Economic capital is…

Transcrição

FINANCIAL RISK MANAGEMENT
ECONOMIC CAPITAL AND THE INTERNAL CAPITAL
ADEQUACY ASSESSMENT PROCESS (ICAAP): PILLARS
OF MODERN OVERALL BANK MANEGEMENT
Dr. Roland Demmel
Athens, March 29, 2007
ADVISORY
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AGENDA
1. INTRODUCTION
2. RISK MEASUREMENT, AGGREGATION AND ADEQUACY
3. CAPITAL ALLOCATION AND LIMIT SETTING
4. PRICING AND PERFORMANCE MEASUREMENT
5. PORTFOLIO MANAGEMENT
6. OUTLOOK AND EXAMPLES
1
Modern Overall Bank Management considers all important bank
risks through Economic Capital hence being the basis for value
optimisation
Protection
Protection of
of
the
the bank
bank
Efficient
Efficient allocation
allocation
Risk-based
Risk-based decision
decision making
making
of
of resources
resources to
to
(e.g.
(e.g. pricing,
pricing, performance
performance
maximize
maximize returns
returns
measurement)
measurement)
How
How much
much capital
capital
What
What are
are the
the areas
areas for
for
does
does the
the bank
bank need?
need?
strategic
strategic expansion?
expansion?
••Risk
Risk appetite
appetite
••Efficient
Efficient capital
capital utilization
utilization
••Compliance
Compliance with
with regulatory
regulatory
requirements
requirements
••Common
Common basis
basis for
for comparing
comparing
strategic
strategic business
business areas
areas
••Protection
Protection of
of target
target rating
rating
••Measurement
Measurement of
-return
of risk
risk-return
relationship
relationship for
for product,
product, clients,
clients,
business
business units
units etc
etc
How
How should
should the
the bank
bank
price
price risk
risk and
and measure
measure
performance?
performance?
••Pricing
Pricing in
in line
line with
with risk
risk and
and with
with
markets
markets
••Pricing
Pricing reflects
reflects diversification
diversification
••Avoidance
Avoidance of
of unprofitable
unprofitable
business
business
•• Correct
Correct steering
steering signals
signals
2
Economic capital allows to integrate the views of all important
stakeholders of a bank from an economic viewpoint
The concept of economic capital is the most appropriate capital
concept for the purpose of many aspects in bank management
Regulatory
constraints
(Basel I, II)
Shareholders’
expectations
Creditors’
expectations
Capital
Management
(Economic and
Regulatory)
Strategic planning
Evaluation of solvency
P&L calculation
Risk management/ control
Capital allocation
Staff incentives
Objective: Optimisation of risk-return profile
3
On the other hand, the new regulatory framework (“Basel II”) lays its
focus on regulatory and economic principles of risk management
With Basel II, the Basel Committee abandons the 1988 Capital Accord’s “one-size-fits-all” method of
calculating minimum regulatory capital requirements and introduces a three-pillar concept that seeks to
align regulatory requirements with economic principles of risk management.
Basel II
Proposed changes to capital accord
Pillar 1
Minimum capital
Credit
Operational
Pillar 2
Supervision
Pillar 3
Market discipline
Market
Focus on Internal
Risk Mgt
Disclosure
Supervisory
Review
Risk Exposures
Minimum Capital
Capital Adequacy
Standardised
Basic
Standardised
IRB
Foundation
Standardised
Internal
IRB
Advanced
AMA
Intervention
4
Key guiding principles of Pillar II distribute duties to both the
regulator and the bank
Principle I
Banks require procedures to assess whether their capital is consistent
with the risk profile of the bank
Banks require a strategy for maintaining the capital level (Capital
Adequacy Assessment Process (CAAP))
Principle II
Bank supervisor authorities should check and assess:
Ö Procedures and strategies for implementing the first principle
Ö The ability of the bank to monitor and assure the regulatory capital
requirements
If the assessment is negative, the bank regulator should take
appropriate action
Principle III
Banks should maintain a capital buffer
If necessary, the bank regulator should enforce this buffer
Principle IV
The bank regulator should intervene at an early stage if there is any
risk to capital adequacy
5
Economic capital vs. regulatory capital: similarities and differences
Regulatory capital is…
To be held against an exactly defined risk
measure which is the same for all banks
Tier 1 and Tier 2 capital as defined by
regulators
Meant to ensure that a bank is able to cover
major potential losses without causing a
banking crisis
Economic capital is…
Anything that can absorb economic losses
without affecting debt holders
Not just book capital, but also includes
expected future profits or losses, hidden
reserves or charges and other reserves and
provisions
Necessary to absorb potential losses
associated with any of the risks already
assumed or to be assumed in the future
Regulatory capital management
helps to ensure the soundness and
stability of the banking sector and
protect depositors.
Economic capital management
helps to identify value-creating
business activities to satisfy
investors’ information needs, and,
with Basel II, to fulfill regulatory
requirements.
6
Different capital concepts have to be considered within modern
overall bank management to manage a bank efficiently
Available capital (AC):
“How much capital do I
have?”
Economic capital (EC):
“How much capital
do I need?”
• Equity-like capital the
bank can really use
for taking on risks
(risk taking capacity)
• Capital which the
bank has to earn a
fair return on
• Amount of capital
necessary to buffer all
unexpected losses
• EC based on internal risk
models and statistical
calculus
• To be compared with
equity and other balance
sheet items to ensure
capital adequacy
Net return
(in Mio. €)
Regulatory capital (RegC):
“How much capital does the
regulator want me to have?
Rating agency capital (RAC):
“How much capital do I
need for my target rating?”
• Amount of capital the bank
has to hold for market, credit
and operational risks
• Ratio - required capital vs.
capital endowment – defined
by supervisors
• Typically, more conservative
capital concept than EC
• Binding constraint for a banks
capital management!
• Amount of capital the rating
agencies would like to see to
support the desired rating
• Not only dependent on
regulatory capital ratio but also
on entire capital structure of a
bank
• Binding constraint for a banks
capital management!
Capital
(in Mio. €)
Error
level α
EC (confidence
level 1-α)
0
0
EC
AC
RegC
RAC
7
Elements of Internal Capital Adequacy Assessment Process
(ICAAP) and Economic Capital (ECAP) management
Strategy & Business Planning
Value risk of
holdings
ICAAP elements
Business risk
Risk taking
capacity
Credit risk
Capital adequacy
Operational risk
Economic
capital
Market risk
Real estate risk
Capital
allocation
& limiting
V
A
L
U
E
Risk adjusted
performance
management
Stress testing
Risk adjusted
pricing
Risk appetite
Liquidity risk
Unquantifiable
risks
Further elements of risk
management/economic capital
management
Risk measurement and management processes
Portfolio
management/
Strategic capital
management
M
G
M
T.
2
8
Capital adequacy requires continuous comparison of risk taking
capacity to overall risk measured by economic capital
Risikotoleranz
Risk appetite
Risk quantification
Market
risk
Operational
risk
Credit
risk
Wahrschein
lichkeit
Exp. Loss
Other
risks
Portfoliomodell
Valueat
Risk
Verlust
in%des
Exposure
Risk aggregation
Overall risk = ECAP
!
<
Risk taking capacity
9
ICAAP requires advanced measurement and management steps
Calculation
of overall risk
capital
requirement
Identification
and
measurement
of risks
Determination
of risk appetite
Setting of target
rating and risk
horizon
Risk taking
capacity
Determination of
components of
actual risk
bearing capacity
Risk bearing
capacity
check
Check of risk
bearing
capacity based
on comparison
of actual
situation and
business
planning
Risk strategy
and derivation
of
risk limits
Decision
regarding limit
structure and
derivation of
consistent limit
system
Business
planning
Planning of future
business and
associated risks,
derivation of risk
profile from this
planning
Evaluation and Reporting
Assumption and methodology
check
10
AGENDA
1. INTRODUCTION
11
Risk types and their measures according to Basel I, Basel II and Best
practice
Market (MR)
(MR)
Market
Credit (CR)
(CR)
Credit
Risk category
Basel I
Basel II
Yes,
Yes, but
but not
not risk
risk
sensitive
sensitive
Yes,
Yes, significant
significant
improvement
improvement
Country
Country risk
risk
No
No
No
No
Trading
Trading book
book
Internal
Internal model
model (VaR)
(VaR)
Internal
Internal model
model (VaR)
(VaR)
Other
Other
No
No
No
No
Equity
Equity
Yes,
Yes, but
but risks
risks
underestimated
underestimated
Yes,
Yes, significant
significant
improvement
improvement
Operational
Operational risks
risks (OR)
(OR)
No
No
Yes,
Yes, internal
internal model
model
possible
possible
Internal
Internal model
model (VaR)
(VaR)
Business
Business risk
risk
No
No
No
No
EaR:
EaR: Earnings
Earnings volatility
volatility
Risk
Risk aggregation
aggregation
Total
Total risk
risk
== MR
MR ++ CR
CR
Total
Total risk
risk
== MR
MR ++ CR
CR ++ OR
OR
Correlation
Correlation matrix,
matrix, factor
factor
model,
copulas
model, copulas
Counterparty
Counterparty risk
risk
Best practice
Integrated
Integrated modelling
modelling of
of
Credit-VaR
Credit-VaR
Integrated
Integrated modelling
modelling of
of VaR
VaR
12
Value-at-Risk (VaR) and Expected Shortfall (ESf) as market best
practise measures for most risk types
Risk tolerance
Methods:
z Variance-Covariance Approach
Use of co-variances of risk factors
z Historical Simulations
Use of historical scenarios for risk
factors
z Monte-Carlo Simulation
Scenarios for risk factors based
on structural model and pseudorandom sampling
Determination of confidence
level:
Determination of time
horizon:
z 99% level in use for many
z Normally, 1 year for all
internal market risk models.
z Derived from target rating
(e.g. 99,97% for AA).
z Maximum rating, so that VaR
or ESf < Risk taking capacity
types of risks and
products.
z Should be differentiated
according to monitoring
intensity and liquidity of
products/risks (e.g. speed
to unwind positions might
differ significantly).
VaR/ESf
VaR: Loss amount which will not be exceeded for given confidence level and time horizon
ESf: Expected amount that will occur if true loss exceeds corresponding VaR
13
Graphical illustration of alternative risk measures
ECAP is determined by:
z Value-at-Risk (VaR) or Expected Shortfall (ESf)
z VaR is more intuitive and widespread among practitioners, ESf has sounder theoretical properties
z Typically, a confidence level of at least 99%is applied
z Applicable time horizon should depend on time it takes to unwind a portfolio.
1%
Confidence level
99%
A
B
Loss
ESf VaR
(A=B)
Profit
0
z Increasing the confidence level increases VaR accordingly.
14
Determination of risk appetite is normally achieved by choosing a
target rating
Risk appetite = Probability that risk coverage buffers potential unexpected losses.
Risk appetite ~ Confidence level
≤
Overall risk
z Risk appetite according to target rating.
Rating (S&P)
Default probability (maximum)
Required confidence level
AAA
0,015%
99,985
A
0,060%
99,940
A-
0,070%
99,930
BBB+
0,110%
99,890
BBB
0,200%
99,800
z The amount of overall risk of the banking business (hence the amount of required risk taking capacity)
is influenced by risk appetite (confidence level in VaR and ESf concept)
15
Measuring and quantifying risks in a consistent manner is critical
105
104
LOSS
RATE
EL
Volatility
(Mean)
UL
•
•
•
•
••
UL
DM Appreciation
• •
••
•
ard
(Standard
on)
Deviation)
•
101
•
EL
100
•
99
98
97
•
•
••
••• •
2 Standard Deviations
•
•
USD Appreciation
96
95
Jan 87
TIME
•
•
RATE
103
102
•
•
Operational Risk
Market Risk
Credit Risk
Jan 88 Jan 89 Jan 90 Jan 91 Jan 92 Jan 93
TIME
Likelihood
of
Occurrence
EL
Likelihood
of
Occurrence
Position
Value
Distribution
Economic
Capital
EL
UL
UL
99.95% (‘AA’)
99.95% ('AA')
Economic Capital
Capital
Economic
Capital
0.00% 0.05% 0.10% 0.15% 0.20% 0.25% 0.30% 0.35%
LOSS RATE (%)
0
16
Excursion credit risk: one of the main input factors for credit risk
modelling is PD
Basel II credit risk parameters
Probability
of Default
PD
Probability of
default of the
borrowers in
each risk
category (rating)
on a one year
time horizon
Loss
Given Default
LGD
Loss after the
event of a
default
Exposure
at Default
EAD
Outstanding
amount at time
of default
Maturity
M
Remaining
effective
maturity of the
EAD
Regulatory
definition of
default event
Rating models are the means for PD estimation
17
Excursion credit risk: overview of the development process and
the requirements for a basic rating tool
Development path: three to twelve months!
I.
II.
Data
Data collection
collection and
and
preparation
preparation
• Determine default
criteria
• Cast all internal
defaults (> 50)
• Cast internal good
clients (2-3 * #bads)
• Cast and clean all
financial & qualitat.
information
Single
Single factor
factor
analysis
analysis and
and factor
factor
selection
selection
• Decide on factors
and compute them
• Analyze their
discrimination power
• Analyze their
correlation behavior
• Decide which ones
are useful
III.
MultifactorMultifactoranalysis,
analysis, ModelModeldevelopment
development
• Combine factors to a
multitude of potential
models based on
statistical models
• Measure model
performance and
robustness
• Decide on optimal
model
V.
IV.
Calibration
Calibration of
of score
score
values
values on
on the
the basis
basis
of
of probability
probability of
of
default
default (PD)
(PD)
• Measure portfolio
default rate over
historical business
cycle and check for
benchmarks
• Decide on which
default rate to use
• Calibrate model
• Validate results
Determination
Determination of
of
master
master scale
scale
• Initial guess of # of
rating clusters
• Define clusters by
mean PD
• Compute rating
distribution and
discrimination
• Change classes
until conclusion
reached
Bottle neck: data availability and quality based on poor credit processes!
18
Aggregating the single risks can be achieved with a couple of
methods
Effect
Business risk
Operational risk
Does not take into account
dependencies between
the risk types and
diversification effects
Credit Risk
Market Risk
Aggregation with joint
distribution of risks
(copulas)
Joint simulation of all risk types
via economic factor models
Takes into account
diversification effects
Business risk
Aggregation with
correlation matrix
Diversification
Operational
risk
Takes
into
account
different
risk
profiles
Credit
Risk
Allows
P&L
simula
tion
Total risk (EC)
Additions of values at risk
of different categories
Properties
Total risk
Methods
Market
Risk
19
Definition of risk-taking capacity and aggregation allows
continuous check of capital adequacy
Risk quantification
Market risk
Balance sheet capital
Operational
risk
Credit risk
Wahrschein
lichkeit
Exp. Loss
Other risks
Tier 1 capital
Tier 2 capital
Expected P&L
Portfoliomodell
Valueat
Risk
Subordinated
debt
Verlust
in%des
Exposure
Aggregation
of risks
Total economic capital
!
<
Risk-taking capacity
Capital allocation and definition of risk limits
Risk-adjusted performance measurement
Strategic planning (including capital planning)
20
Appropriate definition of risk-taking capacity is key to useful
capital adequacy check
Risk-taking capacity:
Capacity of the bank to absorb unexpected losses
without going out of business
Mio. Euro
Hidden reserves
(Forecast)
Expected future
profits
Free reserves
Own shares
Hidden
losses/charges
(Forecast)
„Free“
risk-taking
capacity
Accumulated
balance sheet
profits
Goodwill on
Participations
Subordinated debt
Open reserves
„Core“
„Core“
risk-taking
capacity
risk-taking
capacity
Equity
21
What to do if solvency criteria are not fulfilled?
Risk appetite, single risk measurement
and risk aggregation
Economic capital
>
?
• Option 1: increasing risk taking capacity by issuing equity or hybrid capital or
increasing other risk taking capacity components
• Option 2: reducing economic capital via reducing single risk types through hedging
activities, synthetic securitization deals etc.
• Option 3: changing risk appetite/confidence level
• Option 4: changing risk strategy (e.g. underwriting etc, works in the long-run only)
22
AGENDA
1. INTRODUCTION
23
Economic capital allocation is a precondition for distributing risk
properly across the bank
Economic capital
of a bank
= total bank VaR
Allocation to units as
a function of the
contribution of the
value at risk
Risk
capital
of unit B
Risk
capital
of unit A
Risk
capital of
unit C
The allocation of risk capital to its units aims at:
• Determining the profitability of the units relative to the risk taken (e.g. RARORAC, EVA).
• Providing key information for strategic decisions, the bank’s planning process, and the process of
setting risk limits to business units/ areas
Challenge:
To take the risk diversification effects (e.g. correlations) into account
24
Measuring and allocating the diversification effect is key within the
economic capital management process
Idea
Market risk
Distribution of the diversification
effect
Allocate capital
according
to stand-alone risk of
business units
Pro • Simple method
Risk of unit A
Credit risk
Total risk
Operational risk
Marginal contribution
Formula ECallocated(BUi) = EC(BUi) /
ΣEC(BUi) x EC(P)
Unit B
Business risk
Unit C
Real estate risk
Diversification
between units
Equity risk
Diversification
between risks
Pro rata allocation
• Easy to communicate
Contra • Sets wrong incentive for
risk diversification
especially for big BU’s
• Big BU’s will be rewarded
for their size, not their
contribution to risk
diversification
• Does not yield optimal
portfolio mix
ECallocated(BUi) = EC(BUi) x
∆EC(P) / ∆EC(BUi)
Allocate capital
according to the changes
in overall risk that a
business unit generates
• More complex method
• Harder to communicate
• Sets correct incentives for
risk diversification
• Contributes better to an
optimal risk-return portfolio
mix
• Computational effort still
controllable
BUi = Business Unit I, P = Portfolio
25
Potentials for capital savings can be demonstrated using a
simplistic example
Stand-alone EC
(99.9% VaR)
Business
Unit 1
Business
Unit 2
Business
Unit 3
Market risk
100
50
20
Credit risk
20
350
250
Other risk
60
50
100
EC without
diversification
180
450
Diversification
370
Al
EC after
diversification
Business
Unit 1
Business
Unit 2
81,0
40,5
16,2
Credit risk
19,0
331,9
237,0
Other risk
28,0
23,4
46,7
EC with
diversification
128,0
395,7
Credit
Risk
Credit
Risk
1
Market
Risk
Other
Risk
Market
Risk
Other
Risk
0.7
0.3
0.7
1
0.2
0.3
0.2
1
ion
t
a
loc
Business
Unit 3
Market risk
Correl.
matrix
EC without diversification
Capital saving
1000.0
823.7
17.6%
Capital saving Business Unit 1
28.9%
12.1%
18.9%
EC with diversification
Capital saving
300,0
26
Effective risk limit systems should be based on economic capital
=
Overall risk limit
Economic Capital Allocation
Trading
Loan Dept.
Allocated Capital
=VaR risk limit
Allocated Capital
=VaR risk limit
Break down to portfolio
VaR limits (99%,10day)
Transformation into
nominal amount limits
Portfolio
VaR limit
Portfolio
VaR limit
Portfolio
VaR limit
Nominal
amount limit
Nominal
amount limit
Dept. X
…
Allocated Capital
=VaR risk limit
Transformation into
operational limits
Nominal
amount limit
27
AGENDA
1. INTRODUCTION
28
Basle II parameters are the basis for modern overall bank
management
Value-Based
Management
VBM
Risk transfer
and portfolio
management
Risk aggregation
and allocation
(EC calculation)
EC Management
and Pricing
Portfolio Risk
Measurement
Basle II Risk
Measurement
Credit
Treasury,
Securitisation
Modeling asset/
default correlation
Probability of
Default (PD)
ACPM
Risk-based
pricing
Measuring
portfolio
concentration
Loss Given
Default (LGD)
Computing
portfolio loss
distribution
Exposure at
Default (EaD)
Expected
Loss (EL)
29
Proper Basle II parameter measurement lays a sound fundament
for risk-based pricing!
Pricing
Strategy
Maximum margin
Additional
Margin
Capital costs (CC)
Risk costs (RC)
Operating costs (OC)
Funding costs (FC)
CC = hurdle_rate x EC(PD, LGD, EaD, corr.)
=> Mostly Basle II dependent!
RC = Expected Loss (EL) = PD x LGD x EaD
=> Fully Basle II dependent!
OC = function of efficient credit processes
=> Partly Basle II dependent!
FC = function of IBOR and deposit conditions
=> Not Basle II dependent!
Conclusion: Three out of four important cost types rest on an accurate Basle II framework hence capability of pricing
itself critically hinges upon Basel II!
30
Evolution of RAPM approaches from pure volume to risk- and
value-based measures
Measurement
philosophy
Value driver
focus
Important
variables
Value focus
Risk focus
Revenue and
cost focus
Volume and growth focus

Profit
Total assets
Number of branches
…
60+
Margin
Process costs
DB
ROE
CIR

EP / EVA
…
Focus on value
driver
Expansion on
potential client
value

ROR
RORAC
VaR
…

"Need to stop looking through rear-view mirror and
start looking through the windscreen."
CFO, International Bank
70+
80+
90+
00+
10+
31
Performance Measures: RAROC in comparison with RORAC
Risk-adjusted return on capital (RAROC)
Return on risk-adjusted capital (RORAC)
z Quite comprehensive view at revenues and all
z Quite comprehensive view at revenues and all types
z Takes risk partially into account (via expected
z Takes portfolio risk into account (via ECAP)
types of costs
losses)
z But since it relates risk-adjusted returns to equity
(i.e. a book value) it falls short of reflecting overall
portfolio risk
of costs
z However, does not adjust return for risk that will
materialize almost surely (i.e. expected loss)
z It is a relative measure in that it does not tell anything
about real value creation
z It is a relative measure in that it does not tell
anything about real value creation
RAROC
RORAC
Net Return – Standard Risk Costs
Equity
=
Risk-Adjusted Return
Equity
=
Revenue – Operating Costs – Standard Risk Cost
Equity
=
=
REV – OC – SRC
Equity
=
=
Net Return
Economic Capital
Revenue – Operating Costs
Economic Capital
REV – OC
ECAP
32
Performance Measures: RARORAC in comparison with EVA
Risk-adjusted return on risk-adjusted capital
(RARORAC)
Economic Value Added (EVA)
z Comprehensive view at revenues and all types of
z Includes all relevant cost components to give an
z Takes portfolio risk into account (via ECAP)
z True value-oriented measure which allows the
costs
z Takes ex ante to be expected risk into account (via
expected loss)
economically realistic picture
quantification of additional shareholder value
z EVA equals "excess profit" i.e. the additional company
profit after capital costs
z It is still a relative measure of ex ante profitability
between business lines, products, customers etc
z Does not yet allow any conclusions in terms of real
value creation
RARORAC
EVA
=
Risk-adjusted return
Economic Capital
= Risk-adjusted income
=
Revenue – Operating Costs – Standard Risk Cost
Economic Capital
=(
=
REV – OC – SRC
ECAP
Risk-adjusted income
Economic Capital
- Economic Capital x Hurdle Rate
- Hurdle Rate)
X Economic Capital
RARORAC
= REV – OC – SRC – Hurdle Rate x ECAP
33
Decomposition into different cost components shows true economic
performance
Capital costs =
hurdle rate rh x risk capital
rrhh == rrff ++ β
βii ·· (r
(rmm –– rrff ))
Risk free rate
Market price of
risk
Market risk factor
Interest
and fee
income
Allocated risk capital
Operating
costs
Example
Risk
costs
rf = 3%
Capital
benefit
Capital
costs
(rm - rf) = 6%
βi = 1.5
rh = 12%
SVA
= Net value
contribution
after capital
costs
>> 00
== 00
<< 00
34
A simple example shows how economic value of different business
units can be assessed
RARORAC Calculation
Business
Unit 1
Business
Unit 2
Business
Unit 3
Allocated economic capital (in Mio
US$)
128
396
300
Risk-adjusted return (in Mio US$)
16
58
48
RARORAC = Risk-adjusted return /
Allocated economic capital
12.5%
14.6%
16.0%
Hurdle rate
12.0%
14.0%
15.0%
Economic Value
Economic value added (in Mio. US$)
0.64
2.56
3.00
has been increased
by 6.2 Mio US$
Economic Value Added (EVA) = (RAROCAC – Hurdle rate) * Allocated economic capital
35
What needs to be taken into account calculating useful performance
measures?
General issues: present value vs. periodical view and
consistency of numerator and denominator
Revenue
Determine and split the margin
- Operating Cost
Actual vs. standard costs, costs updated rg. Recent process
changes (SOX 404, Basel II)?
Measurement based on well-calibrated PD-/LGD-/EaDmodels?
- Risk Cost
+ Capital Benefit
Benefit related to risk-free invested, bonded Capital
= Risk-adjusted return
Determination of capital basis:
z Regulatory, economic or dual capital concept?
- Capital Cost
z Drawdown vs. allocated capital?
= Value Contribution
z Allocation of diversification benefits across business units? And
how exactly?
Determination of hurdle rate:
z Methodology (e.g. CAPM, Benchmarks)
z Differentiated or constant?
z Bonus/discount for using too few or too much capital?
36
RAPM allows a bank to compare the performance on a
business unit level...
The RAROC perspective can dramatically change the bank’s view of profitability at a business
unit level and places all lines of business or asset classes on a comparable common platform
Chart 1
RAROC vs. Cumulative Economic Capital (%)
Chart 2
RAROC vs. Total Value Added by Business Activity
Return on Economic Capital (RARORC)
80%
70%
e
ativ
r
t
s
Illu
60%
50%
Hurdle Rate
a
st r
Illu
1,500
A
tive
1,000
40%
B
30%
500
228
-
C
10%
1,367
AM
1,317
1,418
20%
Retail
Trading &
Treasury
ALM
D
-10%
0%
10%
20%
30%
40%
50%
60%
Wholesale
4,665
0%
0%
(500)
20%
40%
60%
Cumulative % of Economic Capital
80%
100%
(1,000)
RAROC [%]
37
... and on a customer level (1/2)
Understanding the typical risk adjusted customer profitability “skew” will result in
wider opportunities
170%
Cumulative
Profits
Today’s risks are
tomorrow’s costs
- Asset pricing
- Risk adjusted
profitability
100%
B
A
40%
• Get more !
C
70%
• Cross-sell
• Improve risk mgmt
and back office
efficiency
100%
• Get less
• Reprice
• Exit if possible
Cumulative
Customers
38
A risk-based profitability calculation reveals value-creating and
destroying activities
Net result:
Unit A – 100 k€
Unit B – 200 k€
Unit C – 50 k€
Profitability - RARORAC:
Unit A – 20.0 %
Unit B – 10.0 %
Unit C – 16.7 %
Allocated capital:
Unit A – 500 k€
Unit B – 2,000 k€
Unit C – 300 k€
Total – 350 k€
Total – 12.5 %
Total – 2,800 k€
CAPM
Hurdle rate:
15 %
Which unit
has generated additional
value for shareholders (SVA)?
In other words: Which unit has
created more value than expected
by the market? Or: Which unit
has earned more than the
hurdle rate?
• Unit B and the total bank have not earned enough – they have destroyed value!
• Units A and C have created value.
39
Successful bank management requires integration of performance
measurement into the planning process
Profitability - RARORAC:
Planning:
Unit A – 20.0 %
Unit B – 10.0 %
Unit C – 16.7 %
• Increase the activities of units A
and C.
• Increase the profitability of unit
B – otherwise scale back their
activities.
Total – 12.5 %
If necessary, adjust
bank’s capital or
otherwise the planning.
Units produce actual
fiscal year’s figures
within the allocated
limits
Adjust the risk limits allocated
to the units.
Compare allocated
limits with bank’s
capital
40
AGENDA
1. INTRODUCTION
41
Why is active credit portfolio management attractive and important?
Development of secondary markets:
Growing Markets
secondary markets
z Increasing product spectrum and increasing
standardisation
z Increasing complexity
4
3
Securitisations (Europe)
400
300
200
2
100
1
0
0
97
98
99
00
01
02
03 04
Source: British Bankers’ Association
Development of business environment:
CREDIT
TRADING
OBLIGOR
SALES
PORTFOLIO
MANAGEMENT
CREDIT
ANALYSIS
SECURITISATION
SECONDARY
MARKETS
z High capital requirements (regulatory, rating
•2004 scaled using semiannual data
•Source: European Securitisation Forum
ACTIVE CREDIT PORTFOLIO MANAGEMENT
due to volume/market share goals
competition
96 97 98 99 00 01 02 03 04*
New Business Models
z Low profitability of “classical” credit products
z Increasing profitability pressure via
Trillion €
z Increasing liquidity for credit products on
5
Trillion $
Credit derivates (global)
agencies)
z Risk-based management concepts
Portfolio optimisation via internal steering
impulses (ECAP allocation, risk limits etc)
Portfolio Optimisation via appropriate
secondary market transactions
42
Because active credit portfolio management can unleash massive
value improvement for a bank!
Active Credit Portfolio Management (ACPM)
Background
Components of ACPM
Different business models lead to portfolio concentrations:
Focus on multinational clients i.e. name concentration
Specialisation on single branches e.g. real estate financing
Concentration of local or regional markets e.g. smaller and
medium sized banks
Construction of efficient portfolios via reduction of portfolio
concentrations and better use of diversification effects
1. Intervention on single name level
2. Diversification via mix of credit derivates not yet sufficiently in
the portfolio
3. Securitisation of loans to release capital
Expected
Return
Two stage concept for value
creations:
Hypothetical
Efficient Frontier
Target
portfolio
Value creation
b) Transition
portfolio
a) Reduction of risk (thus capital)
through selling insufficiently
diversified credit exposure
a) Start
b) Possible investment in
alternative products to increase
expected returns at the same
risk corresponding to a more
Risk
efficient usage of released
(Standard deviation of return) capital
portfolio
43
The following example shows this clearly
Credit portfolio model
EaD Verteilung
250
200
Factor model with dependence structure of two
Obligors m, n in the sectors k, l and regions i, j
150
100
50
0
1
11
21
31
41
51
60
70
80
90
100
asset region
ρ mobligor
=
R
R
ρ
,n
k l k ,l ρ i , j
EaD (Millionen)
EaD: 1.500 loans with the overall amount of 33 billion €
PD: Average default rate of 0.9%
LGD: 40%
Expected loss of 174 million €
14%
12%
10%
8%
6%
PD Verteilung
6
6
7
7
8
5
1.
09
5
1.
19
4
1.
29
4
1.
39
3
99
89
79
69
59
49
8
9
150
39
0
200
9
0%
29
2%
250
19
300
0
4%
350
10
EL:
Portfolio Verlustverteilung
100
50
0
0,0% 0,5% 1,0% 1,5% 2,0% 2,5% 3,0% 3,5% 4,0% 4,5% 5,0%
PD
44
Different scenarios show how ACPM can significantly decrease
ECAP without changing the return resulting in increase of value
Start portfolio of a German Real Estate Bank
Regionally well diversified, but strongly concentrated on real estate sector
ECAP: 1.463 million EUR
Scenario 1
Scenario 2
Scenario 3
Market portfolio
A CDS position in the 5
other sectors is build up
amounting to 5% overall
EaD
EaD
EaD
Portfolio ideally diversified
over 6 sectors
UL: 1.439 Mio EUR
UL: 1.408 Mio EUR
UL: 1.335 Mio EUR
ECAP: 887 Mio EUR
ECAP saving: 2 %
ECAP saving: 4 %
ECAP saving: 9 %
ECAP saving: 39 %
Successive diversification of 5,
10 and 20% of EaD
Return
Ideal market portfolio
Start portfolio
Risk (ECAP)
0,61
0,94
0,96
0,98
1
45
Evolution of Portfolio Management I: “Reactive Controllers”
Loan portfolio resides within branches with all
revenues and costs accruing to them
+Revenues
E
Costs remaining with branches are:
Cost of capital
Branches
Risk costs
Operating costs
Costs/revenues from
hedging/diversifying investments
Hedge
Loan
Hedging
Origin.
Invest.
Overall value based performance distributed
between branches and CPM based on ex-ante
determined split
T.
M
A
Div.
Invest.
Branches naturally service the client
Credit Portfolio Management (CPM) executes
all hedges and/or diversifying investments
based on decisions of a respective committee
to keep economic and regulatory capital under
control
X
CPM
R
K
E
T
-All Costs*
Internal Risk
Assessment
Credit Market
Prices
No requirements on loan booking
CPM as cost centre
* Including hedge costs and revenues from diversifying investments
46
Evolution of Portfolio Management II: “Active Advisor”
Loan portfolio resides within branches with all
revenues and costs accruing to them except
for hedge costs and diversifying investments
Branch performance will still be measured
using “entire risk and profitability picture” and
will still naturally service the client
However, CPM has the mandate to manage
overall portfolio credit risk by taking hedging
and/or diversifying investment positions
Branches have to assure that given constraints
on economic and regulatory capital are being
fulfilled which should be reflected in their
metric
Not central loan booking necessary, but
“central shadow account” would be highly
desirable
CPM can be run as cost or profit centre
+Revenues
+Div.Inv.Rev.
E
Branches
X
CPM
Hedge
Loan
Hedging
Origin.
Invest.
T.
M
A
Div.
Invest.
R
K
E
-All Costs**
-Hedge Costs
Internal Risk
Assessment
Credit Market
Prices
T
** Excluding hedge costs and revenues from diversifying investments
47
Evolution of Portfolio Management III: “Credit Treasury”
CPM tells branch a transfer price (TP) for
every new loan
Revenues
E
The transfer price covers all costs if branch
were to take this loan on its book
The branch has now three options:
i.
If TP <= Net Margin (NM): accept TP
and lock-in a profit
ii. If TP > NM: accept deal and try to cover
shortfall by cross sales
Branches
Servicing
Fee
Loan
Origin.
Hedge
Transfer
Hedging
Price*
A
Div.
Invest.
R
K
E
All booked loans are mirrored to CPM but
formally reside with their origination unit
T
Transfer
The branch still services booked loans but gets
a servicing fee by CPM
Virtual loan booking still possible, but
implementing a central loan booking would be
the most elegant solution
T.
M
Loans &
iii. If TP > NM: reject TP and hence do not
do the deal!
Frequent controls ensure that the branch does
servicing correctly
X
CPM
Price
Internal Risk
Assessment
Credit Market
Prices
48
Potential risk and payment flow chart of an active credit
portfolio management
Margin Swap
Fixed comp. for actual margin
Various
geographies
Loan origination
(branches)
Actual margin
Financial guarantee
Internal Risk Transfer,
Transfer price
Credit Portfolio
Management
(CPM)
Central
location
Guarantee
• Client Relationship
• Asset Ownership
• Actual Margin
• Upfront fees
Client
• Securitisation
• Hedge
• Diversifying
investment
External
Market
•
•
•
•
•
Improved diversification
Control of Eco Cap
Control of Reg Cap
Hedge costs
Investment revenues
z The Guarantee transfers obligor default risk to CPM this removing the main credit risk from CRM at the
cost of a fixed transfer price
z The Margin Swap transfers credit risk dependencies on the margin thus removing negative incentives
with CRM
49
AGENDA
1. INTRODUCTION
50
Critical questions to be future best practise
• Are my risk measurement methods accurate and valid?
- Are rating and scoring models without patches, of strong discriminatory power
and correctly calibrated?
- Is there a back-tested internal market risk model?
- Is the operational risk model robust?
- Is risk aggregation useful?
- Does economic capital allocation preserve correct incentives?
• Are all risk management processes efficient and do they coincide with my corporate
governance rules?
• Am I able to account for operating costs correctly given that many processes might
have changed triggered by SOX 404 and Basel II??
• Am I able to correctly compute my capital costs and use it consistently for pricing
purposes?
• Do I have appropriate and timely updated risk and capital dashboards for reporting?
• Do I have a portfolio management unit/credit treasury including all tools, processes
etc. which is mandated to steer overall risk-return relationship of the bank?
51
Further aspects of future best practise in overall bank
risk management (I): ECAP measurement
Quantitative risk appetite:
z Correlations for calculating diversification benefit: avoid bulk correlations, measure tail correlations!
z If shape of loss distribution is assumed freely (e.g. Beta or Gamma), then at least from time to time
the loss distribution should be cross-checked by doing MC simulations of the credit portfolio
z This cross-check can result in scaling factor to correct biased loss quantiles of assumed distributions
z Mild (1 out of 7 years) and strong (1 out of 25 years) recession scenarios are fine, other scenarios
might be added, for example:
− Which loss would result in a dividend cut and how likely is it?
− Which loss would result in a downgrade of the external or internal rating?
z For such scenarios, one needs to works backwards by first assessing the monetary amount of the
loss and then using the loss distribution to assess its likelihood
Reporting on risk appetite:
z RAROC figures should be reported as well since they are the link between risk and return
z Loss magnitudes with their probabilities and likely consequences should be reported as well
52
Future best practice: Monthly Risk ‘Dashboard’ for CRO
– Illustration –
High-Level Reports for Group Risk
Risk Profile
Economic Capital
by BU and Risk
BU 1
BU 2
BU 3
Economic Capital
% of Limit
…
…
Market Risk
…
…
…
Op Risk
…
…
…
Credit Risk
Credit Risk
Market Risk
Credit Risk Econ. Cap.
Market Risk Econ. Cap.
Credit Risk
BU 1
BU 2
BU 3
ECAP
% Limit
...
...
Market Risk
BU 1
BU 2
BU 3
ECAP
% Limit
...
...
VaR by Business
Distrib. Across Internal Rating
25%
Top 10 Risks
Cmdy .
22%
12%
FX
E qui t y
14%
13%
7%
I R and Cr edi t Spr ead
6%
Description
1%
1
1
2
2
3
4
5
6
7
8
A ggr egat e
CGP
I R Der s .
FX
NY FI
I ns t . E qt y .
Rating
3
…
Distrib. Across Industry
VaR/Stress Limits
Exposure
RE
Power 5%Residential
4%
Media 12%
FI 5%
RE
Non-Residential 6%
Oil and Gas
13%
Telecom 7%
Aggr egate
Capital Adequacy
1 2
Capital
Requirements
Automotive 7%
Forestry
10%
Economic
Cap.
6
CGP
IR Der s.
FX
NY FI
Inst. Eqty.
Cable 12%
Chemicals 9%
Utilities
10%
Operational Risk
Industry Limits
1 0
8
Limit
Tier I and II
Cap.
Exposure
Limit
Op. Risk Econ. Cap.
4
2
0
Reg. Cap.
Media
Cable
Forestry
Automotive
RE Non-
Power
residential
Op. Risk
BU 1
BU 2
BU 3
ECAP
% Limit
...
...
53
Further aspects of future best practise in overall bank
risk management (II): ECAP management
Links between risk appetite and corporate planning process:
z Planning the business volume for the year to come, the following aspects should be considered:
− Quantity and quality (risk-return relationship) of new business
− Effects of maturing old business on portfolio composition
− Effects of migrating old (but still performing) business on portfolio composition
− Overall effect on EC and capital adequacy
− If capital adequacy might look like a problem, then risk appetite might be adjusted, old business
might be securitised or new capital might be issued
− Above all, one should work with scenario analyses here as well!
Documentation:
z It is becoming best practise for banks to have one unique document including descriptions of:
− Risk strategy (as an important component of the overall business strategy)
− Risk appetite
− Risk methodology
− Risk management
54
Some Excel-based examples
55
CV Dr. Roland Demmel
Name
z Dr. Roland Demmel (40)
Qualifications
z Roland is a Master in Economics and Engineering (University Karlsruhe) and holds a Doctorate in
Economics (University of Saarland).
z Methodology leader in:
− Economic capital modeling and performance measurement
− Credit portfolio management
− Simulation-based cash flow modeling for specialized lending
Experience
− Design of rating systems, scorecards and credit portfolio models
z In his consulting career, Roland conducted around 35 projects for banks, insurances, investment
and corporate companies in Austria, Belgium, Denmark, Germany, Kuwait, Luxembourg,
Netherlands, Portugal, Qatar, Russia, Singapore, South Africa, Switzerland and the United
Kingdom
z He worked on the following topics:
− Economic capital modeling and management
− Credit risk measurement and management
− Liquidity and market risk modeling
− ALM for insurances
− General risk management for banks and corporate firms
z Moreover, he has been an invited speaker at several conferences on financial, economic and
actuarial topics
56