SPECIAL REPORT CREDIT PORTFOLIO MANAGEMENT
The credit crisis and ensuing writedowns have provided a number of lessons – and challenges
– for credit portfolio management groups. How did banks fare during the crisis and what
improvements can be made? By Uwe Stegemann and Gösta Jamin
The CPM challenge
Since
the mid-1990s, banks have
invested significant
resources in building up active credit
portfolio management (CPM) functions.
In good times, few questioned the logic
behind this. After all, credit risk exposure
lies at the heart of a bank’s business,
accounting for up to 90% of assets, 70–
80% of capital and 60% of revenues.
CPM desks enabled banks to hedge
against concentration risk, protect against
deteriorating credits and optimise capital,
often through use of the originate-todistribute model.
Today, however, banks and their CPM
functions are under pressure, suffering
some of the worst liquidity and credit
problems in living memory. The true
extent of the crisis will not be known
until the last dollar of losses is taken into
account, but credible estimates point to
something in the region of $1 trillion
across the financial industry. As a
consequence, the originate-to-distribute
model is being seriously questioned.
In this context, bankers are asking
themselves what the future role of CPM
should be. To answer this, they need to
explore where and how CPM helped
before and during the credit crisis, then
seek to push further in those areas where
a redefined CPM can make a difference.
Fortunately, we have good insights
into the strengths of CPM efforts prior
to August 2007, when the credit crunch
started to bite. Our observations are
1 How CPM creates value through four main levers
CPM value levers
Capital
optimisation
• Economic/regulatory capital
management
• Downside risk
reduction
Improved
origination
• Sophisticated
asset pricing,
credit selection
• Origination
discipline
Balance-sheet
management/
(re-)investment
• Managing volatility
• Support capital
reallocation into
growth
Improved
distribution
• Structure to
investors‘
needs
• Create new
markets
Enhanced portfolio transparency
Source: 2007/08 Survey on Credit Portfolio Management Practices
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CPM.indd 64
Importance of value lever
(1 = lowest, 5 = highest)
Capital
optimisation
4.4
Improved
origination
3.7
Balance-sheet
management/
(re-)investment
2.4
Improved
distribution
2.6
based on a survey covering more than 60
of the largest banks in North America,
Europe, Asia and Australia conducted
jointly in 2007/08 by McKinsey, the
International Association of Credit
Portfolio Managers, the International
Swaps and Derivatives Association and
the Risk Management Association.
How CPM can create value
The survey shows that where CPM has
been implemented, banks have benefited
from increased transparency on the risk/
return of the credit portfolio, as well as
from four main value creation levers (see
figure 1). We believe these remain relevant
in the post-crisis environment, although
clearly some levers are more difficult to
operate and/or contribute less attractive
economics due to wider credit spreads and
a lack of liquidity in secondary markets.
Others need to be significantly rethought,
given the new market realities.
The first value lever is better origination. Banks can improve the profitability
of their origination business by adding a
risk/return perspective, in addition to the
pure top-line perspective taken by the
origination group and the risk perspective
taken by the risk division. Origination
can be directed towards higher profitability – for example, by implementing
economic hurdle rates or transfer prices
for credit risks that reflect the economic
opportunity costs of these risks in the
secondary market. A target portfolio
process can also be implemented that
leads to the origination of a desired
portfolio structure. CPM can ensure
origination explicitly takes into account
changes in funding and capital costs and
reduced opportunities for selling credit
risks in the secondary market.
The second important element is capital
optimisation. Selling or hedging assets in
the secondary market safeguards the bank
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2 How CPM units cover the asset spectrum of their institution
Multinationals/large cap
Investment
grade
Companies surveyed
against concentration risks and helps
prevent losses from defaults or deterioration in creditworthiness. Firms, in turn,
are able to conduct more business with a
given set of customers.
Optimisation also reduces economic and
regulatory capital requirements, freeing
capital to make new investments to
diversify the portfolio, invest in new
business growth or leverage customer
relationships. Clearly, the credit sector is
currently under stress, causing prices in the
secondary market to plunge and liquidity
to evaporate. However, the economic
rationale for actively managing an
otherwise illiquid and concentrated credit
portfolio remains valid. We strongly
believe some form of market-based
exchange of credit risk will re-emerge, but
CPM functions need to adjust their credit
strategies to reflect the current lack of
liquidity in the credit markets. Beyond
this, there is scope for developing alternative techniques, including private club
deals, risk pooling concepts and improved
transaction structuring to avoid moral
hazard or liquidity crunches.
CPM can also help a bank manage its
capital base more actively in times of
capital constraint – for example, by
developing a perspective on how capital
will behave through the cycle and where
the structural differences between capital
performance requirements and actual
performance lie. Banks can introduce a
capital efficiency perspective into the riskweighted assets (RWA) calculation process,
which can result in a reduction of RWA
requirements of 10–25% without affecting
the underlying businesses. The key factor
here is that CPM has the advantage of
being able to offer an integrated perspective on the RWA calculation process,
whereas other functions (for instance,
origination, middle office or risk) only
focus on parts of it.
The third value lever is balance-sheet
management or reinvestment. By balancesheet management, we mean the risk/
return optimisation of the asset portfolio
in the current market environment.
Changes in liquidity availability, funding
and capital cost can cause significant
changes in the profitability of some credit
businesses and require a re-evaluation of
balance-sheet usage. CPM can help make
these changes transparent and provide
advice to a bank’s decision makers on
balance-sheet capacity and capital
allocation. By reinvestment, we mean
simply that (excess) capital can be
High yield
Asset-backed credit
Mid cap
Small cap
Commercial
real estate
Covered
Not covered
Retail lending
Project and
structured
finance
Other
Residential
real estate
Consumer
Small
business
Other
NPLs
Source: 2007/08 Survey on Credit Portfolio Management Practices
invested in credit assets that provide
enhanced yield or diversify the portfolio.
Given the current market environment
and correspondingly high spreads, this
lever can be particularly interesting for
banks with sufficient capital and a good
funding base – provided they understand
the operational and structural risks
inherent in these positions.
Finally, CPM can help banks improve
distribution and generate extra fee income
by using the credit portfolio to create
investment opportunities for clients. CPM
can add value by offering insights into the
availability of appropriate assets and by
guiding originators towards more
standardised business that is eligible for
distribution, thereby linking origination
with capital markets. This is probably the
value lever that has suffered most from the
current crisis, not least because of investors’
lack of trust in complex structured credit
products. CPM units can contribute to
regaining trust by further developing and
explaining the bank’s approach to CPM
and making risk/return significantly more
transparent to credit investors.
The next horizon for CPM
Why couldn’t CPM prevent financial
institutions from being hit by the crisis?
The survey shows CPM techniques benefit
only parts of a bank’s credit assets – in
particular, corporate credits with
traditionally significant secondary market
liquidity. In many cases, active management
of other exposures is still in the early stages
of development. This applies to the
exposures worst hit by the credit crisis
(subprime credit, leveraged loans, etc).
However, financial institutions that
took an advanced proactive portfolio
management approach to a large part of
their credit exposures appear to have
suffered less during the turmoil and
successfully limited the volatility of their
credit books relative to other institutions. This sort of performance suggests
the basic concepts behind CPM are
robust. However, the new funding and
capital environment, the repricing of
liquidity and credit risk and the fundamental questioning of the originate-todistribute model call for some fundamental changes.
Value proposition and performance
measurement
In the presence of liquid secondary
markets, the key focus of credit portfolio
managers was on capital optimisation,
distribution and reinvestment – each with
a short time horizon and often with a
strong focus on revenue and return on
equity. Activities were mainly aimed at
generating interest income, reducing
concentrations, managing credit events,
recovering hedge costs, diversifying asset
risk.net
CPM.indd 65
Counterparty risk
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3
4
5
6
7
8
9
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13
14
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24
25
26
27
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43
44
45
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49
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SPECIAL REPORT CREDIT PORTFOLIO MANAGEMENT
3 Three different business models based on CPM’s impact on value creation
CPM impact
Companies surveyed
Pricing
CPM model
Hedging
Structuring
Creating
markets
(Re-)
Investing
Decision making
III
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
46
47
48
49
50
Value
levers
CPM impact
Decision-maker
Shared decision
making
Credit
Treasury
Advisory power
Low involvement
Portfolio
optimiser
Risk
limiter
II
Adviser
I
Controller
Improved
origination
• Target portfolio
• Limit setting
• Evaluation and
pricing
Capital optimisation
• Regulatory capital mgmt.
• Economic capital mgmt.
• Improved risk mgmt.
techniques
• Downside risk reduction
(Re-)investment
• Investments
in credit risk/
assets
• Credit risk
trading
Improved
distribution
• Syndication
• Securitisation/
product
development
Source: 2007/08 Survey on Credit Portfolio Management Practices
4 Perceived implementation success of CPM objectives
Main objectives
Importance
1 = low, 5 = high
4.7
4.2
4.4
4.4
Diversify concentration risk
Release credit capital
Capital management/
optimisation
Enhance portfolio liquidity
Active cycle management
Maximise absolute earnings through reinvestments
Create new markets
5
68
64
48
33
63
65
15
64
56
13
3.9
3.5
3.3
3.6
2.9
3.6
3.6
3.6
3.4
2.9
2.7
3.8
2.5
2.7
2.2
47
8
4.1
4.4
5.0
Limit unwanted
risks/losses
Controllers
48
4.3
3.4
3.7
4.2
4.3
4.3
Increase transparency of
portfolio risk/return
Advisers
60
3.6
3.0
Discipline origination
Decision makers
Implementation success
%
Scope
66
48
4
38
25
5
45
38
20
47
3
24
34
0
* Average calculated over total sample
29
45 *
Source: 2007/08 Survey on Credit Portfolio Management Practices
bases and arbitraging the regulatory
weaknesses of Basel I.
Currently, portfolio managers report a
reinforced focus on improving origination (3.7 out of 5), but still see capital
optimisation as the most important value
lever (4.4 out of 5). However, these
objectives need to be embedded in a
clearly articulated credit strategy and
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CPM.indd 66
cycle downturn (83%), only a minority
(38%) currently pursue an active cycle
management approach.
The cycle management strategy will
help CPM to detect deviations from
long-term fundamental values, identify
bubbles and respond to opportunities
from mis-pricing that arise as a result of
the cognitive biases of market participants (for instance, overconfidence,
extrapolation of short-term trends into
the future and loss aversion). These biases
have been partly driving prices for many
credit assets during this crisis. In future,
portfolio managers will see their role as
optimising the long-term risk-adjusted
performance of the credit book through
the cycle.
However, there is a lack of consensus
regarding appropriate performance measures over the course of the credit cycle. A
majority (57%) were not fully satisfied
with indicators used. Some portfolio
managers even question the meaning of
measuring the performance of CPM.
This explains a finding in the survey that
the contribution made by active CPM is
sometimes not clearly understood or
recognised within organisations, causing
top management to challenge the value
created by the function.
If the discipline is to develop, banks
will need to agree on clear, simple and
cycle-informed performance measures
that acknowledge the long-term time
horizon of the CPM effort.
CPM needs to operate with a longer time
horizon. Credit portfolio managers need
to explain why the bank is an appropriate owner of a particular credit asset or
portfolio in case it will remain on the
balance sheet.
Portfolio managers also see the need for
a more active cycle management strategy.
Despite the fact most had foreseen the
As figure 2 shows, the focus of many CPM
desks has been on investment-grade
corporate lending business, for which
relatively liquid credit derivatives markets
have developed. In the current crisis,
however, writedowns have occurred
primarily in less transparent and less liquid
parts of the portfolio – primarily leveraged
loans and residential mortgage-backed
securities. In some cases, there was a heavy
reliance on rating agencies to assess the risk
of structured credit transactions, which led
some banks to invest in collateralised debt
obligation tranches without fully
appreciating the risks involved.
Perhaps unsurprisingly, nearly threequarters of the portfolio managers
surveyed regard liquidity risk as increasingly important. They also observed the
active management of correlation risk is
beneficial in a market downturn, because
correlations typically increase in stress
situations, meaning portfolio hedges
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CREDIT PORTFOLIO MANAGEMENT SPECIAL REPORT
might change dramatically.
This suggests a need to take a comprehensive approach to managing the overall
risk of a bank’s portfolio. CPM can
provide transparency on the profitability of
credit assets through the cycle and the various risk factors that can affect the
portfolio’s profit and loss. The function can
also suggest measures to improve the
portfolio’s risk/return structure.
Mandate and objectives
Figure 3 describes the three different
portfolio management mandate models
that emerged from the survey: decision
maker, adviser and controller. The
decision-maker model accords the greatest
power to the CPM function; the controller
model the least.
Decision makers can be further
classified into: risk limiters, who only
have veto/decision rights for capital
optimisation; portfolio optimisers, who in
addition have veto/decision power
regarding reinvestments; and credit
treasurers, who also have veto/decision
rights over loan origination, typically
with asset transfers. The survey shows the
advisory and decision-maker models are
equally prevalent (44% each), while
controller is the least common (12%).
Although the survey in general showed
the effectiveness of CPM grows with the
assigned power (see figure 4), it does not
automatically follow that a decisionmaker approach is the right model for
every bank. The optimal model depends
on the strategic objective a firm wishes to
pursue with CPM. An adviser model
might be more suitable in some cases –
for example, if the main objective is to
increase secondary market liquidity of
the credit book by providing guidance to
origination on how to achieve this. In
future, banks will have to think carefully
about which mandate they assign to
CPM groups to ensure successful
implementation of their objectives in the
new market environment.
Functional responsibilities, tools and
infrastructure
Before the crisis, CPM had in many cases
limited influence on the origination
business of banks. That’s because secondary
markets were considered to be infinitely
liquid, implying undesired exposures on the
credit book could be easily offloaded.
Today, CPM survey participants emphasise
the need for a strengthened relationship
with the origination team to ensure risk-
5 Choice of business model reflected in location of CPM units
Percentage of
respondents
CPM business models
Controllers
Location
within
institution
Advisers
Decision
makers
Product/
regional LoB
32
50
71
Central
risk/finance
function
68
50
29
Growing sophistication
accompanied by relocation to
business function
Source: 2007/08 Survey on Credit Portfolio Management Practices
Organisation and governance
case, CPM is closer to the individual
businesses, and it is easier for the group to
actively manage a stand-alone profit and
loss. However, the function’s scope is
limited to the credit assets of the respective
business line.
In the second case, CPM can oversee
the credit book of the institution, but is
by nature more focused on mitigating
risks instead of optimising risk/return.
Stronger mandates are typically located in
the line of business, whereas weaker
mandates can be found in the risk or
finance function (see figure 5).
Although there is no single model for
establishing CPM units, banks must
ensure their CPM function is equipped
with sufficient authority – in particular,
versus the business lines – and is visibly
represented in the relevant decisionmaking bodies of the firm. A reasonable
balance of power between business lines
and the CPM function can also help
ensure there is a culture in which the two
groups can challenge each other.
We have outlined some general guidelines on how CPM can evolve to support
the overall performance of credit businesses and be more effective in dealing
with events such as the credit crisis. It is
also important to note that if CPM is to be
successful, it must be applied in a manner
that is consistent with each individual
bank’s culture and strategic orientation, as
well as the new market environment. L
Two potential organisational models for
establishing CPM functions have evolved
in recent years, which are almost evenly
distributed within the survey population:
CPM in the business line; and CPM in
the risk or finance function. In the first
Uwe Stegemann is a director at McKinsey &
Company, based in Cologne. Gösta Jamin is
an associate principal, based in Munich. Email:
uwe_stegemann@mckinsey.com, goesta_jamin@
mckinsey.com
adjusted pricing of new business and
provide clear guidance on asset quality and
structure, both for future syndication/
securitisation transactions and for defining
and implementing a target portfolio.
The survey reveals the need to improve
infrastructure and tools used by CPM
functions. To date, models have been
mostly backward-looking or dependent
on the assumption of efficient capital
markets (for example, in the parameters
used for model-based transfer pricing),
and have proved insufficient to deal with
complex instruments in real-life market
conditions. Many institutions involved in
reinvestment activities relied heavily on
external ratings and did not develop their
own perspective on the attractiveness of
certain transactions.
Interestingly, banks with weaker CPM
functions (advisers) were more likely to
reinvest in complex structured instruments (52%) than banks with stronger
CPM functions (decision-makers 38%).
In future, banks need to develop a
forward-looking risk infrastructure and
go beyond extrapolating past trends to
take a more integrated perspective on
future developments in the credit cycle.
By doing so, CPM groups can play a
significant role in identifying and
managing structural risks that can affect
overall performance.
risk.net
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