Basel II-Icaap And Other Topics


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Basel II-Icaap And Other Topics

  1. 1. Basel II ICAAP -Some thoughts and ideas 2008/10/ 30 Eric Kuo
  2. 2. Restricted ICAAP is a supervisory process mandated under Pillar 2… Taiwan, FSC has designed the guideline for banks to comply with.. Indicators Principle Risk Appetite Principle 1 行 略 High • 略 行 度 度 行 利 利 略 • Principle 2 行 度 略 行 略 立 • Risk Based Pricing 行 聯 量 • Limit Setting 行 易 • Principle 4 行 了 易 易 Level 易 • 行 易 易 立 Principle 5 行 行 • 行 易 不 行 • 行 行 Portfolio Concentration Risk Management 行 行 • ….. 行 立 理 Principle 12 行 不 降 • Stress Testing 行 來 Principle 13 力 Low 不利 度 行 行 暴 度 力 列 2008 Prepared by Eric 2
  3. 3. Restricted … here I’d like to share some of my ideas regarding the important components in ICAAP. As I am more focus on credit risk discipline, I ‘d use credit risk as illustration. Risk identification & 1. Type of risk a bank is facing measurement • Business risk • Economics risk • Liquidity risk Risk Capital • Interest rate risk Estimation • Reputation risk Risk governance • Market risk & organization • Operational risk Stress testing • Country risk • Concentration risk • …. Risk appetite 2. Here, I am referring to the measurement of credit risk • PD • LGD • EAD Risk management & control • Correlation among industries , countries, products or obligors Reporting & monitoring Capital management 2008 Prepared by Eric 3
  4. 4. Restricted Basel committee generates a general form of unexpected loss formula for banks to calculate the capital. –”a simplified version of EC”. Risk identification & 1. Rudimentary capital estimation approach measurement • Basel II Standard approach • FIRB approach Subtract EL • AIRB approach Risk Capital based Correlation Estimation provision Risk governance ⎡ ⎤ ⎡ ⎤ & organization 0. 5 ⎛R⎞ ⎢ LGD × N ⎢(1 − R ) × G (PD ) + ⎜ ⎟ × G (0.999 )⎥ − PD × LGD ⎥ − 0.5 ⎝1− R ⎠ Stress testing ⎢ ⎥ ⎢ ⎥ K= ⎣ ⎦ ⎢ ⎥ ⎣ ⎦ × (1 − 1 .5 × b ) × [1 + (M − 2 .5 ) × b ] −1 Risk appetite Tenor adjustment Risk management & RWA = K * 12.50 * EAD control Reporting & Capital = RWA * BIS Ratio monitoring Capital management 2008 Prepared by Eric 4
  5. 5. Restricted EC can be leveraged to prove internal capital adequacy, risk appetite, portfolio stress testing, capital allocation and limit management… EC has become a core of modern banking management. Risk identification & 2. Sophistication approach refers to the economic capital estimation measurement Loss Distribution 10% Risk Capital 9% Target Rating =A Estimation Cumulative 8% Risk governance Frequency 4.4% of probability & organization possibility result of Loss =99.9% 7% Stress testing in a ‘800’ potential loss 6% within 1 year 5% Risk appetite 4% 0.1% of possibility 3% the loss will exceed 2,000 Risk management & 2% control 1% 0% Reporting & 0 100 200 300 400 500 600 700 800 900 1000 1100 1200 1300 1400 2000 2200 monitoring $ of Loss Amount 500 Capital management EL Unexpected Loss = 2,000-500 =1,500 = Economic Capital 2008 Prepared by Eric 5
  6. 6. Restricted Stress testing is a process to identify and quantify potential low frequency with high impact stress scenarios for testing bank capital adequacy. Risk identification & 1. Identification of potential risk sensitivities and vulnerabilities measurement based on the comprehensive assessment of the bank’s risk exposures: • – By risk types Risk Capital • – By activities Estimation 2. Development, selection and prioritization of relevant stress Risk governance scenarios for testing and reporting based on identified risk & organization sensitivities, vulnerabilities and cross-risk/activity linkages. Stress testing 3. Quantifying the likelihood and severity of each scenario, and hence total risk. Classification and alignment of risks with business strategy. Benchmarking potential losses against capital Risk appetite adequacy. 4. Sophisticated macro-economy regression or econometric models are less intuitive and difficult to implement, due to • Data availability Risk management & control • Model complexity • Difficult to explain internal and externally • ..however it is a ‘goal’ to achieve. Reporting & monitoring Capital management 2008 Prepared by Eric 6
  7. 7. Restricted The Development Process of Stress Testing involves external data collection. Interest Rate on New Loans of Macroeconomi Five Leading Banks House Price c Index Lag3 Index Consumer Stock Price Unemployment Confidence Index HPI Rate Index Lag3 Lag1 House House Demand Index Supply Index • Third Stage • First Stage • Second Stage To execute stepwise regression Take the mortgage’s NPL% as To collect relative analysis,find primary macroeconomic observation variable to derive the macroeconomic data for variables Interest Rate on New correlation between NPL% and mortgage,quarterly data Loans of Five Leading Banks —lag3 macroeconomic’s change rate(the Unemployment Rate—lag1 same/lag1/lag2…etc) and monthly data. CTCB HPI—lag3 . 2008 Prepared by Eric 7
  8. 8. Restricted Expected result is to predict the potential credit loss. Business Environment - changes in unemployment rate(Lag1) Consumer Burden --- changes in Interest rate on new loans of Five Leading changes in NPL Banks(Lag3) Housing Prosperity --- changes in CTCB HPI(Lag3) Mortgage actual NPL% Mortgage Actual NPL% v.s Predict NPL% Predict NPL% 6% 4% 2% 0% 2008 Prepared by Eric 8
  9. 9. Restricted Frequent requested methods are event driven – what if the past events happen again. Asian Recent low Financial Dual card crisis SARS of the stock Crisis market Recent China bottom of the Missile Test housing 331 market earthquake 921 earthquake 10% 16 14.57% 14 8% 12 10 6% 3.86% 8 4% 6 2.42% 4 2% 2 1.72% 0% 0 1 3 1 3 1 3 1 3 1 3 1 3 1 3 1 3 1 3 1 3 1 3 1 3 Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q 95 95 96 96 97 97 98 98 99 99 00 00 01 01 02 02 03 03 04 04 05 05 06 06 2008 Prepared by Eric 9
  10. 10. Restricted Portfolio stress testing refers to the change of risk parameters and utilize the economic capital model to estimate the stressed economic capital. Simulation Approach - Illustrative CRE loss distribution output Risk Parameters Loss simulation model % of scenarios PD 50% In individual scenarios, for bps each entity 45% Tail of the 20 distribution Determine if defaults 40% 15 LGD If defaults, calculate loss as 35% 10 LGD * Exposure 30% 5 Sum across entities to 25% 0 determine portfolio loss 1.1 1.3 1.5 1.7 1.9 2.1 2.3 2.5 20% CRE losses $ BN 15% Correlations Repeat scenario 20,000x 10% PD – PD, PD - 5% Bank losses $MM LGD 0% EAD 0 400 800 1200 1600 2000 2400 Build loss distribution 2008 Prepared by Eric 10
  11. 11. Restricted The amount of EC held by a bank reflects the risk appetite of a bank. Identification of risk appetite is a considered as risk governance of a bank. Risk identification & 1. Bank hold economic capital to protect against unexpected loss. measurement EC links to bank‘s Probability of target rating Risk Capital loss ‘AA’ rating Estimation ‘A’ rating :Confidence of Loss Distribution :Confidence of =99.97% Risk governance & organization =99.9% Stress testing Better rating requires increased capital holding and Risk appetite demonostrates the appetite of a bank Credit Risk management & Losses control 0 Loss Tail Risk Expect Unexpected loss Reporting & ed loss = Economic Capital monitoring Regulator Capital is also used to cover unexpected loss.The Basel Comittee uses a general form of Capital management formula to proxy the UL 2008 Prepared by Eric 11
  12. 12. Restricted Risk appetite makes explicit how much risk the institution is willing to take. Winterthur Illustrative The bank’s current available Link to its target rating capital is sufficient to cover 99.97% 99.7% is equal to ‘AA’ ‘s potential unexpected loss. The possibility of loss amount exceeds the current available capital is 0.03% Sources: Credit Suisse analyst day presentation 2006 2008 Prepared by Eric 12
  13. 13. Restricted Identify the ‘RISK APPETITE ‘ means to ask ‘what is the maximum amount of loss that senior management team can endure’. Risk appetite metrics Metric Illustrative Definition Management options We target a Moody’s rating of ‘A’ on Granular measurement of Target debt 1 our senior debt, at all times staying ECAP rating above ‘A-‘ Top down decision Defines ECAP requirements Do not miss consensus earnings Quantitative stress testing of Earnings forecast by more than 10% at a 99% business plans 2 volatility confidence level We will aim to consistently target dividend of 2 dollars We do not wish to see a loss more Bottom up risk measurement Maximum 3 than 50 Billion at the 99% loss confidence interval 2008 Prepared by Eric 13
  14. 14. Restricted Stress testing is wildly used by best practices and serves as an important factor to decide risk appetite and also bank should demonstrate the financial health under stress scenarios. 2008 Prepared by Eric 14
  15. 15. Restricted Credit risk appetite is about to managing the risk/return trade off... A important decision of C-Level managers. Source: ANZ report 2008 Prepared by Eric 15
  16. 16. Restricted Key management tools includes Limit management, RAPM, capital allocation.. ..that also link to risk appetite identification. Risk identification & 1. Limit management measurement Bank can set portfolio limit based on stress testing results, the selection Risk Capital process is called risk appetite. Estimation Risk governance Estimated Profit/(Loss) & organization Scenario ‘Extra loss’ Capitalization Likelihood after stress Stress testing , 量行 Major economic Unexpected loss crisis in the , Risk appetite 行 BIS Ratio 1 in 20 years PRC, prompting a general 7 BN -2.7BN economic 9.4% 20年 Risk management & downturn across control the economy Stressed scenarios Real Estate Reporting & 1 in 20 years 5.7BN -1.4BN 9.8% Collapse monitoring Joint large group defaults – 99th 1 in 100 years 7.3BN -2.9BN 9.4% percentile Capital management 2008 Prepared by Eric 16
  17. 17. Restricted Applying the stress testing skill to find out the max loss tolerance and use this figure as the max loss tolerance...and the final decision will become ‘limit boundary’. Illustrative .. and stress the loss under different scenario to figure our the how much ‘extra EL‘ it may occur. Key to find a appropriate loss tolerance need to understand the Compare whether if the ‘extra EL’ can be absorbed by the current P&L… profit within 1 year or cumulative years of profits. Stress scenario and loss impact for Mortgage Mortgage Product P&L Limit Loss Tolerance Scenario Parameter Current Cumulative Profit Product Life Long EL 18.1 Implied a ‘0’ • Current market conditions Basel :3.5 Risk Adjusted Profit Total profit in 3 Extra EL - consecutive Based • Ave. PD increases EL 22.88 year 2007 3.5 26% • Conservative outlook Basel : 7 • 1 in 3 Year Recession Extra EL 4.77 • Ave. LGD EL 29.3 • Worse case Basel : 31.5 increases • 1 in 10 Year Extra EL 11.2 • Ave. PD LGD EL 31.3 • 921 Earthquake Basel : 66.5 increases • 1 in 20 Year Extra EL 13.1 2008 Prepared by Eric 17
  18. 18. Restricted Through the stress testing , we will have a picture on how much amount of loss will occur at what level of probability. The risk appetite is to ask if senior management can tolerant of. If they can then it become limit. Probability of loss BIS =10% 1 in 3 1 in 10 1 in 20 Scenario 1 4.7 Scenario 2 11.2 Scenario 3 13.1 Unexpected loss Expected loss Tail Risk Current Capital Consumption xxxx 18.1 89.9 Total Asset = xxxx 2008 Prepared by Eric 18
  19. 19. Restricted RAROC and Economic Profit extend the traditional ROE measure by incorporating risk. Risk identification & 1. RAPM is a core to understand the bank performance. measurement RAROC* Economic Profit Risk Capital Estimation Interest Income Interest Income Risk governance & organization – Funds transfer price – Funds transfer price Stress testing + Non-Interest Income + Non-Interest Income Risk appetite – Operating Expenses – Operating Expenses – Expected Loss – Expected Loss Risk management & control Risk-adjusted profit Risk-adjusted profit Capital – Cap Hurdle Rate Reporting & monitoring = RAROC (%) = EP ($) Capital management Capital can be Economic Capital or *Risk-Adjusted Return on Capital AIRB Regulatory Capital 2008 Prepared by Eric 19
  20. 20. Restricted RAROC is an important performance measurement for assessing if the risk / return is justified… Illustrative Return & Capital allocation Concentration Analysis-Industry Most of the lending business rarely can deliver risk Lending business will inevitable faces industry adjusted profit, banks require to cross sell more fee- concentration, though, bank need to balance the risk based income to compensate the risk taking and return. activities. Share of total RAROC 25% Share of loan Share of capital 20% A X-Sell 15% Cost of Capital A 10% 24% of 100% of Capital total capital 5% RAROC-Credit Asset RAROC-Incorporate Cross-Sell 0% A B C D E F G H I Note: Industry classification is based on Moodys’ classification. Reason of industry concentration risk: GDP of a country is usually relies on certain industry. 2008 Prepared by Eric 20
  21. 21. Restricted ..on the other hand, economic profit reflects the size of the value contribution. Illustrative Risk Adjusted Return On Capital Economic Profit •RAROC estimates the return over the invested capital •One advantage of economic profit or SVA over RAROC is and gives picture if the return exceed bank’s hurdle rate that EP reflects the size of the value contribution. (Chinatrust bank uses cost of capital). •Some transactions or segments may have large EP •Some transactions or segments may have higher RAROC transactions and businesses even though they may not have but limited investment opportunities. the highest RAROC values. Not the highest RAROC RAROC but contributed the most B B of the EP A A Cost of Cap 100% of Capital 80% 80 % of Cap Total EP of Cap Note : some uses the phrase SVA(Shareholder Value Added) instead of EP. EP = (RAROC – Cost of capital) * Invested capital 2008 Prepared by Eric 21
  22. 22. Restricted Understand current pricing based on rating is the first step to boost profitability. Average Breakeven Basis Point Average Pricing Analysis EP Hurdle Rate EL EL+OP Cost Margin Minimum pricing for EP =0 EL+OP Cost+ hurdle rate avg RAROC Hurdle Rate Minimum pricing for RAROC =0 Cross-Sell Margin Cost of Capital OP Cost Annualized Credit Spread Expected Loss Rating 2008 Prepared by Eric 22
  23. 23. Restricted Fast and transparency allows C-level to quick respond to the economic turbulence. Risk identification & 1. Reporting is a matter or efforts or database and MIS measurement 2. Once a bank has this capability, bank can conduct data mining to explore the behavior of obligor and use these information to design strategy Risk Capital Estimation Risk governance & organization Stress testing Risk appetite Risk management & control Reporting & monitoring Capital management 2008 Prepared by Eric 23
  24. 24. Restricted Ultimately, capital management will converge to risk management. Risk identification & 1. A mechanism of annual review for the risk budgeting can measurement facilitate the communication between FiCon ,Credit and BU. Risk Capital BU Credit FiCon Estimation Risk governance Assess the Business Plan & organization Business Plan on Estimate on Stress testing •Where to grow •RAROC for Pillar 2 •Limit control review •Expected EAD •AP •Expected EAD Risk appetite •Expected PD, LGD •Capital usage •Expected PD, LGD •Expected NII, Fee •Capital budgeting •AIRB Economic capital Risk management & estimation control Based on available capital Consolidate the view on Reporting & monitoring 1. Industry view for industry limit 1. Target EPS control 2. Capital raising ? 2. Stress testing to identify ‘risk 3. If provision is enough to appetite’ Capital management support BU expansion? 3. Past performance 2008 Prepared by Eric 4. Future profitability 24
  25. 25. Restricted The management team will have a better picture on how to re-allocate the limited capital through analyzing the relationship between RAROC and capital consumption. Illustrative = Industry or Line of Business Low Observation High Capital usage High •Usually the capital heavy users don’t y = -9E-11x + 0.5702 outperform the peers. R2 = 0.6437 •Higher the capital usage lower the RAROC, though the RAROC still exceed the cost of capital (hurdle rate) Contributed majority of Risk-adjusted Action can be taken : profit •Invest in high RAROC segments and RAROC increase return on the capital heavy Average RAROC of users. portfolio Challenge may face •Limited opportunities in high RAROC segments •Strong bargaining power in the capital Cost of Capital heavy users. Low Average allocated capital 2008 Prepared by Eric 25
  26. 26. Restricted The disclosure of RAROC to investors and to demonstrate the return of taking risk has become common. Moreover, it is an important part of future business planning . Return on economic capital and return on invested Demonstrate target income growth rate and capital shown by business segment RAROC.. Allows investors to distinguish between different risk- balance growth and return and as business return profiles planning Target Income growth rate Hurdle rate or cost of capital Note: Citigroup ‘s investor’s presentation. 2008 Prepared by Eric 26
  27. 27. Restricted ICAAP involve cross organization collaboration… and this is the ‘Risk governance and risk organization’ Illustrative Loss Distribution Responsibility Target Rating A CEO Board Member decides Risk Risk Appetite appetite based on the CSO EL bottom up information .. UL=Capital = Risk Appetite RBG Overseas ..Senior management CFO Industry/ Capital / Resource decides resource allocation CSO Allocation Product based on risk appetite… CBG CRO Limit Cap (Credit Risk) ..BU review Limit by CCO Industry/Products based on Limit Setting BU allocated resource….. Capital Industry/ ..Portfolio manager Manage the Portfolio as % of Product/ Concentration Risk to prevent CCO Management Total from catastrophe ... Produc ..through structured credit Return instruments, such as Hedge Hedge / Securitize Securitization Loan sell/CDS/Securitization. CCO Policy Must have decision process and Risk policy 2008 Prepared by Eric 27