Credit Portfolio Management – The Principles

Credit management is not confined to appraising a particular borrowing proposition. It extends to

managing the lender’s portfolio of credit facilities, in other words, managing the lender’s loan book. The
approach to managing a credit portfolio is similar to that of managing an investment portfolio.

The essence of portfolio risk management is to manage concentration risks of the lender. Concentration
risk is the risk that the bulk of lending will be made to one particular type of borrower or to borrowers in
a particular sector of the economy. This amounts to placing all ones eggs in one basket.

Another principle in managing portfolio risk is to identify the profitable segments of the economy and
allocate capital to lending to borrowers in those sectors, at the same time bearing in mind the dangers of
concentration risk. Dedicated staff should therefore be appointed to continuously monitor developments
in the economy and advise management accordingly. Related to identification of profitable segments is
the setting of limits for each sector e.g. 20% lending to agric, 10 % to manufacturing and so on,
depending on the assessed risk pertaining to each sector.

Portfolio Risk Management refers to the management of the bank’s credit exposure as a portfolio
of assets using portfolio management tools adopted for the anagement of investments portfolios.

The philosophy underlying portfolio management is that the bank exposes itself to a high risk
when the bulk of a bank’s loans are concentrated in a specific sector, or other subdivision of the
bank’s portfolio. If that particular sub-division fails, it would have a significant impact on the
bank’s capital and profits.

The key to portfolio management therefore lies in spreading the bank’s risks across the various
sub-divisions of the portfolio, thereby keeping risk at a minimum.
Another important key is the correlation between two or more aspects of the portfolio. Where
two subsectors show a strong correlation in terms of profitability, it is better to treat them as one.

Credit portfolio management involves continuous measurement and monitoring of the risks and
returns associated with the various constituents of the portfolio and restructuring the portfolio in
the light of developments in the markets and within the various sectors of the portfolio.

Principles of Credit Portfolio Management

A review of literature shows that there are a number of principles underlying credit portfolio
management. These include:

 Credit Culture and aggregate policy and underwriting exception system

 Identify the role and mandate of CPM function
 Definition of portfolio to be managed
 Portfolio segmentation and Risk Diversification objectives /Setting of portfolio objectives
and risk tolerance limits and
 Standardize risk measures and models
 Manage concentrations/ Rebalance portfolio to achieve strategic objectives
 Stress testing of portfolio
 Management information systems – deal with data issues
 Align accounting conventions with portfolio management practices
 Independent and effective control functions
 Transparency in disclosures

Credit Culture

Understanding the credit culture and risk profile of a bank is central to a successful loan portfolio
management (OCC, 2000). It is important that staff understand the bank’s credit culture and risk
profile. Such knowledge should be widespread in the organization and should be disseminated by
an institution’s Chief Credit Policy officer to accounts officer as well as administration support.

Features of Credit Culture

A bank’s credit culture is the sum of its credit values, beliefs and behaviors e.g. speedy credit
delivery, zero tolerance for connected credit, attitude to deterioration in the credit portfolio.
Approach to evaluating credit risk – accuracy in credit appraisal and the use of analytic in
managing the loan portfolio.

The credit culture relates to what is done in credit and how credit goals are accomplished. The
credit culture exerts a strong influence on a bank’s lending and credit risk management. Values
and behaviors that are rewarded become the standards and will take precedence over written
policies and procedures.

Credit Risk Profile

A bank’s credit risk profile is more measurable than its credit culture.
A risk profile is a description of the various levels and types of risk in a portfolio.
It is determined by the credit culture, strategic planning and day to day activities of making and
collecting loans. The risk profile changes over time as portfolio composition and internal and
external conditions change.

Bank Credit Policy

The credit policy provides a general framework and guideline for management of credit in the
organization. It provides organization wide standards for credit management. It also provides a
direction for the credit management process.
The credit policy is very essential in ensuring operational consistency and adherence to uniform,
sound practices.

A credit policy should normally provide for the following:

 Detailed and formalized credit evaluation/appraisal process.
 Credit approval authority at various hierarchy levels including authority,
processing/reporting, for approving exceptions
 Limits on aggregate loans and commitments
 Risk identification, measurement, monitoring and control
 Risk acceptance criteria
 Credit origination and credit administration and loan documentation procedures.
 Roles and responsibilities of units/staff involved in origination and management of credit.
 Target markets
 Portfolio mix
 Price and non-price terms
 Reporting requirements
 Off balance sheet exposure
 Guidelines on the management of problem loans.

Identify the Role and Mandate of the CPM Function

Another key principle of CPM is putting in place the role and mandate of the CPM function. The
board or senior management must give the CPM function a clear and formal mandate if it is to be
effective in managing an institution’s credit risk.
The mandate of CPM usually expands from defensive oriented ‘rule of thumb’ measures around
concentrations and credit concerns as to more offensive minded elements of CPM including the
adoption of return oriented approaches

Mandate of CPM Function

The mandate of CPM may revolve around the following goals

 Improvement of risk adjusted return of a retained credit portfolio

 Mitigation of event risk (headline) risk by reducing single name and industry concentrations
 Reduction of exposure to deteriorating credit
 Minimization of economic capital required to support the extension of credit
 Increase velocity of capital so that they could be redeployed in higher margin activities.

Delineation of Responsibility

Organization roles and responsibilities should be clearly documented including the relation
between credit origination, credit approval and portfolio management

Core Competencies of CPM

The CPM function should be staffed by a combination of individuals with core competencies in
the following areas:

 Fundamental credit experience

 Quantitative analytics
 Market/credit trading experience

Definition of the Portfolio to be Managed

IACPM recommends that the lender should define the portfolio to be managed. The first step in
portfolio management is to define distinct loan classes and classify the various components of
the portfolio into the different categories. An institution should manage all credit risk generated
through its business activities

The portfolio should be aggregated on a consistent basis. All credit risk of the obligor should be
aggregated. Credit should be managed on a holistic basis taking into consideration the correlation
between the different elements of the portfolio.
The portfolio manager should group assets that behave similarly and aggregate portfolio
according to consistent criteria.

Some characteristics that could be considered include:

 Default probability
 Recovery estimates in terms of
 Geography
 Legal system
 Facility structure
 Type of credit.

Categories

 Commercial
 Industrial loans
 Real estate
 Consumer
 Corporate
 Other Examples
 Borrower’s industry
 Geographic area
 Collateral
 Tenor
 Facility structure
 Risk rating

Detailed Classifications

 Loans to consumers working for the same employer or in the same industry
 Loans to commercial companies that are dependent on the same suppliers or that sell to the
same consumers
 Loans to affiliated borrowers
 Loans to industry sectors that are likely to react in a similar manner to a change e.g. trucking
and airline industry due to sensitivity to oil prices.

Multiple Characteristics

In view of the fact that loans have multiple characteristics, it is possible that they would be
included in more than one portfolio segment. For example, a construction loan may be included
in real estate, geographic concentration and non-amortizing loans.

Setting Loan Portfolio Objectives

A bank must set portfolio Objectives And Measure Performance. Risk diversification is a basic
tenet of portfolio management. Managing the portfolio includes managing any concentration of
risk. By segmenting the portfolio into pools of loans with similar characteristics management can
evaluate them in the light of portfolio objectives and risk tolerances, and when necessary develop
the strategies for reducing diversifying or otherwise mitigating the associated risks.

Loan portfolio objectives establish specific measurable goals for the portfolio.
They are informed by the credit culture and risk profile of a lending institution.

Overarching Objectives

The overarching objectives for granting credit are:

 To grant loans on a sound and collectible basis – repayment

 To invest the bank’s funds profitable for the benefit of shareholders and protection of
depositors
 To serve the legitimate credit needs of their communities
 Reputation
 Relationship

Specific Credit Objectives

Credit objectives should proceed on strategic plans put in place by the board an senior
management of a bank. The plans should be consistent with the strategic direction and risk
tolerance of the institution. They should be drawn with a clear understanding of the risk reward
consequences of credit. They should be review periodically and modified as appropriate.

In drawing strategic objective, senior management and the board should consider establishing:

 What proportion of the balance sheet the advances portfolio should comprise
 Goals regarding loan quality
 Goals for portfolio diversification
 How much the portfolio should contribute to the bank’s financial objective
 Loan product mix

Specific Objectives should include:

 Loan growth targets by product, market and portfolio segment

 Product specialization
 What the bank’s geographical markets should be
 Targeted industries
 Targeted market share
 Community needs and services
 General financial objectives e.g. increase in fee income.
 
The Portfolio Management Function should have clearly defined performance
management standards

To be effective, performance management standards and targets must be measurable and specific
with regard to type of measure, relative importance of the target and period of measurement. It
must be noted that some targets may conflict e.g. management of regulatory capital and return on
capital targets.

There should be a clear understanding of the relative priority of each measure and any minimum
requirement for each performance metric
Performance measures may take many forms including revenue targets, risk/return ratios,
internal risk measures, portfolio guidelines and external benchmarks.

However defined, portfolio measures need to be relevant to the institution’s overall business plan
and clearly understood by senior management

Role of Senior Management In Setting Targets

Senior management must participate in setting and agreeing on performance measures and
targets, both to ensure that they have a clear understanding of the measures and objectives that
will drive management of the portfolio and to ensure that these are consistent with the strategy
being implemented elsewhere in the institution.

Portfolio measurement targets should be consistent with the mandate of the portfolio
management function.

Standardize Risk Measures And Models

The institution should define a risk-based economic valuation framework that permits it to assess
and report its credit business. Risk measures are key building blocks to set up and perform
effective credit portfolio management. With the increasing complexity and volume of credit
portfolio of most financial institutions, portfolio management can no longer be practiced on the
basis of qualitative analysis only but must be supported by sound quantitative measures.

Financial institutions normally subjected to external capital constraints imposed by regulators

and rating agencies. Nonetheless each institution should define its own risk measures. The
valuation framework should encompass all products and risk contained in the portfolio. It should
permit the institution to estimate the economic values of the products under both actual and
hypothetical scenarios. It should account for credit quality tenor, structural credit risk, mitigation
element and embedded options

Economic Value Added

The institution should compute a value distribution for its credit portfolio that captures
deviations in economic value from the expected.
Measures typically used include:

 Value at risk (percentile) or shortfall (expected value above the percentile) at a given
probability level of the value distribution both of which capture the size of losses in the tail
 The standard deviation(or a multiple thereof) can be used if no fail risk measure is available

The value distribution should reflect changes in the portfolio’s economic value that can occur
due to both defaults or quality and migration

Default Impact

The default impact will be based on

 The frequency of default

 The severity of the default

Representing respectively the probability of default and the losses from such event
The migration impact will be assessed by estimated change in economic value upon transition to
a different risk grade.

Key Elements of Model

Key elements that must be addressed by the models include;

 Default frequency
 Severity of loss
 Credit migration
 Interdependency of risk – correlation
Severity of Loss

This is defined as the product of exposure at default and Loss given Default
Since uncertainty of severity tends to be fairly high it should be modeled as a stochastic variable
that incorporates volatility around the severity of loss estimate and the interrelationship between
probability of default and the severity of loss
Then the parameters will be obtained from historical data that the institution will have collected
over time, or from product specific studies performed by e.g. credit rating agencies. Severity of
loss will depend on factors such as seniority, security, industry and jurisdiction.

Statistical Distribution

Most institutions will use a pre-determined time horizon to compute the portfolio value
distributions and related risk measures

When obtaining a portfolio value distribution, a key ingredient is the interdependency of risks –
often measured through correlation

Level of Granularity

The institution’s risk measure should have the level of granularity sufficient to identify major
risk concentrations. As an input to rebalancing actions of the credit portfolio, the institution
should be able to break down the measures of expected loss and capital to relevant sub-
portfolios. The level of granularity should match the institution’s ability to change the size of
these positions by buying risk, selling risk or performing other portfolio actions.

Validation of Models

Institutions may use different model types including:

 Probability of default models (PD)

 Recovery models (LGD)
 Utilization models (EAD)
 Asset valuation models (VaR)
 Economic Capital models (EC)
 Risk adjusted performance models (RAROC and EVA)

Validation processes and governance around these models should be estimated and approved.
Validation consists of three components:

 Vetting
 Review of Parameters and Assumptions
 Back-testing
The models should be continuously vetted to ensure that they are appropriate for the purpose
intended and are calculating correctly. Models are based on assumptions which the institution’s
management must review and approve.
CPM function should begin building the internal data set that would be used for back-test and
also investigate data-pooling exercises.

Manage Concentrations/ Analysis Of Portfolio Risk Reward Trade-Offs

The goal of portfolio management is to achieve the desired balance of risk and return for the
portfolio as a whole. Management should have performance standards, risk tolerance levels and
business goals for each concentration and it should be able to relate these to the overall loan
portfolio management strategy.
Smaller banks may have geographical concentration. Larger banks may develop concentration of
risk through mergers or gain leverage or build on industry expertise

Understanding Determinants of Portfolio Risk

Borrowers in portfolio concentrations exhibit similar financial characteristics such as capital

sources, repayment sources and balance sheet structure. Management should identify the
common characteristics that influence credit risk. Focusing monitoring efforts on common
characteristics simultaneously simplifies and strengthens the supervision of risk within the pool.
Stress testing using common financial indicators will determine which pools are most vulnerable
to credit risk and require increased attention.

Concentration management strategies include:

 Setting exposure limits or ceilings on concentrations

 By changing composition:
 Increasing geographical diversification
 Altering product mix e.g. reducing commercial lending and increasing consumer lending
 Changing risk profile of target market
 Turning from middle-market non-investment grade customer to well-capitalized investment
grade customers
 Assets sales – whole asset or portion through syndications, sell participations and securitize
certain types of loans.
 Credit derivatives.

Each of the approaches entails risk/reward tradeoffs that must be evaluated in the light of the
bank’s strategic objectives

Stress Testing of Portfolio

The institution should have a ‘top down’ stress testing process in place to analyze the impact of
‘extreme economic events’ on the credit risk of the overall credit portfolio. The main objective of
stress testing is to inform management about the portfolio’s vulnerabilities and to establish the
portfolio’s sensitivity to risk factors.
Stress testing may also help in setting or refining limits, defining contingency plans, planning for
liquidity, identifying migration issues.

Categories of Stress Tests

There are two main categories of stress testing:

 Scenario testing
 Sensitivity testing

Scenario Testing

Scenario testing evaluates the impact of particular events (deemed as stressed) on the portfolio,
the events may be actual or hypothetical. One defines an event and determines its impact on
‘stressed’ parameters such as PDs and LGDs as a result of the event and then compute the
economic capital or some other measure.
Approach to Stress Testing

The institution should also supplement a ‘top down’ approach with a ‘bottom-up’ stress testing
process to measure the impact of adverse events on obligors with significant exposures in the
credit portfolio.

In this case, one is concerned with the impact of events or scenarios on specific exposures or
obligors.

The institution necessarily has to rely on expert judgment for the selection of scenarios and their
impact on exposures or obligors

Sensitivity Tests

Sensitivity tests are normally statistical in nature. They aim to establish the impact of a change in
one or more risk drivers or parameters in the portfolio. E.g. the impact of a 5% increase in
default probability of the risk measure.

MIS – Dealing With Data Issues

A management information system is key to portfolio management. Such a system should

include both on and off-balance sheet exposure. If a bank lacks adequate data on each loan or
does not have a system to slice and dice the data for analysis, management’s ability to manage
the loan portfolio would be compromised. Identifying the concentration is half the job,
understanding the dynamics of the concentration and how it will behave in different economic
scenarios is the other half

A bank must strive to understand the various segments of the portfolio.

For example, if the bank has significant exposure in the communications industry, it should be
able to monitor developments within that industry, track the performance of the portfolio
segment, and relate developments in that segment to the portfolio as a whole. The portfolio
manager must have in mind, synergies and correlations.

Align accounting conventions with portfolio management practices

 
Options available in official accounting rules should be:

 Used to reveal the true economics of positions.

 Applied in the context of defined risk management policies and strategies.
 Options include valuing assets at fair value – Held for Sale or at amortized value – held to
maturity

Independent and Effective Control Functions

Besides the loan policy, the primary controls over a bank’s lending activities are its credit
administration, loan review, and audit functions. Independent credit administration, loan review,
and audit functions are necessary to ensure that the bank’s risk management process, MIS, and
internal and accounting controls are reliable and effective. The bank’s control functions can also
provide senior management and the board with a periodic assessment of how the bank’s
employees understand its credit culture and whether their behaviors conform to the bank’s
standards and values.

Transparency in disclosures

The institution should disclose:

 The mandate of its credit portfolio management function

 Summary credit portfolio data
 The products and structures used to manage the portfolio.
 The results achieved by its portfolio management activities.

Summary/Conclusion

The principles enunciated above are time tested principles underlying credit portfolio
management in banks. Credit portfolio management is based on common sense principles which
when applied can greatly contribute to the fortunes of a financial institution. Neglected, it could
spell the ruin of the financial institution