Some Observations on Improving a Bank's Share Value with Credit Portfolio Management, Credit-transfer Pricing and Stress Testing

by Jeffrey R. Bohn of Solition Financial Analytics, Tokyo, and
Roger M. Stein of Moody's Research Labs, Inc.

June 30, 2011

Abstract: Prudent credit risk management within a bank requires that a number of agents within the firm communicate, agree and act in a concerted fashion to manage credit exposures both at the individual exposure level and at the broader portfolio level. This can be challenging given the nature of credit portfolios. Even if highly diversified, credit portfolios display heavily skewed loss distributions that imply relatively long quiescent periods (during which losses are lower than their mathematical expectations and the benefits of risk management less visible) and occasional periods of much higher losses. In this non-technical paper, which draws on and extends portions of Bohn and Stein (2009), we reflect on some of these challenges and discuss mechanisms, such as credit-transfer pricing by which banks can better align the behaviors of underwriters, risk managers and senior managers within large institutions while also increasing the communications between these groups. This approach grew out of industry practice and is currently in use to varying degrees by a number of large banks worldwide. While many challenges still persist in its implementation, innovations in both credit modeling and credit markets suggest that these challenges have begun to diminish in recent years.

JEL Classification: G31, G11, C15, C44, C52, D61, E17, G2.

Keywords: credit risk management, portfolio management, transfer pricing, bank value, stress testing, bank management, incentive allignment, bank strategy

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