Dissertation - Miguel Angel Hernandez Solis

University of Glamorgan
Credit Risk and Economic Capital Allocation: a Mexican Bank Case

Dissertation for Master of Business Administration
Miguel Angel Hernandez Solis 08007314 September 2009
Contents
Contents ....................................................................................................................... 2 Acknowledgements ....................................................................................................... 3 Abstract ........................................................................................................................ 4 Introduction ................................................................................................................... 5 Chapter 1 - Research Aim and Objectives ................................................................. 5 Chapter 2 - Literature Review .................................................................................... 8 Chapter 3 - Research Methodology ......................................................................... 22 Case Study ................................................................................................................. 25 Chapter 4 - The Company: Banco Nacional de Mxico ......................................... 25 Chapter 5 - Credit Risk Measurement The Obligor Credit Risk Grade .................. 27 5.1 Legal Framework: Circular nica Bancaria .................................................. 27 5.2 Country Risk .................................................................................................. 31 5.3 Obligor Risk ................................................................................................... 34 5.4 Industry Risk .................................................................................................. 44 5.5 Payment Experience ...................................................................................... 45 Chapter 6 - Capital Allocation .................................................................................. 47 6.1 Regulatory Reserves under CNBV Rules & Model ......................................... 47 6.2 Economic Capital Allocation in Banamex ....................................................... 52 6.3 Comparison between Regulatory and Economic Capital ................................ 62 Conclusion .................................................................................................................. 67 References ................................................................................................................. 73 Appendices ................................................................................................................. 79 Appendix A Vaciado nico Banamex ...................................................................... 79 Glossary ..................................................................................................................... 80
Acknowledgements
Acknowledgements
This dissertation, although has one author, has the contribution of several people which without their help would have been impossible to finish it. Although impossible to mention all of them, people from Banamex who were interviewed and that provided worthy information to this research. Particular gratitude is to Vanessa Resendez for her advices on the subject and for providing a different approach besides helping to depict several algorithms of Economic Capital. On the other hand special thanks to Bob Morgan the assessor and Paul Davies which advices guided this research into a very specific point and help to structure the idea. As a personal recognition the author would like to thank to his parents: Blanca Luvia Solis Aguilar and Miguel Hernandez Ramirez as well to his siblings Omar Yarid and Paulina Hernandez for their unconditional support and affection. Also to his friends for all the support received during all this year: Magdalena Hernandez, Joel Orozco, Armando Gonzalez, Megan Jane Popplewell, Sorin Vasile Secan, Marios Savva Evagorou, Rebecca Fawcett and her family, Lumeme Matandu, Ike Oyoke, Deepak Kumar and Jose Mara Gonzalez and all the classmates from the MBA. Without your support this Dissertation would not be a reality. Thank you very much indeed.
Abstract
Financial Crises are related to the management of risk and capitalisation levels that a bank holds, although it is not clear how these two elements are determined within a bank in order to provide confidence to the stakeholders. Credit Risk has been an intrinsically related element of loans although its relation with Capitalisation levels is not simply viewable. In this paper it is intended to show how a Bank located in Mexico, with that particular characteristics and situations calculates Credit Risk considering basically four aspects of a borrower: the country the borrower is located, the industry this borrower has its core or main activities, its payment behaviour internal and external, finally its quantitative and qualitative characteristics. Then it is related this calculation to the capitalisation of the bank considering two aspects the Regulatory Reserves in charge of the expected losses and the Economic Capital in charge of the unexpected losses. The calculation of these two aspects follow different algorithms, the former based on the regulations set in Mexico, and the latter following the policies set by the headquarters. Among these two completely different processes is the bet that Mexico will adopt completely the advices proposed by Basel II. It is concluded with an analysis of a potential lack of assessment of both concepts and the effect on the financial system exemplified with the sub-prime crisis.
Introduction
Introduction
Chapter 1 - Research Aim and Objectives
The question this dissertation intends to answer is: How Economic Capital is allocated considering Credit Risk? This question relates two wide topics: Risk and Capital. In terms of Risk, a Bank faces different types of risk due to its operation: Market Risk, Operational Risk, Business Risks, and Credit Risk represent the business as usual of the banks. By taking these risks Banks are able to generate profits, however, as the word Risk states, it implies the possibility of an opposite result, producing a loss. It means that Banks have to find the way to reduce them or at least control them (main objective of Risk Management areas of the Banks), but also they have to find a way to quantify these risks, to determine the level of losses the Banks are exposed to. For this dissertation the focus will be Credit Risk, and in this sense it will be intended to determine three main questions: What is it? How is it managed? And finally, how is it measured? Although the focus will be the last question, the two first questions will help to establish the framework in which the capital allocation can be determined. The measurement of Credit Risk expresses in a numerical figure, what is the quantity a Bank will lose. This will determine the amount of Capital required to cover those loses. The previous paragraph refers shallowly the second topic of this Dissertation: Capital. In general terms this is the amount of money that the shareholders provide for the banks operation. However the concept is more complex than that and it also implies that there are different types of capital with different purposes. Equity Capital, Regulatory Capital and Economic Capital, could have the same origins, but definitely different purposes. Equity Capital can be easily measured and determined through accountability standards and principles, however, regarding Economic and Regulatory Capital, although its purpose seems similar as well as their composition, they have a slight difference: the difference between what is expected and what is not. This dissertation will intend to answer then these questions: What is Economic Capital?
What is the difference between Economic and Regulatory Capital? Finally, besides answering these questions, as an aim of the research it will be answered: How Economic Capital is allocated? This question (in general terms because it implies to consider the other types of risk a Bank faces), will link the concept of Credit Risk Measurement to Economic Capital Requirements. Allocation implies how much is required to cover the probabilities of loss, independently if they are expected or unexpected. This dissertation will also intend to demonstrate the importance of an appropriate appraisal of the credit risk, which can bring a correct assessment of the losses a bank is exposed to. This will help to maintain the correct levels of capitalisation a banks need, for two main purposes: first, to comply with the requirements set by the regulators, which in general try to establish the minimal requirement to be a healthy institution which can cover the expected losses; second to comply with the requirements set by the market, in which unexpected losses can affect severely the operation of the Bank, producing up to the bankruptcy, a fact that affects not only the financial system of a country but the whole economy. However this is not a theoretical exercise, rather it intends to show empirically how Credit Risk and Economic Capital are related in a real life case. It has been explained that it will be intended to provide an explanation of both concepts, Credit Risk and Economic Capital, therefore, in the literature review, it will be summarised the information available regarding these two subjects, to provide with a clear framework of the relevance of the topic to the banks, though not deepen into the practical approach. Then, in the Research Methods it will be basically explained two basic ideas; the type of research and the methodology employed to obtain the information required. This section is important to understand the development of the second section which is the section that contains a Case Study. This case study has two particularities besides that is the place where the researcher worked: first, it is located in Mexico, so as a first
Introduction
objective of the case study it will be to explain how both Economic Capital and Credit Risk are determined under a different set of rules and conditions to those in UK. The second aspect is that it is part of an international conglomerate and in spite of the belief that it has to follows the policies set by the headquarters it has to find the way to comply with both regulations. Thus the case study is divided in first, describing the background of the bank (in this case Banamex), second to explain how Credit Risk is calculated and third How Economic Capital is allocated in that particular bank. It will be finally developed a conclusion on the findings in two senses the way it is calculated and improvements that can be done in order to have a reliable model.
Chapter 2 - Literature Review

To determine the impact of credit risk it is important to understand the concept of credit risk. Glantz (2003) expresses that the simplest way to define credit risk is as the probability of a counterparty to not fulfil its obligations in the previous agreed terms. Kendall (1998) agrees but adds the idea of default. Although default is in general terms failure, its determination could sometimes not really mean an actual failure (Basel Committe on Banking Supervision, 2004). This concept will be discussed further later. On the other hand Fabozzi et al. (2003) argue that credit risk is not only the probability of failure or inability to meet its obligations, but it also includes another element called the credit spread risk, which is the variance of spread in a fixed income portfolio. It is important not to confuse interest rate risk (or better-known as the cost of money) with spread risk (which is basically the margin or mark-up). However, it can be arguable that this risk instead of a credit risk is a market risk because it implies the negotiation of the portfolio in a market. Because of this, the concept to consider in this dissertation will be credit default risk. Kendall (1998) describes that this risk has three components: the value of the credit (exposition), the estimation of what may be collected (recovery) and the likelihood of occurrence of failure (probability of default). These components are the basis for measuring credit risk. When credit risk is measured it could also be measured the impact on the capital of the bank. Fabozzi et al. (2003) explain the previous concept describing the loss is equal to the debt minus any collection as a result of foreclosure liquidation or restructuring. Banks have to deal with the previous concept in a daily basis. As Bluhm et al. (2002) express it is needed only a brief look to the banks portfolio to understand that default is part of the business. Credit risk is the business as usual of the banks so they have to manage it. The reasons, as Glantz (2003) expresses, are in first place that the success of a bank resides in the prudence and the parameters of the risks assumed. It involves policies and procedures to identify, monitor and control the levels of risk. Bluhm et al. (2002) explain that because of this, banks started thinking on ways to insurance the
Introduction
loans, which led to the first idea of credit risk management. However credit risk management is not only hedging loans, Glantz (2003) expresses that the goal of credit risk management is to maintain the credit risk within acceptable parameters, thus maximizing the rate of return of the bank. The previous idea implies not only the portfolio as a whole but also each credit, and the relation with other risks inclusive. At this point, it becomes important to understand that the portfolio of a bank does not necessarily mean all the customers of the bank. The general segmentation of customers in a bank is retail and wholesale banking, or consumer and commercial loans. Retail banking refers basically to loans to individuals whereas wholesale is the lending of money to companies. The management of those portfolios may vary from bank to bank, and that is the reason there is not too much academic relevant information about the management of this two kind of portfolios, for instance retail banking can be managed from a pool to a very close relationship, although usually measured trough a generic scorecard. On the other hand Commercial Loans are generally managed by a relationship manager, but instead of scorecards it is considered financial information of the customer presented in the terms of the General Accepted Accountability Principles valid on the country of operation or the place the information is requested. The structure of the credits tend also to be different as well as the purpose. From now on, in this dissertation when talking about credit risk it will be referred only to wholesale or commercial loans. In this type of loans, particularly referring to credit risk management, one of the main tasks that should be done is the Credit Risk Review. As Glantz (2003) expresses the Credit Risk Review helps to detect weaknesses in actual credits but also to avoid granting of weak credits. Dietrich & Kaplan (1982) propose that there is not a prescribed procedure to do the review, although generally it should include analysis of both financial figures and current subjective situation. Glantz (2003) posits that the worst thing a banker can do is to dismiss or hide the problems. In this sense, one idea
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of credit risk management is to classify them into five categories to determine the best way to manage them. These five categories were originally proposed by the Office of the Comptroller of the Currency in the United Stated in 1938 (Office of the Comptroller of the Currency, 2005) and they are: I or Current: Normal acceptable banking risk; IA or Specially Mentioned Assets: evidence of weakness in the borrowers financial condition or an unrealistic repayment schedule; II or Substandard: severely adverse trends or developments of a financial, managerial, economic or political nature which require prompt corrective action; III or Doubtful: full repayment of the loan appears to be questionable. Some eventual loss (as yet undetermined) seems likely. Interest is not accrued. IV or Loss Loan is regarded as uncollectible (Dietrich & Kaplan (1982, p. 1), Glantz (2003, pp. 310-312) and Office of the Comptroller of the Currency (2005, p. 10)). Classification process is an initial effort to determine the best strategy to remediate or recover the loans reducing its impact on capital. Credits which are classified IA or worst should be managed by a specific area with certain expertise. Glantz, (2003) expresses that workout areas have two main goals: to explain why a credit is not performing and to develop solutions for that issue. However this may not be considered as a core activity of the bank. Kendall argues: One practitioner of credit risk management was quoted recently as saying that two recent trends disturbed him about the UK today. One was the practice of outsourcing debt collection which thought was an integral part of credit management I tend to disagree on this and the other was the practice of cutting resources in the credit management departments during upturns in the economy only to recruit when the business cycle turns down (Kendall, 1998, p. 119). Even though the previous debate, it is important to remember that classification process helps preventing an unexpected loss to impact beyond the estimated. Finally, as part of credit risk management, it is also important to measure the credit risk in order to facilitate the process of management but it will also help to determine the
Introduction
11
reserve for a potential loan loss necessary in financial reporting as Dietrich & Kaplan (1982) express. Teale et al. (2003) comment that when trying to measure risk it is important to consider two variables, the risk probability of occurrence and the consequences the occurrence brings. As expressed before the risk of credit is default and default is the failure of the counterparty to meet its previously agreed obligations. However, the Basel Accord includes in the definition of default more situations that need to be differentiated. The first one is that a default is when the bank considers that the counterparty will fail (Basel Committe on Banking Supervision, 2004). The previous idea brings potency to the concept, however, in terms of credit risk measurement, actual and potential, or default and probability of default have different effects, more over in Regulatory Reserves, because it could increase the charge of capital required. Another difference is noted in the Basel Accord (2004) definition such when a loan is set in a non-accrual status, which basically represents the recovery status, though it does not necessarily mean a failure itself. The probability of default is the main element that needs to be quantified in the measurement of credit risk. Dhaene et al. (2003) introduce us to the measurement of credit risk by expressing that several kinds of models can be constructed to assess the credit risk but there are basically two types of models: the Two-sided Risk Measure and the One-sided Risk Measure (TRM and ORM respectively). The former measures the distance between the risk and the free risk situation when both are considered whereas the latter measures the same distance but only considers the risk situation. This classification brings the basics of Credit Risk Measurement; and it implies the measurement of the probability of default. However credit risk measurement has evolved since another point of view. For instances, one of the first ways for measuring credit risk was the subjective analysis or the expert system, which is relying on the judgment of the banker. Altman & Saunders (1998) refer to the four Cs of credit: Character, Capital, Capacity and Collateral, which were the main characteristics
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bankers analyzed of a potential or an actual borrower. Glantz (2003) propose a similar model called PRISM, formed by the analyzing of the following elements: Management: what the borrower is, history and prospects; Intention, or loan purpose; Repayment, analysis of internal (normal operations) and external (debt or equity) sources of cash; Safeguards, analysis of internal (quality and soundness of financial statements), and external (collateral and loan covenants); finally Perspective, which is the analysis to pull other sections together: risk and reward. However judgement is not always the best way to assess the credit risk, therefore, it evolved to an accounting based credit scoring systems (Altman & Saunders, 1998). The bases of this method are the concepts of financial distress and insolvency. Glantz (2003) expresses that financial failure is when cash flow decays and whereas insolvency is when the market value of the liabilities is greater than the market value of the assets. Accounting scoring systems intention is to determine through financial statements those concepts, and for that purpose there exist two types of models: the univariate models and the multivariate models. Altman & Saunders (1998) explain that univariate models are basically the comparison of key accounting ratios with certain norms. Glantz (2003) explains the concept further, and comments that there are three main uses for ratios: the structural analysis or the relation of these with the financial reports; the time-series analysis which is the historical analysis of performance; finally the comparison with other companies or industry or cross-sectional analysis. However ratios can be affected by inflation or by an atypical business situation (Glantz, 2003). They also can be limited because they depend on the information provided by the borrower. One of the main uses of ratios is to determine a rating in combination with another qualitative analysis, Fabozzi (2003) for instance comments that American agencies (e.g. S&P, Moodys) consider besides the ratios the analysis of the quality of management, the outlook of the industry, or the
Introduction
13
economy to finally determine a rating. The use of a rating as Bluhm (2002) explains is to assign them a probability of default or the process of mapping. Multivariate models, as Altman & Saunders (1998) explain, are the combination of some accounting variables to then be weighted, thus producing a score, which is compared to a benchmark. These models, as Glantz (2003) explains, are used to determine financial distress, which can have the form of forecast or the result of grouping the creditor into some previously set groups. In this sense there are four groups of methods to develop a multivariate credit scoring system: the linear probability models, the logit models, the probit models and the discriminate analysis models, as Altman & Saunders (1998, p. 3) expressed. Among these four approaches mainly two systems have been developed by theorists: the logit models or the use of past information to predict the future values, and the discriminant models which basically produce indexes that are compared to certain previous set information or benchmarks (2003). Altman & Saunders (1998) explain that logit models basically analyze some accounting variables to determine the probability of a counterparty to default assuming a logistically distribution of default. Some examples of these models were developed by Platt and Platt (1991) to test different types of ratios, or Lawrence et al. (1992) who use them to determine the probability of default on home loans. In the case of discriminant models, as Altman & Saunders (1998) explain, this kind of analysis intends to develop a linear function of different market and accounting variable to distinguish clearly a borrower in one of the classification groups: repayment or non-repayment. One important example of this kind of models is the ZETA model developed by Altman in 1977 expressed in the next equation:
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Where: X1 X2 X3 X4 X5 = = = = = Working Capital / Total Assets (as a percentage) Retained Earnings / Total Assets (as a percentage) EBIT / Total Assets (as a percentage) Market Value of Equity / Book Value of Debt (as a percentage) Sales / Total Assets (times)
The two predefined groups are as follows: If Z > 2.99: Financially sound; If Z < 1.81: Financially distressed or bankruptcy
Equation 1
Glantz (2003) expresses that this model was developed to analyze manufacturing companies, although it has suffered several modifications to analyze different markets as Altman & Saunders (1998) comment. Glantz (2003) defines that the model relies on two main effects, high leverage companies, will be affected by a relatively small change in the market and that an uncontrolled growth on assets implies a bankruptcy. Although the accounting models and specifically the multivariate scoring models have demonstrated to be reliable they have been criticized in three ways As Altman & Saunders (1998) comment: first these models are based on book values, which imply historical values but they are not dynamic enough to detect fast changes on conditions, second that these models are linear analysis, but world is non-linear inherently. Finally these models are basically theoretical approaches not practitioners. In this sense there has been developed new approaches such as risk of ruin or a model similar to Black and Scholes where the assets and the liabilities are assessed as well as the volatility of the assets for analyzing options. A second approach is the one that intends to determine probabilities of default by analyzing the risk and the risk free corporate securities. Finally a new approach is the mortality rate models which consist in deriving probabilities of default of the past and relating them to credit grades. This last model is wide used by rating agencies however it is criticized for the lack of an appropriate size
Introduction
15
database of defaulted cases (Altman et. al. (2002), Jarrow et al. (1997) Altman et al. (1998) Slater (2005)). In recent years a new approach to develop models for credit risk measurement has been the portfolio analysis. Previous models implied the analysis of a loan or borrower however risk can be measured as a whole as expressed at the beginning. Altman & Saunders (1998) express that a traditional approach of maximizing returns by diversification or the law of large number diminishes the risk, plenty used in stock markets. This portfolio analysis includes the use of betas to determine risk levels and borders. However there has not existed a broad study relating these concepts to credit, loans and bonds. Carey (2000) expresses that the major advance in portfolio analysis is the suggestion of the correlations of loan losses with systematic factors. However, floating rate loans have a modest upside potential which make them different from equity portfolios. Avesani et al. (2006) consider that in the last ten years there have been several efforts for credit risk modelling which main objective is to determine the distribution of probabilities of default of a loan and debt instruments portfolio. Altman & Saunders (1998) argue that although these attempts this is still an unresolved area. Crouhy et al. (2000) decribe the main initiatives of portfolio credit risk modelling made public to analysis: in first place CreditMetrics from JP Morgan is based on credit migration analysis and the probability of change the quality of credit in a one-year period, to determine the distribution. Secondly KMV Corporation developed its own model and methodology which is based on Expected Default Frequency thanks to an extensive database helpful to assess default probabilities. Third CreditRisk+ developed by Credit Suisse Financial Products is based only on default risk however it is famous due to a three factors explained by Avesani et al. (2006) requires basic inputs and mainly related to the Basel IRB approaches explained later, uses Poisson distribution, and studies concentration of risk. Finally CreditPortfolioView developed by McKinsey,
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as CreditRisk+ focuses on default risk, but in this case relates them to macroeconomical variables. One of the purposes of this Dissertation is to understand how Credit Risk affects the calculation of Economic Capital. For this purpose, it has been explained the concept of credit risk and how it can be measured in order to determine the probability of default of a loan or the whole portfolio. Previous findings are helpful to the bankers to determine the minimal amount of reserves needed to stay sustainable in the banking market. This is what is called the capital. Glantz (2003) expresses that Bank Capital promotes public confidence while having a support for contingencies, thus, protecting suppliers (depositors) from any failure. In general Bank Capital brings the benefit of time to recover the losses and to gradually reduce the impact of the contingencies without affecting other businesses. Chorafas (2004) expresses that because of the trends of new economy, based mainly in services capital is used for warrant the future performance. In this sense is important to clarify that according to Glantz (2003) bank capital is not only used for solvency, due that solvency is related mainly to the quality of their Assets and Liabilities. Capital does also try to cover what is called the expected and unexpected losses in the management of both aspects. This is the reason why there exist different types of capital with different purposes. The main classification of capital is proposed by several authors but briefly explained by Glantz (2003): first, Equity Capital or the Book Value of Capital, which is the core of the capital mixture and its basically the initial capital or the proportion of participation of the shareholders; second, Regulatory capital, which is the minimal amount of capital needed to cover the expected losses as determined by authorities or regulators such as the Basel Accord; finally, the Economic Capital which tries to cover the unexpected losses. Chorafas (2004) explains that for Basel there are three types of capital: the core capital which has similar characteristics as Equity Capital, the Additional Capital which in general terms is the mixture of regulatory and economic capital, and finally Tier 3 Capital which
Introduction
17
are different instruments of capitalisation. This dissertation will focus on the Additional Capital, which has common elements of capital, however, it is important to understand the concepts of Regulatory and Economic Capital, thus understand its differences. Regarding Regulatory Reserves and before explaining the concept itself, it is necessary to understand what the Basel Accord is. This is an accord of central banks and credit institutions of the Group of Ten countries (G-10) (Basel Accord (2004) and Chorafas (2004)). This accord particularly by an internal committee named the Basel Committee on Banking Supervision, released the New Capital Adequacy Framework in 1999 to propose the new regulations on capital requirements (Basel II). Basically, as a judgment of Chorafas (2004), Basel II intends to establish the capital requirements to solve the new challenges that a service economy brings with it. In this sense, Basel II intends to cover the three main risks a bank faces: Credit Risk, Market Risk and Operational Risk. Thus Regulatory Reserves are the minimum amount of capital set by a regulator, in this case the Basel Accord, to cover the expected losses of these three main risks. However Regulatory Reserves concept has varied with time, and as Chorafas (2004) expresses, the concept itself represents evolution because it is related to economic developments, accounting standards and jurisdictions. For instance, before Basel II there was a previous agreement known as Basel I which basically established a percentage of the reserves after analyzing the assets and the liabilities of the banks, this percentage was 8%. This percentage had an assumption and it was that all the banks and all the countries are under the same circumstances. However, as Chorafas (2004) expressed, for regulatory capital requirements to be meaningful they should be established coherently, objectively and verifiable. For this, Basel II framework rests on three pillars, the Pillar 1 is explicitly dedicated to the capital adequacy or the capital requirements. The Basel Accord tries to change the paradigm of being only regulators or the police and instead, intends to make the commercial banks its partners by delegating the computing of capital adequacy through
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three strategies: the Standardized Method, the Foundation IRB method, and the Advanced IRB Method. These strategies are options for the banks (though not a discretionary selection, instead banks have to comply with certain requirements) with different levels of responsibility of calculation of the main variables considered to determine the Regulatory Reserves: The Probability of Default (PD), the Loss Given Default (LGD) and the Exposure at Default (EAD). The PD as it has been explained before is the level of risk of a borrower; Bluhm et al. (2002) explains LGD as the proportion of loss in the event of default whereas the EAD is the amount owed by a borrower at the moment of default. These three variables are combined as it will be shown in equation 2 to determine the Reserves. Basel II establishes that for the first strategy, the standardized approach, Basel Accord will calculate the three variables; in the Foundation IRB strategy, the banks will calculate the PD whilst Basel Accord will calculate the LGD and the EAD; finally for the Advanced IRB strategy, banks will calculate the three variables. Once each variable is calculated either by the bank or the regulator they will be multiplied following the criteria of equation 2. It is important to notice that first variable is Expected Losses which is what Regulatory Capital intends to cover:
Where: EL PD LGD EAD = = = = Expected Losses Probability of Default Loss Given Default Exposure at Default
Equation 2
Due to this approach of doing banks partners of the regulator, Pillar number 2 intends to determine the regulators necessity and obligation to inspect the procedures, systems and models developed by banks to determine its regulatory capital requirements. Finally Pillar 3 is related to transparency to promote a market discipline. Because of the
Introduction
19
relevance banks have in economic issues it is important to develop a market discipline or specifically reliable financial disclosure. Not only regulators but also stakeholders will be able to scrutinize the banks performance (Basel Accord (2004) and Chorafas (2004)) Regarding Economic Capital and its definition, it involves a major issue to distinguish between two different approaches to define the word. Whilst in accounting Economic Capital means the core capital or the market value of equity in the Banking Literature means the amount of reserves needed to be stable in the market. Both do not coincide with practitioners point of view as Chorafas (2004) explains by quoting a Bundesbank survey. There is an attempt to homologate the definition: if regulatory capital purpose is to cover expected losses then economic capital purpose is to cover unexpected losses. Rowe et al. (2004) express that banks need to assess the amount of capital needed to cover the unexpected losses of three main risks: credit, market and operational. On the other hand several authors (Burns (2005), Chorafas (2004), Stein (2009), Basel Accord (2004)) consider that not only those risks but also Business Risks (Liquidity, Reputational, Environmental Risks, etc) should be covered by the Economic Capital. Walter Pompliano from S&P expresses that Economic Capital is an amount such that any loss in value larger than this amount has a really small predefined probability (In Chorafas (2004)). The new confusion rests on the dilemma if Economic Capital is only the additional part of regulatory capital to cover unexpected losses or it is all the capital included the allocation to regulatory Capital. Chorafas clarify that Total Economic Equity is compounded by regulatory capital and the amount required by on-balance and off-balance operations. Elizalde & Repullo (2004) consider that Economic capital is the capital that shareholders would choose in absence of regulatory capital, meaning that this will cover both Expected and Unexpected Losses. However there exists regulatory capital and an Entity in charge of set the rules. Both forms of capital are there to face expected and unexpected losses. And as Chorafas
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(2004) explains, both regulatory and economic capital are related to banks financial strength, the former to cover expected losses while the latter besides the protection to unexpected losses, it helps the institution to generate profits. Together they become the financial resources to cover all significant risks. As expressed previously Regulatory and Economic Capital are closely related one with each other. Besides the already quoted difference of one covering expected losses while the other covers unexpected losses Chorafas (2004) explains more differences: for instance Regulatory capital are minimum requirement imposed by an authority whereas Economic Capital is the amount of money the institution itself determines to comply with a prudent risk management. Another difference is the fact that there are events with high frequency but low impact covered by the regulatory capital and events with low frequency but high impact, covered by economic capital. One difference more explained by Chorafas (2004) is that Economic Capital role is to assure that also under downturn conditions the bank will be able to obtain counterparties, be solvent but mainly stay on business. Elizalde & Repullo (2004) explain in the allocation of capital the difference between Economic and Regulatory Capital. They posit that Regulatory Capital is determined by the Probability of Default, the Loss Given Default and the Exposure at Default and the Confidence of Regulator. Economic Capital, besides the three former variables, includes also interest rate (for loans and deposits) and the cost of capital. One of the important elements of the definition, which also is the basis for allocation of Capital Economic and Regulatory, is the difference between Expected and Unexpected Losses. Chorafas (2004) considers that a good start for differentiating them is that Expected Losses are Expected Events and usually these events have a High Frequency but a Low Impact; on the other hand Unexpected Losses are Unexpected Events and these usually have a Low Frequency but a High Impact. These assumptions raise the analysis of the loans of an institution through mathematically, actuarial and statistical analysis and mainly determined through a probabilistic
Introduction
21
distribution (Poisson, Normal, etc.). Bluhm et al. (2002) express that once the Expected Losses are calculated as explained before, the normal way to determine the Unexpected Losses is, following the probabilistic distribution, one Standard Deviation of the historical information previously collected. However there is still a slight probability that Unexpected Losses go beyond a Standard Deviation. Banks need to determine different ways to consider also statistical reliability.
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Chapter 3 - Research Methodology

If there is a considerable amount of alternatives to determining both, Credit Risk and Economic Capital, what will be found in this dissertation? In every research, as in several human activities, the main outcome in general and wide terms is Knowledge: The relation between a subject and an object (Castaeda Jimenez, 1995). There is a structured and defined process to create knowledge which will be depicted in this chapter, although its intention is not to describe but to support the main issues raised during the research. However, before discussing the research terms it will be explained in general terms how this dissertation was developed, thus to understand the research methods. Credit Risk has been studied and developed widely in terms of understanding the probability that a customer will pay or not mainly to decide whether or not to grant a loan. Although Economic Capital has moved into a homologated concept, its calculation has not, hence creating a gap between the theoretical and the practical approach. The conceptual relation between these two concepts has belonged to internal bank areas rather academic limiting their theoretical analysis despite the efforts explained in the literature review and as it will be seen in the case study. Thus, this dissertation intends to describe this process, obtaining information from two main sources, interviews with people implicated in the process and second analyzing the internal policies that affect both calculations. That was in general terms how the dissertation was developed. As a start point it will be defined which kind of research is being done, and according to Riley et al. (2000) this is an Applied Research, because this has a practical implication by understanding how these two concepts are related in a real life case. Although it has some references to theoretical sources, it is mainly with the purpose to compare and critique with what is being done in reality. Therefore in this Dissertation is depicted the process and criticized with theoretical information. Continuing with Riley et al. (2000) classifications, regarding the source of information this is mainly a Primary Research, the information was obtained from interviews and scrutiny of information (explained later on), however
Introduction
23
there will be references to theoretical sources to understand why some aspects are done in a particular way. Mendez A. (2001) describes another classification which is the main issue in this dissertation. He says that this classification includes three types of research: Exploratory (which describes the problem), Descriptive (which proposes solutions to the problem), and Explanatory (which select a solution to be implemented). Because of the lack of case studies for this subject, it is believed that is important to first to describe the problem for further research develop solutions to this particular issue. It is assumed that this is an exploratory research because it is described the situation, and although there are some attempts to promote solutions they are shallow to provide more detail on the actual process. Another aspect that should be discussed is the philosophy of the research explained by Saunders et al. (2007), and it includes defining Ontology, Epistemology and Method of the research. To define these elements is particularly confusing mainly by two assumptions. First of all, the research is related to analyze mathematical formulas that will determine the best option. Math is an abstract concept although related to real life objects in this case money whereas the best option relates a potential subjective appreciation. Second, it is based mainly on probabilities which has a strong argument on math but depends on the philosophical debate if the future can or cannot be determined. Despite previous judgment, this is a subject that can be measured and intends to describe mathematical models that are independent from a subjective appraisal. Therefore, ontologically this research favours Realism or Objectivism. Because of the sources which are mainly policies, the Epistemology of the research is Positivism: reserves allocation intends to be independent from human behaviour and although they are related to analysis of customer behaviour, it is realized through statistical information. Finally the Data Collection includes two main strategies: interviews and scrutiny of documents. Interviews will be done with people in charge of the processes which will depict or clarify the normal loophole of the Policies and
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Documents that will be reviewed, which are mainly two: The software and its policy to calculate Credit Risk and the Mexican Regulation Document for estimating Reserves. These are the sources of information to understand How Economic Capital is calculated considering Credit Risk. Finally it is important to discuss the Ethical Issues. Regulations in Mexico are public, though subject to interpretation. In this research rather than interpret the regulation the intention is to criticize the interpretation done by the Bank to that regulation particularly. Therefore, it is intended to avoid a judgment without previous knowledge and preparation. In the case of interviews, subjects were willing to participate though in order to keep the research objectively and to avoid any judgment, subject will remain anonymous.
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Case Study
Chapter 4 - The Company: Banco Nacional de Mxico
To be able to determine how Economic Capital is allocated regarding Credit Risk it will be analyzed the procedures followed by a bank which is located in Mexico: Banco Nacional de Mxico (Banamex). Banamex was founded 125 years ago, due to the merger of two banks in 1884 (Banamex, 2009a). Banamex currently is part of a global bank with presence in more than 100 countries: Citigroup. Its recent history can be covered in three main stages: the first stage is called the Nationalization and it occurred in 1982 when the banks were to bankruptcy and the Mexican government as a measure of economical stability decided to protect savers by buying the banks (Tello, 1984); the second stage is called the Privatization and it occurred in 1991 when government decided to return banks to the private sector. A group of investors headed by Roberto Hernandez and Alfredo Harp owners of Acciones y Valores (Accival) a Stock Brokers House, invested to buy Banamex then they formed what now is known as Grupo Financiero Banamex Accival (Ortiz, 1991); the last stage is the acquisition or takeover of Banamex by Citigroup. Several aspects surrounded the operation, even more the operation itself represents a whole analysis and produced a complete set of different points of view of history, though is not the aim of this dissertation to discuss them. In 2001 after getting all the required approvals and permissions by government and authorities, the acquisition was performed in the Mexican stock market (similar to a hostile takeover). In this way they obtained several benefits, including the avoidance of taxes payment (Romn Pineda, 2001) (Banamex, 2009a). Despite the ownership of the bank, Banamex is still constituted (or established) and ruled under the Mexican Laws. Furthermore its structure and functioning followed the standards previous the acquisition, because Citigroup, as a strategy to fulfil the needs of a market which was at a certain point unknown and particularly new for their policies (Aleman, 2001) (Ramos Perez, 2001)
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and strategies, hence they believed that it would minimize the market impact as well as the organisational culture impact. As expressed before, due to its nature of being part of two different countries, Mexico and the United States of America, Banamex Capital Allocation follows two different legal and financial frames, the first are set by the Secretara de Hacienda y Crdito Publico (SHCP) which has similar functions as the ministry of Treasury and the Comisin Nacional Bancaria y de Valores (CNBV) an organism in charge of reviewing, regulating and supervising the functioning of financial institutions (CNBV, 2009a); second, those rules set by the American government and authorities. In financial terms the bank has to present its financial information in American General Accepted Accountability Principles (USGAAP) when talking to the headquarters and American Regulators whereas when they refer to local authorities the follow Mexican GAAP which are based on International Financial Norms (IFN). It is not the intention of this research to show the differences between the two accountability systems or standards, although it is to show how economic capital is allocated in a bank and specifically a bank set in Mexico, therefore how economic capital is allocated within the conditions and situations of that country.
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Chapter 5 - Credit Risk Measurement The Obligor Credit Risk Grade

5.1 Legal Framework: Circular nica Bancaria As mentioned in the previous chapter, Banamex has to follow the standards established by the CNBV, particularly those expressed in a document called Circular nica Bancaria (CUB) which is basically the legislation Financial Institutions have to follow punctually for not failing into fines or even closure. The CUB contains almost all the requirements in terms of operation and disclosure of information. Among all the requirements, rights and obligations it contains, the CUB also refers to two important processes in the determination and allocation of reserves: the Credit Risk Administration, including the determination of Credit Risk Grade of Credit Lines, and the guidelines to Capital Requirements based on Basel II rules explained in the Literature Review. Regarding to Credit Risk Grade the CUB explains the next as the process to determine the risk grade a customer has:
Analyze Credit Quality of Obligor
Mark Credit Variables of Obligor
Set and Obligor Credit Risk Grade
Diagram 1
This algorithm is the General Methodology to determine a Risk Grade for an obligor or customer. Each of these steps contains a set of processes and procedures established by the CNBV to qualify a customer, and this qualification will be published in several means, besides CNBV databases such as a Credit Bureau or a Society of Credit Information (Buro de Crdito, 2009a), as it will be explained with more detail later. What the process intends to explain is that it will be needed first to analyze the customer not only financially but also its environment including its country and industrial sector giving as a result an Obligor Credit Risk Grade (OCRG). The scale of
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Risk Grades was previously established by the CNBV and it is represented in the following table.
CNBV Risk Grades A-1 A-2 B-1 B-2 B-3 C-1 C-2 D E
Level of Risk Lower
Higher
Table 1
In general terms (but it depends on which situation are used) these grades represent the level of risk of certain aspect, being the A-1 level the lowest risk whereas the E level represents the highest risk. Once obtained the OCRG, the Regulatory Reserves can be determined by setting the OCRG as the level of risk of a Facility or Credit Line; however this level can be affected depending on the type and seniority of claim of a collateral or guarantee as it will be explained in the next chapter. Although previous explanation is vague it is on purpose because first it is necessary to explain another aspect of the CUB. As expressed previously, the CUB follows certain rules set by Basel II, hence, they aloud Financial Institutions to develop an own algorithm for determining the OCRG. In this sense Financial Institutions can follow three different ways to determine the OCRG, although the final result should be mapped to the scale of risk grades from table 1. The CUB expresses that Financial Institutions can: 1) Develop a new methodology to qualify the obligor not only the standard version, 2) to calculate the Probability of Default of an Obligor and map it to the Risk Grades; or 3) to calculate the Estimated Loss by calculating the Severity of Loss and assuming the Recovery Rate. All of them need to be validated and authorized
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by the CNBV. In the case of Banamex, they decided to follow the first option and to develop a particular model for qualifying the Obligor, although following certain advices proposed by CNBV contained in the CUB. This model proposed is contained in a document of internal circulation, and it explains how the methodology works and provides general rules of application and guidelines. As well as the guidelines it is also explained a worksheet called Vaciado Universal Banamex (VUB) which is a Banamex electronic media or software which calculates semi-automatically the OCRG as well as the Regulatory Reserves. The VUB is an Excel file that every relationship manager or risk analyst has to complete in order to determine quarterly (according to CNBV rules) the levels of risk of the obligors as well as the corresponding levels of Regulatory Reserves. Even though it was the best option at its time, has recently suffered several criticisms mainly related to security issues and also programming. In the research it was founded both which will be explained on the way. This file consists of three worksheets principally (besides others not really related to Credit Risk Grade though related to Risk Management). The first one is the Comparative Financial Statements. In this page the analyst and/or the relationship manager, type the Financial Information of the customer. It is important to have certain accountability sense because the fields in this file are specific and try to differentiate between and operative and non-operative entry, which affects the Cash Flow. This page does several different calculations including Cash Flows and Financial Ratios, and also providing several summaries, however for the calculation of Credit Risk Grade it is only needed one year of financial information. Once the financial information of an Obligor (or its related parts) are typed, it can be calculated the OCRG. As explained before to calculate the OCRG, Banamex uses their model although based on the model described in the CUB. This general process tries to consider all the risks involved in a credit operation, assessing a risk grade (the same as Table 1) for each of them and determining a qualification. The most marked
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difference between the Banamex methodology and the CNBV methodology is the analysis of the obligor. In the next diagram it is expressed the overall methodology proposed by CNBV which is the one that Banamex programmed in the VUB. However, the algorithm to measure each aspect is slightly different as it will be explained in the next sections:
Country Risk
Obligor Risk
Industry Risk
Payment Experience Analysis

Diagram 2
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5.2 Country Risk Regarding the first risk, the country risk, The CUB on its appendix 20 expresses that it intends to consider the risk involved in operations of loans granted to foreigners, considering foreigners those which the payment demand should be done in a country different from the lender, in which risk factors could affect the borrower payment capacity. Hoti & McAleer (2004) express that country risk broadly is the probability of a country (government) or an obligor within that country to be able or have the will to pay its obligations with foreign parties. Ries (2007) focus not on the customer but on the environment and his definition of Country Risk expresses that it is all the changes that can occur within the context of a country reducing profitability of business, operations and assets. However country risk can be a wide concept covering several but different types of risk, for this reason, Hoti & McAleer (2004) argues that country risk could be enclosed in financial, political and economical factors. These three factors affect the international cash flows. Ries (2007) follows the previous statement and he states that there are mainly three types of Country Risk: 1) political changes or political parties and economic policy changes, 2) macroeconomic mismanagement or fiscal and monetary policy, and finally 3) others risks such as war. However Chorafas (2004) tries to specify the concept and he mentions that Country Risk has two main concerns, the default of the counterparty due to changes in its environment and the government policies changes. A government can prohibit the payments to certain sovereign countries discretionary. Due to all the previous statements it is important to quantify the intrinsic risk of a country including the point of view of the country where the loan is originated, in this case Mexico. The CUB establishes that it will follow the ratings assessed by rating agencies, particularly those provided by Moodys, Fitch and S&P. The worst rating obtained by a country is the one that will be considered as the country risk. Then after determining this rating it will be mapped with the table as follows to set the initial Accumulated Risk Grade (ARG) of a customer. In case that the customer is located in
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Mexico, it is assumed that it would not incur in Country Risk by being both parties, the lender and the borrower, within the same environment and conditions, for this case the ARG will be A-1.
FITCH AAA AA+ AA AAA+ A ABBB+ BBB BBBBB+ BB BBB+ B BCCC CC C D/E
Rating Agencies Equivalent Rate MOODYS Aaa Aa1 Aa2 Aa3 A1 A2 A3 Baa1 Baa2 Baa3 Ba1 Ba2 Ba3 B1 B2 B3 Caa Ca C
S&P AAA AA+ AA AAA+ A ABBB+ BBB BBBBB+ BB BBB+ B BCCC CC C D
CNBV Risk Grades A1 A2 B1 B2 B3 C1 C2 D E
Table 2
Though it is the legislation, it has several weak points academically speaking. It can be argued for instance, the ARG obtained by a country not rated by these agencies. If it is the case then instead of being rated with an E it is rated with D. Chorafas (2004), expresses that country risk is not important when a customer defaults due to other factors. For instance, it is important to analyze the insolvency legislation and the differences of the legal frame between each country. The loss can be higher than expected for these agencies. Finally the confidence on these agencies has been put in
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doubt in several occasions (i.e. Enron). Expressed by Kaminsky & Schmukler (2002), agencies have been under scrutiny for several reasons such: 1) pro-cyclical grading or qualifying a country depending on its stage of the economical cycle, 2) the weight of their announcements on investors, 3) because of previous statement they have direct impact on prices, and 4) the access to information they can have and particularly in countries where information disclosure is still an issue. Basically they argue how can be determined that these agencies are truly independent.
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5.3 Obligor Risk The second step of the process is to analyze the Obligor Risk, obtain an Obligor Risk Grade known as the Banamex Risk Rating (BRR) which will then be compared with the ARG obtained from the analysis performed in previous section. From the comparison is obtained a new Accumulated Risk Rating by determining which of both, Country Risk and Obligor Risk, represents the higher level of risk. The obligor analysis, as explained by the CUB and the Banamex circular, is the quantitative and qualitative analysis of several available information of the borrower, however CNBV and Banamex analyze different variables as it will be shown later. The quantitative analysis is the analysis of financial figures from the Financial Statements and other sources, and according to the CNBV this is the main information to be considered in assessing a Borrower. Qualitative analysis is the analysis of certain aspects not completely related to financial statements but that can help to differentiate between one level of risk and another. According to the CUB the Obligor Analysis follows these two steps expressed in the next diagram:
Quantitative Analysis Qualitative Analysis
Cash Flow Liquidity Gearing Profit and Activity
Management Competence Organisational Structure Shareholders Mixture and Decision Making
Diagram 3
As it can be seen in the previous diagram, the CUB process refers to the analysis of these specific variables from the Borrower however in an independent way. Banamex decided to develop its own algorithm and analyze specific variables as well as including others as it can be seen in the next diagram:
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Quantitative Analysis
Operative Margin Interest Cover Debt Cover Indebtedness Capacity Liquidity Capacity Sales Real Growth
Qualititative Analysis
Enterpreneur Profile Market Share Customers Concentration Suppliers Concentration Quality of Financial Information
Diagram 4
In this diagram is expressed that quantitative and qualitative analysis are not independent, they are related to obtain the BRR. In the VUB can be seen that they are part of the formula to calculate the BRR which will then be mapped to the CNBV Risk Grades. The BRR is the result to the algorithm proposed by Banamex and represents as other methodologies the level of risk of a Borrower. In a simple way the BRR is the sum of the weighted scores of the previous variables. However the procedure is not as simple as it is defined. Each of these variables should fit into one of the ranks (previously established and explained later). Each of these ranks has a score, which is the one that is obtained by that particular variable. This score is multiplied by a weight (previously established and explained later) giving a factor that will be then summed to obtain an overall average, this average is then mapped to a BRR ranks and obtained the BRR. Trying to represent mathematically the previous statement with all the weights it resulted in the following formula. The figures included in this formula are the weights that each variable has for instances Operative Margin has a weight of two whereas Debt Cover has a weight of four:
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Where: f( ) = Score of OM = Operating Margin IC = Interest Cover DC = Debt Cover IDC = Indebtedness Capacity LC = Liquidity Capacity SG = Sales Real Growth EP = Entrepreneur Profile MS = Market Share CC = Customers Concentration SC = Suppliers Concentration QI = Quality of Financial Information
Equation 3
As it was expressed in the literature review, there are different models to determine the level of risk of a borrower. In this particular case it can be assumed that this is a Multivariate Model because as Altman & Saunders (1998) expressed, Multivariate models combine accounting variables and weight them to produce a credit rank. For Banamex this is specifically a Discriminant Analysis model, looking to compare market and accounting variables to distinguish the borrowers. At this point, and just to clarify, although the CUB proposes the elements to consider in the assessment of risk of a borrower, it does not specify the weight or form they should be measured. There is no a model available (or accessible by the researcher of other Financial Institutions) within the context of the Mexican situation to compare it with Banamex model. However the analysis will be done particularly on the variables they measure. Another important point that needs to be explained of this function is the score system which can be identified in the next table. Table 3 shows the variables, but also the ranks in which results can be arranged. Once information is calculated and arranged, it is fitted into this table which at the top row contains a number that is the score for that variable. Then this score will be multiplied by the weight as expressed in the previous formula. The general explanation of how the ranks were set, is that it was an analysis of several customers current and historical data, which conclude into a logic of how,
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under the Mexican Economic and Political characteristics, companies or enterprises would behave. It is important to remember that for Banamex being so long time in market represents also a valuable source of information. However it is important also to clarify that although it represents a basic and major point in the calculation of reserves it is not the purpose of this dissertation to disclosure or depict all the processes of Banamex model, but most important to understand them.
Variable
Operational Margin Interest Cover Debt Cover Indebtedness Capacity Liquidity Capacity Sales Real Growth Entrepreneur Profile Market Share Customers Concentration Suppliers Concentration Quality of Financial Information
0
<= 3% <= 1 <=7% <=4% <=20% <=0% N/R <=5% >35% >35% Audit and Cons. >3% >1 >7% >4% >0% >5%
1
<=6% <=2 <=6% <=1%
Score 2
>6% >2 >6% >1% <=9% <=3.5 <=23% <=8% <=60% >9% >3.5 >8%
3
<=12% <=5 <=10% <=4%
4
>12% >5 >30% >10% >80% >4% Institutional >25% >5% >5% Not Audited
<=15% >15%
>23% <=30% >60% <=80% N/R >20% <=25% >5% >5% <=20% <=20%
>20% <=40% >40% Familiar
<=2.5% >2.5% <=20% <=30% <=30%
Professional
<=15% >15%
>30% <=35% >20% >30% <=35% >20%
Audit Not Cons.
Table 3
Operating Margin, as Gitman (2000) expresses, measures what is left from sales after all the expenses without including interest and taxes. Financeterms.org (2009) concludes that it represent how much a company is efficient in its operations but also in its pricing. Banamex considers that Operating Margin will say how efficient a company is, if it generates profit after all the core activities. The VUB expresses that the formula is equal to divide Operating Profit over the Turnover, only if the Operating Profit is greater than zero, that in the case, the Operating Margin will equal zero. Interest Cover as Ross et al. (2001) express, measures the times a company can cover its obligations on interests. Investopedia (2009a) argues that these ratios express how
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easily a company can pay its interests. Usually Interest Cover is measured by dividing the EBIT or Operating Profit over the Interests. Although the common formula to calculate Interest Cover is that expressed above, some authors such Ross et al. (2001) argue the EBIT includes an element which is a non-monetary expense specifically the Depreciation. For that reason, this formula is usually affected by summing the Depreciation to the EBIT. The VUB follows that criteria though considers other scenarios, and this includes the comparison of the interest profit against the interest expenses. Where the EBITDA is greater than zero and the interest gained are greater than the interest expenses then exists an interest cover of a hundred, meaning that they are able to pay the interest of a loan with the interest earned by their investments and also means that this profit will not be expensed on other areas of the company. However if there exists an EBITDA equal or lower than zero in spite of a positive difference of Interest Profit and Interest Expenses, the Interest Cover will be equal to zero. If none of both scenarios appear then a normal calculation will be done. Debt Cover (usually known as the Debt Service Coverage Ratio) is defined by Pieterz (2006a) as a ratio that reflects the cash flow available for repayments that are due. Several sources (e.g. Investopedia (2009b)) coincide that this ratio measures basically how much cash flow a company produces to fulfil the debt repayments for that particular period. Although the VUB tries to follow the same logic of previous statement, the formula employed is different because they have already considered the Interest Cover. This means that whereas in the general formula is included the interests that are due, the VUB formula considers that interests are covered by Operational Profit and there is no point to include them in this formula. To clarify the difference, the normal formula is EBITDA divided by the Repayments Due (included Debt Repayments, Interests and taxes by interests), in the case of the VUB, it refers to two different concepts, the Gross Origination which is the result of Net Profit plus Depreciation and other Non Cash-Items (particularly Inflation and Foreign Exchange
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Effect) divided by the sum of Short and Long Term Banking or Onerous (with cost) Debt. As it can be seen in the Gross Origination are included the Interest Expenses, it can be noticed as well that this formula does not include the repayment of the period but the whole debt, producing a percentage rather than times. The two previous ratios have the higher weight because from this ratios the bank considers can be reflected how a customer will behave against its debt. These two ratios propose if the company in its daily operation will produce the resources necessary to fulfil its obligations. The two previous ratios measure how much a company is able to pay today or now, however how much debt a borrower is able to acquire can be determined by the next two follow ratios. The first one as translated from Spanish is the Indebtedness Capacity, not too much literature is available about this specific ratio, although is very similar to operating cash flow ratio, defined as the proportion of current liabilities
covered by the cash flow from operations (Investopedia, 2009c). Pieterz (2006b) explains that this ratio is a benchmark that expresses if the company has or has not generated enough cash to cover its short term debt. However, this ratio only considers short term liabilities whereas the VUB formula considers all onerous debt. Mills & Yamamura (1998) explains the Total Debt Ratio (Also known as Cash Flow to Total Debt Ratio) that measures how long it will take for a borrower to pay its debt, although it implies as well that all cash flow generated by the companys operations is addressed to both debts: short and long term. The VUB expresses that to calculate indebtedness capacity it is equal to divide the sum of Cash and Operative Generation over the sum of all onerous debt. One point that is important to notice is that the formula talks about operative generation that is obtained by the cash flow statement, using only the first part or cash flow from operating activities. According to Dechow (1994) and Zeller & Stanko (1994) agree that many analysts have changed is focus on cash flow rather than income, because according to them is less distorted or subject to distortion, and it will provide with a more reliable source of a firms ability to generate inflows for
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covering operating aspects. Finally Casey & Bartczak (1985) conclude that cash flow is not only the cash & receivables or the net income, it is as well all changes in current assets and liabilities. Banamex considers all these theoretical elements and includes them in its calculation. The two last elements of Quantitative analysis are the Liquidity Capacity and the Sales Growth. The Liquidity Capacity ratio is a variation of the Quick Ratio explained by Watson & Head (2007) as the result of dividing Current Assets minus the stock (which should not be considered if it takes long time to convert it into turnover or its first sold to credit which means that is converted into trade receivables rather than cash (Gitman, 2000)) over the current liabilities and in general it measures the capacity of a company to fulfil its operative and financial obligations. The VUB, however, although it follows the same logic, is concerned only by the banking liabilities, meaning that they want to know how much of the Working Capital is left to cover the Short Term Banking or Onerous Debt. The VUB rests from the Current Assets the Stock and the Non-Banking Liabilities (or sum from Current Liabilities the Short Term Banking debt), which refers Working Capital then this is divided over the sum of all banking or onerous debt. The result gives the proportion of how much Assets are left to cover the Short Term Debt. To finish the qualitative analysis and regarding to Sales Growth, it is the comparison of the sales of one period against the previous period discounting the effects of inflation, therefore talking in real figures not nominal. The support of this is the assumption that in Mexico companies are considered to have a sustained growth when their sales are greater than the inflation levels. Qualitative Analysis then is the analysis of the competitive position in non-financial aspects of the borrower. What the VUB tries to do is to set these characteristics into a numerical measure. In the case of entrepreneur profile, it is intended to be measured how developed is the structure of the company and how dependant is this structure on the owner or shareholders. Market Share, Customer Concentration and Supplier
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Concentration reflect how the company has evolved regarding their market experience. The calculation of these elements is simple though is discretional to adopt different approaches. For Market Share the sales are divided by the total sales of that segment. On the case of Customer Concentration and Supplier Concentration, from the list of Customers and Suppliers is determined which percentage of the sales represent the top 5 customers/suppliers. Finally Quality of Information refers to the fact that the financial information can be subject to (voluntary or not) certain inconsistencies or affectations. If the information is reviewed by an external auditor then it will not suffer any punishment, though on the other side, if it is not audited, then it will receive a diminishment in the BRR of at least eight points. As a final discussion, before understanding the Discriminant Model it is important to understand the role of the ratios when predicting financial distress. Several authors have focused their efforts to relate a ratio with specific performance areas of companies. Gombola & Ketz (1983) argue that ratios can analyze specific aspects of the company however some ratios can measure different aspects although is the same result. Analyzing specific ratios will eliminate the redundancy and overlooked of aspects of performance. Gibson (1985) takes the previous idea and conducted a survey in which he asked the Chartered Analysts which are the ratios that they use to analyze certain aspects of companies. The conclusions of the previous survey showed that usually analyst use most of the ratios mentioned before to analyze a Company Debt and Capacity to Pay. It can be concluded that the VUB analyze in the quantitative part, the capacity of a borrower to pay its debt. However the VUB is not only a quantitative analysis but an overall review of the company and that is what is called a Discriminant Model explained before.Jayadev (2006) explains that Discriminant Models are sophisticated approaches to combine distinct variables that are statistically proved, which will then obtain a result compared to a benchmark which will be useful as a decision making. Following the previous idea and understanding the formula, in the
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VUB model for determining the BRR, two aspects are combined: a quantitative and a qualitative analysis of the company. In this model according to the formula and score table the rank of possibilities goes from minus six when all the variables are scored at their minimum to a hundred, when all the variables are scored to their maximum as it can be seen in table 4. Another point that can be noticed from this formula is that although the scale is wide, seventy two points are obtained from the analysis of financial figures. It has been argued that financial figures are a good method to predict a default however using only this kind of information can bring two types of issues: first, the reliability of financial information used to analyze the customer because if it is not reviewed by an external entity, the borrower only would lose eight points, that according to the table 4 will represent only one grade of risk. The second issue is the possibility of grading a customer with a higher risk rating although it is a competitive customer and is covering its payments, on the other hand, grading a customer with lower risk although it is past due. These two previous issues are related to the same criticisms to Discriminant Models (Altman & Saunders, 1998), because they are linear and they are based on historical data, they do not show the actual conditions of the Company. However, there is a strategy in both CNBV and Banamex models, to minimize this effect and is the Payment Experience as it will be explained later. Once the calculation is done the borrower will obtain, according to the following table, the BRR which as explained before will be compared against ARG. That level of risk which represents the higher risk will be set as the new ARG for the borrower, e.g. if a customer is from Argentina and after the analysis of agencies it is determined that it has a Country Risk of B-2 (initial ARG) but the Obligor Risk (BRR) has a level of B-1 then the ARG will be B-2:
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Points
-6 11 21 31 41 51 70 10 20 30 40 50 70 100
Risk Grade
E D C-2 C-1 B-3 A-2 A-1 Table 4
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5.4 Industry Risk The third step of the process is to analyze the Industry Risk, which basically refers to understand the outlook of the industry, the opportunities or threatens that the specific sector within the Borrower has its main activity. Empirical studies and facts imply that industry expertise is valuable for lending to banks as Stomper explains (2003). He argues that several banks have reported in its internal rating systems to consider the industry outlook, which is mainly performed by internal units, with the common goal of providing unified information about a specific sector to all the customers of the bank. He explains that the traditional theory focus its efforts on diversification or in other words that the bank does not lend only to one particular sector, but several, to minimize risks, therefore by not being experts becomes a strong reason to include the risk analysis of the industry. The CUB agrees with the previous statement and considers that the industry outlook should be done by third parties, however seems contradictory in the fact that the CUB expresses that the only effect on the ARG is to benefit one grade to those borrowers that have a B-1(turning them into a A-2) and a B-2 (turning them into a B-1) this is the only effect that the industry risk analysis or outlook has on the ARG. There is no other implication of this element, as it can be seen in the next table. Otherwise the ARG will remain the same as in previous analysis.
Industry outlook
Positive Neutral Negative
Industry Risk Grade

A-1 A-2 Other
Affects
B-1 & B-2 B-1 & B-2 None
Table 5
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5.5 Payment Experience The last element of the process is the Payment Experience or basically to review what is the behaviour of payment of a borrower in the last 12 months being this review to a Credit Bureau report or internal information. This step is curiously based as Galindo & Miller (2001) express in a psychology hypothesis: a future behaviour can be predicted by previous behaviours. A common source of information was needed to store all the historical information of several borrowers. Falkenheim & Powell (2001) intend to depict the creation of credit bureaus in Emerging Markets. They explain that Credit Bureaus initially existed as a solution to a particular concern: large debtors who can cause chaos to initially exclusively to a single bank up to the whole Financial System. Overtime it included besides other debtors two more capabilities sharing information between lenders and to provide access to a database of information. Several international companies with the support of local banks established its businesses in emerging markets. However as well, several challenges affect these companies. As Lindenmayer (2005) explains, many countries for instances forbid Banks and Financial Institutions to share the positive information of their customers. For the previous reason, in these countries Credit Bureaus Companies usually sell its services former to Banks rather than Consumers, to promote a culture of credit. In this way Credit Bureaus appeared in emerging markets (Mexico included). Particularly in Mexico the main company is called Buro de Crdito a consortium of different entities, one of them TransUnion as its main shareholder (Buro de Credito, 2009c). This company is regulated under Mexican Laws of Credit Information, and audited by the SHCP (Buro de Credito, 2009b). Galindo & Miller (2001) explains that Credit Information obtained a major role in determining the probability of repayment hence the profitability of a loan. In this sense it is important information disclosure, however in Mexico as explained above, Credit bureaus are limited and this could produce adverse selection in credit market. In their study they comment that particularly in Mexico two factors are combined: Trans Union represents practically a
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monopoly in terms of Credit Bureaus, only other company offers the service with not a high coverage, and second, banking sector is highly protected to competence forbidding the interchange of information. It could be added that the Credit Bureau in Mexico was established in 1998 hence it has only ten years of existence. In this sense the question is how reliable is a Credit Bureau for a Credit Scoring. Galindo & Miller (2001) explain that there is not too much evidence and they conclude that it is a solution to provide historical information although is not the only option. However the CUB considers this as an important point and as it was explained before, it intends to provide a more dynamical solution to the customer current situation. In this sense in order to set the OCRG it has to follow the next table to the ARG. Basically from the report, the Relationship Managers or Analysts have to find the relevant credits and how many days are past due (if they are). Finally they have to find the equivalence in this table which is going to be the final OCRG which represent the Credit Risk of an Obligor:
Accumulated Risk Grade A1 A2 B1 B2 B3 C1 C2 D E
Days Past-Due
Current A1 01-14 A2 15-29 B1 30-44 B2 45-59 B3 60-89 C1 90-179 C2 180-365 D >365 E
A1 A1 A2 B1 B2 B3 C2 D E
A1 A2 B1 B2 B3 C1 C2 D E
A2 A2 B1 B2 B3 C1 C2 D E
B1 B1 B1 B2 B3 C1 C2 D E
B2 B2 B2 B2 B3 C1 C2 D E
B3 B3 B3 B3 B3 C1 C2 D E
C2 C2 C2 C2 C2 C2 C2 D E
D D D D D D D D E
E E E E E E E E E
Table 6
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Chapter 6 - Capital Allocation

6.1 Regulatory Reserves under CNBV Rules & Model There are some questions that are left after knowing the process to determine an OCRG, for instances, what does the OCRG tell to the stakeholders? What is the practical use of a Risk Grade? And more important, what is the relation of it with the Capital or Reserves? As it was explained in the literature review the intention of measuring risk is to determine the probability of default or the likelihood that a borrower will honour its debt or not. It is important to understand that the probability means potency whereas a defaulted borrower represents a fact. When a borrower is defaulted the bank does not have to cover a potential default they have to cover the loss, therefore, instead of increasing capital they have to decrease the profit. The previous statement have brought a debate in the sense that although a customer defaulted there have existed in some cases some recoveries that minimize the impact of the loss, why then should they cover the 100% of the debt when there is also a probability or rate of recovery? All previous ideas bring to the debate a basic question: what is the correct amount of capital that shareholders have to contribute in order to cover both regulatory (or an expected level of losses) and economic (or unexpected level of losses)? The answer is wide although is necessary first to determine the probability of default because when the probability of default is known, it becomes easier to estimate the amount of cash necessary to cover a loss. It is easy to set levels of Capital known as regulatory or the expected losses because authorities already set the requirements, however to understand the levels of unexpected losses, several banks use different methodologies as it will be explained later. According to the methodology followed by Banamex, the regulatory reserves are determined by two aspects, first the OCRG and the Recovery Grade, which is basically translated as the amount it could be recovered due to the guarantee of the loan in the
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event of default thus foreclosure of collateral. In the particular case of the OCRG it is related to a probability of default, the CUB establishes which is the probability of default in each of the OCRG scale therefore establishes which should be the reserve that each of this borrowers should have in the assumption that the facilities or loans they keep with the bank does not have any collateral or other possibility of recovery attached to it. This next table explains the percentages of probability of default.
Probability of Default
0% to 0.50% 0.51% to 0.99% 1% to 4.99% 5% to 9.99% 10% to 19.99% 20% to 39.99% 40% to 59.99% 60% to 89.99% 90% to 100%
Risk Grade
A-1 A-2 B-1 B-2 B-3 C-1 C-2 D E Table 7
However and in order to consider the probability of recovery due to foreclosure of collateral, each facility or loan hold by a borrower must be analyzed on a single-basis to determine the level of reserves required by each facility or credit line. It is common that a piece of collateral covers several facilities or that several collateral covers one facility, though not always the collateral will cover exactly the amount owed. In this sense two main concepts need to be differentiated in order to assess the reserves according to the factor of recovery: Exposed and Covered part. An Exposed part is simply the proportion of a loan that will not be affected by the foreclosure of collateral, whereas the Covered part is the proportion of a loan that will be recovered due to foreclosure of collateral. Facilities or Credit Lines will be reserved according to the level of risk they acquire after the analysis of collateral, thus the Exposed Part will be the
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same as the OCRG due that there is no other way to minimize a loss, whereas the Covered Part will vary depending on the priority and type of collateral. It is important to understand though, how the CUB describes the process in order to set the reserves for each loan. The first step is to set a level of risk that according to the VUB, it will be the OCRG. This means that all loans will initially be classified as the OCRG set for the borrower, following the model explained in previous chapter. If there is no collateral supporting the facilities, then automatically the facility will keep the OCRG as its level of risk, qualifying the loan as exposed, moving to the assessment of reserves. If not, then it will be differentiated the type of collateral, including generally the four following kinds: 1) Financial Institution or Governmental Guarantee, 2) Personal Guarantee, 3) Cash, Shares and Governmental instruments and 4) Real Estate. In the first two cases the Guarantee will be only considered if it covers 100% of the loan, as well as if the OCRG of the institution which is guaranteeing the loan is below B-3. For the last two cases it will be applied a percentage to the value of the Collateral, due to its level of liquidation. These values are from 50% to 100%. Each of them has their own rules of application: For the former it will be considered the OCRG of the guarantor as the line level of risk if it is lower than that of the Borrower. In the case of personal guarantee will only improve one grade the OCRG of the borrower if this is higher than the OCRG of the personal guarantee. In the case of cash and financial instruments, due that they are highly liquid they will have a value of 100% then the amount supported will be rested from the value of the loan to determine the Exposed and the Covered part of the loan (this last will get an A-1 grade). In the case of shares if they have high marketability then they will obtain a value of 70%. Finally in the case of shares of low marketability and real estate guarantee will only obtain a value of 50%. The same procedure should be done and each collateral value will be multiplied by its percentage of value and then it will be rested to the loan amount to determine both the Exposed and Covered part. In this sense it is important to clarify
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that the Covered part will increase one level of risk whereas the exposed part will keep the OCRG level of risk. Once obtained these two previous levels of risk then the facility or Credit Line will be reserved according to the following table:
Risk Grade
A-1 A-2 B-1 B-2 B-3 C-1 C-2 D E
Covered
Exposed
0.5000% 0.5000% 0.9900% 0.9900% 1.0000% 4.9900% 5.0000% 9.9900% 10.0000% 19.9900% 20.0000% 39.9900% 40.0000% 59.9900% 60.0000% 89.9900% 100.0000% 100.0000%
Table 8
As expressed and explained before Regulatory Reserves purpose is to cover the expected losses that a Financial Institution will incur due to its daily business operations. It is primary an insurance to certain events which basically intends to avoid a collapse in the Bank therefore in a Financial system. However two issues are related to this concept, its legal aspect therefore the obligation and strictness of its application hence generating a second issue, the methodology used to obtain the reserves. Several researches have been done regarding Basel II, however at this point it is important to understand that Mexico is not part of the G-10, and although Basel Accord is intended not to be a regulator but an entity to promote better practices, not all of these practices are acquired by Mexico (CNBV, 2004). For instances, although the CUB aloud the use of Basel II Techniques for capitalization, the General Methodology (not included in Basel II and as it was seen in previous chapter is for Banamex local requirements) is the main procedure to calculate the reserves. Nevertheless this dissertation intention is not to determine the difference and the benefits of both approaches but to describe the process of Economic Capital Allocation in Mexico and
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under Mexican rules, thus explaining the capital allocation which currently follows Banamex, and as it was being explained this model has two intrinsic disadvantages: 1) it is too rigid in its application not permitting too many adjustments, and 2) there is not too much literature explaining the model besides the CUB or the rules that guide it. However these are the rules and banks must comply with them.
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6.2 Economic Capital Allocation in Banamex In the previous chapter has been shown how Banamex calculates a level of risk or risk grade for the borrowers, according to CNBV framework or guidelines (only improving the obligor risk) to determine the probability of default of a Borrower. The probability of default then will be utilized to determine the level of reserves required depending on the value and type of collateral which represents the amount to be recovered. After evaluating both the Obligor and the Collateral, it will be obtained a percentage or factor which will then be multiplied to the balance of the loan. The result is called Regulatory Reserves or the minimum amount of capital required by the Authorities of Mexico and it is also considered the amount required to cover the Expected Losses. Regulators, authorities and banks agree that this algorithm is adequate to determine the amount needed to cover the defaults that occur in a daily basis in a bank. However, Banks are not only worried about these events. Economy has changed and that brings new challenges, hence new risks are taken. Unexpected losses, hence Economic Capital becomes relevant in several senses, for instance, because it will permit to be financially healthy, therefore have an image and reputation of strong and correctly managed. Economic capital then is not only an insurance to cover risks; it is also a measure of healthiness and good reputation. National Underwriter (2001) expressed that Economic Capital is the amount required to achieve as a targeted measure, the financial strength budgeted. The debate about what economic capital is, has been expressed in the literature review, then in this dissertation it will be used the empirical approach of Economic Capital or the amount required to cover the Unexpected Losses that is the definition that Banamex uses. To define Economic Capital is not a major problem as it is to measure it, or to assess it. The difference between Expected and Unexpected is an abstract concept as it is to know what will and what will not occur. Thus, if regulatory reserves represent what is Expected (which is actually a prediction), then, how to predict what is Unexpected? Or even more, what will be the impact? Guill (2004)
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supports this idea by expressing that Economic Capital was at the beginning a conceptual idea and an estimated number, and the gap between the model and the estimation was the ability to measure the Economic Capital, a gold mine for financial theoreticians and statisticians. In the literature review, on purpose, it was not included the (considerable amount of) approaches available nowadays to calculate and allocate Economic Capital, because it was important to understand first what Economic Capital is, and how it will be differentiated from the estimation of Regulatory Reserves. Hall (2002) summarized the approaches into four groups for Allocation of Capital: Regulatory Perspective, Debt Holder Perspective, Shareholder Perspective and Financial Distress. The Regulatory Perspective considers a justification of the allocation of Capital considering the rules but justifying the differences. The Debt Holder perspective suggests that Capital Allocation is done through the requirements set by Rating Agencies, to obtain certain grade. The Shareholder perspective is the use of Probabilistic Models, (Standard Deviations and Correlations between different risks), and Risk Valuation Methods. The Financial Distress approach is a focus on the tail of the loss distribution or expressed in a simple way focus on the effects of the unexpected losses. At this point it was interesting the assumptions done in order to understand how Banamex calculates Economic Capital. After explaining the concepts of OCRG and Regulatory Reserves under CNBV, a Regulatory Perspective would be an adequate and obvious solution. Though the Regulatory Perspective is based on Basel II rather than CNBV it could be assumed that either Banamex stressed the Risk Grades or stressed the Percentages of Reserves. If there was not a Regulatory Perspective then they could consider a Shareholder Perspective, by calculating the Mean of the reserves thus the Standard Deviation to determine a higher reliability in the loss distribution. However all of the assumptions were not accurate. Then, how does Banamex calculate its Economic Capital? Surprisingly Banamex does follow a Regulatory Perspective,
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however not based on the CNBV model instead it is based on the Basel II model. Besides they use a Shareholder Perspective to stress the PD used in the same model. In other words instead of using the regulatory reserves already calculated through the process described above, they adjust the OCRG to an Obligor Risk Rating (ORR) which represents the PD under the headquarters assumptions. The PD is stressed following the valuation and probabilistic model developed by Vacisek (2002), and then multiplied by the EAD and LGD. To express this mathematically, equation 2 has been improved as it is detailed in equation 4:
Where: UL= Unexpected Losses f(PD) = Probability of Default Stressed EAD = Exposure at Default LGD = Loss Given Default
Equation 4
The difference between the Basel II formula and the formula used by Banamex is the derivation of the PD, or in other terms, the stressing of the PD to increase the level of risk in order to determine the amount of total reserves. Burns (2005) express that although this model is commonly used to determine Economic Capital it is important to consider that Regulatory Capital (under Basel II) and Economic Capital are not synonymous. The reason to differentiate both concepts is that, although with this formula is possible to allocate both Regulatory Capital (again under Basel II) and Economic Capital, the purposes are different. One concept that helps to understand the difference between is called Confidence Level, which is the level of accuracy of the model in order to cover the losses that a bank could incur, and generally according to Smithson (2007) it is a figure of 99.97%. This means that none of their customers should have a probability of default lower than 0.03% in order to have a 100% of coverage of the distribution of probabilities.
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In order to be able to compare the model against the current model of Regulatory Reserves it will be explained the elements of the formula, to understand the relevance in the calculation of the Economic Capital. Regarding to Exposure at Default (EAD) this is basically the amount that a Borrower would owe in the event of default. According to Basel II (2004) it should consider On-Balance and Off-Balance loans, or in banking lexicon Outstanding and Commitments. The difference between this two concepts is simple: Outstanding are basically Term Loans whereas Commitments are those service and contingent lines (Overdrafts) not already drawn but could represent a potential debt because the bank is committed to lend to the Borrower. Bluhm et al. (2002) explain that in times of Financial Distress, Borrowers tend to use these lines and at the moment of default these lines become drawn and undrawn, for that reason Overdrafts should be considered in the loss analysis. As explained in the Literature Review, Basel has three approaches in the calculation of Regulatory Capital: The Standard, the Foundation-IRB and the Advanced-IRB approach. In the Standard and the Foundation-IRB approaches the EAD is set according to the rules of Basel which basically follows two main options, in the case of On-Balance loans they will be rested from the deposits available, in the case of OffBalance loans, only if they are not cancellable then they could be multiplied by a factor 75% to their value, whereas in the case of loans able to be cancelled they could be multiplied by a factor of 0%. In the Advanced approach each bank suggests the best way to determine both the Outstanding and the Commitments of each of the Borrowers though it has to follow certain rules for instance that the EAD will never be a number below the current drawn balance. That basically means that Outstanding will follow the Foundation approach, however in the case of Commitments, the banks are allowed to develop their own models, provided that those models are approved by the corresponding Authority. In the specific case of Banamex, they follow the FoundationIRB approach and it is important to remember that this formula is used as an
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alternative to calculate Economic Capital, and it is not the calculation of the regulatory capital under Basel II. Loss Given Default (LGD), has a considerable relevance as an element of the formula, however as Bluhm et al. (2002) express, there is little progress in developing models to determine it, mainly because is a new concept and has not been in the sight of analysts. Before discuss into depth the previous idea it is important to understand the concept of LGD. According to Bluhm et al. (2002) LGD is since a mathematical point of view the proportion of loss or one minus the percentage recovered of a loan in the event of default. In other words it is the amount that will not be recovered if a loan would default. Schuermann (2004) expands the concept explaining that loss given default is not only the value of the loan minus the recovery but it also includes, maintenance and workout expenses which should be rested from the recovery to produce a net recovery. LGD is then the proportion of recovery after all the expenses that the Bank incurs for maintaining a defaulted loan. To define LGD is not as difficult as it is to measure it and as Bluhms et al. (2002) express one of the reasons is the lack of internal information and databases of Banks available to determine it. To understand how LGD could be calculated two concepts are fundamental to be considered in order to determine the LGD: the Quality of Collateral and Seniority of Claim. The Quality of Collateral, as it was explained in the regulatory reserves, is basically the type and liquidity of it, or how easy is to convert it into a repayment of the debt thus decrease the debt. The Seniority of Claim is the grade of claim of the borrower assets by the lender. Although these two concepts are needed to determine the probability of recovery, they are not the only elements that have to be considered in the calculation. According to Basel II as well as in EAD, considers the three approaches. Under the Standard and Foundation-IRB approaches, Basel indicates that loans which are unsecured (or without collateral correctly documented or recognised) but have senior claims should set a LGD of 45%,
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whereas if the loans are subordinated then they should set an LGD of 75%. However on the case where loans are secured the LGD depends on several factors starting for the type of collateral (financial, real state, receivables, etc.), but limited to the minimum LGD that a loan can obtain. The advanced approach in LGD is the creation of models which relates several figures and variables into the concept of severity of loss under certain guidelines. As important is to consider these guidelines it is also to prove the reliability of the model, by explaining the methodology, using historical figures and all sort of information available for a bank or groups of banks, and also to develop calibration. Schuermann (2004) adds an interesting point, he expresses that LGD is not only related to Securitisation or Collateralisation, but also it has a relation between the EAD, or particularly the Undrawn Commitments, because it will affect the severity of loss or to be more precise the model should include how to predict how much of these loans will be protected by the two factors. All these elements should be considered when developing a model. However Banamex developed its own model, which is not disclosure really, because as explained before this calculation is not subject to Basel II supervising. From the model are obtained two figures 35% LGD for Corporate Loans and a 45% LGD for Small & Medium Enterprises (SME) regardless of their collateral (Corporate & SME are segments within the Commercial Bank, segmented mainly by the amount of turnover and the organisational structure). The last element of Basel II formula, the Probability of Default (PD) and how it is determined under Banamex approach has been widely discussed in chapter 5. However, it is important to remember that Basel under both IRB approaches (Foundation and Advanced) delegates the responsibility of determining the PD to the Banks, hence the models vary from bank to bank although there have been a considerable amount of efforts to homologate its calculation (Gordy, 2000) (Jackson & Perraudin, 1999) (Turnbull, 2000). However the information available for every bank
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varies affecting the development of models. And particularly in the case of Banamex they have opted to follow CNBV recommendations. Surprisingly again, Banamex, to obtain the amount of Economic Capital, does not use the PD of the CNBV methodology, instead they migrate the OCRG and the relevant financial information of customer to another system called Debt Rating Model (DRM), or the model used by Citi to determine an Obligor Risk Rating (ORR) thus this ORR is associated to a PD previously determined under the headquarters regulations. The details of migration are not relevant as it is to understand why they do this. But before moving into that analysis, up to this point it is important to remember what exactly this element brings to the formula. It has been explained the EAD as the amount owed (or that will owe) by a borrower in the event of default. Naturally, this is the amount that is on risk of being unrecoverable. But Capital or Reserves cannot be determined as 100% of probability of all loans being unrecoverable. A second element enters to judgment and it is the Severity of loss of a portfolio of the Bank. LGD provides a percentage of what historically and probabilistically has been the amount that a bank has lost in the event of default. If the EAD is multiplied by the LGD it will be the proportion of the loan that a Bank estimates that will loss for a loan, and as it was explained in Banamex it represents a 45% for SME portfolio and a 35% for corporate portfolio. For instance, if a loan has been determined to have an EAD of 100; it is a SME loan hence it will have a 45% of LGD, thus the expected loss of that loan will be 45 (100 * 45%). However, a point is missing and it is the probability that this expected loss occurs, or specifically the probability that a Borrower makes the bank incurs in that loss usually called the Probability of Default. As an example (and assuming that the PD is not migrated to DRM but exactly the same as proposed in table 8 where it will be considered the exposed part), if the customer from previous paragraph obtained and OCRG of B-1 or a PD of 4.99% then the Expected Losses would be 2.2455 (EL = 4.99% * 100 * 45%). Basel II (and a
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considerable amount of mathematicians and statisticians) considers that for a loan with these characteristics that should be the reserve. The question is how to differentiate these regulatory reserves (which are not required yet to Banamex as they follow CNBV) to economic capital? The answer is simple though it is not the procedure: to stress the PD, or in simply words to increase the PD to determine a higher probability of default thus increase the amount of reserves. At this point it is important to remember a basic idea: Basel I established that banks should have an 8% of reserves of the assets it was a number determined historically however it did not considered several factors that affect the probability. Due to changes in market, Banks started to develop models of assessing probabilities of default which could anticipate both the expected and unexpected losses, although these models should be competitive in terms of cost and pricing. Thus, Banks started to develop models of Economic Capital similar to the one that actually uses Basel II. These models should consider both aspects to represent to shareholders the lower cost to cover the expected and unexpected losses. This basically means that they have to develop accurate and precise models that will determine with higher level of confidence the probability of default of customers, therefore, the need to cover those probabilities in a precise way: not more, not less. The use of advanced and complex probabilistic and statistic models resulted in accurate measure to cover expected losses. Basel II takes this idea and tries to merge the Regulatory Capital into the Economic Capital. The previous idea is useful to understand that to stress a portfolio it does not only represent to increase the grade of a borrower because it will not show accurately which will be the unexpected losses. To increase the PD several models consider factors that could affect the Probability of Default. One model developed by Vacisek (1987), followed the previous idea and through derivations and correlations, he determined that
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the PD would be affected by the Country Risk, or the state of the Economy. In mathematical terms previous statement can be reflected as follows:
Where: p(Y) = Probability of default under a Economy scenario N = Independent Standard Normal Variables Y = Borrower exposure to Economy Factor p = Average Probability of Default 1-= Probability of Default of Borrower Equation 5
In order to understand how this formula works it is important to understand two aspects of this framework. First, according to Vacisek (2002) the Probability of Default is determined by the probability that the Value of Assets (A) of the Borrower decrease below the value of Debt (B) at certain point in time (T). He uses a cumulative distribution function which is a probabilistic model that calculates the probability that a random variable (in this case the Assets) obtain a value lower or equal than another variable (the Debt). Second the value of assets is affected by a common factor through a correlation, in this case an Economic Index, therefore the value of assets is derived considering the Country Risk Factor increasing the probability of lowering its value. The effect of the previous model can be seen with the example explained before, where the PD is originally 4.99%. When applying the model, it is supposed that the PD will increase to 6%, then the reserve will increase up to 2.7000 (6% * 100 * 45%). This amount represents the reserve for that loan including the Regulatory Reserves (2.2455) which is expected loss and the provision for unexpected losses (0.4545). The model thus concludes that unexpected losses are the increment of risk on a borrower related to the state of economy, and this supposition has been accepted widely for Financial Institutions. However, there is a trend to explain that the model can
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be perfectible in one way. The assumption that the Economy only affects the probability of default of the borrower is valid though incomplete. Sen (2008) expresses: there is strong empirical evidence, however, that default and recovery rates both vary with the economy (Sen, 2008, p. 1). The new assumption is that not only Probability of Default (PD) but also Loss Given Default (LGD) vary with the economy and therefore new models should be developed. However there is also evidence that LGD varies among the type of debt and the industry meaning that LGD responds in a different way to Economic Downturns. The model proposed by Sen improves the Vasicek model considering the variation of LGD (correlation) with the Economy. However this model is not used yet by Banamex.
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6.3 Comparison between Regulatory and Economic Capital In the previous section it was discussed the way that Economic Capital is calculated in Banamex, regardless of the calculation of the Regulatory Capital or Reserves followed according to rules of the CNBV. However, as the reader may have noticed, in this case it is hard to find the relation between the two concepts which according to the theory are intrinsically related, therefore, a question has to be answered: do these calculations really cover the Expected and Unexpected losses? The first conclusion would definitely be No, because the process of calculating the CNBV Regulatory Reserves does not include the variables recognized by Basel, therefore the calculation of Economic Capital, would be based on different aspects producing not really relevance on the Regulatory Capital, a conclusion based on the observation of the findings of the research but no really underpinned. Banamex has a different opinion of the situation as it will be explained. In order to develop a debate about the differences, worth it to understand the similarities among these two approaches if there is any. A first observation suggests that although the name of the variables is different, its concept and its raison d'tre are similar, though not the same. In other words whilst Basel II considers the PD, LGD and the EAD, CNBV considers a PD, an Exposure and a Recovery (exposure mitigation). In other terms, CNBV includes in its calculation all the premises of a calculation of Expected Loss. This CNBV calculation can also be detailed in a formula which will be used to compare it with the formula proposed by Basel II. The mathematical representation of CNBV Regulatory Reserves is on equation 6 and 7 because it considers two scenarios:
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if E > CV
if E < CV
Where: E = Exposure CV = Collateral Valuation PDU = Probability of Default Uncovered Part PDC = Probability of Default Covered Part Equation 6 & Equation 7
The collateral valuation refers to the type and value of it, as it was explained in section A of this chapter; the collateral appraisal is adjusted depending on the liquidity of it. This term considers current conditions of the foreclosure of that collateral under the market and legal situation of the country, in this case Mexico. As it can be noticed there are two formulas to avoid an under-reservation in the case that CV covers above the value of debt, because under Mexican laws, a bank has right over collateral only up to the value of the obligation. As a quick comparison the effect of the CV is the same effect as the LGD, considering that the LGD reduces the EAD to be reserved, whilst the CV considers the recovery of a particular loan. The first comparison that can be done is the EAD versus Exposure. The EAD, as it was explained in previous chapter, considers the Outstanding or Term Loans plus the Commitments multiplied by a factor of probability of drawn. For Exposure under CNBV, the same rule applies considering both Outstanding and Commitments. However, the difference rests in a simple element, the factor applied to Commitments. Basel II, as explained before, offers three approaches but basically the factor depends on the probability that an overdraft is drawn previous to a default. CNBV however expresses that the factor for Commitments should be a fixed percentage of 50%. This percentage seems more aggressive than the 75% proposed in the Foundation approach of Basel II however it is important to consider that this approach also considers irrevocable and
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revocable commitments. This means that whilst CNBV sets a 50% for all contingent loans, Basel II considers a 0% for revocable commitments and a 75% for irrevocable. There is no scientific or empirical evidence that for a bank the half of the loans are revocable and the other are not, neither in an average probability. Another important difference, although not as obvious as the previous one, is the effect of Accountability Principles to Classified loans. In USGAAP, even though a loan is not defaulted, it can be qualified as Non-Accrual, which in general terms means that every payment is used to reduce its exposure stopping the calculation of the interests. On the other hand, in PCGA, the calculation of interests follows independently of this qualification. If a payment is received by a Non-Accrual loan, in PCGA is applied to interests due and then to capital, whereas in USGAAP it is applied completely to capital. The Exposure will vary because these payments will reduce dissimilarly. A second aspect to be compared is the PD and the initial assumption is that there is no difference between the two approaches, because Basel delegates the responsibility of calculating the PD to the Bank, using their own statistical and probabilistic models. Hence the model proposed by CNBV would be the logic option to be used as the model to determine the PD, when calculating the Economic Capital, moreover, if it is actually used to calculate Economic Capital not Regulatory, therefore, not subject to approval. However, as explained before, Banamex migrates both, the OCRG and the Financial Information to a system called Debt Rating Model (DRM). The DRM is a computer software (as well as the VUB although on a stand-alone platform), that under certain assumptions, determines a level of risk. In other words this is other option to calculate a Level Credit Risk called the Obligor Risk Rating (ORR). This system is the standard internal model developed by Citigroup, and it is based on a scale of 10 numbers, running from 1 to 10, which the first 6 can be calibrated with a minus or a plus sign (depending on risk) to obtain a 22 grades scale (+1,1,-1...+6,6,-6...7,8,9,10). This model has been calibrated to probability of default slightly different from the CNBV,
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however, this model was initially developed using American industries and companies information. Two questions were raised to understand the process: why does not Banamex use the CNBV model to calculate the PD? And intrinsically related, why do Banamex use the ORR model? Two similar questions although under different approaches, the first question is answered with one phrase Corporate Governance. It is important to remember that Banamex is part of a conglomerate, in other words, it is a subsidiary of a Bank located and established in New York, not in Mexico. Thus, several regulations and policies are set by the Headquarters which in general intend to homologate the processes in order to reduce implementation costs. VUB is a model which is only applicable to Mexico characteristics and situations, whereas DRM is a more customisable model. The second question is almost answered although the fact that if it is customisable, has it been customised to Mexico characteristics? And the answer is indeed it has. There have been several efforts to migrate the information from VUB to DRM that all that information is used to calibrate the model. Thus, a final question was raised, because it is still a double function, and it was: why is not the ORR the standard for calculating the OCRG to determine the regulatory reserves? Even more if the CUB aloud the banks to present an own alternative to calculate the OCRG, and the answer is simple although not deep. The CUB offers to Banks that they can propose an own model to calculate risk. However this proposal is subject to approval and as anyone can suspect this model has been rejected, therefore not permitted its use as a PD model, although the reasons are particularly not revealed. The third aspect is far more difficult to compare than the previous two because, although for both the basic concept is the severity of loss, LGD is based on a probability model of all loans of a portfolio, whereas CV is an assumption of the amount to be recovered for a specific loan with a piece of collateral. Besides the approach from general to specific, certain kind of collateral are treated different: Whilst CNBV
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considers Cash as collateral, Basel considers Cash as an option to reduce the EAD, reducing as well as the base to calculate the reserves. It can always be argued that the final effects in both are the same however there is not academic or empirical evidence of this happening. Therefore this part is not as similar as it can be thought. Finally as expressed before LGD does not only consider the collateral but all the costs associated to obtain that recovery for a loan, in the case of CV, it considers the value of collateral and the factor is an average (not clearly defined its algorithm) of the costs that implies to foreclose that collateral. So how the calculations result in a number to calculate reserves for expected and unexpected losses? The answer is simple. To comply with authorities, Regulatory Reserves are calculated according to CNBV guidelines, however Economic Capital calculation is stressed, this means that besides including a Regulatory Reserves calculation (meaningless considering that previously was performed the CNBV calculation) which covers expected losses under a different model, it does also includes the calculation of unexpected losses. In other words for Citigroup there is more reliability on the model of Economic Capital which will cover both losses rather than calculate Regulatory Capital and then stressed them hence it is assumed that Economic Capital calculation will never been lower than that from the CNBV model. For CNBV this would mean that Banamex is over-reserved. This also means a bet for the future: To adopt Basel model for calculating the reserves in Mexico, but it will depend on the complexity of the Mexican Financial System.
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Conclusion
It has been explored in the case study how Credit Risk is calculated considering different aspects of risk that surrounds a borrower. These four aspects are commonly the important elements that will affect the performance of a company. However it is important to remember that these four aspects are only head titles for what intrinsically is analyzed in each of them. In Country Risk it is analyzed (although delegated to rating agencies) political, social and economical issues, as long as they are different from the country of the lender. In Obligor Risk it is analyzed, besides the financial figures of the customer among a particular period, the market, the structure and the competence. Industry Risk is a particular analysis of the key points that will determine if an industry has growing possibilities or is a mature market. Finally payment experience, analyze internal and external historical information about the behaviour of a borrower. The analysis of all of these elements and then an assignment to them of a weight or a grade which is combined will finish in a standardised qualification previously established by an organism which is in charge, besides other functions, of reviewing the correct estimation of risk. As well as rating agencies have a standardised scale of grades, the CNBV scale will help to the market and the stakeholders to understand what risk a borrower represents by holding a particular level or risk. Why to calculate the credit risk? There are several reasons hence implications. It is initially a tool to understand a borrower since an objective point of view. It is not anymore a simple and discretionary activity in which a relationship manager determined the quality of a borrower, which also implied that the relationship manager used his or her subjective perception to feel the probability of default. The calculation of credit risk becomes a measurement tool useful to compare a borrower with other borrowers with similar characteristics. It also helps tp approve or authorize the draw of a loan whether with an approval of an independent partner or of a committee because of more accurate or at least more evident information than the judgment. Besides this benefit, it also implies a way to determine the price, considering the law of cost-benefit,
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or particularly risk-profit. When a customer has low levels of risk is likely that every bank will try to lend him, although it produces a reduction in price or interest rate. While the risk is increasing the price will as well. So this is another implication of credit risk, it is used to determine the level of risk of a borrower, or what is called the probability of default. To know a probability of default has several benefits, but the most important is to understand the management required by that particular customer. A high risk customer will raise hot spots therefore will demand a different strategy or at least start to be prepared for a complicated scenario. Finally to understand the probability of default implies to know how much will be lost in the case of default, therefore it helps to determine the amount required to absorb a loss. The second part of the case study referred to this previous aspect, to determine the Capital or Reserves. Regulatory Reserves in first place are the minimum amount that has to be contributed in order to counteract the effects of a loss. They are determined following the rules set by a regulator, in this case the CNBV, which intends to keep healthy the financial system to avoid a financial crisis. These rules basically consider the Credit Risk (in the case of Banamex defined as OCRG) which is related then to a probability of default, however there are considered two more aspects: the exposure and the collateral. These elements will affect the effect of the probability of default as mitigating the amount that will be loss usually known as the Severity of Loss. At this point is important to remember that this algorithm is established as the general methodology applied to Mexico. However, it is different from that proposed from Basel II which is more related to concepts of Economic Capital. Both methodologies consider same aspects though the difference rest on the methodologies they use to quantify them. Basel II considers aspects of Economic Capital, which are the probability of default (PD), the loss given default (LGD) and the exposure at default (EAD). Whilst Regulatory Capital under Basel II algorithm considers these variables as they are,
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Economic Capital tries to be conservative by stressing the PD using an algorithm which considers the country risk, model proposed by Vacisek. Regulatory and Economic Capital have a major implication, their raison d'tre is to cover a Financial Institution or Bank for contingent events. This will in first place avoid losses and profitability and in second place keep them working and functioning. One of the main disadvantages of credit is that a loss in one loan should have to be recovered with several profits from other several loans, because the resources are the savings from retail banking or public and private investors. An interesting theorem of credit explains the previous argument and it is that if a bank has 10 loans of 10 each, with an interest rate of 10% they will generate a profit of 10 per year (not considering cost of money). If one loan defaults then it will be needed the profit of one year of the 9 loans left, plus the profit of one loan next year to cover the defaulted loan. This represents a catastrophic situation for the bank hence these events are what reserves intend to cover. Particularly two types of them, expected and unexpected. Expected events are covered by the Regulatory Reserves and usually they have a continuous occurrence whereas unexpected events are rarely situations although with a high impact. Economic Capital, in its calculation, intends to consider both events first assuming that variables are performing within a normal scenario or situation and then stressing the PD by considering a riskier scenario or deterioration of the economy of a country (systematic risk and correlation). When a bank has correct levels of capitalisation they avoid what will be explained in the next paragraphs since the bankruptcy to a complete economical crisis. The last but not least important aspect and implication of knowing, measuring and assessing both economic capital and credit risk, is the mitigation of a probability of default of the lender, the bank or the financial institution which can derive into an economical crisis. The subprime crisis is the perfect example in which it could be related the lack of assessing both concepts to counteract the effects of risk. Regarding
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to Credit Risk, in this dissertation has been explained that credit risk was primarily determined to evaluate if a loan should or should not be granted. Then credit risk is useful to determine the probabilities that these borrowers will repay their debt. Finally, it is an important element to determine the Economic Capital. Thus, was in the sub-prime crisis appropriately determined the risk inherent on this operations? Probably the answer would be not. According to Jagger (2008), besides others, the sub-prime crisis guilty falls on rating agencies which do not evaluated appropriately the debt and further more they did endorse it. Many researchers argue that the sub-prime crisis has its roots on a particular event and it is the cut of interest rate promoted by United States of America and the Federal Reserve System, despite the events that normally would force to increase them (Elliot, 2008). Diminishing interest rates or reducing the cost of money produced two events, easy access to loans hence low profits for a market which was becoming a commodities market: the credit market. The snowball created therefore is easy to understand and explain: easy access to credit created an increment in consumption, thus an increasing in prices usually named inflation, which was actually not sustained in real economic growth. But because of the need of banks for creating income and profits there was not really performed credit analysis which determined the risk that a bank was acquiring by lending as a bargain. Elliot (2008) expresses that many banks relaxed their requirements for granting a loan, furthermore, as Peston (2008) recounts, some companies were established which were lending without even consulting a credit information society such as Buro de Crdito detailed in chapter 5. Therefore the quality of these loans was really poor hence the risk really high. The reason to lend with these levels of risk was to create the amount of profits that shareholders were demanding at that time. But the cost was really high, although not explicitly considered at that time.
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Despite the idea of contempt of the risk associated with these loans, banks actually realized of them, so in order to manage and reduce the credit risk, hence reduce capital requirements which in somehow represent cost, they devised a way to pack these loans into credit derivatives which will be traded by bankers and which will be rated by Agencies as Jagger (2008) explains. She relates that in Bear Stearns (considered the parents) were created the Collateralised Debt Obligations by five mathematicians, which neither the executives nor the heads of banks did understand, however they were worried about if they were sellable, rather than the risk and the performance they had. Peston (2008) expresses another important factor that motivates the creation of these instruments, due as well as explained before, for the low interest rates: there was not any motivation for saving. In this sense, banks needed a way to raise funds therefore they packed these high risks assets in order to sell them, thus obtain money which will then be invested again. However, how these new instruments were rated becomes the most important element of failure therefore a wrong assessment of Credit Risk. Peston (2008) comments that rating agencies used historical data, or in other words, how many of these instruments have defaulted during its existence, and previous the crisis they were completely tradable but they did not defaulted. Thus this instruments obtained a AAA rating, which basically means that they were impossible (unlikely is more appropriate though) to default. There is the reason of why Credit Risk assessment becomes a crucial activity for becoming a healthy bank. And in this sense is how Economic Capital becomes a major issue on crisis events, in order to be a healthy bank. The credit crunch appeared when somebody realized that these instruments value were less (more less) than what banks and agencies valued them. Jordan et al. (2008) resume all capital injections that central banks did in order to keep the financial sector surviving. However as an example list, Lehman Brothers, BNP Paribas, Merrill Lynch, Citigroup, Northern Rock, Royal Bank of Scotland, UBS,
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Barclays among others, had inappropriate levels of capitalisation which produced in some of them the bankruptcy. The story is well known, as hard as it was to determine the subprime bonds risk, was as well for them to determine the amount of losses they had to assume. There was not a correct level of capitalisation because neither the expected nor the unexpected losses were correctly determined or at least known. Economic Capital would have considered the three elements explained before but none of them was. The sub-prime bonds have intrinsically two benefits for banks, new contribution of money and risk reduction by being qualified as AAA. This means that they were generating profits by reducing its level of risk therefore reducing their capital contribution and besides gambling with the probability that all the mortgage borrowers would or would not default. However they did, producing a collapse in the financial system and finally and economic crisis. And these are the reasons why both concepts are so important to be known by all actors, it is not simply a question of credit in an abstract world. It is the implication that has in the economic and financial system. If a bank does understand their risks they will be able to mitigate them, by employing the appropriate resources required, in the case, that another event such as the sub-prime crisis occurs again. Assessing appropriately the credit risk will imply that they know their customer and what they are betting, therefore they will also know how much money is required in order to keep to bank functioning and avoid as much as possible a bankruptcy.
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Appendices
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Appendices
Appendix A Vaciado nico Banamex
80
Glossary
Accival
Acciones y Valores was a stock broker house created by Alfredo Harp y Roberto Hernandez which bid for buying Banamex in the privatisation of Banks. Accumulated Risk Grade it is a temporal variable used in the algorithm to determine the OCRG each element will add its weight to this. One of the most important Mexican Banks currently owned by Citigroup. A group of central banks from the G-10. The first of rules of capitalisation which basically established a minimum amount of 8%. The new rules proposed by the Basel Accord which considered a dynamic methodology for calculating Capital. Banamex Risk Rating. The Grade obtained from the Obligor Analysis in the OCRG methodology. It is a particular grade for the borrower after analysing its quantitative and qualitative data. Comisin Nacional Bancaria y de Valores it is an institution in charge of reviewing several financial institutions processes in order to maintain financial system healthy. Circular Unica Bancaria it is a document that contains the rules that banks have to follow. Exposure at Default the amount owed at the moment of default it includes draw loans and commitments for drawing loans. Loss Given Default the prediction of amount that will be irrecoverable in the event of default. Obligor Credit Risk Grade the classification that a borrower obtains after being analyzed under the CNBV methodology. With cost, usually the banking debt, used to discriminate from the operative liabilities. Principios de Contabilidad Generalmente Aceptados these are the accountability principles applicable contained in several bulletins and circular as the minimum requirements to present financial information and other aspects in Mexico. Probability of Default, likelihood of an entity to fulfil its obligations. Secretara de Hacienda y Crdito Pblico is in charge of the taxation and fiscal policies of the country. Vaciado Unico Banamex is the software used to determine the OCRG or the level of Credit Risk.
ARG
Banamex Basel Accord Basel I Basel II BRR
CNBV
CUB EAD LGD OCRG Onerous PCGA
PD SHCP VUB

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Credit Risk and Economic Capital Allocation: a Mexican Bank Case

Miguel Angel Hernandez Solis 08007314 September 2009

Credit Risk and Economic Capital Allocation: a Mexican Bank Case

Credit Risk and Economic Capital Allocation: a Mexican Bank Case

Credit Risk and Economic Capital Allocation: a Mexican Bank Case

Credit Risk and Economic Capital Allocation: a Mexican Bank Case

Chapter 2 - Literature Review

Credit Risk and Economic Capital Allocation: a Mexican Bank Case

Credit Risk and Economic Capital Allocation: a Mexican Bank Case

Credit Risk and Economic Capital Allocation: a Mexican Bank Case

Credit Risk and Economic Capital Allocation: a Mexican Bank Case

Credit Risk and Economic Capital Allocation: a Mexican Bank Case

Credit Risk and Economic Capital Allocation: a Mexican Bank Case

Credit Risk and Economic Capital Allocation: a Mexican Bank Case

Chapter 3 - Research Methodology

Credit Risk and Economic Capital Allocation: a Mexican Bank Case

Credit Risk and Economic Capital Allocation: a Mexican Bank Case

Chapter 5 - Credit Risk Measurement The Obligor Credit Risk Grade

Analyze Credit Quality of Obligor

Mark Credit Variables of Obligor

Set and Obligor Credit Risk Grade

Credit Risk and Economic Capital Allocation: a Mexican Bank Case

Level of Risk Lower

Credit Risk and Economic Capital Allocation: a Mexican Bank Case

Payment Experience Analysis

Credit Risk and Economic Capital Allocation: a Mexican Bank Case

S&P AAA AA+ AA AAA+ A ABBB+ BBB BBBBB+ BB BBB+ B BCCC CC C D

CNBV Risk Grades A1 A2 B1 B2 B3 C1 C2 D E

Credit Risk and Economic Capital Allocation: a Mexican Bank Case

Quantitative Analysis Qualitative Analysis

Cash Flow Liquidity Gearing Profit and Activity

Management Competence Organisational Structure Shareholders Mixture and Decision Making

Credit Risk and Economic Capital Allocation: a Mexican Bank Case

>20% <=40% >40% Familiar

<=2.5% >2.5% <=20% <=30% <=30%

>30% <=35% >20% >30% <=35% >20%

Audit Not Cons.

Credit Risk and Economic Capital Allocation: a Mexican Bank Case

Credit Risk and Economic Capital Allocation: a Mexican Bank Case

Credit Risk and Economic Capital Allocation: a Mexican Bank Case

Credit Risk and Economic Capital Allocation: a Mexican Bank Case

Industry Risk Grade

Credit Risk and Economic Capital Allocation: a Mexican Bank Case

Accumulated Risk Grade A1 A2 B1 B2 B3 C1 C2 D E

Chapter 6 - Capital Allocation

Credit Risk and Economic Capital Allocation: a Mexican Bank Case

Credit Risk and Economic Capital Allocation: a Mexican Bank Case

Credit Risk and Economic Capital Allocation: a Mexican Bank Case

Credit Risk and Economic Capital Allocation: a Mexican Bank Case

Credit Risk and Economic Capital Allocation: a Mexican Bank Case

Credit Risk and Economic Capital Allocation: a Mexican Bank Case

Credit Risk and Economic Capital Allocation: a Mexican Bank Case

Credit Risk and Economic Capital Allocation: a Mexican Bank Case

Credit Risk and Economic Capital Allocation: a Mexican Bank Case

Credit Risk and Economic Capital Allocation: a Mexican Bank Case

Credit Risk and Economic Capital Allocation: a Mexican Bank Case

Credit Risk and Economic Capital Allocation: a Mexican Bank Case

Credit Risk and Economic Capital Allocation: a Mexican Bank Case

Credit Risk and Economic Capital Allocation: a Mexican Bank Case

Credit Risk and Economic Capital Allocation: a Mexican Bank Case

Credit Risk and Economic Capital Allocation: a Mexican Bank Case

Credit Risk and Economic Capital Allocation: a Mexican Bank Case