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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
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..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
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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
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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
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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.
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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
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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
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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’
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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 ) ⎦
⎣ ⎣⎝ ⎠⎦
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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
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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
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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
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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
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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
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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,
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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
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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
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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
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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
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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 .
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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
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