With an eye on what lies ahead for the industry in 2015, SmartBrief conducted an e-mail interview with Jeffery Weaver, Chairman of the International Association of Credit Portfolio Managers. Mr. Weaver is an Executive Vice President and Group Head of CPM at KeyCorp.
The role of Credit Portfolio Managers in the management of credit exposures has evolved since the end of the Great Recession and one of the most significant changes is the expansion of regulation. How has this heightened regulatory scrutiny changed the role of risk management?
The role of credit portfolio management has become more strategic to the firm as the perpetual assessment of emerging risks and their potential impact on the credit portfolio is under taken.
In order to deliver high quality stable earnings with a sustainable growth profile, risk must be monitored across the organization in a collaborative and transparent manner. The optimally performing bank of today promotes prudent and effective decision making premised on a predefined set of strategic operating principals – while maintaining alignment with a risk management philosophy that has broad support by the firm’s Board of Directors, senior management, and its primary regulators.
Maintaining profitability is ever more challenging in today’s banking environment. What would you say is the greatest obstacle banks are now facing?
While certainly not a new challenge, regulation remains a significant hurdle with guidelines and procedures proliferating in an attempt to reduce systematic risk and protect depositors. Many firms have been asked to carry significantly more Tier 1 Capital to demonstrate their ability to comply with the new regulator-enforced self-insurance model of banking. The approach is intended to motivate firms to continuously demonstrate the sufficiency of capital to survive contrived scenarios and idiosyncrasies of their various operating models. As such, a number of banks now generate a return on equity to their shareholders that is a percentage of what was delivered pre-2007; and currently trade around their book value. Further, this new banking landscape includes greater regulator focus on the adequacy of capital levels and eliminates many fringe activities within banks. Intended to reduce the amount of capital at risk, this places tremendous pressure on banks to ensure that the remaining earnings are sustainable and provided with minimal volatility.
In addition, banks are expected to develop and demonstrate a deeper understanding of the latent and emerging risks that could subject their earnings to unexpected fluctuation. In the new landscape of banking, Credit Portfolio Managers have an opportunity to provide this level of precision.
The losses experienced during the Great Recession remain fresh in our collective memory. How can banks get comfortable extending credit with this in mind?
I think that a key component is the ability to articulate and measure risk, specifically loss volatility. With lower returns on equity, tolerance for frequent credit events that result in outsized losses is meaningfully lower. Enterprise risk and loss volatility are measured at the time the loan is originated and recalibrated as the bank’s credit portfolio composition changes and the external credit markets re-price. Credit Portfolio Management, at a firm such as KeyCorp, has been asked to increase its involvement in the strategic allocation of capital and participate in the implementation of a proactive and anticipatory enterprise risk management. In this approach, risks are evaluated both collectively and individually.
As a bank adds various credit exposures to its portfolio, the portfolio credit risk of the retained portfolio and its portfolio loss volatility alters – requiring a dynamic recalibration of the risk contribution of the portfolio and enhanced portfolio monitoring for concentration and latent inter-asset correlation. Origination support from credit portfolio management functions, when done collaboratively, can advise on the shape of the risk profile of the credit portfolio and drive the optimization of the capital allocated with the firm to generate a moderately higher return. An intended consequence of such an effort may be a reduction of default risk with less capital deployed in higher risk sectors.
Low oil prices and energy sector exposure is the ” topic du jour” for banks, but concern over a potential spike in oil prices was top of mind just 6 months ago. How can banks navigate this emerging risk minefield?
Managing concentration risk, the degree to which a firm’s capital or exposure is concentrated in any given borrower or industry, is a core function of our discipline. The practice of credit portfolio management within an enterprise risk management process can lead to the development of a framework that reduces the likelihood of excessive pooling of risk. A frequently calibrated framework should be customized to reflect the expertise of the firm and its ability to manage moderately higher positions where it has a demonstrated expertise. This is essential to ensuring that a bank is paid for its captive credit portfolio and its ability to optimize its return relative to its risk profile. Borrowers, asked to provide a return for a unique cost of credit, cannot be expected to compensate a bank for its concentration risk. Thus, a bank must work to avoid loan concentrations where it reduces its return on equity. Oil & Gas and the work that has gone into better understanding the risk-return paradigm over the last year has been a great opportunity for credit portfolio managers to prove their worth.
While these hot topics occupy a good deal of time and energy, the focus of risk management is to maintain portfolio performance through the credit cycle. What other processes and tools are critical to this end?
Enterprise monitoring of the credit portfolios, using inter-disciplinary committees in addition to various portfolio management functions, result in faster and more deliberate action, which ensure minimal credit losses. Many banks, such as KeyCorp, employ various portfolio credit risk systems that use simulation approaches to assess the latent portfolio loss volatility. The timely credit insights from these sorts of tools are helpful in providing a quantitative element to the process of portfolio shaping. Additionally, loan sales, 1st loss hedging, credit hedges and other tools that allow risk transfer of concentrated or unwanted exposures are frequently used in the industry to address potential risk concentration problems.