RBS 2010 Annual Report Download - page 151

Credit risk mitigation*
The Group employs a number of structures and techniques to mitigate
credit risk. Netting of debtor and creditor balances will be undertaken in
accordance with relevant regulatory and internal policies; exposure on
over-the-counter derivative and secured financing transactions is further
mitigated by the exchange of financial collateral and documented on
market standard terms. Further mitigation may be undertaken in a range
of transactions, from retail mortgage lending to large wholesale financing,
by structuring a security interest in a physical or financial asset; credit
derivatives, including credit default swaps, credit linked debt instruments,
and securitisation structures; and guarantees and similar instruments (for
example, credit insurance) from related and third parties are used in the
management of credit portfolios, typically to mitigate credit concentrations
in relation to an individual obligor, a borrower group or a collection of
related borrowers.
The use and approach to credit risk mitigation varies by product type,
customer and business strategy. Minimum standards applied across the
Group cover: general requirements, including acceptable credit risk
mitigation types and any conditions or restrictions applicable to those
mitigants; the means by which legal certainty is to be established,
including required documentation and all necessary steps required to
establish legal rights; acceptable methodologies for the initial and any
subsequent valuations of collateral and the frequency with which they are
to be revalued (for example, daily in the trading book); actions to be taken
in the event the current value of mitigation falls below required levels;
management of the risk of correlation between changes in the credit risk
of the customer and the value of credit risk mitigation; management of
concentration risks, for example, setting thresholds and controls on the
acceptability of credit risk mitigants and on lines of business that are
characterised by a specific collateral type or structure; and collateral
management to ensure that credit risk mitigation remains legally effective
and enforceable.
Credit risk measurement
Credit risk models are used throughout the Group to support the
quantitative risk assessment element of the credit approval process,
ongoing credit risk management, monitoring and reporting and portfolio
analytics. Credit risk models used by the Group may be divided into three
categories, as follows.
Probability of default/customer credit grade (PD)
These models assess the probability that a customer will fail to make full
and timely repayment of their obligations. The probability of a customer
failing to do so is measured over a one year period through the economic
cycle, although certain retail scorecards use longer periods for business
management purposes.
Wholesale businesses: as part of the credit assessment process, each
counterparty is assigned an internal credit grade derived from a default
probability. There are a number of different credit grading models in use
across the Group, each of which considers risk characteristics particular
to that type of customer. The credit grading models score a combination
of quantitative inputs (for example, recent financial performance) and
qualitative inputs, (for example, management performance or sector
outlook).
Retail businesses: each customer account is separately scored using
models based on the most material drivers of default. In general,
scorecards are statistically derived using customer data. Customers are
assigned a score, which in turn is mapped to a probability of default. The
probabilities of default are used to group customers into risk pools. Pools
are then assigned a weighted average probability of default using
regulatory default definitions.
Exposure at default
Facility usage models estimate the expected level of utilisation of a credit
facility at the time of a borrower’s default. For revolving and variable draw
down type products which are not fully drawn, the exposure at default
(EAD) will typically be higher than the current utilisation. The
methodologies used in EAD modelling provide an estimate of potential
exposure and recognise that customers may make more use of their
existing credit facilities as they approach default.
Counterparty credit risk exposure measurement models are used for
derivative and other traded instruments where the amount of credit risk
exposure may be dependent upon one or more underlying market
variables such as interest or foreign exchange rates. These models drive
internal credit risk activities such as limit and excess management.
Loss given default
These models estimate the economic loss that may be experienced (the
amount that cannot be recovered) by the Group on a credit facility in the
event of default. The Group’s loss given default (LGD) models take into
account both borrower and facility characteristics for unsecured or
partially unsecured facilities, as well as the quality of any risk mitigation
that may be in place for secured facilities, plus the cost of collections and
atime discount factor for the delay in cash recovery.
149RBS Group 2010
Business review
Risk and balance sheet management