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					Insolvency Practice and the Credit Process

                     Philip D. Sherman
                    Senior Adviser in Asia
              The Risk Management Association
                       November 2004

• 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
        Expected Loss = Probability of Default X Exposure at Default X
                        Loss Given Default
                                   . . . with focus on the last two terms
    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.

                    EAD and LGD loom large in the arithmetic

            LGD Is Particularly Important in Asia

•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


                                         Restructuring of
                      Refinancing          Business &

                           Bank Credit Processes Lay Out the Drill for Credit

                                            Portfolio Acquisition                                              Portfolio Maintenance
   Port-folio Management
       Credit Policy &

                                                   Credit                 Credit             Documentation
                                Marketing        Application             Approval            & Disbursement   Monitoring          Workout

                                                                Credit Organization and Culture

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

  The Credit Equation Ties Closely to the Credit Process

   Process       Credit
   Element      Equation
Credit Policy   Uses all
Marketing       Based on
Credit            PD
Credit            PD
Documentation     LGD
Monitoring      EAD, PD       Feedback
Workout           LGD          •Process
                           •Credit Specifics

Capital Is Allocated Against “Unexpected” Losses

    The Credit Equation is Used to Determine Credit
           Capital by Way of “Risk Weights
Standardized Approach Mandates Capital in Accordance with Rated or Unrelated Risks,
                       incorporating all equation elements

         Rating     AAA to          A+ to A-            BBB+ to        Below BB-   Unrated
                     AA-                                 BB-
          Risk       20%               50%            100%               150%       100%
         Pillar I   1.6%                4%                   8%          12%         8%

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)

        Rating      AAA to           A+ to A-           BBB+ to        Below BB-   Unrated
                     AA-                                 BB-
       Standard     1.6%                4%                   8%          12%         8%
         IRB        1-2%               2-4%               4-11%         11-30%       NA

                      *Mandated LGD assumption in Foundation Process

           Banks Build the Equation into Their
              Credit Management System
•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:

                Low Facility
                Rating, e.g.        Manage Risk,
                                                         High EL -
                High LGD            Monitor client,

                                                      Manage Risk,
                                     Low EL -–        Monitor client,
                High facility        Manage returns
                Rating, e.g.                          collateral
                Low LGD
                                High Risk                    Low Risk
                                Rating, i.e.,                Rating, i.e.
                                Low PD                       High PD

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
                •Adequate insurance
                •Property monitoring, e.g., to
                 ensure taxes paid
                •Environmental liability risk

                          . . . 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                                         Collateral Analysis
•Stress testing                                      •Dependence between borrower and
•Comprehensive view of ―loss‖                         collateral value
                                                     •Currency mismatch
•Consistency of default definition                   •Conservative valuation/estimation of
•Key characteristics of borrower/facility/product     workout period
•Country and industry factors                        •Conservatism!!!!
                                                     •Clear, consistent collateral policy
•Legal factors including insolvency regime            keeping in mind creditworthiness of
•Procedure for overrides of grades                    obligor
•Collateral analysis                                 •Robust collateral management systems
                                                        •Concentration monitoring/action
                                                        •Policies on appropriateness of collateral,
                                                         liquidation potential and revaluation

            Basel Defines “Default” and “Loss”

Per 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

      ―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).

           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.

                       S & P Has Developed “Loss Stats” Date
                                                    Type              Recovery    Recovery   Recovery
                                                                         %           %          %
General recovery                                                      1988-2001    1998-       2003
data unsurprising,
                                     Bank                                84         74         72
but 2003 a bad year
                                     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              Ultimate
                                            Recovery %
    Debt below (i.e., how senior?)             16
    Collateral                                 13
                                                                Recovery heavily correlated to
    Debt above                                 10
                                                                structural financing factors
    Aggregate default rate                      7
    Industry factor                             7
    GDP                                         0

Fitch Produces Similar General Results, but Clarifies a Skewed
    Type               Loan Recovery %    Bond Recovery%
    Senior Secured           72                 62
    Senior Unsecured         52                 42

Moody’s Results Are Congruent but Lower

          Rating Agency LGD Models
               •    S & P Loss Stats
              •     Moody’s LossCalc
                   • Fitch’s DART

                                      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
•   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
     –   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

An RMA Paper Digs into Causes

             LGD = (Charge-off - charge-off recovery) / Outstanding balance at default
        α: The beta distribution’s center parameter and can be derived from equations below
        β: The beta distribution’s shape parameter and can be derived from equations below
                                      Min: Minimum of all cases
                                      Max: Maximum of all cases
                       α and β are then derived from the follow ing equations:

                                             w here 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.

          RMA Conducts Cooperative LGD Studies
              Data Model
      •Facility and Customer Number
             •Type of Company
            •Syndication indicator                     Loss Calculations
              •Facility risk rating          There are very extensive breakdowns with in
              •Obligor risk rating           categories. Methodology to calculate actual
               •Authorized limit             economic losses is defined in some detail
      •Amount outstanding at default         as well as is the event of default, which for
        •Spread index and per cent           purpose of this study includes:
                                                              •Past due
                  •Collateral                              •Unlikely to pay
•Collateral value and evaluation frequency                         •Non accrual
  •Unfunded risk protection information                             •Credit loss
         •Credit mitigation produce                                •Facility sale
                 •Facility type                              •Distressed restructuring
                                                              •Bank-filed bankruptcy
                                                             •Obligor-filed bankruptcy
               •Facility purpose                             •Unknown (which please
                 •Credit event                                       minimize)
           •Cash flow information
            •Expense information
              •Resolution event

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

   RoC’s JCIC Pioneers Data Collection

                                    Cash Flow                Behavior

                               Recovery                 Opportunity cost
                                  Seniority               Moral hazard
                                  Collateral Type         Adverse selection
                               Direct Costs               APR rule
                                  Legal/Trustee Fees    Choice of auctioning
                                  Accountant            vs. restructuring.
                               Indirect Costs
                                  Management fee
                                  Duration of workout

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

            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

                      Asia’s NPL Estimates Appear Too Low
 Country       2002        2003                                          Comments
                Av.        Est.
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
Indonesia         20       15-17    “Impaired assets 150% above official levels” of 8%. Most bad loans were shipped off
                  46                to IBRA and the low number industry number reflects the low level of lending
              incl. IBRA
India            23         30      Indian NPL rules set at 180 days although change planned for 2004.

                                   Source: S & P Asia-Pacific Banking Outlook 2004

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

                   Country                Est.
               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

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

    An Informal “Expert Panel” Generally Confirms the List
                                                                                                Importance for
                                      EAD/LGD Factors                                            LGD in Asia,
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
     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

             Philip D. Sherman
           Senior Adviser in Asia
     The Risk Management Association or
         Telephone: 65-6836-1297
           Mobile: 65-9788-5001