How to Coordinate Regulation (Basel III), Market and Business Strategy in the Planning of a Financial Institution: Optimize or die!

Optimize or die
How to coordinate regulation
(Basel III), market and business
strategy in the planning of a
financial institution
Ramon Trias
CEO
AIS Aplicaciones de Inteligencia Artificial
rtrias@ais-int.com
www.ais-int.com
Madrid, September 2013

Motivation
Balance Sheet and P&L Projections
Conclusions
Agenda
2 | © 2012 Global Association of Risk Professionals. All rights reserved.

Motivation
Conclusions
Agenda

Traditionally we have focused on separated risks: credit, market, liquidity…
We have learnt numerous methodologies and developed technologies which
are useful to treat them separately – siloed approach - .
Now we are able to plan the optimal strategy considering the whole business:
calculating the optimum distribution of the portfolios in order to meet the
A Little History…
calculating the optimum distribution of the portfolios in order to meet the
bank’s business objectives, taking into consideration all types of restrictions
and all kind of risks.
This has been the evolution…

Financial Modeling Evolution
Credit Macroeconomics
Other risks
Failure –
oriented
(bankruptcy /
default )
CreditPortfolioView,
Stress testing, RDF
Operational,
reputational,
liquidity, ...
Market CorporateMerton
COSO
Basel II
Stress
test
Business
Integration
Optimization
Main attention
to prices.
speculation,
volatility
B/S Projection

What happened in the PAST is not the best answer to forecast the
FUTURE.
WHY?
Statistical methods are based on historical information
Control and regulation based on ratios have sense in stable times or quiet noise
evolution.
Where Are We Going To?
evolution.
Complexity has raised (and goes on arising) from different sources.
But, risk management makes more sense if it does integrate all risks with
business objectives.
To do so, it is necessary to OPTIMIZE.

We, risk experts, are also the best qualified on modeling
business functions in Financial Institutions:
Rescuing well known tools and concepts

The next step into this new position is
Strategic Planning
Tools for Balance Sheet and P&L projection, subject to
optimization criteria, in a changing environment.

Motivation
Conclusions
Agenda

To implement a system that really helps managers to make decisions
about which strategy to follow, by laying out the optimum asset and
liabilities structure from the leading objective perspective.
Integrating –convoluting- all sources of profit and loss – risks, earnings,
funding ...
Our Proposal
Considering all limitations and restrictions (Basel III, market, business…)
Mixing economic forecast from a formal model with extra model
scenarios.
Using a dynamic view, not a still photograph.

Our Proposal
Current Portfolio, regulatory
Results
• Balance
• Results
Macro-economy Macro Scenarios
Financial System
Dynamics
Scenarios Generator
Current Portfolio, regulatory
restrictions, market restrictions
Proposal
• Cash Flow
Statement
• Req. capital
• Regulatory
capital
• RAROC/ROE
• Bank value
• Liquidity
Feedback
Risk Tolerance
Other Restrictions
Optimization Criteria
Risks:
Credit, ALM, Liquidity,
Interest Gaps,
Treasury, Other

Example
How Should This System Work?
The effect of anticipating the schedule of implementation of Basel III short
term liquidity ratio.
Let’s see how, the anticipation of this ratio affects the forecasted assets and
liabilities in the optimale plan.
We consider the optimization of a balance sheet of a hypothetical bank. The
optimization criteria is the maximization of profit. The active restrictions are Basel II
and Basel III frameworks.

Comparacion_Proy1
The maximum
The maximum
profit that could be
reached is lower
than before.
The first victim
would be the
trading portfolio.
1 2

Comparacion_Proy1
Mortgage loans
Mortgage loans
would fall
The debt structure
would change

Comparacion_Proy1
Cash increase
Cash increase
Lower profit
1 2

Optimization. All the Limitations Together.
ratioCooke
leverage%
ratiocoveragestablenet
ratiocoverageliquidity
amountfinacingtermLong
availablefinancingtermLong
FlowCashNet
=
=
=
=
=
=
=
rc
ap
nscr
lcr
IRFE
FDE
SHL
tsLiquidAsse
developersStateRealSMEstoLoans
CapitalTotal
CapitalTier11
1TierEquity:CapitalCore
%80LTVMortgages
=
=
=
=
=
<=
AL
CR
CT
C
CB
M
Basel II Basel III
1
*85.065.0
1
)*25.0,max(
1
03.0
≥
+
+
=
≥
−
+
=
+
=≤
CRM
sLongliabilitieCT
nscr
outinout
depBCcash
lcr
CRM
C
ap
[ ]
[ ]
[ ]
[ ] [ ]BICTBIICT
QISdelIIgoupparaaprox
CRMBIICT
CRMBIIC
CRMBIICB
≅
+≥
+≥
+≥
2010
08.0*)75.035.0(
04.0*)75.035.0(1
02.0*)75.035.0(
[ ]
[ ]
[ ]BIICTCT
BIICC
BIICBCB
QISdelIIgoupparaaprox
CRMCT
CRMC
CRMCB
≅
≅
≅
+≥
+≥
+≥
175,01
5.0
2010
105.0*)75.035.0(
085.0*)75.035.0(1
07.0*)75.035.0(

50
100
150
200
250
300
350
400
Hipo
Retornos
capEconomico
max PyMEs
max Hipotecas
Liquidez Largo
Apalancamiento
Capital Total
Tier1 Ampliado
Capital Base
balance
Restricciones
50
100
150
200
250
300
350
400
Hipo
50
100
150
200
250
300
350
400
Hipo
Optimization. All the Limitations Together.
50 100 150 200
PyMEs
50 100 150 200
PyMEs
50 100 150 200
PyMEs
50 100 150 200
PyMEs
50
100
150
200
250
300
350
400
Hipo
50 100 150 200
PyMEs
50
100
150
200
250
300
350
400
Hipo
When calculating the best plan to reach
the business objectives of the bank, it is
a must to consider all the restrictions
involved: regulation, market, policies...
Any single change gives a new assets
and liabilities position.

Required Technology To Make This System Work
• Macro variables forecast: VAR models. Multiequational and
multivariable. Cointegrated.
• Conditional distributions mixes extra-model scenarios with formal
forecasts.
• Microeconomic models links macroeconomic scenarios with internal
flows –PD, LGD, credit demand, cost of funds, ...
• Risk drivers: Macroeconomic together with residual variables from
micro models.
• Capital Economic: optional (Vasicek multifactor, RDF …)
Macroeconomic
Scenarios
• System dynamics: modeling the accounts and flows.
• Optimization gives us the best values of controllable flows – New
credits, portfolios sales, new funds, capital issues, ...
• Limits: ratios, accounts and flows, orthogonal and combined
• Restrictions: lineal and non-lineal. Internal point method
• Objective function: SVA, EVA …
• Computing modules: NRC, IPOPT, C++
Optimization
Engine

Macroeconomic Scenario. Building The Models.
MacroEconomic
VAR model
{ }[ ] { }ttYB ε=Φ )(
Scenario
{ }[ ] { } { }[ ] { }TttTttt YYY ,1,1
*
∈∈
⊂→∃
Conditioned
Generalized Forecast
[ ]*
,ˆ; YYY ΣΩ
It would be useful that the
methodology used to build the
macroeconomic scenario model
allowed to automatically
computed projections of the
non-defined variables
B/S,
Parameters,
Coefficients,
Micro Economic
flows models
{ } { }[ ]i
tt
ii
t YLz ε,=
[ ]*
,ˆ; TnTnTnTn YYY ×××× ΣΩ
Portfolios
covariance
[ ]YPortfolios G Σ=Σ
Economic Capital
model
{ }[ ]YLK tt ≤
ε as Risk Appetite
{ }[ ][ ]
( ) { }[ ]YLVaR
YLCDF
tt
t
=
⇒=
ε
ε
Feeds
Optimization
Model
Coefficients,
Maturity

Macroeconomic Scenario. Building The Models.
Optimization assumes as
restrictions equalities and
inequalities about accounts
and flows
System Dynamics
Accounts and Flows
Feeds
Optimization
Model
{ }[ ]
{ } { }[ ]
xXWZ tt
xt
,max =
Optimization
Objective Function
{ }{ }{ }[ ]
{ }{ }{ }[ ] LTt
Tt
xXSVA
xXEVAZ
∈∀
∈∀=
,
,max
Accounts and Flows
{ } { }{ }{ }{ }[ ]11 ,,,, −−= tttttt xXxXGxX
{ } { }[ ]
{ }[ ] { }nitxXF
xXGxXts
tt
itittt
,1,;0,
,,..
∈≥
= −−
Output to
BudgetingExecutive FormatNew scenarios

Macroeconomic Scenario. Macro Variables Forecast.
Forecasted
Scenario
Expert
Validations

Macroeconomic Scenario. Conditioned Forecast.
Forecasted
Scenario
Expert
Validations

FUNDS
PORTFOLIO
Collection
Formalizations Oustanding
Interest
Recoverd
Outstanding
capital
recovered
Partial amortization,
Prepayments
Associated
Costs
Installments
Optimization Engine. System Dynamics
The system should
be able to simulate
the progression of
the accounts and
flows
DEFAULT
RESULTS
Default
Recoveries
RECOVERED
ASSETS
Total
Debt
Bad Loan Losses
Current
Interest
Default interest

FUNDS
PORTFOLIO
Collection
Formalizations Oustanding
Interest
Recoverd
Outstanding
capital
recovered
Partial amortization,
Prepayments
Associated
Costs
Installments
Optimization Engine. System Dynamics
The system should
be able to simulate
the progression of
the accounts and
flows
Eg. Mortgages(t)=Mortgages(t-1)-Amortizations(t)-Early Cancelations(t)-
New Past due Loans(t)-Portfolio Sales(t)-Securitizations(t)+New
Mortgages(t)
DEFAULT
RESULTS
Default
Recoveries
RECOVERED
ASSETS
Total
Debt
Bad Loan Losses
Current
Interest
Default interest
- Amortizations is an “arithmetic” function of maturity and conditions.
- Early Cancelations, New Past due Loans are statistical functions that
depend on macroeconomic variables.
- Portfolio Sales, Securitization and New Mortgages are calculated by the
Optimization module.

Optimization problem can be stated as:
{ }[ ]xXWZ tt ,max = ( )
xandXtoimposednsrestrictiothedefinesit
linealnonbecanfunctionsionalmultidimenaisF
What Can Optimization Do For Strategic Planning?
An optimization based system
explores automatically a
universe of possible asset,
liabilities and capital structures
and chooses the best plan
{ }[ ] { }
{ } { }[ ] { }nitxXGxX
ntxXF
ts
itittt
tt
,1,,,
,10,
..
∈=
∈≥
−−
( )
( )
( )nstransactioflowsofVectorx
accountsstatesofVectorX
criteriaonoptimizatitheDefinesW
nstransactioandaccountsofdynamicsthedefinesit
linealnonbecanfunctionsionalmultidimenaisG
xandXtoimposednsrestrictiothedefinesit

What Can Optimization Do For Strategic Planning?
Asset
Asset
Asset
Asset
Asset
Capital needed
Internal capital
calculation
Given
N assets to 1 capital
Ratios, states
Valuation
Usually…
Optimized Plan
Asset
Asset
Asset
Asset
Asset
Asset
Capital Limits
Given
Other Restrictions
Internal capital
calculation
Objective 1 capital to N assets (& funds)
Calculated with iterations
Non lineal function

Prioridades
Priorities
If it is not possible to
accomplish all
restrictions, the system
should allow to
establish priorities.

Optimization Engine. Restriction Analysis.
Mortgages
granted
Restrictions can be
active or superfluous.
The system should
then show the
gap/excess amount.
Time

Financial
prospects
Board Commercial
Commercial
Risk
appetite
Strategic
guides
Services
Who Takes Advantage of That?
Commercial
direction
Financial
direction First
commercial
plan
Adjusted
budget
Treasury
Portfolio
manager
Detailed
budget
Branches
Follow-up, risk,
quality,
profitability
Funds
offer
Services
& credit
demand
* Maximum value subject to: accounting constrains, Basel II & III rules, commercial limits, strategic guides, risk appetite

Financial
prospects
Board Commercial
Commercial
Risk
appetite
Strategic
guides
Services
Who Takes Advantage of That?
Commercial
direction
Financial
direction First
commercial
plan
Adjusted
budget
Treasury
Portfolio
manager
Detailed
budget
Branches
Follow-up, risk,
quality,
profitability
Funds
offer
Services
& credit
demand
Strategic
Planning
Tool*
* Maximum value subject to: accounting constrains, Basel II & III rules, commercial limits, strategic guides, risk appetite

Motivation
Conclusions
Agenda

“Financial Risk Management started as one thing and has ended as another.”
(Manz, 2011)
We, risk experts, are also the best qualified on modeling business functions in
Financial Institutions.
The next step into this new approach to Strategic Planning, tools for Balance
Conclusions
Optimize or die…
The next step into this new approach to Strategic Planning, tools for Balance
Sheet and P&L projection, subject to Optimization criteria, in a changing
environment.

Main attention to prices. Volatility. Stocastic processes, Fourier diffussion
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Vasicek, O. (1977), An Equilibrium Characterisation of the Term Structure. Journal of Financial Economics 5
(2): 177–188.

Credit Risk
Failure – oriented (Bankruptcy / Default )----
Actuarial model, Binomial Gamma Negative Binomial Distributions, Characteristic
Functions
AIS (1987), Credit Scoring Models, Behaviour Scoring, shops channel.
Altman, I.E. (1968), Financial Ratios, Discriminant Analysis and the Prediction of Corporate Bankruptcy.
Journal of Finance: 189–209.
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Credit Suisse Financial Products (1997), CreditRisk+,
http://www.macs.hw.ac.uk/~mcneil/F79CR/creditrisk.pdf
Fair Credit Reporting Act (1970), http://www.ftc.gov/os/statutes/fcradoc.pdf
FICO Credit Scoring History http://www.fico.com/en/Company/Pages/history.aspx
Trias, R. et al. (2008), El método RDF, El nuevo estándar de stress testing de riesgo de crédito, AIS
http://www.ais-int.com/wp-content/uploads/2011/12/RDF_Articulo_01.pdf
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Vasicek, O. (1987), Probability of loss on loan portfolio. KMV Corporation
Wells Fargo First Behaviour Scoring. In http://www.fico.com/en/Company/Pages/history.aspx

Other risks & other models
1990s Minor worries about .Basel II Pillar II – Systems, Pension, Concentration, Reputational, Liquidity and
Legal Risk.
Actuarial approach: data collection, events distribution – Poison, Gamma distributions, Extreme Value
Theory, Distribution Mixtures, Survival analysis, Statistics for rare events, convolution, characteristic
functions. …
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Operational Risk
Basel II Capital ratios
Basel II – Capital reinforcement. Capital ratios
COSO (1991), Internal Control: Integrated Framework. Committee of Sponsoring Organizations of the
Treadway Commission.
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Vol1 No 1, pp.63-72
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Risk and Regulation.
Baring Bank destruction (1995)

Macroeconomic
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Eng.pdf

Corporate
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Ong K.M. (1999), Internal Risk Models. “Capital Allocation and Performance Measurement”. Risk Books

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