Placing credit portfolio management within the organizational structure
The credit portfolio management function within many financial institutions has evolved significantly as risk mitigation and distribution mechanisms have developed. Questions arise about whether it’s better to have the credit portfolio management function inside or outside the originations process, on the private or public side of the information barrier, or with a narrow or wide scope. This article explores those issues as well as governance of the credit portfolio management function.
The liquidity explosion in recent years in both the credit default swap and secondary loan markets allows institutions of various sizes and scopes to better manage retained credit risk–whether such risk stems from commercial lending, derivatives, or other credit-related businesses.
Regardless of the form it takes, a key element in the success of credit portfolio management is a commitment to its mandate by senior management. This mandate should specify that all of the retained credit risk within an institution should be actively managed within the context of market liquidity, risk appetite, and the overall credit risk management effort of a firm.
The structure selected for portfolio management should also be influenced by the group’s objectives. For example, various firms may prioritize the following common goals of credit portfolio management differently:
* Improvement of the risk-adjusted return of a retained credit portfolio.
* Mitigation of event risk (headline risk) by reducing single-name and industry concentrations.
* Reduction of exposure to deteriorating credits.
* Minimization of the economic capital required to support the extension of credit.
* Increase in velocity of capital so that it may be redeployed in higher-margin activities.
As these goals can conflict at times and must be achieved within budgetary constraints, the mandate of portfolio management should be transparent and well communicated. While recognizing that a one-size-fits-all approach to the design and structure of a portfolio management function remains elusive, this article will evaluate the following issues as they pertain to a broad spectrum of institutions:
* Organizational structure. Where is credit portfolio management placed within an organization, and what are the advantages and disadvantages of being aligned with or separate from the originating businesses?
* Public versus private. Is credit portfolio management a public-side group with relatively few trading restrictions, a private-side function with an ability to influence the onboarding of risk, or a hybrid of both?
* Scope. Which businesses and types of assets fall within the scope of credit portfolio management?
* Governance. How will the role of compliance affect both private- and public-side functions?
The decision of where to place credit portfolio management within an organization will hinge in large part on the mandate of the function, the scope of risk it manages, and the nature of the underlying retained risks emanating from the firm’s client businesses. Portfolio management can reside in various parts of an organization, with the most common models placing portfolio managers either within the originating business or as part of a centralized risk management or finance function. The latter structure is more prevalent among larger institutions, according to a 2004 survey of credit portfolio management practices conducted jointly by the International Association of Credit Portfolio Managers (IACPM), the International Swaps and Derivatives Association (ISDA), and the Risk Management Association (RMA). This study indicated that 55% of respondents resided within the broadly defined risk management or finance functions.
There are several advantages to centralization. When a firm has a variety of businesses that hold retained credit risk, a broad, centralized risk management stripe allows aggregation of different risks to the same customers under one credit risk management umbrella.
Such risk aggregation also helps a firm prioritize its concentrations and credit migration risks, especially when the firm is making allocation decisions for potentially scarce hedging resources.
Centralization also can reduce transaction costs whereby two businesses within the same firm take the opposite side of a trade.
Further, portfolio management decisions are more likely to fulfill the mandate of the credit organization with respect to reducing exposure to concentrated positions or deteriorating credits. Decisions also are less subject to pressures from origination/ client management to generate business.
Conversely, there are two key problems with credit portfolio management residing outside the originations business:
1. It can be more difficult to communicate portfolio management objectives to colleagues in the business.
2. It can be more difficult to create transparency around the credit portfolio management decision-making process.
Both problems could be further complicated by inside- and outside-the-wall considerations, as discussed in the next section.
The location of credit portfolio management within the originating businesses is more likely to be effective when a firm’s business is more narrowly defined. In contrast, a firm with diversified activities may have pockets of credit risk extended to an overlapping group of customers that is created outside the core originations line, making a centralized function more appropriate.
Public versus Private
The decision of whether credit portfolio management will reside on the public side of a firm’s information barrier will be influenced at the very least by the earlier discussion of whether the function will be part of the originating business. More importantly from the standpoint of the overall mandate, though, the decision is influenced by the firm’s breadth of business, the scope of risks managed by credit portfolio management, and the level of public market trading expected. The broader the mandate, the business mix of the host firm, and the scope of risks managed, the more likely it is that steady public market access will be needed to effectively manage risks. In that case, a public-side model would be more advantageous. When considering market access, we are specifically referring to the credit default swap (CDS) market, but other trading venues could be involved as well. To the extent that profit generation, proprietary trading, or cost-mitigating position-taking are part of the credit portfolio manager’s mandate, it becomes all the more likely that an outside-the-wall format will be selected. To the extent that the breadth of the underlying origination businesses and the scope of risks managed by portfolio are narrower, and trading activity and public market access are less of an issue, a private-side model may be better.
It is likely easier for most firms to locate portfolio management on the public side if the group is part of the risk management or finance function. Figure 1 illustrates a potential structure of a public-side group within a money-center bank. The basis for such a structure is that it allows for credit portfolio management to remain on the public side and trade CDS in a name even if material, nonpublic information (MNPI) exists elsewhere in the firm. Of course, the appropriate compliance structure must be in place to establish policies and procedures to “wall off’ the public-side portfolio management function from MNPI that may reside on the private side. For large institutions that may often have private information on a wide range of clients, this public-side model should result in fewer trading restrictions and more flexibility to actively manage the portfolio in the CDS and secondary loan markets. Furthermore, for firms with a diverse range of activities, this information barrier should also reduce the risk that clients of other businesses perceive the firm to be front-running or inappropriately trading in the firm’s own account.
An additional benefit of portfolio management residing on the public side is that the group can be structured as a “buyside” asset manager that in essence takes a “second look” at credits in the portfolio, providing ratings validation and improving the odds that problem credits will be detected prior to further deterioration. Since the credit portfolio managers are not involved in risk onboarding decisions, they can have a more objective approach to risk mitigation decisions. Furthermore, a public-side portfolio management group may also have extensive contacts with the public-side trading desks and research departments of Wall Street–contacts that will likely be more restricted for private-side portfolio management functions.
However, this approach is disadvantaged in that portfolio management may be more isolated from the business, which can result in less effective communication of business priorities and, hence, less effective use of hedging budget resources. For example, portfolio management may reduce risk to a name with which the originations business is not planning on conducting further activity, with the two sides unable to communicate as a result of compliance restrictions. Moreover, it becomes more difficult for credit portfolio management to be used as a business-enablement function in creating capacity (i.e., reducing risk) for a given client or sector as it becomes difficult to communicate the needs of the business in this regard across the information barrier.
Figure 2 illustrates a potential structure of a private-side portfolio management function within a money-center bank. Private-side portfolio managers have the ability to influence the composition of the portfolio through their involvement in the risk onboarding decision, a distinct advantage over public-side counterparts. Furthermore, residing on the private side allows portfolio management and the originations business to develop a coordinated set of outlooks for individual companies and industries. These views can then be implemented in both the secondary loan and CDS markets, as well as through originations targeted toward a certain credit profile. Portfolio managers are able to share practical market limitations, such as the degree of liquidity in a name in the CDS market. Additionally, the loan-sale-request process will likely be smoother as a result of the ability of the private-side portfolio manager to discuss a credit and the rationale for reducing risk to a name. Finally, this structure can often result in more efficient loan trading, particularly for smaller companies where the details governing the loan agreement are not publicly available. In general, private-side portfolio managers will have a better understanding of portfolio risks when private companies are involved. However, a significant exchange of trading flexibility may be required to obtain the aforementioned advantages. Thus, while every institution will bring a distinct set of considerations and requirements, keeping credit portfolio management on the public side generally works well for large, complex institutions. Similarly, a private-side model may be best for small and midsize institutions new to the credit portfolio management discipline and having less liquid portfolios.
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Beyond determining where portfolio management resides within an organization, management must determine the scope of the credit risks managed by the function. The potential commercial credit risks to be considered include:
1. Large corporate/investment bank credit facilities.
2. Commercial bank/middle-market credit facilities.
3. Counterparty credit risk of derivatives transactions.
4. Market risk of derivatives.
5. Hedge fund and asset management credit risk.
7. Private banking.
9. Treasury services.
Based on a recent discussion conducted with members of the IACPM, we believe that all retained credit risk within an institution should be actively managed, within the context of market liquidity, risk appetite, and the overall credit risk management effort of a firm. Taking the example of a typical large U.S. bank with a diversified set of businesses, at a minimum the scope of portfolio management should include all exposure to any credit that trades in the CDS market. Additionally, credits that can currently or may in the future be sold in the secondary loan market also should be included for active portfolio management. Furthermore, portfolio management may be able to construct synthetic vehicles where credit risk extended to illiquid companies may be diffused, or it may enter into correlated trades whereby reducing risk to one industry participant benefits the overall portfolio.
Once the scope of a portfolio manager’s responsibility has been determined, the tools available to mitigate risk should be identified. Key to determining the scope of alternatives available is the institution’s reporting and finance infrastructure. At the outset, a lack of sophistication in this regard may limit the instruments available to portfolio managers to single-name hedges and loan sales. As an organization moves up the portfolio management learning curve and systems become more robust, other products–such as credit indexes, tranches, baskets, or other structured transactions–may be employed.
Regardless of whether a firm opts for portfolio management within or outside the originations business, on the private or public side of the information barrier, or with a narrow or wide scope, maintaining a robust compliance function is critical to the integrity and success of portfolio management.
For public-side portfolio management, appropriate compliance policies and procedures should be enacted that are reasonably designed to limit the flow of nonpublic information so that transactions effected by the public-side group are not made on the basis of MNPI that the private side may have received. In today’s rigorous regulatory environment, ensuring the sanctity of the information barrier may not necessarily be the end of the process, as even the perception that there could have been a wall breach may prove a liability to a firm from a headline or reputational risk perspective. Complexities around such issues as decisions to maintain or unwind hedges, relationship approvals for loan sale requests, and hedges on distressed credits are just a few of the areas that will require advice and guidance from a firm’s legal and compliance functions.
For private-side portfolio management, a robust compliance function is equally important, particularly when determining which procedures will be used to determine if the firm and/or portfolio management is in possession of MNPI. This is in recognition that significant legal, regulatory, and reputation risk exists for institutions and individuals that trade CDS while in possession of MNPI. This governance structure may result in the group being frozen from adding new hedges or unwinding existing hedges, often at the most volatile time for a company’s debt instruments as news is being disseminated.
Several options are available to limit the restrictions placed on private-side portfolio managers. For example, when the firm is agent on a credit facility, the portfolio managers may be approved to receive only syndicate-level information so that trading in the secondary loan market is not restricted. Regardless of the specific decisions taken in establishing the function, it is important that regulators and other constituents fully understand the governance of portfolio management.
Further details surrounding the handling of MNPI by North American and European credit market participants are detailed by the Joint Market Practices Forum and are available at www.isda.org.
Regardless of the structure selected when introducing active portfolio management to an organization, the function should be flexible enough to evolve as an organization’s needs change. For example, credit portfolio management often starts out in a defensive mode, attempting to eliminate concentration risk and to cull unprofitable relationships. A second, more developmental stage can add optimization through the rebalancing of existing exposures. A more advanced stage may add managing the portfolio to improve its risk/return profile and its relative value performance. This evolution may result in portfolio management beginning as a private-side function located within the business with a limited scope, but evolving into an independent public-side group charged with managing a diverse set of credit risks.
As mentioned at the outset of this article, one key to the success of active portfolio management is senior management’s commitment to the function’s mandate. This mandate should delineate that all of the retained credit risk within an institution be actively managed within the context of market liquidity, risk appetite, and the overall credit risk management effort of a firm. With this mandate, the structure of a portfolio management function should be dictated by the unique business scope and needs of a firm. In general, residing on the public side generally works well for larger institutions with a diverse set of businesses. Similarly, a private-side model may be best for small and midsize institutions new to the discipline and having less liquid portfolios.
[c] 2005 by RMA. William Ingrassia is a managing director, Credit Portfolio, and Peter Greatrex is a vice president at JP Morgan Chase, New York, New York.
Contact William Ingrassia by e-mail at email@example.com; contact Peter Greatrex at firstname.lastname@example.org.
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