Warm welcome! If you have risk management or related expertise create an account by clicking here and help improve the Risk Manual.
Can't find what you were looking for? Click on the feedback window at the bottom and we will try to help!

Best Practices in Credit Portfolio Management

This page offers a concise summary of what might be considered Best Practices in Credit Portfolio Management' (CPM). The content builds loosely on the original publications of IACPM[1], the BIS[2] and other sources. For the definition and objectives of CPM see Credit Portfolio Management. CPM may practised by a wide range of entities. This summary aims to be (to the degree possible) agnostic about whether the firm managing the portfolio is a bank, a credit insurer, an asset manager or any other institution exposed to a portfolio of credit risks

Caveats

  • Credit Portfolio Management is defined here more narrowly than Credit Risk Management
  • The best practices outlined here apply to business models that involve ongoing exposure to credit risk (sometimes denoted as buy-and-hold or hold-to-maturity business) as opposed to business models built around exchange based (or OTC) trading of credit risk, e.g. via credit risk sensitive instruments such as bonds or credit derivatives (Trading business models are generally assumed better managed under Market Risk Management, although with significant more difficulty and model risks than trading in more liquid markets)
  • There is an assumption that the credit portfolio is of a certain size so that a portfolio management approach is meaningful
  • As a corollary of the previous point, there are meaningful resources dedicated to portfolio management, either as dedicated or shared responsibilities
  • These best practices are focusing on optimal intrinsic management of credit portfolios and may or may not automatically satisfy (any) regulatory requirements
  • Last but not least, after the great financial crisis various new concepts and practices are being increasingly used and a new best practices list is by nature an ongoing project

Best Practices Grouping

The best practices list can be grouped for convenience in five conceptual groups

  • The Organization and Mandate of the CPM function
  • The Factual Basis (Data) underpinning the framework
  • The Credit Portfolio Modelling Framework
  • The use in Business Operations
  • Linkages with other internal / external frameworks and requirements

Organization and Mandate

1: Clear Portfolio Management Mandate

  • Formal and Clear mandate by the firm's management / other stakeholders as to what are the objectives and policy instruments available for credit portfolio management activity
  • Items of such a formal mandate may include
    • Concentration risk management. Mitigation of event risk (headline risk) by reducing single-name and industry concentrations.
    • Assessment of the risk capital required to support the extension of credit and capital planning
    • Managing NPL, reducing exposure to deteriorating credits
    • Improvement of the risk-adjusted returns of the portfolio

2: Effective Organizational Structure

  • Clear roles and responsibilities within the organization
  • Clear delineation of "ownership" relation with the managed portfolio (owner or advisor role)
  • Execution independence for CPM specific transactions
  • Regulatory compliance of the CPM function

3: Availability of Suitable Expertise

  • Credit risk skills (analysis, origination, monitoring) and portfolio management experience
  • Risk analytics knowledge for monitoring and optimising the portfolio
  • (Where suitable) market / credit trading experience

Factual Basis (Data)

1: Portfolio Completeness

CPM provides a materially complete view of the credit portfolio and its risk profile

  • Avoiding silos along business lines, product or client segments
  • Avoiding blind spots such as credit risks emerging not as primary business activity

2: Portfolio Aggregation Consistency

CPM data aggregation is part of the firms overall Risk Data Aggregation process and potentially other business data aggregation. The process must

  • Avoid different assessment / view of risks depending on business line / origination channel
  • Ensure consistent metrics of credit risk
  • Provide risk based grouping of obligors

3: Accurate Single Obligor Aggregation

  • Aggregating all exposure to a given legal entity irrespective of where it might arise in the business
  • Use of such aggregated metrics in limits monitoring and concentration / correlation analysis

4: Portfolio Aggregation at Sufficient Granularity

  • Enable identification of concentrations

5: Portfolio Data Availability

  • Static (Reference) Data
  • Transaction Data (Product Data)
  • Historical Data (Cashflows, Valuations etc)

6: Portfolio Performance History

  • Internal Risk Metrics as function of time
  • Provisions
  • Relevant external loss data

7: Portfolio Data Quality

  • Processes for reviewing data at the time of entry
  • Data Integrity Validation and reports
  • Regular reporting of the data
  • Data filtering

8: Portfolio Metadata Management

  • Mapping between internal and external identifiers
  • Linking of data fields to established public standards such as the EBA NPL Template

Credit Portfolio Modelling Framework

1: Objective Risk Based Analytical Framework

The CPM framework aims to represent as faithfully as possible the current state of the portfolio

  • Comprehensive framework that covers all relevant risks
  • Culminates into an overall risk capital (or other similar comprehensive metric)
  • Targets the most objective possible (economic) view of risks (as distinct from regulatory or accounting views) (NB: The introduction of IFRS 9 / CECL removes the large discrepancies of previous accounting standards but does not completely eliminate them)

2: Enable Scenario Analysis and Stress Testing of Credit Assets

  • Support analysis and stress testing under a complete range of probability-weighted scenarios
  • Create probability-weighted estimates of individual credit loss under the different scenarios (see for example Monte Carlo Simulation of Credit Portfolios)
  • Take into account all material interactions and correlations (Establish Correlation as First Class Risk Parameter)
  • Aggregate portfolio risk metrics at various levels of granularity
  • Allocate (where applicable) risk metrics back to individual contributions

3: Enable Scenario Analysis and Stress Testing of Liabilities

The CPM framework provides scenario analysis linking asset to liability performance

  • Adequate representation of (any) liabilities (capital structure)
  • Realistic and where possible validated connection between asset performance and liability performance (including assumptions about refinancing ability)

4: Management of Inherent Model Risk

CPM recognizes and manages the significant model risk inherent in credit portfolio models

  • Model Risk Transparency and Quantification (Alternative Models)
  • Adoption of transparent Open Source modelling frameworks
  • Model Validation Function (Ensure independent view as separate from possible commercial bias)

Embedding and Use in Business Operations

1: Clear Objectives

The CPM organization and resources aim to serve fulfilling defined Objectives. Objectives are defined in terms of measurable Performance Targets with specific quantification formulas and applicable time periods

  • CPM Objectives should align with the institutional mission and strategy and Risk Appetite
  • Objectives should align with the stated CPM mandate to ensure realizability
  • Multiple Objectives should minimize conflicts but in any case should be managed jointly
  • Examples:
    • Portfolio Guidelines
    • Internal Risk Measures
    • Revenue Targets
    • Risk/Return Ratios
    • External Benchmarks

2: Manage Risk Appetite via a Limit framework

CPM contributes to the firm's Limit framework. These limits should incorporate the essential insights produced by the CPM analytical framework

  • Establish Limits based on various indicators, both
    • Direct Notional / Exposure and
    • Model based Risk Adjusted indicators (e.g. by attributed risk capital)
  • Set and monitor Limits for the various types of portfolio driven Concentration Risk
  • Set and Limits for portfolio Correlation Risk and Contagion effects

The limit framework benefits from clearly defined and agreed governance within the firm

  • Clear specification of limit type (soft / hard limits)
  • Articulation of escalation procedures
  • Articulation of actions post limit breach
  • Reporting framework

3: Use in Stress Testing

The CPM platform supports a flexible Stress Testing program that

  • reflects all available information
  • is forward looking and comprehensive in its scenarios
  • is consistent across portfolios and across time
  • has top-down elements that focus on macro-economic factors
  • has bottom-up elements that focus on portfolio specific factors

Results from stress testing are used

  • identify portfolio vulnerabilities
  • establish and manage sensitivity to concrete risk factors
  • inform limit setting
  • inform Capital adequacy planning

4: Portfolio Transactions

CPM may support or perform any portfolio transactions within its mandate and towards fulfilling the portfolio management objectives. Such activities may include:

5: Embedding Objectives In Employee Contracts

  • Aligning incentives with CPM / firmwide objectives via the use of CPM generated measures

Internal / External Linkages

1: Consistency with Other Reporting

CPM Metrics and Reports must have a well established relationship with other reporting frameworks (where applicable), with an established waterfall report explaining the differences. This applies for examples:

  • Reconciliation with Financial Statements
  • Alignment with Accounting (IFRS 9 / CECL)
  • Reconciliation with Regulatory Reporting

2: Adequate External Reporting

CPM generates or enhances reports and disclosures:

  • Annual Reports, presentation materials for investors
  • Supervisory Authority Reporting
  • Rating Agency Discussions
  • Open Data Sets (downloads from company portal)

Reporting provides transparency versus CPM mandate, portfolio state and dynamics, management methodology and results

References

  1. IACPM, Sound Practices in Credit Portfolio Management, 2005
  2. BIS, Range of Practices and Issues in Economic Capital Frameworks, March 2009

Contributors to this article

» Wiki admin