Credit Portfolio Management at Japanese Financial Institutions― Current Status and Challenges ―May 2007
Study Group on Credit Portfolio Management

The original paper was prepared in Japanese and released on April 20, 2007.

Contents
Foreword……………………………………………………….……………………………2
Chapter 1 An Introduction to CPM..................................................................................4A.

The Features of CPM ................................................................................................4

B.

Types of CPM............................................................................................................6

C. CPM's Historical Development .................................................................................6
Chapter 2 CPM's Basic Framework and the Initiatives at Major Banks ...................11
A. The objectives of CPM............................................................................................11
B. Evaluating credit portfolios .....................................................................................13
1. Credit portfolio evaluation methods ..................................................................13
2. Determining basic CPM policies .......................................................................16
C. Credit risk control methods .....................................................................................17
1. Selecting control methods..................................................................................17
2. Calculating indicated prices ...............................................................................20
D. Verifying CPM performance ...................................................................................21
E. CPM's organizational structure................................................................................23
1. Loan ownership and recognizing earnings.........................................................23
2. Cooperation with the marketing division...........................................................24
3. The placement of the CPM department .............................................................25
Chapter 3

Challenges for CPM in Japan and Approaches to Addressing Them .......27

A. More objective evaluations of the economic value of loan transactions.................27
1. Identifying the profitability of loan holdings.....................................................28
2. Introduction of Credit Transfer Pricing..............................................................30
B. Raising the liquidity of loan assets..........................................................................33
1. Switching to loan contracts that make it easier to transfer claims .....................34
2. Establishing practices concerning the fair handling of nonpublic information .36
Closing……………………………………………………………………………………...40

1

Foreword
Credit Portfolio Management (CPM) refers to such activities as financial institutions
evaluating the risk/return profile of the credit portfolio and enhancing the soundness andprofitability of the portfolio through credit risk transfer transactions. Unlike traditionalloan management, CPM is characterized by the fact that it not only assesses the credit risk
and profitability of individual loan assets, but also controls the overall risk/return profile ofthe credit portfolio. In recent years, more and more globally active financial institutions in
the US and Europe have been proactively engaged in CPM, rebalancing their loan asset
portfolios while utilizing the credit market's functions to the full. There are also manycases where institutions evaluate credit concentration risk and mitigate it mainly throughcontrol of the loan approval process, without involving themselves in active market
transactions of this sort.
In Japan, while the financial system has regained its soundness as a whole, there arestill issues with the earning power of financial institutions and credit concentration risk.
There is a growing awareness that CPM may be an effective way of dealing with theseissues, particularly among major banks. That said, CPM is still in its infancy at Japanesefinancial institutions. The relatively few financial institutions that have started taking aproactive approach to establishing CPM departments are going through a trial and error
phase while facing various constraints such as the underdeveloped credit market.
In light of this situation, credit portfolio managers at major banks, and staff from theCenter for Advanced Financial Technology of the Bank of Japan's Financial Systems andBank Examination Department held seven meetings of the Study Group on Credit Portfolio
Management between April and November 20061.
In launching this Study Group, the following three objectives were adopted.
(1) To deepen understanding of CPM by exchanging information on practices atindividual banks.
(2)

To exchange views on common challenges that have been identified throughinitiatives to date, including practical issues and obstacles arising from systems andcustoms, and to study possible approaches to addressing them.

(3) To provide financial institutions and other entities interested in CPM with referencematerials by publishing the results of the Study Group's discussions in the expectation

1

The Center for Advanced Financial Technology in Financial Systems and Bank Examination
Department of the Bank of Japan served as the secretariat of the Group. The Group's
membership is listed in the Attachment.

2

that this will further encourage the discussion on CPM in Japan.
This paper summarizes the Study Group's discussions mainly in line with objective(3), and is organized as follows2.
Chapter 1 provides an overview of CPM, examining the underlying concepts ascompared with traditional loan management and tracing its development in the US andEurope. Chapter 2 explains CPM's basic framework by taking a more specific look at its
objectives, credit portfolio evaluations, credit risk control, the verification of its effects, andorganizational structures. It also introduces the initiatives at major Japanese banks in eacharea. Finally, Chapter 3 takes up points of discussion that are recognized as common
challenges from the viewpoint of increasing risk hedging flexibility and promoting progress
in CPM, as well as introducing approaches to improving CPM.

2

The "major banks" referred to in this paper are the four banks participating in the study group as
members. In addition, this paper only addresses the issue of CPM in Japan and does not cover
trends at overseas offices.

3

Chapter 1
A.

An Introduction to CPM

The Features of CPM
With traditional loan management, interest income from a loan itself has always

occupied an important position as a source of earnings. At the same time, it has been
considered important to maintain and increase loans as a means of building favorable
relationships with customers while seeking various business opportunities going forward.
Based on this approach, marketing divisions have generally executed loans and held them tomaturity or default. When working to reduce exposures in response to a deterioration in aborrower's creditworthiness, they usually curb new credit or reduce the amounts of rollovers
on existing credit. They normally do not sell off loan assets because of concerns that thismight cause the relationship with the client to deteriorate. And since they do not envisage
market sales, they do not as a general rule use fair value (or theoretical value) for evaluating
loan assets.
In the case of credits premised on CPM, on the other hand, the lender executes theloan by not only judging the creditworthiness of individual borrowers, but also after
considering its impact on the credit portfolio's overall risk/return profile and, in some cases,
estimating the gains that may be available should the loan asset be sold in the market.
Therefore, the expected loss (EL), unexpected loss (UL) and Risk Adjusted Return on
Capital (RAROC) arising when the subject loan is added to the portfolio become importantcriteria for judgments, along with the transactional relationship with the customer, its shareof the loan to the customer, and gross operating profits.
If it becomes necessary to improve the risk/return profile of the credit portfolio after
granting a loan, the credit risk exposure should be flexibly reduced through sales, the credit
derivative market or the securitization market.

Conversely, if there is leeway to makeadditional use of capital, the exposure can be increased by making use of market
transactions, not just new credits. With CPM, therefore, fair value (or theoretical value) is
often used in managerial accounting to evaluate loan assets on the assumption that the credit
market will be used for credit risk transfer transactions (risk hedging or risk taking).
Quite often, this kind of control over credit risk/return is covered by specialist
departments (CPM departments) organized separately from the marketing divisions.

4The following table provides a comparison between the features of CPM andtraditional loan management3.
Traditional loan management

CPM

Originate & Hold to theOriginate & Distribute if

maturity/default

necessaryStand-alone Analysis

Relative to Existing Portfolio

Secure loan interest

Entry ticket to fee andSecure outstanding loans (share)commissions business5

Net business profit

Risk-adjusted returns

Loan evaluations

Acquisition cost

Acquisition cost/fair value

Risk/return

Control of the loan approval

Also use the credit market

adjustments

process only

Risk/return adjusting

Marketing Division/Credit

Specialist department (CPM

entityDivisiondepartment)

Investment policy
Loan transaction
evaluation criteria
Loan incentives4Management
indicators

Source: Prepared using Smithson and Hayt [2], etc.

3

4

5

This table attempts to draw conceptual contrasts between traditional loan management and CPM.
In reality, there are many cases where the boundaries between CPM and other loan management
methods are not necessarily as clear as depicted here.
One of the loan incentives ― the creation and maintenance of transactional relationships withcustomers ― has been treated as common to both traditional loan management and CPM. In
the CPM practiced by US commercial banks, for example, single-name credit default swaps thatallow silent risk transfers are used for risk hedging at the individual company level out ofconsideration for transactional relationships with customers. There are also cases where silent
loan participation is used even in sales of loan assets (please refer to The Thompson Corporation
and Bank Loan Report [2004]).
This approach sees loans as an entry ticket to securing more profitable fee and commissions
business ― investment banking business ― from customers. Financial institutions that haveadopted investment banking-type business models see loans as simply one product in the line-up
necessary to build and maintain transactional relationships with customers, and believe theirmain source of earnings lies in their ability to offer comprehensive financial services. When
this approach is adopted, risk/return performance that views loans and commissions business,
etc., on a total basis is strictly monitored within the CPM framework.

5

B.

Types of CPM
CPM takes various forms depending on the development status of the credit market,

the features of the credit portfolio (level of credit concentration, etc.), the importance oflong-term relationships with customers, relationships with a broader range of stakeholders,and management strategies that take such factors into account. To simplify our discussion
in this paper, it is useful to set up two categories: risk-hedge-oriented CPM, and enhanced
return-oriented CPM.
Risk-hedge-oriented CPM focuses more on reducing risk in the credit portfolio thanon increasing returns, and typically aims to free up economic (or regulatory) capital bycorrecting credit concentration. Currently, major Japanese banks have basically adopted
this type of CPM which, for example, involves reducing rollovers or selling off loan assets
when large loans exceed internal credit limits.
On the other hand, enhanced return-oriented CPM aims to improve the risk/return
balance by not only reducing risk, but also raising returns. More specifically, the intention
behind this type of CPM is not simply to release economic capital, but also to makeeffective use of it, and it is normally used in the credit market for flexible rebalancing ofcredit portfolios (risk hedging and risk taking). The next section looks at the history of
CPM, which started in the US as risk-hedge-oriented CPM before evolving into enhanced
return-oriented CPM at some financial institutions.

C. CPM's Historical Development6[Risk-hedge-oriented CPM]
In the second half of the 1980s, US commercial banks faced declines in capital
adequacy ratios and rising funding costs against a background of non-performing loans.
As a result, bank managements became increasingly aware of the need to shrink theirbalance sheets and boost their earning power, and moved to sell off their non-performing
loans and reinforce their credit risk management systems.

These moves marked thestarting point for the subsequent development of the US credit market.
In the 1990s, the major commercial banks drew on these experiences by establishing
CPM departments within their risk management divisions, and started proactive initiatives
to reduce credit concentration risk aimed at their large corporate credit portfolios. Most

6 See IACPM [1], Walenta [2003].

6

activity in the early stages was at the individual company level and involved control of theloan approval process, loan sales and hedging through single-name credit default swaps(CDS)7. Subsequently, measures to reduce risk were adopted at a portfolio level throughCDS targeting specific segments, and securitization.
These more proactive risk hedging activities by the banking sector are said to havecontributed to the development of the credit market by encouraging new investors such as
insurance companies, institutional investors and hedge funds to participate.
[Enhanced return-oriented CPM]
While the profitability of loans to large companies declined in the second half of the
1990s, the credit market's liquidity increased, encouraging commercial banks to view CPM
as an effective way of increasing ROE (or shareholder value). More specifically, they tookbold steps to reduce lending to barely profitable large companies within a CPM frameworkthat was clearly conscious of the cost of economic capital. At the same time, they moved
rapidly to channel their management resources into more profitable transactions. These
included investment banking sectors such as asset turnover business and commissions
business, and retail business with individuals, medium-sized companies and SMEs. Assetturnover business included flexible lending and sales to investors in high value-added areas
such as corporate turnarounds and M&A deals, as well as normal loans to companies.
This switch in business models is believed to have resulted from strong top-down directives
from managements conscious of shareholder value, and against a background of progress incredit risk quantification techniques.
In recent years, more frequent use is being made of a framework (Credit Transfer
Pricing) whereby loans extended to large companies by marketing divisions are transferredto the CPM department at fair value or theoretical values. At such marketing divisions, acredit market perspective is used to establish explicit rules for the pricing of new loans, andif the margins applied are below the relevant levels, the shortfalls must be clearly coveredby other economic advantages. CPM departments are not only used to hedge credit risk,
but are also required to flexibly enhance returns through the market operation and to play arole in achieving the high ROE targets imposed on the organization as a whole.

7

It is said that US commercial banks used CDS to hedge against individual company credit risk
for the first time in 1991 (see Smithson and Mengle [2006]).

7

Box 1:Case Study ― Deutsche Bank

In 2002, Deutsche Bank drew up a new management plan based on specializing in corebusinesses, reducing credit risk and cutting costs. The plan set the achievement of pre-tax
ROE of 25% as its medium-term management target, and introduced ROE-based economic
capital management schemes.
Under the plan, the bank took steps in 2003 to minimize loan losses assumed for the
next downturn, establishing a new Loan Exposure Management Group (LEMG ―equivalent to a CPM department) and adopting a de-risking strategy to improve therisk/return profile by switching lending toward large businesses to the retail and investmentbanking divisions.
The LEMG has jurisdiction over credit portfolio management for large businesses in
Europe, the United States and Asia, and for medium-sized companies in Germany itself. Its
primary missions are to (1) reduce credit concentration risk (free up economic capital) and(2) improve the transparency of the credit process.
(1) Reducing credit concentration risk (freeing up economic capital)
Based on its threshold policy, the LEMG works to reduce credit concentration risk in its
portfolio by proactively hedging against risk using CDS, securitization, loan sales and othermethods. The LEMG is expanding the scope of its risk hedge targets in stages, as shown
below.
<2003> Investment-grade loans with an original maturity greater than 180 days
(excluding loans to medium-sized companies in Germany)<2004> Loans to medium-sized companies in Germany with an original maturity
greater than 360 days added to hedging targets (excluding preexisting loans)<2005> Shorter-maturity loans in both categories and preexisting loans
added to hedging targets
It is reported that these initiatives have had the following results.
[Total outstanding loans]

Down 13%(from €265 billion at the end of 2001 to €230 billion at the end of June 2003)8[Total credit lines for top 100 companies]

Down 40%(from €107 billion at the end of 2001 to €64 billion at the end of June 2003)[Economic capital]

8 Excluding a €65 billion drop in lending due to the disposal of three consolidated subsidiaries.

8

Loans to large companies down 38% between 2003 and 2004
Loans to individuals and SMEs up 10%, investment banking division up 5%(both between 2003 and 2004)
With regard to the large company credit portfolio (€48 billion at the end of June 2006),
approximately 45% of the medium- to long-term commitment line was hedged using CDS(primarily single-name CDS) or securitization, making it possible to keep the credit cost
ratio assumed for the next downturn (0bp in the first half of 2006) to less than 20bp9.

Thebank is also making progress in diversifying risk under the threshold policy, and has recently
been practicing more active CPM aimed at improving the risk/return profile.
On the other hand, with regard to the credit portfolio for medium-sized enterprises inGermany (€18 billion at the end of June 2006), approximately 20% of the medium- tolong-term commitment line was hedged using CDS or securitization, and the hedge ratio was
expected to reach around 40% by the end of December 2006. As a result, it should bepossible to keep the credit cost ratio assumed for the next downturn (5-15bp in the first halfof 2006) to less than 50bp.

While it used proactive restructuring through market

transactions for its large business credit portfolio, it is improving the risk/return profile of its
medium-sized enterprise credit portfolio by focusing instead on cost-cutting through a morerational credit screening system, higher fee and commissions earnings (cross-selling), andstronger pricing discipline when making loans.
(2) Improving the transparency of the credit process
The LEMG has introduced the following Credit Transfer Pricing scheme for the credit
portfolios as part of its internal infrastructure for promoting greater transparency in themarketing division's credit and pricing processes, and realizing flexible CPM through thecredit market. It has been phasing in the Credit Transfer Pricing scheme, using similar
credit concentration reduction targets and timing to those mentioned above.
(a) Evaluation of loans at market prices
When the marketing division extends a new loan, the LEMG indicates a reference
price derived from the cost of hedging it in the credit market (e.g., the CDS premium).

In

the case of loans that do not involve credit market transactions (such as loans to
medium-sized enterprises in Germany), it calculates reference prices on the basis of internalratings, loan size, lending period, type of collateral and examples of loans in similar deals.
(b) Decisions by the marketing division
Taking into consideration the reference prices indicated by the LEMG, the marketing
9The "credit cost ratio" mentioned here refers to the ratio between provision for loan losses after
taking the hedge effect into account, and the loan balance.

9division makes an overall judgment based on the transactional relationship with thecustomer, and the prospects for securing fee and commissions earnings before deciding
whether it should enter into the new loan and if so, at what interest rate.
(c) Marketing division earnings
After the loan is made, the loan book is transferred from the marketing division to the
LMG at the above-mentioned reference price, and the realized gain or loss on this internaltransaction is recognized by the marketing division. If the marketing division realizes asales loss because it set the loan interest rate too low, it must endeavor to make up theshortfall by itself by, for example, increasing fee and commissions earnings.
(d) Risk hedging by the LEMG
For its part, the LEMG hedges against risk on the transferred loan on the basis of its
threshold policy. Since the loan in question was acquired at the above-mentioned reference
price, risk hedging should be profit-neutral for the LEMG provided there are no subsequent
fluctuations in market prices.
By introducing this Credit Transfer Pricing scheme, the bank has clearly separated the
responsibility for originating individual loans at appropriate prices and the responsibility forcontrolling credit risk in the overall portfolio between the marketing division and the LEMG.
Starting with its financial accounts for 2007, Deutsche Bank has been assessing asubstantial part of its loans to large companies at fair value in accordance with theInternational Financial Reporting Standards (IFRS).

The information in this box draws on Deutsche Bank's annual reports, its IR materials
for investors and published articles.

10Chapter 2

CPM's Basic Framework and the Initiatives at Major Banks

Major Japanese banks are currently implementing CPM with the primary objective of
reducing credit concentration risk towards large companies.
The following sections examine the general approach to individual aspects of CPM
by taking a point-by-point look at its objectives, the evaluation of credit portfolios, credit
risk control, the verification of its performance, and organizational structures. It also
introduces actual initiatives undertaken by major Japanese banks in each area.
A.

The objectives of CPM
CPM's objectives ultimately boil down to improvements in risk/return profiles, but its

direct targets can be broadly broken down into three categories as follows10.
1. Reduce credit concentration risk
Reflecting various factors, including the financial institution's marketing policies,
business base and lending practices, credit may well end up concentrated in certain
areas, business sectors and/or individual companies. Some observers have pointed outthat main bank system in Japan has been a factor in causing concentrations of credit
with certain business partners.

It has also been noted that regional financial

institutions find it difficult to diversify their borrowers because their business bases arestrong in certain areas and business sectors.
The experience since the collapse of the economic bubble in Japan clearly
demonstrates that credit concentration risk has a major impact on financial institution
management at times of stress, such as recessions. Reducing credit concentration risk
is thus a vital issue for many financial institutions, and CPM can be seen as apotentially effective solution.
2. Reduce credit risk (economic capital)
CPM is effective not only in reducing credit concentration risk as seen above, butalso in ensuring that capital is adequate vis-à-vis credit risk. Even when current credit
risk is judged not to be excessive, CPM can be broadly applied to adjusting the risk
10

According to an overseas survey of 44 major US and European institutions conducted in 2004
(see Rutter Associates LLC [2004]), the key objectives of CPM as seen by credit portfolio
managers were, in order of importance: (1) management of concentrations; (2) protection
against risk deterioration; (3) reduction of economic capital; (4) portfolio risk/return
optimization; and (5) reduction of regulatory capital.

11

profile by taking steps to reduce credit risk as part of protective preparations against
potential stress situations, such as the next downturn. Broadly speaking, category 1
and category 2 can be described as risk-hedge-oriented CPM.
3. Risk/return optimization
In cases where management is also conscious of the need to optimize shareholder
value, CPM's direct objectives will be to reduce risk while improving returns as ameans of improving the balance between the two. In this case, the primary aim is toensure that the risk/return relationship is optimized at all times by dynamicallyreplacing credits that bear a poor risk/return profile with credits that bear a better one,while monitoring risk-adjusted return indicators.

This kind of enhanced

return-oriented CPM normally develops from risk-hedge-oriented CPM. For example,
this development tends to be triggered by strategies for allocating to new sectors or
priority operations, etc. any risk capital (risk-taking capacity) released by reducing
credit concentration in certain business sectors or large individual companies.
[Initiatives at major banks]
Currently, major Japanese banks have focused on category 1 (the reduction of credit
concentration risk) as CPM's main objective.

An analysis of organizational lines ofcommand also shows that CPM departments are granted authority, budgets andresponsibility in connection with credit portfolio risk hedging. The reason for this is thatwhen the impact of any future stress on management is considered, there is a common
awareness that reducing credit concentration risk continues to be an important issue formanagement even after the quality of the bank’s loan portfolio has improved substantiallybecause credit concentration in certain counterparties or industrial sectors remains, partly
because of the impact of management consolidations. Since credit concentration risk is
not covered by Basel II's Pillar 1 (minimum capital requirements), major banks haveadopted their own approaches to creating and operating more sophisticated internal control
systems, including business management based on economic capital.
The

CPM

currently

practiced

by

major

Japanese

banks

is

thereforerisk-hedge-oriented. If the CPM departments of major banks deliver a certain level ofresults by reducing credit concentration risk, and a strong consensus forms within theorganizations that CPM is effective and useful, it is believed that there could be steadyprogress towards enhanced return-oriented CPM.

12

B. Evaluating credit portfolios
1. Credit portfolio evaluation methods
Credit portfolio evaluation consists of identifying concentration in the credit portfolio,
the risk/return profile and other factors in accordance with the objectives set for CPM.
More specifically, it means identifying counterparties with high credit concentration risk,
assets that have significant amounts of risk, and low-return counterparties in order toprovide objective information that will contribute to the formulation of credit portfolio
management policies.
[Initiatives at major banks]
The major banks use the following evaluation indicators after segmenting their credit
portfolios into several sub-portfolios based on internal ratings, business sectors, individualcompanies and groups, and regions.
Specific examples of indicators
Credit amount indicators

Gross credit amount, unsecured credit amount

Earnings indicators

Gross operating profits, net business profits11

Credit concentration indicators

Compliance with thresholds (excess over credit limits)
Diversification indicator (Effective Dispersion Index,
HHI, etc.)12 13

Risk amount indicators

EL (Expected Loss)

11

Only gains on loans are taken into consideration when evaluating the profitability of the lending
entity on a stand-alone basis. Returns in the form of total gains on loans plus fee andcommissions earnings are calculated when evaluating overall profitability including fee andcommissions earnings.
12 Effective Dispersion Index = (the square of the total credit amount) / (total values of squared
individual company credit amounts)
When using the Effective Dispersion Index, it is necessary to bear in mind the fact that
calculation results may fluctuate according to the coverage and the method used for identifying
multiple accounts under the same name as a single entity (name gathering).
13 HHI (Herfindahl-Hirschman Index)= Total values of squared credit shares by industry (or individual companies)
The reciprocal of this indicator is the Effective Dispersion Index.

13

UL (Unexpected Loss)
Risk-adjusted returns indicators(Return amount indicators)
Returns after credit costs14
Shareholders Value Added (SVA)15(Return ratio indicators)
Rates of return after credit costs (RAROC, RAROA,etc.)16 17

The major banks are developing more sophisticated credit risk quantification methods
and generally measure the above-mentioned indicators on a monthly basis. Since the main
objective of CPM today is to reduce credit concentration risk, the evaluation indicators that
get the most attention in implementing CPM are company/group-specific limit excess
amount and EL/UL.

Risk-adjusted return indicators are generally used as referenceindicators when monitoring the profitability of credit portfolios and individual transactions
and in the simulation analyses described below.
In evaluating credit portfolios, CPM departments use not only the static indicators
referred to above but also the following dynamic analyses and market information.
(1) Stress tests
Stress tests are divided into two types: (a) analysis of its overall impact on thecredit portfolio (verification of capital adequacy); and (b) analysis of its impact on
specific individual companies and groups, or business sectors (verification of whether
the credit portfolio includes any areas that are exceptionally vulnerable to stress).
At major Japanese banks, the former is covered by the risk management division,and the latter by the CPM department. In other words, the CPM department verifies
how much an individual company's EL or UL, as well as its financial reserve burden,
will increase in the case where its internal rating falls by 2-3 notches (so-called"sensitivity analysis"). It also links macroeconomic factors such as economic growthrate and land price fluctuations with the probability of default (PD) or loss given default(LGD), and confirms the extent to which EL or UL are likely to increase in specific
14 Returns after credit costs = Net business profit - Credit costs
15 SVA (Shareholders Value Added) = Returns after credit costs - Risk capital x Capital cost ratio
16 RAROC (Risk Adjusted Return on Capital) = Returns after credit costs / Risk Capital
17 RAROA (Risk Adjusted Return on Assets) = Returns after credit costs / Credit balance14business sectors under certain scenarios (so-called "scenario analyses").
The CPM department then uses the results of these stress tests in selecting assets
for hedging and counterparties for priority monitoring in CPM, as well as incommunications with management and the marketing division concerning its
recognition of risk in the credit portfolio.
(2) Simulation analyses
Simulation analyses are used to identify the impact of specific risk hedging
operations in connection with part of the credit portfolio.
For example, when looking into hedging operations against the specificindividual companies exceeding their credit limits, major banks analyze how these
operations can reduce the credit risk (EL/UL) of the targeted individual companies orthe credit portfolio as a whole. They also confirm the impact of hedging operations on
the risk/return balance, and analyze the impact on financial accounting of such factors
as assumed changes in returns on loans, the provision and hedge costs.
(3) Credit market information
Focusing on counterparties selected for priority monitoring, the CPM
departments of major banks make use of market information such as credit spreads on
bonds and CDS when assessing their credit portfolios. Utilizing signals from thecredit market allows them to respond dynamically to sudden deteriorations inborrowers' credit standing that cannot be observed by regular credit evaluation process.

Box 2: Credit risk factor analysis
Taking the Merton-type credit risk quantification model as an example, the Study
Group looked at methods for analyzing the contribution of credit risk (UL) in the credit
portfolio by risk factors ― systematic risk factors and unsystematic risk factors.
If the size of systematic risk and unsystematic risk in the credit portfolio can be
identified, it should be possible to use the results in CPM risk hedging strategies. For
example, if interest rate products such as government bonds can be used to hedge thesystematic risk portion that is believed to have a strong correlation with economic cycles
primarily, the risk capital allocated to the credit portfolio should be enough to cover just theunsystematic risk portion, not overall credit risk. This approach should also be applicableto the integrated management of credit risk and market risk.
Several conditions must be satisfied if this is to work. First, since the systematic risk
factors of the Merton-type model used by the Study Group cannot be observed directly, it is15necessary to tie them as objectively as possible to observable indicators such as interest rates
and stock prices. Second, it is necessary to promote a common awareness of the stability of
the correlation between credit risk and interest rate risk through appropriate verification.
Clear progress in connection with the second condition should facilitate progress in creating
an environment where it is easy to implement credit risk management focused on systematic
risk factors by reflecting the result of hedges in financial accounting and capital adequacy
requirements, and strengthening intra-organizational cooperation between credit and market
departments.

2. Determining basic CPM policies
Basic CPM policies based on credit portfolio evaluations need to receive top
management approval following discussions within the organization. At the same time,
management grants the CPM department the necessary authority to modify the credit
portfolio in accordance with the basic policies.
[Initiatives at major banks]
When the major banks' CPM departments draw up basic CPM policies at the
beginning of the business period, they use their ingenuity to ensure that the awareness ofrisk and its own message are clear.

It not only prepares a list of regular evaluation

indicators, but also includes drawbacks in the current credit portfolio, the need for
initiatives aimed at improvements, numerical targets, the scale of hedge operations, specificcountermeasures and methods, and information on cost versus effects. The basic policy ispresented to management and the marketing division, where it is discussed, taking into
account such viewpoints as the business advantages stemming from long-term relationships
with customers.
At the same time as it approves the basic CPM policy, management makes a blanket
decision on the size of the risk hedge in the current business period (based on transaction
and/or risk amounts), budgets for risk hedges (hedge costs) and risk hedging methods, andgrants risk hedging authority to the line managers (executives, departmental managers, etc.)
in the department in charge of CPM. The CPM department then freely engages in flexible
hedging operations within the authorized range, without having to obtain managerial
approval in connection with individual risk hedge transactions.
It should be noted that in the debate on basic CPM policies, there are quite a few
16differences of opinion between the CPM department, management and the marketing
divisions. In view of this situation, the major banks' CPM divisions are moving ahead
with studies on creating common standards concerning credit portfolio evaluations. (Oneexample is the approach for improving assessments of the economic value of loantransactions introduced in the first section of Chapter 3.)

Box 3:The role of stocks held for strategic purposes

Japanese financial institutions hold considerable quantities of stocks for strategic
purposes. Currently, there are no moves to make such stocks CPM targets for at least two
reasons: (1) there is a strong awareness that sale of such stocks as part of CPM could damage
stable, long-term relationships with customers; and (2) it would generate a need to adopt
more stringent controls over insider information.
In future, however, it is highly likely that the treatment of such strategic stock holdings
in terms of CPM will become an issue because: (1) the impact of price fluctuations in stock
holdings can have a significant impact on capital; and (2) CPM may well develop to theextent that it has a clearer awareness of the risk/return improvements.

C.

Credit risk control methods
The key points when actually controlling credit risk come down to the choice of acontrol method and the calculation of indicated prices.
1. Selecting control methods
Methods for controlling credit risk18 in CPM include the following.
Specific methods
Control of the loan approval
process
Adjustments through18

Approval / Disapproval of new business and Renewal /Non-renewal of existing business
Loan sales and trading

See Smithson and Hayt [1]17non-market transactions

Debt guarantees
Loan participations(so-called “portfolio exchanges” combining these)

Adjustments through market
transactions

Credit derivatives (CDS, etc.)
Securitization
Loan sales and trading(1) Control of the loan approval process
The most basic credit risk control method available to financial institutions is toadjust risk/return when extending new credits and rolling over existing credits 19 .
Financial institutions evaluate the credit risk posed by the counterparty whenever they
make loans. If they judge that the risk is increasing, they either control it by reducing
the size of the loan, or raise the loan interest rate in an endeavor to secure returns thatmatch the risk. Adjusting the amount of the loan or the loan interest rate are not the
only tools available. They may also raise the frequency of checks and adjustments of
the risk/return profile by shortening the term of the loan, or may require additional
collateral from borrowers.
Control of the loan approval process can be applied to any counterparty and there
are no ambiguities from the legal or accounting viewpoints. However, this approachhas problems with flexibility, and it takes a long time to alter the credit portfolio's
risk/return characteristics using it alone.
(2)

Adjustments through non-market transactions
Adjustments through non-market transactions use credit risk transfer transactions

between certain financial institutions through loan sales and trading and debt guarantees
in connection with borrowers about whom little public information is available. They
allow more flexible control of credit risk for medium-sized companies, SMEs andunlisted companies than the methods outlined in (1). However, the lack of public
information means there are many cases where transactions are not concluded at theindicated prices, and there are also difficulties in handling nonpublic information, as

19

In the above-mentioned overseas survey (see Rutter Associates LLC [2004]), the mostimportant CPM methods as seen by credit portfolio managers were, in order of importance: (1)Approval/Disapproval of new business and Renewal/Non-renewal of existing business; (2)Single-name credit default swaps; (3) Loan sales and trading; (4) Securitizations; and (5)Portfolio credit default swaps.

18

discussed below.
(3)

Adjustments through market transactions
Adjustments through market transactions allow credit risk transfer transactions inconnection with borrowers about whom a certain amount of public information isavailable to take place in the credit market, where many investors participate in tradingin CDS, asset-backed securities and loan assets. This is the most flexible approach,but although the credit market in Japan is expanding, it is still small and the numbers ofboth issues with sufficient liquidity and market participants are still limited.
[Initiatives at major banks]
Most major banks currently rely on control of the loan approval process as a CPM
control tool. Since this method alone provides little flexibility, they also use market andnon-market transactions, but face various constraints.
More specifically, there are cases with non-market transactions where, for example,
two financial institutions disclose their respective limit excess loans (candidates for sale)and complete the trade after determining a price through bilateral negotiations (a so-called“portfolio exchanges” transaction). With such loan asset sales, the borrower may prefer
not to approve the transfer because it seeks a stable relationship with the financial
institution.

In such cases, institutions use "silent" formats whereby credit risk istransferred not through assignment but through loan participations and debt guarantees that,on the surface, maintain the original contractual relationship with the borrower. Sincesuch non-market transactions are based on limited credit information, it often takes quite awhile before they are completed.
Next, in market transactions, one way of doing that is to buy CDS protection (i.e.,
become a seller of credit risk). The most common case is to purchase large company
single-name CDS protection from investors through a securities company or other brokers
however purchases of CDS protection that refers the obligations of multiple companies
within a specific business sector are also beginning. Another way is to sell loan assets inthe loan market. Currently in Japan, sales are made almost exclusively to regional banks,etc., and the trading market is still small, but since there are many cases where transactions
are concluded when the sales price is constantly offered, there is room for the market to
expand. The third way is securitization. Because of liquidity problems and difficulties inmaking individual sales due to relationships with customers, borrowers are often separated
out into groups and their debts arranged into asset-backed securities for sales to investors.
More banks are gradually moving into market transactions of this type, and in somecases, CPM departments are beginning to take risk by selling CDS protection and19

purchasing asset-backed securities. That said, the Japanese CDS market is far smaller thanthe CDS markets in the US and Europe, where they play a central role in CPM.
Comparison of the Japanese and US credit markets<Syndicated loans>(Flow)(¥tr.)
200
180
160
140
120
100
80
60
40
20
0

<Secondary loans>(Flow)(¥tr.)
25

183.4

20

18.3

15
10
19.7

25.7

3.7

5

3.0

0
2004

2005

(CY)

2004

(Balance)(¥tr.)

20.8

159.9

<Credit derivatives>

2005

(CY)

800
700
600
500
400
300
200
100
0

686.4

276.7

5.5
2004

11.7
2005

US
米国
Japan
日本

(CY)

Source:Estimates from the following data. Syndicated loans: Bank of Japan, Thomson Financial.
Secondary loans: Bank of Japan (excluding non-performing loans), Loan Pricing
Corporation. Credit derivatives: Bank of Japan, FDIC (Federal Deposit Insurance
Corporation).

Note:

Base date: December 31. US market results calculated at the rate of US$1 = ¥117.9.

2. Calculating indicated prices
Irrespective of whether market or non-market transactions are involved, indicatedprices (theoretical fair values) for loan assets subject to hedging are calculated on the basisof internal ratings and other factors.

Details of original contracts (amount, term,

contracted interest rate, and the existence or otherwise of pre-maturity redemption clauses
or transfer restriction clauses), and the relationship between supply and demand in thelending market are taken into consideration.

20

D.

Verifying CPM performance
In order to verify CPM performance, it is necessary to clarify initial targets andestablish a framework for ex post facto evaluations of the extent to which they are achieved.
Evaluating the results of CPM in an appropriate manner clarifies the contribution of the
responsible departments, and creates incentives for even more effective implementation. It
also provides opportunities for reviewing basic CPM policies and internal organizational
structures in light of the issues discovered as a result of the verification process.
[Initiatives at major banks]
Because risk hedging is their primary objective for CPM, major banks have set initial
targets for reducing credit risk by individual company, corporate grouping and businesssector, and for reducing EL/UL in the credit portfolio as a whole. Naturally, management
is involved in verifying the performance of CPM in line with these indicators. In view ofthe fact that control of the credit portfolio takes time, partly due to the nature of
frequently-used measures such as adjustments through the loan approval process, someinstitutions have introduced evaluation frameworks covering multiple fiscal years. If thecredit portfolio's liquidity can be enhanced by switching loan contracts to something morenegotiable, even if this does not actually reduce credit exposures, they may be evaluatedpositively.

21

Box 4:

Concepts behind CPM performance evaluations

The figure below plots changes in returns with time along the y-axis, and changes inrisk with time along the x-axis for the credit portfolio as a whole and for sub-portfolios
based on individual companies, corporate groupings and business sectors. From this figure,it is clear that area A denotes a favorable performance by CPM where risk decreases andreturns increase, while area C denotes an unfavorable performance where risk increases andreturns decrease.
15

10Change in return

A
Risk

-150

Return

-100

B

5

-50

Risk

0

50

-5

Return

100

150

C

D
Risk

Return-10

Risk

Return-15

Chang in risk

Now, how should we evaluate area B (higher risk and return) and area D (lower risk
and return)? One idea is to focus on the extent to which CPM raises marginal ROE. The
diagonal line in the figure below delineates the combined changes in risk and return forachieving the marginal ROE target (set at +10% here). It shows that when returns increase
as a result of newly-taken risk in area B, the marginal ROE of +10% assigned for CPM iscleared in area B+, but not in area B-. In area D, it also shows that the target of +10% set
for marginal ROE is achieved in area D+ because even though absolute return declines, risk
declines even more.
Since CPM by major Japanese banks takes the approach that certain levels of hedging
cost are unavoidable if the primary aim of reducing risk is to be achieved, we can thus
conclude that their strategy should be to aim for area D+ (area A if possible).

22

15

B+

Change in return

10

Marginal ROE= 10% threshold

-150

-100

5

-50

B0

50

100

150

-5

D+

-10

D-

-15

Change in risk

E. CPM's organizational structure
1. Loan ownership and recognizing earnings
With traditional loan management, the marketing division originates the loan, books it
to its account, and acquires any spread earnings deriving from it.

Since CPM does notassume that loans will be held to maturity, on the other hand, it is necessary to makeorganizational arrangements between the marketing division and the CPM department
concerning their authority to dispose of the loans and the attribution of profits and losses
accruing to them.
[Initiatives at major banks]
A comparison with financial institutions in the US and Europe that are proactively
pursuing CPM as described in Chapter 1 reveals that the CPM departments of major
Japanese banks (1) do not have ownership of the loans (the marketing division retains
ownership) and (2) usually incur deficits on risk hedge transactions.

Taking theorganization as a whole, therefore, the CPM department often ends up paying all the costs
necessary for reducing risk, while the system is not set up to make the marketing divisionholding the loans directly aware of the costs involved in reducing risk.
That said, a few major banks have initiated attempts to transfer ownership of loans,23mostly to large businesses, from their marketing division to their CPM department, albeit ona limited basis. This enhances the flexibility of risk hedging because it enables the CPM
department to acquire the authority to dispose of loan assets. However, transfer pricing is
not based on market prices as in the case of US and European financial institutions that areproactively engaged in CPM, but set at levels that assume the CPM department willcontinue to shoulder the hedging costs20.

Box 5:

Discussion points concerning loan ownership transfers

Loan ownership can be broken down into two concepts: "write-off responsibility" ―gains on loans and the responsibility to shoulder losses if a credit event occurs are attributed
to the owner ― and "disposal authority" ― the authority to hedge risk through sales andother tools. Transfers of loan ownership can take several possible forms, including theattribution of both write-off responsibility and disposal authority to the CPM department,
and the sharing of disposal authority between the marketing division and the CPM
department while leaving write-off responsibility with the former.
Even if ownership is transferred to the CPM department, the marketing division is
responsible for subsequent intermediate risk monitoring activities, including reviews ofinternal ratings and self-assessment of loans. This is only natural in cases where write-off
responsibility is left with the marketing division, but it is nonetheless fundamental for themarketing division to carry out intermediate monitoring even when write-off responsibility istransferred to the CPM department.

This is because the CPM department is involved inrisk hedge transactions with the market and should preferably avoid acquiring the nonpublic
information necessary for assigning internal ratings and determining borrower classifications
for self-assessments.

In such cases, the CPM department may well pay the marketing

division a commission for intermediate risk monitoring.

2.

Cooperation with the marketing division
The CPM department ensures ample cooperation with the marketing division20

Under Credit Transfer Pricing, risk hedging costs are passed on to the marketing division.
Please refer to the explanation of Credit Transfer Pricing described in Chapter 3 for more details.

24originating loans, and encourages it as necessary in accordance with the CPM objectives.
If risk hedging is the primary objective of CPM, it is important that the CPM department
and the marketing division share a common awareness of the current problems in the credit
portfolio.
[Initiatives at major banks]
Based on this awareness of the issues, the major banks endeavor to ensure smoothcooperation between the two by not only creating opportunities for discussions about theabove-mentioned basic CPM policies involving management, but also establishing an officewithin the marketing division to liaise with the CPM department, and holding regularcross-sectional meetings concerning CPM. The CPM department may also be placed aspart of the marketing division.
The CPM department explains the advantages that CPM brings to the marketing
division as follows: (1) reducing credit concentration risk enhances the capability to extend
additional credit for customers; and (2) checking customer-specific risk/return from theCPM department's viewpoint can provide marketing guidelines for selecting customers thatshould be targeted for expanded commissions business.
3.

The placement of the CPM department21

Generally, specialist CPM departments are set up to clarify the role andresponsibilities of the CPM function, strengthen the organization's ability to formulate andimplement CPM plans, and accumulate practical know-how.
[Initiatives at major banks]
The placement of CPM departments at major banks follows several patterns.
Organizational structure, authorities and lines of responsibility should vary according towhat management seeks from the CPM function, including the extent to which it attaches
priority to credit concentration risk.

21 See Ingrassia and Greatrex [2005].

25

Responsible division

Features

Caveats

Business management
Allows management's thinking
Risk management functions
division
to be directly reflected in CPM.
may be duplicated.
Risk management
division

Easy to implement CPM
functions to deal with credit
concentration and other risk
hedging objectives.

Costs for adjustments with themarketing division are high.

Clarifies the division of roles
and areas of responsibility
between the CPM department andthe marketing division.
Marketing division

Easier to build a cooperative
system with branches.
Easier to obtain information
concerning loan market
development.

26

Tends to be impacted by themarket division's return targets
and thus to restrict flexible risk
hedging.
Requires more stringent
control of nonpublic information.

Chapter 3

Challenges for CPM in Japan and Approaches to Addressing
Them

In recognition of a number of challenges learned from implementing CPM to date,major Japanese banks have started working on improving the transparency of the credit
process and the flexibility of risk hedging. These efforts incorporate elements designed tomake today's risk-hedge-oriented CPM more effective and perhaps help it evolve into
enhanced return-oriented CPM in the future. Currently, the main efforts pursued by the
major banks can be separated into: (1) more objective evaluations of the economic value ofloan transactions; and (2) greater liquidity for loan assets. Both are important aspects ofefforts to improve the loan market liquidity. This chapter examines challenges that arecommonly recognized for both of them respectively, and introduces examples of approaches
to improve them.
A. More objective evaluations of the economic value of loan transactions[Common challenges]
Amidst intensifying lending competition between financial institutions in recent years,
spreads on loans to large companies and blue-chip companies have tended to tighten.
Assuming current quantification methods, therefore, the view is that there are quite a few
cases where it is unclear whether returns are actually commensurate with the credit risks
involved. This implies that there is the possibility that current pricing at the primarymarket makes it difficult to sell loan assets at the indicated price and therefore contributes tothe high cost of risk hedging22.
In the case of loan transactions with large borrowers, moreover, the marketing
division may object if the CPM department decides that risk hedging is needed to correct
credit concentration, or that it is appropriate to sell because profitability is low from arisk-return perspective.

These objections might include the detrimental effect on thetransactional relationship with the customer, or the fact that overall profitability is not low if
the fee and commissions earnings arising from the long-term relationship are taken into
consideration.

Within an organization, therefore, creating a consensus concerning

economic assessments of loan transactions is in itself quite difficult.
Because there is often some ambiguity about the economic value of loans that are

22

Other factors probably have an impact, including the fact that since the credit market is still
small, liquidity is low and bid-ask spreads are wide.

27

held for a long time, the CPM departments of some banks are devising methods to identify
these values from various angles, thereby stimulating the in-house discussion on the subject
and providing support for managerial judgments pertaining to the lending business.
Another approach is to consider introducing Credit Transfer Pricing.

Credit Transfer

Pricing can be regarded as the core mechanism of US- and European-style CPM (see thecase of Deutsche Bank in Box 1) and its introduction can be described as an "osmotic"
approach to establishing an awareness of market discipline within the organization. The
following sections look at these two approaches.
[Efforts for improvement]
1. Identifying the profitability of loan holdings
The fact that trustworthy valuation criteria have not been established is probably one
reason why assessments of loan profitability differ according to point of view, as in the caseof CPM departments and marketing divisions. From this perspective, the largest problem
with general risk-adjusted return indicators is the fact that they are calculated on a single
fiscal year basis. Given the business model adopted by Japanese financial institutions,which looks for profit-earning opportunities from long-term relationships with customers,such single fiscal year figures invite objections on the grounds that they fail to fit the realityand do not reflect the fact that there are no problems with total profitability over the longterm. It is therefore necessary to ascertain the profitability of loan transactions in line withthe realities of continued holdings, and the following formula gives one possible example ofa suitable indicator.
(1)

Rate of return to maturity after credit costs (maturity-based RAROC)23=(2)(Assumed net business profit to maturity - Assumed EL to maturity) /(No. of years to maturity)
Assumed UL to maturity

Returns to maturity after capital costs (maturity-based SVA)
= Assumed net business profit to maturity - Assumed EL to maturity - Assumed
capital costs to maturity

23"Maturity" here refers to the period up to the final recovery of the loan, including continuancesin the case of rollovers.

28

= Value of loan transaction"Assumed net business profit to maturity" as referred to here includes fee andcommissions earnings. Using the formula for identifying loan values as described here, it
becomes easier to apply organizational checks when evaluating the total profitability of theloans, including checks on whether or not the outlook is overly optimistic.

And since theevaluation takes credit costs and capital costs into account, profitability vis-à-vis risk andthe opportunity costs of loan holdings can be discussed. Of course, it cannot be denied
that such evaluation methods necessitate various assumptions, including hypotheses
concerning rollovers and the outlook for long-term rating migrations, or that the resulting
figures may be quite vulnerable to change.

Nevertheless, they are likely to haveconsiderable significance if the entire organization, including management, is encouraged tomake the most objective possible evaluations of overall profitability within common
parameters.

29

2. Introduction of Credit Transfer Pricing
Introducing Credit Transfer Pricing, principally with regard to loans to large
companies, represents another attempt to identify the economic value of loan transactions
more objectively. Credit Transfer Pricing is an internal process that reflects credit market
views in loan origination and plays an essential role in US- and European-style CPM.
More specifically, (1) it transfers loan ownership from the marketing division to the CPM
department24, and (2) it sets the transfer price based on the credit market price (or atheoretical price calculated rationally using credit market parameters).
The Credit Transfer Pricing Mechanism25
Transfer price<Origination>

L+30bp[Marketing division]

Gain
10bp
Execute loan

[CPM department]

EL portion 20bp

L+50bpCompanyA<Risk hedge>

Capital cost portion
10bp

Funds forrisk hedge
20bp

Gain
0bp

CDS premium
20bp

CDS
marketProtection

Expenses 10bp

[Business management unit]
Capital cost portion 10bp

[Shareholders] Gain 10bp

24

If we envisage a framework for transferring the ownership of all loans to large companies fromthe marketing department in the future, one issue to be studied is that of detaching intermediate
monitoring functions such as the assignment of internal ratings from the marketing division. In
such cases, one option is that the CPM department could engage in intermediate monitoring only
if the internal rule of handling nonpublic information is set in force. Another option is that adepartment other than the CPM department could be established to deal with assigning andreviewing internal ratings.
25 See Dev and Kim [2006]. Credit Transfer Pricing designs take various forms depending on
the management policies and business strategies of the financial institutions in question. The
Credit Transfer Pricing mechanism shown here assumes a business management framework thatfavors returning profits to shareholders.

30(a) Marketing department pursues a loan deal to company A.
(b) Reflecting the evaluation of a neutral division within the organization, the transfer
price is set at, for example, L+30bp on the basis of company A's credit cost
(EL=20bp) and capital cost (single-name UL x capital cost ratio=10bp)26.
― The transfer price may be determined on the basis of company A's credit spread(hedge cost) in the case where such spread information is available in the credit
market27.
(c) Taking the above-mentioned transfer price into consideration, the marketing
division extends the loan to company A at L+50bp.
(d) The marketing division recognizes a gain of 10bp after the transfer price portion(30bp) and expenses (10bp).
(e) The CPM department uses the 20bp remaining after deducting the capital costportion of 10bp from the 30bp transferred from the marketing division as funds forthe risk hedge transaction.
― If the risk premium paid for the risk hedge transaction in the credit market is
20bp, the CPM department's gain is zero.
― If, on the other hand, the CPM department manages to hedge company A's risk
at a risk premium of 15bp in a timely manner, the 5bp difference is recognized
as a gain for the CPM department. Conversely, if it has no choice but to hedge
the risk at 25bp, the difference of minus 5bp is recognized as a loss28.
(f) The 10bp capital cost portion is returned to shareholders (or kept as retained
earnings).

If this type of Credit Transfer Pricing mechanism functions properly, it clearly
distinguishes the role of the marketing department, which extends the loan at appropriate

26

The level of the transfer price would greatly affect both the breakeven assessment for themarketing department's loan origination and the breakeven assessment for the CPM department's
risk hedge. For this reason, it is necessary to have a framework whereby a department that is
independent of both the marketing division and the CPM department (such as the risk
management division) assesses the appropriateness of the transfer price.
27 US and European financial institutions mainly determine the transfer price on the basis of theborrower's credit spread as observed in the credit market.
28 If company A defaults before the CPM department can hedge the risk, the CPM department has
to bear the loss.

31

pricing, from that of the CPM department, which manages credit risk in an integrated
manner.
(1)

At the same time, it provides both with the incentive to increase their returns.

Earnings-enhancement incentives for the marketing division
Normally, the loan margins offered by Japanese financial institutions areultimately determined with the credit division's participation and in accordance withratings-specific spread guidelines. From the perspective of sound economic reasoning,it cannot be denied that in such cases ambiguities may remain in the guideline spreadand the final decision process.
With Credit Transfer Pricing, on the other hand, the costs charged on the loan
funds are based on economic rationality. If the marketing division extends a loan with
margins that do not match these costs, it will incur a loss for which it will be
accountable to management. Consequently, the marketing division has the incentive to(1) extend loans with margins that exceed these charges29, and (2) expand its fee andcommissions business30.
(2)

Earnings-enhancement incentives for the CPM department
As mentioned earlier, the CPM departments of major banks are normally in

deficit because they have to bear the cost of risk hedges in the face of limited gains on
risk-taking.
With Credit Transfer Pricing, the CPM department acquires a portion of the loan
spread commensurate with the rationally calculated credit costs.

As a result, thegain/loss on the risk hedge can be plus or minus depending on whether this portion islarge or small compared with the risk premium demanded by the market.

Based onthis mechanism, the CPM department does not simply hedge against risk, but has the
incentive to increase its own returns on the same risk hedge by skillfully choosing its
timing and its counterparties as a means of lowering costs31.
This means that the CPM department is no longer a cost center within the29

If capital costs equivalent to credit concentration risk are charged, this functions as an incentive
to curb lending to large borrowers.
30 The marketing division is free to make overall judgments that allow it to set low interest rates
but make up the shortfall through commissions. The key point is that using the transfer priceas a basis makes it possible to clarify whether overall profitability, which is prone to ambiguity
in such cases, is plus or minus.
31 This approach is similar to the case where a portion commensurate to funding costs istransferred from the returns on a loan to the ALM department (Fund Transfer Pricing), whichthen centrally manages interest rate risk within the organization at the lowest possible cost.

32

organization but is transformed into a profit center that is expected to post gains frommarket transactions.

It probably marks the first step towards the type of CPM

practiced by some leading financial institutions in the US and Europe, whereby the
CPM department posts gains while taking on risk exposures of its own by, for example,
purchasing what it believes to be undervalued credit risks from the market.
Whether Credit Transfer Pricing functions well or not depends to a large extent on themanner in which transfer prices are determined. Given that the Japanese credit market isstill underdeveloped today, there are probably many cases where the transfer price has to be
set at the theoretical price obtained using the EL/UL buildup approach. However, it isprobably more meticulous organization-wide discussion on the economic value of loans thatwill lay the groundwork for the development of the credit market.

B. Raising the liquidity of loan assets[Common challenges]
Establishing more objective rules for loan pricing through the initiatives discussed in
the preceding section is an important condition for the credit market's expansion. Apartfrom these initiatives, however, there is still room for fostering the liquidity of loan assets.
We examine two points below.
The first is to negotiate with borrowers and to promote a switch to loan contracts thatmake it easier to transfer claims. Even if the claims are not transferred, it is possible tohedge credit risk in the CDS market. That said, the present CDS market is limited in termsof its size and the number of reference names that can be transacted in a flexible manner,
while CDS are subject to mark-to-market accounting 32 .

From the viewpoint ofdiversifying hedging tools, therefore, it is necessary to make proactive use of measures suchas loan sales and trading. However, transfers of claims require the borrower's approval,
unlike CDS transactions. The problem here is that borrowers tend to be reluctant to32

Current accounting treatment leads to a mismatch in the accounts because loans subject tohedges are recognized at acquisition cost while hedge instruments like CDS are marked tomarket. For example, it has been noted that if a target borrower's creditworthiness improves
after CDS are used as a risk hedging tool, the improvement in the quality of the loan (namely theincrease in fair value) is not reflected in the financial statements, while losses are incurred in the
CDS hedge. For this reason, the overall economic value of the financial institution is notcorrectly communicated to investors.

33

approve claim transfers because they prefer stable, long-term relationships with financial
institutions or have concerns about the prevalence of their nonpublic information.

The

point here is how to negotiate with borrowers and win their understanding.
The second is to establish practices concerning the fair handling of nonpublic
information.

Credit risk transfer transactions tend to fail if a potential purchaser of a credit

risk suspects that there is a large information gap between him and the potential seller.

In

this respect, the CPM departments of major Japanese banks are generally not strictly walled
off from nonpublic information pertaining to the borrower and are acting in a intermediate
mode between the private side and the public side (see the table below)33. To ensure thatrisk hedge transactions are consummated smoothly in this sort of mode, it is necessary toestablish internal procedures so that it is possible to explain that the CPM department does
not have a large information advantage over the purchaser of the credit risk, at least as far as
the borrower subject to the transaction is concerned.
Location of the CPM department

Features

Private side

It is possible to obtain nonpublic information in fullIntermediate mode

It is possible to obtain limited nonpublic
information- Lenient information firewalls

Public side

It is possible to obtain only public information- Rigorous information firewalls[Efforts for improvement]
1. Switching to loan contracts that make it easier to transfer claims
Increasing the liquidity of loans brings the advantage that financial institutions can
reduce liquidity risk premiums, thus lowering capital costs and ultimately increasing thevalue of their credit portfolios. From some points of view, there is a possible disadvantage
for borrowers in that their relationships with specific financial institutions may be diluted,
but there should also be an advantage in that a wider investor base should increase theavailability of funding in the future. Some major banks are already explaining these33

This intermediate format is largely attributable to the fact that the present-day credit market isstill underdeveloped and therefore CPM activities on the public side are limited.

34

advantages to customers, primarily to large borrowers, in an attempt to obtain theirunderstanding. At the same time, they are entering into negotiations on switching to loan
contracts that make it easier to transfer claims while passing on to customers some of theeconomic advantages that financial institutions themselves enjoy.
The following sections look at this in more concrete detail.
(1) Proposal of candidate lists
The CPM department selects candidates for contract switches (e.g., borrowers
with loans exceeding a certain outstanding threshold) and discloses them to themarketing division.
(2)

Negotiations with customers
The marketing division enters into negotiations with the listed customers

concerning a switch in contracts. The aim of negotiations with customers is tochange current loan contracts in such a way that they assume transfers in the future,and cover several aspects: (a) state in the contract in advance that when the claim istransferred, the customer, i.e., the borrower shall approve the transfer without
objection; (b) insert stipulations prohibiting offsets of depository claims and loan
obligations by the customer itself in order to allow use of registrations under the Law
Concerning Special Exceptions, etc., to the Civil Code Pertaining to Perfection ofClaim Transfers (retention of borrower perfection by acquiring third-party perfectiononly); and (c) clarify the parties to which nonpublic information can be disclosed, andthe scope of such disclosures.
(3)

Incentives for the marketing division
To encourage the marketing division to take proactive initiatives, the CPM

department grants incentive gains (contingency fees) to the marketing division incases where contract switches have been achieved34.
(4)

Passing on benefits to customers
Against the background of the extra lending capacity created for the financial

institution by greater loan asset liquidity, the marketing division explains, during theabove-mentioned discussions with customers, that the customer may also be able toprocure funds on a timelier basis. Another possible way in which the financial

34

Another possible approach is to cancel the penalty, which has been imposed on the marketing
division for loans larger than a certain amount, if a switch in contracts is successful.

35

institution may pass on benefits is to tailor loan conditions more to the customer.
Steps like these may well make customers more willing to cooperate.
(5) ComplianceTo ensure that the marketing division does not coerce customers into approving
the contract switches in order to secure incentive gains, compliance procedures arestrengthened by improving guidelines and check sheets concerning the handling ofrelated operations.
Since the above-mentioned initiatives may greatly change the traditional
hold-to-maturity approach of loan operations, they are not necessarily progressing in linewith expectations at the moment. Another probable reason for this is that loan spreads aretight and the benefits that can be channeled back to customers are limited.

2. Establishing practices concerning the fair handling of nonpublic information
In order to eliminate the possibility that they may have a large information advantage
over purchasers of credit risk in risk hedge transactions, some major banks are consideringdrawing up voluntary rules concerning the handling of nonpublic information about theborrower, and explaining to purchasers that they intend to comply with them.

More details

follow below.
(1) In the case of trading in corporate bonds
If the CPM department handles corporate bonds issued by listed companies, it will
not trade in such corporate bonds in cases where material facts concerning trades incorporate bonds (default information) exist within the organization. This is to avoid
the risk of infringing on insider trading regulations under the Securities and Exchange
Law.
(2) In the case of risk hedge transactions
With regard to borrowers who may be subject to risk hedge transactions, the bankshall confirm whether it is in the position of a bond manager or a syndicated loan agent
itself. It shall also note that if it engages in risk hedge transactions while in such a
position, there is a legal risk that it may be accused of infringing on the duty of due

36diligence if the borrower in question subsequently defaults35.
From the viewpoint of preventing unfair transactions using information disparities,
the CPM department shall confirm in advance whether the scheduled risk hedgetransaction is subject to any pre-established check criteria36. Where check criteria
apply, the CPM department shall confirm with the marketing department whether thelatter holds any material nonpublic information concerning the creditworthiness of theborrower targeted by the hedge transaction, and whether it has identified any possibility
that the borrower may default within a certain time in the future.
In the case where the marketing division holds material nonpublic information
about the borrower, prior discussions should be held in-house with the compliancedepartment or with external lawyers. The first aim is to determine whether a riskhedge transaction should go ahead. If the answer is yes, the next aim is to determine
on a case-by-case basis whether there is a need to disclose nonpublic information to thecounterparties and, if there is, the scope of such disclosure37.
(3)

In the case where the counterparty to a transaction seeks proprietary

information concerning risk hedge transactions
Disclosure of proprietary information to a counterparty in a transaction requiresthat consideration be given to matters relating to the duty of confidentiality to theborrower. With this in mind, judgments on proprietary information disclosure are
made on a case-by-case basis after comprehensively considering the five elements
mentioned in the "Report of the Study Group on Disclosure in Loan Markets" publishedby the Japanese Bankers Association (JBA) in 2004. These are: the purpose of thedisclosure; the nature of the information to be disclosed; the impact on the corporate
borrower; the recipient of the disclosure; and the information management system.
Where information is to be disclosed, the following principles shall be observed:(a) the recipients of the disclosed information shall be entities that satisfy certain criteria,such as financial institutions under a certain degree of supervision by the authorities; (b)a non-disclosure agreement (prohibitions on use for unauthorized purposes andinformation leaks; compensation for damages due to leaks; obligation to return or
destroy information when trading negotiations are discontinued, etc.) shall be concluded
35 One possible example of this risk is the case where an agent incurs the obligation to notify other
lenders of any information it receives about a deterioration in a borrower's creditworthiness in its
role as an agent under a syndicated loan contract.
36 Check criteria may, for example, be set to include whether the creditworthiness of the borrower
targeted by the risk hedge transaction falls below a certain level.
37 See the Japan Syndication and Loan-trading Association's [2002] Code of Conduct concerning
disclosure of information in loan sales and trading transactions.

37

with the recipient of the disclosed information; and (c) decisions on information to bedisclosed shall be made for each transaction on a case-by-case basis.
With regard to the handling of nonpublic information, there are some points wherelegal opinions in the form of precedent and theory have yet to be published. In order toensure as much transactional transparency as possible under such constraints, it is desirable
that market participants deepen and share the debate on some form of code of conduct, suchas the internal procedures mentioned above.
Of course, the fact that handling nonpublic information should be a matter of debate
arises because CPM departments are currently in a position where they may obtain
nonpublic information. When we envisage a possible future situation where the players in
the credit market diversify beyond banks and other financial institutions, whose corebusiness is lending, to insurance companies, investment trusts, pension funds and hedge
funds, or where different legal environments apply, it may become a realistic choice to place
CPM departments on the public side and isolate them from nonpublic information.

Box 6: Approach to internal ratings and self-assessments in market-based financing
In connection with syndicated loans and other forms of market-based financing, theStudy Group discussed approaches to assigning internal ratings and determining borrowerclassifications on the basis of self-assessments with a view to promoting the smoother flowof borrower information in the credit market.
With current internal ratings and self-assessments, it is assumed that financial
institutions can obtain quite detailed information on borrowers on the basis of long-term
relationships between the two.

With CPM, on the other hand, it may be possible topurchase loan assets through the secondary market without having a relationship with theborrower. In such cases, financial institutions may not always be able to assign internalratings or carry out self-assessments in their intermediate risk monitoring activities as they
do at present because they cannot obtain the credit information necessary for ascertaining thereal status of the borrower38.
A look at the Japanese loan market in recent years shows an increase in syndicatedloans and other market-based financing. Given the situation, it was suggested that thedevelopment of the credit market might be helped by the establishment of frameworks that38

For this reason, CPM departments often limit their purchases of loan assets to existing
counterparties for which they can obtain the necessary credit information for internal ratings andself-assessments from their own banks' marketing divisions.

38

allow internal rating assignments and self-assessments on the basis of information obtainablefrom the market, such as fair value information and external ratings concerning loan assets.
With respect to the use of fair value, it was suggested that, for such loans as a reliable
fair value can be obtained from the loan trading market, the self-assessment can be
implemented in the same way as the self-assessment for marketable securities, simply byusing the fair value or by applying a theoretical value derived from an internal model.
Another method proposed regarding the use of external ratings was to determine borrowerclassifications on the basis of translating external borrower's ratings into internal ratings
under appropriate rules. In connection with these methods, it was pointed out that it isdifficult to acquire reliable fair values or external ratings at times of stress, such as when aborrower's creditworthiness deteriorates sharply. It was also noted that there is a need tocarefully debate the pros and cons of applying fair value accounting to loans.
Another point raised was the possibility that it might be helpful to adopt a mechanism
whereby the results of the authorities' assessments of agents are shared by the participants ina syndicated loan, as happens with the Shared National Credit (SNC) program of the US39.
There was an opinion, however, that more comprehensive information disclosure byborrowers in the US might be at the foundation of the SNC program. Another was thatborrowers might become less willing to provide information to their main bank.
In any case, one of the basic factors militating against finding a solution would appear
to be the fact that information about borrowers that can be shared by market players is notnecessarily adequate. Inevitably, market-based financing in Japan will at the very least not
be as "market-oriented" as in the United States as a result.

39

The SNC program is a scheme whereby the financial authorities conduct assessments of agent
banks in connection with syndicated loans aggregating $20 million or more in which three ormore banks participate. The results of the assessments are then communicated to theparticipating financial institutions, which, as a general rule, use them as self-assessments.

39

Closing
One of the important changes affecting the management of financial institutions inrecent years is probably the fact that they have started engaging in creative and strategic
activities in order to make their credit portfolio more sound and profitable while making useof the functions of the credit market.

This trend not only improves the management of

individual financial institutions, but also encourages further development of the credit
market, enhances the functions of the financial markets, and may lead to greater efficiency
in the allocation of resources in macro terms.
This paper introduces the current CPM initiatives at the major banks participating in
the Study Group. However, this is a period of transition and the situation may well change
rapidly in the future. CPM styles may also vary from one financial institution to anotherdepending on such factors as management objectives and policies, risk characteristics,
business area and corporate culture. Whatever the case may be, endeavoring to analyze
one's own credit portfolio objectively and striving towards a common awareness of issues
concerning the location of weakness at times of stress as well as profitability are bothessential first steps in improving management. Based on these efforts, CPM may function
as an efficient mechanism for tackling various issues, including management of credit
concentration, overall credit risk control, and enhancing the risk/return profile andshareholder value. That is this paper’s main massage.
Study group members hope that this paper will contribute to arousing greater interestin CPM among a broader range of Japanese financial institutions.

<Inquiries>
The Secretariat for the Study Group on Credit Portfolio Management(c/o Center for Advanced Financial Technology, Financial Systems and Bank
Examination Department, Bank of Japan)
Mr. Fumio Kai

Tel: 03-3277-1136, e-mail fumio.kai@boj.or.jp

Mr. Akihisa Shinmi

Tel: 03-3277-2838, e-mail akihisa.shinmi@boj.or.jp

40

[Materials referenced in this paper]
Dev, A. and Kim, Y., “Active Credit Portfolio Management of Middle-Market Exposures:Transfer Pricing of Credit” The RMA Journal, September 2006, pp.62-68
Ingrassia, W. and Greatrex, P., “Placing Credit Portfolio Management within the
Organizational Structure” The RMA Journal, July/August 2005
Rutter Associates LLC, “Excerpts from 2004 Rutter Associates Survey of Credit Portfolio
Management Practices” 2004
(Available from www.rutterassociates.com)
Smithson, C. and Mengle, D., “The Promise of Credit Derivatives in Non-financial
Corporations” Journal of Applied Corporate Finance, Volume 18 Number 4, fall
2006
Smithson, C. and Hayt, G. [1], “Tools for Reshaping Credit Portfolios” The RMA Journal,
May 2001, pp.34-38(Available from www.rutterassociates.com)
The Thomson Corporation and Bank Loan Report, “Prelim Guidelines Set for
Participations” October 2004
The International Association of Credit Portfolio Managers (IACPM) [1], “Accounting
Issues in Credit Portfolio Management” February 2005
Walenta, J., “Rethinking Large Corporate Banking Part I-III” The RMA Journal, May 2003
(pp.52-55), June 2003 (pp.72-77), July-August 2003 (pp.44-47)
Japanese Bankers Association (JBA), "Report of the Study Group on Disclosure in Loan
Markets," April 2004 (in Japanese)(Available from www.zenginkyo.or.jp)
Japan Syndication and Loan-trading Association (JSLA), "Code of Conduct concerning
Information Disclosure in the Secondary Loan Market," October 2002 (in Japanese)(Available from www.jsla.org)

41

[Reference materials on CPM in general]
Guill, G., “Credit Portfolio Management: an introduction to the challenges and opportunities
in this emerging field” The RMA Journal, July - August 2005
Kuritzes, A., “Active Credit Portfolio Management” Oliver, Wyman & Company, July 1998
Smithson, C. and Hayt, G. [2], “Implementation of New Approaches to Credit Portfolio
Management” The RMA Journal, October 2001, pp.67-71(Available from www.rutterassociates.com)
The International Association of Credit Portfolio Managers (IACPM) [2], “Sound Practices
in Credit Portfolio Management” November 2005
(Available from www.iacpm.org)

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(Appendix)
Members of the Study Group on Credit Portfolio Management
Mizuho Corporate Bank
Mr. Makoto Umemiya, Deputy General Manager, Portfolio Management Division
Mr. Kota Tsubaki, Manager, Portfolio Management Division
Mr. Masahiko Nishida, Deputy General Manager, Strategic Investment Division
Mr. Tetsuo Yamazaki, Manager, Strategic Investment Division

Sumitomo Mitsui Banking Corporation
Mr. Toshio Uto, General Manager, Credit Risk Management Department
Mr. Mitsuhiro Shibahara, Senior Vice President, Credit Risk Management Department
Mr. Hirohiko Tsujino, Head, Portfolio Management & Trading Group, Credit Risk Management
Department
Mr. Katsuyuki Yanagisawa, Senior Vice President, Portfolio Management & Trading Group,
Credit Risk Management Department

Bank of Tokyo-Mitsubishi UFJ
Mr. Hiroshi Kamezawa, General Manager, Credit Portfolio Management Office, Credit Policy &Planning Division
Mr. Takuji Yamamoto, Senior Manager, Credit Portfolio Management Office
Mr. Taizo Makino, Senior Manager, Credit Portfolio Management Office
Mr. Shinichi Sugie, Manager, Credit Portfolio Management Office
Ms. Hikaru Umehara, Manager, Credit Portfolio Management Office
Mr. Kaoru Kobayashi, Manager, Credit Portfolio Management Office

The Sumitomo Trust & Banking Corporation
Mr. Shinichi Yoshimura, Senior Manager, Global Portfolio Management Team, Wholesale
Business Planning Department
Mr. Kazuyuki Inoue, Associate General Manager, Corporate Risk Management Department
Mr. Yasuhiko Tara, Senior Manager, Corporate Risk Management Department

Bank of Japan
Mr. Kazuo Momma, Adviser to the Governor, Financial Systems and Bank Examination
Department
Mr. Atsushi Miyanoya, Deputy Director-General, Financial Systems and Bank Examination
Department
Mr. Fumio Kai, Deputy Director-General, Financial Systems and Bank Examination Department
Mr. Masao Yoneyama, Director, Financial Systems and Bank Examination Department
Mr. Hideaki Higo, Director, Financial Systems and Bank Examination Department
Mr. Akihisa Shinmi, Director, Financial Systems and Bank Examination Department
Ms. Yuko Kawai, Senior Researcher, Financial Markets Department
Note:

Departmental names and titles were current as of November 2006, when the Study
Group concluded its deliberations.

43