Credit Risk Management
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1 Credit Risk Management Alain Louvel Head of Risk Management, North America BNP Paribas Enterprise Risk Management for the Oil Industry Mexico City November Hosted by: Petróleos Mexicanos
2 What Is Credit Risk? At the single counterparty level: risk of loss arising from changes in solvency or from the default of a counterparty, resulting from Specific Risk (evolution in the counterparty s specific risk profile) Systemic Risk (evolution of the counterparty s country environment or industry sector) At the institution level: Aggregation of single counterparty credit risks Excessive concentration on a given industry, country... Granularity 2
3 Measuring single transaction credit risk Assessing two key parameters Probability of default of the counterparty I.e. counterparty rating Recovery rate (or loss given default -LGD-) assuming a payment default has occurred estimating exposure at default (EAD) depending on transaction structure, collateral, asset values etc Expected loss The missing parameter? The real killer: still to be uncovered... 3
4 THE UNEXPECTED LOSS 4
5 What is Credit Risk Management? Risk-Taking Policies Types of counterparties? Transaction structures? Processes? Measurement Methodologies and models to measure and analyze risks? Single Credit Analysis Classical and/or market-based? Credit Risk Management Analysis / anticipation of credit environment Country & industry risks Approval Control / Monitoring Are risks correctly accounted for? Are they reviewed in a timely fashion? Portfolio Analysis Reporting Excessive concentrations, portfolio effects, stress-testing 5
6 Credit Risk Management: What for? Not a single/simple answer To ensure that no losses due to counterparty default will happen? To ensure that losses due to counterparty defaults are kept within acceptable limits? 6
7 What Are «Acceptable» Limits? Variable from one institution to another, depending upon: the type of business and its overall risk profile management risk appetite the ability or willingness to incur credit losses in regards to: Performance targets Own credit standing, ratings objectives risk/return objectives In all cases, this is a Top Management or Board of Directors issue 7
8 How to Determine Acceptable Limits? The question to resolve is: What maximum credit loss is the Institution willing or able to withstand in a given period, at a given confidence level? Unexpected loss Expected loss Volatility Beyond Expected Loss, Economic Capital Quantifying expected loss only is a simple but wrong solution: «unexpected» is the risk (and a lesson from recent experiences is that unexpected occurs) Expected losses are to be compensated for by pricing ; maximum losses, beyond expected ones, are to be sized in relation to the enterprise actual capital 8
9 How to Measure Economic Capital? Data Model Counterparty Probability of Default (PD) and credit migration Country / Industry Sector Transaction Time Horizon Stand-alone Credit Risk Portfolio Effect Correlations Systemic risks Countries / industries Confidence Interval Depending on targeted rating Exposure at Default (EAD) Maturity Expected Loss Loss Volatility Economic Capital Loss Given Default (LGD) Confidence Interval Expected Loss Economic Capital 9
10 Economic Capital for Credit Risk: The Challenges IMPLEMENTATION INTERPRETATION A strong internal rating system Accurate PD, LGD, EAD Economic Capital remains a representation of reality Banks rating systems will be validated by regulators (Basel 2 new capital adequacy rules) A robust internal model Top Management must have a good understanding of methodologies and limits Measurement of portfolio effects (asset correlation) Assessment of concentrations and granularity Reliable data & systems Measuring Credit Risk: still an art, more than a science Requiring intensive use of common sense «Garbage in garbage out» Standardization Processing & datawarehousing But greatly enhanced by modern quantitative tools and rigorous methodologies The cultural shock! 10
11 One Challenge Beyond: Integration of All Risk Types Credit Risk Economic Capital must be aggregated with economic capital for other types of risks Market and liquidity risks, operational risks, business risks Requires capability to measure risk diversification effects Beyond measurement, a key challenge is to implement a consistent / integrated risk management chain across all risk categories 11
12 Back to Management Economic Capital at the institution level A key ingredient for value-based management and capital allocation to business lines A powerful risk measure to help manage excessive concentrations and improve portfolio granularity At the counterparty / transaction level Banks: use of RAROC/EVA as a screening tool for individual transactions/counterparties selection RAROC: Risk Adjusted Return on Capital EVA: Economic Value Added Relevance for industrial/commercial companies? 12
13 Risk Management at BNP PARIBAS GROUP GENERAL MANAGEMENT GROUP RISK MANAGEMENT BUSINESS LINES Internal Audit GENERAL INSPECTION Risk appetite is defined at Executive Committee level Primarily responsibility for risk lies with Business lines/territories Group Risk Management ( GRM ) is the second pair of eyes, performing continuous control ex ante. GRM is completely independent from the Business lines 13
14 Credit Risk Management at BNP PARIBAS Head of GRM Credit Risk Industry & Portfolio Analysis and Reporting Basle II Coordination Credit Risk Retail France Credit Risk Corporates Int l Credit Risk Derivatives & Financial Institutions Market & Liquidity Risk Operational Risk Three Departments cover credit risk approval/control functions Involvement in business/credit decisions vary depending upon type of organizations (Retail vs. Corporate or Investment Banking) In all cases, are given final authority for validating individual risk ratings and full control and responsibility on credit risk control One Department covers methodologies (internal rating and models), industry analysis, portfolio analysis and reporting to Top Management GRM organization is decentralized with regional platforms covering all types of risks 14
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