Stress Testing in the
 context of ICAAP
Stress Testing: The Challenges &
Practical Issues of Implementation
     - A Perso...
Agenda –
•   Introduction and backdrop
•   What is stress testing? - Definition
•   Why stress test (Supervisory & banks’ ...
The 3 Pillars & Stress Testing
              Minimum requirements provide economic
              incentives - in the form ...
Supervisors evaluate how
                 bank performs internal
                 processes for risk
                 mana...
The third pillar seeks to
               leverage the ability of
               markets to provide discipline
  Market
   ...
Pillar 2 Overview
                                                      Supervisory
Firm assessment
                      ...
Capital Planning and Stress
              Testing
Objective:
• That the firm can meet its capital requirements at all time...
Capital Planning and Stress
               Testing
     Illustration: pre/post management actions
£




                  ...
Cyclicality Credit Stress Test
• A subset of Pillar 2 capital planning and
  stress tests
   8Scope is narrower than Pilla...
Pillar 2
Interest Rate Risk in the
     Banking Book
         (IRRBB)
Rules – a selection (paraphrased)
• GENPRU 1.2.30R
    8 Firm must have in place sound, efficient and complete processes, ...
Regulatory approach
• IRRBB will be one of the top three Pillar 2 risks on
  which supervisors will focus when reviewing a...
Stress testing
• Sudden 200 bp parallel shift in both directions is at
  best a crude measure
• FSA expects firms to apply...
Proportionality
• IRRBB approach is as for other Pillar 2 risks:
  8 Firms with relatively non-complex business profiles c...
Non-prescription
• FSA has not sought to prescribe how IRRBB should be
  measured, nor how capital should be attributed.
 ...
From Pillar 1 to 3
  Risk management process
• Basle document (Jan ’96) – spells out stress testing as one of the
  prereq...
2. What is Stress Testing?
             (in banking)

•   Stress testing refers to
    “the analytical process involved in...
Definition
                     Key Points
•   Series of Battery of Tests
-   More than 1 test or set of results


•   Ext...
3. Why Stress Test
 (Supervisory & Banks’ Expectations)
What does the regulator             What does the bank hope to
hop...
Other Considerations
                       Why?
•   Economic downturns always follow
    buoyant periods and economic exp...
Stress-testing and Impact on
Economic Capital in Validation
Basel II-compliant Integrated Approach to Risk Management
                                            – Objective at End P...
Basel II-compliant Integrated Approach to Risk Management
                   - Risk Models & Measurements/Scenario Analysi...
RECAP: Volatility in EL
• For Stress Tests, exaggerate changes in risk drivers
according to different levels of severity
 ...
U.S. Yield Curve Inverts Before Last Five Recessions
             (5-year Treasury bond - 3-month Treasury bill)
% GDP Gro...
Getting the
Basics Right –
The Importance
    of Data
Considerations
Validation via Recessionary Stress Test
Remarks by Governor Susan S. Bies
At the Annual International Symposium on Derivat...
Ensure reliable data
KEY ELEMENTS in
STRESS TESTING                Survey Portfolio & Environment
   Framework
           ...
Minimum requirements for the
      Foundation IRB Approach
•   …….
•   Completeness & integrity of ratings
•   Min. requir...
VI. Portfolio level stress testing,
practical application and range
 of practice - Pillar 2 principles
Implications for Stress Test
• Top-down Approach/Macro-view
• Relate to Objective
   – impact is bank-wide
• Basel complia...
Identify the Main Objective
  What does the bank hope to achieve?
• Identify where the risk concentrations are?
• Impact o...
Risk Monitoring (Stress Test)
                &
        Risk Concentration
• What’s the relationship?
• Worthwhile & logic...
Where to Start?
• First place to start is to examine the
  portfolio of weak assets
   – findings arise from risk monitori...
What to Do?
• With weak assets or customers, one stress
  test model (scenario) is for all of them to
  default

• With th...
How to Do It?
Perform the stress tests at the portfolio level:
• Using scenario analysis (multiple scenarios)
   – e.g. a ...
Why Do It?
I. Stress Tests will yield info about:
• Extent of unexpected loss based on different
    scenarios as well as ...
OVERVIEW
            Corporates
              Listed




             CREDIT
            PORTFOLIO


                     ...
OVERVIEW                                                      OR STRESS
                                                  ...
Stress Test Outputs
• Can yield
  – several types of reports for different
    customer segments
    • corporates, SMEs, c...
IMPACT OF STRESSED ENVIRONMENT
              Credit Portfolio
                                               1) Credit rat...
Probability of Default (PD)
    & Loss Given Default (LGD)
• Both concepts are tied and intimately linked
  to negative ri...
Behavioral Credit Risk Monitoring as a
                  Measure of Impairment Incidences
                                ...
Example of Downgrades in Risk
             Migration for Stress Test Scenario
                               Distribution ...
Application to economic capital
                   calculation and allocation
                         Table 1 Calculating...
Table 2: Calculating the Minimum Capital Requirement

      CALCULATING THE MINIMUM CAPITAL REQUIREMENT:             Janua...
6. Key Elements of a
           Stress Testing Process
                    Background Understanding
•   Majority of banks’...
Key Elements
                 (Assumptions)
1. “Infrastructure” readiness:
• Sufficiency & types of data to cover good & b...
Ensure reliable data
KEY ELEMENTS in
STRESS TESTING                Survey Portfolio & Environment
   Framework
           ...
Reliability of Data
• Stress Testing involves the use of models based
  on unexpected events on a practical basis
• Docume...
Survey Portfolio & Environment
Preliminary work necessary:
• Management & personnel in bank
   involved in stress-testing ...
Identify Risk Factors
• This process will go hand-in-hand with the
  model and scenario chosen
• Different types of risk f...
Construct Stress Tests
• Once the basic prerequisites are satisfied:
  scenario chosen, KRFs defined, relevant
  data coll...
Dimensions of Evaluation

• Risk:
  – Severity & range: Loss Quantum & Range of
    loss quantum, e.g., varying the loss g...
Scenario Analysis
  Causes                Scenario (s)            Evaluation
                     (Potential Event)
      ...
7. Types of Risk Factors
  Counterparty                 Environmental                 Model               Analytics
Deteri...
Session 2
Includes examples for stress testing in:
• Market risk
• Credit risk
9. Sound & Best Practices
                              Stress Testing Decision Sequence
                                 ...
Examples – Market & Credit Risk
•   Type of risk model – market & credit risk
•   Type of stress test – scenario (multiple...
10. Implementation Challenges
Alternatives
1. Lack of data
• Boot-strapping
• Theoretical distributions & model
• Proxy be...
Example: Credit Stress Test Roadmap

                       Balance Sheet        Accounting            Asset-Liability   I...
Linear or non-linear regression
     of own internal model
• Change in firm’s NPL, ∆NPL, dependent on key
  risk factors, ...
Q&A: Implementation Challenges
Alternatives
2. Lack of risk analysis tools
• Qualitative judgement (expert opinion)
  rega...
Low                               High
                 Balance Sheet Stress Test         Stress                          ...
Linking market and credit stress
                   testing
Modigliani-Miller (1958): Firm value = Equity value + Debt val...
Credit Distress prediction horizon (in months) of
        Z-score and “KMV” EDF Models
             (Possible “Alert” Case...
Q&A: Implementation Challenges
Alternatives
3. Lack of real-time MIS & expertise
• Start at sub-organization or initial gr...
Other Considerations
• It is also important to conduct stress tests based on
  assumptions that are less complicated for m...
Stress Test Scenarios:
               Accounting for explanatory power
                   of different risk drivers
   Rep...
Table Loss on the cash flow in 3 different scenarios
     Scenario       THB    IDR    JPY             Loss


   Minor cri...
DEPTH & BREADTH OF
      STRESS TEST STUDY

Stress Test methods are hierarchical
- Sensitivity Analysis: broader in
  cove...
STRESS TEST METHODS
(A) Hierarchy & Overview
               Full-Blown
   Depth         Stress
                Testing


 ...
Overview of Stress Test methods
• Sensitivity Analysis: Shock risk factor by large no of “standard
  deviations”
   – Typi...
Sensitivity Analysis
    a) Using EVT
    b) N X Std. Deviation
    c) Tweaking correlations & volatilities

             ...
1   c1         c2


    1          c3




1   c1 + 15%        c2 + 15%


         1          c3 + 15%
Portfolio: 3 assets
$10 mil portfolio:
1) 500 Citicorp shares with nominal
   value of $5 mil
2) 150 Euroyen Dec futures w...
r1, r2, r3 = 0
σ1 = 15%
σ2 = 13%
σ3 = 20%
ρ12 = 0.5
ρ13 = 0.3
ρ23 = 0.4

1 ρ12 ρ13        =   1 0.5 0.3
  1 ρ23          =...
VAR
Var (N std dev) =                     1 0.5 0.3       15%*N*5
√(15%*N*5 13%*N*3 20%*N*2) *            1 0.4        13%...
Scenario-based
                   Event or Scenario Risk Analysis
Historical Events                         User-Defined E...
The Asian Contagion
                   Liquidity
Trading Market                   Trading
                     Risk
     R...
Annual Correlation & Volatility
                                                                                          ...
Examples
• From US Markets
• Linking Market & Credit Risk
• Balance Sheet Stress Testing
THE US MARKET
• Scenario 1
 – When US Stocks are all Down
• Scenario 2
 – Using historical worst-case P-E,
   P-B or P-S s...
US Market Examples: Scenario 1
When NASDAQ stocks are all down
US Markets: Scenario 2 Using historical
worst-case P-E, P-B or P-S scenarios
Case Study Discussion
• The Sub-Prime Contagion
Subprime Contagion:
                     End-to-End Examination
                                                          ...
EXAMPLES


CONCLUDING REMARKS
• Categories of Stress Test
• Operational Risk Illustration
Risks Are Integrated/Correlated!




Source: Global Risks 2007. World Economic Forum Report
Liquidity Risk Monitoring




      The actual value of “Asset Turnover Ratio” is
      39 and pointed out by black needle...
Impact from OpRisk Event Types on Liquidity
                            Risk manifestation - Example
                     ...
Interplay b/w Oprisk Events & Liquidity
      Risk Manifestation: Sources
It can be caused by the breakdown or
inadequacie...
Where Liquidity Risk could Manifest in the Context of the
         Building Blocks of ORM Framework
              Event   ...
Completeness of Stress Tests
    (environment, duration/stages,
      scenario analysis including
            severity, et...
Evidence/Documentation
• Model assumptions
• Identification of risk drivers/factors
• Data inputs/transformation/outputs:
...
Risk Mitigation Strategies
 • Risk management strategies need to be determined and
   maximized.
                         ...
Example of calculation of the liquidity ratio
                and the observation ratios

                                ...
Rma May22 Stress Testing In The Context Of Icaap
Rma May22 Stress Testing In The Context Of Icaap
Rma May22 Stress Testing In The Context Of Icaap
Rma May22 Stress Testing In The Context Of Icaap
Rma May22 Stress Testing In The Context Of Icaap
Rma May22 Stress Testing In The Context Of Icaap
Rma May22 Stress Testing In The Context Of Icaap
Rma May22 Stress Testing In The Context Of Icaap
Rma May22 Stress Testing In The Context Of Icaap
Rma May22 Stress Testing In The Context Of Icaap
Rma May22 Stress Testing In The Context Of Icaap
Rma May22 Stress Testing In The Context Of Icaap
Rma May22 Stress Testing In The Context Of Icaap
Rma May22 Stress Testing In The Context Of Icaap
Rma May22 Stress Testing In The Context Of Icaap
Rma May22 Stress Testing In The Context Of Icaap
Rma May22 Stress Testing In The Context Of Icaap
Rma May22 Stress Testing In The Context Of Icaap
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Rma May22 Stress Testing In The Context Of Icaap

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This is about my personal view on stress-testing for Basel 2 & ICAAP requirements, but on a practical basis

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Rma May22 Stress Testing In The Context Of Icaap

  1. 1. Stress Testing in the context of ICAAP Stress Testing: The Challenges & Practical Issues of Implementation - A Personal Perspective Khoo Guan Seng, PhD Head, Group Risk (Models Validation) Standard Chartered Bank Khoo.Guan-Seng@standardchartered.com gskhoo@gmail.com
  2. 2. Agenda – • Introduction and backdrop • What is stress testing? - Definition • Why stress test (Supervisory & banks’ expectations) • Stress Test - External Drivers • Stress Test - Internal Drivers • Key Elements of a Stress Testing Process • Types of Risk Factors • Categories of Stress Tests • Sound & Best Practices • Implementation challenges • Liquidity Risk Stress Test (Example)
  3. 3. The 3 Pillars & Stress Testing Minimum requirements provide economic incentives - in the form of lower capital charges* *For those banks that develop better Minimum measures for their exposures to risk Capital and better techniques for managing Requirement their risks Hence, banks perform back-tests on their risk models to ensure they are Pillar 1 valid and measure risk exposures appropriately Generate capital requirements
  4. 4. Supervisors evaluate how bank performs internal processes for risk management Supervisory Review Process Supervisors check that parameters and conditions used to evaluate risk Pillar 2 measures are sound and rigorous – How? One such tool/approach: Outcome of Stress Testing
  5. 5. The third pillar seeks to leverage the ability of markets to provide discipline Market to banks to ensure that they Discipline are not holding unrealistically Requirements low levels of capital Pillar 3 Hence, banks perform stress tests to ensure banks’ capital adequacy in times of shocks Enhanced market transparency & reputation
  6. 6. Pillar 2 Overview Supervisory Firm assessment assessment Identify and assess material Review and evaluate all risk risks and control factors Identify mitigating controls Identify amount of capital in Dialogue Review and assess the and relation to business plan, firm’s risk assessment challenge strategies, and profile Produce capital number and Supervisory conclusion assessment
  7. 7. Capital Planning and Stress Testing Objective: • That the firm can meet its capital requirements at all times through out a reasonably severe economic recession. Why capital planning? • Elements 1 to 3 are static • Assure the firm will have sufficient capital tomorrow Two aspects: • Capital planning, and • Stress testing
  8. 8. Capital Planning and Stress Testing Illustration: pre/post management actions £ CRR (pre) • Cut dividends • Raised extra • Reduced costs capital Capital (post) CRR (post) •Reduced business volumes Capital (pre) time Yr 1 Yr 2 Yr 3 Yr 4 Yr 5
  9. 9. Cyclicality Credit Stress Test • A subset of Pillar 2 capital planning and stress tests 8Scope is narrower than Pillar 2 8Static balance sheet • Same degree of severity (1:25) • The gross test must be assessed under Pillar 1 • The benefit of management actions and capital impact is considered under Pillar 2
  10. 10. Pillar 2 Interest Rate Risk in the Banking Book (IRRBB)
  11. 11. Rules – a selection (paraphrased) • GENPRU 1.2.30R 8 Firm must have in place sound, efficient and complete processes, strategies and systems to identify and manage …. interest rate risk • GENPRU 1.2.42 8 A firm must carry out stress tests and scenario analyses appropriate to its business based on realistic adverse circumstances, and estimate the financial resources needed • BIPRU 2.3.2 G 8 IRRBB will normally be a major source of risk for a bank, building society (and investment firm with non-trading book >15% of total). • BIPRU 2.3.3G 8 Interest rate risk can arise from: • Mismatch of repricing periods (yield curve risk) • Inaccurate hedging where the hedge reprices on a different basis to the exposure (basis risk) • Uncertainties in the timing or occurrence of future transactions (model risk) • Early redemption of fixed rate products (embedded optionality risk) • BIPRU 2.3.7R & 2.3.12 8 Requirement to stress test exposure to interest risk generally (annually) and to a 200bp parallel yield curve shift (at least 1/4ly)
  12. 12. Regulatory approach • IRRBB will be one of the top three Pillar 2 risks on which supervisors will focus when reviewing an ICAAP. • The CRD’s approach to assessment of risk is based principally on changes to economic value arising from a change in interest rates 8Key test is whether a 200bp parallel yield curve shift in either direction reduces economic value by >20% of capital resources • The FSA recognises that firms will normally measure their risks both from an earnings and an economic value perspective 8Relative importance of these measures will vary from firm to firm 8Accept that measures to hedge earnings may increase economic value at risk on an ongoing concern basis
  13. 13. Stress testing • Sudden 200 bp parallel shift in both directions is at best a crude measure • FSA expects firms to apply stresses more relevant to the composition of their Non-Trading Book 8Effect of earnings hedges may be neutralised in assessing economic value at risk 8Allowance may be made for behavioural expectations • Need to document key assumptions 8FSA will particularly wish to understand basis for behavioural adjustments
  14. 14. Proportionality • IRRBB approach is as for other Pillar 2 risks: 8 Firms with relatively non-complex business profiles can apply less sophisticated approaches to capturing and measuring their risks 8 Larger and/or more complex firms may be expected to adopt more advanced modelling techniques, e.g. • Dynamic rather than static balance sheet modelling • Simulation modelling to capture non-linear/option risks • Behavioural models to determine hedging strategies
  15. 15. Non-prescription • FSA has not sought to prescribe how IRRBB should be measured, nor how capital should be attributed. 8Such prescription would in their view be contrary to the principles underlying Pillar 2 8A recent thematic review undertaken by the Risk Review Department identified a range of approaches/market practices in this area 8However, the objective is still that risk should be measured & mitigated • Some overseas regulators are taking a different approach: e.g. APRA 8Has chosen to include IRRBB within Pillar 1 8IRRBB models need to meet general and specific requirements before approval is given for their use 8Calibration is to 99% over a one year holding period
  16. 16. From Pillar 1 to 3 Risk management process • Basle document (Jan ’96) – spells out stress testing as one of the prerequisites for internal model approval • Capital viewed as the last line of defense in a bank. When risk management is insufficient, when reserves are exhausted, capital absorbs losses to prevent a bank’s failure. • But when capital runs out, the bank may become insolvent, leaving public authorities and taxpayers responsible for restoring depositors’ savings The challenge is determining how much capital is sufficient • Stress testing is considered to be an effective and necessary tool that complements statistical models for quantifying & monitoring risk and capital adequacy • By its very nature, stress testing also sets a high qualitative and quantitative standard for risk management
  17. 17. 2. What is Stress Testing? (in banking) • Stress testing refers to “the analytical process involved in subjecting a bank’s portfolio to a series of battery of tests, designed to study the performance of the bank’s portfolio under extreme adverse conditions to generate the potential risk measures under plausible events in abnormal markets”.
  18. 18. Definition Key Points • Series of Battery of Tests - More than 1 test or set of results • Extreme Conditions - Degree of severity critical • Plausible Events in Abnormal Markets - Unexpected and could have happened to competitors or in other countries - Paradigm shift in global financial markets - Historical (local) worst case
  19. 19. 3. Why Stress Test (Supervisory & Banks’ Expectations) What does the regulator What does the bank hope to hope to achieve? achieve? - Able to understand mechanism - Identify where the risk through which stress develops, concentrations are? - Understand impact on bank if - Able to implement measures biggest customers default? when the effects of stress events - Impact on bank if historical evolve into a vicious circle worst-case scenario recur? involving the real economy, - Impact on bank if it is hit by a financial markets and the similar severe credit loss event banking sector that affected competitors in the - etc…… past? - etc…..
  20. 20. Other Considerations Why? • Economic downturns always follow buoyant periods and economic expansions • Unknown issue is when, the severity and scale of the economic recession • Can’t afford to be complacent • Proof of certainty of global recession – next few slides
  21. 21. Stress-testing and Impact on Economic Capital in Validation
  22. 22. Basel II-compliant Integrated Approach to Risk Management – Objective at End Point Key: Reporting Reports Basel 2 Basel 2 Fulfill Requirements of the 3 Pillars Data of Basel II IAS IAS Shared Regulatory Shared Regulatory Internal or Internal or Analysis Analysis management management Market • Organization, • Profitability Discipline Regulatory Reporting Data Mart Regulatory Reporting Data Mart Disclosure Disclosure Policies, Procedures Analysis Requirements • Human Resource, • Portfolio Risk Culture Concentrations & Mitigation Analysis Internal Internal • IT & Systems • Impact Analysis • Process, Culture & from Stress Tests & Regulatory Disclosure Capability Regulatory Disclosure Economic Capital Analysis Analysis Quantification • Risk & Economic • Organization, • Investor Relations Capital • Risk Transfer & Policies, Procedures Information Quantification Diversification • Human Resource, • Stress Test results • Portfolio Risk- • Challenges & Culture Return • Risk & Economic competition Capital Quantification Concentrations • IT & Systems • Environmental Financial and Financial and • Process, Culture & change analysis Management Management GL GL Capability Accounting Accounting • etc. • Risk & Economic Capital Quantification
  23. 23. Basel II-compliant Integrated Approach to Risk Management - Risk Models & Measurements/Scenario Analysis Key: Calculation engines act on Ratings, Calculators Reporting Reports Basel 2 Basel 2 Loss Distribution to yield the PD Data IAS IAS (PE), LGD (LE), EAD, VaR as well Shared Regulatory Shared as EC (CaR) Regulatory Basel II Basel II Severity Severity Calculation Calculation Regulatory Reporting Data Mart Regulatory Reporting Data Mart Disclosure Disclosure Engines Engines Monte-Carlo economic capital (EC) by Internal Internal simulation scenario type Frequency Market & Market & External External De-pegging of USD/RMB CaR1 Asian Financial crisis/Pandemic flu CaR2 Terrorist threat & rise in NPL CaR3 Succession & general election CaR4 IAS Calculation IAS Calculation Sectoral distress, e.g., dotcom bust Engines CaR5 Engines Financial and Financial and Fall in FDI (threat from China/India) CaR6 Management Management GL GL Bank merger & loss of market share CaR7 Accounting Accounting _____ Average Economic Capital Adjust severity & frequency distribution
  24. 24. RECAP: Volatility in EL • For Stress Tests, exaggerate changes in risk drivers according to different levels of severity Rating Data Rating Data • Change in portfolio’s EL, Severity ∆EL, dependent on key risk Severity PD, LGD, EL PD, LGD, EL factors/drivers, e.g., Rating migration Rating migration ∆EL = c1∆I + D + c2∆FX + c3∆GDP + c4∆DR + c5∆CGV + ……. 99.99% level Risk Weights 99.99% level Risk Weights • Volatility in EL leads to Loss distribution => @99% Loss Distribution Loss Distribution confidence level = UL => EC
  25. 25. U.S. Yield Curve Inverts Before Last Five Recessions (5-year Treasury bond - 3-month Treasury bill) % GDP Growth/ Yield Curve 8 % Real annual GDP growth 6 4 2 Yield curve 0 -2 Recession Recession ? Recession Correct Correct Correct -4 Recession Correct 2 Recessions Data though 12/5/00 Correct -6 9 1 3 5 7 9 1 3 5 7 9 1 3 5 7 9 1 -6 -7 -7 -7 -7 -7 -8 -8 -8 -8 -8 -9 -9 -9 -9 -9 -0 ar ar ar ar ar ar ar ar ar ar ar ar ar ar ar ar ar M M M M M M M M M M M M M M M M M
  26. 26. Getting the Basics Right – The Importance of Data Considerations
  27. 27. Validation via Recessionary Stress Test Remarks by Governor Susan S. Bies At the Annual International Symposium on Derivatives and Risk Management, Fordham University School of Law, New York, New York October 8, 2002 Corporate Governance and Risk Management I want to thank Dean Treanor and Alan Rechtschaffen for the invitation to participate in this timely symposium on corporate governance issues. When I joined the Federal Reserve Board of Governors last December, I knew I would be doing more than helping to set short-term interest rates. …….. Another major category of risk is credit risk, which also has become much more quantified. …… the borrower's likely exposure at the time of default, taking into consideration future draw-downs. The greater use of credit models in retail transactions provides a stronger framework to assess risk and ensure that pricing reflects credit quality. For consumer credit, however, models are less proven, since data collection and loss estimates generally evolved after the 1990-91 recession and so have not been proven under stress conditions or for subprime borrowers. Because many of these borrowers did not have significant access to credit in previous recessions, their ultimate default rate in the current cycle should help to validate the strength of the new statistical models. ………….
  28. 28. Ensure reliable data KEY ELEMENTS in STRESS TESTING Survey Portfolio & Environment Framework Identify Risk Factors Construct Stress Tests Yes No Does the bank possess quantitative risk measurement systems? Estimate bottomline of Run Stress-tests using counterparties under counterparty & portfolio stressful conditions risk models Calculate Stress Loss Report Results Take Corrective Action, if reqd Reassess Stress tests for appropriateness
  29. 29. Minimum requirements for the Foundation IRB Approach • ……. • Completeness & integrity of ratings • Min. requirements for estimation of PD • ……. • Use of internal ratings Internal ratings to be used in credit approval process Stress testing, performed at least semi-annually, to be used in the internal assessment of capital adequacy. Such stress tests to cover the impact of broad, downward rating migration and the impact of higher than predicted default rates (PDs) & LGDs At least 3 years’ usage of internal ratings information ……
  30. 30. VI. Portfolio level stress testing, practical application and range of practice - Pillar 2 principles
  31. 31. Implications for Stress Test • Top-down Approach/Macro-view • Relate to Objective – impact is bank-wide • Basel compliant framework – PD and LGD are critical elements of the Standardized and IRB Approaches in the Basel Accord • Risk weight calculations also affected* – Hence, portfolio or sub-portfolio approach recommended • Stress test within generic framework
  32. 32. Identify the Main Objective What does the bank hope to achieve? • Identify where the risk concentrations are? • Impact on bank – if biggest customers default? – if historical worst-case scenario recur? – if it is hit by a similar severe loss event that affected competitors in the past? – etc…..
  33. 33. Risk Monitoring (Stress Test) & Risk Concentration • What’s the relationship? • Worthwhile & logical to start somewhere: – Where? – What? – How? – Why?
  34. 34. Where to Start? • First place to start is to examine the portfolio of weak assets – findings arise from risk monitoring • The weak assets are typically the first to default • Then, proceed with all customer segments as during the Asian crisis, even highly-rated customers were affected
  35. 35. What to Do? • With weak assets or customers, one stress test model (scenario) is for all of them to default • With the other customers including the highly rated ones, one possible scenario is to have all of them downgraded in credit quality by a few notches or severely downgraded to default status
  36. 36. How to Do It? Perform the stress tests at the portfolio level: • Using scenario analysis (multiple scenarios) – e.g. a scenario where all are downgraded with some defaulting or all defaulting, – etc. • Performing sensitivity analysis within each scenario – e.g. varying severity of downgrades (one notch instead of 2 notches), – or increasing the PD or LGD for different customer rating, – etc.
  37. 37. Why Do It? I. Stress Tests will yield info about: • Extent of unexpected loss based on different scenarios as well as degree of severity & risk drivers II. The info above will help provide early warning signs • of where the bulk of the likely credit risk exposures are going to come from and III. Prepare the bank to strategize • on how to avoid or minimize them in case they occur
  38. 38. OVERVIEW Corporates Listed CREDIT PORTFOLIO 1st LEVEL 2nd LEVEL SME’s Consumers Unlisted GENERIC (I) SCENARIO ANALYSIS STRESS Downgrade customer rating through several TESTING notches (have a range of (II) SENSITIVITY ANALYSIS scale, for example: one FRAMEWORK notch down or 2 notches Vary PD and LDG for each down) item Mixture of downgrades & defaults Default some categories of customers
  39. 39. OVERVIEW OR STRESS TESTING THE WHOLE CREDIT PORTFOLIO OF CUSTOMERS USING A GENERIC FRAMEWORK Corporates Listed STRESS TEST PORTFOLIO OF CORPORATES USING a Generic FRAMEWORK STRESS TEST PORTFOLIO OF SMES USING a CREDIT Generic STRESS TEST FRAMEWORK PORTFOLIO OF PORTFOLIO CONSUMERS USING a Generic FRAMEWORK SME’s Consumers Unlisted
  40. 40. Stress Test Outputs • Can yield – several types of reports for different customer segments • corporates, SMEs, consumers – several reports • for different scenarios • different degree of severity – bankwide portfolio reports for different scenarios & degree of severity
  41. 41. IMPACT OF STRESSED ENVIRONMENT Credit Portfolio 1) Credit ratings downgraded Corporates Unlisted & SMEs Consumer (Listed) 2) Higher default incidences Ratings Ratings Ratings AAA 3) Lower recovery rate or higher LGD AA A+ A- A- BBB BBB BB+ BB+ BB- BB- BB- B B B CCC CCC CCC D (default) D (default) D (default)
  42. 42. Probability of Default (PD) & Loss Given Default (LGD) • Both concepts are tied and intimately linked to negative risk factors and economic environments, be it a rise in interest rate, higher unemployment, loss of FDIs, etc. • Changes in PDs and LGDs are the manifestation of negative stressed environments or periods of economic contractions irrespective of the causes
  43. 43. Behavioral Credit Risk Monitoring as a Measure of Impairment Incidences 31 MAY Group 6 Risk Migration - Changes in CRR of Existing Accounts (YTD) 2000 •The same assessment needs to be made 31 MAY Group 1 Risk Migration - Changes in CRR of Existing Accounts (YTD) 2000 for existing customer relationships within 31 MAY Risk Migration - Changes in CRR of Existing Accounts (YTD) 2000 the portfolio to keep track of risk movements. CRR Illustrative SGD ‘millions •The risk migration of existing account are aggregated at the Year to Date level for the 10 8 16 effect on the portfolio risk as the annual 9 1 18 12 SGD ‘millions revisions of the customer relationship are progressively done. 8 Improve 13 10 17 d = 242 7 5 12 12 12 Key Insights Unchange d= 267 last 6 12 27 74 16 5 22 • tracking of YTD CRR changes of existing period Declined customers and the corresponding impact 5 16 19 52 19 10 = 240 on overall asset quality 4 28 21 26 25 9 Total • early warning signal for deteriorating approved accounts 3 18 30 22 18 15 22 limits revised = 749 12 13 22 22 12 2 28 1 CRR 1 2 3 4 5 6 7 8 9 10 No. of this period customers Total 1 2 3 4 5 6 7 8 9 10 CRR - 4 7 11 18 24 9 10 13 3 99 improved declined 0 7 6 4 10 5 4 6 0 ... 42 net effect 0 -3 +1 +7 +8 +19 +5 +4 +13 +3 + 57
  44. 44. Example of Downgrades in Risk Migration for Stress Test Scenario Distribution of Accounts 0.12000 0.10000 Recent Sample Development Sample 0.08000 Proportion 0.06000 0.04000 0.02000 0.00000 Score Score
  45. 45. Application to economic capital calculation and allocation Table 1 Calculating the IRB Risk Weights CALCULATING THE IRB RISK WEIGHTS RISK WEIGHTS: Foundations Advanced EAD PD % LGD % G(PD) 1st paren N(col.F) (1-PD)/PD RW RW Rating $mil LGD=50% actualLGD - AA 210 0.01 0.01 3.719090272 -2.869942924 0.002052795 57.5382393 7.425464426 0.001485093 - A 15 0.05 0.02 3.290559929 -2.390846001 0.008404792 28.32931 19.13508759 0.007654035 - BBB 0 0.77 0.44 2.422833007 -1.420727302 0.077698074 8.44475535 105.9860987 0.932677669 - BB 0 1.11 0.87 2.286927358 -1.268784787 0.102258982 7.16490219 133.4824091 2.322593919 - B 125 3.45 44.81 1.818419019 -0.744992463 0.228138065 4.24728962 267.2481112 239.5077573 - <B 210 5.69 57.62 1.581341423 -0.479939711 0.315635136 3.32895824 356.4417735 410.7634998 - Unrated 95 4.33 63.22 1.713611669 -0.627817846 0.265061575 3.80821185 305.1600339 385.8443468 Total 655
  46. 46. Table 2: Calculating the Minimum Capital Requirement CALCULATING THE MINIMUM CAPITAL REQUIREMENT: January 2001 Proposals Stan dard Foundations EAD ized RWA RW RWA Adv. IRB RW RWA CAPITAL REQUIREMENTS $mil lion EAD * Standar Foundations Advanced s RW RW RW EAD*RW EAD*RW dized IRB IRB 210 0.2 42 0.074254644 15.59347529 1.48509E-05 0.0031187 3.36 1.247478023 0.000249496 AA 15 0.5 7.5 0.191350876 2.870263139 7.65404E-05 0.00114811 0.6 0.229621051 9.18484E-05 A 0 1 0 1.059860987 0 0.009326777 0 0 0 0 BBB 0 1 0 1.334824091 0 0.023225939 0 0 0 0 BB 125 1.5 187.5 2.672481112 334.060139 2.395077573 299.384697 15 26.72481112 23.95077573 B 210 1.5 315 3.564417735 748.5277244 4.107634998 862.60335 25.2 59.88221795 69.00826797 <B 95 1 95 3.051600339 289.9020322 3.858443468 366.552129 7.6 23.19216257 29.32417036 Unrated Total Capital 655 647 51.76 111.2762907 122.2835554 TOTALS Requirement= Capital/Assets 0.07902 0.169887467 0.186692451 =
  47. 47. 6. Key Elements of a Stress Testing Process Background Understanding • Majority of banks’ failures: Credit Risk (recent: Oprisk & liquidity) • Recession cycle: typically 2 years or more • Default likelihood of counterparties or obligors: usually not within the 1st year of getting the loan Before embarking on stress testing, what are the lessons? • Data history • NPL, PD & LGD definitely increase in recessionary times • Consider stress testing at every stage of credit risk management process, including credit assessment & application stage (e.g. cutoff/limit at credit scoring), etc. • Don’t neglect market & operational risks aspects
  48. 48. Key Elements (Assumptions) 1. “Infrastructure” readiness: • Sufficiency & types of data to cover good & bad times • MIS & Data-warehouse capability • Expertise (in-house or external) 2. Scenario selection & appropriateness (The 3 “Rs”): • Relevance: Europe-centric events (Euro crisis) may not apply in Asia • Realistic: Hypothetical Scenarios should be plausible in local context, e.g., LTCM-type loss events may not be applicable to some Asian markets • Reliable & Readily Available Database: The Scenario chosen should be one where the institution is able to collate and analyze the data pertaining to it
  49. 49. Ensure reliable data KEY ELEMENTS in STRESS TESTING Survey Portfolio & Environment Framework Identify Risk Factors Construct Stress Tests Yes No Does the bank possess quantitative risk measurement systems? Estimate bottomline of Run Stress-tests using counterparties under counterparty & portfolio stressful conditions risk models Calculate Stress Loss Report Results Take Corrective Action, if reqd Reassess Stress tests for appropriateness
  50. 50. Reliability of Data • Stress Testing involves the use of models based on unexpected events on a practical basis • Documentation and Access to database is important • Data should be sufficient to capture the downside change as well as the pre-event and post-event dynamics so that the critical risk factors are also captured • Choice of risk factors in determining the explanatory power
  51. 51. Survey Portfolio & Environment Preliminary work necessary: • Management & personnel in bank involved in stress-testing have to arrive at a consensus regarding the scenario or series of scenarios to be “stressed”, • An agreed upon “benchmark” which can also be used in subsequent studies, e.g. historical worst-case scenario and to help define the KRIs for future benchmarking
  52. 52. Identify Risk Factors • This process will go hand-in-hand with the model and scenario chosen • Different types of risk factors may suit different economic environments or types of stress tests, e.g., - with Asian financial crisis, risk factors could be market factors like interest rates, and currency exchange fluctuations - with dotcom bust, default probabilities, corporate bankruptcies or unemployment figures could be used as risk factors
  53. 53. Construct Stress Tests • Once the basic prerequisites are satisfied: scenario chosen, KRFs defined, relevant data collated • Next step is to construct the stress test based on the above in terms of dimensions of evaluation and interpretation of results
  54. 54. Dimensions of Evaluation • Risk: – Severity & range: Loss Quantum & Range of loss quantum, e.g., varying the loss given default (recovery rate) – Frequency & range: Probability of loss, e.g., varying the probability of default
  55. 55. Scenario Analysis Causes Scenario (s) Evaluation (Potential Event) Severity of potential loss Scenarios 1, 2, … Range of severity Failure of relevant risk Typical severity factors Frequency of potential loss Failure of Range of frequency relevant risk factors e.g. THB crash Typical frequency (+ ∆THB) – sensitivity analysis Severity of change in KRF
  56. 56. 7. Types of Risk Factors Counterparty Environmental Model Analytics Deterioration in ability • Financial Market factors • Assumptions • Correlation and/or willingness to • Industry • Holding period • Transition Matrices pay: • Economic • Product • Volatility • PDs complexity • Regulatory • LGDs • Political • Credit Spreads • Sociological • Ecological
  57. 57. Session 2 Includes examples for stress testing in: • Market risk • Credit risk
  58. 58. 9. Sound & Best Practices Stress Testing Decision Sequence Type of risk model Market risk Credit Risk Other (interest rate risk, (liquidity, operational) exchange rate risk, etc.) Type of stress test Sensitivity single factor Scenario Other (multiple factors) (extreme value, maximum loss) Type of shock Individual market variables Underlying volatilities Underlying correlations Type of scenario Historical Hypothetical Monte Carlo simulation Core assets to be shocked, Assumption: Data & MIS size of shocks, and Sufficient & Capable – ideal time horizons state Aggregation, comparison with present portfolio
  59. 59. Examples – Market & Credit Risk • Type of risk model – market & credit risk • Type of stress test – scenario (multiple factors) • Type of shock – underlying volatilities • Type of scenario – Monte Carlo simulation • Allowance for re-test – for varying degrees of shocks or sensitivity analysis Examples – Risk Optimizer, etc.
  60. 60. 10. Implementation Challenges Alternatives 1. Lack of data • Boot-strapping • Theoretical distributions & model • Proxy benchmarking • Peer group (overseas) comparison, e.g. mortgage loan default in neighboring countries • etc
  61. 61. Example: Credit Stress Test Roadmap Balance Sheet Accounting Asset-Liability IRB Compliant Portfolio LLP/NPL Model Model Model Model Stress Test Model Based on Basel 2 Lack of Data on Financial ratio- ALM model Financial ratio- Use of IRB factors PD, LGD, based model like PD, LGD and based model customer ratings Use of equity RW formulations indicators like Altman’s Z-score Emphasis on Incorporates share price and model & Incorporates macroeconomic ratios related to market cap derivatives downgrade of factors – more ratings & increase liquidity and easily available Monte Carlo Trend Analysis of in defaults solvency simulations with Z-scores over a LLP/NPL data adjustments to couple of years Relate results from bank itself Augment with forecasts of directly to capital returns, volatility requirements profitability & e.g., Linear and liabilities efficiency ratios Regression Applicable to sub- Analysis portfolios of Value-add on LLP different customer segments Model Continuous collation of customer data, PD, LGD
  62. 62. Linear or non-linear regression of own internal model • Change in firm’s NPL, ∆NPL, dependent on key risk factors, e.g., – Change in interest rate, ∆I – Change in currency rate, ∆FX – Change in GDP growth, ∆GDP – Dummy variable, D (D = 0, when no terrorist threat, D = 3 when there is terrorist threat) – Coefficients, ci ∆NPL = c1∆I + D + c2∆FX + c3∆GDP + …….
  63. 63. Q&A: Implementation Challenges Alternatives 2. Lack of risk analysis tools • Qualitative judgement (expert opinion) regarding choice of parameters and risk factors & model – expert system • Macro-impact of changes in Balance Sheet, Asset&Liability • etc
  64. 64. Low High Balance Sheet Stress Test Stress Stress 2 1 or less Liquidity – Current ratio Related KRIs 30% 60% or more Solvency from Financial – Debt to Asset ratio Analysis Profitability Negative – Net Operating Income 5% 1% or less - Rate of return on assets 10% 5% or less Example - Rate of return on equity 135% 110% or less Repayment Capacity - Debt coverage ratio 60% 80% or more Efficiency - Operating expense ratio 10% 20% or more - Interest expense ratio 40% 20% or less - Asset turnover ratio
  65. 65. Linking market and credit stress testing Modigliani-Miller (1958): Firm value = Equity value + Debt value; Others: look at credit spread widening & credit indices Equity value Liquid case (e.g. Investment Liquid case (e.g. Investment Firm value Market parameters (Assets) Portfolio): Portfolio): Debt Apply Merton model to link market Apply Merton model to link market factors and default probability PD. factors and default probability PD. Merton model (structural): Exposures (market risk) and credit Exposures (market risk) and credit compute default probability quality (PD corresponds to area quality (PD corresponds to area Asset value distribution below liability level) are affected below liability level) are affected before and after shock simultaneously by shock of market simultaneously by shock of market Asset value parameters. parameters. Illiquid case (e.g. Retail Portfolio): Illiquid case (e.g. Retail Portfolio): Work through the Balance Sheet to Work through the Balance Sheet to understand impact of risk factor understand impact of risk factor Liabilities shocks on P&L, capital etc. shocks on P&L, capital etc. t Default probability
  66. 66. Credit Distress prediction horizon (in months) of Z-score and “KMV” EDF Models (Possible “Alert” Cases) Company Z-score EDF BRWY 11 7 FOHD > 10 > 10 GRPS 12 12 IPCC 6 6 LKNS 37 10 LMGS 14 19 PCIS 29 17 SHOW 9 11 VDHS 7 7
  67. 67. Q&A: Implementation Challenges Alternatives 3. Lack of real-time MIS & expertise • Start at sub-organization or initial group of customers, e.g., consumers • Training & continuing education • Learn from others’ experiences • etc
  68. 68. Other Considerations • It is also important to conduct stress tests based on assumptions that are less complicated for management buy-in. • Also, the stress test results ideally should yield, other than the “loss amount”, information about say, the key risk drivers or factors that have a high explanatory power, i.e., they can explain the loss of the worst-case scenario up to a high degree – see example • Stress Tests also yield different loss amounts based on degree of severity
  69. 69. Stress Test Scenarios: Accounting for explanatory power of different risk drivers Reports Risk factors Relative Loss of Portfolio Explanatory Power changes Value Report 1 DJIA -13% 206% 74% DJIA -13% Report 2 264% 94% FTSE100 -8% DJIA -13% Report 3 271% 97% FTSE100 -8% NIK225 -5% 1. Leaving all other risk factors unchanged, a move of -13% in the DJIA would lead to a relative loss of 206% 2. Leaving all other risk factors unchanged, a simultaneous move of -13% in the DJIA and of -8% in the FTSE100 would lead to a relative loss of 264% 3. etc.
  70. 70. Table Loss on the cash flow in 3 different scenarios Scenario THB IDR JPY Loss Minor crisis -15% -15% 0% USD 58 mil Midsize crisis -30% -30% 0% USD 116.3 mil Major crisis -50% -50% 0% USD 183.9 mil The results provide a considerably more drastic picture of the loss potential of the given transaction than the VAR measure, calculated to be USD 16 mil, by MC simulation.
  71. 71. DEPTH & BREADTH OF STRESS TEST STUDY Stress Test methods are hierarchical - Sensitivity Analysis: broader in coverage - Scenario Analysis: more focused on specifics - “Full-Blown” Stress Test: the ultimate in coincident extreme conditions leading to: “THE PERFECT STORM”
  72. 72. STRESS TEST METHODS (A) Hierarchy & Overview Full-Blown Depth Stress Testing Scenario Analysis Sensitivity Analysis Breadth
  73. 73. Overview of Stress Test methods • Sensitivity Analysis: Shock risk factor by large no of “standard deviations” – Typically VAR-based – use EVT to analyze 99.9...% quantile – consistent with daily risk management – takes into account probability of event • Scenario based: Define scenarios that could hurt – include “the unexpected” (e.g. merger risk) – consider highly correlated crashes – forward looking – Other “what-if” scenarios • Full-Blown Stress Test: The perfect storm - subject scenarios above to multitude and coincidence of extreme events and pressures
  74. 74. Sensitivity Analysis a) Using EVT b) N X Std. Deviation c) Tweaking correlations & volatilities Extreme Value Theory (EVT) Model VAR 98.70% 90 98.7% confidence 80 series 1 7 mil 70 series 2 10 mil 60 Frequency 50 Series1 40 Series2 30 20 10 0 -15 -10 -5 -10 0 Loss
  75. 75. 1 c1 c2 1 c3 1 c1 + 15% c2 + 15% 1 c3 + 15%
  76. 76. Portfolio: 3 assets $10 mil portfolio: 1) 500 Citicorp shares with nominal value of $5 mil 2) 150 Euroyen Dec futures with nominal value of $3 mil 3) 50 QQQ (NASDAQ ETF) shares with nominal value of $2 mil
  77. 77. r1, r2, r3 = 0 σ1 = 15% σ2 = 13% σ3 = 20% ρ12 = 0.5 ρ13 = 0.3 ρ23 = 0.4 1 ρ12 ρ13 = 1 0.5 0.3 1 ρ23 = 1 0.4 =M 1 = 1
  78. 78. VAR Var (N std dev) = 1 0.5 0.3 15%*N*5 √(15%*N*5 13%*N*3 20%*N*2) * 1 0.4 13%*N*3 1 20%*N*2 = VAR (2 std deviation) = √ (5.88) = 2.42 Or With a 95% confidence interval, the value of the portfolio will not decline by $ 2.42 mil If N = 1.65, then it’s 90% confidence interval
  79. 79. Scenario-based Event or Scenario Risk Analysis Historical Events User-Defined Events Shock Names S&P NASDAQ FTSE NIKKEI JPY GBP Black Monday -20.5% -13.4% -10.8% -2.4% 0.0% -0.5% Gulf War -10.4% -13.1% -7.9% -16.8% -2.1% -3.4% Euro Crisis -2.0% -0.6% 7.8% -3.2% -4.5% 8.1% Mexican Peso Crisis 1.9% 4.3% -3.4% -8.4% -0.4% -2.2% Asian Crisis -6.9% -7.2% -2.6% -1.9% -0.2% -1.8% Russian Crisis -12.9% -23.5% -16.8% -13.5% -17.6% -5.5% Tech-Wreck -11.2% -33.1% -8.3% 2.4% -2.2% 0.3% Sept. 11 -11.7% -16.1% -11.9% -6.3% 3.7% -0.1%
  80. 80. The Asian Contagion Liquidity Trading Market Trading Risk Risk Credit Risk Market Asian Credit Liquidity Currencies Spreads Dried Declined Widened Up Enterprise Declining Equities Liquidity Credit Fell Dried Up Quality Interest Financial Defaults Rates System Increased Unstable Under Stress
  81. 81. Annual Correlation & Volatility EXAMPLE: (%) matrix STRESS TEST ASIAN CRISIS •Pre-Thai Baht crash (July 1997) Volatility 10 23 15 14 16 8 11 •Post-Thai (impact on other US SG HK ID TH MY JP markets) **GRANULARITY OF DATA US 1 0.6 0.7 0.56 0.61 0.34 0.41 6-month SG 0.6 1 0.72 .. .. .. .. correlation & volatility HK 0.7 0.72 1 .. .. .. .. matrix ID 0.56 1 .. .. .. 3-month TH 0.61 1 .. .. correlation MY 0.34 1 .. & volatility JP 0.41 1 matrix “PERFECT STORM” Environment : Introduce China factor – Yuan devalued in the midst of crisis! June 1996 June 1997 June 1998
  82. 82. Examples • From US Markets • Linking Market & Credit Risk • Balance Sheet Stress Testing
  83. 83. THE US MARKET • Scenario 1 – When US Stocks are all Down • Scenario 2 – Using historical worst-case P-E, P-B or P-S scenarios3
  84. 84. US Market Examples: Scenario 1 When NASDAQ stocks are all down
  85. 85. US Markets: Scenario 2 Using historical worst-case P-E, P-B or P-S scenarios
  86. 86. Case Study Discussion • The Sub-Prime Contagion
  87. 87. Subprime Contagion: End-to-End Examination Ratings agencies Loan Origination Mortgage Lenders Investment Banks Investors & insurers Securitization Process Map Subprime & Portfolio ALM info Rate the tranches Securitize pools of Seeking high-yield prime borrowers based on portfolio loan receivables “investment grade” info & facility into tranches asset classes Loss rates (DR) No Income No Doc Insurers provide Obtain portfolio Spectrum from Pooling of Loan guarantees based info hedge funds, Exotic on their AAA mutual funds & receivables mortgages: “reassurance” Hire ratings pension funds, etc. ARMS & HEL agencies & Basel 1 or 2 status monolines Sales Incentives Risk Exposures? In theory, optimal risk transfer thro’ originate & distribute model
  88. 88. EXAMPLES CONCLUDING REMARKS • Categories of Stress Test • Operational Risk Illustration
  89. 89. Risks Are Integrated/Correlated! Source: Global Risks 2007. World Economic Forum Report
  90. 90. Liquidity Risk Monitoring The actual value of “Asset Turnover Ratio” is 39 and pointed out by black needle. The The value 10 and 20 are two actual value is calculated on average of all threshold value of Interest subsidiary in year 2004. expense ratio.
  91. 91. Impact from OpRisk Event Types on Liquidity Risk manifestation - Example 7 Categories of Operational Losses Practices & age to Disruption orkplace Delivery & Execution, e ploym Practices Business Products Business External Physical Internal Failures Process System Clients, Assets safety Fraud Fraud t Mgm Dam and Em ad W nt Corporate Finance 8 Business Lines Trading & Sales Standardized Payment & Settlement Approach for 6 business lines Agency Services Asset Management Retail Brokerage AMA Approach Commercial Banking for 2 businesses Retail Banking Inputs Methodologies Outputs Regulatory Statistical Distributions Statistical Models Capital External Operational Loss Data Risk and Control Self-Assessment Management Self-Assessments Workshops Tools Internal Operational Loss Data Reduction in Scenario Analysis Scenarios Operational Losses
  92. 92. Interplay b/w Oprisk Events & Liquidity Risk Manifestation: Sources It can be caused by the breakdown or inadequacies in: - Model use / model risk - Valuation/pricing - Fraud, e.g. losses due to rogue trading - Reputation - External factors - Others – people/business - Etc.
  93. 93. Where Liquidity Risk could Manifest in the Context of the Building Blocks of ORM Framework Event Flow through income Primary focus of capital Frequency statement allocation for operational risk Cause of Risk EXPECTED UNEXPECTED LOSSES LOSSES People Process Liquidity risk zone Systems High-Freq Low-Freq Low External High Impact Impact Catastrophic Risk & Control Assessment Impact Severity Loss Event Management Risk Measures & Reporting Risk Management Process Risk Bankwide Approach Mapping Insurance Program Business Continuity Program Risk Governance
  94. 94. Completeness of Stress Tests (environment, duration/stages, scenario analysis including severity, etc.) • Documentation (thought processes) • Scenario Analysis • Liquidity factors/ratio calculations • Balance Sheet stress test • Etc.
  95. 95. Evidence/Documentation • Model assumptions • Identification of risk drivers/factors • Data inputs/transformation/outputs: macroeconomic, micro-, demand- supply/volumetric analyses • Liquidity portfolio management & diversification • Risk Assessment/Monitoring • Remedial activities (next slide)
  96. 96. Risk Mitigation Strategies • Risk management strategies need to be determined and maximized. RETAIN AVOID TRANSFER REDUCE EXPLOIT • Divest • Accept • Disperse • Insure • Allocate • Prohibit • Re-price • Control • Reinsure • Diversify • Stop • Self insure • Hedge • Expand • Target • Offset • Securitize • Create • Screen • Plan • Share • Redesign • Eliminate • Outsource • Reorganize • Indemnify • Price • Arbitrage • Negotiate • Influence
  97. 97. Example of calculation of the liquidity ratio and the observation ratios Capital charges Residual maturities of Calculation of the liquidity ratio and the due on demand over 1 month over 3 months over 6 months observation ratios up to one month up to 3 months up to 6 months up to 12 months Maturity band 1 Maturity band 2 Maturity band 3 Maturity band 4 A. Total liquid assets 200 100 80 40 B. Total liabilities 160 180 60 80 C.Mismatches (A - B) + 40 - 80 + 20 - 40 D. Positive mismatches (A > B)* + 40 - + 20 - E. Mismatches adjusted 140 60 (A. plus positive mismatches D. of the - 80 (100 + 40) (40 + 20) preceding maturity band) F. Liquidity ratio (A / B) 1,25 - - - (at least equal to 1.0) H. Observation ratios (E / B) ( No minimum levels for the observation - 0,78 1,33 0,75 ratios) *Severity of mismatch – scenario analysis & stress tests

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