Barclays 2005 Annual Report Download - page 59

Barclays PLC
Annual Report 2005 57
Credit Risk Management
Credit risk is the risk that the Group’s customers, clients or
counterparties will not be able or willing to pay interest, repay
capital or otherwise to fulfil their contractual obligations under loan
agreements or other credit facilities. Credit risk also arises through
the downgrading of counterparties whose credit instruments the
Group may be holding, causing the value of those assets to fall.
Furthermore, credit risk is manifested as country risk where difficulties
experienced by the country in which the exposure is domiciled may
impede payment or reduce the value of the asset or where the
counterparty may be the country itself. Settlement risk is another
special form of credit risk which is the possibility that the Group may
pay a counterparty – for example, a bank in a foreign exchange
transaction – and fail to receive the corresponding settlement in return.
Credit risk is the Group’s largest risk and considerable resources,
expertise and controls are devoted to managing it. The importance of
credit risk is illustrated by noting that nearly two-thirds of risk-based
economic capital is allocated to businesses for credit risks. Credit
exposures arise principally in loans and advances.
Credit Risk Management Responsibility
In managing credit risk, the Group applies the five-step risk
management process and internal control framework described
previously (page 51). The credit risk management teams in each
business are accountable to the Business Risk Directors in those
businesses who, in turn, report to the heads of their businesses and
also to the Risk Director.
The Credit Risk function, led by the Credit Risk Director, provides
Group-wide direction of credit risk-taking. This functional team manages
the resolution of all significant credit policy issues and administers the
Credit Committee which approves major credit decisions.
The principal Committees that review credit risk management are the
Risk Oversight Committee and the Board Risk Committee. The Board
Audit Committee reviews and approves impairment allowance decisions.
Credit Risk Measurement
Barclays uses statistical modelling techniques throughout its business
in its credit rating systems. These systems assist the Bank in frontline
credit decisions on new commitments and in managing the portfolio
of existing exposures. They enable the application of consistent risk
measurement across all credit exposures, retail and wholesale. The key
building blocks in the measurement system, which are described
below, are the probability of customer default (expressed through an
internal risk rating), exposure in the event of default, and severity of
loss-given-default. Using these, Barclays builds the analyses that lead to
its decision support systems in the Risk Appetite context described
previously. However, it should be noted that credit risk measurement,
particularly Risk Tendency, can be contrasted with impairment
allowances required under accounting standards, which are based on
losses known to have been incurred at the balance sheet date and not
expected loss.
Probability of Default: Internal Risk Ratings
Barclays assesses the credit quality and assigns an internal risk rating to
all borrowers and other counterparties, including retail customers. Each
internal rating corresponds to the statistical probability of a customer in
that rating class defaulting within the next 12-month period. Multiple
rating methodologies may be used to inform the rating decision on
individual large credits. For smaller credits, a single source may suffice
such as a rating model result.
During 2005 Barclays increased the available accuracy of its 12-grade
internal rating scale for the wholesale parts of the bank. This was achieved
by increasing the number of ratings across the same range to 21. The
12-grade rating scale has historically been mapped to long-term agency
ratings. The new 21 default grades represent the best estimate of the level
of credit risk for each counterparty based on current economic conditions,
so a static link to long-term rating agency ratings is no longer used.
Exposure in the event of Default
Exposure in the event of default represents the expected level of usage
of the credit facility when default occurs. At default the customer may
not have drawn the loan fully or may already have repaid some of the
principal, so that exposure is typically less than the approved loan limit.
When the Group evaluates loans, it takes exposure at default into
consideration, using its extensive historical experience. It recognises
that customers may make heavier than average usage of their facilities
as they approach default.
For derivative instruments, exposure in the event of default is the
estimated cost of replacing contracts with a positive value if
counterparties should fail to perform their obligations.
Severity of Loss-given-default
When a customer defaults, much of the amount outstanding on its
loan or loans is usually recovered. The part that is not recovered, the
actual loss, is called the loss-given-default (LGD). The severity of the
loss is measured as a percentage of the amount outstanding when the
default occurs.
From historical information, the Group can estimate how much is likely
to be lost, on average, for various types of loans. To illustrate, LGD is
low for residential mortgages because of the property pledged as
collateral. In contrast, average LGD is about 70% for unsecured
personal lending and 30% for corporate loans.
The level of LGD depends on the type of collateral (if any); the seniority
or subordination of the exposure; the industry in which the customer
operates (if a business); the jurisdiction applicable and work-out
expenses. The outcome is also dependent on economic conditions that
may determine, for example, the prices that can be realised for assets
or whether businesses can readily be refinanced. Individual defaults
show a wide range of outcomes, varying from full to nil recovery and
all points in between.
Expected Loss: Risk Tendency
The three components described above – the probability of default,
exposure at default and LGD – are building blocks used in a variety
of applications that measure credit risk across the entire portfolio.
One of these applications is a measurement of expected loss called
Risk Tendency (RT).
RT is a statistical estimate of the average loss for the loan portfolio for
the forthcoming 12 months, taking into account the portfolios size and
risk characteristics under current credit conditions. RT provides insight
into the credit quality of the portfolio and assists management in
tracking risk changes as the Group’s stock of credit exposures evolves
in the course of business.
RT is calculated for both corporate and retail loans as follows:
RT = probability of default x expected exposure at default x loss
given default.
Risk management
Credit risk management
2.8