Retail Credit Risk Management

M. Anolli, E. Beccalli, T. Giordani, M. Anolli, E. Beccalli, T. Giordani

• Publisher: Palgrave Macmillan
• Year: 2013
• ISBN:
  9781137006769
• Topic: Business
• Subtopic: Accounting
• Index: Business

Introducing the fundamentals of retail credit risk management, this book provides a broad and applied investigation of the related modeling theory and methods, and explores the interconnections of risk management, by focusing on retail and the constant reference to the implications of the financial crisis for credit risk management.

Part I

Regulatory Framework

1

Introduction

Mario Anolli and Elena Beccalli

1.1 Why retail credit risk management?

Why the need for a book on retail credit risk management? The first, and probably the most important, reason is the perceived usefulness of investigating risk management not only in terms of the general theory on modeling and methods, but also to gauge its managerial implications and its interconnections with other bank operations and with the firm’s organizational structure. Risk management is not simply a tool; it is a managerial action. In fact, risk management materializes in a series of concrete daily actions, and it cannot be limited to risk modeling and regulatory compliance (Basel II and III above all). The insight here is to overcome the merely quantitative risk management approach with two prior aims: on the one hand, to consider risk management as a continuous forecasting action not limited to single events; and on the other hand, to prevail over the common misinterpretation that risk management is solely a necessitated, and to a certain extent annoying, consequence of the regulatory risk-control discipline (Basel II and III).

The second reason is the adoption of a distinctive focus on retail credit, characterized by a huge number of operations and customers – private individuals and small to medium size enterprises (SMEs) – where a single loan has only a negligible impact on the relevant economic dimensions. Although not affected by the complexities of corporate risk management, retail risk management introduces the problem of numerical complexity due to the huge amount of data to be processed. The ability to elaborate, manage, and store a very large amount of data becomes essential and highlights structural synergies with other firm operations, such as IT systems.

The third and last reason is that the 2007 financial crisis has had strong implications for retail risk management, both in the short term and in the long term. In the short term, there is an effect on the cost of portfolio management and the cost of collection. Specifically, in terms of the customers’ creditworthiness, evaluation, and monitoring, a need exists to overcome the highly streamlined evaluation process and the excessive reliance on credit bureau scores without further insights into the current assets and liabilities of the applicants and their income perspectives. As for the long term, clearly the need exists to better capture the link between the macroenvironmental factors and the risk of the credit portfolio, which then affects impairment and capital absorption. The issue is complex due to the lack, to date, of models and tools able to incorporate macroenvironmental factors and certain credit factors that had been undervalued in the previous growth cycle (such as affordability of financial liabilities, over-indebtedness risk, and the resilience of the individual and the household). In this sense, banks now need to develop models that take into account unemployment rates, market interest rates, inflation rates, affordability, over-indebtedness risk, and resilience. Last but not least, due to the crisis the risk management department has to effectively communicate to the senior management the additional risk derived from the crisis in order to add it into the planning actions for capital and commercial pricing. Commercial pricing is not a static input connected with a short-term strategy; it should instead incorporate a line of defense against adverse scenarios mainly connected to the liquidity gap. According to this perspective, risk management should actively participate in the decisions on price setting by providing a “professional” forward-looking perspective not only to minimize impairment and capital absorption but also to guarantee the sustainability of medium-term revenues.

1.2 The book

This book introduces the fundamentals of retail credit risk management, provides a broad and applied investigation of the related theory on modeling and methods, and explores the interconnections of risk management with other firm operations and industry regulations. The distinctive focus on retail customers and the continued implications of the financial crisis for risk management is the main benefit of this book. Furthermore, the involvement of academics, regulators, and professionals from major global banks and consulting firms provides a global focus with the right balance between theory and application.

The book is structured in four parts: Part I provides a comprehensive and updated discussion of the regulatory framework; Part II investigates the first phase of the risk management process (risk taking) by looking at the measurement, pricing, and management of retail credit; Part III is devoted to the second phase of the risk management process, that is, the measurement and management of portfolio credit risk; and Part IV deals with the operational implications of credit risk management for other functions.

1.2.1 Part I: the regulatory framework

Chapter 2, by Damiano Guadalupi, critically discusses the evolution of the Basel Accord. The author argues that the success of the international capital standards in preventing banking distress has been mixed. Basel I’s regulatory rules were arbitraged due to their risk insensitivity; this gave rise to Basel II with its greater focus on risk calibration. However, Basel II collapsed under the 2007 financial crisis when the concern on the procyclicality of the revised Accord became evident. Amendments have since been applied through Basel III. According to Guadalupi, however, even before the new capital buffers under Basel III come into force, if the market perceives that the capital ratio that includes the capital conservation buffer (7%) will never be breached, then dynamic buffers will no longer exist and ratings will again become the only instrument to achieve the two different objectives. These objectives measure the actual creditworthiness of borrowers and mitigate procyclicality. The likely result might be that both of them will remain out of reach.

1.2.2 Part II: risk taking: measurement, pricing, and management

Chapter 3, by Corrado Giannasca and Tommaso Giordani, focuses on the phases within the development of an acceptance model for private individuals. The authors start with the decision to develop the new model, and then progress to its full implementation. Throughout the chapter, the authors assess the pros and cons of credit risk modeling for operational processes, policy definitions, business goal setting, and organizational change. Further, Giannasca and Giordani argue that the 2007 financial crisis has resulted in more scrutiny of the credit risk management tools that have been developed and used in the last decades. The main lessons learned, in their view, are related to an increased awareness of data quality and of the wider scope needed to control the sustainability of customer obligations, and an increased awareness of the role of the macrovariables that become mandatory to evaluate their impact on customers and portfolio performances. Impacts on economic measures that result from stressed economic conditions represent the new risk management’s challenge for long-term business sustainability.

Chapter 4, by Emanuele Giovannini, focuses on the phases within the development of an internal rating model for SMEs. The author discusses the data sources used in the process, the indicators to compute, the variables to include in the shortlist, the correlation model between dependent and independent variables, the caliber function adopted to convert the score rating into the probability of default (PD), and the number of rating classes. Giovannini emphasizes that along common guidelines suggested by the banking authority, each bank develops its own model. He contextualizes the discussion by providing examples related to Italian banks.

Chapter 5, by Elisa Alghisi Manganello and Valentina Leucari, focuses on loss given default (LGD), the critical parameter in risk modeling, by discussing its definition, relevance, and application. In addition to being crucial for compliance requirements, LGD has several implications for the daily management of the credit portfolio. In fact, there are several issues directly related to a business prospective: the recovery cycle’s efficiency and duration, the commission scheme’s efficiency, the pricing definition within a debt sale, the links between sustainable recovery flows, and the impacts on LGD levels and therefore the coverage included within the risk planning. By taking into account both the product-specific characteristics as well as the underlying recovery process, the authors critically discuss the various families of models that can be suitable for LGD estimation: conditional means models calculating an average LGD within certain segments, regression models estimating LGD as a linear function of relevant selected explanatory variables, and chainladder models that aim to predict future recovery curves starting from observed ones.

Chapter 6, by Antonio Arfé and Paolo Gianturco, deals with the internal validation of the rating systems that is part of the general framework for rating system controls. The authors highlight that according to both local and international regulatory requirements, validation activities should not exhaustively use empirical validation methods and tests, but should also be concerned with several aspects of the rating system, and assess the overall functioning of the rating system along different dimensions, including the method, the IT system and data quality, and the processes and governance. Following the Basel Committee on Banking Supervision’s guidelines, to comply with the normative framework “banks must have a robust system in place to validate the accuracy and consistency of rating systems, processes, and the estimation of all relevant risk components. A bank must demonstrate to its supervisor that the internal validation process enables it to assess the performance of internal rating and risk estimation systems consistently and meaningfully.” Their chapter focuses on the rating system’s internal validation approaches for the retail segment. The authors take into account the possible organizational structures for the implementation of the activities, and the main tools and processes. They provide a specific focus on the quantitative aspects in terms of the analysis of the models, the methodological backgrounds of the statistical tests, the interpretation of possible outcomes, and the actions to be taken in accordance with the results.

Chapter 7, by Mario Anolli, offers a framework for investigation into the risk-adjusted performance of decisions relating to retail credit. Taking risk into account in an efficient manner is highly important in retail credit risk management because of the large number of small decisions that could, in the absence of a correct decision-making framework, lead to the undesired bundling of huge risks. The risk-adjusted performance measures are also important to the capital allocation process and to the overall enhancement of the long-term profitability of the bank.

1.2.3 Part III: portfolio credit risk: measurement and management

Chapter 8, by Lorenzo Bocchi and Tiziano Bellini, provides an analysis of the different credit risk models for portfolios, and highlights how these models can be used for both regulatory and managerial purposes. To compute internal capital requirements, the regulatory framework imposes Gordy’s (2003) model of the Advanced Internal Rating Based (AIRB) approach. However, the assumptions of the IRB are not always in line with the managerial issues of banks, so the credit risk models for portfolios are developed with different incentives and purposes; they are primarily for portfolio management, risk-based pricing, capital allocation, and stress testing. A case study complements the chapter, illustrating how to use credit risk models in credit risk management.

Chapter 9, by Tiziano Bellini and Lorenzo Bocchi, emphasizes the role played by credit portfolio models in assessing the capital adequacy of banks. Stress test analyses are required under Basel II in order to use the IRB approach to compute the credit capital requirement. Stress testing comprises several techniques used to assess the vulnerability of a portfolio to major changes in the economic environment and to exceptional but plausible events. The authors show how to implement stress tests in practice, and present a case study on stress testing where the identification of the scenario can be based either on an hypothetical setting (such as that for the European Banking Authority, 2011) or on an historical setting. In addition, they investigate the role of credit risk models for portfolios in the capital planning process by emphasizing the key role of risk-adjusted performance measures to implement effective capital allocation.

Chapter 10, by Tommaso Giordani and Corrado Giannasca, provides an overview of the main ingredients of credit portfolio management. The authors illustrate these ingredients in a comprehensive framework (rather than as single elements) ultimately finalized to minimize both impairment (credit losses) and capital consumption and to measure the risk-adjusted profit for homogeneous clients or individual applicants. The authors identify three managerial areas in the portfolio management framework. First, they identify the portfolio’s vulnerability to the economic cycle, collection efficiency, strategy effectiveness, and the potential impacts from the new model’s development (application, impairment, and capital) and the calibration of the existing models. Second, new business planning looks at the client segment that is considered strategic for the bank, the pricing strategy for the client, and a consistent acceptance strategy. Third, they identify the timely monitoring of the divergences from the key objectives embedded in the plans. Moreover, Giordani and Giannasca explore what should be the optimal organizational structure and communication approach for efficient management of the stakeholders.

1.2.4 Part IV: operational implications

Chapter 11, by Renzo Traversini and Anselmo Marmonti, provides an analysis of the IT systems for credit risk management. These systems, part of the wider IT infrastructure, support key activities such as risk taking, risk management, risk mitigation, and risk pricing. The authors emphasize that all banks have already set up the overall credit management process along Basel II’s guidelines, and that banks are now focusing their attention on the evolution of the system by aiming to increase control over the system overall, and over the performance of their IT systems specifically, ensuring that the resultant measures are available to the business process in good time. Banks also aim to increase the performance of the models for a more precise valuation of the risk. Specifically, large banks aim to improve the quality of the data involved in the process of credit risk management.

Chapter 12, by Francesco Merlin, emphasizes that prior to the recent financial crisis, numerous banks revamped their credit underwriting, monitoring, and collection processes with a focus on speed, costs, efficiency, and customer satisfaction. The one thing they forgot to consider properly was effectiveness, or risk management, and many subsequently got into trouble (meaning a higher rate of nonperforming loans, huge credit losses, and provisions). Several banks are now reevaluating their retail credit processes (along with credit risk models) with a renewed emphasis on risk management and lower losses. By focusing jointly on efficiency and effectiveness, banks can learn important lessons from the crisis and adapt appropriately to the new dynamics of credit demand and supply. This chapter outlines the key structural trends and best practices that are reshaping banks’ retail credit risk man...

Table of contents

• Cover
• Title Page
• Copyright Page
• Contents
• List of Tables
• List of Figures
• Notes on Contributors
• Part I  Regulatory Framework
• Part II  Risk Taking: Measurement, Pricing, and Management
• Part III  Portfolio Credit Risk: Measurement and Management
• Part IV  Operational Implications
• Index