Credit Risk Measurement and Management
Exposure to credit risk is to some market participants an unwelcome by-product of their operations and to others a profitable line of business. Common to all is the need to manage their credit risk exposures to an optimal level where the benefits and the costs of incremental risk reduction equilibrate in the case of the former and the benefits and costs of incremental risk acceptance equilibrate in the case of the latter. Quantifying credit risk in dollar terms is a necessary prelude to risk/return optimization, and in many ways Rutter Associates has “written the book” on credit risk evaluation (for example, see Rutter Associates Founding Partner Charles Smithson’s 2003 book Credit Portfolio Management).
To measure Credit Risk, the first crucial task is to obtain market-consistent and intelligence-driven estimates of the Probability of Default (PD), Exposure at Default (EAD) and Loss Given Default (LGD) of a credit-risky account. These estimates can be obtained from internal or third-party models using an institution’s own data or external data that is purchased or accumulated from common sources. Rutter Associates vets and upgrades PD, EAD and LGD estimation processes for many of our clients and builds custom processes for others.
Expanding the focus from individual exposures to credit portfolios, banks and other firms are increasingly relying on their Credit Portfolio Management (CPM) functions to estimate the Economic and Regulatory Capital needed to support the Credit Risk faced by the firm. Economic Capital is a notional amount that is generally regarded as the primary measure of Credit Risk against which returns to Credit Risk are weighed, and Regulatory Capital is a debt and equity “real capital” amount required to clear minimal regulatory hurdles. Rutter Associates implements Economic Capital Models as well as RaRoC and SVA models taking Economic or Regulatory capital as a key input, helps institutions understand their regulatory capital requirements, evaluates existing implementations and assists firms in determining the most appropriate model inputs (in a portfolio context, default correlation must be determined in addition to PD, EAD and LGD).
Rutter Associates has been actively involved in developing CPM functions in financial institutions. Indeed, Rutter Associates played a crucial role in the creation of the International Association of Credit Portfolio Managers (IACPM) – Rutter Associates provided organizational guidance and infrastructure for the organization’s first year pro bono, and participated in the drafting and editing of “Sound Practices in Credit Portfolio Management” produced by the IACPM. Consequently, Rutter Associates can assist with the tasks that go into CPM — defining the portfolio to be managed, identifying the role and mandate of the CPM function, dealing with data issues, setting limits and managing concentrations, aligning accounting conventions with portfolio management practices.
When a CPM function begins to manage actively the Credit Risk of the institution’s portfolio, CPM will begin rebalancing the portfolio to optimize its risk/return trade-off. This can include synthetically reducing or onboarding Credit Risk using single-name CDS, standard credit indices (and the tranches of those indices) and/or structured credit products. Rutter Associates has a wealth of experience in modeling and evaluating structured and non-structured credit products built from corporate, mortgage, consumer receivable and other collateral as both stand-alone investment instruments and portfolio shaping tools. For example, in a recent project for a credit insurance start-up, Rutter Associates evaluated both the effectiveness (in terms of enhanced RaRoC and regulatory capital relief) of a proposed tranched solution for portfolio risk transfer for a major international bank and the likely internal rate of return to the investor in the tranche (to whom the credit risk was to be transferred).
The counterparty credit risk of OTC derivative contracts has long been recognized, and especially in the aftermath of the Lehman Brothers failure in 2008 participants in the OTC derivative markets have come to realize that measuring, managing and pricing this risk is extremely important. Derivative dealers have established desks devoted to hedging and trading counterparty risk, and end-users are focused on assuring that this risk is being priced properly into their transactions and that their credit exposures to dealers are mitigated appropriately. Rutter Associates has been engaged in the practice of determining the appropriate CVA (Credit Valuation Adjustments) and DVA (Debt Valuation Adjustments) for the OTC derivatives of our client firms and helping them mitigate OTC derivative counterparty credit risk for the better part of a decade.
- Rutter Associates has evaluated the models used by U.S. Banks and Investment Firms to estimate PD and LGD at the behest of Executive Managements and Boards of Directors.
- Rutter Associates has advised Banks in the U.S. and the Middle East in the selection of the most firm-appropriate methods for measuring and modeling economic capital for credit risk.
- Rutter Associates performed a Best Practices Survey of CPM Practices and assisted in the development of resources for use in communicating its CPM Practices to stakeholders.
- Rutter Associates was engaged to evaluate the model used by a large European bank to estimate the probability distribution of future losses on asset-backed securities.
- Rutter Associates created a portfolio credit risk model for a monoline insurance company and evaluated the credit portfolio loss model of another monoline seeking to re-emerge after the collapse of the housing bubble.
- Rutter Associates assisted a multinational non-financial corporation in the development of a credit portfolio model for use in managing its portfolio of customer receivables.
- Rutter Associates was hired by a top-tier accounting firm to develop a “data map” describing the relationships between the input fields for the credit capital models available from third-party vendors.
- Rutter Associates played a crucial role in the creation of the International Association of Credit Portfolio Managers (IACPM) and continues to work with that Association.