TD Bank 2011 Annual Report Download - page 69

TD BANK GROUP ANNUAL REPORT 2011 MANAGEMENT’S DISCUSSION AND ANALYSIS 67
There are two types of wrong-way risk exposures: 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
counterparty 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, 2011, after taking into account risk mitigation strate-
gies, TD does not have a material derivative exposure to any counter-
party considered higher risk as defined by management’s internal
monitoring process. In addition, TD 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
consisting of exposures with similar characteristics. Pools are
segmented by product type and by the PD estimate. We have devel-
oped proprietary statistical models and decision strategies for each
retail product portfolio. Our models are based on 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:
Description One-year PD range
> – <=
Low risk 0.00% – 0.15%
Normal risk 0.15% – 1.10%
Medium risk 1.10% – 4.74%
High risk 4.74% – < 100%
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 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 TD’s model risk rating policy. At least annually, the Risk Committee
is informed of the performance of the credit risk rating system. The
Risk Committee must approve any material changes to TD’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 an economic downturn or a material
market disruption.
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 TD’s own assessment of the counter-
party’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 Wholesale
Banking business, a large portion of loans is to investment grade
borrowers where no security is pledged. Non-investment grade borrow-
ers typically pledge business assets in the same manner as commercial
borrowers. Common standards across TD 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 highly rated 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,
safekeeping, and release of pledged securities.
In all but exceptional situations, we secure collateral by taking
possession and controlling it in a jurisdiction where we can legally
enforce our collateral rights. Exceptionally, and when demanded by
our counterparty, we hold or pledge collateral with a third-party
custodian. We document third-party arrangements with a Custody
and Control Agreement.
We may take guarantees to reduce the risk in credit exposures.
We only recognize irrevocable guarantees that are provided by entities
with a better risk rating than that of the borrower or counterparty
to the transaction.
TD makes use of credit derivatives to mitigate credit risk. The credit,
legal, and other risks associated with these transactions are controlled
through well-established procedures. Our policy is to enter into these
transactions with investment grade financial institutions. Credit risk to
these counterparties is managed through the same approval, limit and
monitoring processes we use for all counterparties for which we have
credit exposure. We also use collateral and master netting agreements
to mitigate derivative counterparty exposure.