Credit Portfolio Management - Open Risk Manual (2024)

Definition

Credit Portfolio Management (CPM) denotes a set of principles, tools, processes that underpin the management of Credit Portfolios (collections of credit assets). The defining characteristic of credit portfolio management activities is that Credit Risk is assessed and managed not on a standalone basis but in an aggregate, portfolio, setting.^[1]

Credit Portfolio Management Approaches

Given the wide variety of borrowers, credit products and markets it is not surprising that there are substantially different management approaches:

• The term Originate and Hold denotes a traditional portfolio management approach that
  • builds credit portfolios via Credit Origination
  • maintains ownership of these assets for the length of their life
• The term Underwrite and Distribute denotes a more market oriented portfolio management approach that
  • builds credit portfolios via Credit Origination
  • engages in the distribution of credit risk to other investors via Securitization, outright sales or credit derivatives

Active Credit Portfolio Management

The term Active Credit Portfolio Management (ACPM) is used to denote a specialized CPM function that is involved directly in the management of a credit portfolio, e.g. via identifying suitable investments and executing hedging activities.

Primary Objectives

According to an international survey the primary high-level objectives of Credit Portfolio Management units are:^[2]

• Provide portfolio information (help assess the current state of the portfolio)
• Help guide the origination of credit assets (help the formation of a future portfolio)
• Improve portfolio structure and reduce concentrations
• Help managing risk appetite (setting and monitoring relevant risk limits)
• Support the management of capital and financial returns

Elements of Credit Portfolio Management

Some commonly found elements of CPM best practices are:^[3]

Organizational Aspects

• Defining in some detail the scope of credit portfolio management activities (including identifying which portfolios, clients or counterparties are in scope)
• Identifying the roles and high level objectives of credit portfolio managers, including the Credit Portfolio Strategy
• Depending on context, a CPM function may be considered a business activity or a risk management activity.

Data Infrastructure and Analytics / Measurement Tools

• Position Data
• Historical Data and Credit Risk Analytics
• Scenario Analysis, Stress Testing
• Risk-based measures and valuation, including Economic Capital frameworks
• Model Validation

Policies and other Management Tools

• Help set and monitor Limits
• Help identify and manage Concentration Risk
• Perform Stress Testing Exercises
• Steer the Origination and Pricing of Credit Assets
• Perform Overall Portfolio Optimization
• Calculate Risk-Adjusted Returns and Risk Capital Allocation
• Calculate Capital Requirements and conformance to Risk Appetite.

Market Tools

The availability of credit portfolio management tools depends on the nature of the credit portfolio, the relevant jurisdiction / regulations and the type and maturity of credit markets. Indicatively:

• Diversifying Investments
• Portfolio Secondary Sales
• Portfolio CDS Hedging is available in markets and for credit exposures that can be referenced by a Credit Derivative
• Portfolio Securitization (Cash or Synthetic) is available in markets and for credit exposures that can be included in a Securitization

Issues and Challenges

• For regulated firms, credit portfolio management is heavily influenced by regulatory requirements and frameworks which are sometimes creating counter-intuitive incentives (Regulatory Arbitrage)
• While credit portfolio management is practised by a wide range of firms and organizations deploying the full range of tools is usually only possible for the largest firms
• Significant prior investment in measurement / algorithms relevant for CPM has been influenced by Basel II requirements which emphasized individual Risk Parameters over sectoral / macro dependencies in the portfolios

Post-Crisis Issues

A significant fraction of what were once considered best practices in credit portfolio management have been challenged by the unfolding of the Financial Crisis of 2008:

• Post-crisis emphasis (for regulated firms) on prescribed Bank Stress Testing exercises must be reconciled with internal CPM views
• Classic portfolio management approaches may need amendments to better capture issues such as Sovereign Risk, Contagion Risk and Political Risk

Technology Issues

• The development of Peer-to-peer Lending and other forms of Decentralized Finance introduce potentially entirely new organizational schemes
• The increased used of Machine Learning and Artificial Intelligence enables potentially new forms of credit portfolio management

Sustainability Issues

• Integrating the principles of Sustainable Finance into credit portfolio management is a major challenge

Related Concepts

• The term Credit Risk Management (CRM) is used sometimes as a synonym for Credit Portfolio Management. Yet CRM is also frequently used to denote more specifically the analysis of individual credit risks
• CPM is closely related to the broader concept of financial asset Portfolio Management. Financial portfolio management encompasses also the management of marketable (liquid) portfolios of assets such as (stocks or bonds) but also portfolios of insurance liabilities. Yet CPM has its own specific characteristics that reflect the nature of underlying credit portfolios and the associated business models.
• Modern credit portfolio management relies quite heavily on credit risk quantification yet as a discipline it is not identical to Risk Management. For example credit portfolio management has an important function in supporting Credit Origination. As a function CPM may be practised separately from risk management.
• Balance Sheet Management and Asset and Liability Management are broader terms that may involve also the management of liquidity / interest rate risk and integrate also the management of the firm's liabilities. CPM is a subset of those activities
• Enterprise Risk Management is another organizational scheme that may partially overlap with credit portfolio management
• Sustainable Portfolio Management concerns (credit) portfolio management in the context of Sustainable Finance

References