Effective Risk Management Techniques to Improve Credit Portfolio Returns

A credit portfolio—comprising loans, bonds, and other such credit exposures—is pivotal to the financial health of a bank or financial institution. Therefore, the return-to-risk ratio of a credit portfolio requires optimization to maximize the value for all stakeholders. Portfolio optimization necessitates a scientific approach toward risk measurement and risk management, which can set appropriate limits and enable strategic changes to credit exposure. This blog outlines essential measures and techniques for advanced risk management that can help financial institutions enhance their credit portfolio returns.

Measuring Portfolio Risk and Ensuring Capital Adequacy

Effective risk management requires accurate measurement of portfolio risk and capital adequacy. This includes:

a. Loss Distribution

The most important step is to determine the quantum of capital required to absorb possible portfolio losses. The average Expected Loss (EL) over a given period calculates the parameter as: EL = PD × EAD × LGD Where

• Probability of Default (PD) is the likelihood that a borrower will default on their loan.
• Exposure at Default (EAD) is the total value exposed to loss at the time of default.
• Loss Given Default (LGD) is the percentage of exposure lost if a default occurs.

b. Stress Testing and Reverse Stress Testing

Stress testing measures a bank’s expected losses (EL) and capital requirements (CR) under different bank-specific and macroeconomic conditions. Likewise, reverse stress testing uncovers scenarios, borrowers, and sectors with more exposure and chances of substantial losses and acts as a wake-up call for banks to realize unknown vulnerabilities. For instance, stress tests conducted during the COVID-19 pandemic showed considerable risks in the Hospitality and Retail sectors. Key metrics for stress testing and reverse stress testing:

• Capital Ratios: CET1, Tier 1, and Total Capital ratios.
• Loan Losses: Projected losses on loan portfolios.
• Profitability: Net income under stress scenarios.

In 2023, the Federal Reserve stress test results found that the largest banks in the U.S. could withstand the most severe recessions and maintain lending flows. Under the stressed scenario, they averaged a 9.7 CET1 ratio. A European bank’s reverse stress test (2023) revealed that a prolonged period of negative interest rates combined with a significant increase in loan defaults could reduce its CET1 ratio by 6 percentage points, potentially breaching regulatory capital requirements.

c. Capital Planning and Risk Appetite

Capital planning refers to actions that ensure that banks remain adequately capitalized and recover from capital shortfalls under severe stress.

As per Basel III, banks need to hold a minimum Common Equity Tier 1 (CET1) capital ratio of 4.5%, with additional buffers bringing the total minimum to around 10.5%.

Setting risk appetite defines the target levels and limits for taking risks that align with market risks and opportunities.

Quantifying the Impact of Each Exposure on Portfolio Risk

Understanding the incremental impact of each exposure on portfolio risk is crucial for making strategic decisions. Key measures include:

a. Risk Contribution

Risk Contribution (RC) indicates the increase in portfolio risk as the exposure increases by $1. It includes the size of the exposure, its standalone risk, and its correlation to the portfolio. In general, this process pinpoints exposures that truly matter for the given portfolio risk and makes a reasonable decision about whether it is a good idea to increase or decrease that exposure.

b. Risk Concentration and Risk Attribution

Identifying risk concentrations in borrowers, sectors, or regions allows banks to manage diversification effectively. Risk attribution further explains the factors driving an exposure’s Risk Contribution, enabling better communication and action upon risk measures.

Setting Limits to Prevent Excessive Risk Concentrations

To avoid excessive risk concentrations, banks and financial institutions can set notional limits that can be determined by using a quantitative and risk-sensitive approach, such as:

a. Segment and Borrower Limits

Banks and financial institutions can use tools to calculate risk-adjusted notional limits for segments and top borrowers. This approach accounts for individual risk attributes and impact on correlation, which can be dynamic and thus maintain risk at an optimal level based on the bank’s risk appetite. This approach accounts for specific risk attributes and correlation impacts, providing a dynamic method to maintain risk levels consistent with the bank’s risk appetite​​.

Increasing/Decreasing Credit Exposure to Enhance Portfolio Return/Risk

Portfolio performance can be optimized by strategically increasing or reducing credit exposure, provided the latter is consistent with the expected return and the expected risk of the portfolio:

a. Asset Selection

By evaluating the Sharpe Ratio of every exposure (expected return divided by incremental risk), banks can prioritize asset selection that offers higher returns to their risk. Portfolio optimization tools distribute investments across segments in such a manner that the overall Sharpe ratio is maximized, balancing the return and risk.

b. Optimal Allocation of Assets

By evaluating each exposure’s Sharpe Ratio (expected return divided by Risk Contribution), banks can prioritize assets that offer higher returns relative to their risk. Portfolio optimization tools help allocate investments across segments to maximize the overall Sharpe Ratio, ensuring an efficient balance between return and risk​​.

Pricing and Sizing New Deals

Ensuring accurate pricing and sizing of new deals is the key to maintaining a balanced portfolio. This involves:

a. Risk-Based Pricing

Determining the Risk Contribution and Sharpe Ratio of new deals enables the bank to price them in a way that will ensure that they justifiably make a positive contribution toward the return/risk profile of the portfolio.

b. Tools

Tools enable easy and quick calculations of return and risk statistics at the point of deal origination while taking key factors—such as credit quality, deal terms, and macroeconomic conditions—into consideration.

Conclusion

Managing credit portfolio risks and returns is crucial for the financial stability and growth of banks. Advanced credit risk management techniques, such as precise risk measurement, strategic adjustments in exposure, and accurate pricing of deals, can help improve the bank’s return-to-risk ratio. Further, integrating the latest trends and regulatory changes with these credit practices can help build a robust and profitable credit portfolio. In a dynamic financial environment, banking success is all about improving and adapting.