TD Bank 2006 Annual Report Download - page 64

TD BANK FINANCIAL GROUP ANNUAL REPORT 2006 Management’s Discussion and Analysis
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These models are reviewed on a regular basis to ensure
ongoing appropriateness, accuracy and validity.
•Implementation of dynamic management processes to monitor
country, industry and counterparty risk ratings which include
daily, monthly and quarterly review requirements of larger
credit exposures.
•Approval of the scoring techniques and standards used in
extending personal credit.
COUNTRY RISK
Unanticipated economic or political changes in a foreign country
could affect cross-border payments for goods and services, loans,
dividends, trade-related finance, as well as repatriation of the
Bank’s capital in that country. The Bank currently has counterparty
exposure in 63 countries with the majority of the exposure in North
America. Country risk ratings are based on approved risk rating
models and expert judgment and are used to establish country
exposureguidelines covering all aspects of credit exposure, across
all businesses. Country risk ratings are dynamically managed and
subject to a detailed review on at least an annual basis.
INDUSTRY RISK
As part of our credit risk strategy, we establish industry and
group limits for credit exposure against specific industry sectors.
Asystematic approach is used to limit industry concentrations
and ensure diversification of the Bank’s loan portfolio. Industry
exposure guidelines are a key element of this process as they
limit exposure based on an internal risk rating score. The rating
is determined through the use of our industry risk rating model
and detailed industry analysis.
If several industry segments areaffected by common risk fac-
tors, we assign a single exposureguideline to them. In addition,
for each industry, Risk Management assigns a concentration
limit, which is a percentage of the Bank’stotal wholesale and
commercial exposure. We regularly review industry risk ratings
to ensure that they properly reflect the risk of the industry.
COUNTERPARTY RISK
Through the use of segment specific models and expert judge-
ment, the Bank assigns each borrower a Borrower Risk Rating
which reflects the probability of default of the borrower. The
Borrower Risk Rating determines the amount of credit exposure
the Bank is prepared to take to the borrower. In addition, using
amodel-based approach, each credit facility extended to a
borrower is assigned a Facility Risk Rating to reflect the expected
loan recovery rates by assessing the collateral and/or asset values
supporting the facility.
For accounts where exposures include derivatives, we use
master netting agreements and/or collateral whenever possible
to reduce our exposures.
We use a risk-adjusted return on capital model to assess the
return on credit relationships according to the structure and
maturity of the loans and the internal ratings of the borrowers
involved. We review the established risk ratings and return on
capital for each borrower at least once every year.
CREDIT DERIVATIVES
We use credit derivatives to mitigate credit risk in our portfolio.
Credit derivatives allow the Bank to transfer risk associated with
an underlying asset to another obligor in a synthetic transaction.
The obligor is paid a fee to take on this credit risk while the Bank
retains the underlying credit asset.
Credit default protection is generally only purchased from
strong investment grade counterparties. When terms of the
protection match the terms of the underlying asset, the notional
exposureof the underlying credit facility is reduced by the
notional amount of the protection.
PERSONAL CREDIT
The personal credit portfolios are large segments, which include
residential mortgages, unsecured loans, credit card receivables,
and small business credits. These portfolios are made up of a
large number of relatively small accounts. Thus, credit risk is
evaluated most efficiently through statistically-derived analytical
models and decision strategies. Requests for personal credit are
processed using automated credit scoring systems or, for larger
and more complex transactions, are directed to underwriters in
regional credit centres who operate within clear authority limits.
Once retail credits are funded they are continually monitored
with quantitative customer management programs to identify
changes in risk and provide opportunities that increase risk-
adjusted performance. The centralized quantitative review of
personal credit has resulted in well-balanced portfolios with
predictable risk performance.
Consistent with its strategy of efficient quantitative evaluation
of personal credit, the Bank channels a large portion of its tech-
nology investment in the platform for retail applications, loan
fulfillment, and customer account management. This ongoing
investment not only improves the Bank’s ability to manage retail
credit losses within predictable ranges, it also strengthens the
control environment that reduces the potential for operational
errors. The infrastructure investment also provides more com-
plete, timely and accurate management information, permitting
measurable improvement in the management of credit risk. Thus,
the Bank’s personal credit strategy is to leverage the disciplined
management of the personal credit portfolio with state-of-the-
art systems, methods and processes.
CLASSIFIED RISK/IMPAIRED LOANS
Classified risk refers to loans and other credit exposures that
pose a higher than normal credit risk. A loan is considered
impaired when, in management’sopinion, we can no longer be
reasonably assured that we will be able to collect the full amount
of principal and interest when due.
Weestablish specific allowances for impaired loans when a
loss is likely or when the estimated value of the loan is less than
its recorded value, based on discounting expected future cash
flows. Allowances for personal credit portfolios are based on
delinquency and type of security.
See the Credit Portfolio Quality section on pages 44 to 50.
Market Risk
Market risk is the potential for loss from changes in the value of
financial instruments. The value of a financial instrument can be
affected by changes in interest rates, foreign exchange rates,
equity and commodity prices and credit spreads.
We are exposed to market risk in our trading and investment
portfolios, as well as through our non-trading activities. In our
trading and investment portfolios we areactive participants in
the market, seeking to realize returns for the Bank through
careful management of our positions and inventories. In our
non-trading activities we are exposed to market risk through
the transactions that our customers execute with us.
MARKET RISK IN TRADING ACTIVITIES
The four main trading activities that expose us to market risk are:
•Market making: We provide markets for a large number of
securities and other traded products. We keep an inventory of
these securities to buy from and sell to investors, profiting from
the spread between bid and ask prices. Profitability is driven by
trading volumes.
•Sales: Weprovide a wide variety of financial products to meet
the needs of our clients, earning money on these products
from mark ups and commissions. Profitability is driven by sales
volumes.