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Insolvency Practice and the Credit Process

Philip D. ShermanSenior Adviser in Asia

The Risk Management AssociationNovember 2004

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Outline

• Banks must take risks . . . They need to have a process to manage the risks and the inevitable losses . . . and a capital cushion

• The insolvency community deals with the risk failures, whether of process problems or due to the environment or borrower or both

• Banks need to tap insolvency knowledge to improve their process and decision-making so that they can

– minimize exposure at the time of default– recover as much as possible of that amount

• We can look at process and capital in terms of the modern credit risk equation:

. . . with focus on the last two terms

Expected Loss = Probability of Default X Exposure at Default X Loss Given Default

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The “Credit Equation” Summarizes the Methodology for Risk Measurement

Expected Loss (EL) =

Probability of Default (PD/ PoD) X Exposure at Default (EAD) X Loss Given Default (LGD)

plus correction factors for tenor and correlations.

Exposure at Default (EAD)

EAD and LGD loom large in the arithmetic

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LGD Is Particularly Important in Asia

Collateral

RefinancingRestructuring of

Business &Management

•Problems of client information mean PD is hard to estimate . . .•Collateral . . . which is a focus of LGD . . . Is a the center of the process•LGD must therefore be managed very well

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MarketingCredit

ApplicationCredit

ApprovalDocumentation

& Disbursement Monitoring Workout

Portfolio Acquisition Portfolio Maintenance

Cre

dit

Pol

icy

&

Por

t-fo

lio

Man

agem

ent

Credit Organization and Culture

Bank Credit Processes Lay Out the Drill for Credit

The Basel Committee requires•An Orderly, professional and imaginative process•The measurement of risk and the use of measurement in all credit activities

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The Credit Equation Ties Closely to the Credit Process

Process Element

Credit Equation

Term

Credit Policy Uses all

Marketing Based on policy

Credit Application

PD

Credit Approval

PD

Documentation &Disbursement

LGD

Monitoring EAD, PD

Workout LGD

Feedback•Process

•Credit Specifics

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Capital Is Allocated Against “Unexpected” Losses

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The Credit Equation is Used to Determine Credit Capital by Way of “Risk Weights

Rating AAA to AA-

A+ to A- BBB+ to BB-

Below BB- Unrated

Risk Weight

20% 50% 100% 150% 100%

Pillar I Capital

1.6% 4% 8% 12% 8%

Rating AAA to AA-

A+ to A- BBB+ to BB-

Below BB- Unrated

Standard Capital

1.6% 4% 8% 12% 8%

IRB Capital*

1-2% 2-4% 4-11% 11-30% NA

Standardized Approach Mandates Capital in Accordance with Rated or Unrelated Risks, incorporating all equation elements

The Internal Ratings Based Approach (IRB) produces a range of requirements based on Expected Loss, with a mandated LGD (Foundation) or a calculated LGD ( Advanced)

*Mandated LGD assumption in Foundation Process

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Banks Build the Equation into Their Credit Management System

Low FacilityRating, e.g.High LGD

High facilityRating, e.g.Low LGD

High RiskRating, i.e.,Low PD

Low RiskRating, i.e.High PD

High EL -Avoid

Low EL -–Manage returns

Manage Risk,Monitor client,Collateral

Manage Risk,Monitor client,collateral

•Some banks already used Expected Loss•A much larger group uses “Risk Ratings” and some LGD assumption•“Facility Ratings are another way to manage LGD and potentially EAD•Ratings translate into action guidelines in risk management:

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Basel Sets Requirements for Collateral Management. . .

•Legal enforceability•Objective market value•Frequent revaluation•First claim•Clear credit policy for collateral•Appropriate liquidation analysis in credit approvals•Distinct operational unit to manage collateral•Adequate insurance•Property monitoring, e.g., to ensure taxes paid•Environmental liability risk management

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. . . and LGD Estimation

Basel LGD Estimate Process•Estimates have to be used for management• “Track record” in using data for at least three years.•Assessment of principal drivers supported by analysis•Adequate time frame•Historical experience/empirical evidence•Adequate statistical base and analysis, with consistent application and with appropriate validation procedures•External comparisons•Stress testing•Comprehensive view of “loss”•Consistency of default definition•Key characteristics of borrower/facility/product•Country and industry factors•Legal factors including insolvency regime•Procedure for overrides of grades•Collateral analysis

Collateral Analysis•Dependence between borrower and collateral value•Currency mismatch•Conservative valuation/estimation of workout period•Conservatism!!!!•Clear, consistent collateral policy keeping in mind creditworthiness of obligor•Robust collateral management systems•Concentration monitoring/action•Policies on appropriateness of collateral, liquidation potential and revaluation procedures

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Basel Defines “Default” and “Loss”

Loss“This should include the discount effects, funding costs and direct and indirect costs association with collecting on the instrument in the de termination of loss. Banks should not simply measure the loss recorded in accounting records, although they should be able to compare the two” (Basel Accord, Para 339).

DefaultPer paragraph 272 of the final Accord document, a default occurs when one or more of the following conditions obtain:•It is determined the obligor is unlikely to pay its debt obligations (principal, interest, fees) in full•A credit loss even associated with any obligation of the obligor, such as charge-off, specific provision, interest or fees•The obligor is more than 90 days past due on any credit obligation•The obligor has filed for bankruptcy of similar protection from creditors

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LGD Studies Are Thin and U. S. Orientated

•Shortage of data and focus on bond markets and syndicated loans •Many definitions and calculation algorithms, particularly “default” and “loss,” are far from being agreed or implemented. •Individual bank universes of defaults are much narrower

•Difference between studies of losses “when all is said and done” and losses as measured by security prices subsequent to default •Both EAD and LGD are very reflective of the bank credit process/willpower

•In Asia, there are wide differences by country.

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S & P Has Developed “Loss Stats” Date

Type Recovery %

1988-2001

Recovery %

1998-2002

Recovery %

2003

Bank 84 74 72

Senior Secured Bond 69 46 29

Senior Unsecured Bond 52 37 21

Senior Subordinated Bond 35 21 NA

Subordinated Bond 30 15 NA

Junior Subordinated Bond 17 3 NA

Available UltimateRecovery %

Debt below (i.e., how senior?) 16

Collateral 13

Debt above 10

Aggregate default rate 7

Industry factor 7

GDP 0

General recovery data unsurprising,but 2003 a bad year

Recovery heavily correlated tostructural financing factors

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Fitch Produces Similar General Results, but Clarifies a Skewed Distribution

Type Loan Recovery % Bond Recovery%

Senior Secured 72 62

Senior Unsecured 52 42

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Moody’s Results Are Congruent but Lower

Rating Agency LGD Models• S & P Loss Stats

• Moody’s LossCalc• Fitch’s DART

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Other Studies

• Edward Altman of NYU’s Stern School has delved into LGD and collateral management issues. papers.stern.nyu/~ealtman/

– Altman and colleagues link recovery and default rates, which is currently not part of Basel thinking.

• A Bank of Italy group produced “Italian Banks Workout Activity: Costs, Timing and Recovery Rates,” which was presented at third FAIR. Principal conclusions:

– Private agreements were much more important in case settlement than bankruptcy proceedings/foreclosure

– Recovery timing ranged from 6-7 years for bankruptcy/composition proceedings to around two years for private agreements. Foreclosures take longer than proceedings based on pledged securities. Foreclosure takes longer in southern and central Italy (PDS note: which have environments closer to Asia than the north) than in northern Italy.

– Annual recovery cost estimated at 1.2% of NPL’s

– Average recovery “by 1999” (it was not clear the period covered but obviously fairly long since the recovery periods were up to 264 months!) was 37% with considerable dispersion amongst banks. (PDS: Bank differences would seem to be a key element for further study)

– Short recovery periods led to higher recovery rates

– Consumer recoveries were better than enterprise recovering; “producer families” were above the mean

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An RMA Paper Digs into Causes

Define:LGD = (Charge-off - charge-off recovery) / Outstanding balance at default

α: The beta distribution’s center parameter and can be derived from equations belowβ: The beta distribution’s shape parameter and can be derived from equations below

Min: Minimum of all casesMax: Maximum of all cases

α and β are then derived from the following equations:

where μ, δ2 are population mean and variance respectively.2. We then transform LGD from a beta to a normal distribution suitable

for use in OLS regressions, using the definitions of α and β as calculated above.

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RMA Conducts Cooperative LGD Studies

Data Model•Facility and Customer Number

•Type of Company•Syndication indicator

•Country•Facility risk rating•Obligor risk rating•Authorized limit

•Amount outstanding at default•Spread index and per cent

•Industry•Collateral

•Collateral value and evaluation frequency•Unfunded risk protection information

•Credit mitigation produce•Facility type

•Seniority•Facility purpose

•Credit event•Cash flow information•Expense information

•Resolution event

Loss Calculations

There are very extensive breakdowns with in categories. Methodology to calculate actual economic losses is defined in some detail as well as is the event of default, which for purpose of this study includes:

•Past due•Unlikely to pay

•Non accrual•Credit loss•Facility sale

•Distressed restructuring•Bank-filed bankruptcy

•Obligor-filed bankruptcy•Unknown (which please

minimize)

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Asia Begins to Implement Basel

Country Response on Pillar I

Singapore The three banks will use IRB

Hong Kong Big banks to use IRB, as they will anyway, flexibility for smaller banks

Malaysia Implementation over time. Standardized - 2008 and IRB (voluntarily) - 2010

Indonesia Basel-like framework introduced but details to come

Thailand Appears will adopt Basel II but details still to come

Philippines Standardized in 2007, IRB possibly by 2010

PRC/India/Sri Lanka

Not hostile to Basel II but sticking to Basel I for now

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RoC’s JCIC Pioneers Data Collection

Cash Flow Behavior

Recovery Seniority Collateral TypeDirect Costs Legal/Trustee Fees AccountantIndirect Costs Management fee Duration of workout

Opportunity cost Moral hazard Adverse selection APR ruleChoice of auctioning vs. restructuring.

Singapore banks work with S & P, results not in yet

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Specific Asian Issues in LGD Study

•Poor historical data —it has been lost, was never created, is difficult to locate and extract

•Mergers mean data is either lost or non-comparable

•Data on paper, not digitized

•Definition difficulties (which however can be resolved up to a point)

•Problems in defining what needs to be measured – some elements, e.g., management willpower – are more measured in results which are still hard to compare

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Asia’s NPL Estimates Appear Too Low

Country 2002Av.

NPL%

2003 Est.

Comments

Singapore 8 7-7 “Reliability ahead of region.”

Hong Kong 5 5-6 Same as Singapore

Malaysia 16 13-14 “Numbers fairly reliable” 16% on three months basis, disclosed by regulator for whole industry although bank standard is six months.

Thailand 30 28-9 “Impaired assets 75% above official levels.” which were 16.5%. Loose rules on loan rescheduling to avoid default, which is at 90 days.

Philippines 32 30 Similar to Thailand. includes large volume of real estate collateral owned by banks, not easily saleable

Taiwan 13 10 “Impaired assets twice official levels” of 6.4%. Interest can be allowed to run for 180 days

Indonesia 2046

incl. IBRA

15-17 “Impaired assets 150% above official levels” of 8%. Most bad loans were shipped off to IBRA and the low number industry number reflects the low level of lending

India 23 30 Indian NPL rules set at 180 days although change planned for 2004.

Source: S & P Asia-Pacific Banking Outlook 2004

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Asian LGD’s Vary A Lot by Country, but Are High Relative to the U. S.

Country Est. LGD

Hong Kong 50

India 70

Indonesia 85

Malaysia 55

Philippines 75

Singapore 25

Taiwan 60

Thailand 70

Source: S & P Asia-Pacific Banking Outlook 2004

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Many Factors Affect LGD Management

• External– Economic Environment– Legal Environment– Financial Markets

• “Banking”– Structure of Facilities– Structure of Borrowers– Structure of Lenders– Documentation– Collateral

• Management– Monitoring – Valuation & Collateral Management– Personnel and staffing– Decision-making and Willpower

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An Informal “Expert Panel” Generally Confirms the List

EAD/LGD Factors Importance for

LGD in Asia,1998-2004

Too many or too diverse banks or too unstructured banking groups 10

No truly lead bank group 7

Local legal environment did not support collection/restructuring efforts 13

Deal documents missing 5

Deal documents poorly drawn 9

Security documents missing 5

Securities not properly registered 6

Security documents poorly drawn 7

Unrealistic collateral valuations 10

Security value is the same as the enterprise value, e.g., machinery, building project 5

Collateral deteriorated in liquidation value but this was  not recognized 8

Collateral monitoring, especially property, did not take account of the risk of "boom" prices 6

Collateral concentrations 5

Deal structure too aggressive in terms of local law and regulations 8

Deal structure too complicated 8

Group financial structure too complex and hard to understand/control 10

Inadequate general credit monitoring allowed advances which could have been avoided 7

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Recommendations for Action in Asia

1. Banks to be required to focus on LGD, data gathering

2. Regulators to set LGD coefficients

3. Regulators should use Basel definitions and standards

4. Regulatory papers to deal with LGD in depth, collateral and recovery process

5. FAIR to recommend a Basel Committee treatment of “recovery”

6. Asian regulators to develop “Asian” treatment for collateral

7. Regulators and banks to collaborate to improved legal environment

8. FAIR to increase bank involvement in its activities

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Philip D. ShermanSenior Adviser in Asia

The Risk Management Associationpsherman@dc.com or phil63772@hotmail.com

Telephone: 65-6836-1297Mobile: 65-9788-5001