Barclays 2006 Annual Report Download - page 80

Risk management
Credit risk management
Barclays PLC
Annual Report 2006
76
Credit risk management
Credit risk
Credit risk is the risk of suffering financial loss, should any of the Group’s
customers, clients or market counterparties fail to fulfil their contractual
obligations to the Group. Credit risk may also arise where the
downgrading of an entity’s credit rating causes the fair value of the
Group’s investment in that entity’s financial instruments to fall. The
credit risk that the Group faces arises mainly from commercial and
consumer loans and advances, including credit card lending.
The granting of credit is one of the Group’s major sources of income and
as its most significant risk, the Group dedicates considerable resources to
controlling it. The importance of credit risk is illustrated by noting that
nearly two-thirds of risk-based economic capital is allocated to credit risk.
Credit exposures arise principally in loans and advances.
In managing credit risk, the Group applies the five-step risk management
process and internal control framework described previously (page 72).
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.
These credit risk management teams assist Group Risk in the formulation
of Group Risk policy and the implementation of it across the businesses.
Examples include:
• maximum exposure guidelines are in place relating to the exposures
to any individual customer or counterparty;
• country risk policy specifies risk appetite by country and avoids
excessive concentration of credit risk in individual countries;
• policies are in place that limit lending to certain industrial sectors
(commercial real estate being one example).
Within Group Risk, 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 runs the
Credit Committee, which approves major credit decisions.
The principal Committees that review credit risk management, formulate
overall Group credit policy and resolve all significant credit policy issues
are the Group Wholesale Credit Risk Management Committee, the Group
Retail Credit Risk Management Committee, the Risk Oversight Committee
and the Board Risk Committee (see page 70 for more details of this
Committee). The Board Audit Committee also reviews the impairment
allowance as part of financial reporting.
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 analysis that leads 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
on expected loss.
Probability of customer default – commonly known as Probability
of Default (PD): Internal risk ratings
Barclays assesses the credit quality of borrowers and other
counterparties and assigns them an internal risk rating. There are two
different categories of default rating used. The first reflects the statistical
probability of a customer in a rating class defaulting within the next
12-month period, and is referred to as a point in time rating (PIT).
The second also reflects the statistical probability of a customer in a
rating class defaulting, but the period of assessment is different, in this
case the period is defined as 12 months of average credit conditions for
the customer type. This type of rating therefore provides a measure of
risk that is independent of the current credit conditions for a particular
customer type, is much more stable over time than a PIT rating and is
referred to as a through the cycle rating (TTC).
Multiple rating methodologies may be used to inform the rating
decision on individual large credits, such as internal and external
models, rating agency ratings, and for wholesale assets market
information such as credit spreads. For smaller credits, a single source
may suffice such as the result from a rating model.
In 2005, Barclays improved upon the granularity of its earlier 12-grade
internal credit rating scale for wholesale credit. 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 Barclays best estimate of
the level of credit risk for each counterparty based on current economic
conditions, and as a result a static link to long-term rating agency
ratings is no longer used.
Exposure in the event of default – commonly known as Exposure
at Default (EAD)
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 should
counterparties fail to perform their obligations.
Severity of loss given default – commonly known as Loss Given
Default (LGD)
When a customer defaults, some part of the amount outstanding on its
loans is usually recovered. The part that is not recovered, the actual loss,
together with the economic costs associated with the recovery process
combine to a figure called the LGD. The severity of the LGD is measured
as a percentage of the EAD.
Using historical information, the Group can estimate how much is likely
to be lost, on average, for various types of loans. To illustrate, LGD is
lower for residential mortgages than for unsecured loans because of the
property pledged as collateral.
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 loss given default – 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
that we use at Barclays, that we call Risk Tendency (RT).