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Risk Appetite: A new Menu under Basel 3? Pieter Klaassen (UBS) voor het Zanders Risicomanagement Seminar 2012

Risk Appetite: A new Menu under Basel 3? Pieter Klaassen (UBS - Firm-wide Risk Control & Methodology) voor het Zanders Risicomanagement Seminar 1 november 2012

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Risk Appetite: A new Menu under Basel 3? Pieter Klaassen (UBS) voor het Zanders Risicomanagement Seminar 2012

  1. 1. Risk Appetite: A new Menu under Basel 3?Zanders Seminar “Effectief Kapitaalmanagement”Pieter KlaassenUBS - Firm-wide Risk Control & Methodology1 November 2012
  2. 2. Agenda What is this “Risk Appetite”? UBS Firm-wide Risk Appetite Framework Basel 3: A Stricter Diet Risk Appetite under Basel 3 1
  3. 3. Section 1What is this “Risk Appetite”?
  4. 4. What is this “Risk Appetite”? Risk Appetite “The level and type of risk a firm is able and willing to assume in its exposures and business activities, given its business objectives and obligations to stakeholders.” “Risk appetite is generally expressed through both quantitative and qualitative means and should consider extreme conditions, events, and outcomes. In addition, risk appetite should reflect potential impact on earnings, capital, and funding/liquidity.” (Senior Supervisors Group, “Observations on Developments in Risk Appetite Frameworks and IT Infrastructure”, December 23, 2010) Context – Papers by the Senior Supervisors Group (SSG) and Institute for International Finance (IIF) established that a comprehensive firm-wide risk appetite framework covering all types of risks is now considered essential and not just best practice – Basel II, Pillar 2: “The bank’s board of directors has responsibility for setting the bank’s tolerance for risks. It should also ensure that management establishes a framework for assessing the various risks, develops a system to relate risk to the bank’s capital level…“ 3
  5. 5. Risk Appetite: Key ElementsRegulatory Expectations and Industry Best Practices Comprehensive approach – integrating credit, market, operational, liquidity, and reputational risks across the firm – Both quantitative and qualitative elements Use of multiple methodologies (taking into account technical limitations of risk metrics, models, and techniques such as VaR) – incorporating, in particular, stress/scenario testing and consideration of risk concentrations Translate risk appetite at the top of the house to risk appetite (limits) for individual risk types and at lower levels of the organization (business units and below) Link to strategic planning and budgeting process - collaboration among risk management, finance, and strategy functions Role of risk culture, ‘tone from the top’ Risk appetite as a continuous, evolutionary, learning process – not just a one-time exercise 4
  6. 6. Defining, Challenging and Monitoring Risk AppetiteFirms’ management, boards, risk management departments, and supervisors allhave roles Management should articulate the firm’s appetite for risk in the context of business strategy – They own the risk and are expected to fully understand the firm’s risk position at all times Boards should – set basic goals for the firm’s risk appetite and strategy, – review and affirm management’s articulation of risk appetite, and – ensure that risks are comprehensively considered and managed CROs should (and should be empowered to): – assess and control the firm-wide risk level – provide an integrated view of the overall risks the firm faces, and – ascertain that the firm’s risk level is consistent with its risk appetite Supervisors have a role in assessing and challenging Boards’ and Managements’ achievement of these goals, risk awareness and understanding, and conformance to (evolving) best practice 5
  7. 7. Section 2UBS Firm-wide Risk Appetite Framework
  8. 8. Earnings/Capital Waterfall Continuum – at Least in Principle Capital Criteria Earnings Criteria Solvency Regulatory Constraints View Rating Change Positive Earnings, Payment of Dividends Risk Exposure: Mean Earnings Deviation from Mean Earnings at: Risk Probability 99.9+% 95% 0 Cushion Capacity / Earnings Capital Dividend Earnings Power/Capacity Event Earnings/Dividend Capital Depletion reduction 7
  9. 9. Evolution of Risk Appetite & Experience during the CrisisShift to ensuring going concern under stressTraditionally, focus on: Solvency perspective – Consideration of Economic Capital and total (or Tier 1) capital Dividend paying ability in most years, also in adverse economic situationExperience during the crisis: Focus on going-concern capital metrics (e.g., Tier 1 ratio) – Loss-absorbing capital is what matters Consider scenario-based stress metrics in addition to statistical metrics – Look beyond historical experience Ensure stable funding sources and ample liquid assets 8
  10. 10. Implications for Risk AppetiteEmbedding multiple complementary criteria Need for complementary criteria (with different time horizons and confidence/severity levels), representing different points in the financial structure/stakeholder waterfall. E.g.: – Traditional EC view at a high (99.9+%) confidence level over 1 year and/or multiple years – Tier 1 ratio or similar view at a lower confidence level over ranges from 1 quarter to multiple years – Earnings view at a lower (one in 5-25 year) confidence level over 1 quarter to 1 year time horizon Focus on high-quality equity capital (convergence to Basel III or similar view) Multiple severity levels, metrics, and risk horizons 9
  11. 11. UBS Firm-wide Risk AppetitePillars UBS Risk Appetite Framework Minimum Tier-1 Earnings Capital Solvency Earnings should Loss-absorbing Ensure sufficient cover the risk capital is sufficient total loss- of losses in to absorbing capital most years meet regulatory to sustain even an + requirements even extreme stress Avoid repeated if a severe loss event (large) quarterly event were to losses occur Stress Stress Stress Stress Stress Statistical Scenario Statistical Scenario Statistical 10
  12. 12. Risk Appetite objectives: Risk Capacity vs Risk Exposure } Buffer Taking into account strategic considerations Earnings Credit Risk Market Risk Capital Risk Appetite Issuer Risk Investment Risk Regulatory requirements Funding Risk and constraints Country Risk Pension Risk Operational Risk Risk Capacity Risk Exposure maximum amount of risk a firm is the amount of risk, by whatever technically able to assume given its metric, actually being taken at a capital base, liquidity, borrowing point in time, or expected/forecast to 11 capacity, and regulatory constraints be taken
  13. 13. Overview of Firm-wide Risk Appetite Framework The framework encompasses all material risk categories, and plays a key role in the decision- making processes in the Bank Firm-wide Risk Appetite FrameworkRisk Capacity Risk Exposure Business Plans E@R / C@R Exposure Firm-wide (projected net Stress Measures earnings and capital) Statistical Stress Risk Categories Measures Measuresless Business Risk Operational Credit Country Investment Pension Risk Funding Risk Market Risk Issuer Risk LU Risk (volatility in Risk Risk Risk Risk earnings) Consequential Risks Position Risks Granular Limit Framework The firm-wide statistical and stress metrics are complemented with a granular limit framework with portfolio and position limits Of the various scenarios in the Firm-wide Stress framework, the most relevant / severe one is used as the ‘binding’ scenario in the Risk Appetite Framework 12
  14. 14. Risk Exposure: Firm-wide measuresUBS has two complementary approaches – one statistical and one stress based Statistical measure which allows the aggregation of firm-wide risks usingEarnings-at-Risk / statistical techniques which can then be tied to probabilities / confidence Capital-at-Risk levels (E@R / C@R) A large number of potential outcomes and associated losses is simulated, rooted in historically observed market changes More intuitive stress measure which calculates the impact of a scenario onFirm-wide Scenario the firm-wide portfolio including the causality chain by which losses would Stress Test arise if the scenario were to unfold Scenarios enable incorporation of forward-looking views Under both firm-wide measurement approaches, we model the first order P&L and capital impacts as well as the consequential capital impacts of downgrades in the Firms portfolio and resulting adjustments to RWA 13
  15. 15. UBS Approach for Firm-wide Stress TestingScenario-based stress tests Risk Factor P&L impacts Sensitivities Macro-economic and/or OCI impacts Aggregation scenario Revaluation RWA impacts methodologiesVarious global Quantitative and Credit Risk Quarterly time profile ofdownturn scenarios qualitative analysis of • P&L (losses, earnings) historical data about Market Risk • OCI impacts defaults, Issuer Risk • Risk Weighted Assets impairments, write- downs etc. Investment Risk and ultimately Tier 1 capital ratio Funding Risk Operational Risk Tier 1 Capital Ratio Pension Risk Critical threshold Country Risk Business Risk Q1 Q2 Q3 Q4 Q5 Q6 Q7 Q8 14
  16. 16. UBS Statistical Risk frameworkComprehensive assessment of risksPosition Risks Consequential Risks Business Risks   = Aggregate Statistical Risk Market Operational Business Exposure Issuer Funding Targeted stress Expecte Probability Credit Pension components d Earnings Country Capture special risks not modeled statistically 0 Investment Earnings Step One Step Two Step Three  = Copula Aggregation Aggregate Group Risk Exposure derived from probability distribution of potential earnings shortfalls, supplemented by targeted stress components. Diversification between risk types is included at each aggregation step 15
  17. 17. Section 3Basel 3: A Stricter Diet
  18. 18. Too-Big-To-Fail Sylvan Wegmann 17
  19. 19. Basel 3: Increased Minimum Capital RequirementsFollowing Basel Committee … … and with “Swiss Finish” BIS Basel 3 Phase-in - Minimum capital requirement FINMA Basel 3 Phase-in - Minimum capital requirement Global Systemically important Banks (G-SIB) Systemically important Banks (maximum 6% progressive component) 20% 20% 18% 18% 16% 16% 6.00% 5.63% 14% 14% 5.12% 4.50% 12% 2.5% 12% 3.75% 3.00% 1.875% 3.00% 10% 10% 2.875% 1.25% 2.75% 2.0% 2.625% 0.625% 2.0% 2.25% 8% 2.0% 8% 2.0% 1.5% 1.50% 1.75% 1.5% 5.50% 2.5% 2.0% 4.88% 1.5% 1.00% 4.25% 3.5% 6% 3.63% 6% 1.5% 2.5% 2.88% 1.5% 1.875% 2.75% 1.25% 1.5% 0.625% 2.50% 4% 1.0% 4% 2% 4.0% 4.5% 4.5% 4.5% 4.5% 4.5% 2% 4.00% 4.50% 4.50% 4.50% 4.50% 4.50% 3.5% 3.50% 0% 0% 2013 2014 2015 2016 2017 2018 Basel 3- Full 2013 2014 2015 2016 2017 2018 Basel 3- Full G-SIB additional capital (max) Tier-2 Capital Additional Tier-1 Capital Progressive component (CoCos 5% trigger) Capital Buffer - CoCos 7% Trigger (max) Capital Conservation Buffer (CET1) Minimum CET1 Capital Buffer - CET1 (min) Minimum CET1 Excludes Countercyclical Capital Buffer (max 2.5%) 18
  20. 20. Basel 3: Lower Eligible Capital + higher RWA AV Corr +1.4% CVA +9.3% RWA vs +7.6% Eligible Capital deductions -16.4% RWA -5.0% DTA + 18.4% -3.6% Inv. in Fin Institutions -2.0% Items > 15% CET1 Other -5.8% Source: EBA Basel III monitoring exercise, deductions average of Group 1 banks, Sept 2012 19
  21. 21. In addition to impact of Basel 2.5Stress VaR, IRC, CRM, and modified securitisation treatment increase UBS market risk RWA by 400% Source: UBS 3Q12 Report 20
  22. 22. Basel 3: UBS RWA Targets Source: UBS 3Q12 Results Presentation 21
  23. 23. Basel 3: New items on the menu Liquidity Coverage Leverage Ratio Ratio Net Stable Funding Ratio 22
  24. 24. Basel 3: UBS Balance Sheet DevelopmentInfluences Leverage Ratio capital requirement Target reduction of Assets excl PRVs to 600bn in 2015 Source: UBS 4Q11 & 3Q12 Results Presentation 23
  25. 25. Section 4Risk Appetite under Basel 3
  26. 26. Basel 3 is estimated to lead to increased product costs Source: “Basel III and European banking: Its impact, how banks might respond, and the challenges of 25 implementation”. McKinsey & Company, Working Papers on Risk 26, November 2010.
  27. 27. Basel 3: Capital Market Businesses are most affectedStructured credit, rates, and equity most affected; FX and cash equities least Mitigating actions:  Portfolio optimization  Model refinements + data quality improvements  Conserving capital, liquidity and funding  Operational enhancements Source: “Day of reckoning? New regulation and its impact on capital-markets businesses”, McKinsey & Company, Working Papers on Risk 29, October 2011. 26
  28. 28. Basel 3: Considerations for Earnings ObjectivesFocus on profitability of Core Businesses Original objective (2003) was to ensure minimum dividend payment – Even in adverse situation, with high probability Since the 2007-2008 financial crisis – Profits have been used to increase tangible equity instead of paying dividends – Risk taking has reduced substantially – Inventory of legacy exposures have been wound down – Market circumstances have been challenging Focus on profitability instead of paying dividends – For Core Businesses - Legacy exposures supported by capital – Differentiated tolerance for losses in different businesses New balance to be found between risk and return 27
  29. 29. Basel 3: Choices for Capital ObjectivesSufficient capital to ensure going-concern after severe stress Consider Basel 3 CET1 phase-in or fully-applied? – Regulatory capital based on phase-in – Analyst focus often already on fully-applied What minimum CET1 ratio to choose under stress for Tier-1 Capital objectives? – Impairment of capital buffer requires plan to replenish the buffer – Impairment of capital buffer can lead to restrictions on shareholder distributions and discretionary pay – up to imposing measures to increase capital and/or reduce RWA – Latest point at which FINMA interferes is 8.75% CET1 ratio – 50% impairment of capital buffer – Well before triggering high-trigger (7%) CoCos Maintain Solvency objective – Loss-absorbing capital as Risk Capacity Alignment with Recovery and Resolution plans 28
  30. 30. Potential Extensions of Risk Appetite objectives Leverage ratio objective – Satisfying minimum leverage ratio also after a stress event? – FINMA leverage ratio denominator calculation (“assets”) to be finalized – Minimum leverage ratio requirement to be reviewed Establish connection with liquidity framework – Minimum liquidity and funding requirements after a stress event – UBS satisfies existing interpretation of LCR and NSFR Separate (but aligned) objectives for major legal entities Cascade Risk Appetite objectives to Business Divisions – Continue to do so through limit framework – In addition, consideration of business-specific objectives Balance between comprehensiveness, simplicity & transparency 29