TD Bank 2009 Annual Report Download - page 75

TD BANK FINANCIAL GROUP ANNUAL REPORT 2009 MANAGEMENT’S DISCUSSION AND ANALYSIS 71
The facility risk rating maps to LGD and takes into account facility-specific
characteristics such as collateral, seniority of debt, and loan structure.
Internal risk ratings are key to portfolio monitoring and management
and are used to set exposure limits and loan pricing. Internal ratings
are also used in the calculation of regulatory capital, economic capital,
and general allowance for credit losses.
Derivative Exposures
Credit risk on derivative financial instruments, also known as counter-
party credit risk, is the risk of a financial loss occurring as a result of
the failure of a counterparty to meet its obligation to the Bank. We
use the Current Exposure Method to determine regulatory capital
requirements for derivative exposures. The Treasury Credit group within
Wholesale Banking is responsible for implementing and ensuring
compliance with credit policies established by the Bank for the
management of derivative credit exposures.
We use a range of qualitative and quantitative methods to measure
and manage counterparty credit risk. These include statistical methods
to measure and limit future potential exposure and stress tests to
identify and quantify exposure to extreme events. We set gross notional
limits to manage business volumes and concentrations and we regularly
assess market conditions and the pricing quality of underlying financial
instruments. Counterparty credit risk may increase during periods
of receding market liquidity for certain instruments. Treasury Credit
Management meets regularly with Trading Risk Management and front
office Trading to discuss evolving market conditions and the interde-
pendencies between market risk and counterparty credit risk.
The Bank actively engages in risk mitigation strategies through the
use of multi-product derivative master netting agreements, collateral
and other credit risk mitigation techniques. Derivative-related credit
risks are subject to the same credit approval, limit, monitoring and
exposure guideline standards that we use for managing other transac-
tions that create credit risk exposure. These standards include evaluating
the creditworthiness of counterparties, measuring and monitoring
exposures, including wrong-way risk exposures, and managing the
size, diversification and maturity structure of the portfolios.
There are two types of wrong-way risk exposure: general and specific.
General wrong-way risk arises when the probability of default of the
counterparties moves in the same direction as a given market risk factor .
Specific wrong-way risk arises when the exposure to a particular coun-
terparty moves in the same direction as the probability of default of the
counterparty due to the nature of the transactions entered into with
that counterparty. These exposures require specific approval by the
appropriate level within the credit approval process. We record specific
wrong-way risk exposures in the same manner as direct loan obligations
and control them by way of approved facility limits.
As part of the credit risk monitoring process, management meets on
a periodic basis to review all exposures, including exposures resulting
from derivative financial instruments to higher risk counterparties. As
at October 31, 2009, after taking into account risk mitigation strategies,
the Bank does not have a material derivative exposure to any counter-
party considered higher risk as defined by management’s internal
monitoring process. In addition, the Bank does not have a material
credit risk valuation adjustment to any specific counterparty.
Retail Exposures
We have a large number of individual and small business customers
in our retail credit segment. We use automated credit and behavioural
scoring systems to process requests for retail credit. For larger and
more complex transactions, we direct the requests to underwriters in
regional credit centres who work within clear approval limits. Once
retail credits are funded, we monitor current internal and external risk
indicators on a regular basis to identify changes in risk.
We assess retail exposures on a pooled basis, with each pool consist-
ing
of exposures with similar characteristics. Pools are segmented by
product type and by the PD estimate. We have developed proprietary
statistical models and decision strategies for each retail product port-
folio. Our models are based on seven to ten or more years of internal
historical data. Credit risk parameters (PD, EAD and LGD) for each
individual facility are updated quarterly using the most recent
borrower credit bureau and product-related information. We adjust
the calculation of LGD to reflect the potential of increased loss
during an economic downturn.
The following table maps PD ranges to risk levels:
One-year PD range
Description > – <=
Low risk 0.00% – 0.15%
Normal risk 0.15% – 1.10%
Medium risk 1.10% – 4.75%
High risk 4.75% – 99.99%
Default 100.0%
Validation of the Credit Risk Rating System
Credit risk rating systems and methodologies are independently
validated to verify that they remain accurate predictors of risk. The
validation process includes the following considerations:
•
Risk parameter estimates – PDs, EADs and LGDs are reviewed and
updated against actual loss experience and benchmarked against
public sources of information to ensure estimates continue to be
reasonable predictors of potential loss.
•
Model performance – Estimates continue to be discriminatory, stable
and predictive.
•Data quality – Data used in the risk rating system is accurate,
appropriate and sufficient.
•Assumptions – Key assumptions underlying the development of the
model remain valid for the current portfolio and environment.
Risk Management ensures that the credit risk rating system complies
with the Bank’s model risk rating policy. At least annually, the Risk
Committee of the Board is informed of the performance of the credit
risk rating system. The Risk Committee must approve any material
changes to the Bank’s credit risk rating system.
Stress Testing
To determine the potential loss that could be incurred under a range
of adverse scenarios, we subject our credit portfolios to stress tests.
Stress tests assess vulnerability of the portfolios to the effects of severe
but plausible situations, such as a material market disruption or an
economic downturn.
Credit Risk Mitigation
The techniques we use to reduce or mitigate credit risk include written
policies and procedures to value and manage financial and non-
financial security (collateral) and to review and negotiate netting
agreements. The amount and type of collateral and other credit risk
mitigation techniques required are based on the Bank’s own assess-
ment of the counterparty’s credit quality and capacity to pay.
In the Retail and Commercial Banking businesses, security for loans
is primarily non-financial and includes residential real estate, real
estate under development, commercial real estate and business assets,
such as accounts receivable, inventory and fixed assets. In the Whole-
sale Banking business, a large portion of loans is to investment grade
borrowers where no security is pledged. Non-investment grade
borrowers typically pledge business assets in the same manner as
commercial borrowers. Common standards across the Bank are used
to value collateral, determine recalculation schedules and to document,
register, perfect and monitor collateral.
Security for derivative exposures is primarily financial and includes
cash and negotiable securities issued by governments and investment
grade issuers. The Treasury Credit group within Wholesale Banking
is the central source of financial collateral processes. These processes
include pre-defined discounts and procedures for the receipt, safe-
keeping and release of pledged securities.