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We are always interested in speaking to members of the media on news and events affecting the world of corporate credit risk. We look forward to hearing from you.
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Credit Portfolios: Banks lag in diversification management
Source: International Financing Review
Date: June 28, 2003
Author: Jean Haggerty
Mandatory marking-to-market and disclosure of banks' retained credit portfolios is at least five years away. Yet mark-to-market is an essential prerequisite of decision-making processes aimed at improving diversification and therefore banks' risk-return ratios. In addition to rendering this a more visible risk, Basle II offers the platform for active diversification management, according to John Andrew McQuown, chairman of Moody's KMV. Lack of diversification is at least as big a potential problem as insufficient capital, he believes.
In a recent examination of more than 80 major banks, Moody's KMV found the risk-return ratio of corporate credit portfolios retained by banks to be seriously inferior to that delivered by other managers of corporate credit portfolios. Whereas corporate credit portfolios held by banks exhibit risk-return ratios between 0.1 and 0.3, non-originating asset managers of corporate credit often achieve Sharpe ratios of well over 0.5. Some serious-minded managers assemble corporate credit portfolios, from secondary markets, with Sharpe rations over 1.0, Moody's KMV noted.
"Extracting real value from IRB (internal ratings based) models will necessitate 'active' diversification management because that is where the critical buy/hold/sell decisions are made," McQuown pointed out. When the equity investment community takes note, banks employing next-generation practices will be rewarded with higher and less volatile share prices, he added.
Banks have for some time been actively managing new credits brought into a portfolio to ensure that they are adequately compensated for taking on the risk. For the banks, applying threshold policies for counterparties to which they extend credit is also fast becoming common practice.
"I would be surprised if most banks don't have some type of concentration management in place," said Malcolm Perry, managing director and global co-head of the credit portfolio group at JP Morgan in London. Within the next few months, JP Morgan is expanding its threshold policy, which currently operates by counterparty name, to cover industry limits.
Active portfolio managers, when they transact, do so at market values, and the analysis leading to these decisions requires market values. Few, if any, banks are disclosing these marks to their shareholders. "If a bank is going to shed risk, it needs an accounting regime that gives it credit for doing that," one official said. Today, this is not the case, he added.
Banks deal with thousands of counterparties, but only a small percentage of them have observable credit markets. "The question becomes where do you mark-to-market to?" Perry said. With this question in mind, JP Morgan three months ago started using an internal cost of credit capital methodology driven by Moody's KMV's estimated default frequencies (EDFs). Use of market-driven model valuations remains uncommon, but it tends to be a better predictor of outcomes than the traditional historical analysis approach, Perry said.
No banks disclose their marks today, and they are not obliged to. For the near future, accrual accounting will remain because mark-to-market implies a market where one does not necessarily exist. Basle II will change matters only inasmuch as it encourages banks to quantify the credit risk in their books and evaluate credit risk in a more sophisticated way.
However, Basle II, in that it requires banks to upgrade their data capture and risk management infrastructure, does set the stage for generating higher returns per risk. This is because the incremental cost for diversification management is minor in the overall scheme. In addition, banks can reap economic benefit from controlling the performance of their credit portfolios, McQuown said.
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