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Credit risk management: a survey Credit risk

management
of practices
Ali Fatemi
Department of Finance, DePaul University, One East Jackson Blvd.
Chicago, Illinois, USA 227
Iraj Fooladi
Department of Finance, School of Business Administration,
Dalhousie University, Halifax, Nova Scotia, Canada

Abstract
Purpose – Proposes to investigate the current practices of credit risk management by the largest
US-based financial institutions. Owing to the increasing variety in the types of counterparties and
the ever-expanding variety in the forms of obligations, credit risk management has jumped to the
forefront of risk management activities carried out by firms in the financial services industry. This
study is designed to shed light on the current practices of these firms.
Design/methodology/approach – A short questionnaire, containing seven questions, was mailed
to each of the top 100 banking firms headquartered in the USA.
Findings – It was found that identifying counterparty default risk is the single most-important
purpose served by the credit risk models utilized. Close to half of the responding institutions utilize
models that are also capable of dealing with counterparty migration risk. Surprisingly, only a
minority of banks currently utilize either a proprietary or a vendor-marketed model for the
management of their credit risk. Interestingly, those that utilize their own in-house model also utilize
a vendor-marketed model. Not surprisingly, such models are more widely used for the management of
non-traded credit loan portfolios than they are for the management of traded bonds.
Originality/value – The results help one to understand the current practices of these firms. As
such, they enable us to make inferences about the perceived importance of the risks. The paper is of
particular value to the treasurers intending to better understand the current trends in credit risk
management, and to academics intending to carry out research in the field.
Keywords Credit control, Risk assessment, Financial institutions, Surveys
Paper type Research paper

1. Introduction
Shareholder value maximization requires a firm to engage in risk management
practices only if doing so enhances the value of the firm and, by implication, its value
to shareholders. This value enhancement can arise from one of three sources: (1)
minimization of the costs of financial distress, (2) minimization of taxes and (3)
minimization of the possibility that the firm may be forced to forego positive NPV
projects, because it lacks the internally generated funds to do so (i.e. minimizing the
probability of the occurrence of the under-investment problem).
In contrast to the shareholder value maximization, the managerial risk aversion
hypothesis (which is based on an agency argument) holds that managers will seek to
maximize their own personal well being. This means that managers may, at times,
engage in risk management practices at the expense of shareholders. Specifically, when
the interests of shareholders are not perfectly aligned with those of the managers,
managers may pursue risk management strategies designed to insulate their own Managerial Finance
Vol. 32 No. 3, 2006
personal wealth from the effects of changes in interest rates, commodity prices, or pp. 227-233
foreign currency values. These steps may be taken without regard for the # Emerald Group Publishing Limited
0307-4358
consequences of these decisions for shareholders’ wealth. DOI 10.1108/03074350610646735
MF It follows, therefore, that regardless of whether shareholder value maximization or
32,3 managerial risk aversion is the driving force, engagement in risk management
practices is to be observed. One of the most important forms of these practices pertains
to the management of credit risk, particularly for banks and other firms in the financial
services industry[1].
Credit risk arises from uncertainty in a given counterparty’s ability to meet its
228 obligations. The increasing variety in the types of counterparties (from individuals to
sovereign governments) and the ever-expanding variety in the forms of obligations
(from auto loans to complex derivatives transactions) has meant that credit risk
management has jumped to the forefront of risk management activities carried out by
firms in the financial services industry[2].
Given this importance, it is surprising to observe that not much is known about the
extent by which banks engage in the practice of credit risk management. In recent
years, a number of studies have provided the discipline with insights into the practice
of risk management within the corporate sector. Fatemi and Glaum (2000) provided a
comprehensive picture of the risk management practices of German firms, including
interest rate risk management, foreign exchange risk management, the use of
derivatives, risk management systems, and the behavioral aspects of risk
management. Belk and Glaum (1990); Lessard and Zaheer (1990); Edelshain (1992);
Glaum and Roth (1993); Batten et al. (1993) reported on the exchange risk management
practices of multinational corporations. Others, such as Bodnar et al. (1995); Bodnar
et al. (1996; 1998); Berkman et al. (1997); Grant and Marshall (1997); Howton and Perfect
(1998); Bodnar and Gebhardt (1998) have reported on the use of derivative financial
instruments by non-financial firms. Yet others, such as Nance et al. (1993); Mian (1996);
Jalilvand et al. (1997); Geczy et al. (1997) have investigated the question of the
determinants of corporate hedging policies. However, not much has been reported on
the state of the art in the practice of credit risk management.
This study is designed to provide some answers in this area. More specifically, we
aim to shed light on the question of the state of the art practices of credit risk
management by the largest US-based financial institutions.

2. Tools of credit risk management

Prompted by the Bank for International Settlements, and in some cases required by
regulatory mandate, banks and other financial institutions have been on the lookout
for new means of measuring and managing their credit risk. Adding fuel to the fire has
been a series of related events, including: a rapid pace of product innovations, further
diversification by financial institutions into new geographical and product market
areas, and a stepped up rate of credit intermediation (both in scope and pace). The net
effect has been that we have witnessed the development of more sophisticated
approaches to the measurement and the management of credit risk exposure. Included
among these has been the introduction of the increasingly more sophisticated and
complex hedging techniques. More intriguing, and of particular interest (at least for
our purposes in this study), has been the development of models that can be used to
measure credit migration and default risk at the portfolio level and that can also be
used to allocate capital. These can be broadly classified into two types; proprietary
(internal) models of credit risk management, and the vendor-marketed models which,
in-spite of their general-application nature, are almost universally quite elaborate. For
clear reasons, not enough information can be obtained about the capabilities of the
former category of these models. However, some detail is generally available about the Credit risk
latter category.
This category includes models marketed by Algorithmics, CreditMetrics,
management
CreditRisk+, KMV’s Portfolio Manager, Loan Pricing Corporation, and McKinsey’s
Credit Portfolio View. In what follows, we will briefly describe a few of these models.
Marketed by J.P. Morgan, CreditMetrics was one of the first portfolio models
developed for evaluating credit risk. It incorporates a methodology for assessing a
portfolio’s value at risk (VAR) arising from changes in counterparty credit quality. It
229
establishes an exposure profile of each counterparty, represented within the portfolio,
and combines the volatilities of the individual instruments (taking into account
correlations between credit events) to model the volatility of the aggregate portfolio.
CreditRisk+, marketed by Credit Suisse, is an adaptation of the Credit Suisse Group’s
methodology for setting loan loss provisions. It is capable of assessing risk capital
requirements in an environment where illiquid loans (with little associated data) are
held to maturity. Accordingly, its methodology may be more appropriate for firms with
retail and institutional loan portfolios, as opposed to those with more bond-oriented
compositions.
KMV’s Portfolio Manager measures the risk and return characteristics of a portfolio
and allows the user to explore the incremental effect of a changing exposure to an
individual asset. It also provides for an examination of the effect of a large-scale change
to the portfolio mix and, an assessment of potential changes in tactics and strategy.
Further, it can be a valuable tool for determining aggregate capital requirements and
the allocation of economic capital. Finally, McKinsey’s Credit Portfolio View takes into
account specific country and industry influences in order to arrive at better estimates
of default and credit migration probabilities. It incorporates the evolution of the global
macro-economy into country- and industry-specific speculative default rates. It then
maps these rates into cumulative migration probabilities by country and by industry.
As this brief description of some of these models suggests, the increasing
complexity of the world of credit risk has given rise to an equally complex set of models
designed to measure and manage this risk. This study is designed to provide a picture
of the use of such models by the largest US-based banks.

3. The survey and the results

A short questionnaire, containing seven questions, was mailed to each of the top 100
banking firms headquartered in the US. A total of 25 responses were received, of which
four were not usable. (Three of the responses had to be excluded because most items
were not answered. A fourth one was discarded due to apparent inconsistencies in
answers.) The 21 usable responses were from a wide spectrum of banks: those in the
top as well those in the bottom deciles by size, international as well as regional banks,
publicly traded as well privately-held banks, and diversified as well pure play banks.
Therefore, there are no apparent differences between the respondents and non-
respondents. As such, it can be argued that the respondents represent the population of
banks surveyed.
Our first question was designed to elicit from the respondents the types of risk their
credit risk model is designed to identify. More specifically, we wanted to determine
whether the type of model employed by the bank is designed to only estimate portfolio
loss arising from default, or it is designed to also deal with migration risk[3]. Table I
reports the results. According to these results, 90 per cent of the respondents indicate
that identifying counterparty default risk is the single most-important purpose served
MF by their credit risk models. Almost half of the respondents indicate that their models
are also capable of dealing with counterparty migration risk. The usage of credit risk
32,3 models to deal with default and migration risks at the portfolio level is much less
frequent, with 38 per cent and 29 per cent indicating such uses, respectively.
We next asked our respondents to indicate whether they use, or plan to use, any of
the six vendor-marketed models for either their traded bond portfolios or their non-
traded credit loans. The results are summarized in Table II. According to these results,
230 only a minority of banks currently utilize these models for either purpose. Relatively
speaking, however, they are more widely used for the management of non-traded credit
loan portfolios. Insofar as relative preferences for these vendor-marketed models the
are concerned, KMV’s Portfolio Manager model edges out CreditMetrics by a small
margin.
Table III provides a tally of the responses to our question regarding the current or
planned use of in-house proprietary models. According to these results, again, only a
minority of banks utilize, or plan to utilize in-house models of credit risk management.
Interestingly, with only one exception, banks that use their own proprietary models of

Frequency of response Per cent of responses

Table I. Counterparty default risk 19 90
The types of risk the Counterparty migration risk 10 48
bank’s credit risk model Default risk at the portfolio level 8 38
is designed to identify Migration risk at the portfolio level 6 29

Traded bonds Non-traded credit

Planned Used Planned Used
Algorithmics 4 2
CreditMetrics 1 3 4 3
Table II. CrediTRisk+ 2 2 3
Planned or current KMV’s portfolio manager 1 5 7 4
usage of vendor- Loan pricing corporation 1
marketed models McKnisey’s credit portfolio view

Traded bonds Non-traded credit

Planned Used Planned Used
Internal risk model 1 6 2 9
Risk term, default mode model 3 2
Risk term, mark-to-market model 2 4
Default correlation modelling, via
asset correlation 2 2 3
Default correlation modelling, via
Table III. default rate volatility 3 7 4
Planned or current Technical concept, analytical model 2
usage of proprietary Technical concept, simulation model 2
models Other, please specify
credit risk management are the same ones that also utilize a vendor-marketed model. Credit risk
Therefore, those that do utilize a model of credit risk management, do so both through
an in-house model and an outsourced one as well.
management
The usage of models based on correlation modelling via default rate volatility
dominates all others. Mark-to-market models are the second most widely utilized type
among the proprietary models. Others are not that widely used. Further, it appear that
these models are more widely used for non-traded credits, than they are for traded
bonds.
231
We next asked our respondents to indicate what best describes the purpose for
which they currently use their credit risk portfolio system: assignment of economic
capital for individual transactions, assignment of economic capital for portfolios, or the
pricing of individual transactions. The results are reported in Table IV. According to
these results, the assignment of economic capital for portfolios is the leading usage of
such models. The pricing of individual transactions and the assignment of economic
capital for individual transactions rank second and third, respectively.
We also asked our respondents to indicate whether they currently use a Markowitz-
type approach to optimize their credit portfolios. The uniform response was negative.
Finally, we asked our respondents to indicate whether credit risk policy is part of
their company-wide capital management policy. The results are reported in Table V.
The overwhelming majority indicate that their credit risk policy is part of their
company-wide strategy for capital management.

4. Concluding remarks
In a survey of the largest financial institutions based in the US, we find that identifying
counterparty default risk is the single most-important purpose served by the credit
risk models utilized. Close to half of the responding institutions utilize models that are
also capable of dealing with counterparty migration risk. Surprisingly, only a minority
of banks currently utilize either a proprietary or a vendor-marketed model for the
management of their credit risk. Interestingly, those that utilize their own in-house
model also utilize a vendor-marketed model. Not surprisingly, such models are more
widely used for the management of non-traded credit loan portfolios than they are for
the management of traded bonds.

Frequency of Per cent of

response responses
Assignment of economic capital for individual 10 48 Table IV.
Transactions The purpose served by
Assignment of economic capital for portfolios 17 81 the credit risk portfolio
Pricing of individual transactions 13 62 modelling system

Frequency of response Per cent of responses Table V.

Is credit risk policy part of
Yes 19 90 the company-wide capital
No 2 10 management strategy?
MF Notes
32,3 1. BIS, for example, maintains that ‘‘. . . the major cause of serious banking problems
continues to be directly related to lax credit standards for borrowers and counterparties,
poor portfolio risk management, or a lack of attention to changes in economic or other
circumstances that can lead to a deterioration in the credit standing of a bank’s
counterparties.’’ See Principles for the Management of Credit Risk, Consultative paper
prepared by the Basel Committee on Banking Supervision, July 1999.
232 2. Consider, for example, forwards or swaps. These derivatives usually have a market
value of zero when they are first entered into. Given that mark-to-market exposure does
not capture the potential for market values to increase over time, effective assessment of
the risks involved requires that some probabilistic metric of potential credit exposure be
used.
3. Migration risk ideals with the possibility that, at some point in the future, the credit
rating of an obligor may deteriorate, leading to a diminution in value.

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233
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Jorion, P. (1997), Value at Risk, Irwin, Chicago, IL.
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Smithson, C.W. (1998), Managing Financial Risk: A Guide to Deriviative Products, Financial
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Stultz, R.M. (1999), Rethinking Risk Management, Reprinted in The New Corporate Finance, 2nd
ed., Donald Chew. (Ed.), Irwin, Chicago, IL.
Tufano, P. (1998), ‘‘Agency costs of corporate risk management’’, Financial. Management, Vol. 27,
Spring, pp. 67-77.

Corresponding author
Ali Fatemi can be contacted at: afatemi@[Link]

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