Risk Management Review May 1, 2007 Outline for todays discussion - - PowerPoint PPT Presentation
Financial Integrity, Oversight and Broadened Capital Markets Risk Management Review May 1, 2007 Outline for todays discussion Introductions Review of objectives of risk management sub- component and specific tasks Overview of
Introductions Review of objectives of risk management sub-
Overview of Risk Management
Definitions and terminology Credit Risk Operational Risk
Discussion of your ideas and objectives Next steps
Native of North Carolina Wharton MBA, CFA Thirty years of experience in investment and commercial
Top bank regulator in Commonwealth of PA for banks,
Consulting for past 12 years in primarily emerging markets
Worked with CBJ on risk management, early warning
Address practical issues for implementation
Build risk management capacity in Jordanian
Provide roadmap for evolution to IRB
Conduct kick-off session to identify practical
Follow up with private interviews Work with interested banks to develop
Conduct risk management diagnostics
Provide general overview of risk and risk
Establish a baseline of risk knowledge,
Provide overview of different credit rating/risk
Hear from you
Develop methodology for creating a
Conduct individual bank diagnostics
Gap analysis Focus on policies and procedures Reports for monitoring Organizational structure
Supply and demand
Rational investors
Efficient markets
20 40 60 80 100 120 140 160 1 2 3 4 5 6 7 8 9 10 Series1 Series2
Tail Probability = 2.5%
Distribution of actual or expected occurrences
Features Features
Required rate of return determines the price
Perceived risk determines the required return
Risk Free Rate Level of Risk Common Stock Rate of Return Risk Premium Treasury Bonds First Mortgage Bonds 2nd Mortgage Bonds Subordinated Debentures Income Bonds Preferred Stock
AAA AA A BBB BB B CCC MV=PV = Σ C + TV
t=0-n (1+r)t (1+r)t
E x p e c t e d R e t u r n Risk/Standard Deviation A C B
Short-term vs longer-term Liquidity Floating vs fixed rates Credit Leverage
On and off balance sheet credit exposures Interest rate and equity risk in trading book; FX and commodity risks in banking and trading books Primarily failed processes or event risk (not strategic or reputational risk)
Credit Risk Market Risk Operational risk
Capital protects depositors and creditors
Safety and soundness Supports growth Is a buffer against losses Can be in the form of non-equity Equity capital represents owners’ interests Last creditors to be paid in liquidation Requires a return in cash income and appreciation Retained earnings are a good source of capital
Capital is a non-interest bearing source of funds
Equity capital is the most expensive source of funds Must earn a required rate of return (ROE) Is a scarce resource
Management’s goal is to maximize risk-adjusted
Competes with risk-free rate and alternative
Affects pricing and competitive position if too much
Focus is historical cost of assets and recognition of impairment (fair value) Focus is historical cost of assets and recognition of impairment (fair value)
Accounting capital Market capital Economic capital Regulatory capital
Focus is income, the market’s expectations and required return Focus is income, the market’s expectations and required return Focus is market value (PV of cash flows) of assets/liabilities Focus is market value (PV of cash flows) of assets/liabilities Focus is balance sheet and income risk and capital components Focus is balance sheet and income risk and capital components
BIS II attempts a more precise calibration of economic and regulatory capital
Book values represent present values of future
Market values of capital stock reflect net present
Economic capital is the same as net book value Regulatory capital would be a realizable value
Japanese Bank US Bank Capital 2% 6% USD 2 million USD 6 million ROE 30% 20.8% Loan USD 100 million USD 100 million Net interest margin .6% 1.25% Income USD 600,000 USD 1,250,000
Align regulatory capital requirements more
Emphasis is on banks’ risk management and
There is flexibility in assessing capital
Credit Risk
Market Risk
Operational Risk
Minimum 8% of Capital to Risk-Weighted Assets
Pillar 3: Market Discipline
management process and capital adequacy
Pillar 1: Minimum Capital
and control environment
Pillar 2: Supervisory Review
Mutually reinforcing factors that determine capital adequacy
Quantitative Requirement Qualitative Requirement Public Disclosure
rational
rational
The less the history, the less reliable the
The less certain or transparent, the greater
The more the risk, the more capital needed All the above implies higher capital levels
“The nature of Risk Management in banks is changing
in damage limitation. Now it is becoming an important weapon in the competitive struggle between financial institutions. Those who can manage and control their risks best will be the most profitable, lowest priced producers. Those who misjudge or mis-price will be out on their ear.”
The Risk Game The Economist, Survey of International Banking (1996)
TRADITIONAL PERFORMANCE MEASURES
losses
losses
RISK-ADJUSTED PERFORMANCE MEASURES
higher margins
higher margins
Risk Control
Risk Management
What risks and how much
What risks, how much and how well managed Historical Analysis Historical Analysis and Forward modeling
Credit Risk Management Internal Audit Treasury Management ALM
Set Policies and Objectives (including FTP rules) Gather External Information Develop and Assess Scenarios Collect and Analyze Internal data Set Liquidity Policy Set Interest rate position Set FX Exposure position
Set investment and earnings management guidelines
Execute
Interest Rates FX rates Economy Competition Business strategy & credit policy
Drives strategy and credit risk management Source: Booz-Allen & Hamilton
Systems
Policies & Processes
Risk Management Organization
Methodologies
RAROC = Profit Economic Capital Provisions _
Revenue less funding and
Predictable losses are expensed The cushion needed to support Unexpected Losses
RAROC: Risk-adjusted return on capital
Interest and fee income xxx Less cost-of-funds (xxx) Net interest income xxx Less “expected loss” (xxx) Less non interest expenses (xxx) Pretax income xxx Less tax (xxx) xxx Divided by Economic xxx Capital RAROC X% Interest and fee income xxx Less cost-of-funds (xxx) Net interest income xxx Less “expected loss” (xxx) Less non interest expenses (xxx) Pretax income xxx Less tax (xxx) xxx Divided by Economic xxx Capital RAROC X%
Applied to hurdle rate
Loan/Product/Branch
Pricing guidelines FTP Credit analysis Direct and allocated indirect costs Allocated capital
Risk
Risk Free Rate
Return
Business Units, Sub-Portfolios, Transactions
Frontier
RAROC
RAROC uses a bank’s own allocation RORAC uses BIS assigned weights The more the capital the more the perceived
The more the capital the higher the required
Standardized Approach Internal Ratings Based Approach Foundation
Advanced
The potential that a bank borrower or counterparty will fail to meet its obligations in accordance with agreed terms
“Principles for the Management of Credit Risk” - BIS 1999
“The risk that a borrower will not pay what we lent – in full and on time” Must also include all threats to value, in a probability / net present value sense; e.g. deterioration in quality throughout the life of the loan is a credit risk in itself
The primary objective is to minimize the volatility
perceived by investors) and at the same time earn a ROE to maintain the value of the common equity.
Foregone Interest and provisions And mark-to-market losses Losses in economic capital
And price appropriately!
Expert systems Credit scoring models Rating systems
Final ratings are ultimately judgmental, but graders are provided with a “template” of quantitative benchmarks for each rating category Graders are provided a “scoresheet” which combines a set of objective characteristics with subjective factors in a predetermined manner Grades are derived purely mechanically, with no role for subjective inputs Grades are set judgmentally against a set
guidelines
Template
Model Scoring Judgment
R ATIO FO RM U LA WEIG H T FAC TO R WE IG H TED R ATIO Return on Total Assets Earnings Before Interest and Taxes
Sales to Total Assets Net Sales
x 0.999
Equity to Debt M arket Value of Equity
x 0.6
Working Capital to Total Assets Working Capital
x 1.2
Retained Earnings to Total Assets Retained Earnings
x1.4
Standalone risks
Portfolio risks
Credit risk management means diversifying and transferring risk
Industry sector Competitive position Financial strength Cash flow/ debt serv.
SAMPLE DATA COLLECTION
e x a m p l e s
Category
Industry Financial Condition ♦ Industry profile -- 3 years ◊ Size, growth ◊ Concentrations ◊ Cyclicality/seasonality ◊ Explanation of trends ♦ Industry outlook ♦ Profiles of key competitors (top two) ♦ Regulatory profile -- current, recent changes, expected changes ♦ Borrower’s strategy ♦ Key alliances: ◊ With government ◊ With private sector ◊ With other influential players ♦ Company financials -- 3 years ◊ Profit & loss statements, balance sheets ◊ Supplementary statements -- reconciliation of net worth, fixed assets\ ◊ Audited where possible ♦ Creditor facilities ◊ Banks ◊ Suppliers Data Required Data Sources ♦ Internal ◊ Files ◊ Research department ◊ Other managers familiar with industry ♦ Third parties ◊ Ministries ◊ Multilateral agencies -- World Bank, IADB, etc. ◊ Other government organizations ◊ Trade associations ◊ Other banks ◊ Other companies in industries ♦ External -- customer calls ♦ Business press ♦ Internal ◊ Files ◊ Other managers familiar with borrower ♦ Issuer ◊ In person calls ◊ Site visits amounts and condition
Raw data Raw data Individual Scores Individual Scores Economic Interpretation Economic Interpretation Calibrated Rating (PD) Calibrated Rating (PD) Aggregation to
Aggregation to
Input Calculation Output
qualitative Factors
comparable for all factors
(e.g. linear algorithm)
fixed May be different by segment (size, state -owned /private, industry, available information)
What is the likelihood a borrower will default? Probability [%] If the borrower defaults, how much are we likely to lose? Amount [JOD or %]
Three measures for credit risk
IRB uses banks’ own rating systems with
Provisions should equal expected loss where
Capital must be held for UL
1 2 3 4 Standard Deviation
X = 2% Y = 4% X = 4% Y = 5%
X Corporate Loans Y Credit Cards
S & P RATING MOODY’S EQUIVALENT DEFAULT PROBABILITY (SUBSEQUENT YEAR)
AAA Aaa 0.01% AA Aa3/A1 0.03% A As/A3 0.10% BBB Baa2 0.30% BB Ba1/Ba2 0.81% B Ba3/B1 2.21% CCC B2/B3 6.00% CC B3/Caa 11.68% C Caa/Ca 16.29%
How we can we classify individuals into broad risk bands to manage our actuarial risk?
Example: Life insurance company
Set hypothesis Examine experience Select variables Test predictability Test and Calibrate
Example: Life insurance company
Risk factor: Obesity Set hypothesis Examine experience Select variables Test predictability Test and Calibrate
10 20 30 40 50 60 70 80 90 40 k 60 k 80 k 100 k 120 k 140 k 160 k 180 k
20 40 60 80 100 40 k 60 k 80 k 100 k 120 k 140 k 160 k 180 k
10 20 30 40 50 60 70 80 90 40 k 60 k 80 k 100 k 120 k 140 k 160 k 180 k 20 40 60 80 100 1 2 3 4 5 6 7 8 9 10 20 40 60 80 100 1 2 3 4 5 6 7 8 9 10 20 40 60 80 100 1 2 3 4 5 6 7 8 9 10 20 40 60 80 100 1 2 3 4 5 6 7 8 9 10 20 40 60 80 100 1 2 3 4 5 6 7 8 9 10 20 40 60 80 100 1 2 3 4 5 6 7 8 9 10 20 40 60 80 100 1 2 3 4 5 6 7 8 9 10
Example: Credit Cards Examples of predictive factors for credit cards
20 40 60 80 100 1 2 3 4 5 6 7 8 9 10 20 40 60 80 100 1 2 3 4 5 6 7 8 9 10 20 40 60 80 100 1 2 3 4 5 6 7 8 9 10 20 40 60 80 100 1 2 3 4 5 6 7 8 9 10 20 40 60 80 100 1 2 3 4 5 6 7 8 9 10 20 40 60 80 100 1 2 3 4 5 6 7 8 9 10 20 40 60 80 100 1 2 3 4 5 6 7 8 9 10
20 40 60 80 100 1 2 3 4 5 6 7 8 9 10 20 40 60 80 100 1 2 3 4 5 6 7 8 9 10 20 40 60 80 100 1 2 3 4 5 6 7 8 9 10 20 40 60 80 100 1 2 3 4 5 6 7 8 9 10 20 40 60 80 100 1 2 3 4 5 6 7 8 9 10 20 40 60 80 100 1 2 3 4 5 6 7 8 9 10 20 40 60 80 100 1 2 3 4 5 6 7 8 9 10
Backtesting Stress testing Validation
Expected loss How much we expect to lose (probability) on a credit or group of credits Often abbreviated as “EL” – also known as “ROL” (risk of loss) May be expressed as a per cent or an absolute number
Expected loss Probability
Loss given default Exposure at default
Expected loss Probability
Loss given default Exposure at default
1 0.01 2 0.03 3 0.05 4 0.25 5 0.70 6 1.50 7 6.00 8 20.0 9 50.0 10 100.0 Rating PD % 10 25 50 75 100 LGD % 100 EaD %
Expected loss Probability
Loss given default Exposure at default
.03 or 3% .06 .50 1.00
1 0.01 2 0.03 3 0.05 4 0.25 5 0.70 6 1.50 7 6.00 8 20.0 9 50.0 10 100.0 Rating PD % 10 25 50 75 100 LGD % 100 EaD %
So if the credit is JOD 7,000, EL for that credit is JOD 210 (3% x 7,000)
3% .06 .50 1.00
1 0.01 2 0.03 3 0.05 4 0.25 5 0.70 6 1.50 7 6.00 8 20.0 9 50.0 10 100.0 Rating PD % 10 25 50 75 100 LGD % 100 EaD %
JOD 210 .06 .50 JOD 7,000
Losses Probability
10 20 30 40 50 60 70 80 90 100 1 2 3 4 5 6 7 8 9 10
10 20 30 40 50 60 70 80 90 1 2 3 4 5 6 7 8 9 10 20 30 40 50 60 70 80 90 100 1 2 3 4 5 6 7 8 9 10
10 20 30 40 50 60 70 80 90 100 1 2 3 4 5 6 7 8 9 10
Expected Loss (EL) Expected Loss (EL)
rate
income statement
rate
income statement
Unexpected Loss (UL) Unexpected Loss (UL)
loss rate
assignment of capital
loss rate
assignment of capital
Amount of Loss Probability
Unexpected Loss (Standard Deviation)
Unexpected Loss Requires capital support - as a cushion
Mean “expected” Loss
Required Capital Total “Economic” Capital = Reserves + Equity Uncovered Risk Mean “expected” Loss
AA AAA .003 .001 BBB A .03 .01
Solvency Standard Unexpected Loss ( 1 Standard Deviation)
Credit Analysis and Structuring Probability
Expected Loss Loss Given Default Risk Rating: Borrower and Facility
Based on historical risk rating data A function of analysis and structuring Feedback process: annual review & experience
EL=PD x LGD x EAD
Based on analysis & identified comparative standards
Feedback loop
Exposure at Default
Quantitative modeling includes
Credit risk management means
Research continues to integrate new
Management control of day-to- day activities including:
recording
Internal Control
Independent review to ensure controls working as intended, risks are controlled and operational inefficiencies are identified during:
Internal Audit
Enforces
All non-credit and non-market risks
“Routine processes” Payments/Settlements Documentation IT, regulatory, legal, fraud Strategy and planning
Managed by organizational and other internal
Segregation of duties and dual controls Internal audit scope, procedures, findings and
Self-assessment process
“An effective internal control system requires
Bank for International Settlements, Framework for Internal Control Systems in Banking Organizations
Third line of defense Business partner not adversary Separate from risk management oversight Responsible to ensure that controls and
Individual interviews Diagnostic reviews Standardized risk rating system Individual Workshop ? Sarah (Sally) Hargrove