This is the fifth and final article in a series of excerpts

Transcription

1 TRENDS IN PORTFOLIO MANAGEMENT Implementation of to Credit Portfolio Management by Charles Smithson and Gregory Hayt This is the fifth and final article in a series of excerpts from Managing Credit Risk: Toward a Portfolio Approach to Credit Risk Management, a forthcoming book by Charles Smithson and Gregory Hayt of Rutter Associates. We covered a lot of ground in the first four articles: Managing Credit Portfolios by Maximizing Risk-Adjusted Returns (December 2000 / January 2001) discussed the principles of portfolio management and their extension to portfolios of credit assets. State of the Art in Credit Portfolio Modeling (March 2001) reviewed the various credit portfolio models KMV s Portfolio Manager, Riskmetrics Group s CreditManager, MacroFactor Models 1, and CSFB s CreditRisk+. Tools for Reshaping Credit Portfolios (May 2001) described the way in which credit derivatives, loan sales and trading, and asset securitization can be used to alter the portfolio. Optimizing the Allocation of Capital (July/August 2001) introduced various measures of capital for a financial institution (and how that capital can be attributed to business units or transactions), surveyed measures of return on capital or economic profit for a business, and outlined the first steps toward optimizing the allocation of capital to business units or transactions. This concluding article looks at the organizational changes necessary to establish an effective loan portfolio management. The guiding philosophy is the asset manager approach, that is, managing from the perspective of an investor in credit assets whose objective is to maximize the value of the portfolio. While this approach will be tempered by the realities of the banking environment, it nevertheless points the way to many of the necessary organizational changes. Beyond prescribing what should be done, we examine what is being done among a sample of large banks and institutional investors. The Asset Manager Approach It is generally believed that many highly regarded banks still have half or more of their capital tied up in loans, commitments, and derivatives exposures to investment-grade counterparties, generating less than acceptable returns. When we surveyed the originators of loans, almost two-thirds of them reported that large corporate and middle-market loans do not 2001 by RMA and Rutter Associates. Smithson is managing partner and Hayt is principal at Rutter Associates, a New York-based risk management consultancy. Smithson and Hayt have both presented at RMA conferences and have coauthored other articles in The RMA Journal. 71

2 have returns sufficiently high to add to shareholder value. (Drilling down further, about half said that these loans did generate positive returns but that the returns were less than the cost of capital. The other half said that the returns were actually negative.) To increase returns, managers of credit portfolios must adopt the principles of Modern Portfolio Management, principles that have formed the basis of asset management for 40 years. In essence, this approach implies the following: Measuring the risk of assets within the portfolio (that is, calculating a portfolio risk contribution) and the capital associated with the portfolio as a whole. Measuring return net of reserves, direct expenses, and transfer prices. Assigning a cost of capital and generating a riskadjusted return. Requiring that assets brought into the portfolio add value, or if an asset is not priced adequately, that the sponsor make up the difference. Actively managing the portfolio with respect to new business and existing assets in order to move the portfolio toward greater efficiency. One might add a fifth element applicable to banks, which is to communicate the asset manager philosophy to originators and establish consistent incentive compensation. Figure 1 summarizes the differences between what we might call a traditional credit function and an asset management approach. The differences in management stem from the idea that the bank s objective as an asset manager is for the entire portfolio of credit assets to add economic value to the organization. In contrast to the traditional model, the credit portfolio need not buy every loan that the bank originates. A loan that the bank s portfolio does not buy must be distributed outside the organization, in which case it must carry a competitive yield. This imposes a discipline that requires the internal transfer price for a loan to mirror the prevailing price in the marketplace. There are, of course, times when a bank may be willing to use a loan as a loss leader, that is, the bank may be willing to offer a loan at lower than market price in order to get other profitable business from the client. That can still occur under the asset management approach, but accountability is imposed. The below-market subsidy is assigned to the business unit by transferring the loan into the portfolio at the market-determined price. This puts a price on loss leadership and imposes the requirement to identify where that loss will be made up. If the bank s asset managers expect to receive credit assets at market-based values, the originators need to have the tools necessary to price different structures. This includes an assessment of the economic capital the transaction will consume and the bank s expected risk-adjusted return for credit assets. Originators should be able to see how specific adjustments to the terms of the facilities affect the value of the transaction, ensuring few surprises when the deal is brought to portfolio management. Figure 1 Traditional versus Asset Manager Approaches to Credit Portfolio Management Traditional Credit Function Asset Management Approach Organizational structure A number of subportfolios One portfolio of credit assets (organized by geography, industry, or product type) Investment philosophy Originate and hold Underwrite and distribute Transaction evaluation Independently Relative to existing portfolio Who "owns" the loans Originators Credit portfolio management and other credit assets? (relationship managers) Pricing Grid Portfolio (and market) driven Incentive to Volume Contribution to economic profit originate loans 72 The RMA Journal October 2001

3 Evolving Credit Management Practice While we know banks are making changes in their lending businesses, it is difficult to know the extent of those changes. In an attempt to get some perspective on current practice, Rutter Associates conducted a survey at the end of 2000 that covered a small sample of loan originators and investors. 2 This survey was supplemented by additional questionnaires collected in March The results reported in this article are based on the survey responses of 20 large, internationally active banks and six institutional investors in loans and other credit assets. Organizational structure and goals. The banks and investors that responded to our survey have all begun the process of moving toward a centralized credit portfolio. All of the banks and all but one of the institutional investors reported that that they had a credit portfolio management group in their organizations. We asked the banks and investors to identify the goals of credit portfolio management, using a range of 1 (most important) to 5 (least important). The average ranks for five possible goals are provided in Figure 2. While both banks and institutional investors ranked economic or shareholder value added as the most important goal, investors appear more focused on value added. The average rank for this goal was 1.2 for institutional investors but 2.2 for banks (not that much different from the ranks for diversification and reducing economic capital). This is consistent with anecdotal evidence that bankers are managing to multiple objectives. Another telling difference between banks and investors is how they characterize the management of the portfolio. Almost seven-eighths of the banks characterized the style of their credit portfolio management activities as defensive. By comparison, Figure 2 Goals of Credit Portfolio Activities (1 = most important; 5 = least important) two-thirds of institutional investors characterize their style as offensive. Allocation of decision rights. If the credit portfolio is to be run like an investment portfolio, it is clear that credit portfolio management must have the decision rights with respect to the loans and other credit assets. Credit managers should have the ability to reject new loans that don t add value and to take steps to hedge or transfer existing assets that are no longer desired. In practice, complete ownership of the decision rights may not be practical; however, focusing on the economics can help banks create the right structures. Since banks rely on selling a variety of services to their customers, there will always be sensitivities to the sale of loans or the refusal to renew a facility, both of which go hand-inhand with the asset manager approach. While the reality of cross-selling must not be ignored, the question of ownership rights determines how decisions get made and who takes responsibility. For example, the credit portfolio manager might reject a loan because of insufficient risk-adjusted return; if the loan is designed as a loss leader, however, there will be another business unit (the one that will recognize the profit from the follow-on business) ready and willing to transfer funds or create an internal I.O.U. for the shortfall. In practice, it has not been easy to implement this prescription in banks. The allocation of decision rights and the question of how loans get priced and transferred within the organization are only beginning to be sorted out. For example, only about 10% of the banks indicated that the credit portfolio man - ager owns the loans exclusively. More than 50% indicated that a portfolio management / line unit partnership owns loans. To examine the question of decision rights, the Rutter Associates survey asked what Reducing Reducing Reducing Economic regulatory economic size of or shareholder capital capital balance sheet Diversification value added Banks Institutional Investors happens if the projected income on a proposed transaction is less than that required by the portfolio manager. About one-fourth of the responding 73

4 banks indicated that the business unit sponsor must pay the shortfall (the difference between projected income and the income required) to the portfolio manager that is, the portfolio manager has the decision rights. On the other hand, about 40% of the banks indicated that the business sponsor decides whether the transaction gets done or not in other words, the line unit has the decision rights. The remaining 30 % indicated that the business sponsor creates an internal IOU, which strikes us as a softer allocation of decision rights toward the portfolio manager. Implementation of credit portfolio management. In Tools for Reshaping Credit Portfolios (May 2001), we described how loan sales and trading, credit derivatives, and asset securitization can be used to manage the credit portfolio. The survey asked about the degree to which these tools are being employed. All of the banks and all of the institutional investors indicated that they buy and sell loans in the secondary market. Only one of the banks and one of the institutional investors indicated that they do not make use of credit derivatives, which means that more than 90% use credit derivatives to manage the credit portfolio. Only four of the banks and one of the institutional investors (less than 25%) indicated that they do not make use of asset securitization to manage the credit portfolio. (Again, note that these results are for a small sample of large institutions.) Loan valuation. Today, loans are typically priced using a grid system, that is, various financial ratios for the obligor and information about the characteristics of the facility jointly determine a point in a grid of credit spreads. At some institutions, the grid system is supplemented by information about return on capital at the institution, information that will suggest whether the grid spread is adequate given the bank s assumptions about capital usage and the cost of capital in other words, a hurdle rate of return on the transactions. However, almost 90% of the bank respondents indicated that they currently mark credit assets to market (or model) or plan to do so. It is important to note that, of those 90%, fewer than half (about 40%) indicated that they plan to use the mark-tomarket/model (m-t-m) valuation for P&L reporting. The majority indicated that they use or plan to use m-t-m valuation for risk management or other MIS purposes. Since true market prices are currently observable for only a small fraction of obligors and facilities, a number of institutions are developing more sophisticated loan-pricing models. These models rely on the same no-arbitrage pricing techniques that are associated with the derivatives market. Such models effectively use a risk-neutral probability of default that is implied by prevailing market data, rather than an empirical probability of default from historical data. These models also explicitly incorporate the options embedded in credit assets, that is, the borrower s option to draw down a commitment or to prepay an obligation. 3 While it is clear that the modern approach to portfolio management requires that banks move in the direction of no-arbitrage models, there remain many practical difficulties in implementing these approaches. Credit models and data. Only one of the banks and one of the institutional investors indicated that they do not employ a credit portfolio model. (Again, remember that these are large institutions.) For the 90 % that responded that they do use a credit portfolio model, we were interested in which model they use and the data they use to load the model. Most of the banks reported that they use vendor-supplied models 50% reported that their primary credit portfolio model is KMV s Portfolio Manager and 20% reported that RiskMetrics Group s CreditManager is their primary model. Only 25% reported that their primary credit portfolio model was developed internally. In contrast, most of the institutional investors reported that they use internally developed models. Approximately half of the banks and institutional investors indicated that they use KMV s EDFs as their primary measure of default probability. A little less than one-third reported that they rely on bond migration studies, and about 15% reported that they rely on internal portfolio migration data. Less than 10% reported that they rely on probabilities of default implied by the term structure of spreads. A little more than one-third of the banks and institutional investors cited industry-wide studies as their primary source of data on recovery in the event of default, while a little less than one-third cited rat- 74 The RMA Journal October 2001

5 ing agency analysis as their primary data source. The remainder cited internal review of charge-offs (onefifth of the respondents) and third-party databases. A Cautionary Note Earlier we observed that bank portfolio managers typically manage to multiple objectives, something that can put them at a disadvantage relative to nonbank investors. Typical objectives may be numerous, including targets for return on assets and on regulatory capital, incremental relationship revenues, and league table standings. Some are consistent with maximizing value added and some are not. If banks are to behave like asset managers with respect to the credit portfolio, they must keep in focus the primary objective of maximizing economic profit. That is not to say that other objectives and Your Turn! to Write for The RMA Journal John Cassis, Dev Strischek, Frank DiLorenzo, Ellen Yan, Ronald Cathcart, Richard Hamm, Joseph May, Jennifer Fagg, James Zeiger, Mark Southern, Andrew Kresse, & Darren Lydting are just a few of the bankers who have contributed recently to The RMA Journal. You, too, have knowledge and experience that can move the industry forward when you share best practices, lessons learned, risk management innovations, practical advice, opinions, and more with other readers. Send an to bfoster@rmahq.org; let s discuss your contribution to the Journal. Subscribe to The RMA Journal Fax this form to (215) constraints will go away. However, maximizing economic profit provides the basis for putting a cost on constraints and a value on achieving different objectives so that management can make the best tradeoffs possible. Rutter Associates Web site can be found at Notes 1 The first such publicly discussed model was McKinsey s CreditPortfolioView. In the article, we also discussed the demonstration model developed by Rutter Associates. 2 Results from this original survey appeared in the December 2000 issue of Credit. A downloadable spreadsheet containing the results can be accessed at 3 Both Algorithmics and KMV are developing such loan-pricing models. To order a one-year subscription to The RMA Journal, please complete the information below and fax this page to To pay by check, make payable to RMA and mail to Customer Relations, RMA, 1650 Market Street, Suite 2300, Philadelphia, PA, Orders can also be placed at RMA s Web site, RMA member U.S./Canada: $40 Other: $85 Nonmembers U.S./Canada: $95 Other: $140 Name: RMA Member #: Date: Bank/Company Name: Phone: Fax: Address: City: State: Country: Postal Code: Charge to: VISA M/C Exp. Date Account #: 75