Credit Risk: From Transaction to Portfolio Management

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Senior vs. subordinated debt (subordinated debt will provide an

extra-cushion to the senior debt).

The proportion of debt within the capital structure that ranks below

secured status is important in determining recovery rates. If the com-

pany defaults, the senior debt is accorded the highest priority and there

may not be enough capital to compensate the subordinated junior

debt holders.

The maturity of the facility is important. The agencies will view short

horizons more favourably. The reason behind this is that the cumula-

tive default risk will be lower for shorter maturities. Additionally some

of the loan will probably have been returned resulting in a better asset

to loan value coverage. These factors may produce potentially a single

notch upwards in rating.

Surprisingly the extent of the covenant will not typically have a large

impact on the loan rating. The covenant is simply a set of terms which

govern the borrower’s behaviour to assist in the repayment of the facil-

ity. In particular they include limitations on additional debt, actions

on asset sales, maintenance of fixed-charge coverage and restrictions

upon distribution of dividend.

2.9 Risk management

Commercial banks collect deposits and lend. All these transactions

comprise ‘the banking portfolio’. Their investment banking cousins

and sometimes colleagues (in the case of large global banks), are also

in the business of brokerage and trading. These transactions comprise

the ‘market portfolio’. This section is written from the perspective of

the global bank which has large banking and market portfolios.

The major component of risk within the banking portfolio is interest-

rate risk. This is because the asset base comprising loans and deposits

usually have a different rate exposure causing interest-rate sensitivity

and potentially liquidity risk. (There may also be embedded optionality.)

This is a book about credit so we do not wish to dwell too long on

these risks. But we must establish how credit risk is perceived and

organized within the risk-management hierarchy. Figure 2.5 shows the

risks inherent in both types of portfolio.

We now describe how the organizational structure of the bank reflects

the risk activities.

Rate and liquidity risk within the banking portfolio is managed by

the treasury. This concern addresses the issues of defining and devis-

ing hedging programmes for rate risk, liquidity and optionality. The

Loan portfolio 107

treasury does not typically manage credit or market risk on the trad-

ing book.

These are managed both centrally and in a more devolved manner.

Decisions to extend credit are delegated to the syndicate desk and the

subsequent credit exposure is managed by the loan portfolio group.

Both of these functions are subject to some degree of supervision by

the credit committee. We can see from Figure 2.5 that the various

activities of the bank generate very different risks. The way to remem-

ber the distinction is that banking portfolio does not produce market

risk and the market portfolio is not a source of interest-rate risk. Loan

portfolio management is a central function. Most of the loans origin-

ated stay on the banking book, however if the bank has an appreciable

investment banking operation a fraction will be transferred to the market

portfolio where they will be managed at a more local level.

The rationale behind this arrangement is that the individual at the

business level is committed to maintaining customer relationships

together with the pressure of meeting commercial targets, there are

incentives to take risk.

The committees are not affected by such concerns which makes it

easier to judge what is an acceptable level of risk. The figure below

shows a summary of risk management and supervision within a global

bank (Figure 2.6).

Risk management is a central function which can be thought of as

both a top-down and bottom-up process. At the top-level target earn-

ings and risk limits are defined. These global goals are translated into

signals to business units which line managers incorporate into cus-

tomer transaction policy. The monitoring and reporting of risks how-

ever is a bottom-up activity starting with transactions and ending with

consolidated statements.

Usually there are two specific organizational devices employed to exe-

cute the risk-management function. These are the transfer pricing sys-

tems between business units (central management devise the margin)

108 Credit risk: from transaction to portfolio management

Banking portfolio

CreditLiquidity Market

Market portfolio

Interest rate

Figure 2.5 Origin of risks banking and market portfolios.