Modelling credit losses of a retail portfolio

Deyan IVANOVRetail Risk Methodology and ValidationRaiffeisen Bank International AG

Slide no.2

0. Agenda

1 Types of Loan Loss Provisions in the Retail Segment of RBI

2 Individual Loan Loss Provisions (ILLP)

ILLP – Treatment of Restructured Accounts

ILLP – Calculation steps

3 Portfolio-based Loan Loss Provisions (PLLP) - Overview

PLLP – Flow Rates, Loss Factors, Transition Matrix – Definitions and Examples

PLLP – Gross Provisions, Recovery Models, Net Provisions - Calculations

4 Alternative provisioning methodologies – Basel 2

5 Experience from the roll-out across the RBI Group

6 Challenges/Issues

Slide no.3

Portfolio-based loan loss provisions Flow rate model or Transition Matrix model – to calculate “Gross

Provisions” Vintage Recovery model – to calculate final “Net” Provisions PD/LGD - based model

Individual loan loss provisions Accounts in Loss status (in Retail currently defined as 180+

=>Absorbing status) Early Losses (Frauds, Bankruptcy, etc.) Certain Restructured loans (if NPV is lower than actual balance)

1. Types Of Loan Loss Provision models in RBI

Slide no.4

180+ accounts

90_180 accounts

Accounts with no delinquencies

1_90 accounts

360+ accounts

180+ accounts

90_180 accounts

Accounts with no delinquencies

1_90 accounts

360+ accounts

Balance Provisions

NPL

PLLP

ILLP

New volume No provisions

1. Types Of Loan Loss Provisions in RBI (cont’d)

Slide no.5

Restructured loans:

- Re-agings- Extensions- Rewrites

Early Losses:- Frauds- Bankruptcies- Deceased

customers

Accounts in Loss status (180+

dpd)- Recovery collection starts at this point

2. Individual LLP - Overview

If objective significant evidence of loss exists individually, such accounts are excluded from the Portfolio-based Loan Loss Provisions and these accounts shall be evaluated individually

ILLP are allocated for the following cases:

Slide no.6

2. Individual LLP - Accounts in 180+ dpd

Individual Loan Loss Provisions at 100% of gross exposure must be applied for any exposure which is 180 days

past due

If there is a mortgage or a pledge of a vehicle (or other assets in case of leasing) is repossessed (and not sold yet) at

those accounts, Provisions are set at 100% of Net Exposure (Gross Exposure reduced by discounted Weighted

Collateral Value)

If the collateral is other than real estate or repossessed asset, Gross Exposure is not reduced as we believe

that non-repossession of the collateral before 180+ (7 months) suggests one of the following problems: no possession of collateral the collateral is not liquid operational breakdown

Slide no.7

Early losses are accounts which are identified as uncollectible (likelihood that a loan will be paid is very low)

ILLP at 100% of the exposure is allocated for such accounts, it may be reduced by discounted WCV of real estate or

already repossessed assets

Typical examples of Early Losses are:

Frauds – there are some evidence (received official information) about a fraudulent activities of the customer,

our partners or internal fraud is detected (e.g. at underwriting) Bankruptcy – a court decision is available Deceased customers – there is official information

2. Individual LLP - Early Losses

Slide no.8

2. Individual LLP – Basic rules in Restructuring In order to prevent artificial improvement of the portfolio quality

out of restructuring activities, RBI has set the following rules for restructured accounts: borrower must show a renewed willingness and ability to repay the loan; this is observed for at least three months after the restructuring and is

extended by any period of significant reduction* of the instalment account shall not be restructured more than once within any 12-month period

and twice within any 3-year period => If breached, ILLP at 100% on the net exposure.

additional funds/limit can not be advanced to enable new payment; A newly opened account which replaces the old account as a result of

restructuring is considered a restructured account as well Definition of Significant reduction:

The new instalment is lower than the interest only payment For FX denominated loans – out of devaluation of the LCY the new instalment

in EUR is lower than the original one The new reduced instalment caused extension of the tenor beyond the

maximum product tenor set by RBI Retail Credit Policy The maximum period of temporary significant reduction may not

exceed 12 months

Slide no.9

2. Individual LLP - Impairment of Restructured Accts.

Restructured loans (other than Deferrals) are always to be checked for impairment, if:

the interest rate is lower than it was upon account opening

(except where the interest rate is decreased in order to conform to current market conditions);

the maturity is extended and the instalment amount is unchanged;

there is a reduction in the amount of debt (principal, interest, fee) and this reduction is not charged off against P&L.

If NPVnew (Net present value of new instalment plan) < NPVold, a 100% provision for the NPVold-NPVnew must be booked!

Slide no.10

2. Individual LLP – DPD of Restructured Exposures

After restructuring the account should be kept in the same delinquency bucket it was prior to the restructuring for at least 3 months – introduce a parallel DPD counter and “freeze” the restructured dpd (DPDr)

Any new delinquency (DPDc) during the observation period is “added” to the DPD at the date of restructuring and thus the provisioning bucket is determined. Respectively, the observation period is restarted until 3 consecutive instalments are repaid in time and in full. (total DPD=DPDr+DPDc)

If a customer has paid all due payments within the observation period, the account is put to the current bucket and added to the portfolio assessment (! – provided there was no impairment due to restructuring) and the dpd before restructuring is no longer maintained.

If during the observation period the total DPD reached 180+ it can not go to current bucket but will stay in 180+ forever

Slide no.11

Individual Loan Loss Provisions ILLP1 ( Early losses, 180+ accounts -unsecured)=>

Net Provisions = 100% of Exposure

I

II Individual Loan Loss Provisions ILLP2 ( Early losses,1 80+ accounts - secured)=>

Net Provisions = 100% of Exposure – discounted WCV for Mortgages, repossessed Vehicles and leasing assets

Market value must be estimated at the time of entering 180+ (or not older than 6 months)

WCV is calculated according to GD Collateral evaluation using certain discounts WCV must be further discounted to consider the time when we plan to sell the

collateral (time value of the money)

III Individual Loan Loss Provisions ILLP3 ( check Restructured Loan for Impairment)=

Net Provisions = PLLP @ restructuring da(using special DPD and observation period)+ Impairment due to a restructuring

2. Individual LLP - Summary

Slide no.12

Flow Rate

AVG Flow

Rate

Loss Factor

Gross Provisions

Recovery Rate

Net Provisions

Flow rate model

Provisioningcalculation

Risk Costs

Influenceon P/L

3. Portfolio-based LLP - Overview

Slide no.13

 Bucket (i)Previous month balance Bi(t-1)

Current month balance Bi(t) Monthly Flow rate (%) FR

Current (1) B10[1] B11 FR1[3] = min(100%; B21/B10)1-30 dpd (2) B20 B21 [2] FR2 = min(100%; B31/B20)31-60 dpd (3) B30 B31 FR3 = min(100%; B41/B30)61-90 dpd (4) B40 B41 FR4 = min(100%; B51/B40)91-120 dpd (5) B50 B51 FR5 = min(100%; B61/B50)121-150 dpd (6) B60 B61 FR6 = min(100%; B71/B60)151 - 180 dpd (7) B70 B71 FR7 = min(100%; B81/B70)180+ (8) B80 B81 100%[1] B10 – balance of loans in the category (Current Bucket) in month “t-1” (previous month)[2] B21 – balance of loans in the category (1_30) in month “t” (current month – for which the reporting is done)[3] FR1– Flow rate (%) of rolling from Current bucket to 1-30 dpd bucket corresponding to the actual month (t) for which the reporting is done.

It is based on the assumption that an account either flows down or is paid out

Flow rate is calculated as a ratio – the balance in dpd bucket from actual month over the balance in the previous dpd bucket from previous month (maximum 100%)

3. Portfolio-based LLP - Flow Rate Model

Slide no.14

The Loss Factor reflects the probability that an account will flow from current state to Loss (180+)It is determined as the product of all flow rates between the bucket (where an account is now) to the Absorbing state (180+)

 Bucket (i) Probability of loss (Loss factor LF)

Current (1)LF1 = AVG FR1 * AVG FR2 * AVG FR3 * AVG FR4 * AVG FR5 * AVG FR6 * AVG FR7

1-30 dpd (2) LF2 = AVG FR2 * AVG FR3 * AVG FR4 * AVG FR5 * AVG FR6 * AVG FR7

31-60 dpd (3) LF3 = AVG FR3 * AVG FR4 * AVG FR5 * AVG FR6 * AVG FR7

61-90 dpd (4) LF4 = AVG FR4 * AVG FR5 * AVG FR6 * AVG FR7

91-120 dpd (5) LF5 = AVG FR5 * AVG FR6 * AVG FR7

121-150 dpd (6) LF6 = AVG FR6 * AVG FR7

151 - 180 dpd (7) LF7 = AVG FR7

3. Portfolio-based LLP - Loss Factor Calculation

Slide no.15

LF%

Net Bal BOP

Current MOB1_12

Current MOB 13_24

Current MOB 25_36

Current other 1_30 31_60 61_90 91_120 121_150 151_180 Paid

Loss (180+) Loss (180+)

new Volume 5.079 4.741 0 0 0 0 0 0 62 0 0 276 0 0,00%Current MOB1_12 90.608 62.755 9.571 0 0 3.914 1.909 2.120 1.794 1.495 915 5.926 208 0,23%

Current MOB 13_24 73.071 0 45.134 10.916 0 2.587 2.332 2.346 2.207 1.776 1.330 4.130 314 0,43%Current MOB 25_36 64.720 0 0 32.095 13.446 4.233 2.223 2.055 2.660 1.019 1.586 4.880 524 0,81%

Current other 107.398 0 0 0 76.576 8.906 2.447 2.240 2.156 2.159 1.640 10.061 1.214 1,13%1_30 20.497 543 803 1.801 477 6.102 3.527 1.340 883 633 585 1.029 2.771 13,52%31_60 5.888 138 165 150 150 37 850 465 189 138 334 254 3.019 51,27%61_90 3.931 0 94 42 100 39 48 264 126 53 213 143 2.808 71,43%91_120 3.520 0 0 14 21 26 36 46 113 82 152 92 2.937 83,45%121_150 3.566 0 0 0 0 0 4 7 11 29 123 72 3.322 93,14%151_180 4.889 0 0 0 0 0 0 33 35 44 58 55 4.664 95,40%

Total 383.166 68.176 55.769 45.017 90.770 25.844 13.375 10.917 10.237 7.427 6.936 26.918 21.781

Paid / Loss

BOP State

EURO

EOP State (after 7 months)

TMM is based on a matrix that describes the probability of moving the accounts (exposures) from one state (BOP) to each of the other states (EOP) over two periods, generally just the probability of a move to Loss state is used at the end.

This model calculates using the complex account behaviour (all possible movements are taken into account) in contrast to FRM.

3. Portfolio-based LLP - Transition Matrix Model

Slide no.16

Accounts that went into Loss status (180+ dpd) can be partly (or fully) recovered in the future as an outcome of internal collections or debt sales

All payments that came after an account reached Loss status are considered recoveries

Recovery rate can be calculated either by using Vintage recovery model (strongly recommended) or Simple recovery model

Irrespective of the model used the Debt sale accounts must be excluded from the recovery modeling data (only exception is if it is a forward flow type of deal)

3. Portfolio-based LLP - Recovery Models

Slide no.17

Recovery in last 12 months 1

180+ new in last 12 months 2Recovery Rate% =

1) Sum of payments in last 12 months on accounts after they reached Loss status 180+; regardless whether they reached Loss status in last 12 months or sooner

2) Sum of balances of those accounts that rolled in Loss status 180+ in the last 12 months

This model is possible only for retail and only for those countries, who have not the recovery history to build the Vintage recovery model

3. Portfolio-based LLP - Simple Recovery Model

Slide no.18

Vintage Recovery model estimates the recoveries after Losses (180+)

The output of VRM is a recovery ratio, which represents the portion of accumulated payments (recoveries) after Losses divided by the amount that rolled into 180+

3. Portfolio-based LLP- Vintage Recovery Model

Recovery Rate

0%

10%

20%

30%

40%

50%

60%

1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41 43 45 47Time Since 180+

Discount Factor must be taken into account

The discount rate to be used is the APR which was in force at the time the account entered Loss status

Slide no.19

A1

B

C

A2 A3

D

Months since write-offWrite off

dateWrite-off amount 1 2 3 4 5 6 7 8

Month, when account rolled into 180+

Account balance at roll to 180+; see also comments to mortgage ptf.

Loss dateAmount

at Loss

Months since Loss

3. Portfolio-based LLP - Vintage Recovery Rate

Slide no.20

PLLP

4. Alternative provisioning methodologies

Performing loans:

=PD long-avg

default probability (1y horizon)

LGD » (1-RR)given a default,

economic loss ratio On-bal exposure

» Basel II’s EADLIP factor

Loss identificationperiod

» Basel II’s 1 year expected loss … scaled by LIP factor

ILLP (secured)

Non-performing loans (“Basel II defaulted”):

= On-balance exposure – PV of future expected Cash Flow

Set the Loss Event status to BII-default

» Loss Factor

ILLP (unsecured) = On-balance exposure BEEL

Slide no.21

4. Alternative provisioning methodologies

Remove the absorption status at 180+ dpd► Replace it with a “cure” period, e.g. 6 or 12 months

Move the loss definition from180+ dpd to 90+ dpd► Use the Basel 2 default definition as a loss definition for

provisioning

Adjust the outcome period for the Transition matrix model to 1 year► Achieve comparison among the units who are using either the

Flow-rate model or the Transition matrix model or the PD/LGD model

Estimate the LIP for the default-probability models who use 1-year outcome period

The existing methodology also needs updates:

Slide no.22

5. Experience from the roll-out across RBI Group A Survey across all Network banks was performed recently,

covering the following components of Retail Provisioning Methodology DPD Portfolio segmentation Restructuring FRM,TMM, Loss Rate Calculation Recovery Rate Calculation ILLP / Collateral Value

Data processing and assessment (subjective) Based on responses to questionnaire with pre-defined answers, where

applicable NWUs were graded by the proximity of the local implementation to the

Group Directive standards Different topics were weighted to reflect importance/sensitivity ILLP and Restructuring topics got the highest weights (30% and 20%)

as they are playing the most important role regarding the provision adequacy

Slide no.23

5. Experience from the roll-out across RBI GroupPrivate Individuals

NWB DPD Portfolio segmentation Restructuring Loss rate

calculationRecovery rate

calculation ILLP (WCV) Overall

1 8 9 9 1 0 9 8 8 .9

2 1 0 9 1 0 9 8 1 0 9 .4

3 9 9 7 9 9 5 7 .1

4 8 0 0 3 0 4 3 .3

5 9 1 0 3 6 7 7 6 .4

6 6 8 0 7 6 6 5 .0

7 9 1 0 6 9 6 7 7 .3

8 9 9 3 7 8 8 6 .9

9 1 0 1 0 7 1 0 7 8 7 .8

10 1 0 9 9 8 7 6 7 .5

11 9 9 6 8 8 8 7 .9

12 1 0 9 4 7 0 8 6 .2

13 1 0 1 0 3 4 6 7 6 .1

14 9 9 6 7 8 7 7 .2

15 - - - - - - -

ConservatismNWB PI

1 5

2 5

3 8

4 1 0

5 7

6 8

7 7

8 6

9 7

10 8

11 6

12 4

13 7

14 8

15 -

MicroSME

NWB DPD Portfolio segmentation Restructuring Loss rate

calculationRecovery rate

calculation ILLP (WCV) Overall

1 8 9 9 1 0 5 8 8 .3

2 1 0 9 1 0 9 9 1 0 9 .6

3 9 9 7 7 8 4 6 .5

4 9 0 0 3 0 4 3 .3

5 9 1 0 3 6 7 4 5 .5

6 6 8 0 7 6 6 5 .0

7 9 1 0 7 8 2 5 6 .2

8 9 9 3 8 8 8 7 .0

9 9 9 6 8 2 8 6 .5

10 1 0 9 9 8 7 6 7 .5

11 9 9 6 8 9 8 8 .0

12 5 0 0 3 0 9 4 .0

13 1 0 1 0 3 4 6 7 6 .1

14 9 9 6 7 8 7 7 .2

15 - - - - - - -

ConservatismNWB Micro

1 4

2 5

3 9

4 1 0

5 9

6 8

7 8

8 8

9 6

10 8

11 6

12 6

13 7

14 8

15 -

Slide no.24

6. Challenges - Data availability/volatility Historical data is insufficient (immaterial portfolios or short

history) to develop reliable flow rate or recovery rates, OR Historical data is too volatile to calculate reliable factor

estimates

Solution: Use regional benchmarks (from other NWUs, RBI has

highly standardized Retail Credit Policy) Use longer averages

Slide no.25

6. Challenges – Revaluation of collaterals Mortgages on residential real estate serve to reduce the

loss potential on an impaired asset According to the internal rules, it is required that

collaterals are revaluated ate least once per year; in a volatile market – more often

The mispriced collaterals lead to underestimation of the credit losses, and

Have an adverse impact on the overall recovery rate due to the delayed realization process

Solution: Apply statistical methods for revaluation based on

market/own data Introduce additional discount for each year of delay in

revaluation

Slide no.26

6. Challenges - Discount rate for recovery model The discount rate (APR) for the Vintage Recovery Model

cannot be applied for each account in the 180+ cohort due to system limitations

Solution: Use exposure weighted APR from the total portfolio

Slide no.27

6. Challenges - Impairment test of multiple accts.

In many cases during the crisis time the bank have to address quickly large number of aging exposures

Banks prepare restructuring campaigns with predefined conditions

However, it is impossible from technical perspective to perform individual impairment test

Solution:

Group the exposures of same product, similar MoB, tenors, interest rate, instalment amount, etc.

Calculate the impairment rate for a sample of loans for the concessions given (if any) or consider only the time-value of money

Apply the (average) impairment rate on all accounts from the respective group

Slide no.28

6. Challenges – Impairment of revolving credits

In certain cases a revolving loan is restructured into an instalment loan. How to estimate if there is impairment?

Solution:

If the conditions on the instalment loan do not differ from the market conditions for a similar loan or from the conditions the bank will normally offer to its other customers, then no impairment (write-down) will be assumed; Nevertheless, all other provisioning rules apply (“freezing” the dpd for the and the loan has to be monitored closely for subsequent impairment

If conditions are beneficial compared to the market average or the ones the Bank generally offers, then impairment would be measured against those conditions (e.g. discount the new contractual CFs by the product average rate)

Slide no.29

6. Challenges – Consolidation of exposures

In certain cases several exposures can be merged into new one with a longer instalment plan with the aim to reduce the monthly burden of the obligor, e.g. a credit card and an unsecured loan, or unsecured loan(s) with a mortgage loan. How to estimate the impairment?

Solution:

Discount the cashflows expected from the new exposure by the weighted average EIR of the individual exposures.

Slide no.30

6. Challenges – Write-off rules

When to write-off? According to IAS 39 the asset “can be derecognized if the contractual rights to the cash flows from the financial asset are expired or if the financial asset was sold”. RBI’s current internal rule:

a)time since last payment is longer than 360 days (payments below € 10 are not considered for the calculation of the time since last payment);

b)all funded collaterals were charged up against the claim and further no real estate collateral is pledged in favour of the group unit resp.;

c) the workout process is completed regarding realisation of the collateral

According to 2009 IASB ED “Financial Instruments: Amortised Cost and Impairment, a write-off is “a direct reduction of the carrying amount of a financial asset measured at amortised cost resulting from uncollectibility. A financial asset is considered uncollectible if the entity has no reasonable expectations of recovery and has ceased any further enforcement activities”

Solution: (on the next page=>)

Slide no.31

6. Challenges – Write-off rules

Solution: point b) considered fulfilled also in any of the situations below:

Collateral is legally not enforceable Low realization value of, illiquid despite of intensive remarketing Collateral is situated in area of no demand (high crime, war conflict,

natural disaster, heavy pollution) Point c) fulfilled by preparation of a formal protocol for

termination of workout/collections process with all details of the past measures

Further considerations:Why should the consideration of uncollectibility have to be preceded by exhausting all legal means and giving up contractual rights on cash flows? Isn’t it rather implied “that it is not practical or desirable to defer writing off an essentially worthless asset even though partial recovery may be realized in the future”*.* IMF WP14/170 Supervisory Roles in Loan Loss Provisioning in Countries Implementing IFRS

Slide no.32

6. Challenges – Write-off (partial)

Shall a partial write-off be allowed? In many cases the existing restructuring instruments (temporary instalment reduction, grace periods, payment holidays, extensions of final maturity) do not work due to continuous or permanently reduced repayment capacity of the obligor and/or limited maximum tenor of the exposure. Solution:

It makes sense to split the original distressed loan into two sub-loans

- a “good” one which represents the portion of the original principal that is expected to be fully collected along with contractual interest as adjusted to the new (reduced) credit capacity of the obligor and - a “bad” one which is deemed uncollectible, hence can be provisioned fully and written-off. The same approach can be applied for a mortgage loan,

especially when the current LTV exceeds 100%

Slide no.33

6. Challenges – Interest income recognition

How to recognize the interest income from an impaired asset?

According to IAS 39, the interest income from an impaired asset should be based on the original EIR applied on the current recoverable amount of the asset. However, in most of the cases it is not possible to implement due to system limitations – an EIR is not available and/or the recoverable amount is not available in the core-system Solution:

Continue the normal interest accrual based on the contractual interest rate on the current principal and adjust the income for the amortization of the fees and the percentage of impairment (offset against provisions)

Implement “stop-accrual” (switch-off the on-balance sheet recognition of interest income vs. accrued receivables) and recognize it on a cash basis

Slide no.34

6. Challenges – Loss Identification Period

How to estimate the loss identification period?The Loss Identification Period is the time lag between the occurrence of the actual loss event and the observation of the loss event by the lender.

Solution: Alternative 1: Approach a sufficiently large random sample

of customers/exposures in loss status and perform an inquiry on the reason for and the timing of the loss event

Alternative 2:

Slide no.35

6. Challenges – PIT vs. TTC- provisioning system

PIT- vs. TTC- provisioning system? ► a PIT-provisioning system ensures losses are recognized and reported soon

after their occurrence, BUT increases volatility of P/L ► a TTC-provisioning introduces stability in the P/L BUT tends to

underestimate losses in distressed timesA change in Credit Policy provides for an increase in the maximum acceptable DTI ratio. How do we know if we have made a mistake and how much do we have to allow for this mistake?

Example for consideration:► Under the current Flow-Rate model we would almost immediately

spot the increase of the delinquencies => we can shorten the averaging period for the loss rate to 6 or even 3 months and thus increase gradually the provisioning

► Under a PIT PD/LGD model we would use parameters calibrated based on 1-year old history => use behavioral scorecards with strong PIT-variables (e.g. dpd-based) and have more frequent re-calibration

Slide no.36

Q & A

Slide no.37

Thank you!Deyan IVANOVRetail Risk ManagementMethodology & ValidationRaiffeisen Bank International AG

Tel.: +43 1 71707-1962 Email: deyan.ivanov@rbinternational.com