Oxstones Investment Club™Banks can no longer manage loan books in isolation. A new survey reveals how portfolio managers are dealing with growing complexity.
Credit portfolio management (CPM) is a key function for banks (and other financial institutions, including insurers and institutional investors) with large, multifaceted portfolios of credit, often including illiquid loans. Historically, its role has been to understand the institution’s aggregate credit risk, improve returns on those risks—sometimes by trading loans in the secondary market, and hedging—and identifying and managing concentrations of risk. In contrast to traditional origination and credit risk-management functions that look only at individual deals or borrowers, CPM looks across the entire credit book.
The financial crisis of 2007 changed the way most functions at these institutions operate, and CPM is no exception. The historical role of CPM remains. However, new regulatory requirements, especially with respect to capital and liquidity, increasing cost and margin pressure, and changed market conditions have pushed CPM into a broader role with the need to align closely with other areas, such as finance, treasury, risk data and methodology, and business-origination functions.
To understand exactly how the role of CPM is evolving, McKinsey, in collaboration with the International Association of Credit Portfolio Managers (IACPM),1conducted a survey of 41 financial institutions around the world (see sidebar, “About the survey”). We asked what changes were afoot, what CPM’s mandate should be, how it should be organized to deliver on that mandate, and what tools and analytics were required. We discovered that there is broad agreement on the need for change—and change is under way in many institutions. Just as there has never been a unique template for the CPM function, there is no consensus on how it will evolve. Much will depend on the institution and its business model. The results point, though, to certain trends. And they highlight the choices that senior managers in banking, asset management, and insurance will have to make to adapt and shape their CPM functions for high performance.
Why CPM’s role is evolving
While several factors came to light, institutions identified three main reasons for the changes in CPM’s role.
Capital and liquidity constraints
Some 85 percent of institutions surveyed said that regulations relating to the levels of capital and liquidity that banks must hold—and the prospect of even tighter regulation ahead—were the main reason. Institutions need to restructure their balance sheets to achieve required target ratios, optimize the use of capital, and help drive profitability. As the largest component of the balance sheet is typically the credit book, they are looking to draw on CPM’s unique portfolio-management expertise, and to encourage CPM to influence loan origination as well as asset sales.
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McKinsey analysis shows that many of the world’s top 150 banks by assets, especially in Europe, hold only a little more capital than the “fully loaded” minimum requirements of Basel III. In some cases, depending on the nature of their business, banks may face a significant capital shortfall under the provisions of the so-called Basel IV rules, driven by regulations currently under consultation, such as a changed credit risk standardized approach, new internal-ratings-based approaches, and potential capital floors. Another complication for CPM is the multiplication of different and sometimes contradictory requirements (such as the rules on risk-based capital minimums, which are at odds with the leverage-ratio rules). The thicket of rules requires institutions to keep an eye on many constraints simultaneously, and renders a single measure of return on capital misleading.
This is a significant change. Until recently, CPM teams could manage the loan portfolio largely independently from the rest of the balance sheet. Funding and leverage were not an issue for CPM. The team was free to manage for return on equity. Now, with all the multiple requirements in play (including rules on capital, funding, liquidity, and leverage), credit, the largest asset class on most balance sheets, is front and center in the new approach to integrated balance-sheet management.
Increasing cost and margin pressure
Weakening margins add to the pressure exerted by the regulatory demands and make optimization of scarce resources particularly urgent. Some 59 percent of surveyed institutions named the resulting cost and margin pressure as a motive for CPM’s evolution. The issue is most significant in Europe, where 71 percent of participants named cost pressure as a factor. From 2010 to 2015 the cost-income ratio of the 150 largest institutions in Europe increased from 59.1 percent to 65.6 percent, while the income-asset ratio was essentially unchanged.
Changing market conditions
Postcrisis market conditions are a third dimension in the evolution of CPM, though less important than rising capital needs and cost pressures: only about 40 percent of surveyed institutions felt that this is a key driver for change. Significantly reduced opportunities for hedging and secondary trading, low risk appetite for going long credit in secondary markets, and lack of acceptance of going short credit exposure generally have led to a shift of focus toward portfolio management at the point of origination.
For example, activity in securitization markets and single-name credit-default swaps (CDS), CPM’s main hedging tool, have declined significantly because of higher costs and stricter rules for CDS. According to the Bank for International Settlements, single-name CDS outstanding had a global notional value of $18.1 trillion in the second half of 2010. By the second half of 2015, this had more than halved to $7.2 trillion.2Multiname CDS, a useful tool for managing portfolios and correlations, have also been hard hit by changing bank-capital rules. Here too, volume more than halved over the same time period, from $11.8 trillion to $5.1 trillion. To get rid of unwanted exposures, CPM units often look to bundle similar assets. But securitizations in Europe declined by more than 50 percent since 2010 and are still below 2007 levels.3In the United States, securitization volumes have rebounded slightly, starting in 2010.
In this context, CPM has had to rethink its main job, of mitigating risk within the portfolio and maximizing risk returns.
How the role of CPM is evolving
Together, these three factors are altering CPM’s mandate, the tools it needs to carry out that mandate, the way in which it works with the rest of the organization, and its data requirements. Most banks and other institutions are good at originating, structuring, and pricing risk, but not as good at holding volume on their balance sheet. That has to change—even as banks wrestle with an urgent challenge to substitute interest income with fee income. CPM has to revamp its offering for banks’ changed circumstances.
A broader role in balance-sheet management
Once largely focused on the loan book, in many institutions CPM is now managing the entire range of credit exposures and their effect on the balance sheet. With that, CPM functions are also conducting new activities. For example, 54 percent of respondents said they already observed a change in the scope of the function and the tasks it was conducting, with an increasing focus on loan origination, expanded analytics (for example, on deposits and client profitability), use of additional metrics (such as the leverage ratio), more explicit alignment with risk appetite, and additional legal entity reporting.
There is, however, no single template for that extended role. In Europe and Asia–Pacific, most institutions (up to 80 percent) expect CPM to assume an active, first-line role in managing the portfolio, taking responsibility for reducing credit risk and optimizing the balance-sheet structure to secure the highest return on equity or return per risk within the constraints of regulation. This might include, for example, a closer alignment of the credit portfolio with the particular funding strategy (asset-backed funding, securitization, syndication, and so on).
In North America, an advisory, second-line role is more common, in which CPM ensures compliance with risk limits and risk-appetite constraints, assesses market opportunities and capital requirements, offers a perspective on stress testing and its strategic implications for the lending portfolio, and recommends actions to business leaders. An essential component of CPM’s contribution is a superior market perspective and the capability to identify business opportunities. Seventy-six percent of North American respondents foresee the role in this way.
The design choice appears to be driven by historical precedents, market context, management priorities and regulatory emphasis; the size of the institution is also a factor. In the United States, for example, we think that the Comprehensive Capital Analysis and Review might push CPM into an advisory role because of the expertise required for stress testing. In Europe, where liquidity is tighter, more active portfolio management might be required. In addition, the survey shows that smaller institutions tend to favor a second-line CPM function, while larger ones often choose a more active role for the function, with direct market access.
But whatever the design choice, an essential component of the evolving function—if it is to fulfill its value potential—is the aggregation of risk and funding information from across the organization in order to make strategic decisions or proffer strategic advice while providing oversight and control.
An enhanced management framework and tool set
To carry out its new mandate and earn the right to participate in strategic decisions—an important component of the potential value CPM can contribute to an institution today—will require superior analytics and a new management framework. Survey respondents identified tools for measuring regulatory capital and capital allocation (that is, discipline at origination) as the most important for the CPM function, and growing in importance; 88 percent plan to use regulatory capital-allocation mechanisms. Sophisticated tools and analytics will allow them to earn credibility, participate in the primary market, and be a strategic partner to the business.
In the secondary market, survey participants see wholesale loan purchases and sales as the most important CPM tool. Their use is growing. Some 60 percent already use them, and 71 percent expect to do so in the near future. In contrast, tools such as index options and single-name CDS hedges are losing influence. In addition, the survey showed a likely shift in the way CPM makes hedging and sale decisions. Only 5 percent of respondents said CPM currently has the capabilities to consider a holistic view of the portfolio, including stress outlook and capital and liquidity usage. But 39 percent said they aim to develop these capabilities in the future. Exhibit 1 shows how other considerations are also changing.
http://www.mckinsey.com/business-functions/risk/our-insights/the-evolving-role-of-credit-portfolio-management
Tags: balance sheet, Banks, CPM, CPM function, CPM tool, financial crisis, financial institutions, IACPM, illiquid loans, Institutional Investors, insurers, International Association of Credit Portfolio Managers, Market Conditions, regulation