A portfolio approach to credit risk management

Since the 1980s, banks have successfully applied modern portfolio theory (MPT) to
market risk. Many banks are now using earnings at risk (EaR) and Value-at-Risk
(VaR)12 models to manage their interest rate and market risk exposures. Unfortunately,
however, even through credit risk remains the largest risk facing most banks,
the practical application of MPT to credit risk has lagged.
The slow development toward a portfolio approach for credit risk results from the
following factors:
Ω The traditional view of loans as hold-to-maturity assets.
Ω The absence of tools enabling the efficient transfer of credit risk to investors while
continuing to maintain bank customer relationships.
Ω The lack of effective methodologies to measure portfolio credit risk.
Ω Data problems.
Banks recognize how credit concentrations can adversely impact financial performance.
As a result, a number of sophisticated institutions are actively pursuing
quantitative approaches to credit risk measurement. While data problems remain
an obstacle, these industry practitioners are making significant progress toward
developing tools that measure credit risk in a portfolio context. They are also using
credit derivatives to transfer risk efficiently while preserving customer relationships.
The combination of these two developments has precipitated vastly accelerated
progress in managing credit risk in a portfolio context over the past several years.