TD Bank 2014 Annual Report Download - page 81

TD BANK GROUP ANNUAL REPORT 2014 MANAGEMENT’S DISCUSSION AND ANALYSIS 79
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. The Bank uses 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 regulatory
capital requirements for derivative exposures. The Global Counterparty
Credit group within Capital Markets Risk Management is responsible
for estimating and managing counterparty credit risk in accordance
with credit policies established by Risk Management.
The Bank uses 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. The Bank establishes various limits including gross notional
limits to manage business volumes and concentrations. TD regularly
assesses market conditions and the valuation of underlying financial
instruments. Counterparty credit risk may increase during periods of
receding market liquidity for certain instruments. Capital Markets Risk
Management meets regularly with Market and Credit Risk Management
and Trading businesses to discuss how evolving market conditions may
impact the Bank’s 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. The Bank also executes
certain derivatives through a central clearing house which reduces
counterparty credit risk due to the ability to net offsetting positions
amongst counterparty participants that settle within clearing houses.
Derivative-related credit risks are subject to the same credit approval,
limit, monitoring, and exposure guideline standards that the Bank uses
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 expo-
sures, and managing the size, diversification, and maturity structure
of the portfolios.
There are two types of wrong-way risk exposures, namely 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. The Bank measures and
manages specific wrong-way risk exposures in the same manner as
direct loan obligations and controls them by way of approved credit
facility limits.
As part of the credit risk monitoring process, management meets
on a periodic basis to review all exposures, including exposures result-
ing from derivative financial instruments to higher risk counterparties.
As at October 31, 2014, after taking into account risk mitigation
strategies, TD does not have material derivative exposure to any coun-
terparty considered higher risk as defined by the Bank’s credit policies.
In addition, the Bank 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 vali-
dated on a regular basis 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, appro-
priate, 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 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 the Bank’s credit
risk rating system.
Stress Testing
To determine the potential loss that could be incurred under a range
of adverse scenarios, the Bank subjects its 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 the Bank uses 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
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, automobiles, and other
business assets, such as accounts receivable, inventory, and fixed assets.
In the Wholesale Banking business, a large portion of loans is to invest-
ment 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 frequency of recalculation, and to docu-
ment, register, perfect, and monitor collateral.
The Bank also uses collateral and master netting agreements to
mitigate derivative counterparty exposure. Security for derivative expo-
sures 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, the Bank secures collateral by
taking possession and controlling it in a jurisdiction where it can
legally enforce its collateral rights. In exceptional situations and when
demanded by TD’s counterparty, the Bank holds or pledges collateral
with an acceptable third-party custodian. The Bank documents all
such third-party arrangements with industry standard agreements.
Occasionally, the Bank may take guarantees to reduce the risk in
credit exposures. For credit risk exposures subject to AIRB, the Bank
only recognizes 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.
The Bank 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. The Bank’s policy is to
enter into these transactions with investment grade financial institutions
and transact on a collateralized basis. Credit risk to these counterparties
is managed through the same approval, limit, and monitoring processes
the Bank uses for all counterparties for which it has credit exposure.
The Bank uses appraisals and automated valuation models (AVMs)
to support property values when adjudicating loans collateralized by
residential real property. These are computer-based tools used to esti-
mate or validate the market value of residential real property using
market comparables and price trends for local market areas. The
primary risk associated with the use of these tools is that the value of
an individual property may vary significantly from the average for the
market area. The Bank has specific risk management guidelines
addressing the circumstances when they may be used, and processes
to periodically validate AVMs including obtaining third party appraisals.