Enterprise Risk Modeling

We go beyond traditional credit risk modeling by taking an integrated approach to modeling all risk types, all asset classes, and their interactions. This area of research includes modeling joint dynamics of interest rate and credit risk, modeling liquidity risk, and capturing both credit risk and interest risk in asset-liability management.

IFRS 9 materially changes how institutions set aside loss allowance. With allowances flowing into earnings, the new rules can have dramatic effects on earnings volatility. In this paper, we propose general methodologies to measure and manage credit risk in the earnings of a loan portfolio under IFRS 9. We walk through IFRS 9 rules and the different mechanisms that it interacts with which flow into earnings dynamics. We demonstrate that earnings will be impacted significantly by credit migration under IFRS 9. In addition, the increased sensitivity to migration will be further compounded by the impact of correlation and concentration. We propose a modeling framework that measures portfolio credit earnings volatility and discuss several metrics that can be used to better manage credit risk in earnings.

Authors: Amnon Levy, Xuan Liang, Yanping Pan, Yashan Wang, Pierre Xu, Jing Zhang
Date: March 2017
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The answer is a definitive “Yes,” suggesting increased project finance investment could become an important tool for addressing sluggish growth concerns brought about by the Great Recession. Empirical results, based on a comprehensive and unique project finance loan database not previously available, show that increasing project finance by one percentage point of GDP could increase real GDP growth per capita by 6 to 10 percent, with growth effects higher for upper-middle income and advanced economies. In other words, in these countries, if GDP per capita is growing at three percent annually, the boost provided by project finance could deliver cumulative, additional growth as high as two percent during the next five years. These results suggest that proposals for stimulating economic growth and productivity via increased project finance merit careful consideration. In contrast, in low-income countries, project finance appears to have less of an impact, possibly owing to deficiencies and weaknesses in financial systems and regulatory frameworks. By addressing these deficiencies, less developed countries could unleash increased growth and productivity.

Authors: Jorge A. Chan-Lau, Kevin Kelhoffer, Jing Zhang
Date: July 12, 2016
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As part of the response to the last financial crisis, the International Accounting Standards Board (IASB) recently issued IFRS 9. This reformed accounting standard for financial instruments is required in more than 100 countries. Improvements include a logical model for the classification and measurement of financial instruments, a forward-looking “expected loss” impairment model, and a substantially reformed approach to hedge accounting. IFRS 9 aims to streamline and strengthen risk measurement and the reporting of financial instruments in an efficient and forward-looking manner, and it will have far-reaching impacts on global institutions’ accounting practices and performance results.

This paper focuses specifically on the IFRS 9 impairment model. We discuss the new requirements for measuring the impairment of financial assets, namely the expected loss model for impairment. We highlight challenges faced by institutions in interpreting the IFRS 9 requirements and meeting requirements in areas such as portfolio segmentation, thresholds for transitions among impairment stages, and calculating expected credit losses. We then lay out various solutions for overcoming these challenges leveraging Moody’s Analytics expertise in credit risk modeling.

Authors: Eric Bao, Maria Buitrago, Jun Chen, Yanping Pan, Yashan Wang, Jing Zhang, Janet Zhao
Date: January 12, 2016
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This webinar discusses the importance of effective credit risk management for commercial real estate lending. Commercial real estate (CRE) mortgages can often make up a significant part of the loan portfolio. To gain competitive advantage in the marketplace, lending officer's must acquire an in-depth understanding of their borrowers' CRE portfolios

Presenters: Christian Henkel, Sumit Grover
Date: August 6, 2015
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The Comprehensive Capital Analysis and Review (CCAR) program is an annual capital adequacy exercise conducted under the requirements of the Dodd-Frank Wall Street Reform and Consumer Protection Act rules. For the 2015 CCAR program, the Federal Reserve published three macroeconomic and financial scenarios to be used in the stress tests of 31 CCAR financial institutions. In this study, we analyze 22 of these financial institutions, with a total of more than $558 billion in exposures to commercial real estate loans, under the Moody’s CMM Stress Testing framework.

Authors: Megha Watugala, Wenjing Wang, Jun Chen, Kevin Cai, Eric Bao
Date: December 01, 2014
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Central to post-crisis financial regulatory reform is the concept of banking system resilience. This report defines banking system resilience and how it can be measured. It then provides a framework for assessing the cumulative progress made toward implementation of the various new regulatory requirements and industry-initiated efforts.

Authors: Christopher Crossen, Xuan Liang, Andriy Protsyk, Jing Zhang
Date: November 19, 2014
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This paper seeks to establish an integrated framework for the valuation, interest rate risk quantification, and funds transfer pricing of non-maturing deposits (NMD).

Author: Robert J. Wyle
Date: May 22, 2014
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In this paper, we first provide a background on stress-testing, discuss infrastructure challenges and issues related to legacy data and remediation requirements, including the costs and benefits of improved data management and the challenges of managing multiple hierarchies and reporting dimensions required by the Supervisory Authorities. Next, we cover data governance issues, the data requirements of meeting U.S. stress-testing mandates, and the basic elements of a sound data management infrastructure. We discuss some of the workflow challenges that may require firms to rethink existing business processes and provide a practical example, which involves how banks think about and plan new business actions over a forecast horizon. Last, we profile a stylized system integration for a Systemically Important Financial Institution (SIFI), talk about how the new requirements impact customers, and conclude with some thoughts on the road ahead.

A version of this paper appears as a chapter in CCAR and Beyond: Capital Assessment, Stress Testing and Applications, Jing Zhang, ed., London, UK: Risk Books, 2013.

Authors: Thomas Day, John Haley
Date: March 3, 2014
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Deposits are the most important funding source for virtually all U.S. Bank Holding Companies, and the interest paid on deposits is a significant interest expense component of BHCs’ Pre-Provision Net Revenue. This paper links deposit balance dynamics of the 30 Bank Holding Companies participating in CCAR 2014 with the macroeconomic variables chosen by the Federal Reserve Board in their supervisory scenarios. As large banks’ deposits are considered to be very safe and liquid, they are the last resort for many investors seeking low risk investments during severe economic downturns.

Consistent with this intuition, our projections show that total domestic deposits grow by an average of 1.9% per quarter during the first five quarters under the Severely Adverse Scenario when real GDP declines. However, once the flight to quality subsides, persistent low income slows the growth of deposits to 1.2% per quarter during the latter phase of the Severely Adverse Scenario. We also find that the dynamics of the different deposit types are significantly different, suggesting two banks that have different deposit compositions may experience different total deposit growth under the same scenario.

Authors: Vishal Mangla, Yashan Wang, Amnon Levy
Date: March 27, 2014
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Comprehensive Capital Analysis and Review (CCAR) has quickly become one of the most dominant regulatory regimes for US banks in recent years. Of the new regulatory requirements BHCs must address, CCAR is widely considered to have the greatest influence on banks’ risk management and business practices. Against the backdrop of CCAR’s profound impact, there have been few, if any, systematic treatments of the subject. CCAR and Beyond: Capital Assessment, Stress Testing and Applications, a new book published by Risk Books, is designed as a unique source of information and insight from key figures involved in CCAR. This book, with fifteen contributed chapters, represents a timely, concerted and collective effort to provide comprehensive and authoritative coverage of CCAR and its implications.

Author: Jing Zhang
Date: February 1, 2014
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This paper discusses estimating credit losses for commercial real estate (CRE) loans under the stressful macroeconomic scenarios formulated by regulators in conducting stress testing programs. The focus is to provide a coherent analytical framework, where the top-down macro view can be married with bottom-up, loan-level specifics to derive accurate credit loss estimates for CRE loans.

A version of this paper appears as a chapter in CCAR and Beyond: Capital Assessment, Stress Testing and Applications, Jing Zhang, ed., London, UK: Risk Books, 2013.

Author: Jun Chen
Date: February 1, 2014
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This paper discusses various quantitative approaches for linking macroeconomic scenarios with PPNR items. Given the broad range of PPNR categories, each item requires special consideration when developing a modeling approach. Modeling approaches range in granularity and depend upon the availability and quality of historical data, statistical properties of the line item, business use and application, and model consistency across balance sheet and income statement items.

Author: Amnon Levy
Date: January 27, 2014
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This paper documents the effect of Treasury supply on the amount of savings and time deposits supplied by the commercial banking sector at aggregate and individual bank levels. We find that, for a one percent increase in Treasury supply net of Treasuries held by the Fed over a given year, the aggregate savings deposits rise by 44 basis points and the aggregate time deposits fall by 49 basis points over that year.

Breaking the aggregate time deposits by denomination defining more than $100,000 as large, we find that large time deposits have higher elasticity with respect to net Treasury supply (71 basis points), compared to that of small time deposits (27 basis points). In the cross section of banks, large time deposits of big banks have higher elasticity than that of small banks. However, bank size does not matter for respective elasticities savings and small time deposits. To explain these patterns, we present a simple theoretical model, in which, households derive utility from their holdings of bank deposits.

Author: Vishal Mangla
Date: October 03, 2013
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In this white paper, we discuss how with SME lending increasingly shifting from bank financing to non-traditional financing sources, the need for SME credit funds to adopt some of the tools and practices in place at banks will become more prevalent.

Authors: Jim Sarrail, Maxime George, Christian Thun
Date: September 3, 2013
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Required economic capital (EC) and regulatory capital (RegC) are two measures frequently used in loan origination and other decisions related to portfolio construction. EC accounts for economic risks such as diversification and concentration effects. When used in measures such as return on risk-adjusted capital (RORAC) or Economic Value Added (EVA™), EC can provide useful insights that allow institutions to optimize risk-return profiles, facilitate strategic planning and limit setting, as well as define risk appetite. Meanwhile, when RegC is binding, an institution faces a tangible cost, in that additional capital is needed for new investments that face a positive risk weight. Given these observations, both EC and RegC should influence decision making. After all, a deal with lower RegC but the same EC is favorable, and a deal with lower EC but the same RegC is favorable. In this paper, we formalize RORAC and EVA measures that incorporate both RegC and EC. The new measures allow institutions to rank-order their portfolios and potential deals in a way that accounts for economic risks and regulatory charges.

Authors: Amnon Levy, Andrew Kaplin, Qiang Meng, Jing Zhang
Date: January 10, 2013

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Download this whitepaper to understand how Moody’s Analytics’ analysis derives the credit loss estimates for CRE loan portfolios held by CCAR firms. Our analysis estimates the expected nine quarter, cumulative CRE portfolio loss through the end of 2014 is 4.7% under the CCAR 2013 Severely Adverse scenario. In the current paper we discuss these results, and how we attribute the lower loss estimate compared to last year’s stressed scenario to a number of different factors.

Author: Megha Watugala, Jun Chen, Kevin Cai
Date: January 9, 2013

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A major source of firm funding and liquidity, credit lines can pose significant credit risk to the underwriting banks. Using a unique dataset pooled from multiple U.S. financial institutions, we empirically study the credit line usage of middle market corporate borrowers. We examine to what extent borrowers draw down their credit lines and the characteristics of those firms with high usage. We study how line usage changes with banks’ internal ratings, collateral, and commitment size and through various economic cycles. We find that defaulted borrowers draw down more of their lines than non-defaulted borrowers. They also increase their usage when approaching default. Risky borrowers tend to utilize a higher percentage of their credit lines as well.

Author: Janet Yinqing Zhao, Douglas W. Dwyer, Jing Zhang
Date: December 12, 2011

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Evaluating an economic capital model’s quality is an important issue for both financial institutions and regulators. However, a major obstacle to economic capital model validation remains: the limited number of events where extreme losses were realized. Credit risk models normally estimate economic capital over a one-year horizon and at a high confidence interval, which requires a large number of years to produce sufficient observations to evaluate model accuracy. Using a long history of public firm defaults from Moody’s Investor Services and Moody’s Analytics, this study illustrates a validation approach for jointly testing the impact of PD and correlation upon model performance. We construct predicted default distributions using a variety of PD and correlation inputs and examine how the predicted distribution compares with the realized distribution. Results demonstrate that a through-the-cycle style parameterization results in a less conservative view of economic capital and substantial serial correlation in capital estimates. Results also show that when point-in-time measures are used, the tested economic capital model produces consistent and conservative economic capital estimates over time.

Authors: Zhenya Hu, Jing Zhang, Amnon Levy

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Commercial real estate (CRE) exposures represent a large share of credit portfolios for many banks, insurance companies, and asset managers. It is critical that these institutions properly measure and manage the credit risk of these portfolios. In this paper, we present the Moody’s Analytics framework for measuring commercial real estate loan credit risk, which is the model at the core of our Commercial Mortgage Metrics (CMM)™ product. We describe our modeling approaches for default probability, loss given default (LGD), Expected Loss (EL), and other related risk measures.

Author: Jun Chen and Jing Zhang
Date: May 3, 2011

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There are advantages to measuring credit risk quantitatively, when possible. Nevertheless, qualitative factors may add information, because some credit risk determinants cannot be captured by quantitative measures. We present a framework for producing an internal rating system by overlaying additional factors onto a quantitative model, such as Moody’s Analytics RiskCalc™ EDF™ (Expected Default Frequency).

Authors: Douglas Dwyer, Heather Russell
Date: November 15, 2010

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While the sophistication and adoption of the data, models, and software systems for individual risk types has become more widespread, the tools for consistently measuring integrated risk lag. Typically, individual risk components are aggregated in ways ranging from simple summation to employing copula methods that describe the relationship between risk types. While useful, these “top-down” approaches are limited in their ability to describe the interactive effects of various risk factors that drive loss.

Authors: Nan Chen, Andrew Kaplin, Amnon Levy, Yashan Wang
Date: January 20, 2010

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This document provides a high-level overview of the modeling methodologies implemented in RiskFrontier™ to address the challenges faced by a credit risk manager or a credit portfolio manager. RiskFrontier attempts to accurately model the value of a credit investment at the analysis date and its value distribution at some investment horizon, as well as the correlation between two instruments in a portfolio. The approach is designed to explicitly analyze a wide range of credit investments and contingencies, including term loans with prepayment options and grid pricing, dynamic utilization in revolving lines of credit, bonds with put and call options, equities, credit default swaps, and structured instruments.

Author: Amnon Levy
Date: December 29, 2008

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