1. The Credit Limit Boundary as a
Means of Concentration
Management
-Risk Appetite
-Limit Setting
Experience Sharing
Eric Kuo
2008
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EXECUTIVE SUMMARY
Developing a limit setting that based on a bank’s risk appetite is crucial to manage
concentration risk
l Implementing credit limit boundaries that not only to ensure the credit risk is properly
managed but also meet the pillar 2’s requirement.
Purpose
l Such a limit framework links to bank’s risk appetite in order to protect bank’s credit rating and
earnings growth from adverse surprises.
l The core component of any system of limits is single name limits (varying by credit rating);
System of portfolio limits are also essential to control the concentration risk, such as credit rating,
industry, and product.
Limit
l We have implemented credit limits with varying degree of rigidity of their enforcement
– Limit ceiling act as inflexible rules, which can be circumvented only after a review by
senior management (the board meeting),
Type of Limit
– Warning trigger serve as “management action points”; limit breaches trigger reviews by
risk and/or senior management, not an automatic veto.
2009 Prepared by Eric —Confidential
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Although most banks have some sort of limit settings in place for long time, they are
based on ‘expert judgmental', not utilizing the risk parameters, such as PD,LGD,EAD.
AGENDA OF TODAY
Definition of concentration varies. The core element of
1. How dangerous
the concentration identification is: one or few sizable segments or obligors might
risk could be cause significant losses that jeopardize bank’s solvency.
The credit limit boundary is driven by the risk appetite that determined
2. How to set limit annually. Following the appetite we express the limit boundary in exposure for
boundary easier to communicate internally and daily business management.
Setting limit doesn’t represent there is no exception and limit banking
3. What’s the daily business. Instead, it is a alarm signal to warn management team to pay
management additional attention on the potential risk.
2009 Prepared by Eric —Confidential
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Definition of concentration varies, many definition under Basel II.
..correlated portfolio is also considered as
Single name concentration is foremost one… concentration risk
773. Banks should have in place effective internal 773. Continue..
policies, systems and controls to identify, measure,
• Credit exposures to counterparties in the same
monitor, and control their credit risk concentrations.
Banks should explicitly consider the extent of their economic sector or geographic region;
credit risk concentrations in their assessment of • Credit exposures to counterparties whose financial
capital adequacy under Pillar 2. These policies should performance is dependent on the same activity or
cover the different forms of credit risk concentrations
commodity; and
to which a bank may be exposed. Such concentrations
include: • Indirect credit exposures arising from a bank’s CRM
activities (e.g. exposure to a single collateral type or
• Significant exposures to an individual counterparty
to credit protection provided by a single
or group of related counterparties. In many jurisdictions,
counterparty).
supervisors define a limit for exposures of this nature,
commonly referred to as a large exposure limit. Banks
•Basel elaborates many types of concentration risk
might also establish an aggregate limit for the
through the survey of best practices.
management and control of all of its large exposures
•However, these definitions don’t necessary imply a
as a group; bank is current facing.
Source: Base 2 International convergence of capital measurement and capital standards 2009 Prepared by Eric —Confidential
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Paradoxically, banks tend to have concentrated exposure to their best customers
or certain industries.
Illustrative
Banks tend to willing to have deeper relationship with
well-established or public listed corporations.
Most banks face concentration risk, resulting from small portion of
obligors (or industries, geographic) account for majority of income or
exposure…
…also consume most of the bank’s capital. l Distribution of Risk Capital
by credit ratings is one of
Non-investment
the most important
grade
40 indicators of the overall
Non-Public Listed 50 50
60 level of risk in the portfolio
Other industries
90
l Conducting diagnosis of
Investment credit portfolio will have a
grade 60 better picture on the
50 50
Public listed 40 concentration risk
corporations
Star industries 10
# of Exposure Regulatory Economic Revenue
Obligor Capital Capital
2009 Prepared by Eric —Confidential
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Large unexpected losses will not only threatening bank’s credit rating, but also
discouraging investors’ confidence and result in significant market cap declines..
l In addition to putting
in danger target credit
rating, large losses
can erode shareholder
confidence
l Implications for
• JPMC lost a total of perhaps market capitalization
$0.5 billion in the course of can far exceed actual
Enron meltdownYet, as events losses
unfolded, shareholders lost
confidence and share price
plummeted to all time low
• JPMC’s share price fell from about
$40-$15 dollars, destroying
about $50 billion of market cap
2009 Prepared by Eric —Confidential
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..and the credit crisis tends to be resulted from certain concentrated business
(such as names or portfolio or products) .
Examples of losses by financial institutions
$ Millions Too many
banks
Loss size* No downgrades
triggered by these
1,025
losses
826
Too many losses
531 451
260 247
U.S. AmEx – Fleet JP BONY – Capital One Sub-Prime Crisis
Bancorp – high Boston – Morgan telecom – subprime
airline yield Argentina Chase – loans and lending
exposure bonds bonds Enron bonds
after 9/11
2001 2002 2007~Current
Loss/ book Too many banks
7% 7% 3% 1% 4% 7%
equity** either bankrupted
or bailout
* Pretax
** Assuming book equity in 2003
Source: Literature searches; 2009 Prepared by Eric —Confidential
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It doesn’t need to pay much attention on the high risk with low exposure
portfolio, instead, it is necessary to review the clients whom have low risk with
significant large exposure. Illustrative
Illustrative – Impact of concentration on portfolio Explanation
loss distribution
• Credit concentration risk is the largest
Probability source of risk to the solvency of a bank,
Company X or industry and this can occur in the form of the
High risk and low exposure default of a large customer, the
Even in the event of default simultaneous default a few sizeable but
, bank can cover the loss
with EL based provision
weak customers, or a downturn in the
industry the bank is exposed to.
• Credit expected loss risk is something
Company Y
that can be priced for in most
Low risk and very high exposure circumstances, whereas concentration
Solvency
In the event of default, EL provision risk is simply too expensive to price for in
is not enough, and require capital most cases.
cover the unexpected loss. • Paradoxically, banks tend to have
Potential
Loss concentrated exposure to their best
customers, and hence underwriting
standards alone would not be sufficient
Provision Bank available Capital to control this form of credit risk.
2009 Prepared by Eric —Confidential
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Few sizeable obligors or segments or industries may contribute significant
revenue to bank in good time. What’s the impact in the poor state of economy?
Assuming bank has a 100 obligors, each Goal of this exercise
has identical risk parameters (PD, LGD)
except for the EAD
• Observing how the EC change if portfolio has
Risk parameters Portfolio statistics
concentration risk. What will the EC changes
PD=10% Portfolio EAD= 10,000
1.
a Diversified loan portfolio, each has the same
LGD=50% EL =500 exposure, PD, LGD.
a EAD=100 for all Bank target rating = A l Under 6.25% of correlation
1
obligors
b
2. 1 obligor has significant weight of total portfolio
b
EAD=1,090 for 1
(1,090)
obligor
EAD=90 for the l Under 6.25% of correlation weight
2
rest obligors c
3. 10 obligors have significant weight of total
c EAD=280 for 10 portfolio (each 280, total 2800)
obligors
l Under 6.25% of correlation weight
3
EAD=80 for the
rest obligors l This 10 obligors, each has 25% of
4
correlation weight; while the rest has
6.25% of correlation weight
2009 Prepared by Eric —Confidential
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10. Case 1 illustrates a diversified portfolio’s potential risk. There is a possibility that ‘33’
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segments/ obligors will default together within 1 year(0.01% of probability). The
potential max loss is 1,650 given 10 thousand of exposure. The portfolio Economic
Capital=900. Illustrative
Joint Default Distribution Loss Distribution
Frequency of Joint Default Frequency of Loss
9% 10%
8.2% 經由模
9%
8% 擬發現, Target Rating =A
8% 有接近 Cumulative
7%
61% 的 probability =99.9%
There is a 0.01% of 7%
6% possibility that 33 情況,損 3.5% of
6% possibility result
segments or obligors 失不會 in a ‘800’
5% will default together 5% 超過EL potential loss
within 1 year. within 1 year
4% 4%
In other word, this
might happen once 3%
3.5% 0.01% of possibility the
3% in 10,000 year loss will exceed 1,400 ,
2% Max loss=1,650
2%
0.8% 1%
1%
0.01% 0%
0
100
200
300
400
500
600
700
800
900
1000
1100
1200
1300
1400
0% Max loss
33
0
2
4
6
8
10
12
14
16
18
20
22
24
26
28
1,650
$ of Loss Amount
500
# of Joint Defaulted Segment or Obligors
EL Unexpected Loss = 1,400-500 Tail risk
1st case : 6.25 % of correlation = 25% of correlation weight. =900 = Economic Capital
EC Simulation tool. 2009 Prepared by Eric —Confidential
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Case 2 exhibits the single name concentration risk. In this case, the potential max
loss increase to 2,120. Required 1,350 of Economic Capital.
Illustrative
Joint Default Distribution Loss Distribution
Frequency of Joint Default Frequency of Loss
10% 10%
9.19%
9% 9%
Target Rating =A
8% Cumulative
8%
probability =99.9%
7%
7%
6%
6%
5%
5% 0.01% of probability
that there is a 34 4%
4% obligors occurs joint
default event, 3%
3% Max loss
although it is once in
2%
2% 10,000 year
1 in 10,000 year
1%
1%
0%
0
180
360
540
675
765
855
945
1035
1125
1220
1350
1490
1670
0% 2,120
0
2
4
6
8
10
12
14
16
18
20
22
24
26
28
30
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500 $ of Loss Amount
# of Joint Defaulted Segment or Obligors
EL Unexpected Loss = 1,850-500
Case 2: one obligor has accounts for 10.9 % of total =1,350 = Economic Capital
exposure. The rest assumptions are the same as the base
case. Base case EC =900 Eric —Confidential
2009 Prepared by
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Case 3 demonstrates another type of concentration risk; few sizeable obligors have
significant portion of total portfolio. The max ’joint default’ increase to 40 clients.
The EC also to 1,220 Illustrative
Joint Default Distribution Loss Distribution
Frequency of Joint Default Frequency of Loss
9% 7.0%
8% 6.0% Target Rating =A
Cumulative
7%
5.0% probability =99.9%
6%
4.0%
5%
3.0%
4%
3% 0.01% of 2.0%
Max loss
possibility
2% 1.0% 1 in 10,000 year
I in 10,000 year
1%
0.0%
152
304
456
608
760
912
1,064
1,216
1,368
1,520
1,672
1,824
1,976
2,040
-
0%
40
0
3
6
9
12
15
18
21
24
27
30
33
38
# of Joint Defaulted Segment or Obligors 500 $ of Loss Amount
EL Unexpected Loss = 1,720-500
=1,220 = Economic Capital
Case 3: 10 obligors, each has a 2.8% share of total exposure.
The rest assumptions are the same as the base case. Base case EC =900Eric —Confidential
2009 Prepared by
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Few sizable obligors with higher correlation further impact on portfolio loss and
result in a higher EC requirement. The EC=2,200.
Illustrative
Joint Default Distribution Loss Distribution
Frequency of Joint Default Frequency of Loss
9% 12%
8% Target Rating =A
10%
Cumulative
7%
probability =99.9%
8%
6%
5% 6%
4%
4%
3%
Max loss
2% 2% with 0.01%
0.02%
1%
0%
180
360
540
720
900
1,080
1,260
1,440
1,620
1,800
1,980
2,160
2,340
-
0% 2,750
0
3
6
9
12
15
18
21
24
27
30
33
36
39
500 $ of Loss Amount
# of Joint Defaulted Segment or Obligors
EL Unexpected Loss = 2,700-500
Case 4: 10 obligors, each has a 2.8% share of total =2,200 = Economic Capital
exposure. Further each has 25% of asset correlation. The
rest assumptions are the same as the base case. Base case EC =900Eric —Confidential
2009 Prepared by
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This is the reason why Basel suggests banks should have in place effective
mechanism to control credit risk concentrations. And to consider the extent of
concentration risk in the assessment of capital adequacy under Pillar 2.
Illustrative
Base case
100 1 obligor has 10 obligors, 10 obligors,
obligors, EAD =1,090; each has each has 2.4 2,200
each has rest has EAD EAD=280 EAD=280 and X
100 EAD =90 ;rest has Asset Corr
with Asset Corr EAD =80, All =25%;rest
Asset Corr =6.25% obligors have has EAD =80
= 6.25% AssetCorr AssetCorr
=6.25% =6.25% 1.5 X 1,350
1,220
# of joint 33 34 40 55
default 900
obligors in the
worst case
Economic 900 1,350 1,220 2,200
capital
$ of max 1,650 2,120 2,040 2,750
credit loss
Diver- Single Few Correlat
Capitalization 9% 13.5% 12.2% 22% sified name sizable ed
rate = EC / portfo- concen- concn- sizable
EAD lio tration tration concn-
tration
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The foremost thing in setting limit is to find a concurrence risk appetite.
AGENDA OF TODAY
Definition of concentration varies. The core element of identification is: one or
1. How dangerous
few sizable segments or obligors might cause significant losses that
the concentration
jeopardize bank’s solvency.
risk could be
The credit limit boundary is driven by the risk appetite that
3. How to set limit determined annually. Following the appetite we express the
boundary limit boundary in exposure for easier to communicate internally
and daily business management.
Setting limit doesn’t represent there is no exception and limit banking
3. What’s the daily business. Instead, it is a alarm signal to warn management team to pay
management additional attention on the potential risk.
2009 Prepared by Eric —Confidential
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Comprehensive ‘D.R.E.A.M’ approach in designing ‘limit setting’.
Diagnosing Current Risk Appetite Establish the Analyzing the Managing Limit
Portfolio Determination Limit Structure Breach Cases Structure
• Analyzing Finding the ‘Max Design a rule to Examining •Refine policy
current Risk tolerance’
translate the max loss • Breach cases
portfolio to find
Utilize • Initiate
current tolerance into limit
concerns. •Market Benchmark discussion
ceiling with BU .
• Determine •Stress testing.
type of risks to
•Benchmarking-
be controlled
single name
Such as
•Internal survey
1. Single name
2. Specific
industry
3. Products
4. Portfolio rating
grade
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Bank should analyze his current portfolio to find emerging issues. 示例
Diagnosing Current Risk Appetite Establish the Analyzing the Managing Limit
Portfolio Determination Limit Structure Breach Cases Structure
EAD (Mn)
EAD
EAD (Mn) 21% of total
NPL% NPL %
in terms
Increased Average 6%
2007H Increased by ofEAD
by 13.1% NPL % = 2.87%
2008H 42.8% butNPL % is
higher than 5%
average
Increased 4%
by 25.4%
3%
2%
1%
0%
制造业
商业及服务业
能源、采矿及农业
运输业及物流业
房地产业
公共事业
建筑业
金融业
其他企业贷款
个人住房贷款
信用卡贷款
其他个人贷款
境外贷款
商业及服务业
信用卡贷款
制造业
运输业及物流业
其他个人贷款
房地产业
公共事业
建筑业
能源、采矿及农业
境外贷款
个人住房贷款
金融业
其他企业贷款
公司贷款 个人贷
22%
59% 款19% 2009 Prepared by Eric —Confidential
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The objective of limit setting should be made clear from the outset.
Diagnosing Current Risk Appetite Establish the Analyzing the Managing Limit
Portfolio Determination Limit Structure Breach Cases Structure
Illustrative
Expected Loss
Profit Margin
PD1
72% of profit
PD1
Accounts for 53% of total EL
PD2
PD2
PD3 0 100 200 300 648 700
400
PD4
PD4
PD5
PD3
EAD Capital
2009 Prepared by Eric —Confidential
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For the single name concentration, bank should ask himself what is the maximum
amount of exposure he’d lend to a clients. Illustrative
Diagnosing Current Risk Appetite Establish the Analyzing the Managing Limit
Portfolio Determination Limit Structure Breach Cases Structure
Market Survey of Maximum
Single Name Exposure Implication Survey of Taiwan Financial Holding
16%
• Different survey has 15.99%
different results 14.07%
13.02%
10% • All the available 11.74% 11.34%
surveys are
conducted by the
5% 1.5% foreign banks 7.67%
1%
0.2%
Survey 1 Survey 2
Max single Max single
name exposure name
as % of total allocated
capital capital as % Bank1 Bnak2 Bnak3 Bank4 Bank5 Bank6
of total capital
Note:各金控網站 2009 Prepared by Eric —Confidential
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For the portfolio limit, applying the stress tests to test the max loss tolerance level
with the consideration of profitability.
Diagnosing Current Risk Appetite Establish the Analyzing the Managing Limit
Portfolio Determination Limit Structure Breach Cases Structure
Illustrative
P & L of sub-Portfolio
Stress scenario and loss impact for sub-portfolio
(such as industry, product)
Limit Loss Tolerance BIS Ratio
Risk Adjusted
Scenario Parameters Current P&L
Profit Total
• Current EL 5 10 11%
All in Revenue 15
• Ave. PD 發生後扣掉EL
Loss in 備抵後會造成 考量行內的收益
- EL -5 • 1 in 3 Year increased by
後,仍會有
10% excess of
Recession 12 dollars of 10.8%
EL 2 dollars of profit
Per Year = 10 • 可能3年發生一次 • 造成PD上升 loss
10% 的收益
的額外損失
• 921 Earthquake • Ave. LGD Loss in
increases excess of 20 -10 10%
• 1 in 10 Year EL
• Subprime • Ave. PD Loss in
LGD excess of 40 -30 8%
• 1 in 80 Year increases EL
2009 Prepared by Eric —Confidential
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Through the stress testing , we will have a picture on how much amount of loss will
occur at what level of probability. The risk appetite is to ask if senior management can
tolerant of.
Probability of
loss
Target Rating
1 in 3
1 in 10
1 in 20
Loss
Scenario 1 12
Scenario 2 20
Scenario 3 40
Unexpected loss
Expected loss Current Available Bank Capital
5 1,000 Tail Risk
Size of Asset
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Stress testing is wildly used by best practices and serves as an important factor to
decide risk appetite …
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..and also bank should demonstrate the financial health under stress scenarios.
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ANZ faced a catastrophe in 2001, and determined a target 3.5% of loss rate as
ANZ’s ‘RISK APPETITE’ and ‘RULE of THUMB’ as well.
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Citi Bank establishes limits by segment to manage risk and to balance return on
capital as well.
2009 Prepared by Eric —Confidential
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For the portfolio limit, the stress testing play an important role in identifying the
risk appetite and guide the managers to set a proper limit...this also list in Pillar 2.
Credit concentration risk Concentration is mandated in Pillar 2
774. A bank’s framework for managing credit risk 777. In the course of their activities, supervisors should
concentrations should be clearly documented and should assess the extent of a bank’s credit risk concentrations,
include a definition of the credit risk concentrations how they are managed, and the extent to which the bank
relevant to the bank and how these concentrations and considers them in its internal assessment of capital
their corresponding limits are calculated. Limits adequacy under Pillar 2. Such assessments should
should be defined in relation to a bank’s capital, total include reviews of the results of a bank’s stress tests.
assets or, where adequate measures exist, its overall Supervisors should take appropriate actions where the
risk level. risks arising from a bank’s credit risk concentrations are
775. A bank’s management should conduct periodic not adequately addressed by the bank.
stress tests of its major credit risk concentrations
and review the results of those tests to identify and
respond to potential changes in market conditions that
could adversely impact the bank’s performance.
2009 Prepared by Eric —Confidential
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Based on the max loss tolerance we then design a method to translate the risk
appetite into limit boundary.
Diagnosing Current Risk Appetite Establish the Analyzing the Managing Limit
Portfolio Determination Limit Structure Breach Cases Structure
1 Name level limit Portfolio level limit Illustrative
2
1. Finding a rule to translate the 1. The Stress testing results
max loss tolerance into ceiling
Loss
• Risk capital Limit
Tolerance
Scenario Current P&L
Maximum Exposure for the • Current market
1 EL 5 10
investment grade is based conditions
on risk appetite Loss in
• 1 in 3 Year excess of The results of
2 Slope of the curve is a 8 2
Recession EL stress testing
function of PD, LGD,
EAD, Tenor and asset serve as a
correlation • 921 communication
Loss in
Earthquake platform for
excess of 10 0
senior managers
• 1 in 10 Year EL
to discuss with
• Subprime Loss in the consideration
Rating Grades excess of 20 -10 of economic
• 1 in 80 Year EL situation
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Our portfolio limit structure clarifies risk appetite for different sub-portfolio.
Illustrative
2 Portfolio limit structure
Recommendation
Area Explanation of Limit Boundary Concern
Industry 1 • Evidence of overheating in the market • YY BN High
• Allow business growth at industry level, but review
in detail high risk real estate accounts and limit to
certain location
Industry 2 • Cash cow • X% of total exposure Medium
• Profitability / vulnerability to credit shocks are main
considerations for setting risk appetite
Product • There is not a significant portfolio concentration, • Z% of total exposure Low
though, still need to monitor.
High Risk • Prevent from over concentration in speculative • % of total exposure Medium
Rating Grade grades
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Diagnosing the current portfolio to see if there are any breaching cases before
formally implementation.
Diagnosing Current Risk Appetite Establish the Analyzing the Managing Limit
Portfolio Determination Limit Structure Breach Cases Structure
Illustrative
Single name Portfolio name Re – design limit ceiling
•Analyzing if there are clients •Examining the relationship and •Based on the feedback and
that exceed the limit. profitability generated by clients internal communication and
•Identifying if these are negotiation to set final proposed
exceptional (such as State own limit metric for this year.
corporations, or guaranteed by •The limit framework requires to
government) review each year.
•Examining the relationship and
profitability generated by these
breach lists
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Limit setting is a reflection of both of a bank’s risk appetite and risk culture.
AGENDA OF TODAY
Definition of concentration varies. The core element of identification is: one or
1. How dangerous
few sizable segments or obligors might cause significant losses that
the concentration
jeopardize bank’s solvency.
risk could be
The credit limit boundary is driven by the risk appetite that determined
3. How to set limit annually. Following the appetite we express the limit boundary in exposure for
boundary easier to communicate internally and daily business management.
Setting limit doesn’t represent there is no exception and limit
3. What’s the daily banking business. Instead, it is a alarm signal to warn
management management team to pay additional attention on the potential
risk.
2009 Prepared by Eric —Confidential
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Whether if limit setting mechanism workable, it all relies on the risk culture of a
bank.
Diagnosing Current Risk Appetite Establish the Analyzing the Managing Limit
Portfolio Determination Limit Structure Breach Cases Structure
Illustrative
Legal limit cap
Many daily
• 對於各項信用風險曝險所設定之絕對上限，
discussion
除非取得董事會核准外，不得超越此一上限
requires
Limit 。 Marketing and
Ceiling Credit’s
• 對於各項信用風險曝險所設定之警戒線
collaboration and
，當任何曝險超過警戒線時，即應進行
wisdom to
曝險之調節或控管，或採取適當的處置 operate.
方式。 After-all, both of
Warning the marketing
Trigger and credit are
work for the
interests of
shareholders.
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The ‘limit framework’ is only a means to control risk not a tools can reduce risk.
Solution of expansion & constraint
Industry Portfolio Limit Local Overseas
boundary Market Size Opportunity Solution Challenge
•CDS •Subprime adds more
Y N
Hi-Tech
difficulty
•CLO
Room for •Usually for the
Service N Y
expansion •Buy insurance
transaction based lending
Financial Y Y •Most common
•Loan sell
Telecom Y
•Sub -participation
Manu-
Reduce exposure
facturing Y
Limit Capped
Current Exposure
Risk needs to be transferred instead of simply being controlled.
However, the reality is, it is difficult to execute portfolio hedge.
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In conclusion, limit structure is a common agreement between BU and Credit that
reflects senior manager’s ‘risk appetite’.
It is not a ‘RISK’ driven but an outcome of consensus and self-discipline.
Most bankers haven’t time to contemplate on what their ‘risk
appetite’ are, due to lack of information…
…but easier to budget a ‘profit appetite’…
Hunger for ‘RETURN’ without a pre-defined
…limit boundary is an important way to balance risk/return
and to facilitate the communication . appetite of ‘RISK’ can lead to disaster
Illustrative value distribution • How much you might be lost when an
Probability unexpected event happen ?
Stress test the Happy test the • How much loss are you able to and
risk appetite profit appetite :
annual target willing to absorb based on the current
Conservative Scenario
Profit =0
profit momentum / BIS target ?
• Based on the above information
Normal Scenario
management team make decision for
BIS Ratio
below 8% setting risk appetite.
Capital wiped out
Aggressive • Based on the appetite, BU and Credit
Scenario
set a common agreement for the ‘Limit
-10,000 -5,000 0 5,000 10,000 Ceiling’ for this year.
2009 Prepared by Eric —Confidential
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