Credit's worthy start

Credit Portfolio Management

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Major banks in South Africa are experimenting to find the most appropriate credit portfolio management approach for their particular businesses. The practice, which is now commonplace at medium-sized and larger banks in the US, Europe and beyond, involves measuring and managing exposures arising from loans, bonds and other forms of credit risk as a portfolio. Often overturning traditional notions of how credit and counterparty risk should be handled, credit portfolio management's introduction has been as challenging for banks in South Africa as it has for them elsewhere. Still, important advances are being made.

Take FirstRand Bank, for instance. The holding company for several entities, including investment bank Rand Merchant Bank, retail bank First National Bank and credit finance specialist WesBank, it began to put the first building blocks in place for a portfolio management approach to credit risk in 2004 following the implementation of an internal credit rating system and related credit risk measurement tools. The outcome has been the establishment in February of a dedicated group-wide credit portfolio management unit within the group's balance-sheet management division.

The unit operates centrally across the group, while drawing on expertise and resources from various business divisions. The wholesale credit risk unit provides support with concentration risk management, Rand Merchant Bank's debt capital market solutions provides expertise in credit structuring and distribution, and the macro portfolio management team within the balance-sheet management division provides financial markets hedge execution services.

"A more active approach towards credit portfolio management is still a relatively new activity in the context of the bank," says Gert Kruger, head of group credit portfolio management in the balance-sheet management unit at FirstRand Banking Group. "However, great strides have been made in the past 12 months in the use of financial market hedges to hedge retail credit risk, and the use of structured credit markets such as securitisations to change the balance-sheet profile and specifically manage wholesale credit concentrations and capital."

While most would concur that securitisation has flourished in South Africa, were you to question most about the state of the local credit derivatives market, the response may not paint such a rosy picture. "The single-name market is on an ask-only basis and not actively traded," says Moss Brickman, head of credit and international derivatives in the debt capital markets division of Nedbank Capital, the investment banking arm of Nedbank.

Various reasons are put forward to explain the lack of two-way flow. The local head of credit at a European bank in the country says that, because of the finite size of the local market and the dominance of the big five banks, there is little opportunity for the banks to take risk off one another's books because they are generally exposed to the same names. Nedbank, together with FirstRand, Absa, Investec and Standard Bank, all of which are based in Johannesburg, comprise the quintet.

Boshoff Grobler, a senior transactor at Rand Merchant Bank, believes other factors may be holding back the evolution of the local credit derivatives market. "The infancy of our corporate bond market hampers us in having deliverable obligations - physical settlement as opposed to cash settlement - which in other jurisdictions could have forced the market to turn to digital credit derivatives where you have fixed recovery rates," he explains. "However, under Basel I and early Basel II we are discouraged from entering into digital trades, since these trades may not result in regulatory capital relief," he says.

Corporate bonds

The corporate bond market is now starting to take off. Corporate issues grew 47.3% during the first seven months of 2007 compared with the previous year, while the corporate share of the total nominal value of bond listings grew to R208 billion in 2006 - up 7% from the previous year to 29%. Also, some South African corporate names are now being traded outside the country. "We have had some high-yield debt placement out of South Africa into the international market, and those names are actively traded in the credit markets in Europe," says Grobler. "So we see European prices on those names, and that gives us some price discovery and transparency with respect to those names in the South African market."

These factors, plus the more sophisticated capital management demands of Basel II, which comes into force in South Africa on January 1, 2008, will most probably boost the incipient credit derivatives market, says Grobler. Other observers agree, and anticipate that banks will takes steps to foster the market, such as creating a network to make prices available to selected asset managers.

Basel II has had a considerable influence on South African banks' attitude to credit risk, and driven an extensive upgrade in internal modelling capabilities, data quality and systems. In terms of models and technology to support credit portfolio management, Moody's KMV's Portfolio Manager (desktop) and RiskFrontier (enterprise) correlation data and analytics are the systems of choice in the country, and are used by Absa, FirstRand and Standard.

Absa also uses the Risk Framework system from Chicago-based Quantitative Risk Management (QRM) for its retail portfolios. "Moody's KMV's Portfolio Manager is strong on the wholesale side, while QRM's simulation, macroeconomic scenario sensitivity and consumer behavioural modelling capabilities are more suitable for retail credit portfolios," says Andre Blaauw, executive in the group credit division at Absa. Meanwhile, Nedbank treads a different path from many of its peers and uses in-house models and systems.

Beyond the undoubted traumas of technological change, introducing a credit portfolio management approach also brings with it considerable theoretical and cultural challenges. Blaauw categorises these challenges into three main areas: the question of ownership of credit assets; the problem of measuring the performance of the credit portfolio management unit; and the problem of managing the potential conflict between loan origination and portfolio management objectives.

In terms of ownership of assets, South African banks are aware of the various approaches that European and US banks have devised and are reviewing them against their own circumstances. At the one end is central ownership of credit assets - a regime pioneered by Deutsche Bank whereby the credit portfolio management unit prices all loans at market prices, with business divisions having to make up any shortfall should they decide to price differently; loans are also booked centrally with data largely controlled by the credit portfolio management unit. At the other end, the assets remain with the business divisions, and credit portfolio management is an overlay conducted at a higher level.

Nedbank currently falls into the latter camp. It has a dedicated portfolio management unit within its capital management function. "Although we have always viewed credit risk on a portfolio basis, by exposure to industry type and correlation, we only dedicated resources to looking at these formally since the inception of Basel II," says Nedbank's Brickman.

Centralisation of asset ownership is seen as the way to go, says Brickman. The bank wants to offer the various divisions the opportunity to implement a credit portfolio management approach themselves before it attempts any centralisation. Brickman says his preference is for a dual approach, with the divisions taking as much responsibility as they can, but with a high level of oversight that will look for risk concentrations and diversifications across divisions. "We've got retail, business, corporate, capital and other divisions, and while, say, capital might manage its credit very effectively, we might still have pockets of overexposure because corporate may have very similar assets and, although both areas are happy with their exposures, as a bank we may not be happy because of the concentration risk," he says.

Balance-sheet management

Meanwhile, FirstRand's approach is already closer to that of the Deutsche model. Its balance-sheet management committee owns all the assets of the banking group. This committee, which comprises the balance-sheet management team and the chief executive officers of all the group's main businesses, makes strategic decisions about the assets based on advice from entities such as the credit portfolio management unit. This can include recommendations to securitise loan portfolios.

FirstRand's approach obviously raises questions about performance measurement and attribution. If performance is measured via return on risk capital, for instance, what happens when the central group removes credit risk with an action such as securitisation?

"When we do a balance-sheet management action, we assess the business as if the transaction wasn't done, so we clearly differentiate the performance of the underlying business from the balance-sheet management action that was done on top of it," says Kruger. So - if the balance-sheet management unit securitises a loan portfolio - then, for performance purposes, the business unit is assessed as if it still holds the assets.

"We look at the portfolio overlay's cost and we compare it with the cost of other strategies of capital raising, credit protection and so on. And we've got a recovery mechanism whereby we recover the cost of the overlay from the business. Doing performance measurement, this way, in two tiers, gives us the desired result," he says.

As one of the key tools for credit portfolio managers, securitisation has taken off quickly in South Africa because of the very adoption of credit portfolio management together with the influence of Basel II. "Securitisation is now seen as the preferred and most effective way to manage credit risk," says the head of credit at a European bank operating in the country.

"Securitisation can give you a credit impact, a funding impact and a capital impact concurrently, so it is a favoured tool to achieve our wider balance-sheet objectives," says FirstRand's Kruger. "However, to change the profile of the balance sheet you have to do it in size."

The big five are all now active in the securitisation market. Over the past 18 months, FirstRand has securitised home and auto loans and even issued a R20 billion synthetic securitisation of wholesale loans in August. In March, Standard Bank concluded its first international residential mortgage-based securitisation with the placement of EUR233 million of notes with offshore investors. This was in addition to R2.2 billion of notes placed in the domestic market in February - both transactions taking place through its Blue Granite securitisation programme.

In June, Nedbank Capital announced that it had, via its Octane ABS 1 special purpose vehicle, successfully placed R2 billion of notes backed by auto loans made by its asset-backed finance specialist subsidiary Imperial Bank. Meanwhile, in July, Absa announced its first home loans securitisation - an issuance of up to R3.5 billion worth of notes via its Dublin-based ZAR Capital special-purpose vehicle.

Most of the banks' securitisations, both domestic and international, have been heavily oversubscribed - Standard's international issue was three times oversubscribed, for instance, while domestic investors simply "gobble up" issues, says Brickman. So far, little reverberation has been felt in South Africa from the US-based subprime mortgage crisis. "We are somewhat removed from the subprime issues in that we have a credit act that only permits the banks to prudently lend money, so being able to raise money like they do in the US for subprime loans is not permitted in South Africa," he says. South Africa asset-backed securitisation issues are now sought after internationally because in South Africa, most home and auto loans are secured with an initial deposit, and house prices have doubled in the country in the past three years, he says.

FirstRand's Kruger believes it is still too early to say what long-term impact the crisis might have on the country, especially since it is effectively a two-tier market. On the one hand, exchange controls and other regulation has prevented domestic investors from buying into the US subprime market. On the other, it is not yet clear whether international investor risk aversion following the crisis will lead them to steer away from South African instruments.

So far, the prices of internationally issued South African securitisations have held up compared with the spreads of European issues, says Rand Merchant Bank's Grobler. What the crisis may affect is the timing of future issues. "We continue to build up assets that could be securitised but, in terms of timing of placement, we will do it at an opportune time in the market," says FirstRand's Kruger.

Meanwhile, Brickman says there are now numerous asset managers and hedge funds actively seeking rand exchange risk. "In the past, we would have to structure issues in dollars or euros, but now many funds are actively seeking investments in rand and are willing to take on the currency risk themselves. For them it is diversification," he adds.

One area of securitisation that has not taken off as anticipated is in the financing of low-income housing, says Stuart Grobler, general manager at The Banking Association South Africa based in Johannesburg. There was an expectation that the country's Financial Sector Charter, which came into effect in 2004 and encouraged institutional investors such as pension funds, life assurers and non-originating banks to invest in development projects, would draw financial institutions outside of the primary mortgage lenders into the low-income housing market.

However, this would have required the government to guarantee that the lenders would be able to evict payment defaulters and obtain beneficial use of the vacant property in order to protect the income from the securitised mortgages - something the government, given the political hot potato of evicting the poor from any kind of housing, has so far been unwilling to provide.

"If you don't have the possibility of obtaining beneficial possession of vacant property then mortgage finance is not an option," says Stuart Grobler.

"There is a long history of community resistance to evictions and the resale and occupation of the vacant properties in South Africa. Banks say they don't mind taking on the normal commercial financial risk of lending for low-income housing, but have to be able to repossess and utilise if necessary and government, in terms of its own risk management processes, won't underpin this at the moment. The whole issue is very complicated and the stakeholders are engaging each other to find acceptable solutions to the risks involved."

While local sensitivities such as this, and the peculiarities of South Africa's thriving financial market, continue to present challenges, credit portfolio management looks set to develop fast in South Africa.

Foreign banks active in the country, such as ABN Amro, Deutsche Bank and JP Morgan, have brought their credit portfolio management practices with them. And two of South Africa's big five banks, FirstRand and Standard, are members of the International Association of Credit Portfolio Managers, which has a philosophy of knowledge-sharing.

"Although we are from competing banks, everyone is very open about sharing information about their approach to credit portfolio management," says one member of the association familiar with the South African market. "The reality is that the more people who see the world our way, the easier it is to do business: the more banks that manage their credit portfolios, the more of a market there is for single-name credit derivatives and securitisations."

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