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Sound Credit Risk Experience Sharing   Vietnam Fsa And Bank
Sound Credit Risk Experience Sharing   Vietnam Fsa And Bank
Sound Credit Risk Experience Sharing   Vietnam Fsa And Bank
Sound Credit Risk Experience Sharing   Vietnam Fsa And Bank
Sound Credit Risk Experience Sharing   Vietnam Fsa And Bank
Sound Credit Risk Experience Sharing   Vietnam Fsa And Bank
Sound Credit Risk Experience Sharing   Vietnam Fsa And Bank
Sound Credit Risk Experience Sharing   Vietnam Fsa And Bank
Sound Credit Risk Experience Sharing   Vietnam Fsa And Bank
Sound Credit Risk Experience Sharing   Vietnam Fsa And Bank
Sound Credit Risk Experience Sharing   Vietnam Fsa And Bank
Sound Credit Risk Experience Sharing   Vietnam Fsa And Bank
Sound Credit Risk Experience Sharing   Vietnam Fsa And Bank
Sound Credit Risk Experience Sharing   Vietnam Fsa And Bank
Sound Credit Risk Experience Sharing   Vietnam Fsa And Bank
Sound Credit Risk Experience Sharing   Vietnam Fsa And Bank
Sound Credit Risk Experience Sharing   Vietnam Fsa And Bank
Sound Credit Risk Experience Sharing   Vietnam Fsa And Bank
Sound Credit Risk Experience Sharing   Vietnam Fsa And Bank
Sound Credit Risk Experience Sharing   Vietnam Fsa And Bank
Sound Credit Risk Experience Sharing   Vietnam Fsa And Bank
Sound Credit Risk Experience Sharing   Vietnam Fsa And Bank
Sound Credit Risk Experience Sharing   Vietnam Fsa And Bank
Sound Credit Risk Experience Sharing   Vietnam Fsa And Bank
Sound Credit Risk Experience Sharing   Vietnam Fsa And Bank
Sound Credit Risk Experience Sharing   Vietnam Fsa And Bank
Sound Credit Risk Experience Sharing   Vietnam Fsa And Bank
Sound Credit Risk Experience Sharing   Vietnam Fsa And Bank
Sound Credit Risk Experience Sharing   Vietnam Fsa And Bank
Sound Credit Risk Experience Sharing   Vietnam Fsa And Bank
Sound Credit Risk Experience Sharing   Vietnam Fsa And Bank
Sound Credit Risk Experience Sharing   Vietnam Fsa And Bank
Sound Credit Risk Experience Sharing   Vietnam Fsa And Bank
Sound Credit Risk Experience Sharing   Vietnam Fsa And Bank
Sound Credit Risk Experience Sharing   Vietnam Fsa And Bank
Sound Credit Risk Experience Sharing   Vietnam Fsa And Bank
Sound Credit Risk Experience Sharing   Vietnam Fsa And Bank
Sound Credit Risk Experience Sharing   Vietnam Fsa And Bank
Sound Credit Risk Experience Sharing   Vietnam Fsa And Bank
Sound Credit Risk Experience Sharing   Vietnam Fsa And Bank
Sound Credit Risk Experience Sharing   Vietnam Fsa And Bank
Sound Credit Risk Experience Sharing   Vietnam Fsa And Bank
Sound Credit Risk Experience Sharing   Vietnam Fsa And Bank
Sound Credit Risk Experience Sharing   Vietnam Fsa And Bank
Sound Credit Risk Experience Sharing   Vietnam Fsa And Bank
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Sound Credit Risk Experience Sharing Vietnam Fsa And Bank

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  • 1. Credit Risk Management Eric Kuo 2007
  • 2. Restricted Credit risk management can be grouped by 3 important parts : Rating, underwriting and management- in our view… Credit Rating Credit Underwriting Credit Management Single name exposure limits Risk-based pricing assessment Loan Rating Approval application Tool decision Risk-based delegation of authority Customer relationship profitability Underwriting standards Decision Taken Warning signals Portfolio Portfolio Loan loss & differentiated Limit Management provisions Improved information or processes monitoring setting 20070709 Eric — Confidential 2
  • 3. Restricted ..among these 3 groups -Building a internal rating system is the starting point of credit risk management. : PD ,LGD ,EAD Estimation 1. Internal rating Loan Process of lending 2. Loan origination Origination Process Reserve provision for the bad debt Loan portfolio 3.EL based management provision Provisioning Policy What factors should bank need to consider for the price of a loan 4. Risk based Internal pricing Rating System Economic Capital Risk-based Measuring the credit performance based Pricing on EP, RAROC 5. Risk adjusted performance measurement Risk-adjusted Performance How to calculate the IRB Capital and Measurement) economic capital 6. Economic capital Diversification and manage loan in a 7. Credit portfolio portfolio level management 20070709 Eric — Confidential 3
  • 4. Restricted Credit risk measurement has converged to an accepted standard, now embodied in Basel II. EL (NTD) Expected Loss = = 1. What is the probability that a client Probability of PD (%) = 1 is going to default? Default X 2. How high should we expect Exposure at EAD (NTD) = the amount outstanding to be in 2 Default the event of default ? X 3. How much of the outstanding Loss Given 3 LGD (%) = amount we expect to lose ? Default 20070709 Eric — Confidential 4
  • 5. Restricted Choice of rating model depends on the size or nature of client segment. It is similar to the retail customers in terms of SME’s rating model . Examples of rating models Focus •Business segments •Rating model •SMEs and retail customers (e.g., Chaid: recursive parti- mortgages, credit lines, consumer loans), tioning (decision tree) Logistic regression/ Scoring •Midsize/large corporates, multinationals Regression models Hybrid systems •Banks Bond rating replication •Project finance / Structured finance Risk factor models, Monte Carlo simulations 20070709 Eric — Confidential 5
  • 6. Restricted Part of the SME’s rating model requires to combine with human judgmental, due to many factors are difficult to factor into the model. •Not covered •Fully covered •Subjective •Factors determining default risk assessment •Scoring •Quantitative Cash flow/debt factors Debt/equity •Ability to Etc. service credit •Qualitative Management quality factors Competitive position •Default Strength of the industry probability Etc. •Willingness to Creditor’s character service credit Reputation Personal finances Etc. 20070709 Eric — Confidential 6
  • 7. Restricted Financial statement is most likely trustworthy in larger size of corporation and play an important role in building a model. Examples of rating models Focus •Business segments •Rating model •SMEs and retail customers (e.g., Chaid: recursive parti- mortgages, credit lines, consumer loans), tioning (decision tree) Logistic regression/ Scoring •Midsize/large corporates, multinationals Regression models Hybrid systems •Banks Bond rating replication •Project finance Risk factor models, Monte Carlo simulations 20070709 Eric — Confidential 7
  • 8. Restricted Process of internal rating for corporate clients The key successful factor of building a rating model is ‘Data’. Illustrative Foundation Setting & Grading Tool Construction Data Collection Construction Factor Single Correlation Regression Historical and Pilot Generation Factor Tables Analysis Defaults Testing Collect Identify potential Determine Determine Develop optimal Apply overlay to the model information on set of factors that relationship relationships weights for historical defaults may be between a single between factors, factors based Calibration of and non-defaults factor and default predictive of and isolate upon model to PD default independent sets development Or credit experts Output is the of factors sample Confirm grade current Output is a factor factor short list accuracy of loans long list to be as well as any Output is a set of model using “out tested factor potential sub- Selection of a of sample” transformation models to be representative testing of the discussed sample model or rank ordering Factor Long List Factor Short List Factor Transformation Multi-Factor Analysis Low Power High Power Financial Qualitative T OT AL INT EREST ASSET S COVER % Population RDFs % Population RDFs Financial Factor 140% 30% 300% 30% Factors Factors 120% 250% 100% 20% 200% 20% Gearing 80% 150% 60% 100% 10% 10% 40% Debt Capacity 50% 20% Single Factor 0% 0% 0% 0% Liquidity >14.1 5.7 to 2.6 to 0.9 to <0.9 <2700 2700 to 6900 to 32000 to >555000 4.1 5.7 2.6 6900 32000 555000 Analysis Activity & Turnover Scorecard Prototype Profitability Solvency 20070709 Eric — Confidential 8
  • 9. Restricted Model can only deliver a ‘Figure’ and it is the beginning of whole ‘Rating process’. Statistically optimised core Example – Structure Larger Middle Size Corporate Rating Rating process Financial Non-Financial Model Model Rating Tool Construction Financial Score Non-Financial Score Model Combination Step 1 Preliminary Score Apply Model for New Obligor & Get a Preliminary Score Step 2 Standalone Rating Map the Preliminary Score to the External Rating Step 3 Supported Rating If Receiving a ‘guarantee’ From Parent Company Step 4 Final Rating Overriding if ‘Committee’ decides to ‘Downgrade’ or ’Upgrade’ 20070709 Eric — Confidential 9
  • 10. Restricted Map internal rating to the external rating, will make bank acts like a rating agency – a better one from my personal view points. CTCB previous rating grade New ORR PD Old ORR S&P Moody’s TCRI 0.03% 1 1 AA- or better Aa3 or better 0.10% A+ to A- A1 to A3 2 1 1 TwAAA - twAA 0.16% BBB+ Baa1 twAA *- 3 2 2 0.26% BBB Baa2 twAA- 4 2 3 0.42% BBB- Baa3 twA+ 5 3+ 4 0.61% BBB- *- Baa3 *- twA 6 3+ 0.90% BB+ Ba1 twA- 7 3+ 5 1.35% BB Ba2 twBBB+ 8 3 6 2.04% BB- Ba3 twBBB 9 3 3.15% BB- *- Ba3 *- twBBB- 10 3 7 4.93% B+ B1 twBB+ 11 3 7.82% B B2 twBB 12 3- 8 12.61% B- B3 13 4 9 twBB- or worse 20070709 Eric — Confidential 10
  • 11. Restricted The cumulative default considers the ‘tenor’ for a specific rating grade , further extend the default modeling. Cumulative default probability Time Periods (years) Rating 1 2 3 4 5 6 7 8 9 10 AAA 0.00% 0.00% 0.02% 0.03% 0.05% 0.08% 0.10% 0.13% 0.16% 0.19% AA+ 0.00% 0.02% 0.05% 0.13% 0.19% 0.26% 0.33% 0.40% 0.48% 0.57% AA 0.01% 0.02% 0.07% 0.16% 0.26% 0.38% 0.49% 0.62% 0.75% 0.89% AA- 0.01% 0.05% 0.13% 0.23% 0.36% 0.51% 0.66% 0.82% 0.98% 1.15% A+ 0.03% 0.11% 0.22% 0.37% 0.56% 0.76% 0.98% 1.20% 1.43% 1.65% A 0.04% 0.13% 0.26% 0.43% 0.62% 0.84% 1.07% 1.32% 1.58% 1.85% A- 0.08% 0.23% 0.42% 0.66% 0.92% 1.20% 1.49% 1.80% 2.12% 2.44% BBB+ 0.12% 0.32% 0.57% 0.87% 1.20% 1.55% 1.93% 2.32% 2.72% 3.13% BBB 0.21% 0.54% 0.91% 1.32% 1.89% 2.30% 2.67% 2.97% 3.34% 3.74% BBB- 0.42% 1.07% 1.87% 2.74% 3.63% 4.48% 5.27% 6.00% 6.66% 7.26% BB+ 0.72% 1.89% 3.20% 4.52% 5.74% 6.85% 7.84% 8.75% 9.47% 10.18% BB 1.46% 3.08% 4.79% 6.51% 8.11% 9.48% 10.69% 11.78% 12.71% 13.53% BB- 2.80% 5.19% 7.48% 10.63% 12.50% 14.06% 15.36% 16.44% 17.46% 18.46% B+ 4.15% 8.81% 12.54% 15.02% 17.09% 18.86% 20.05% 21.51% 22.22% 22.84% B 5.71% 11.75% 16.29% 19.12% 21.36% 23.36% 24.51% 26.26% 26.98% 27.67% B- 10.55% 16.81% 20.89% 24.60% 27.08% 29.20% 29.99% 32.12% 33.50% 34.98% CCC+ 15.93% 22.52% 26.14% 30.86% 33.64% 35.90% 37.38% 38.87% 41.00% 43.36% CCC 17.83% 25.20% 29.25% 34.53% 37.64% 40.16% 41.82% 43.50% 45.87% 48.52% CCC- 23.06% 32.60% 37.83% 44.66% 48.69% 51.95% 54.10% 56.27% 59.34% 62.76% CC 28.29% 40.00% 46.42% 54.80% 59.73% 63.74% 66.37% 69.03% 72.81% 77.00% C 34.90% 49.35% 57.27% 67.61% 73.70% 78.65% 81.89% 85.17% 89.83% 95.00% Source: Fitch rating . 20070709 Eric — Confidential 11
  • 12. Restricted EAD estimates ‘How high should we expect the amount outstanding to be in such a case?’ EL (NTD) Expected Loss = = 1. What is the probability that a client Probability of PD (%) = 1 is going to default? Default X 2. How high should we expect Exposure at EAD (NTD) = the amount outstanding to be in 2 Default the event of default ? X 3. How much of the outstanding Loss Given 3 LGD (%) = amount we expect to lose ? Default 20070709 Eric — Confidential 12
  • 13. Restricted EAD represents for the ‘Exposure at Default’ which measures the impact of the ‘Loss at Default’ . Default date Credit Line =100 Account limit 90 90% of Limit utilisation limit 30 Time Today As of last year 1 Year Horizon 20070709 Eric — Confidential 13
  • 14. Restricted LGD estimates ‘How much of the outstanding amount must we expect to lose?’ EL (NTD) Expected Loss = = 1. What is the probability that a client Probability of PD (%) = 1 is going to default? Default X 2. How high should we expect Exposure at EAD (NTD) = the amount outstanding to be in 2 Default event of default? X 3. How much of the outstanding Loss Given 3 LGD (%) = amount we expect to lose? Default 20070709 Eric — Confidential 14
  • 15. Restricted LGD is the economic loss suffered by the bank upon default by the customer. Economic Loss LGD = Exposure At Default Exposure At Default − PV (Re cov eries − Costs) = Exposure At Default Workout period Economic loss Recoveries – collateral, liquidation NPV Time Costs – legal, accounting, expenses Exposure At Default 20070709 Eric — Confidential 15
  • 16. Restricted Take away Credit rating model doesn’t make a perfect world, but equip bank with good lenses but not able to guarantee model can identify ‘Black & White’. EXAMPLE Good loans 850 Bad loans 150 Impossible! There is no such a •Currently scoring model that Perfect causes no volume 850 world loss •Profit margin = One of the ways to 4.98% reduce volume •Cut-off loss is to raise interest rate or 290 average recovery Scoring rate or to 150 191 model accurately predict 145 137 individual recovery 92 rate 63 Profit margin = –8.2% 25 24 11 8 8 6 Recovery rate model is necessary Default rate (%) •2 •4 •6.5 •7.4 •28.4 •35.5 to improve the accuracy of loan •Profit margin = 2% •Profit margin = –27% approval and to maximize loan performance 20070709 Eric — Confidential 16
  • 17. Restricted All of these risk parameters estimate the cost of doing loan business and link to ‘Provision policy’. EL (NTD) Expected Loss = = 1. What is the probability that a client Probability of PD (%) = is going to default? Default X 2. How high should we expect Exposure at EAD (NTD) = the amount outstanding to be in Default such a case? X 3. How much of the outstanding Loss Given LGD (%) = amount must we expect to lose? Default 20070709 Eric — Confidential 17
  • 18. Restricted Objectives of credit underwriting processes is to shorten/simplified the process. : PD ,LGD ,EAD Estimation 1. Internal rating Loan Process of lending 2. Loan origination Origination Process Reserve provision for the bad debt Loan portfolio 3.EL based management provision Provisioning Policy What factors should bank need to consider for the price of a loan 4. Risk based Internal pricing Rating System Economic Capital Risk-based Measuring the credit performance based Pricing on EP, RAROC 5. Risk adjusted performance measurement Risk-adjusted Performance How to calculate the IRB Capital and Measurement) economic capital 6. Economic capital Diversification and manage loan in a 7. Credit portfolio portfolio level management 20070709 Eric — Confidential 18
  • 19. Restricted Automation works for all but the most cases, human judgemental is still required for special cases. Example Selection rules Credit Decision System Senior credit officer Percentage of total credits Special transactions 10% High risk and/or high complexity Doubt Clients 10% Illustrative Standard transactions Good OK 70% Low risk and/or low complexity Bad •Rating Scoring model 10% STOP 20070709 Eric — Confidential 19
  • 20. Restricted Credit decisions on anomalous cases in day to day activities can be stremlined but doesn’t mean model can replace ‘Human’ and ‘model’ won’t go wrong. •From traditional approach ... •… to best practice approach Review every day all anomalous Review anomalous transactions after transactions classification and prioritisation Take decision according to account Take decision on risk-based judgment manager judgement following pre-defined rules and shadow limits* For small business segment event- driven management is totally automated and driven by behavioural score 20070709 Eric — Confidential 20
  • 21. Restricted Systematic loan review process can also be streamlined if ‘Data Stream’ is available. •From traditional approach . . . • . . . to best practice approach Credit review process every 6 months Credit review on continuous basis Review of all positions Review the selected customers according to the risk classification of Credit Rating System (e.g. focus on worst 30%) Review process independent of risk Differentiate review process according to assessment risk of position 20070709 Eric — Confidential 21
  • 22. Restricted Expected Loss represents for the cost of doing loan business and bank should reserve the provision based on the ‘EL’. : PD ,LGD ,EAD Estimation 1. Internal rating Loan Process of lending 2. Loan origination Origination Process Reserve provision for the bad debt Loan portfolio 3.EL based management provision Provisioning Policy What factors should bank need to consider for the price of a loan 4. Risk based Internal pricing Rating System Economic Capital Risk-based Measuring the credit performance based Pricing on EP, RAROC 5. Risk adjusted performance measurement Risk-adjusted Performance How to calculate the IRB Capital and Measurement) economic capital 6. Economic capital Diversification and manage loan in a 7. Credit portfolio portfolio level management 20070709 Eric — Confidential 22
  • 23. Restricted EL represents for the cost of doing loan business and bank should reserve the provision based on the ‘EL’. EL (NTD) Expected Loss = = 1. What is the probability that a client Probability of PD (%) = is going to default? Default X 2. How high should we expect Exposure at EAD (NTD) = the amount outstanding to be in Default such a case? X 3. How much of the outstanding Loss Given LGD (%) = amount must we expect to lose? Default 20070709 Eric — Confidential 23
  • 24. Restricted Risk-based Provisioning Framework Risk-based Provision Ratio – Corporate Banking LGD 0 1A 1B 2 3 4 5 6 7 8 9 10 PD 0.00% 2.50% 7.50% 15% 25% 35% 45% 55% 65% 75% 85% 95% 1 0.03% 0.00% 0.00% 0.00% 0.00% 0.01% 0.01% 0.01% 0.02% 0.02% 0.02% 0.03% 0.03% 2 0.10% 0.00% 0.00% 0.01% 0.02% 0.03% 0.04% 0.05% 0.06% 0.07% 0.08% 0.09% 0.10% 3 0.16% 0.00% 0.00% 0.01% 0.02% 0.04% 0.06% 0.07% 0.09% 0.10% 0.12% 0.14% 0.15% 4 0.26% 0.00% 0.01% 0.02% 0.04% 0.07% 0.09% 0.12% 0.14% 0.17% 0.20% 0.22% 0.25% 5 0.42% 0.00% 0.01% 0.03% 0.06% 0.11% 0.15% 0.19% 0.23% 0.27% 0.32% 0.36% 0.40% 6 0.61% 0.00% 0.02% 0.05% 0.09% 0.15% 0.21% 0.27% 0.34% 0.40% 0.46% 0.52% 0.58% 7 0.90% 0.00% 0.02% 0.07% 0.14% 0.23% 0.32% 0.41% 0.50% 0.59% 0.68% 0.77% 0.86% 8 1.35% 0.00% 0.03% 0.10% 0.20% 0.34% 0.47% 0.61% 0.74% 0.88% 1.01% 1.15% 1.28% 9 2.04% 0.00% 0.05% 0.15% 0.31% 0.51% 0.71% 0.92% 1.12% 1.33% 1.53% 1.73% 1.94% 10 3.15% 0.00% 0.08% 0.24% 0.47% 0.79% 1.10% 1.42% 1.73% 2.05% 2.36% 2.68% 2.99% 11 4.93% 0.00% 0.12% 0.37% 0.74% 1.23% 1.73% 2.22% 2.71% 3.20% 3.70% 4.19% 4.68% 12 7.82% 0.00% 0.20% 0.59% 1.17% 1.96% 2.74% 3.52% 4.30% 5.08% 5.87% 6.65% 7.43% 13 12.61% 0.00% 0.32% 0.95% 1.89% 3.15% 4.41% 5.67% 6.94% 8.20% 9.46% 10.72% 11.98% 20070709 Eric — Confidential 24
  • 25. Restricted EL estimates a average / general loss across a time period that can cover most of the loss situation. Credit Risk-based Provisioning – EL Approach losses Provisioning In-flow • Provisioning based on risk rating & expected loss • Post write-off recovery Loan Interest Income EL Time (years) Expected Loss (EL) Provision Pool • Anticipated average annual loss rate • Foreseeable ‘cost’ of doing business • Equal to the mean (average) of losses Provisioning Out- over an economic cycle flow Bad loan write-off • Anti- economic cycle • Avoid the dilemma over heavily increase provisioning in bad years • Reduce the volatility of income statement 20070709 Eric — Confidential 25
  • 26. Restricted Different price for the different clients based on its corresponding risk. : PD ,LGD ,EAD Estimation 1. Internal rating Loan Process of lending 2. Loan origination Origination Process Reserve provision for the bad debt Loan portfolio 3.EL based management provision Provisioning Policy What factors should bank need to consider for the price of a loan 4. Risk based Internal pricing Rating System Economic Capital Risk-based Measuring the credit performance based Pricing on EP, RAROC 5. Risk adjusted performance measurement Risk-adjusted Performance How to calculate the IRB Capital and Measurement) economic capital 6. Economic capital Diversification and manage loan in a 7. Credit portfolio portfolio level management 20070709 Eric — Confidential 26
  • 27. Restricted Loan pricing should compensates the EL , OpCost and capital cost and to generates economic profit. Credit Spread 12% EP Hurdle Rate Ideal loan pricing 10% Minimum pricing for EP =0 Cost of Capital 8% If not being able RAROC Hurdle Rate to price at this ABC / OpCost Minimum pricing for ideal price, RAROC =0 6% banks should ‘Cross-Sell ‘ for compensate the risk and add 4% return for doing EL loan business. 2% 0% Worst Rating Best Rating Worst Score 20070709 Eric — Confidential Best Score 27
  • 28. Restricted RAROC & EP Analysis RAROC and Economic Profit extend the traditional ROE measure by incorporating risk. RAROC* Economic Profit Interest Income Interest Income – Funds transfer price – Funds transfer price + Non-Interest Income + Non-Interest Income – Operating Expenses – Operating Expenses – Expected Loss – Expected Loss Regulatory AIRB / Economic Capital Risk-adjusted profit Risk-adjusted profit Attributed in relation to risk AIRB Capital – RCap Hurdle Rate Hurdle Rate Bank’s minimum = RAROC (%) = EP ($) Return on Capital (8.5%) EC = Economic Capital *Risk-Adjusted Return on Capital RC = AIRB Regulatory Capital RAROC >= 8.5% EP >=0 20070709 Eric — Confidential 28
  • 29. Restricted Economic Prefit estimates the contribution added to the shareholders. Illustrative Economic Profit of loan portfolio AP EL =2% *1,000 RAROC = Capital 50 20 20 = = 20% 100 Assumption : : Assumption Exposure ==1,000 Exposure 1,000 Assumption : : Assumption Spread =5 % Spread =5 % ABC/OpCost =10 ABC/OpCost =10 Capital * *Cost of capital 10 Capital Cost of capital Basel 11Risk Weighted Basel Risk Weighted =100 *10% =100 *10% Asset =1,000 Asset =1,000 =10 =10 BIS Target Ratio =10% 10 20 BIS Target Ratio =10% Capital consumption Capital consumption =1,000* 10% ==100 =1,000* 10% 100 10 Cost of capital =10% Cost of capital =10% EL Ratio =2% of exposure EL Ratio =2% of exposure Net Expected ABC Accounting Capital EP Interest Loss Profit Cost Op Cost Income 20070709 Eric — Confidential 29
  • 30. Restricted Building a internal rating system is the starting point of credit risk management. : PD ,LGD ,EAD Estimation 1. Internal rating Loan Process of lending 2. Loan origination Origination Process Reserve provision for the bad debt Loan portfolio 3.EL based management provision Provisioning Policy What factors should bank need to consier for the price of a loan 4. Risk based Internal pricing Rating System Economic Capital Risk-based Measuring the credit performance based Pricing on EP, RAROC 5. Risk adjusted performance measurement Risk-adjusted Performance How to calculate the IRB Capital and Measurement) economic capital 6. Economic capital Diversification and manage loan in a 7. Credit portfolio portfolio level management 20070709 Eric — Confidential 30
  • 31. Restricted Capital calculation is similar under STD approach and Basel 1 . While as under IRB , the capital is a complicated formula. Under Basel 1 and Basel 2 STD , the risk Under Basel II , the risk weight is a weight is 100% for all corporate clients. product of PD, LGD, Tenor. 10 100 10 BIS =10% 1 5 10 Capital Capital RWA Loan Outstanding RWA Loan Outstanding 20070709 Eric — Confidential 31
  • 32. Restricted Basel estimate a general form of unexpected loss formula for banks to calculate the capital. Basel estimates Factors in Basel2 A General formula For banks 1 Year PD is considered, •PD instead of cumulative PD K= Based on historical data ⎡ ⎤ ⎡ ⎤ 0.5 ⎛R⎞ •LGD ⎢ LGD× N ⎢(1 − R) × G(PD) + ⎜ ⎟ × G(0.999)⎥ − PD × LGD⎥ −0.5 ⎝1− R ⎠ ⎢ ⎥ ⎢ ⎥ ⎣ ⎦ ⎢ ⎥ ⎣ ⎦ × (1 − 1.5 × b ) × [1 + (M − 2.5) × b ] Current status of EAD −1 •EAD RWA = K * 12.50 * EAD [0.11852 − 0.05478 × ln(PD)]2 •Tenor B= Capital = RWA * BIS Ratio ⎡1 − e (−50× PD ) ⎤ ⎡ ⎛ 1 − e (−50× PD ) ⎞ ⎤ ⎥ + 0 .24 ⎢1 − ⎜ ⎜ 1 − e − 50 ⎟ ⎥ •Correlation 0 .12 × ⎢ ⎟ 1 − e (− 50 ) ⎦ ⎣ ⎣⎝ ⎠⎦ 20070709 Eric — Confidential 32
  • 33. Restricted Basel 2 IRB capital approach captures the unexpected loss which based on our target ‘BIS Ratio’, usually disregard the tail loss. Probability of loss 99.xx% Confidence level Expected loss Unexpected loss Extreme loss (Tail loss) Amount of loss A B Expense AIRB Capital (Regulatory capital) Extreme loss (Tail loss) For Doing Business 20070709 Eric — Confidential 33
  • 34. Restricted Bank can estimate the capital requirement based on this general formula. Factors in Basel2 1.35% •PD EL = PD * LGD * EAD = 1.35% * 45% * 100 Mn = 0.61 Million 45% •LGD AIRB K = 0.082 NTD 100 Million RWA = K * 12.50 * EAD •EAD = 0.082 * 12.5* 100 Mn = 102 Million •Tenor 2.5 Years Capital = RWA * BIS Ratio =102 Mn * 10% =10.2 Million 0.1811 •Correlation 20070709 Eric — Confidential 34
  • 35. Restricted Tail risk is 8.7 times of capital charge in this case. Probability of loss BIS = 10% Expected loss Extreme loss (Tail loss) Unexpected loss A B 0.61 Million 89.19 Million 10.2 Million Cost of Capital doing consumption business Max Loss = Total lending amount = 100 Million 20070709 Eric — Confidential 35
  • 36. Restricted The capital requirement depends on the rating of a client, the LGD of collateral and the tenor of a loan. 1.06X Case Study ORR Change 21 17.6 14.9 13 11.5 10.2 8.9 PD = 1.35% 7.6 6.4 5 3.9 3 1.4 LGD = 45% 1 2 3 4 5 6 7 8 9 10 11 12 13 Tenor = 2.5 Year EAD =100 1.1X LGD Change 21.6 19.3 17 14.8 12.5 10.2 7.9 5.7 3.4 1.7 0.6 0 100 0 1A 1B 2 3 4 5 6 7 8 9 10 100 * 10% (BIS Ratio) =10 Tenor Change 0.6X 16 14.7 13.4 10 12.1 10.2 10.9 10.2 9.6 8.3 EAD Basel 1 Basel 2 1 2 2.5 3 4 5 6 7 Capital Capital Year 20070709 Eric — Confidential 36
  • 37. Restricted Building a internal rating system is the starting point of credit risk management. : PD ,LGD ,EAD Estimation 1. Internal rating Loan Process of lending 2. Loan origination Origination Process Reserve provision for the bad debt Loan portfolio 3.EL based management provision Provisioning Policy What factors should bank need to consider for the price of a loan 4. Risk based Internal pricing Rating System Economic Capital Risk-based Measuring the credit performance based Pricing on EP, RAROC 5. Risk adjusted performance measurement Risk-adjusted Performance How to calculate the IRB Capital and Measurement) economic capital 6. Economic capital Diversification and manage loan in a 7. Credit portfolio portfolio level management 20070709 Eric — Confidential 37
  • 38. Restricted The goal of credit portfolio management : Support the shift from ‘Original & Hold’ to ‘Original & Distribute’ . Active credit portfolio management approach Traditional credit management Credit •Loan Management Origination Origination Trading Relationship Relationship •CDS Monitor Active Management Management Workout Primary •CDS Primary Secon- Credit Index dary Portfolio Market Market Manage- •CDO Market ment •ABS Credit Credit •Portfolio Approval / Approval / Trading Rating Rating Source : ERisk, 20070709 Eric — Confidential 38
  • 39. Restricted We cannot direct the wind but can adjust the sail. There are 5 key successful factors in ‘Credit Portfolio Management’. Explanation A clear business strategy. From ‘Originate & Hold’ ‘Originate & Distribute’ ‘Buy & Sell’ •Strategy Next step of CTCB Diversify credit risk through secondary market Capital Management •Application Structured Credit Product Does the return compensate the risk RAROC / EP Concept. Limit setting •Management Risk /Return Analysis & Capital Allocation Rocket science •Measurement Economic Capital Concept Portfolio Model •Infrastructure Database 20070709 Eric — Confidential 39
  • 40. Restricted The essence of the credit hedge is risk- transfer. Bank can leverage Credit Default Swap to manage capital. Illustrative Investor receive a better return than deposit. Funded based CDS Tenor can match investor’s need 1 Deposit :100 Loan :100 Protection Reference Protection Seller Interest : 10 2 Interest :20 Buyer Principle Asset 3 CTCB Default Case : Cash settlement or physical deliver CTCB pays for the hedge cost. Receive a Deposit as collateral Reduce RWA and capital 20070709 Eric — Confidential 40
  • 41. Restricted Loan origination is in support of client relationship and complemented by cross-sell. Illustrative Structured credit activities are key to bank’s franchise as it provides : -Capacity for more origination and continue growth -Risk/Return enhancement -Improve liquidity in banking balance sheet Cross-sell to deepen relationship Investors Clients CLO Bank CDS Enhance client Lending supports relationship client business growth 20070709 Eric — Confidential 41
  • 42. Restricted Portfolio theory suggests us that we can enhance portfolio performance by re-weighting, and banks finally can adopt the theory into practice. Conceptual Portfolio Performance Enhancement 12% Hedge : Reduce risk / uncertainty 1 -Tool : Buy CDS, Loan Sell, Insurance, Securitization Efficient Frontier 10% Enhance Yield : Invest in High Yield Return 2 given the same ‘risk’ 4 8% -Tool : Secondary loan, Sell 2 CDS, CDS Index, securitization. 3 Current Portfolio 1 6% Swap Asset 3 Synthetics : Reduce risk and utilize the 4 4% free up capital to invest in credit. 5% 15% 25% 35% Risk 20070709 Eric — Confidential 42
  • 43. Restricted Portfolio Improvement is achieved by both reweighing existing exposure holdings and by hedging unwanted risk. Risk-Return Optimization Conceptual Efficient Frontier Same Risk Portfolio The efficient frontier for the portfolio is calculated Current Portfolio by optimizing within the portfolio. The frontier can be moved by expanding the portfolio assets to Same Return Portfolio include diversifying exposures. Optimal Sharpe Ratio By introducing new exposures that diversify the portfolio risk-return tradeoff will improve, allowing for the construction of optimal portfolios . 20070709 Eric — Confidential 43
  • 44. Restricted Our ultimate goal is to ‘Deliver a Stable and Sustainable profit growth for investors and to sustain through ‘economic cycle’. •Learn our lesson from recent credit crisis.. •..and create our own blue ocean strategy EPS Managing concentration Managing concentration risk. risk. Bank Diversifying portfolio Diversifying portfolio through Buy & Sell credit. through Buy & Sell credit. Max Return Becoming Market Maker Becoming Market Maker Other Banks in Taiwan Credit market in Taiwan Credit market Min Risk Support both of client’s & Support both of client’s & CTCB’s business growth. CTCB’s business growth. Ensuring business Ensuring business growth with good credit growth with good credit quality quality Time 20070709 Eric — Confidential 44
  • 45. Restricted Take away –Ideal ‘Credit Portfolio Management’ takes time to build up and the core is the ‘DATA’. Interest Margin 8.0% Max exposure Average Margin for Grade 5 6.0% Operating Costs Cost of Capital** 4.0% Improved Expected 2.0% diversification Loss Rating 0.0% 0 1 2 3 4 5 6 7 8 9 10 Risk Grade Better Single name underwriting 3 exposure limits Risk-based 1 2 pricing assessment Faster, cheaper Loan Rating Approval credit process application Tool decision Better pricing Risk-based & structuring delegation of Reduction in 4 authority Bad debt Customer relationship profitability Underwriting standards Better account planning 6 5 Decision Taken Warning signals Industry Portfolio Loan loss & differentiated Limit Management provisions Improved information or processes monitoring setting 20070709 Eric — Confidential 45

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