OWC 1 July1998

Active credit portfolio management

The changing business model in wholesale banking. By Andrew Kuritzes
every facet of the current business model, including client coverage and origination, pricing, portfolio investment, product management, risk control, balance sheet velocity, and capital utilization. This article describes the forces that are propelling the shift to active credit portfolio management, and highlights the major organizational implications and challenges of the new model. Universal banks with roots in both commercial lending and bond underwriting are coming to view loans and bonds as substitutable products in the same asset class. Loans, bonds, and derivative exposures to the same names are being managed as a single portfolio. Traders and loan originators are recognizing that these instruments are all different means for transforming credit risk just as swaps, forwards, and futures are different means for transforming interest rate, foreign exchange, and other market risks. s Need for improved portfolio diversification: Simultaneously, banks are becoming increasingly aware of the limitations of a fixed origination infrastructure. Most banks (particularly regional banks) are significantly underdiversified relative to the market as a whole. Yet one banks risk concentrations can become another banks risk diversification. Oliver, Wyman & Company estimates that the potential gains from improved diversification are on the order of a 25% reduction in economic capital for a typical multinational bank; the gains would be even larger for a more focused regional portfolio. The gains from diversification can overcome a limited credit appetite for internal originations and improve the economic returns of the loan portfolio. s Potential for tax and regulatory capital arbitrage: Apart from the need for greater diversification, there is also a growing recognition that traditional buy and hold origination is inefficient from a tax and capital perspective. Moving loan assets off bank balance sheets and into the hands of mutual funds, pension funds, hedge funds, and other pass-through vehicles eliminates regulatory capital requirements and the double taxation penalty on bank net income. On the demand side, non-bank investors are becoming increasing willing to hold credit assets, leading to a growing ERisk.com

Forces driving active portfolio management

ne of the most significant changes to affect wholesale banking in recent years is the shift from the traditional buy and hold origination model to active credit portfolio management. In the active credit portfolio management approach, a centralized group of portfolio managers assumes responsibility for making buy/sell/hedge decisions about the composition of the portfolio, and acts to optimize the risk/return performance of credit assets. Like most such changes, the transition to active portfolio management is born, in part, of necessity in this case, the legacy of industry overcapacity; high and volatile loan losses; underpriced credit assets; widespread cross-subsidization; and below hurdle-rate returns. In response, the new approach is based on unbundling origination and portfolio investment into distinct economic activities, each of which must stand on its own feet. At the same time, active portfolio management will open new channels to the secondary market, allowing internal loan originations to be directly compared with and diversified by market alternatives. Although still in its early days, the emerging active portfolio management model will have a lasting impact on the structure of lending businesses. It will affect virtually

The shift to active credit portfolio management is being driven by a number of related forces: s Increasing liquification of loan markets: Perhaps the most important force is increasing loan liquidity across the credit spectrum. Rising volumes in loan sales, syndication and trading are widening the windows on the secondary market, particularly for high-quality large corporate debt. The windows are allowing portfolio managers to rebalance a banks internal loan book through sales and purchases of loans, bonds, commercial paper, and other credit instruments. At the same time, the take-off of credit derivatives is creating new possibilities for risk transformation through innovative structures, of which credit linked notes, default swaps, and CLOs (such as JP Morgans Bistro deal and SBC Warburgs Glacier deal) are early examples. Further derivative structures may involve the indexing or reinsuring of illiquid middle market and commercial real estate loans, as well as the creation of short positions in credit risk. This will greatly increase the power and flexibility of portfolio strategies. s Convergence of fixed income trading and large corporate lending: An important consequence of increased market liquidity is the convergence of traditional fixed income and corporate lending activities.

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I. Traditional business model

client management portfolio investment

II. Emerging business models

"credit alco" client management origination portfolio investment

syndication secondary market

origination borrowers

credit approval

monitoring

borrowers

loan trading product structuring securitization

rating/ valuation

portfolio information

servicing

servicing

source of off-balance sheet investment. s Advances in credit risk analytics: The state of the possible in portfolio management is defined by the power of underlying credit risk analytics. In the past few years, there has been a revolution in the science of credit risk measurement, with the widespread adoption of risk rating, expected loss, and economic capital methodologies, and, more recently, the development of sophisticated credit portfolio models. Advances in analytics will continue to push out the frontier for active portfolio strategies. Each of these forces is gathering speed at the present time. Not surprisingly, their impact is compounding. For example, sophisticated credit risk analytics create the potential for new derivative structures; new forms of derivatives help to liquify a broader part of the credit spectrum; increased liquidity provides additional avenues for diversification; and better diversification improves the risk/return performance of the credit portfolio. All of this is leading to a significant reappraisal of the wholesale lending process, built around active portfolio management capabilities.

Organizational implications: unbundling the business

Realizing the potential of active credit portfolio management will require a fundamental realignment of the wholesale busi-

ness model. The starting point for most banks is the traditional buy and hold origination paradigm. As illustrated in Chart I, the traditional paradigm is an integrated model. The business is largely split between two main functions. The line consisting of individual account officers owns credit assets, and is responsible for originating, monitoring, and servicing loans, holding them until maturity (or default). Credit is responsible for making yes/no approval decisions, and for collecting and analyzing portfolio information. In most of wholesale lending (apart from large corporate syndications), the asset flow is one way, from the banks customers onto the balance sheet. The active portfolio management approach, by contrast, is based on a centralized portfolio investment unit. The portfolio unit sits between the banks internal originators and the secondary market. It assumes ownership of credit assets, and exercises P&L responsibility for the portfolio as a whole. Unlike the individual account officers in the traditional model, the portfolio unit is intended to act like an asset manager ie, to make decisions about what to buy and sell, and at what price, based on a portfolio assessment of risk and return. The creation of a centralized portfolio unit will force the traditional buy and hold structure to unbundle. As shown in Chart II, the new model is comprised of

several distinct activities each of which is a separate source of economic value. In the emerging end-game, these activities will include: s Client management/asset origination: The customer front-end will focus on sales of both credit and non-credit products. Account officers will add value by (i) servicing customer needs across a range of products; (ii) pricing credit deals at or above the hurdle requirements set by portfolio management; and (iii) managing their own productivity and cost efficiency. As in the capital markets and the mortgage industry, the coverage/origination function could evolve into a fee-based activity, where the fee varies with the level of value creation. s Credit rating/valuation: Rather than a yes/no approval function, the role of credit in the portfolio model will be to establish an objective risk rating, and hence asset valuation. The rating/valuation function will be key to determining the transfer price (and related fee) of internally-originated assets. To avoid conflicts of interest, the rating/valuation function should be independent of both origination and portfolio investment. s Portfolio investment: This unit will own credit assets and assume P&L responsibility for the credit portfolio. The portfolio investment unit will act as an asset manager, setting the price at which it is willing to buy 1 July 1998

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internal deals, and executing purchase/sales/hedge transaction in the secondary market. The unit will add value by setting the internal prices to achieve hurdle (or target) returns, and by improving the diversification mix of the portfolio (and reducing economic capital requirements) through secondary market transactions. s Credit ALCO: Just as the interest rate ALCO sets overall targets for the banks gapping and funding risk, a Credit ALCO will set overall financial and capital targets for the credit portfolio. The Credit ALCO will also delimit the scope of authority (in terms of asset classes, permissible investments and instruments) of the portfolio investment unit, and resolve cross-business issues. s Servicing: With the unbundling of origination and portfolio investment, a separate function could also be set up to service the loan portfolio. The servicing function will be a scale-sensitive processing activity, which adds value through cost efficiency. Potentially, the function could also be outsourced to a third party provider. A significant virtue of the active portfolio business paradigm is its transparency. Individual functions are held accountable for the sources of value within their control such as pricing and productivity, for origination; credit returns and economic capital utilization, for portfolio investment; and scale and cost efficiency, for servicing. The transparency alone will go a long way toward eliminating the cross-subsidies that often make credit a loss leader, and aligning incentives with market developments. Beyond that, there are four key ways in which the new approach will add economic value. First, it will instill better risk-pricing discipline at the front-end, by centralizing price setting authority for credit in the portfolio management unit. Second, it will improve diversification and reduce economic capital costs through the active search for portfolio hedges in the secondary market. Third, it will seed the develop-

Every institution will have to determine a best fit solution that is responsive to its business mix and competitive advantage

ment of new business opportunities in loan trading, product structuring, and credit derivatives, by generating demand from a large, internal customer. And fourth, it will encourage the streamlining of processes by making distinct functions (particularly, support functions, like rating/valuation and servicing) accountable for their own cost management. A final advantage of the new active portfolio management approach is that it will promote specialization. In the buy and hold model, all banks were forced to pursue similar strategies based on an integrated approach to the business. The new, unbundled model will ultimately allow banks to choose the activities in which they wish to compete. In fact, it is possible that some banks may even cede the portfolio management functions to others and become origination arms for larger portfolio players and packagers of credit risk.

Challenges in the transition

While the transition to active portfolio management is likely to result in a more profitable, specialized, and risk-efficient business, banks will need to overcome considerable challenges along the way. The design of the new model will raise unique organizational questions that cut across risk classes and business areas. For example: q What is the relevant scope for portfolio optimization? Should the credit portfolio be managed as a single, global portfolio, or divided into sub-portfolios, each of which will be locally optimized? q Which activities should be organized centrally, across business units (eg, product structuring, credit derivatives), and which should be decentralized, within business units (eg, origination)? Which should be

treated as independent profit centers, and which as support or service functions? q More broadly, where within the emerging business structure should an organization position itself for long-term success? What are the sources of competitive advantage? q How can the change in responsibilities implied by the new portfolio model be achieved without demotivating existing account and credit officers? There is no single right answer to these questions. Each institution will have to determine a best fit solution that is responsive to its business mix, market position, organization culture, and competitive advantage. Some banks are already beginning to address these issues. Market leaders in North America and Europe are starting to make the transition from buy and hold origination to active portfolio management. The initial steps are mostly being taken in the large corporate market, where existing liquidity makes the need for active portfolio management most compelling. At the same time, a few pioneering institutions are reorganizing mid-market and commercial lending around the new business structure. The question for other banks is not whether to move to an active portfolio model, but when. Current market leaders have recognized that there are considerable benefits to being an early mover. As the market adopts a more sophisticated portfolio model, banks that fail to act will become increasingly vulnerable to adverse selection and cherrypicking. Banks that act first will gain a clear advantage relative to latecomers, in terms of their ability to capture new business opportunities, influence market practices and regulatory standards, and attract scarce, talented resources. Andrew Kuritzkes is a Managing Director of Oliver, Wyman & Company, and global head of the firms Wholesale Lending Practice 1 July 1998

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