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
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-
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
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
Figure 2.5 Origin of risks banking and market portfolios.