Corporate Risk Management

CHAPTER 13Portfolio Management of Credit Risk

This chapter presents the first model for portfolio management of credit risk, developed by J.P. Morgan in the 1990s to meet capital requirements of the Basel regulation. This model arose because investment banks found that the capital requirements for credit risk stipulated in Basel I were too severe in evaluating default risk asset by asset, without considering dependencies between asset risks. The CreditMetrics (CM) model consequently proposes a portfolio management approach to bond management for a given bank. It shows how considering the correlations between default probabilities and bond credit migration can reduce optimal capital. Several banks currently use extensions of this model to manage credit risk under the Basel II Accord, which was put in place in 2004. No major changes were put in place for credit risk under Basel III.

13.1 CREDITMETRICS

CreditMetrics (CM) is an analytical model for the credit risk of a bond portfolio based on Value at Risk. It can calculate the required regulatory capital for banks and can also be used for optimal portfolio management, either for investment decisions or to protect portfolios from overly high default risks. It can also calculate credit limits.

Developed by the business bank J.P. Morgan for education and promotion purposes, this model does not necessarily correspond to the real model that the bank uses to manage its credit risk. The complete CM document can be found on the bank's ...