Principles of default management in Investment Banks

11 January 2011

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The recent financial crisis has showed that even the biggest companies can endure hard times or even be forced to default. For banks, investment banks particularly, the management of bad debt, i.e. debt of companies in default, is a complex matter.

Default and the specifics of provisions

First, with a lot of companies weakened nowadays, let’s revisit what a company in default exactly is. As defined by the Basel texts, the default of a debtor occurs when one of the following three conditions is satisfied:

1.      A significant deterioration of the financial position of the counterparty casting doubt on its capacity to repay the total debt without verifying if appropriate measures such as offering guarantees are being taken. This first condition is subjective in nature and requires expert judgment.

2.      The backlog on an important debt exceeds 90 days (and is not caused by specific circumstances that are independent of the financial situation of the debtor).

3.      The counterparty is subject to a judicial proceeding (bankruptcy in Belgian law, Chapter 11 in the USA, etc.)

Note that the default status is only temporary: either the counterparty goes bankrupt, or it regains a sound financial position. Even if bankruptcy implies mostly a loss for the bank, the other alternative, a financial recovery, is not painless for the creditor either. In most cases it involves renegotiating debt, rescheduling short-term debt, a capital injection or even waiver of debt (including interests).

The most significant consequence of bankruptcy of counterparty is the creation of a specific provision for credit risk by the bank. The provision is an amount allocated to cover future potential loss of debt owed by the counterparty. The provision is specific since the probability of non-payment of important yet healthy debt is covered by collective provisions; bad debt needs to be covered by provisions specific to each defaulting counterparty. Finally the amount of the provision should be updated every quarter, as long as the counterparty is in default.

The other important process related to bankruptcy is the collection of losses and recovery. This process aims to identify with precision the amounts and types of recovery flows from the defaulting cases in order to enhance calculation and backtesting of the LGD (Loss Given Default), i.e. the expected loss rate on defaulting debt.

A complex process

While the process of default management is generally well developed and controlled in retail banks, the same doesn’t apply to investment banks for three main reasons. First, the large sums involved and the complexity of the cases, especially in structured finance, require internal expertise of the investment bank and therefore oppose any outsourcing of recovery management. On the other hand, the low proportion of bankruptcy cases in each bank makes it difficult to develop or enhance this process since it generates only a small profit. This process is therefore rarely fully developed. In terms of organization certain investment banks centralize default management in a specialized team, while in other investment banks defaulting counterparties are continuously followed by operational teams (Middle Office) in charge of the cases before they defaulted. Of course, in both cases the operational team works together with the financial management and the risk management.

The second organizational form (management of defaulting cases by Middle Offices which were already in charge of the case) should result in a better monitoring of risk since the Middle Office is familiarized with the counterparty and industry specifics. In particular, this may facilitate a subsequent restructuring. On the other hand, while the Middle Office knows the details of his case, he is not specialized in default management. This process is indeed generally poorly known and poorly anticipated being by definition exceptional. Moreover, most of the Middle Offices are not regularly involved in this process but only a few quarters, the period when one of their cases is defaulting. This lack of practice is even more problematic seen the complexity of the implicit tasks and are more oriented to accounting. In particular, the calculation of the provision amount should be made following several standards (BE GAAP, IAS) with specific rules for each standard (the IFRS applies stricter accounting regulation for provisions than BE GAAP).

Additionally provisioning is above all a decision related to portfolio management and falls therefore under general management. Thus, the historic data of defaulting counterparties allows defining an expected loss ratio, specific to the counterparty, as a function of its characteristics (nationality, industry, guarantees, etc.) But in practice, the final provisioning rates, specific to the counterparty, is a long discussion between the business line and the general management (which, depending on organizations, can be represented by itself or by the Financial Management or Risk Management). Indeed, for the business line, the impact of provisions is very important on all indicators (output, RWA, cost of risk) and for the management it is a possible means to drive results.

As a result of these lengthy discussions, in certain cases, the final decision will only be made at the end of the quarter leaving only a few days for the operational level in charge of provisioning to complete their work on schedule. Once the process enters the accounting process, it must be completed closely after the end of the quarter, the definition of the amount of provision requires however many round trips between the services involved, both for the validation of the level of provisions as for the decree of the commitment amount. This forces all players to begin their tasks far ahead (more than a month before the end of the quarter) and thus increase further the number of exchanges, because approximations need to be made of the situation at the end of the quarter several weeks before its deadline.

Finally, the number of actors on this process is the last hurdle: Risk Management, Financial Management, legal services, several business lines working on complex cases etc. Communication between all this entities is as difficult due to the two previous points: the exceptional nature and limited time.

Default management in investment banks implies a complex process and unlike in retail banks, it is difficult to develop and to outsource. In contrast, in investment banks, as elsewhere, it seems preferable to centralize these tasks. Centralization can take several forms: either within the business lines through a transverse Middle Office ( performing the tasks alone or in collaboration with the historical Middle Offices of the respective cases), or through an entity responsible for the overall management of counterparty default and litigation which can be a business line on its own or attached to Risk Management. In either way, the quality of the provisions and therefore of the indicators of the business line lies primarily in the involvement of operations in this exercise. Therefore, the task of default management can in no way be seen as a task with low value added but should rather be valorized by the management.

Sia Partners

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