjustments: Adjust the Basel II
ordinary loans and receivables. events over a one-year time horizon. LGD numbers in the following way:
• Adjustments: Apply Basel II models A PD is determined for any borrower – Base LGD calculations on the
to relevant IFRS portfolio and take and for any credit transaction in the carrying amount instead of
into account that portfolio variations retail business by the use of internal the LGD.
might require changes in Basel II rating systems.
– Take all of the collateral into account.

– Use effective interest rates instead of risk-free rates to discount future
cash flows.
– Neutralize the Basel II downturn LGD effect.
Adjustment of expected loss to incurred loss concept

• Basel II: “Plain vanilla” EL models are used.
• IFRS: Consider credit losses incurred at the time of the impairment loss
calculation.
– If losses already have been identified, then impairment losses need to be
calculated on an individual level in case of significant financial assets or on a
portfolio level, assuming a PD of one.
– If losses have not been identified so far (an “incurred but not reported
loss”), apply the EL based loan loss calculation on a portfolio level.
• Adjustments: Introduce the loss identification period (LIP) concept to manage
the transition from expected to incurred losses. The LIP is the time period
between the occurrence of a specific impairment event and objective evidence
of impairment becoming apparent on an individual basis—that is, the time
between the loss event and the date an entity identified its occurrence. The
LIP can be incorporated into the expected loss equation via the LIP-factor
calculated as:
Given this, the IL can be calculated as:
The LIP concept is illustrated in Figure 8.
Figure 8: Loss Models
Conclusion
Basel II models can serve as a starting point to calculate loan loss provisions under
IFRS—but specific adjustments are needed to transform Basel II expected loss
numbers into incurred loss amounts required by IFRS. Consequently, leading banks
are currently implementing detailed and complete IFRS-compliant approaches for
loan-loss provisioning using synergies with Basel II models and results.
Going to the Limit

On the Use of Advanced Credit Risk Measures in a Credit
Risk Limit System
Under Basel II Pillar 1, new

quantitative measures for
credit risk, such as proba-
bility of default, loss given
default, and exposure at
default, have been intro-
duced on a large scale.
Similarly, under Basel II
Pillar 2, the concepts of
risk-bearing capacity,
economic capital, risk
correlations, and concen-
trations have gained
increased attention from
risk managers and regula-
tors alike.
Ralf Hennig (Germany) and Francesco As discussed below, three dimensions The Metrics for Measuring
Merlin (Italy) explain how these risk need to be considered in designing a
measures and concepts can be used credit limit system that serves this
Credit Risk
With the improvements that Basel II
to create risk-sensitive credit limit purpose:
has brought about for the quantifica-
systems going beyond the traditional • The risk metrics used to measure tion of credit risk at the individual and
gross exposure limits. the credit risk portfolio levels, a number of metrics
• The different objects of limitation can now be used to measure credit
The purpose of a credit risk limit
together with the specific reasons risk (as depicted in Figure 9).
system is to ensure that a bank’s
for their limitation
actual risk-taking is in line with its risk-
• The way the limit system is embed- The characteristics defined in Figure 9
bearing capacity. A particular focus is
ded in the organization and business can be classified along two dimen-
on the avoidance of excessive risk
processes sions: (1) the extent to which a metric
concentrations, which may jeopardize
the existence of a bank. With this
objective in mind, a limit system needs Figure 9: Characteristics of Different Credit Risk Measures
to be consistent across all parts of an
organization to ensure that a bank’s
risk-bearing capacity is not exceeded at
the aggregate level.
This goal implies that the actual size of

the limits must be derived from the
bank’s risk appetite, business objec-
tives, and risk-bearing capacity. This
process is often guided by qualitative
considerations; however, quantitative
techniques are also being applied,
including the definition and quantifica-
tion of stress scenarios against which
the bank aims to protect itself by credit KPMG in Italy, 2007
risk limitation techniques.
is risk sensitive and (2) the extent to Table 1: Limitation Dimensions

which it is capable of taking worst-case
losses correctly into account. Possible Reason of Possible Risk
Entity
Characteristics Limitation Metric
As shown in Figure 9, traditional credit
Single Economic-risk enti- Highest correlation Net exposure,
risk metrics, such as gross or net expo- Obligors ties in terms of affili- between names contribution to
sure, are less risk sensitive than others ated group within one economic capital
because they do not change with the economic risk
credit quality of the obligor, but rather entity in terms of
affiliated group
focus strongly on worst-case losses
such as the default of a single large Largest Group Sum of largest Portfolio with less Net exposure
obligor or a sovereign transfer risk Exposures single obligors (e.g., tendency towards
event. By contrast, statistical risk largest five obligors) concentration in
metrics—such as expected loss, regu- few single obligors
latory capital (in particular in the case Countries All sovereigns and Highest correlation Net exposure
of the internal ratings–based approach), privately held enti- in case of sovereign
or even economic capital—are much ties in the country default and transfer
more risk sensitive in that their values events for all enti-
change with credit quality and, in the ties in the country
case of economic capital, credit risk Regions Group of countries Economic depend- Economic capital
concentrations, but fail to capture in a geographic ence between
worst-case scenarios. region countries in a
region
Also, statistical risk measures are much
more subject to model risk than expo- Industries Industry segments Correlation between Economic capital
with high default single addresses in
sure-based metrics, but they often correlation the private sector
permit a more meaningful risk aggrega- within economic
tion across, for example, products, cycle of the industry
obligors, or business lines than their
exposure counterparts. The classic Rating Single rating classes Determination of Expected loss
Classes or groups of rating desired portfolio
example of credit lines that are diffi- classes composition across
cult to aggregate under normal condi- risk classes
tions is the case of counterparty risk
limits and traditional credit lines for a “Hot spots” Risky portfolio Striking concentra- For example net
subsets that are tion in “hot spot” exposure,
single obligor. defined by risk and risk political expected loss or
management based considerations economic capital,
These considerations show that no on general risk conditional on
single risk metric is a panacea. Rather, policy dependence of
the question of which to use depends obligors within
on which risk metric best fits the “hot spot”
purpose at hand.
Credit Risk Limitation Conversely, a net exposure metric may Most important, the risk limit system
fail to pick up risk concentrations from must be understood by client relation-
Scenarios exposures of medium size but lower ship managers and credit risk managers
Table 1 links entities and related
credit quality—which are jointly more alike. From this point of view, there are
reasons for credit risk limitation with
vulnerable to adverse economic condi- advantages for simple exposure limits.
potential risk metrics.
tions—or from exposures that exhibit Therefore, tools that translate more
Depending on the object and the other common risk characteristics. complicated risk-sensitive credit limits
related reason for the limitation, a Such issues are more easily recognized into traditional exposure limits are
combination of a “worst-case” metric as risky by an economic capital metric. required. Users should acknowledge
and a more risk-sensitive metric can be that, in contrast to fixed exposure
Another important consideration in limits, the “exposure limits” resulting
appropriate. For example, consider the
choosing a risk metric for a credit risk from such a translation are liable to
case of a large exposure with a very
limit system is the availability of up-to- change along with changes in the char-
high credit quality obligor. Although in
date risk figures, especially with regard acteristics of the transaction, the
such a case the economic capital
to economic capital. Proxies may be obligor, or economic conditions.
metrics would rule it out as a major
required to obtain an estimate of the
source of risk, a net exposure limit
true economic capital figure between
might kick in and protect the bank
proper calculations.
against lending excessively to an entity
that at some future point may pose
serious risk.
Finally, not all of the above objects of limitation will or should play the same role As a result, a credit risk limitation
in a credit limit system. While a combination of exposure and economic capital system with material risk management
limits may prove useful on the single-obligor level, other limits such as industry impact may create substantial
or rating class limits will be considered only at the level of the whole portfolio. conflicts. These conflicts not only arise
Rather than being perceived as “strict limits,” the latter may be used as softer between business units and credit risk
guidelines along which to structure the credit portfolio. Also, in practice, one may management, which may inhibit busi-
use a smaller or different choice of limit objects than those offered in the table. ness due to the limitation, but also
emerge as different business units
Embedding the Limit System in the Organization and compete for the finite risk-taking
capacity of the bank.
Business Processes
While comprehensibility of the limits system is a prerequisite for embedding it in Appropriate governance structures and
the processes of a bank, the key issue arising in this context is described in processes can eliminate a large part of
Figure 10. the conflict potential. Useful elements
of such a structure would be:
Figure 10: Linking Credit Limit System to Bank Organization
• A credit strategy and guidelines in
accordance with overall credit
portfolio objectives
• A limit reservation concept
• An escalation procedure in cases of
scarce risk-bearing capacity.
It may, however, be even more promis-

ing to join the pure risk view conveyed
by a credit limit system with a value
perspective. This combined view may
be introduced very effectively through
an active credit portfolio management
unit that keeps the bank-wide credit
risk under control while interacting
Source: KPMG in Germany, 2007 flexibly with the business units, based
on the principles of value-based
Recall that the purpose of a credit risk limit system is to ensure that a bank’s management and risk-adjusted pricing.
overall risk-taking is in line with its overall risk-bearing capacity. Figure 10 illus- These ideas will be explored further
trates the interaction of the organizational structure (represented by the horizon- in the section, “An Orchestrated
tal view) and the risk limits, which extend across the business areas. This Approach to Value Creation.”
interaction creates a bank-wide risk view that management can use to protect
the bank against undesired risk concentrations.
Enabling decentralized decision making while maintaining a bank-wide view of

the risk creates challenges. At first glance, an approach would be to break down
the limits to the different business units, giving rise to a matrix structure similar
to the one in Figure 10. This approach would, however, be highly inflexible, and
the frequent result in practice would be (1) the implementation of a complicated
system of limit transfers and limit lending or (2) the allocation of wide limits to
the business units to contain interference with operations. The latter approach,
however, often leads to bank-level limits that are so high as to be totally out of
proportion with the bank’s risk-bearing capacity and are only tolerated with the
tacit understanding that they will not all be used at the same time.
Exploring the Unexpected

Developing and Using Credit Risk Stress Testing in
Risk Management
The inclusion of stress test- “Stress testing is a risk management Once these issues are clarified,
technique used to evaluate the poten- management can consider the param-
ing requirements within the tial effects on an institution’s financial eters to be stressed and the types of
Basel II framework is an condition of a specific event and/or stress tests to be considered.
opportunity for institutions movement in a set of financial vari-
to integrate their quantita-

ables. The traditional focus of stress The Environment
testing relates to exceptional but plau- To define how stress tests could affect
tive and qualitative methods sible events”1 an organization, management should
and to reduce the model To understand the general approach
consider the types of stress the bank
encounters and the environment in
risk that arises. toward stress testing, it is important to which it operates. Essentially there can
understand the following key aspects: be two sources of stress: (1) purely
As Steven Hall (United Kingdom),
Francesco Merlin (Italy), and Kristian • The environment in which banks idiosyncratic events such as the default
Tomasini (Italy) explain, the require- have to operate (considering the of a large obligor and (2) developments
ments drive banks to explore issues of range of exceptional but plausible affecting the entire market, such as an
unexpected loss, economic capital, and events) economic downturn. A large default or
regulatory capital more widely than in • The definition of unexpected loss adverse market developments such as
the past. (within the formal risk management a mild recession may affect one bank
sphere) more severely than another, depending
• How to use the outcome of the on the aggressiveness of its lending
stress test strategy or business model.
1
Bank for International Settlements, Committee of the global financial system, January 2005: Stress
testing by large financial institutions: survey results and practice.
As a consequence consider the

following:
• Stress tests are a useful exercise to
(1) help an institution identify plausi-
ble but extreme combinations of
idiosyncratic and market events that
could endanger the stability of the
institution and (2) define potential
strategies and policies as a stand-
alone response to those events. The
bank should set its internal level of
capital with the intention of meeting
such events and based on its current
environment and status.
• Extreme systemic catastrophic
events have to be managed in a
coordinated way by the appropriate
supervisory authorities within the
financial system. Thus, a common
framework for stress testing and its
thresholds should be defined at the
international level, whereupon indi-
vidual institutions would calibrate
and refine this framework based on
their own circumstances.
Unexpected Loss
Unexpected loss (UL) could be defined
as the difference between expected
• Reduce the risk of a specific sub- For regulatory capital the well-known
loss (EL) and the value at risk (VaR) at
portfolio with the help of securitiza- risk parameters are the probability of
a given confidence level, or the
tion or syndication default (PD), the loss given default
expected shortfall exceeding the VaR.
• Readjust the threshold for the limit (LGD), and the exposure at default
One problem with this approach is that
system. (EAD). PD is by far the most popular
such a loss might be not only unex-
risk parameter for stress, and tests are
pected but also quite unrealistic, as In general, the indicators should be often done either through the rating
this definition is purely statistical in those that the risk management func- assignment or by direct modification
nature. Therefore, stress tests can be tions already consider to understand of PD.
useful either to determine which unex- the portfolio’s risk profile. Indicators
pected losses are plausible or to could include EL, UL, expected short- In the first method, the change in
provide information to help determine fall, increase in capital charge economic conditions causes a variation
the level of economic capital to be held (economic and/or regulatory), solvency of the inputs used to calculate the
by the institution. ratio, or risk performance measure- rating, and this variation leads to a
ment indicators. change in the rating assignment. Thus,
“Reading” a Stress Test
a possible stress scenario could be
When integrating the information
obtained from a stress test into the
Credit Risk Stress Testing: determined after identifying the risk
drivers that produce those changes and
institution’s management framework, The Risk Parameters
relative impact. Another scenario could
management should consider how to Once it has defined the boundaries of
be obtained by simply “shocking” the
use it in an active way rather than as a the stress test, the meaning of UL,
rating class distribution for part of a
standalone regulatory compliance and how to use the stress test out-
portfolio without defining a parametric
requirement2. puts, a bank can identify risk parame-
framework that links the shifts to
ters for the credit risk stress test. The
Therefore, it could be useful for the specific risk factors. In general, a stress
first step is to distinguish between a
institution to introduce indicators and test where the assignment of the
stress test and (1) available risk meas-
thresholds to help determine when to: obligor rating grades is altered has the
ures for regulatory capital and (2) risk
advantage of allowing for the inclusion
• Inform management about potential parameters for economic capital.
of transitions to nonperforming loans.
critical developments
• Constrain the expansion of the insti-
tution’s business into a risky area
2
The management body has ultimate responsibility for the overall stress-testing framework.
In the second method, the direct modi- Types of Stress Tests approach is that sufficient data
fication of the PDs for rating grades After defining the institution’s environ- enables one to associate a specific
could have its origin in the influence of ment, the meaning of unexpected loss, probability with the scenario.
systematic and idiosyncratic risk and the purpose of the stress test • Hypothetical scenarios: focuses on
factors that could be estimated (regulatory capital versus economic rare events that might have an
through historical statistical analysis. capital), it is useful to consider the two important impact on the portfolio but
This approach could be too complex to major approaches to stress testing: have not been observed yet.
be implemented in the first stage.
• Constant stress test: this involves With respect to the design of stress
Therefore, another possibility to modify
the (simultaneous) movement of risk scenarios, approaches can be either:
the PDs directly could be derived from
component(s), without taking into
analysis of historical rating transitions • Portfolio or bottom-up: the identifi-
account the properties of the sub-
in periods of economic stress. In cation of risk drivers is strictly
portfolios or the interrelations with
general, the advantage of modifying dependent on the portfolio composi-
external events (that is, a flat stress
the PDs directly is in the great variety tion (for example, relevant drivers for
is applied for PDs).
of changes that can be made; the main a bank focusing on real estate would
• Model-based stress test: this
disadvantage is that there is no change be GDP, employment rate, and infla-
approach could be divided into
in the assignment to performing and tion rate rather than oil price,
univariate (relying on one random
nonperforming loans and this process exchange rate, and so forth)
variable) and multivariate (involving a
has to take place at the start of the PD • Event or top-down: a study of the
number of independent mathematical
modification process. impact of a chosen scenario (for
or statistical variables) approaches.
example, the terrorist attack of
The other risk measures, LGD and These methods attempt to explore
September 11, 2001).
EAD, are by definition already condi- the relationship between risk drivers
tioned to the situation where the (e.g., macroeconomic variables)
and the impact on risk parameters
Conclusion
obligor is in default. In addition, the As banks’ portfolios and activities
estimation of LGD and EAD must be through econometric models. This
become increasingly complex and
appropriate for an economic downturn. approach also considers the potential
financial and economic circumstances
Consequently, the ability to stress portfolio effect, allowing for the
continue to change, the use of stress
these quantities is restricted to: possibility that a single risk driver
testing to understand the impact of
could have a positive impact on one
• Exogenous factors such as exchange portfolio and individual events becomes
specific sub-portfolio and a negative
rates for EAD or collateral values for ever more important. Increasingly,
impact on another (e.g., an increase
LGD regulators are turning to stress testing
in energy prices could have a nega-
• Risk drivers that could influence all as a way of understanding how compa-
tive impact on the retail portfolio
the risk parameters (that is, a risk nies will respond in given situations.
but a positive impact on the corpo-
driver that affects the collateral value Senior management has a key role in
rate lending portfolio focused on
at the same time as the PDs). establishing a robust and comprehen-
energy companies). Importantly, it
sive stress-testing framework.
To estimate economic capital, the risk also considers the influence of the
parameters PD, LGD, and EAD might identified risk factors on different
not be sufficient to design appropriate risk types.
stress tests. In addition to the parame-
Both approaches depend in some way
ters described above for regulatory
on the definition of the scenarios, which
capital, one has to take into account
could be specified in three ways:
the building blocks for the credit risk
portfolio model (such as correlation • Historical scenarios: extreme
between loans, correlation between universes of risk factors observed in
risk measures, concentration, and so the past that are related, largely, to
forth). Therefore, to define a method historical events and crises. They are
for stress testing economic capital, the applied to the current situation and
first step is to analyze the bank’s portfolio.
specific portfolio model, consider its • Statistically based scenarios:
components, stress them; and try to based on the joint statistical distribu-
cover situations where the model may tion of risk factors. The key challenge
likely fail to indicate the risk properly in this approach is to have enough
due to known and accepted shortcuts historical data to define the distribu-
in the modeling. tion. The great advantage of this
Pricing at All Costs

Comments on the Credit Pricing Today and Its
Post-Basel II Future
Prior to Basel II many in the industry

felt that bank credit was too cheap,
meaning that banks were not earning
credit spreads sufficient to cover the
costs—in particular, the true economic
costs of risk and capital—for the loans
they were granting. With the wide-
spread introduction of calibrated proba-
bility of default (PD) rating systems,
Basel II laid the foundation to obtain
large-scale quantitative evidence to
substantiate this uneasy perception of
cheap credit. Accordingly, “risk-
adjusted” credit pricing was expected
to play a much bigger role in the
post–Basel II era5. It is probably too
early to assess whether this prediction
has materialized, particularly as the
economy has moved into a benign
credit environment since 2002.
Nevertheless, an almost unanimous

view has emerged on the elements
that a state-of-the-art, risk-based,
credit-pricing scheme should contain.
Banks using such an approach typically
Under the so-called “use test,” Basel II requires banks consider four major components:
applying the internal ratings–based approach to use their • Their own refinancing costs
• “Standard” risk costs as expressed
internal ratings as an essential part of their credit risk by the expected loss
management processes3 and, hence, of the pricing of • Administrative or operating costs
credit4. As a consequence, many in the industry • Capital costs6
expected IRB banks to review their credit pricing In an IRB bank, expected losses are
methodology to reflect the “true” risk-adjusted cost of typically calculated using the PDs asso-
ciated with the respective internal
credit as estimated by the risk parameters derived from rating grades. The fact that Basel II
their Basel II rating systems. PDs cover only a one-year time horizon
is often dealt with by introducing rating
This task may be much more challenging than suggested by current cost-based
transition matrices.7 These contain
approaches to credit pricing, as Bernd Granitza (Germany), Maxine Nelson
historical probabilities of obligors
(United Kingdom), and Daniel Sommer (Germany) contend.
migrating from a given rating grade to
another rating grade within one year
from the rating date. By iteratively
3
International Convergence of Capital Measurement and Capital Standards (referred to as Basel II in the applying these matrices to the original
sequel) paragraph 444 one-year PDs, cumulative PDs for
4
See, for example, the German regulator’s MaRisk BTO 1.2 (6), which requires that there be a reason-
able link between a bank’s risk assessment and its pricing of a loan. longer time horizons are calculated.
5
As an example, see Jäger, Redak: “Austrian Banks’ Lending and Loan Pricing Strategies against the These are then used to determine
Background of Basel II,” Austrian National Bank Financial Stability Report 12, pp. 92–103
6
As one source of evidence, see “Results from the survey of European banks carried out for the guide
expected losses for longer-term loans.
How to deal with the new rating culture: A practical guide to loan financing for small and medium-sized
enterprises,” May 2005, European Commission
7
Alternatively, some banks use rating agency multi-year credit default frequencies associated with the
PDs from their internal rating systems. This approach is subject to problems similar to those of the
transition matrix approach.
Three questions arise as a result: assigned. If, however, the rating obligor and the obligors in one rating
• Are Basel II PDs suitable for deter- system exhibited features of a through- grade all had exactly the same one-
mining expected losses in the the-cycle rating, which focuses on the year PD. As previously stated, the tran-
context of cost-based loan pricing as structural ability of an obligor to with- sition matrices for a point-in-time and a
outlined above?8 stand adverse economic conditions, through-the-cycle rating would be quite
• Is the cost-based approach suitable using recent information about the different. Hence, iteratively multiplying
for determining an economically general state of the economy or the a transition matrix would yield
sensible risk-adjusted price of credit? obligor’s industry to adjust the Basel II completely different multi-year PDs for
• How else could Basel II ratings be PDs for pricing purposes would give a the point-in-time and through-the-cycle
used in the context of credit pricing? more accurate risk assessment. obligors. This paradox results because
this technique of multiplying matrices
The Basel Committee acknowledges ignores the effects of the business
Suitability of Basel II PDs that taking simple averages over past cycle on PDs and rating transitions.
for Determining Expected default histories—as is often done in
Losses for Cost-Based calibrating PDs—will be an effective Third, in a through-the-cycle rating
means of determining default probabili- system migrations may be subject to
Credit Pricing ties per rating grade only if the rating rating momentum. This means that a
Basel II requires that “a borrower rating system is point-in-time.12 further downgrade at a given rating
must represent the bank’s assessment date is more likely to occur if the
of the borrower’s ability and willingness Moreover, whether a rating system is obligor had already been downgraded
to contractually perform despite adverse point-in-time or through-the-cycle will at the preceding rating date. Some
economic conditions or the occurrence also strongly affect the migration char- agency ratings have this property.14 In
of unexpected events.”9 Moreover, acteristics between rating grades. the presence of rating momentum, iter-
Basel II stipulates that “PD estimates While rating migrations in a point-in- ating on a transition matrix with dimen-
must be a long-run average of one-year time rating system will be heavily sions confined to the rating grades will
default rates for borrowers in the dependent on the economic cycle, this yield incorrect multi-period PDs.
grade…”10…and later explains that dependence is not an issue for a
these may be taken from internal through-the-cycle rating. This observa- As a preliminary result, unadjusted
default experience, mappings to exter- tion has three important implications. one-year Basel II PDs or multi-year PDs
nal agency ratings, or statistical default calculated using historical averages of
prediction models.11 First, it is impossible to avoid explicitly past rating transitions would not be
taking into account the effects of the suitable for use in credit pricing
Contrast these requirements with economic cycle when estimating histor- models. Rather, it is necessary to
the fact that when pricing a loan a ical PDs for pricing purposes. Either determine carefully to what extent a
bank must form the best possible they need to be considered in estimat- given rating system exhibits point-in-
estimate of the probability that an ing the one-year PDs in a through-the- time or through-the-cycle characteris-
obligor will default before the contrac- cycle rating because PDs per rating tics and whether the transitions are
tual repayment date, given all current grade fluctuate with the business cycle subject to rating momentum. These
and past obligor- and economy-related or they influence the estimation of the properties have to be taken into
information. transition matrix in a point-in-time account by making appropriate adjust-
rating.13 Either way, taking simple aver-
A long-run average of one-year default ments to Basel II PDs and transition
ages of past default histories will not
rates can only be an appropriate esti- probabilities. Such adjustments are
suffice to obtain reliable estimates of
mator for the default probability explicitly permitted by Basel II and do
multi-year PDs for pricing purposes.
required in credit pricing if the rating not contradict the requirements of the
system is fully point-in-time, with the Second, the technique of generating use test.15
obligor re-rated regularly. By definition, multi-year PDs by iteratively multiplying
such a rating system would reflect the one-year Basel II PDs by a ratings
every non-minor change in an obligor’s transition matrix is highly questionable.
probability of default—whether idio- To see why this is the case, suppose,
syncratic or economy-related—by an for the sake of argument, one knew
immediate change of the rating the correct one-year PDs for each
8
We will refrain from considering the LGD-component for the sake of simplicity.
9
Basel II paragraph 415
10
11
12
Basel Committee on Banking Supervision, Working Paper No. 14, Studies on the Validation of Internal
Rating Systems, February 2005, pp 18–20
13
The latter would be even worse from a statistical point of view because it combines the already diffi-
cult task of estimating a full transition matrix with the problem that the observed rating transitions are
drawn from different distributions, which themselves depend on the business cycle.
14
Standard & Poor’s Annual 2006 Global Corporate Default Study And Rating Transitions
15
Basel II, paragraph 444
Suitability of the Cost-Based particularly in a world of increasing done carefully the resulting credit
possibilities for credit (risk) transfer. prices may be much more in sync with
Approach for Determining the market and truly risk-adjusted pric-
Risk-Adjusted Prices for Uses of Basel II Ratings in ing than the output of the cost-based
Credit Credit Pricing approaches discussed previously.
Suppose the previous issues regarding Nonetheless, Basel II ratings and asso- In addition to mapping internal Basel II
the determination of suitable PDs had ciated PDs do have a role to play in ratings to external agency ratings,
been solved. Would one be well credit pricing. If used to link the banks may look toward rating method-
advised to use a cost-based pricing market’s prices for credit risk to the ologies that agencies have developed
system, as outlined in the introduction, fundamental credit quality of a given for analyzing SME-CLOs.17 These
for credit pricing? An important point to loan, Basel II ratings provide an indis- models are not a substitute for inter-
remember is that one of the funda- pensable element in a credit-pricing nally developed rating models.
mental principles of modern asset pric- model. To serve this purpose, the However, a mapping may be estab-
ing theory is that “risk-neutral” important point is not whether an inter- lished between a bank’s internal
PDs—that is, PDs that already take the nal Basel II rating is more point-in-time Basel II ratings and such agency
market participants’ risk aversion into or through-the-cycle but whether a models to enable a bank to gauge
account—should be used for pricing stable relationship can be established how its SME portfolios would behave
purposes. Therefore, the key to a with ratings used in the credit markets. under a potential CLO scenario. The
useful credit pricing formula is to find
objective is to infer information from
an economically sensible movement A case in point is liquid credits where
the (primary) CLO market for credit
from historical to risk-neutral PDs. Basel II ratings tend to be derived from
pricing purposes. Again, the prices
agency ratings by means of shadow
In this cost-based approach, the two thus obtained would fully incorporate
rating methodologies. For these credits
components of funding costs and capi- the bank’s internal risk assessments of
the market has learned to associate
tal costs could be that key. Certainly, the respective credits and related
what are essentially through-the-cycle
when a bank’s securities—whether market prices of credit risk, but they
ratings with obligors’ point-in-time,
debt or equity—are traded in the would rightly be independent of a
forward-looking risk assessments
market, the expected excess returns bank’s legacy credit portfolio and its
expressed through their CDS (credit
quoted provide a market assessment other activities.
default swap) spreads.
of the risk in a bank’s portfolio of
Whatever the route to credit pricing,
investments and activities, and hence Alternatively, recent rating agency
the important message is that to obtain
transit from the historical to the risk- research looks at inferring agency-type
risk-adequate credit prices, a bank must
neutral PDs. However, when a bank ratings from CDS spreads.16 Results
carefully study and understand the
has multiple activities and holds a from such investigations may prove
characteristics and dynamics of the
legacy credit portfolio that is large helpful in facilitating the move
rating systems it is using. These factors
compared with new loans, its expected between a historical PD and a risk-
will become fully apparent only by
excess returns on equity and debt are neutral PD or—what amounts to the
observing the behavior of a given rating
far more reflective of the market’s risk same thing—provide a link between
system through a business cycle, and
assessment of its existing portfolio and the market price of credit risk and the
they will be dependent on the rating
activities than of the market’s risk respective agency rating class. The
culture in a given organization. It is up
assessment of the new loans. beauty of this approach is that these
to the credit risk controlling unit to
market prices are frequently updated
Thus, rather than providing a solution gather and analyze relevant data and
and are available for a number of matu-
to the issue of risk-adequate credit link the internal Basel II rating systems
rities without the need to resort to
pricing, the only question that the cost- to relevant external models and hence
transition matrices.
based approach to credit pricing can to market prices for credit risk.
safely answer is: At what price—other As IRB banks have typically developed
The price that will then be quoted to
things being equal—is a given bank mappings between their internal
the client will, however, not be the
economically capable of taking a master rating scales and agency rating
result of a pure model calculation but
certain loan on its balance sheet? scales, one may try to extrapolate
will depend on many factors including
market prices for credit risk from the
While the answer is an important piece the techniques available to the bank for
liquid credit market to the less liquid
of information for a bank’s controlling refinancing the loan and hedging the
segments of the corporate credit
department, it will not be a pricing associated credit risk. The more flexibil-
market. While crossing the border
strategy that helps a bank to compete ity in these techniques, the more
between publicly rated and non-publicly
successfully in the credit business— competitive the bank is likely to be.
rated entities is never a trivial step, if
16
Fitch CDS Implied Ratings (CDSIR) Model, Fitch, 2007
17
Small and medium-sized enterprise collateralized loan obligation. As an example consider S&P’s “Credit
Risk Tracker“
Growth Processes
Leveraging Basel II Scoring Models and Data to Improve
Credit Processes
Those companies that have

been able to maintain focus
on the value creation aspect
of the newly introduced risk
measurement methods
throughout the Basel II
implementation process are
likely to find themselves
with competitive advantage
in the post-Basel world.
Ben Begin (United Kingdom), Frank
Glormann (Germany), and Steven Hall
(United Kingdom), show how, by build-
ing on and combining the newly intro-
duced scoring methodologies with
customer value analytics, the credit
processes and the general interaction
with retail and small-business
customers can be improved and
more value can be created.
A key requirement of Basel II is to inte- Simplifying and Streamlining Credit Processes

grate the credit scoring methods used Through the advent of statistical scoring tools, credit decisions are often made
for regulatory purposes into the credit on the basis of automated scorings (Figure 11).
risk management processes. This inte-
gration along with linking those meth- Yet, an average of less than 50 percent of all credit decisions in mortgage banks
ods to customer-value considerations, across Europe that are made on the basis of an automated scoring is indicative
can enhance the credit processes to of considerable room for efficiency improvement in the credit buisness with
allow faster growth and value creation. retail and small business customers.
The improvements relate to four Figure 11: Decision Ranking for Mortgage Applications Across European Markets
elements in the relationship with
a customer:
• Simplifying and streamlining the
credit processes as a result of
improved risk measurement
techniques
• Improving credit decision making
based on customer values
• Leveraging customer value informa-
tion for sales optimization purposes
• Preserving value by improving the
early warning, collections, and
recoveries processes
Source: European Mortgage Federation, 2006

In fact, automated decision-making Figure 12: Customer Value Concepts

approaches using statistical scorecards
allow companies to consider opportuni-
ties to centralize credit risk manage-
ment and measurement as well as the
outsourcing of the operational manage-
ment to specialist providers. These
actions can give rise to improved qual-
ity and consistency of credit decision
making as well as cost savings.
However, beyond these results, the

key area on which to focus is value
generation in customer interaction and
opportunities for its improvement.
Here we are looking to move from a Source: KPMG in Germany, 2007
pure risk-based cutoff (in line with

Basel use-test requirements) to a
Strategies for interacting with the customer may be defined more appropriately
value-based decision metric.
and flexibly depending on the result of the customer-value calculation. In particu-
lar, a focus on risk-adjusted profitability of the customer relationship would revolu-
Improving Credit Decision tionize credit risk decision making, especially in the retail context, where a focus
Making Based on Customer on customer value may lead to a different result than a purely risk-based decision
Values (Figure 13).
Retail companies have wanted to Figure 13: Risk- or Value-Based Cut-off
improve ”customer-value management”
for a long time. Basel has created the
opportunity by “forcing” them to Value Credit -Risk
High Value, High Value,
capture robust and granular data Cut -off
Low Risk High Risk
across all customers, thereby allowing
consistent analysis across segments.
Using this and other data in a frame-
work that combines risk, marketing,
and finance models, banks can deter-
mine the risk-adjusted profitability of
Too Credit
the client relationship. The easiest way Value -Based
Risky
to approach this problem is to consider Cut -off 0 Risk
the current customer value only. More
advanced models also would take Value destroying
future customer value into account.
Low Value, Low Value,

Low Risk High Risk
Both measures would restrict doing

business in this region
Even though the concepts are not difficult to master, the implementation is likely
to be fraught with challenges. A typical issue is implementation of the value
concept throughout the organization, most importantly in the distribution units
where incentives must be linked to the underlying value concept rather than pure
sales volume. The two factors can, however, be reconciled using the concept of
risk appetite (Figure 14).
Figure 14: Combined Cut-off from Value and Risk Dependent on Risk Appetite
Following a four-step procedure is appropriate:

• First, define the bank’s risk appetite, which determines the risk-return trade-off
it is willing to accept.
• Second, agree on a targeted sales volume.
• Third, set the rejection criteria to ensure rejection of credit applications likely to
destroy value while ensuring the feasibility of meeting sales targets.
• Finally, monitor and adjust the combined “Credit Risk & Value Cut-off” on an
ongoing basis as the “Risk Appetite” changes and / or the underlying value
concept becomes commonly accepted, also within the sales organization.
Leveraging Customer Value Information for Sales

Optimization Purposes
Further leverage can be gained by combining customer risk and value information
as well as market understanding with propensity models, which help to identify
likely customer behavior. The results can be used to customize and target product
offerings, providing greater flexibility and greater customer focus without compro-
mising measurement or quality. In addition, the bank’s sales staff is given greater
insight into customers’ risk and value profile in the initial customer interaction
(Figure 15).
Figure 15: Combining Customer Value Analytics with Propensity Information to

Increase Revenue Base

Figure 16: Sales Cockpit Containing All Relevant Information for Sales Optimization
Such improvements require control to Preserving Value by Defaults and the need for collection
ensure that no arbitrage or gaming of and recovery processes will continue
rating systems takes place among
Improving the Early despite these efforts. Basel models, in
sales functions. They also call for Warning, Collections, and particular the loss given default predic-
greater systems capability to deal Recoveries Processes tive models, together with customer
with the improved customization of With a focus on the rising level of value models are likely to become a
sales offerings and performance arrears worldwide, companies must core part of banks’ collection and
measurement. Figure 16 illustrates a consider early identification of default- recovery strategies. These ideas will be
front-end tool—a ”Sales Cockpit”— ers, looking at pre-delinquency as further explored in the section on “The
providing distribution people with rele- standard. Value in Bad Debt” at the end of this
vant information for client meetings document.
and sales activities—e.g., basic infor- The enhanced Basel II models and
mation on the customer, customer’s tools that organizations have developed
segment information, customer’s should permit improved early warning
banking volume in terms of specified account management. Institutions
RAP/value metric, customer’s attrition should look to combine traditional
risk, customer’s current product “early warning” measures (for exam-
usage, customers’ propensities/affini- ple, missed payments) with quantified
ties for the (unused) products of a risk measures produced by the Basel
bank’s product portfolio, and realized model suite to optimize arrears
and unrealized wallet-share, informa- management performance. This
tion-specific distribution activities. approach should allow institutions to
meet the challenge of being appropri-
ately risk-sensitive and dynamic.
Figure 17: Tendency to Increase Numbers of Arrears (U.K. and Germany)
Source: KPMG International, 2007

An Orchestrated Approach to
Value Creation
Opportunities and Challenges in Active Credit
Portfolio Management
While a number of leading While Basel II has preserved a strict • Continuing market growth for
focus on individual loan exposures, credit derivatives and structured
banks have been success- markets are progressively taking a credit products. The credit deriva-
fully testing the waters for portfolio view on credit risk manage- tives market has grown spectacularly
some time, a more active ment. This shift has been fostered by a over the past decade—faster than
number of mutually reinforcing devel- any other derivative market. The total
and portfolio oriented opments: notional value outstanding of credit
approach to credit risk • Improved risk measurement tech- derivatives has increased by more
management is starting to niques. Most banks have invested than 100 percent over the past two
substantially in risk modeling capabil- years, with market size exceeding
appeal to a larger audience. $20 trillion by the end of calendar-
ities and data warehousing as part of
Vijay Krishnaswamy and Christian their Basel II compliance efforts. year 200618. This development has
Heichele (both, Germany) provide These efforts have improved the been accompanied by a further stan-
insight into the impetus for investing in quality of credit rating tools and risk dardization of products and the
active credit portfolio management estimates and, perhaps for the first growth in market share of index
(ACPM) capabilities, implementation time, given rise to serious efforts to products, which in turn has
approaches and phases, and potential address data quality issues and increased liquidity. New products
benefits and challenges. improve the quality of reporting such as loan CDSs are starting to
derived from those data. emerge, providing both investors
and protection seekers with a wider
array of instruments. A natural
18
British Bankers Association, BBA Credit Derivatives Report 2006
consequence is that bank senior ACPM Business Models

management is keen to explore how Credit portfolio management units are implemented as central units that manage
such instruments may be used to credit risk across the bank, typically for the following portfolios:
meet their strategic objectives.
• Wholesale loan portfolio (e.g., SME, large corporation)
• Improved pricing and incentive
• Investment portfolio (e.g., bond portfolio)
plans. By actively managing credit
• Trading book (e.g., counterparty risk)
risk and thereby making use of an
increasing range of capital market Banks’ approaches to implementing credit portfolio management are quite
instruments, banks can price better diverse but can be generally classified along two fundamental models (see the
versus the market, increasing their table below):
competitive positioning and the
• Active portfolio trader, with a focus on relative value investing
longer-term sustainability of the busi-
• Portfolio optimizer, with a focus on managing concentration risks
ness. The other side of the coin is
the need to create for sales and rela- In addition, there are hybrid models combining features of the above.
tionship managers incentives that
are more aligned with the bank’s
objectives and to increase the trans- Portfolio Optimizer Active Portfolio Trader
parency of their value-added contri- Mandate and • Focus on portfolio optimiza- • Full ownership of credit risk
butions. Philosophy tion by reducing name-level • Generation of positive risk-adjusted
• Focus on the management of or industry-/geography-level returns through exploitation of
concentration risk. While the volatil- concentrations market opportunities
• Reduction in regulatory or
ity in earnings due to unpredictable
economic capital to create
credit losses has always been a capacity for new business
concern, banks have sharpened their
focus on bulk or concentration risk— Key Activities • External risk transfer through • Relative-value investing to optimize
that is, the possibility that a single credit derivatives or securiza- portfolio diversification and risk-
tion of parts of the loan book adjusted return
large credit exposure to what
• Advisory role in origination • Direct impact on origination and
appears to be a creditworthy and pricing pricing decisions
borrower or sector could quickly turn
into a huge loss. This possibility has Performance • Cost-center approach or • Profit-center approach, with full
Measurement profit-center approach using ownership of credit risk reflected in
led banks to look for ways to better,
accounting-based P&L RAROC and EVA metrics
and more nimbly, manage such risks. metrics • Often combined with
• Focus on value-creating use of risk internal transfer pricing
capital. Credit businesses have tradi- to transfer credit risk from origina-
tionally followed buy-and-hold tion business to CPM
models, relying on strong customer
relationships and the syndication Note: RAROC = risk-adjusted return on capital; EVA = economic value added; CPM = credit portfolio
market to gather assets. However, management
with the availability of new, deeper
markets, managing exposure inflows Figure 18 is an illustration of the typical setup of an ACPM unit showing key
and outflows has been taken to a functional interaction and risk transfer.
new, more active level. This develop-
ment has been helped by the realiza- Figure 18: Illustrative Example for a Bank’s Organizational and Functional Setup
with ACPM
tion by banks that one of their key
value levers is to increase the veloc-
ity of capital turnover. Typically, credit
risk capital is the largest component
of capital utilization. Thus, unlocking
even a small piece of value in this
area directly translates into the
overall value of the bank.

Phased Evolution Benefits from ACPM Internal Performance Measurement

Banks that want to develop a model The potential benefits of active credit Implementing ACPM places the
for ACPM usually embark on an evolu- portfolio management are significant. performance of the bank’s credit busi-
tionary approach to the mandate, They can include: ness in sharper focus. Internal credit
tasks, and targets for the ACPM unit. risk transfer pricing mechanisms allow
• Lower economic capital require-
for a separation of credit margins from
ments due to better management of
Before reaching the “portfolio opti- other performance elements and
concentration risk
mizer” or “active portfolio trader” level, thereby increase transparency on
• Higher transparency regarding value
banks typically start with a reactive where value is being created—and
creation in the credit business that
design of their ACPM model. In this where it is being destroyed. This trans-
allows for improved incentive
first phase, banks move from the gath- parency has a profound impact on
systems/performance measure-
ering, analysis, and reporting of portfo- incentive systems and therefore must
ment/value allocation (distribution
lio risks that is often performed by be well designed to avoid moral
versus risk taking)
credit risk control to implementing a hazard. Additional layers of complexity
• Better pricing of origination business
specific unit that sets principles for might be needed if different parts of
• Revenue generation through relative
dealing with portfolio risk such as the portfolio are managed under differ-
value investing
concentration risks. It might also set ent premises—for example, trading
• Improved capital utilization
out guidelines to influence the portfolio versus banking book exposures—
inflow by means of setting hurdle rates which in turn underscores the need for
for profitability or minimum ratings of Implementation Challenges well-designed phasing of new key
counterparties. In a next step, the Governance and Organization
performance indicators.
CPM unit might move from influencing A key issue in the implementation of a
portfolio inflows to a more active credit portfolio management unit is the Multidisciplinary Approach
approach by directly influencing the organizational setup and the question Implementing a CPM model typically
portfolio outflows via portfolio hedging of reporting lines. Typical alternatives represents a significant interaction
instruments, such as securitizations, or include integration into the chief risk among numerous bank functions—
individual hedges, such as CDSs. officer area, a front-office business including, for example, sales, trading,
However, it is only when CPM obtains such as a trading and investment bank- risk management, treasury, manage-
full ownership of risk and responsibility ing unit, or the treasury function. While ment information systems, finance,
for hedging and reinvestment deci- criteria such as availability of skilled tax, and compliance. This important
sions that a truly active approach to resources, current infrastructure, regu- interaction adds substantially to the
CPM is established. latory aspects, and implications for complexity of the project and requires
business processes and interfaces that leaders obtain a dedicated
While the evolutionary steps toward may play an important role in determin- mandate with clear implementation
an active management of credit risk ing the best organizational setup, one accountability, together with strong
are similar in most banks, different has to acknowledge that strategic and board and senior management support.
target levels—and speeds toward real- political aspects cannot—and should
ization—are typically applied for differ- not—be ignored. Given that the imple- Scarcity of Resources and
ent parts of the portfolio. Banks that mentation of ACPM is closely tied to Know-How
aim for the active credit risk trading performance expectations in terms of Demand is high for people with the
design usually first limit this approach economic value added, capital effi- diverse skill sets to manage credit port-
to the most liquid areas—for example, ciency, and reduction in bad debts, this folios, but the available pool of talent is
large corporate portfolios where decision is often one of the most criti- small. Capabilities include a good
secondary loan trading or CDS transac- cal design aspects of such a function. understanding of, and experience in,
tions are available. However, with the primary and secondary credit markets;
growth of secondary markets and new Cultural Change quantitative skills in single-product
innovative product designs, they will An ACPM model is typically accompa- valuation as well as portfolio modeling;
likely extend their efforts to other port- nied by a transfer of credit risk into a and knowledge of regulatory and
folios in the future. centralized team, which is a change in accounting requirements.
the roles and responsibilities of the
The ultimate choice of approach and traditional sales functions, which typi- IT Infrastructure and Data
phasing is a careful decision that cally “own” the credit risk—including Availability
needs to consider the nature of the the credit risk margins—of the loans From an IT perspective, ACPM can be
portfolio, especially in terms of recycla- they originate. Further, the implemen- even more demanding than Basel II.
ble risk, size, capital position, business tation of a transfer pricing approach While leveraging the Basel II IT archi-
strategy, peer group practices, regula- also calls for a change in the origination tecture to obtain risk and capital data is
tory environment, and infrastructure. mindset to drive greater focus on pric- a natural approach, these data repre-
ing, deal structuring, and cross-selling sent but one key input into ACPM’s
potential, apart from traditional relation- decision-making processes. ACPM also
ship banking concerns. needs to consider risk from an
economic perspective—through meas- At the extreme, hedge accounting for Volatility of market credit spreads
ures such as credit VaR or economic credit risk could be a beneficial option; combined with high leverage ratios
capital as well as the return on a however, IAS 39 imposes stringent require high market awareness and an
loan—to get a complete picture of the requirements, the fulfilment of which optimized setup to avoid unwanted
risks as evidenced by the recent devel-
risk-return relationship. The quality of must be demonstrated on a regular
opments in the credit markets in the
the data is another important issue. In basis over the life of the hedge. More
wake of the subprime crisis.
a positive sense, the use of such data widely applied alternative solutions
in real day-to-day portfolio manage- include the application of the fair value Finally, while only a few big players are
ment decisions actually helps uncover option or the use of financial guaran- likely to make full use of market oppor-
challenges and provides opportunities tees under IAS 39. tunities—given the need for a critical
to address them. mass to justify the substantial invest-
Compliance
ment an ACPM requires—many more
Methodological Challenges: Credit The ACPM function usually trades with
mid-sized to large banks are likely to
Risk Capital, Pricing of Illiquid the market through the bank’s trading
develop their own, customized
Positions, and Atypical Structures desk, at least in the active portfolio
approach to a more active manage-
Ideally, CPM transfer prices are based trader model, and is therefore subject
ment of credit risk.
on observable market prices. This pric- to compliance with regulations such as
ing is not possible for exposures that the EU’s Markets in Financial
lack such benchmarks, and often repre- Instruments Directive. On the other
sent the bulk of the portfolio. A key hand, the sales and credit monitoring
requirement to price such exposures is functions typically have access to
the methodology to determine how private information that must not be
much risk they contribute to the portfo- made available to the trading func-
lio using measures such as credit risk tions. Thus, the information flows to
capital (hence capturing diversification) and from the ACPM function must be
and concentration effects. Further, non- clearly defined and implemented.
standard structures are uncharted in
terms of robust pricing methodologies. In sum, banks need to be aware that
To integrate these exposures into an the implementation of an active CPM
active management of credit risk unit involves many potential pitfalls and
requires a proxy or a mark-to-model represents a significant investment.
approach, both of which have draw- However, the benefits usually signifi-
backs. While the former approach cantly outweigh the costs involved.
suffers from the lack of a closely repre-
sentative proxy, the latter will typically Outlook
leverage existing pricing plans based A number of banks have substantially
on Basel II parameters. As shown in progressed in their Basel II implemen-
the section “Pricing at All Costs,”such tations and are now looking ahead at
Basel II based approaches might not evolving challenges. One consequence
always produce results consistent with of the Basel II rules is that regulatory
external market observations and capital requirements will become more
therefore would have to be adjusted volatile because capital levels are now
carefully. explicitly linked to probability of default
and loss given default measurements,
External Performance Management: which tend to be cyclical. The implica-
P&L Volatility tion for banks is that they will have
The active use of credit derivatives to less control over their capital adequacy
mitigate credit risk positions results in positions versus their targeted ratios.
a greater possibility for volatility in the In this context, the role of CPM will
profit and loss statement (P&L), arising gain in importance because the main
from frequent changes in the mark-to- source of volatility is credit risk, which
market valuation of such instruments is also typically the single largest risk
under IFRS rules19. Although these type for most banks. As a result, most
issues can be addressed in numerous banks are expected to expand their
ways, each has its own complications. perspective on CPM.
19
Under IAS 39, derivatives, including credit derivatives, generally need to be valued at fair value and thus
have a direct impact on the P&L.
Calculations with many Unknowns

The Implications of Credit Derivatives for Corporate
Restructurings
Over the past decade,

developments in credit risk
transfer have included a
significant evolution in
traded credit products, such
as credit derivatives and
securitizations.
Elizabeth J. Murphy (Canada) highlights
some of the new and complex chal-
lenges that could arise during a corpo-
rate restructuring process in which the
debtor or subject of the restructuring is
the subject of a credit derivative cover.
The rapid growth in the credit risk

transfer markets has contributed to the
distribution of risks across markets,
both within and outside the traditional
financial sectors. In the credit deriva-
tives market, some unease prevails
concerning its mostly OTC-based expanding to USD33 billion by the end (coupled with the increased appetite
nature, including possible hidden coun- of 2008, and notes that the market is for risk and the commoditization of
terparty risks and disruptions in the now a trading market (Figure 19).20 risk), the increasing participation of
infrastructure that have not been fully hedge funds in the credit derivative
tested by an extended or severe credit The exponential growth in the volume market, and improved standardization
downturn. Restructuring market partici- of credit derivatives has been attrib- of terms. An additional factor is the
pants, such as lawyers, financial advis- uted to a variety of factors, including increasing variety of traded credit
ers, and scholars, have also voiced increased liquidity in the market
concerns about the significant develop-
Figure 19: Global Credit Derivatives Market
ments in the risk transfer markets.
Credit derivatives are an important
aspect of credit risk transfer markets;
this section addresses the implications
credit derivatives may have for corpo-
rate restructurings.
Overview of the Credit

Derivatives Markets
The credit derivatives market began in
the early 1990s, driven primarily by
large banks that wanted to manage
their credit risks more effectively and
efficiently by transferring default risk to
third parties, thereby reducing credit
concentrations and diversifying their
exposures. The British Bankers’
Association (BBA) estimates that the
global market for credit derivatives will
be USD20 billion by the end of 2006, 20
For additional information on size of the global credit derivative market, refer to BBA Credit Derivatives
Report 2006 (British Bankers’ Association, London, 2006).
derivative products from credit default side of the market (Figures 20 and 21). tions within the banking sector varies
swaps to synthetic collateralized debt The BBA observes that while banks between regions and between larger
obligations (CDOs) to tradable indexes. still constitute the largest market and regional banks.
participant as both buyers and sellers
While the banks are still the dominant of credit protection, two thirds of the Among the U.S. banks, five “dealer
players in the market, their share has derivatives volume of banks is now banks”—J.P. Morgan Chase, Citibank,
declined as hedge funds and other due to trading and a third is related to Bank of America, Wachovia, and HSBC
market participants increasingly take a their loan book. According to Fitch Bank USA—carry out 77 percent of the
greater share of both the buy- and sell- Ratings, the net sold and bought posi- credit derivative volume. These institu-
tions “house the vast majority of the
Figure 20–21: Buyers and Sellers of Credit Protection Market Share
notional exposure and virtually all of
the ‘protection sold’ volume. The major
Buyers of Credit Protection – Market Share securities firms and, to a lesser extent,
a few major Canadian banks, represent
2008 the bulk of the remaining notional
Type 2000 2002 2004 2006
(estimate) volume in North America….The other
Banks – Trading activities 39% 36% U.S. and Canadian banks that use
81% 73% 67% credit derivatives employ them prima-
Banks – Loan portfolio 20% 18% rily as a risk mitigant against exposures
Hedge funds 3% 12% 16% 28% 28% in their banking book.”21
Pension funds 1% 1% 3% 2% 3% While investment-grade corporate obli-

gations (i.e., those rated BBB or better)
Corporates 6% 4% 3% 2% 3%
have comprised most of the underlying
Mono-line insurers 2% 2% 2% credit transferred in the credit deriva-
3% tives market to date, the percentage of
Reinsurers 7% 3% 2% 2%
below-investment-grade obligations
Other insurance companies 3% 2% 2% 2% traded in the market is expected to
Mutual funds 1% 2% 3% 2% 3% increase. According to Fitch Ratings,
the global credit derivative exposures
Other 1% 2% 1% 1% 2% by rating sold for below-investment-
grade was 31 percent in 2006, up from
8 percent in 2002. Drivers of a move
Source: BBA Report 2006
down the credit curve include a further
expansion of the credit derivative
market, tight spreads, and a decline in
Sellers of Credit Protection – Estimate of Market Share the number of higher-grade issues.
2008
Type 2000 2002 2004 2006
(estimate) New Challenges Facing
Banks – Trading activities 35% 33% Restructuring Participants
63% 55% 54% So what are some of the potential new
Banks – Loan portfolio 9% 7% challenges on the restructuring envi-
Hedge funds 5% 5% 15% 32% 31% ronment due to the existence of credit
derivatives?
Pension funds 3% 2% 4% 4% 5%
Corporates The answer to this question is not
3% 2% 2% 1% 2%
clear for several reasons. First, because
Mono-line insurers 10% 8% 8% the credit derivative market is not very
21%
Reinsurers 23% 7% 4% 4% transparent and the existence of a CDS
may not be disclosed, determining if a
Other insurance companies 12% 3% 5% 6% link exists between the presence of
Mutual funds 2% 3% 4% 3% 3% the CDS and the dynamics of the
particular restructuring is not always
Other 1% 0% 1% 1% 1% possible. Second, while credit market
observers have reported problems with
credit derivatives during a restructur-
Source: BBA Report 2006
21 Fitch Ratings, “Global Credit Derivatives Survey: Indices Dominate Growth as Banks’ Risk Position
Shifts” (Fitch Special Report Financial Institutions, Septembers 21, 2006) <derivativefitch.com>
ing, no firm evidence exists on the • The party with the largest economic credit protection, could face some
frequency of such problems.22 However, risk may not be involved in the unique challenges arising from being
given a possible combination of a restructuring discussions. participants in the credit derivatives
continuing expansion of the credit • If there are multiple holders of credit market. For example:
derivative market, coupled with a risk through different credit deriva- • Traditionally, relationship lending
further weakening in the credit quality tive contracts, they will have differ- has been an important aspect of
of the corporate entities referenced by ent considerations—such as the commercial banking, and credit
CDSs and an eventual deterioration in amount and duration of the cover, derivatives may enhance bank-client
the credit cycle, debtors will likely be the events that may trigger it, and relationships with a positive impact
the reference entity in credit derivative the means of settlement—with on bank loan supply, which in turn
structures and the existence of the respect to the scope and timing of should lead to easier credit condi-
credit derivatives may have a signifi- their risk coverage. For example, the tions at lower rates. However, if a
cant impact on workout situations.23 debtor may find that the protection bank is a buyer of credit protection
buyer refuses to agree to amend- through credit derivatives, and if the
A number of new challenges face ments to its credit documentation, bank needs to restructure a loan
restructuring participants: such as a payment change or defer- with a borrower and prefers to reach
• The debtor, the protection buyer, and ral and changes to covenants that an amicable work-out, the seller of
the protection seller may all have would otherwise trigger a credit protection, such as a hedge fund,
different economic interests, and event. Or, the protection buyer may may not have the same incentive to
these interests may be affected by be unwilling to agree to the exten- achieve the bank’s goal.
different workout strategies. These sion of the maturity date beyond the • Commercial banks need to establish
different interests in turn may affect protection period unless a credit appropriate infrastructure and inter-
the structure and terms of any event has already occurred or the nal controls to ensure that client
proposed restructuring plans. extension itself qualifies as a credit confidentially and insider trading
• The existence of CDSs will create a event. Holders of protection can also rules are not breached by the trans-
greater challenge to building consen- be expected to weigh the benefits fer of information between the loan
sus in the early stages of distress in and risks of letting a credit event origination area and the credit deriva-
an attempt to restructure outside of occur, or in extreme circumstances, tive trading desk.
formal insolvency proceedings or to precipitating one.
enter formal proceedings with a • After a credit event, credit positions KPMG’s research indicates that new
well-developed reorganization plan. may settle and the number of and complex challenges could arise
Reasons include a lack of certainty interested players may change or during a corporate restructuring
as to who should be at the restruc- increase. These new participants will process where the debtor or subject of
turing table and partial or complete need time to get up to speed, which the restructuring is the subject of a
divisions in economic and legal rights. can lead to delays and perhaps revi- credit derivative cover. However, the
• In the early days of working out a sions and new compromises. extent of any effect will depend on the
problem credit, a debtor may not specific facts in each situation and the
know if it is a named reference New Challenges Facing details of the underlying arrangements.
entity in a CDS contract. Due to lack Commercial Banks24
of transparency in this market, a Commercial banks have been shifting
debtor may have difficulty determin- from traditional buy-and-hold exposure
ing who holds the CDS. This informa- business models to originate-and-
tion will not be in company records. distribute business models.
Additionally, the debtor will not easily Developments in credit portfolio
know how many times the credit management, including the use of
risk may have been transferred credit derivatives, are a significant
through the credit market. reason for this shift. However, in addi-
• Some parties with an interest in the tion to the challenges facing restructur-
restructuring may not want to partici- ing participants described above, the
pate in restructuring negotiations in commercial banks, depending on
order to avoid receiving insider infor- whether they are buyers or sellers of
mation. For example, a counterparty
to a CDS may wish to preserve its
option to trade its credit exposure. 22 INSOL Lenders Group, Credit Derivatives in Restructurings, Guidance Booklet (INSOL International,
Alternatively, a counterparty may 2006, London). The lending group also reports that there is no evidence “that CDSs have caused an
otherwise viable restructuring to fail.”
seek to buy up other claims of the 23 Murphy, E., Sarra, J., and Creber, M., “Credit Derivatives in Canadian Insolvency Proceedings: ‘The
debtor to create a strategic position Devil will be in the Details,’ ” Annual Review of Insolvency Law 2006 (Thomson Carswell, Toronto,
in the workout negotiations. 2006)
24 European Central Bank, Financial Stability Review, December 2006, www.ecb.int/pub/pdf/other/finan-
cialstabilityreview200612en.pdf; Cole, R.T., Felberg, G., Lynch, D., Board of Governors of the Federal
Reserve System, “Hedge funds, credit risk transfer and financial stability,” Financial Stability Review,
Special Issue Hedge Funds (Banque de France, April 2007)
The Value in Bad Debt

On the Management of Sub- and Non-Performing Loans in
Retail Banking
A critical success factor for the United Kingdom, and the United achieved by integrating the numerous
States) has given rise to an increased decisions required during the debt
the efficient management focus on debt management in interna- management process into one coher-
of sub- and non-performing tional retail banking. Advanced players ent decision tree with corresponding
loans—also known as debt have already implemented, or are in risk, profitability, and economic value
the process of implementing, “collec- measures accompanied by detailed
management—is decision tion scorings” to classify loans or decision rules. In addition to the usual
supported by accurate customers according to the expected credit risk metrics, customer value
measurement instruments success of particular collection activi- models play a crucial role in this
ties as well as to determine the most context. Moreover, the decision rules
along the entire debt appropriate collection approach. need to be defined in accordance with
management value chain. the bank’s business model and collec-
While these efforts are steps in the tions and recovery strategy.
Wolfgang Malzkorn, Peter Rindfleisch, right direction, they need to be
and Frank Glormann (all, Germany) extended to cover the entire debt Key Elements of Debt
explain how this goal can be achieved management value chain from the
using a decision tree based on occurrence of the first repayment prob- Management
advanced credit risk and customer lems to the stage when the loan or State-of the-art debt management is
value measurement techniques. customer is either returned to the more than just a reactive function that
performing portfolio or leaves the deals with “erroneous” credit deci-
The increasing number of sub- and bank’s loan book because the contract sions. Instead, it is an active portfolio
non-performing consumer loans in is terminated, liquidated, or sold. This management function for the sub- or
some major economies (e.g., Spain, comprehensive coverage can be non-performing part of the loan book,
which cooperates closely with the
underwriting, monitoring, general credit portfolio management, and analytics

functions. Its general objective should be to preserve as much economic value for
the bank as possible under the given circumstances. In doing so, it should adhere
to the same principles and concepts that state-of-the-art banks apply to their
sales function, including the concepts of present and future value of both individ-
ual deals and entire customer relationships.
To fulfill these objectives successfully, debt management requires a highly

sophisticated and comprehensive approach (Figure 22).
Figure 22: Approach to Debt Management
Each case calls for a clear decision model and measurement instruments that
support it. An efficient process that is compliant with legal standards and
combines in-house activities and outsourcing in an optimal way further underpins
the new vision. This process must be embedded in an organizational structure
that facilitates efficiency through functional specialization. Debt management
specialists need to be sufficiently trained and provided with incentives in accor-
dance with the principle of economic value creation as well as with the specific
debt management strategy. State-of-the-art information technology is needed to
support activities, including data gathering, communications, decision engines,
collateral management systems, and platforms for distressed debt sale. Finally, a
debt management strategy should be formulated and implemented, creating the
basis for all decisions and customer communication.
Banks face a number of challenges in dealing with sub- or non-performing loans.

At the same time, (new) instruments, methods, and techniques are available for
preventing (e.g., application and behavioral scorings, payment protection insur-
ance [PPI]), treating (e.g., collection scorings, specialized collection agencies,
advanced communication techniques), and mitigating the impact (e.g., risk-
adjusted pricing, distressed debt sale) of bad debt. However, the use of those
instruments and methods should align with the bank’s business model and over-
all strategy. Indeed, problems inevitably arise if banks use those instruments
unsystematically or inconsistently with their business model or corporate strat-
egy—possibly resulting in destruction of value, reputation damage, or loss of
customers. Examples of such effects created by questionable practices regarding
PPI and portfolio deals have recently made headlines in the media.
Measurement and Decision Making

Banks can avoid these problems and derive new benefits using a decision tree,
based on the institution’s strategy, that helps prioritize key decisions related to
treatment of sub-performing loans (Figure 23).
Figure 23: Time Structure of Decisions in Debt Management
Four major decisions within the decision tree will likely be required: As illustrated in Figure 24, the objec-
• Should the bank launch procedures to cure the loan? tive at #1 is to decide whether the
• If not, should the bank restructure the loan, taking into account partial loan can be returned permanently to
write-offs and interest rate adjustments? the performing portfolio, preferably
• If not, should the bank terminate the entire customer relationship (or just without encountering any economic
liquidate the sub-performing loan)? losses, and which treatment ought to
• If so, should the bank enter liquidation and recovery procedures or sell be applied to achieve this aim. Key
the loan? success factors are the time horizon in
which action steps are taken (since
At each stage along the decision tree, appropriate measures and detailed the cure rate typically decreases
decision rules can be specified that help to evaluate the alternatives. within a very short period) and effi-
Figure 24: Measurement and Decision Making

cient communication with the If the bank’s decision is not to restruc- The detailed rules that determine the
customer to identify the reasons for re- ture, multi-product customers will decision at this point will focus on
payment problems and arrive at a enter #3 (Figure 25), whereas (in most those metrics. Thus, in addition to the
mutual agreement, if possible. To cases) single-product customers will usual risk measures, customer value
support the decision that is to be made be directly routed to #4. measurement methods and principles
at this point, it is important to measure enter the picture. It is, therefore,
the probability of default or re-default The goal of #3 is to determine the necessary that debt management
of the customer (if cured). prospective relationship with the assume a customer perspective, rather
customer, based on default probabilities than the usual product-related view.
Then #2 comes into play if the decision of the customer’s other products, a
in #1 has been negative—that is, that general reassessment of the Finally, the goal of #4 is to determine
the loan cannot be returned to the customer’s debt service capacity, and whether selling the loan is more prof-
portfolio. The objective will then be to the customer’s value to the bank (infor- itable than liquidation and subsequent
determine whether the bank should mation that would also be needed if the recovery. This question will be posed
replace the non-performing loan with a bank ultimately decided to initiate only if the respective bank is in a posi-
loan that might be less profitable than collection and recovery procedures). tion to perform non-performing loan
the original but still a worthwhile Key success factors at this point are the (NPL) transactions in the credit
investment. Key success factors at this efficiency of the collection and recovery markets and if a suitable deal is
stage are a timely response and deci- processes (in terms of costs and recov- planned. At the same time, however,
sion by the bank as well as a correct ery amount), the appropriate collection banks of all sizes are increasingly gain-
assessment of the customer’s proba- strategy, the client communication to ing access to the skills necessary to
bility to (re-)default on the new loan. reach an agreement, and a correct enter into NPL transactions, mainly by
Relevant metrics at this point are: assessment of the customer’s value to sharing the use of relevant platforms
• Future debt service capacity of the the bank. with other institutions. Thus, the objec-
client, considering the payment char- tive of #4 is becoming relevant for an
Relevant metrics at this point are increasing number of institutions.
acteristics of the new loan
• Probability of (re-)default on the new • Future debt service capacity of the
loan customer’s other products with the
• Profitability of the restructured loan bank
• Expected recovery from a liquidation • Probabilities of default for those
of the original loan (if it is not products
restructured) • The customer’s present and future
value to the bank
Figure 25: Final Decisions and Profitability

Key success factors at this point are an

efficient recovery process (in those
cases where a decision has been made
in favor of liquidation and recovery) and
an efficient link and communication
between the debt management func-
tion and the (credit) portfolio manage-
ment function. In terms of supporting
metrics, the bank should be able to
assess the expected recovery amount
and costs of liquidation and collection
procedures as well as the receipts
from adding individual loans to NPL
transactions.
Prerequisites and Benefits

Although such decision trees have a
common underlying general structure,
they need to be customized to the
respective banks’ business models and
back-office functions. Thus, the effi-
ciency of the debt management
process can be optimized and based
quantitatively on value-based manage-
ment principles. The process needs the
support of appropriate organizational
structures in debt management and
consistent training and staff incentives
as well as state-of-the-art technical
support in customer communication
and workflow management.
Fortunately, evidence indicates that a

redesign of the debt management
function is a worth-while investment.
Recent studies and project experience
show that given the average current
standard in banks globally an invest-
ment in the debt management function
as previously described will yield
surprisingly high returns.
kpmg.com
Contacts
Jörg Hashagen
Managing Partner Advisory
Global Head Advisory Financial Services
KPMG in Germany
+49 69 9587 2787
joerghashagen@kpmg.com
Daniel Sommer
Partner Advisory
Financial Risk Management Head of
Risk Methodology
KPMG in Germany
+49 69 9587 2498
dsommer@kpmg.com
KPMG Contributors to this publication include Ben Begin, Pia Evertsson, Frank Glormann, © 2007 KPMG International. KPMG
Bernd Granitza, Steven Hall, Christian Heichele, Ralf Hennig, Vijay Krishnaswamy, Peter Lam, International is a Swiss cooperative. Member
Marco Lenhardt, Wolfgang Malzkorn, Francesco Merlin, Elizabeth J. Murphy, Maxine Nelson, firms of the KPMG network of independent
Peter Rindfleisch, Jürgen Ringschmidt, Tim Schabert, Daniel Sommer, Kristian Tomasini, firms are affiliated with KPMG International.
Diane Nardin, and Carole Law. KPMG International provides no client serv-
ices. No member firm has any authority to
GSC document code: GSC051 obligate or bind KPMG International or any
other member firm vis-à-vis third parties, nor
The information contained herein is of a general nature and is not intended to address the circum- does KPMG International have any such
stances of any particular individual or entity. Although we endeavor to provide accurate and timely authority to obligate or bind any member
information, there can be no guarantee that such information is accurate as of the date it is received firm. All rights reserved. Printed in the
or that it will continue to be accurate in the future. No one should act on such information without United Kingdom.
appropriate professional advice after a thorough examination of the particular situation.
October 2007
KPMG and the KPMG logo are registered trademarks of KPMG International, a Swiss cooperative.

Managing Credit Risk

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qxp 4/10/07 2:05 pm Page 1

Managing Credit Risk

Laying the Foundations 4

In Search of the Right Measure 7

Going to the Limit 11

Exploring the Unexpected 14

Pricing at all Costs 17

An Orchestrated Approach to Value Creation 25

Calculations with Many Unknowns 29

The Value in Bad Debt 32

Managing Credit Risk: Beyond Basel II 5

Many banks have invested significantly

Leading banks, however, already have

These banks are evaluating how to

In this white paper, KPMG credit risk

1 Managing Credit Risk: Beyond Basel II

Managing Credit Risk: Beyond Basel II 2

• Greater implementation consistency

Some institutions are leveraging their

This observation is somewhat contrary

While banks were focused on Basel II

3 Managing Credit Risk: Beyond Basel II

In retrospect, the implementation of

Managing Credit Risk: Beyond Basel II 4

Laying the Foundations

5 Managing Credit Risk: Beyond Basel II

The Case for Data

Managing Credit Risk: Beyond Basel II 6

deficiencies in source systems

7 Managing Credit Risk: Beyond Basel II

In Search of the Right Measure

ment” both require banks

Managing Credit Risk: Beyond Basel II 8

Figure 6: Loans and Receivables

NOTE: Above-mentioned are applicable for only on-balance-sheet items

Source: KPMG in Germany, 2007

9 Managing Credit Risk: Beyond Basel II

Applying Basel II Models for

Discussed below are the specific

Managing Credit Risk: Beyond Basel II 10

– Take all of the collateral into account.

Adjustment of expected loss to incurred loss concept

Given this, the IL can be calculated as:

The LIP concept is illustrated in Figure 8.

Figure 8: Loss Models

Source: KPMG in Germany, 2007

11 Managing Credit Risk: Beyond Basel II

Going to the Limit

Under Basel II Pillar 1, new

This goal implies that the actual size of

Managing Credit Risk: Beyond Basel II 12

is risk sensitive and (2) the extent to Table 1: Limitation Dimensions

13 Managing Credit Risk: Beyond Basel II

It may, however, be even more promis-

Enabling decentralized decision making while maintaining a bank-wide view of

Managing Credit Risk: Beyond Basel II 14

Exploring the Unexpected

to integrate their quantita-

15 Managing Credit Risk: Beyond Basel II

As a consequence consider the

Managing Credit Risk: Beyond Basel II 16

17 Managing Credit Risk: Beyond Basel II