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CREDIT RISK SOLUTIONS

From Standard & Poors Risk Solutions
NOTE
Part I of our Facility Risk Rating Systems feature appeared in the November / December 2004 issue of Credit Risk Solutions. Part II appeared in Credit Risk Solutions First Quarter 2005. Parts I & II have been combined in this Web version, which is also downloadable as a PDF file for the convenience of our readers.

Facility Risk Rating Systems

Part I: The Key To Complete Credit Risk Assessment
Combining advanced techniques for deriving Probability of Default and Loss Given Default estimates allows banks to create complete internal risk rating systems.

Part II: A Two-Dimensional Approach

Managing credit risk on loan portfolios means looking at individual facilities at origination and going forward significantly enhanced by adding an effective facility risk ratings system.

CREDIT RISK SOLUTIONS

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disinvestment options, and a reduced level of lazy capital caused by inaccurate loan-loss provisioning i.e. capital not providing an optimal return to the shareholder. And, of course, in this era of focus on international banking regulation, Facility Risk Ratings are a cornerstone of the dual rating requirement of the Advanced Internal Ratings Based Approach of the Basel II proposal. Facility Risk Ratings provide banks with more precise loan-loss provisioning methodologies with a more accurate estimate of the cost of credit. Under accrual accounting systems, the loan-loss provision impacts the income statement and unused provisions are held in the loss reserve account on the banks balance sheet, says Kearns. These loan-loss provisions are typically set using the banks internal ratings which should reflect the banks expectations for the future cost of credit. Using expected loss to calculate loan-loss provisioning increases its accuracy allowing it to be attributed to individual loans, borrowers or larger aggregations. And such dynamic budgeting can be refined as portfolio credit quality changes. I know a number of banks who are internally adopting IRB measures while officially adopting the Standardized (Continued on Page 3)

Facility Risk Rating Systems: The Key To Complete Credit Risk Assessment
Combining advanced techniques for deriving Probability of Default and Loss Given Default estimates allows banks to create complete internal risk rating systems.
FACILITY RISK RATING SYSTEMS - PART I
As global head of Credit Risk Services for Standard & Poors Risk Solutions, Gary Kearns talks with a lot of banks. Yet he is surprised by the similarity of responses to the problems posed by calculating credit risk on loan portfolios. Bankers clearly understand the critical importance of the building blocks of credit risk PD and LGD in determining expected loss on individual facilities and portfolios, says Kearns. However, many banks around the world are using a blunt instrument starting with an obligor risk rating and then notching for the facility risk dimension and as a result their risk pricing and economic capital calculations lack precision. Whether banks are adopting the Internal Ratings Based Approach (Advanced or Foundation), or using the Standardized Approach, under Basel II, Kearns believes that all banks need to separately measure PD and LGD. An internal ratings system cannot accurately reflect risk if it does not go beyond borrower credit quality to examine the collateral supporting a loan, says Kearns. High probability of default on the borrower does not necessarily translate into a high expected loss. Collateral supporting such a facility can in fact give it a low expected loss. But if the rating scale only looks at probability of default, it will fail to reflect this. (see chart below) Facility Risk Ratings allow for a more effective discrimination of risk, more precise loan pricing, more accurate loss forecasting, optimal portfolio management, better evaluation of investment and

AAA

Low Risk: Fast Decision Track OBLIGOR RATING

Focus on Accurate Obligor Rating and Covenants

Focus on Collateral Value and Enforceability

LOW RISK

High Risk: Reject, Exit

FACILITY RISK RATING

HIGH RISK

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Approach, says Kearns. They do this anticipating a future transition to the Advanced Approach, but also because it gives them a competitive advantage by knowing which borrowers add to shareholder value and which detract from it, says Kearns. Many bankers dont have a mechanism to determine if they are adequately pricing their loans, or where they should be targeting growth. They tend to make decisions about growth and risk concentration more from gut feel than statistical grounding, and this is dangerous, noted Kearns. The leading edge bankers are analyzing their loan portfolio along the lines of Risk/Reward patterns, he notes. (See chart at right)

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for their loan portfolios, says Kearns. This work includes structured analytical rating frameworks for both obligor and facility ratings, plus an integrated IT platform to implement them. Our primary goal is to design a suitable approach for each bank given their own particular circumstances borrower and market characteristics, areas of concern or growth, and data availability, among other factors. Usually, we start with a judgmental system incorporating the banks experience both credit and line officers and Risk Solutions rich global database of recovery data, notes Kearns. Simultaneously we begin a process to collect data. This dual track approach enables a bank to immediately start using a Facility Risk Ratings framework that gets more robust as data is collected. Ultimately, with the banks own data supported by benchmark data from Risk Solutions, models can be created to show recovery distributions facilitating more robust modeling and risk analysis. If the data doesnt exist, Risk Solutions works with individual banks to build data in a number of ways. First, youd be surprised at how effective even an interim system can be in creating discipline around credit extension and portfolio management, observes Kearns. Second, we are very

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Analyzing Risk/Return patterns allows banks to develop "portfolio improvement action plans" and measure their progress against these plans.
HIGH Who are these customers? Why are they producing above average returns?

RETURN
Who are these customers? Why are they producing below average returns? LOW LOW

RISK

HIGH

Data: The Missing Piece

Many banks want to effectively manage their credit risk with a Facility Risk Rating system, but they often struggle from a lack of appropriate data. Standard & Poors Risk Solutions helps banks build the data and rating frameworks for Facility Risk Rating systems, with a range of services aided by technological advances, data and analytical tools that leverage the long credit experience of one of the worlds leading ratings agencies. Banks are coming to us for help in developing their internal rating systems

creative in helping banks find data, whether from workout units or more unusual places, like bank leasing units that have rich residual value data that can support the process, he notes. Where the time or cost of collecting data is prohibitive, we have led data consortia around the world and in numerous asset classes to provide benchmark data.

Better Credit Risk Management

Facility Risk Rating systems are critical for effective origination and management of loan portfolios

and capital management, whether youre one of the largest banks in the world or a small community lender, says Kearns. Banks should adopt dual rating systems for obligors and facilities as a matter of prudent practice, so that they can effectively price loans reflective of all risks. In most markets around the world, its usually the bank with the weakest rating system that sets the ceiling for loan pricing, Kearns says. If the other banks want to play along, at least they will know how much they are subsidizing the borrower, or how much they need to cross-sell to achieve their target ROE.

CREDIT RISK SOLUTIONS

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Facility Risk Ratings: A Two-Dimensional Approach

Managing credit risk on a loan portfolio means looking at individual facilities, both at origination and going forward, which can be significantly enhanced by adding an effective facility risk ratings system.
FACILITY RISK RATINGS - PART II
The new Basel II Accord will move risk management into the forefront of competitiveness for commercial lenders, says Bill Chambers, a Managing Director at Risk Solutions. Banks now have an increasing appreciation that only by being able to drill into the individual sources of risk which arise from their credit portfolios will they be able to manage those risks more effectively.For those adopting the Advanced-IRB approach to Basel II but for many others as well this means adding a distinct facility dimension to their internal scoring systems. This defines potential loss given default (LGD) associated with an individual exposure, in addition to the traditional one dimensional obligor-focused internal credit scores that are based primarily on probability of default (PD). And Chambers continues: Best practice is the ability to assess and quantify these separate risk elements and to use that knowledge to inform a whole host of risk management in the event of default (LGD). A two-dimensional approach supersedes traditional ratings scales, which have tended to measure risk according to a single scale one that combines PD and LGD considerations in different proportions. But given the fundamentally different factors driving obligor risk and LGD, any single dimensional system will inevitably misrepresent facility risk. In a system with ten grades, for instance, it is possible for a borrower considered to be a good credit risk to be rated nine even if an eventual default might produce ultimate losses of 90%. The nine rating attached to this exposure therefore clearly underestimates the attendant risks. By the same token, the system may rate another facility at two due to perceived weakness in the borrowers credit quality but ignore the presence of a high level of recoverable collateral that significantly mitigates this risk from an economic perspective. Indeed, some would say (Continued on Page 5)

Internal Rating Systems A Business Management Tool

Risk-Based Economic Capital

Portfolio Risk
Facility Rating

Regulatory Capital

Loss Reserves

Sector, Geographic, Credit Quality Limits

Borrower Rating
Trade or Hold Lend / No Lend Decisions Pricing Decisions

decisions from limit and pricing setting to portfolio management and economic capital requirements. (See chart above, A Business Management Tool.) If internal rating systems are the microscope used to examine risk, it is necessary that they focus at the correct levels first the obligors risk of default, which will have an impact on all the various obligations of that borrower, and second, the unique characteristics of each facility and the

protection afforded the lender. This accounts for the actual risk factors that make up LGD, varying from facility to facility, even for the same borrower. Varying risk factors require specific forms of measurement and management, meaning a Facility Risk Ratings System (FRR) is necessary. This focus on facility-specific estimates allows for the use of dual ratings scales that account for both the risks attached to the obligor (PD) and those surrounding recovery prospects

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that the traditional focus on obligor risk allows for less dynamic risk engagement than a renewed focus on recovery prospects allowing, as it does, for performing loans with a high default risk to be retained in the portfolio due to their good recovery prospects. A two-dimensional system allows banks a far more sophisticated range of responses to risks uncovered on new and existing facilities, and for these responses to apply across a range of lending types, explains Chambers. This in turn allows for strategic decisions to be made about where to target growth representing multiple improvements on traditional risk rating systems. Whereas traditional approaches have tended to divide up general and asset-based lending, with the former focusing primarily on default risk and the latter emphasizing collateral and recovery (or loss) in the event of default, facility ratings yield comparable results for all lending. Where traditional approaches only generate nominal (i.e. undiscounted) loss estimates, facility ratings are generally set to estimate real economic losses. Where traditional systems build a retrospective loss picture of limited use when it comes to unrated borrowers that have never defaulted in

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the past facility ratings endeavor to identify recovery drivers that can be considered when originating new facilities. And where traditional approaches have relied on general understandings that secured debt is preferable to unsecured, as is more collateral and stronger covenants facility ratings actually quantify the degree to which recovery value is improved by these respective factors.
associated with different facilities. The FCR framework is one of three interrelated pieces: 1. Exposure: Exposure is calculated by starting with the current outstanding exposure for a particular facility adding potential additional extensions such as future draws against revolving credit facilities. This gross potential exposure is reduced by any readily accessible hard collateral eligible financial collateral in Basel II parlance to arrive at an adjusted, or net, potential exposure. 2. Recoveries: Recoveries in the event of default can come from several sources realization of collateral in the case of secured facilities, liquidation or reorganization of the obligor, or sale of a defaulted or distressed security in the secondary market. Each of these avenues must be explored, though for any particular obligation, one of the three sources usually dominates the others. 3. Facility Coverage Ratio (FCR): Examining the potential recoveries on a facility in the context of the adjusted exposure provides a good estimate of the overall loss potential for that facility and the ability to assign any facility to an appropriate facility or LGD bucket. (See Facility Coverage chart, page 6.) The basic FCR framework can be

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established immediately and fairly simply by most institutions. The degree of sophistication and detail added into the basic framework, and the granularity of its results, can be geared to the amount of information and data available. Furthermore, even if the institution does not initially have detailed information on particular questions, the framework itself can be used to gather and organize data going forward, permitting more sophistication and precision to be added in an incremental manner.

Facility-Specific LGD Estimation

Traditional analysis of recovery and loss potential particularly for collateralized facilities has focused largely on determination of the loan-to-value ratio. This is determined by an estimate of collateral value, usually subject to a haircut (reflecting the lenders degree of conservatism and the volatility in value of different types of collateral) being weighed against the amount of the loan outstanding in the event of default. Risk Solutions has found that an expanded formulation of this approach, termed a Facility Coverage Ratio (FCR), is extremely intuitive, effective and flexible in organizing data surrounding exposure, recovery and loss, says Chambers. It therefore provides an excellent framework for assessing risk

Data Collection
The ability of the FRR to produce accurate estimates is ultimately tied directly to the quality and quantity of the data which the institution can gather regarding both exposure and recovery, Chambers says. This extends beyond the level of exposures and subsequent losses or recoveries, but also to the risk drivers behind these results. What, for example, determines the level of drawdowns against a revolving facility? For a retailer financing inventories, the drawdowns may be closely correlated with seasonality, but for other borrowers different dynamics may apply. Is there a borrowing base covenant in place that regulates (Continued on Page 6)

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exposures against the amount of inventories or receivables pledged against a different facility? If there is collateral pledged, how is the collateral valued both initially and subsequently? And how is the collateral monitored to ensure that it is always in place? How has the actual realization value on that type of collateral corresponded with the a priori valuation? How has the value of different collateral types varied over time, and what key factors were behind this variation? The latter will clearly be instrumental in determining what levels of haircuts should be taken against the nominal value of collateral to provide a better estimate of realizable value. These data collection efforts are made with the aim of creating normative economic loss estimates, especially for assets which do not benefit from secondary or distressed market pricing (for example, to project finance or SME loans).

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economic loss which will be incurred as a result of a default. For immediate sales in a secondary market, the differences between nominal and real loss values tend to be very minor. For workout situations, however, the loss estimates must incorporate estimates, implicit or explicit, of the time lag between default and recovery, and determination of an appropriate discount rate to bring future receipts back to a net present value. To accomplish this objective, data must be collected across a wide range of relevant fields to allow for its use rating future facilities including facility type level of exposure, terms, maturity and repayment profile, collateral, guarantees and covenants, seniority of the debt, and recovery method. This data must also be tied to the borrowers characteristics, since many of those features will also affect and drive the recovery/loss estimate. For example, if recovery takes the form of equity or debt in a reorganized entity, knowledge about the reorganized entitys business will be key in the estimation of loss. But few, if any, institutions in the world currently have sufficient data to be able to estimate LGD properly on a significant portion of their portfolios. This has prompted substantial data (Continued on Page 7)

Developing A Facilities Coverage Ratio

Exposure
Current Exposure

Recovery Potential
Collateral Unsecured Recovery Estimate

+
Additional Draws Value Change / Add-Ons

Haircut(s) Applicable To Each Collateral Type Allocate Collateral to Supported Facilities Eligible Financial Collateral Other Eligible Collateral

=
Exposure at Default

Adjusted Financial Collateral Recovery

Estimate Discount For Time to Recover and Recovery Cost

=
Adjusted Exposure

Facility Coverage Ratio

Collateral + Unsecured Recovery Adjusted Exposure

Recovery Drivers
One of the primary elements of the analysis centers on the process by which a lender recovers value subsequent to a default, says Chambers. Does it immediately try to sell the exposure on the secondary market, or does it initiate a workout process whereby some ultimate value

is recovered after an extended period of time? For traded assets, recovery can be measured according to market pricing including estimating future distressed pricing. Although the choice between workout and sale will usually be determined by circumstance including the portfolio management aims of the bank and the importance attached to the lending relationship there are also intrinsic pros and cons affecting such a decision. Distressed sales may mean immediate recovery

and (relatively) fixed costs, but the liquidity premium required may mean taking an unnecessarily large haircut on recovered value. By contrast, workouts may bring a higher overall recovery for any distressed asset but mean higher costs, more uncertainty and a longer recovery time (with the attendant higher discount rate this implies). Best industry practice, as well as the Basel II requirements, dictates that the bank estimates of the real

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collection efforts internally, as well as efforts to leverage external data sources. Clearly, creating meaningful internal data bases along these lines will require not only considerable resources, but also the passing of sufficient time for a statisticallycredible volume of defaults to actually take place. This will be difficult enough for most parts of the credit portfolio, but particularly challenging for low default rate segments and idiosyncratic credits in the portfolio.

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produce reasonable loss estimates in the immediate time frame and to establish a process that can grow and evolve over time. Such an interim approach needs to strike a balance between robustness, and sufficient flexibility to adapt to changes required internally due to feedback from the validation process and externally, further evolutions to the regulatory environment. But it must still achieve a meaningful level of data integration, in a usably short timeframe and at reasonable cost (often by easing migration from or encouraging continued use of existing data platforms). As such, the run-up to A-IRB implementation of Basel II is likely to see banks going forward with a combination of integration and extension of existing data systems to support spreadsheet-based calculation of Exposure at Default (EAD) and LGD to be used in the credit origination and assessment process. Beyond regulatory compliance there are the questions of economic capital, competitiveness, practical risk management needs and internal control requirements, says Chambers. Economic capital needs and allocations are definitely set to benefit from greater accuracy in expected loss estimates attributable to facility risk ratings. Under traditional accrual systems

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of accounting, loan-loss provisions have an impact on the banks income statement, with unused provisions being held in the loss reserve account on the banks balance sheet. Given that loan-loss provisions are typically set using future expectations of the cost of credit, basing calculations on a finer and more variable set of risk parameters increases their accuracy. Indeed, attributing expected loss to individual loans, borrowers or larger aggregations creates a much greater potential for dynamic loan-loss budgeting, along with ongoing refinement as portfolio credit quality changes, concludes Chambers.

An Evolving System
There is clearly the need for an interim approach from both data and system design perspectives to

RISK SOLUTIONS CONTACT INFORMATION

E-mail us at risksolutions@standardandpoors.com or contact one of the global contacts listed below.
NORTH AMERICA
Bill Chambers Managing Director Standard & Poors Risk Solutions 55 Water Street, 46 Floor New York, NY 10041-1003 USA Tel: 1 212 438 7885 Fax: 1 212 438 1423 E-mail:

EUROPE
Paul Waterhouse Managing Director Standard & Poors Risk Solutions 20 Canada Square, Canary Wharf London E14 5LH UK Tel +44 (0)20 7176 3718 Fax +44 (0)20 7176 3565 E-mail:

ASIA / PACIFIC
Corinne Neale Managing Director Standard & Poors Risk Solutions Prudential Tower, Floor 17 Singapore 049712 Tel: +(65) 6 239 6313 Fax: +(65) 6 438 2320 E-mail:

bill_chambers@standardandpoors.com

paul_waterhouse@standardandpoors.com

corinne_neale@standardandpoors.com