Trends in Credit Risk Management:

Can Systemic Banking Crises Be Avoided?

Ernest D. Napier, Managing Director
Financial Services Ratings
Standard & Poors, New York

Oslo, Norway
September 12, 2002
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Agenda
I.

Revisiting the Past: What Went Wrong

Last Time Around?

II.

Exploring New Advances and Techniques in

Credit Risk Management

III.

Navigating the Potential Roadblocks

IV.

What Lies Ahead: Can Banks Learn From

Their Mistakes?

10
9
8
7
6
5
4
3
2
1
0

No L/T rating

BBB

BBB+

A-

A+

AA-

AA+

1996
2002

AAA

Number of ratings

Nordic Financial
Institutions Ratings 1996
vs 2002

Global Banking Crises

Source: International Financial Statistics

A Deadly Chain Reaction

Capitalization
Profitability
The Asset
Quality Cycle

Liquidity
6

Nordic Banks
Risk Management Scorecard
Parameter

Pre-Crisis

Post-Crisis

Change

Loan Growth

Rapid

Moderate

Customer Exposures

Extremely Large

Large

Industry Exposures

Large

Large

Underwriting Process

Weak

Satisfactory

Provisioning Policies

Adequate

Adequate

Risk Awareness

Low

High

Financial Flexibility

Moderate

Good

Regulatory Environment

Inadequate

Adequate

The New Frontier: Greater Volatility

Interest Rates
Exchange Rates
Borrower Credit Quality
Shareholder Expectations

New Developments in
Credit Risk Management

PORTFOLIO MANAGEMENT

CREDIT MODELS

DERIVATIVES

ASSET SECURITIZATIONS

LOAN SALES

DYNAMIC PROVISIONING

CREDIT INSURANCE

Bankers Toolbox

The Role of Models

Automate Mechanical Tasks

Provide Base Line for Comparison
Speed Surveillance
Simulate Complex What If Scenarios
Decision Making Tools
Analyze Complex Multidimensional
Interactions
Optimization over Several Variables
10

Various Types of Modeling

Rating Estimate Models

Probability of Default Models
Recovery Models
Correlation Models
Portfolio Loss Models

11

dbRiskOffice

GlobeOp

Portfolio Accounting

Portfolio Analytics

Market Risk Management

Credit Risk Management

Performance Attribution

Performance Measurement

No Yes Limited Planned

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* Fixed Income Only

Wilshire

BlackRock*

SunGard

Barra

RiskMetrics

Askari

Trading

Measurick

Algorithmics

System Functionality

Modeling Capability
Probability density versus RGD and
collateral

13

Modeling Capability
Probability Density Versus RGD and
Default Rate

14

Modeling Capabilty
Point Probabilities Versus Debt Cushion

15

Model Risk Prevails

Models Assume Steady State Markets, Not

Systemic Shocks
Sensitive to Look back Period Chosen and
Other Assumption
Even Stress Scenarios Are Only As Good
As Those Who Design Them

16

Unexpected Financial Shocks

1987

1990

1992

1987 Stock
Market Crash

1994

1995

1997

1998

1999

2000

2001

1999
Brazil Crisis

1994 US Interest
Rate Hike
1997
Asian Crisis

1990 Nikkei
Crash

2000
Tech
Meltdown
1998
Russian Crisis

19941995
Mexican Peso Crisis
1990 High
Yield Tumbles

2001 Tech
Meltdown

1998 LTCM
1992 European
Currency Crisis

Source: Risks Magazine

1995 Latin
American Crisis

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911 Terrorist
Attacks

Default Rates For Static Pools

1981-2000
CCC

BB

BBB

AA

AAA

1 year Average Rate

21.94

8.3

.94

.22

.05

.00

.00

3 Year Average Rate

34.37

21.00

4.62

0.74

0.17

0.00

0.03

Minimum (3 yr)

6.67

8.24

1.22

0.00

0.00

0.00

0.00

Maximum (3yr)

58.33

24.38

14.18

2.99

1.15

0.86

0.45

Cumulative

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Who Absorbs the Credit Losses?

Typical Asset Securitization Transaction
Average expected losses

Covered by risk premium

Covered by most subordinated
tranche, equity, or reserve account

Covered by next most

subordinated tranche

Covered by investment
grade tranches

Expected Loss Distribution

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Global Banks: Ratings

Distribution
70%

1990
1995
2000

60%
50%
40%
30%
20%
10%
0%
AAA

AA

BBB

Ratings
20

BB & B

CCC

Average Ratings of Major

International Banks
AAA
AA+
UK

AA

Australia

AA-

US

A+

France

Nordic

AJapan

BBB+
BBB

1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000

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Credit Trends: This Time

Around?
Moderate increase in total leverage via the
banking sector
More pronounced increase in household sector
leverage
Continued disintermediation (growth of the
corporate bond market)
Improved credit assessment in banking

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Key Points

All banks tend to relax their lending standards during periods of

economic prosperity.
Good credit judgment will often be ignored due to competitive
pressures.
Banks cannot escape the impact of the market conditions and
regulatory environments in which they operate.

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Contact Information

Ernest D. Napier, Managing Director

Telephone (1) 212 438-7397
Fax (1) 212 438-7375
ernest_napier@standardandpoors.com

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