Future of credit risk management

Credit risk management has two basic processes: transaction oversight and portfolio
management. Through transaction oversight, banks make credit decisions on individual
transactions. Transaction oversight addresses credit analysis, deal structuring,
pricing, borrower limit setting, and account administration. Portfolio
management, on the other hand, seeks to identify, measure, and control risks. It
focuses on measuring a portfolio’s expected and unexpected losses, and making the
portfolio more efficient. Figure 11.9 illustrates the efficient frontier, which represents
those portfolios having the maximum return, for any given level of risk, or, for any
given level of return, the minimum risk. For example, Portfolio A is inefficient
because, given the level of risk it has taken, it should generate an expected return of
E(REF). However, its actual return is only E(RA).

Credit portfolio managers actively seek to move their portfolios to the efficient
frontier. In practice, they find their portfolios lie inside the frontier. Such portfolios
are ‘inefficient’ because there is some combination of the constituent assets that
either would increase returns given risk constraints, or reduce risk given return
requirements. Consequently, they seek to make portfolio adjustments that enable
the portfolio to move closer toward the efficient frontier. Such adjustments include
eliminating (or hedging) risk positions that do not, in a portfolio context, exhibit a
satisfactory risk/reward trade-off, or changing the size (i.e. the weights) of the
exposures. It is in this context that credit derivatives are useful, as they can allow
banks to shed unwanted credit risk, or acquire more risk (without having to originate
a loan) in an efficient manner. Not surprisingly, banks that have the most advanced
portfolio modeling efforts tend to be the most active end-users of credit derivatives.
As banks increasingly manage credit on a portfolio basis, one can expect credit
portfolios to show more market-like characteristics; e.g. less direct borrower contact,
fewer credit covenants, and less nonpublic information. The challenge for bank
portfolio managers will be to obtain the benefits of diversification and use of more
sophisticated risk management techniques, while preserving the positive aspects of
more traditional credit management techniques.