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The business of banking has witnessed a lot of changes in the past few years. It would be safe to say that the entire business model has been transformed because of intense competition as well as constantly increasing regulatory pressures.
The fast pace at which businesses now work makes it mandatory for banks to give out loans at the fastest pace possible. If they take too much time in evaluation, the customer may approach another bank for the same loan. Hence, the approach now is to give out the loan first.
Once the loan has been given out, there is a separate department that is created to decide what action needs to be taken on the loan. They decide to securitize some loans, sell some others and hold some to maturity.
This decision is based on their understanding of the bank’s internal risk policy, the risk concentration levels of the bank’s current portfolio, and the characteristics of the loan, the department makes a decision about how the loan should be handled.
Active credit portfolio management is an alternative to the buy-and-hold strategies that have been used by banks for decades. As a part of this strategy, banks are constantly comparing the expected returns from their assets with a hurdle rate. This hurdle rate is the cost of funds for the bank. Based on the comparison against this hurdle rate, banks decide whether they want to hold a loan to maturity or whether some form of credit enhancement or credit transfer is required.
Active credit portfolio management allows banks and other financial institutions to trade loan assets amongst each other. This allows all banks to have risk-adjusted portfolios amongst themselves regardless of who originated the loans in the first place.
Earlier, bankers use to measure the risk of individual loans with the help of loan officers who specialized in assessing risks related to a particular industry. However, over time, banks have realized that even if the transactions appear to be risk-free when you consider them one by one, they could have considerable risk when bundled together.
As a result, the concept of credit portfolio risk was created which measures the risks of all assets bundled up together. This risk is measured using metrics such as the Sharpe ratio and risk-adjusted return on capital.
Credit portfolio risk management allows risk managers to correlate their returns with the amount of risk being taken. Hence, portfolio managers can fine-tune their risk based on their expected return. Reduction of concentration via diversification is the basic principle used in credit portfolio risk management.
There are several advantages of active credit portfolio management. Some of these benefits have been listed below:
The fact of the matter is that independent, departmental, and point-to-point efforts at credit risk management do not produce the best results. Over the long term, banks have found this approach to be expensive and inconvenient. This the reason that active credit portfolio management has become quite popular. In a way, the adoption of this approach was the precursor to the large and diversified market for credit derivatives that we see today.
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