THE RATIONALE FOR CREDIT PORTFOLIO MANAGEMENT
Credit portfolio management is closely related to the business model of banks. Under the "buy and hold" business model, the bank originates loans and keeps them in its balance sheet until maturity (or default). Under the "originate and distribute" business model, the bank originates loans but resells them, thereby freeing up some capital for originating new business, the main technique for doing so being securitization.
Traditional banking builds up on relationship management. Banks build a relationship with clients and sell customized solutions, notably to the large clients. The traditional relationship model has its drawbacks. Relationship banking creates a customer base, but it also tends to creates concentration and specialization. Credit portfolio management refers to all actions serving for re-shaping and "optimizing" the risk-return profile of the credit portfolio of the bank.
There are many incentives for developing active portfolio management. A primary motivation is expanding new business, while still complying with risk limits, by off-loading credit risk onto the markets. Off-loading credit risk can be done through securitizations or the use of credit derivatives that transfer risks to the seller. Another motivation is to increase diversification and reduce risk concentration. Originating new loans in different industries would be the classical way. Selling credit derivatives to gain credit exposures without entering into cash transactions is more flexible.
Portfolio management techniques aim at enhancing the profile of the portfolio and on the means to achieve such goals. The first major innovation in this area is the implementation of portfolio models. The second innovation is the flexibility provided by credit derivatives, such as credit default swaps (CDSs), whose market expanded considerably. Active portfolio management emerged when techniques and instruments developed allowing direct sales of loans, securitizations, or credit risk hedging.
Transfers of assets from origination to a loan portfolio management unit requires transfer prices between origination and portfolio management, for allocating income to each of these two poles. In terms of organization, the credit portfolio management unit buys internally all or some of the portfolio of loans of the bank. It is separated from the originating unit, which is dedicated to developing new business. The transfer within the bank between the two units should be done at mark-to-market values, since the portfolio management unit operates in capital markets. It implies the transfer of risk, measured as the cost of allocated capital. Once the two units are organized, credit portfolio management acts in a way similar to asset-liability management (ALM) for liquidity and interest rate risk, in that it operates over the whole portfolio, rather than on focusing on single transactions, as the origination unit does. Credit portfolio management can be seen as an equivalent of ALM for credit risk.
Portfolio management makes lending activities of banks closer to the trading philosophy since it implies changing the structure of portfolios for optimizing its risk-return profile. The portfolio management unit becomes a profit center and lives with its own goals, tools and techniques to achieve "optimization." Securitizations have been used for a long time for managing credit portfolios. Credit derivatives further facilitated this task and added new degrees of freedom.
At the time of writing, the future of active portfolio management and securitizations is subject to uncertainty because these techniques are associated to the contagion of risk to the entire financial system. However, the issues raised by the 2007 financial crisis do not dismiss such techniques. The economics of reshaping portfolios through securitizations and credit derivatives can and should be economically sound. To a large extent, the crisis is more the outcome of improper usage of these techniques, rather than flaws embedded in the techniques.