Financial Integrity, Oversight and Broadened Capital Markets Risk Management Review May 1, 2007
Outline for today’s discussion � Introductions � Review of objectives of risk management sub- component and specific tasks � Overview of Risk Management � Definitions and terminology � Credit Risk � Operational Risk � Discussion of your ideas and objectives � Next steps
Sarah (“Sally”) W. Hargrove � Native of North Carolina � Wharton MBA, CFA � Thirty years of experience in investment and commercial banking in NY, NC and PA � Top bank regulator in Commonwealth of PA for banks, savings institutions, licensed lenders � Consulting for past 12 years in primarily emerging markets (technical assistance and training in bank appraisals, risk management and corporate governance) � Worked with CBJ on risk management, early warning system, and corporate governance
General objectives of risk management sub-component � Address practical issues for implementation of risk management systems for BIS II compliance � Build risk management capacity in Jordanian banks by providing useful tools and solutions to practical problems � Provide roadmap for evolution to IRB (Foundation) in 2012
Objectives for first phase of risk management sub-component � Conduct kick-off session to identify practical problems in implementing risk management and BIS II � Follow up with private interviews � Work with interested banks to develop methodology for standardized risk rating system � Conduct risk management diagnostics
Today is a kick-off � Provide general overview of risk and risk management � Establish a baseline of risk knowledge, common terminology and understanding of BIS requirements � Provide overview of different credit rating/risk measurement approaches � Hear from you
Follow-up individual or group meetings as requested � Develop methodology for creating a standardized internal risk rating system � Conduct individual bank diagnostics � Gap analysis � Focus on policies and procedures � Reports for monitoring � Organizational structure
Certain principles rule financial intermediation in free markets � Supply and demand Interest rate as the “clearing price” � Opportunity cost of consumption/investment � � Rational investors Risk averse � Maximize return/Minimize risk � � Efficient markets Allocation of resources � Information impounded in prices � Competition �
Perceived risk is based on historical or expected volatility 160 140 120 100 Series1 80 Series2 60 40 20 0 1 2 3 4 5 6 7 8 9 10
Universally risk is defined by volatility Features Features � Normal distribution � Skewed distribution � Range � Variance � Standard deviation Tail Probability = 2.5% 0 Distribution of actual or expected occurrences
The higher the risk, the higher the required rate of return � Required rate of return determines the price � Current income stream � Capital appreciation � Perceived risk determines the required return � The greater the historical volatility the greater the risk � The greater the uncertainty the greater the risk � The longer the horizon the greater the risk
Risk is priced by the discount rate: absolute and relative MV=PV = Σ + TV C t=0-n (1+r) t (1+r) t Rate of Return CCC Common Stock B Conv. Preferred Risk BB Premium Preferred Stock BBB Income Bonds A Subordinated Debentures AA 2nd Mortgage Bonds AAA First Mortgage Bonds Treasury Bonds Risk Free Rate Level of Risk
Risk measurement allows us to make a trade-off with return C n r u t e R d e t c e p B x E A Risk/Standard Deviation
There is risk-reward trade-off inherent in financial intermediation � Short-term vs longer-term � Liquidity � Floating vs fixed rates � Credit � Leverage Risk is defined as volatility in earnings and/or capital
Capital needs to support major risks in financial institutions On and off balance sheet Credit Risk credit exposures Interest rate and equity risk in trading book; FX Market Risk and commodity risks in banking and trading books Primarily failed processes or event risk Operational risk (not strategic or reputational risk)
So how much capital does a financial institution need? “Enough…but not too much.”
What is enough capital? � 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
What is too much 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 returns � Competes with risk-free rate and alternative investments � Affects pricing and competitive position if too much
Capital adequacy is in the eyes of the beholder Focus is historical cost of Focus is historical cost of � Accounting capital assets and recognition of assets and recognition of impairment (fair value) impairment (fair value) Focus is income, the Focus is income, the � Market capital market’s expectations market’s expectations and required return and required return Focus is market value Focus is market value (PV of cash flows) of (PV of cash flows) of � Economic capital assets/liabilities assets/liabilities Focus is balance sheet Focus is balance sheet and income risk and and income risk and � Regulatory capital capital components capital components BIS II attempts a more precise calibration of economic and regulatory capital
In a perfect market the different capital values would be equal � Book values represent present values of future cash flows discounted at current required rates of return � Market values of capital stock reflect net present values � Economic capital is the same as net book value � Regulatory capital would be a realizable value of assets in excess of liabilities
Capital requirements can be a competitive advantage Japanese Bank US Bank Loan USD 100 million USD 100 million Net interest margin .6% 1.25% Income USD 600,000 USD 1,250,000 Capital 2% 6% USD 2 million USD 6 million ROE 30% 20.8%
BIS II permits banks to customize capital adequacy assessment � Align regulatory capital requirements more closely with underlying risk � Emphasis is on banks’ risk management and economic capital allocations � There is flexibility in assessing capital adequacy: standardized vs. IRB approaches
Capital must be allocated to support major banking risks Credit Risk • Standardized Approach • IRB Approach • Foundation • Advanced Minimum Market Risk 8% of Capital to • Standardized Approach Risk-Weighted • Internal Models Approach Assets Operational Risk • Basic Indicator Approach • Standardized Approach • Internal Measurement Approach
Capital adequacy is a function of three pillars Pillar 1: Minimum Capital • Internal capital assessment process and control environment • Capital f (how sound the process is) Mutually reinforcing factors that Pillar 2: Supervisory Review determine capital • Review assessment process adequacy • Evaluate IRR in banking book Pillar 3: Market Discipline • Formal disclosure policy • Describe risk profile, capital levels, risk management process and capital adequacy
Ultimately the financial market is the harshest regulator Quantitative Requirement Qualitative Requirement Minimum Capital Supervisory Requirement Review Process • Many players • Many players • Self interested, • Self interested, rational Market Discipline rational • Independent • Independent • Real time • Real time Public Disclosure
Capital required is a function of the quality of information � The less the history, the less reliable the data � The less certain or transparent, the greater the risk � The more the risk, the more capital needed � All the above implies higher capital levels for some institutions in less mature markets
Capital absorbs unexpected losses and supports growth “Capital is not a substitute for inadequate Capital is not a substitute for inadequate “ control or for risk management control or for risk management processes.” ” processes. - Bank for International Settlements
Assumption of risk is the raison d’etre of banking � Banks make money by assuming risk � Banks lose money by not managing risk or by not getting paid for the risk assumed � Banks manage what they measure
A formalized risk management framework is best practice Risk Management is the deliberate acceptance of risk for profit – making informed decisions on the trade-offs between risk and reward and using various financial and other tools to maximize risk-adjusted returns within pre-established limits.
A Risk Management facilitates informed decision-making Identify Measure Manage Monitor
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