TD Bank 2012 Annual Report Download - page 72

TD BANK GROUP ANNUAL REPORT 2012 MANAGEMENT’S DISCUSSION AND ANALYSIS70
The facility risk rating maps to LGD and takes into account facility-
specific characteristics such as collateral, seniority ranking of debt,
and loan structure.
Internal risk ratings are key to portfolio monitoring and manage-
ment and are used to set exposure limits and loan pricing. Internal risk
ratings are also used in the calculation of regulatory capital, economic
capital, and incurred but not identified 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 TD. We use the
Current Exposure Method to calculate the credit equivalent amount,
which is defined by OSFI as the replacement cost plus an amount for
potential future exposure, to estimate the risk and determine regula-
tory capital requirements for derivative exposures. The Treasury Credit
group within Wholesale Banking is responsible for estimating and
managing counterparty credit risk in accordance with credit policies
established by Risk Management.
We use various qualitative and quantitative methods to measure
and manage counterparty credit risk. These include statistical methods
to measure the current and future potential risk, as well as conduct
stress tests to identify and quantify exposure to extreme events. We
establish various limits including gross notional limits to manage
business volumes and concentrations. We regularly assess market
conditions and the valuation of underlying financial instruments.
Counterparty credit risk may increase during periods of receding
market liquidity for certain instruments. Treasury Credit Management
meets regularly with Market and Credit Risk Management and Trading
businesses to discuss how evolving market conditions may impact our
market risk and counterparty credit risk.
TD 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 expo-
sure guideline standards that we use for managing other transactions
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 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 within the credit approval process. We measure and manage
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, 2012, after taking into account risk mitigation strate-
gies, TD does not have 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.
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 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 borrower’s or 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, fixed assets and automobiles. In the
Wholesale 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 TD are used to
value collateral, determine recalculation schedules and to document,
register, perfect and monitor collateral.
We also use collateral and master netting agreements to mitigate
derivative counterparty exposure. Security for derivative exposures is
primarily financial and includes cash and negotiable securities issued
by highly rated governments and investment grade issuers. This
approach includes 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.
From time-to-time, we may take guarantees to reduce the risk in
credit exposures. For credit risk exposures subject to AIRB, we only
recognize irrevocable guarantees for Commercial and Wholesale
Banking credit exposures 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.