4th SEACEN-ABAC/ABA/PECCPublic-Private DialogueThe Credit Risk EconomicCapital-Concept-Applications-ChallengeExperience Sh...
Restricted    Myself and my contact. Myself …                                                             My contact      ...
RestrictedBanks hold ‘Economic Capital’ (or “Risk” Capital) to protect against“Unexpected Loss”.                          ...
Restricted      Bank capital is reserved as a cushion to absorb unexpected loss.                                          ...
Restricted    Economic capital takes ‘diversification’ and ‘concentration’ effects into    consideration to gauge the leve...
RestrictedEconomic Capital has been evolved into many banking managementapplications.                                     ...
Restricted    Although there are many applications of Economic Capital developed in the    past decade, we consider the ke...
Restricted 1 Risk Governance of a bank : Determine risk appetite of a bank     The amount of EC held by a bank reflects th...
Restricted     Aiming at better rating, requires more capital and shows bank’s risk     appetite.                         ...
Restricted      Risk appetite makes explicit how much risk the institution is willing to      take.                       ...
Restricted     Banks need to design a process to demonstrate their capital adequacy     under the pillar 2.               ...
Restricted   2 Internal Capital Adequacy Assessment Process      Capital adequacy is typically shown from a regulatory per...
Restricted   3 Communicate with Rating agency      Rating agencies welcome EC disclosure.      Higher capital ratio doesn’...
Restricted     Bank can leverage EC to demonstrate the potential unexpected loss and its     related probability to the lo...
Restricted  4 Performance & investors communication      RAROC and Economic Profit extend the traditional ROE measure by  ...
Restricted         The disclosure of RAROC to investors and to demonstrate the return of         taking risk and as part o...
RestrictedUse of ‘Economic Capital’ requires time to build the confidence internallyand encouragement from externally as w...
Restricted    Our experience shows that the EC is lower than AIRB credit capital…                                         ...
Restricted     ..also utilize the ECap to identify the concentration risk .                                               ...
RestrictedWe are currently leveraging the AIRB Capital as risk adjusted measureinstead of EC.            RAROC*           ...
Restricted     RAROC is an important performance measurement for assessing if the     risk / return is justified…         ...
Restricted     ..on the other hand, economic profit reflects the size of the value     contribution.           Risk Adjust...
Restricted     Furthermore, the RAROC measure is utilized to identify if the obligors     added value to our shareholder. ...
Restricted       The management team will have a better picture on how to re-allocate the       limited capital through an...
Restricted   Internal capital management and performance management and based on   RC to align with external compliance. I...
Restricted  1    Accuracy of the EC measure      Understand your MODEL and what is the ASSUMPTION before further      appl...
Restricted2    The lower the EC the better ?     EC largely depends on the target rating a bank is aiming at.     Moreover...
Restricted3   Do investors care EC    Inevitably, investors look at simple indicator.    Requires time to communicate with...
Restricted  In sum, to encourage the use of EC requires continuous communication  externally and internally.              ...
RestrictedWe cannot direct the wind but can adjust the sail.Face the unpreventable risk.                                  ...
Restricted    Traditional commercial banking model relies on lending as ‘Entry product’    and aims at cross selling to de...
Restricted   Usually the low possibility of ‘Large unexpected loses’ not only wiped out   the profits but also results in ...
Restricted    ..and the credit crisis tends to be a cyclic event…    Examples of losses by financial institutions         ...
Restricted     ..that explains why the outcome of credit portfolio is asymmetric – A small     number of bad loan may wipe...
Restricted    EC estimation only exhibits the Unexpected Loss of a bank’s credit risk,    but the risk won’t disappear awa...
Restricted  Banks require to develop a mechanism to transfer risk and manage bank  capital.                               ...
Restricted   A new business model emerges through Credit portfolio management.                                            ...
Restricted   Portfolio theory suggests us that we can enhance portfolio performance by   re-weighting, and banks finally c...
RestrictedPortfolio Improvement is achieved by both reweighing existing exposureholdings and by hedging unwanted risk.    ...
Restricted..also aiming at improve the single-name credit risk management.                                                ...
Restricted   Our ultimate goal is to ‘Deliver a Stable and Sustainable profit growth for   investors and to sustain throug...
Restricted     The International Association of Credit Portfolio Manager established in     2001 to further promote the pr...
Restricted    Participants not only from commercial banks .Aareal Bank                               DZ Bank              ...
RestrictedIn sum, credit risk need to be accurate estimated, managed andtransferred.                                      ...
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Economic capital Management Experience Sharing

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  1. 1. 4th SEACEN-ABAC/ABA/PECCPublic-Private DialogueThe Credit Risk EconomicCapital-Concept-Applications-ChallengeExperience Sharing2008/08/18Eric Kuo
  2. 2. Restricted Myself and my contact. Myself … My contact l Eric is a credit portfolio manager at l 886-2-2722-2002 Ext : 1492 Chinatrust bank and responsible for the credit portfolio management. l Kaiyuan.kuo@chinatrust.com.tw l He has experiences on implementation of EC and its applications. l Eric also acts as lead contact and participates in IACPM (International Association of Credit Portfolio Managers) activities.Eric (Kai-yuan) Kuo l Before taking on his current role, Eric was involved in the strategic planning, databased marketing and datawarehouse. l Prior to joining Chinatrust bank in 1999, Eric worked for credit scoring model and cash card product development at one major retail bank in Taiwan. 2008 Prepared by Eric — CTCB Confidential 2
  3. 3. RestrictedBanks hold ‘Economic Capital’ (or “Risk” Capital) to protect against“Unexpected Loss”. AGENDA OF TODAY 1. What is Credit Economic capital is estimated to gauge the ‘Unexpected EC ? Loss’ of a bank’s credit portfolio. Economic capital is wildly utilized in all aspects of bank’s management. Three key management applications : l Risk governance 2. What is EC for l External communication l Internal management To promote and encourage the use of EC requires both of the 3. Our experience encouragement and continuous communication with regulators, and challenges rating agencies and equity analysts. Create value through manage credit portfolio to sustain through 4.Beyond EC ‘economic cycle’. ‘Delivering a Stable and Sustainable profit growth’ for investors. 2008 Prepared by Eric — CTCB Confidential 3
  4. 4. Restricted Bank capital is reserved as a cushion to absorb unexpected loss. Conceptual Generate risk parameters (PD,LGD,EAD) Bank capital (risk or economic capital) from historical loss data. is prepared as cushion to absorb the The expected loss estimation is the cost unexpected credit losses. of doing loan business. Target Capital is used to rating 1. Basel cover these Credit loss generates a Credit Loss extraordinary loss general form of Risk Appetite formula to proxy the Bank’s actual loss Risk ‘unexpected experience Unexpec- Average ted loss Capital loss’ and as credit loss capital requirement. 2. It might over or EL under estimated the Time Probability risk.Note : Expected Loss = PD*LGD *EADEL doesn’t necessary equal to the historical loss experience, due to the portfolio component may change. Prepared by Eric — CTCB Confidential 2008 4
  5. 5. Restricted Economic capital takes ‘diversification’ and ‘concentration’ effects into consideration to gauge the level of ‘UNEXPECTED LOSS’. Illustrative Total = 30 Total = 27 5 2CreditRegulatory Capital Regulatory Diversification Concentration - Economic Bank’s current Capital Effect- Benefit Punishment , due Capital available Requirement from correlation to concentrated on capital certain name , industry… Regulatory capital is the EC is the maximum amount of unexpected lossesDefinition minimum amount of capital to potentially arising from all sources that could be meet regulator’s request absorbed while remaining solvent, with a given level of confidence over a given time horizon. 2008 Prepared by Eric — CTCB Confidential 5
  6. 6. RestrictedEconomic Capital has been evolved into many banking managementapplications. AGENDA OF TODAY 1. What is Credit Economic capital is estimated to gauge the ‘Unexpected Loss’ of a bank’s credit portfolio. EC ? Economic capital is wildly utilized in all aspects of bank’s management. Three key management applications : 2. What is EC for l Risk governance l External communication l Internal management To promote and encourage the use of EC requires both of the 3. Our experience encouragement and continuous communication with regulators, and challenges rating agencies and equity analysts. Create value through manage credit portfolio to sustain through ‘economic cycle’. 4.Beyond EC ‘Delivering a Stable and Sustainable profit growth’ for investors. 2008 Prepared by Eric — CTCB Confidential 6
  7. 7. Restricted Although there are many applications of Economic Capital developed in the past decade, we consider the key management applications are as follows: Key applicationsThe most commonapplications of economic 1 Risk Governance : Determine risk appetite of acapital are as following : bank 1 l Demonstrate the desire rating of a bank which shows Risk Governance : the risk appetite… l …and therefore, determine the amount of Economic Determine risk Capital that required to hold for protecting ‘Unexpected appetite of a bank loss’ . 2 Internal Capital Adequacy Assessment2 3 Process : Pillar 2 compliance Internal Capital l Utilize the EC to compare with the regulatory capital Communi- and to illustrate the sufficiency of solvency. Adequacy Access- cate with 3 Communicate with Rating agency menet Rating l Capital ratio doesn’t have a direct link to bank’s rating. Process agency l Rating agency welcome more information to – Pillar 2 demonstrate the transparency of the risk. compliance 4 Performance & investors communication4 l RAPM :To gauge the return over the risk of line of Internal Performance business Management & l Use a basis of capital allocation and strategic decision process. investor communication l Limit Setting / Pricing 2008 Prepared by Eric — CTCB Confidential 7
  8. 8. Restricted 1 Risk Governance of a bank : Determine risk appetite of a bank The amount of EC held by a bank reflects the risk appetite of a bank. Illustrative EC link to bank‘sProbability of target ratingloss ‘A’ rating ‘AA’ rating Loss Distribution :Confidence of :Confidence of =99.9% =99.97% Better rating requires increased capital holding and demonostrates the appetite of a bank Credit Losses0 Loss Tail Risk Expected Unexpected loss loss = Economic Capital Regulator Capital is also used to cover unexpected loss.The Basel Comittee uses a general form of formula to proxy the UL 2008 Prepared by Eric — CTCB Confidential 8
  9. 9. Restricted Aiming at better rating, requires more capital and shows bank’s risk appetite. Bank’s Loss DistributionFrequency of Loss 9% EL may be Target Rating 8% sufficient to =A 7% cover the loss within 1 year PD=0.1%Target Rating 6% at 64% of =A+ 5% probability PD=0.04% Target 4% Rating =AA Max loss with 0.01% 3% PD=0.02% of possibility, happen once in 2% 10,000 years 1% $ of 0% Loss 300 E Amount EL EC = 100 Tail risk Regulator Capital 120 EC = is also used to cover unexpected loss.The Basel Comittee uses a EC = 130 general form of formula to proxy the UL 2008 Prepared by Eric — CTCB Confidential 9
  10. 10. Restricted Risk appetite makes explicit how much risk the institution is willing to take. Winterthur Link to its target rating The bank’s current available capital is sufficient to cover 99.7% is equal to ‘AA’ 99.97% ‘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 — CTCB Confidential 10
  11. 11. Restricted Banks need to design a process to demonstrate their capital adequacy under the pillar 2. Pillar I Pillar II •Capital calculation’s primary purpose Principle 1: Banks should have a process for is for regulatory minimum, not bank assessing their overall capital adequacy in relation to their risk profile and a strategy for capital planning and risk maintaining their capital levels. management minimum. Principle 2: Supervisors should review and •Pillar 1 not tailored to institution’s evaluate banks’ internal capital adequacy business mixes, strategies and risk assessments and strategies, as well as their appetites. ability to monitor and ensure their compliance with regulatory capital ratios. Supervisors should •Taiwan regulator considers the IRB take appropriate supervisory action if they are bank should develop EC not satisfied with the result of this process.Note: some banks or regulators are considered EC as Pillar 1. 2008 Prepared by Eric — CTCB Confidential 11
  12. 12. Restricted 2 Internal Capital Adequacy Assessment Process Capital adequacy is typically shown from a regulatory perspective and by comparing EC with available book equity. Illustrative Example of Credit Suisse n Breakdown of economic capital by risk type, showing diversification benefit n Historical comparison shows like-for-like evolutionSources: Credit Suisse annual report 2005 2008 Prepared by Eric — CTCB Confidential 12
  13. 13. Restricted 3 Communicate with Rating agency Rating agencies welcome EC disclosure. Higher capital ratio doesn’t necessary lead to a better rating. Tier 1 capital ratio by S&P rating Observation Capital ratio is one of the rating criteria. Higher ratio doesn’t necessary rated a better grades. • Capital ratios are only one of multiple factors taken into consideration by ratingTier 1 ratio agencies Some A+ rating13% banks have higher • Agencies reward EC disclosure :12% tier 1 ratio than Moody’s* has revised their rating AAA’s methodology and welcome the disclosure11% of economic capital, stress testing and10% earning volatility. 9% • Historically, capital ratios have been inversely correlated to ratings – with 8% highly rated banks being more leveraged 7% Upper quartile than lower rated banks. 6% Average • Factors that rating considers important : 5% Wider range of 1. Extensive franchise Lower quartile Tier 1 Ratio 4% 2. Diversified business mix AAA AA+ AA AA- A+ A A- BBB+ BBB 3. Strong risk managementSource :Mercer Oliver Wyman analysis based on a sample of 160 banks in 2003 obtained from Bankscope 4. Stable, predictable earnings * : Moody’s Special Comment: Risk Disclosures of Banks and Securities Firms, May 2006 2008 Prepared by Eric — CTCB Confidential 13
  14. 14. Restricted Bank can leverage EC to demonstrate the potential unexpected loss and its related probability to the loss. Illustrative Bank’s Loss DistributionFrequency of Loss 9% EL may be 8% sufficient to cover the loss Current S & P 7% within 1 year Rated bank as 6% at 64% of ‘A’… 5% probability .. But given Bank’s 4% current available 3% capital, it is sufficient to AA 2% rating 1% $ of 0% Loss Amount EL Economic Tail risk Capital AIRB Capital Bank Available Capital 2008 Prepared by Eric — CTCB Confidential 14
  15. 15. Restricted 4 Performance & investors communication RAROC and Economic Profit extend the traditional ROE measure by incorporating risk. RAROC Economic Profit Interest Income Interest Income – Funds transfer price – Funds transfer price + Non-Interest Income + Non-Interest Income – Operating Expenses – Operating Expenses – Expected Loss* – Expected Loss Economic Capital Attributed in Risk-adjusted profit Risk-adjusted profit relation to risk ÷ Economic Capital – EC × Hurdle Rate Hurdle Rate = RAROC (%) Bank’s minimum = EP ($) Return on Capital *Risk-Adjusted Return on Capital EC = Economic Capital* : Some banks have implemented credit transfer pricing and utilize the CDS price tohedge the credit risk. If it is fully hedged through CDS or similar instruments the ECwill be zero. 2008 Prepared by Eric — CTCB Confidential 15
  16. 16. Restricted The disclosure of RAROC to investors and to demonstrate the return of taking risk and as part of business planning.n Return on economic capital and return on n Demonstrate target income growth rate and invested capital shown by business segment RAROC..n Allows investors to distinguish between different n ..to balance growth and return and as business risk-return profiles planning Note: Citigroup ‘s investor’s presentation. 2008 Prepared by Eric — CTCB Confidential 16
  17. 17. RestrictedUse of ‘Economic Capital’ requires time to build the confidence internallyand encouragement from externally as well. AGENDA OF TODAY 1. What is Credit Economic capital is estimated to gauge the ‘Unexpected Loss’ of a bank’s credit portfolio. EC ? Economic capital is wildly utilized in all aspects of bank’s management. Three key management applications : 2. What is EC for l Risk governance l External communication l Internal management To promote and encourage the use of EC requires both 3. Our experience of the encouragement and continuous communication and challenges with regulators, rating agencies and equity analysts. Create value through manage credit portfolio to sustain through ‘economic cycle’. 4.Beyond EC ‘Delivering a Stable and Sustainable profit growth’ for investors. 2008 Prepared by Eric — CTCB Confidential 17
  18. 18. Restricted Our experience shows that the EC is lower than AIRB credit capital… Illustrative Capital Comparison* Unit : % 100 15 9 91 20 65 RC Corporate Retail - Retail - Diversifica- Credit Bank’s (AIRB**) Banking Secured Unsecured tion EC**** Available effect *** Capital* Illustrative only, the figures show here not represent for the actual information or current situation.** Chintrust internal aim at 10% of BIS Ratio.*** Diversification effect comes form correlation-different classes of asset won’t default together.****While estimating the EC, Chinatrust bank target at Global ‘A’ for EC calculation. 2008 Prepared by Eric — CTCB Confidential 18
  19. 19. Restricted ..also utilize the ECap to identify the concentration risk . Illustrative Industry ConcentrationThe chart exhibits theindustry concentration risk. EC = RCIf the EC is equal to the EC > RC illustrates the demonstrates the risk For the industries that ECAIRB Cap which means the higher risk or is properly expressed > RC, Banks need to digrisk is properly identified by concentration risk in UL under Basel 2 into further to understandusing the Basel 2 capital context. formula. theformula, as shown in the ‘B’industry. -Profitability AHigher EC than RC, for -Industry outlook EC > RC Zoneexample the ‘A’ industry, B -Relationshipillustrates the the AIRBcapital is under-estimate the Economic Require -Business strategycapital and also is an good to Capital before taking action. Reduce Opportunityillustration of ‘Concentration risk to IncreaseRisk’. exposure risk For those industries thatThe causes of the exposure EC<RC:concentration effect may Banks can considerresult from : expansion after consider•Larger ‘exposure’ EC < RC stands for -Industry outlook•Rating the UL is lower than•Recovery rate of collaterals Basel 2‘s . -Market size•Net interest income AIRB Capital -Cross-sell opportunity•Correlation…of certain industries 2008 Prepared by Eric — CTCB Confidential 19
  20. 20. RestrictedWe are currently leveraging the AIRB Capital as risk adjusted measureinstead of EC. RAROC* Economic Profit Interest Income Interest Income – Funds transfer price – Funds transfer price + Non-Interest Income + Non-Interest Income – Operating Expenses – Operating Expenses – Expected Loss – Expected Loss AIRB Capital Attributed in Risk-adjusted profit Risk-adjusted profit relation to risk ÷ AIRB Capital – RCap × Hurdle Rate Hurdle Rate = RAROC (%) Bank’s minimum = EP ($) Return on Capital *Risk-Adjusted Return on Capital RC = AIRB Capital 2008 Prepared by Eric — CTCB Confidential 20
  21. 21. 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 Lending business will inevitable faces industry risk adjusted profit, banks require to cross sell concentration, though, bank need to balance the more fee-based income to compensate the risk risk and return. taking activities. Share of totalRAROC 25% Share of loan 20% Share of capital A X-Sell Cost of Capital 15% A 24% of 100% of Capital 10% total capital 5% RAROC-Credit Asset RAROC-Incorporate Cross-Sell 0% A B C D E F G H INote: 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 — CTCB Confidential 21
  22. 22. Restricted ..on the other hand, economic profit reflects the size of the value contribution. Risk Adjusted Return On Capital Economic Profit Illustrative •RAROC estimates the return over the invested •One advantage of economic profit or SVA over RAROC capital and gives picture if the return exceed bank’s is that SVA reflects the size of the value contribution. hurdle rate (Chinatrust bank uses cost of capital). •Some transactions or segments may have large EP •Some transactions or segments may have higher transactions and businesses even though they may not RAROC but limited investment opportunities. have the highest RAROC values. Not the highestRAROC RAROC but contributed the most of the EP A A Cost of Cap 100% of Capital 80 % of Cap 80% Total EP of CapNote : some uses the phrase SVA(Shareholder Value Added) instead of EP.EP = (RAROC – Cost of capital) * Invested capital 22 2008 Prepared by Eric — CTCB Confidential
  23. 23. Restricted Furthermore, the RAROC measure is utilized to identify if the obligors added value to our shareholder. Example Cross-Sell RAROC CoC Miss-Pricing Zone CoC Credit RAROCNote: CoC = Cost of Capital. 2008 Prepared by Eric — CTCB Confidential 23
  24. 24. 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 High Observation Capital usageHigh •Usually the capital heavy users y = -0.1515Ln(x) + 3.5837 don’t outperform the peers. R2 = 0.6642 •Higher the capital usage lower the RAROC, though the RAROC still Contributed exceed the cost of capital (hurdle majority of Risk- rate) adjusted profitRAROC Action can be taken : •Invest in high RAROC segments Average RAROC of and increase return on the capital portfolio heavy users. Challenge may face •Limited opportunities in high Cost of Capital RAROC segments •Strong bargaining power in theLow capital heavy users. Average allocated capital 2008 Prepared by Eric — CTCB Confidential 24
  25. 25. Restricted Internal capital management and performance management and based on RC to align with external compliance. Issues Description •Require tailored made of correlation for consumer banking. OtherMeasurement •EC model is complex Challenges •Difficult to validate the EC figure, due to historical loss experience is not longer enough. Accuracy of the EC measure •Capital attribution and performance measurement basedManagement on RC to align the external compliance. •Line of business tends to embrace EC when there is Lower the EC the diversification effect exists, decline to recognize EC better ? when concentration effect occurs . Concentration Diversification effect effect Do investorsSituation care aboutmay faces EC?whenimplementEC Regulatory EC with EC with Capital 2008 Prepared by Eric — CTCB Confidential diversification concentration 25
  26. 26. Restricted 1 Accuracy of the EC measure Understand your MODEL and what is the ASSUMPTION before further application. Findings from credit portfolio management study in 2004 Comments 1. Different models may have Which models are used? different results. CSFB Credit Risk+ 6% • Each vendor model has his own features. In-house Credit Metric 6% Vendor • Understand what are youdeveloped model doing when using 44 % MKMV 42% 66% vender’s model. 2. Longer the tenor, usually, Macro Model 2% requires more EC. • Common practice is How long of the tenor is applying in estimating the EC? apply 1 year horizon to estimate the EC. 1- year Full Banks need to understand what horizon maturity methods are you using in 54% 46% estimating EC and gain confidence internally before communicating with regulator.Source: IACPM -Survey of CPM practices 2004 2008 Prepared by Eric — CTCB Confidential 26
  27. 27. Restricted2 The lower the EC the better ? EC largely depends on the target rating a bank is aiming at. Moreover, EC alone doesn’t illustrate the RETURN by taking RISK. What Return is generated is Aiming at better Rating requires to hold more EC more importantProbability of Global Rating = ‘AA’loss 1. Combine with the return (99.97% of confidence interval) information, banks can : Global Rating = ‘A’ (99.9% of confidence interval) • Measure risk-adjusted business unit Global Rating = BBB (99.85% of confidence interval) profitability to gauge the portfolio performance. • Demonstrate efficient usage of shareholder funds 2. However, it is difficult to Loss compare with peers, due to EL Economic Capital • Model may be different BBB • Target rating may be A different AA 2008 Prepared by Eric — CTCB Confidential 27
  28. 28. Restricted3 Do investors care EC Inevitably, investors look at simple indicator. Requires time to communicate with and to promote the use of RAPM .Inevitably, investors look at simple indicator when Require time to communicatechoosing stock. with and to promote EC .Traditionally, Equity analyst and investor look at EPS.. 1. Provide EC and Risk Adjusted Performance Measures demonstrate a bank P/E Ratio = Stock Price • Knows RISK well EPS • Examine if bank added value to shareholders ..the RAROC doesn’t have a direct link to stock price 2. It may not have a direct link to stock price, however , in my Net Income Capital Return on Capital opinion, gradually, the effect will reflect on the P/E ratio, due to Return RC 100 10% • Transparency of bank risk on RC disclosure 10 = • Alternative indicator for EC 50 Return 20% investors to measure the on EC management team’s performance. 2008 Prepared by Eric — CTCB Confidential 28
  29. 29. Restricted In sum, to encourage the use of EC requires continuous communication externally and internally. Reason of use Challenge may face l Measure the risk capital l Know your model – Link to bank’s target rating – Assumption of the model – Consider the diversification and – Parameters that you put into theEC as risk concentration effects modelmeasurement l Basel 2 may not be appropriate to gauge – Interpret the results carefully risk in emerging market l Build confidence – The Basel 2 capital may not capture/ – EC is not a regulator requirement reflect the risk in Emerging market.. – Explanation of the difference – …it may over or under estimate the risk. between RC and EC l Risk appetite l Require continuous communication – Link to bank’s target rating – There is little comparability acrossEC as risk l ICAAP firms in EC approaches –management – Requirement of Pillar 2 therefore numbers have to be l Rating communication taken with a pinch of salt – Encourage the EC disclosure l Investors communication – Accounting metrics are still – Generally more information, especially on dominant to investors. risk, is welcomed. – Internal communication to l Performance and compensation develop the confidence and clear – Gauge the performance of line of up doubts. business l Market competition l Limit setting / Portfolio stress testing l Capital allocation and planning – May not be able to price based on 2008 Prepared by Eric — CTCB Confidential 29 risk.
  30. 30. RestrictedWe cannot direct the wind but can adjust the sail.Face the unpreventable risk. AGENDA OF TODAY 1. What is Credit Economic capital is estimated to gauge the ‘Unexpected Loss’ of a bank’s credit portfolio. EC ? Economic capital is wildly utilized in all aspects of bank’s management. Three key management applications : 2. What is EC for l Risk governance l External communication l Internal management To promote and encourage the use of EC requires both of the 3. Our experience encouragement and continuous communication with regulators, and challenges rating agencies and equity analysts. Create value through manage credit portfolio to sustain through ‘economic cycle’. 4.Beyond EC ‘Delivering a Stable and Sustainable profit growth’ for investors. 2008 Prepared by Eric — CTCB Confidential 30
  31. 31. Restricted Traditional commercial banking model relies on lending as ‘Entry product’ and aims at cross selling to deeper relationship with clients. Conceptual Facing the same down-side risk but the up-side is totallyTraditional model of commercial banking different that makes the stock investment – an attractive investment. Obligor Return Stock Deposit Loan With Bank possibility Different compensation of ‘high’ returnn Banker as the intermediary – Cross-sell profit collecting deposit and providing Credit income loans that were held to maturity – Loan consumed ‘Capital’ With high 0 possibility of – Regulatory legislation ‘constant’ watch BIS ratio and NPL return – Bank focuses on bi-lateral relationships But faces the same down - 100 % side loss withn This model has been under low possibility pressure for the past 40 years Facing the same loss 2008 Prepared by Eric — CTCB Confidential 31
  32. 32. Restricted Usually the low possibility of ‘Large unexpected loses’ not only wiped out the profits but also results in significant market cap decline…XX Bank l In addition to putting in danger bank’s target credit rating, large losses can erode shareholder confidence l Implications for • XX Bank lost a total of market perhaps $0.5 billion in the capitalization can course of Enron meltdown. Yet, as events unfolded, far exceed actual shareholders lost confidence losses and share price plummeted to all time low • XX Bank’s share price fell from about $40-$15 dollars, destroying about $50 billion of market cap 2008 Prepared by Eric — CTCB Confidential 32
  33. 33. Restricted ..and the credit crisis tends to be a cyclic event… Examples of losses by financial institutions Too many $ Millions No downgrades banks triggered by these Loss size* losses 1,025 826 Too many losses 531 451 260 247 U.S. AmEx – Fleet JP BONY – Capital Sub-Prime Crisis Bancorp – high Boston – Morgan telecom One – airline yield Argentina Chase – loans and subprime exposure bonds bonds Enron bonds lending after 9/11 2001 2002 2007Loss/ book 7% 7% 3% 1% 4% 7% equity** * Pretax ** Assuming book equity in 2003Source: Literature searches; 2008 Prepared by Eric — CTCB Confidential 33
  34. 34. Restricted ..that explains why the outcome of credit portfolio is asymmetric – A small number of bad loan may wipe your capital out - ’Once in a blue moon’ ?Probability of loss The game of credit portfolio • Asymetric risk return pay-off. It rare happens but once it does , • Long tail and you are concentration – ‘Sayonara’ ‘Once in a blue Reserve Capital moon’ is more common than we Potential “unexpected” think. Zero Expected Potential “unexpected” losses against which itlosses level of loss losses for which capital would be too should be held expensive to hold capital0% Loss 100% rate 2008 Prepared by Eric — CTCB Confidential 34
  35. 35. Restricted EC estimation only exhibits the Unexpected Loss of a bank’s credit risk, but the risk won’t disappear away by itself. IllustrativeBanks tend to have deeper relationship with well-established or public listed corporations.Most banks face concentration risk, resulting from small portion EC indicates the potential riskof obligors (or industries, geographic) account for majority ofincome or exposure… (UL), but risk won’t disappear…also consume most of the bank’s capital. away by itself.Non-PublicListed / other 40 Remedy 50 50industries 60 1. Diversified your credit 90 portfolioPublic listed 2. Active manage yourcorporations / 60 portfolio throughStar 50 50industries 40 - Risk mitigation 10 - Risk transfer # of Exposure Regulatory Economic Revenue Obligor Capital Capital 2008 Prepared by Eric — CTCB Confidential 35
  36. 36. Restricted Banks require to develop a mechanism to transfer risk and manage bank capital. Illustrative Traditional credit management Active credit portfolio management approach •Loan Credit selling Origination Management Origination •CDS Relationship Monitor Relationship Active •CDSPrimary Management Workout Primary Management Credit Secon- Index Portfolio daryMarket Market •CLO Manage- Market ment •Insuranc Credit Credit e Approval / Approval / •Portfolio Rating Rating TradingSource : ERisk, 2008 Prepared by Eric — CTCB Confidential 36
  37. 37. Restricted A new business model emerges through Credit portfolio management. Illustrative •Create More Business Opportunities. •RM Focuses on Relationship •Support BU / Client growth.Capital Market Collaboration Framework Within Chinatrust Current Customers Trade & SELL BUY & SELL & Control Capital Market FINANCIAL GROUP BU • Alternative mean of •Support Business Loan Bank 1 Trader capital raising Growth Bank 2 CDS 1 CDS 2 •Control RWA. •Reduced EL/ •Utilize Capital more CapCost Obligors efficient Structur CREDIT PORTFOLIO CLN 2 ed CLN 1 • Control • Minimize Concentration risk Unexpected Loss Finance Investors CLO2 CLO1 •Reduce credit risk •Optimize Economic Capital 2008 Prepared by Eric — CTCB Confidential 37
  38. 38. Restricted Portfolio theory suggests us that we can enhance portfolio performance by re-weighting, and banks finally can adopt the theory into practice. Conceptual Portfolio Performance Enhancement 12% 1 Hedge : Reduce risk / uncertainty -Tool : Buy CDS, Loan Sell, Insurance, Securitization Efficient 10% Frontier 2 Enhance Yield : Invest in High YieldReturn given the same ‘risk’ 8% 4 2 -Tool : Secondary loan, Sell 3 CDS, CDS Index, securitization. Current Portfolio 6% 3 Swap Asset 4 Synthetics : Reduce risk and utilize the 4% free up capital to invest in credit. 5% 15% 25% 35% Risk 2008 Prepared by Eric — CTCB Confidential 38
  39. 39. RestrictedPortfolio Improvement is achieved by both reweighing existing exposureholdings and by hedging unwanted risk. Risk-Return Optimization Conceptual Same Risk Portfolio Efficient Frontier The efficient frontier for the portfolio is calculated by optimizing within the Current Portfolio portfolio. The frontier can be moved by expanding the portfolio assets to Same Return Portfolio include diversifying Optimal Sharpe Ratio exposures. By introducing new exposures that diversify the portfolio risk-return tradeoff will improve, allowing for the construction of optimal portfolios . 2008 Prepared by Eric — CTCB Confidential 39
  40. 40. Restricted..also aiming at improve the single-name credit risk management. 3 LGD and Fee 2 Fee Incr 5 EDF Decr 1 LGD Decr 4 Commit Expected Spread Initial Risk Reducing/Return Enhancing Scenarios: –Scenario 1: Risk mitigation – reduce LGD from 35% to 15% –Scenario 2: Increase usage fee from 3.49% to 5.50% –Scenario 3: Reduce LGD and increase usage fee –Scenario 4: Reduce commitment to $20 mil –Scenario 5: Assume terms remain the same, but EDF drops from 11% to 9% Risk Contribution 2008 Prepared by Eric — CTCB Confidential 40
  41. 41. Restricted Our ultimate goal is to ‘Deliver a Stable and Sustainable profit growth for investors and to sustain through ‘economic cycle’.Learn our lesson from recent credit crisis.. •..and create our own blue ocean strategyEPS l Managing concentration risk. Bank l Diversifying portfolio through Buy & Sell credit. Max Return l Becoming Market Maker Other in Taiwan Credit market Banks Min Risk l Support both of client’s & CTCB’s business growth. l Ensuring business growth with good credit Time quality 2008 Prepared by Eric — CTCB Confidential 41
  42. 42. Restricted The International Association of Credit Portfolio Manager established in 2001 to further promote the practice of credit exposure management . Who We Are and What We Are About Share ideas and exchange experiences •Established in 2001 . •Promote the practice of credit exposure management by providing an forum to exchange ideas on topics of common interest. •There are 87 financial institutions worldwide that are members of the IACPM… •..and from 14 countries and include many of the world’s largest commercial wholesale banks, investment banks and insurance companies, as well as a number of asset managers. •Represents its members before legislative and administrative bodies. •Conducts research on the credit portfolio management field.Note: Free document in IACPM web site, www.iacpm.org. 2008 Prepared by Eric — CTCB Confidential 42
  43. 43. Restricted Participants not only from commercial banks .Aareal Bank DZ Bank National City BankABN AMRO Bank Euler Hermes Group NatixisAllianz AG Export Development Canada Nationwide InsuranceAtradius Fifth Third Bank NIBC BankAustralia and New Zealand Banking Group FirstRand Bank PB CapitalBank of America Fortis PNCBank of Ireland Goldman, Sachs Primus Asset ManagementBank of Montreal HSBC RaboBankBank of New York Mellon HSH Nordbank Royal Bank of CanadaBank of Tokyo-Mitsubishi UFJ Hypovereinsbank Royal Bank of ScotlandBarclays Capital IKB Deutsche Industriebank ScotiabankBear Stearns ING Capital SEBBNP Paribas Intesa Sanpaolo Shinsei BankBluecrest Capital JPMorgan Chase Société GénéraleBP KBC Bank Standard Bank of South AfricaCalyon KeyBank Standard CharteredCapital One KfW Sumitomo Mitsui Banking CorporationCIBC World Markets KfW IPEX-Bank SunTrust BanksCitigroup Landesbank Baden Wurttemberg Swiss ReCitizens Financial Group Lloyds TSB Bank TD SecuritiesChinatrust Financial Holding Manulife Financial Corporation TIAA-CREFCommercial Industrial Finance Corp. Merrill Lynch UBS AGCommerzbank MetLife U.S. BancorpCommonwealth Bank of Australia Mizuho Corporate Bank Wachovia CorporationCredit Suisse Monte Dei Paschi Di Siena Wells Fargo BankDEPFA Bank plc Morgan Stanley WestLBDeutsche Bank Munich Reinsurance Westpac Banking CorporationDexia SA National Australia Bank WGZ BankDresdner Kleinwort National Bank Financial XL Capital 2008 Prepared by Eric — CTCB Confidential 43
  44. 44. RestrictedIn sum, credit risk need to be accurate estimated, managed andtransferred. TAKE AWAYS OF TODAY Bank holds ‘Economic Capital’ to protect ‘Unexpected Loss’. 1. What is EC l Not for the regulatory compliance purpose l But to know what is ‘True Risk’ Economic capital is wildly utilized in all aspects of bank’s management. Three key management applications : 2. What is EC for l Risk governance l External communication l Internal management To promote the use of EC requires time to build confidence 3. Our experience internally and both of the encouragement and continuous and challenges communication externally. Knowing risk without action to offload risk won’t prevent bank from risk. 4.Beyond the EC To deliver a Stable and Sustainable growth to shareholders, bank need to well managed and take actions. 2008 Prepared by Eric — CTCB Confidential 44

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