Pillar II - Modelling credit and concentration risk on the portfolio of a commercial bank

The client was seeking to develop a more risk sensitive measure of credit and concentration risks for internal steering purposes, and to comply with supervisory requirements. Avantage Reply assisted the client to identify the possible methodology options, and to conduct an impact study to estimate the impact on internal capital.

The client is one of the largest financial institutions in France. It offers its clients a wide range of products and services: savings, investment, treasury, financing, insurance and investment solutions.

Following an ECB on-site inspection, many findings pointed to the inadequate quantification approach for the evaluation of credit and concentration risks. In this context, the institution decided to launch a quantitative study to assess what would be the most appropriate quantitative approach to assess credit and concentration risks regarding the nature and the diversity of institutions’ portfolio.

Avantage Reply started its study by elaborating a benchmark of market practices in terms of credit risk quantification methodologies. In conjunction with scientific literature, several methodology options were proposed and discussed, including HHI index formula, Gordy granularity adjustment, tailored correlation parameters, and full credit portfolio model. Through various dedicated workshops and iterations, it was decided to test two different approaches to build tailored correlation parameters:

• An extension of an asymptotic single risk factor model that recognises diversification or concentration based on the single factor Merton model.
• A correlation matrix calibration, with the default rate correlation-based mode as in this modelling approach, and the correlation matrices estimated based on the Vasicek analytical equations using the empirical default rate (TD) for each category.

For each approach, our team has implemented a computerised mock-up to assess the impacts in terms of internal capital on a portfolio sample. At the end of this first phase of the project, further R&D investigations were still necessary to evaluate the internal capital impacts on the entire portfolio.

Through its practical experience and various elements of best practices, Avantage Reply has completed this study in line with client’s expectations. Both approaches have been specified and tested as the outcomes of the simulations and have allowed the client to demonstrate potential savings in terms of internal capital and a better measure of concentration/diversification of the portfolio. Being still in an R&D phase, our team has gathered a list of areas of improvements to integrate both approaches in the system.