Value Orientated Risk and Capital Management Dr. Oliver Kaufmann FI Risk & Portfolio Management
Contents / Agenda
1.
Capital vs Risks
2.
Regulatory Background
3.
Risk Adjusted Portfolio Management
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Banks balance sheet Liabilities (Debt Capital) Assets Equity Capital (= Assets - Liabilities)
• Optimise return on equity capital: RoE as key indicator for investors and shareholders • Limitations from regulator: Minimum required equity capital compared to business activities - Solvency - Stable financial systems, protection of local depositors
Main internal steering factor: Optimisation of limited resource equity capital
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Risks of banking business
Risks unavoidable
No Risk no Business !
Challenge: Detect, measure and manage true risks adequately to prevent unexpected losses !!
Credit Risk
Operational Risk
Market Risk
Unexpected losses due to default of borrowers, counterparties, emittents
Unexpected losses due to failures of Systems, processes, human or technical errors, external events and legal processes
Unexpected losses due to market movements of risk factors like interest rates, stock and currency prices
e.g. subprime crisis
e.g. Barings Bank, SocGen
e.g. new economy crash
Liquidity Risk Unexpected losses due to: a) unability to repay liabilities b) higher refinancing costs c) lacking market depth to sell assets
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Capital adequacy Regulator: Cover risks by adequate Equity capital to ensure solvency
Risks
Equity Capital
Operational Risk Market / Liquidity Risk Credit Risk • Derivatives • Off balance sheet • Risk weighted balance sheet assets
Capital Ratio
Risk Weighted Assets (RWA) covered by adequate equity capital to survive‚ realised‘ risks?
Credit Risk
Tier 1
Tier 2 Tier 3
Tier 1 • Common stakeholders Equity and minority interests • Retained earnings • Preference shares • Innovative capital
Tier 2 • equity reserves / cumulative • preference shares • Subordinated debt Tier 3 • Equity reserves / cumulative • preference shares • Subordinated debt
Capital Ratio: Equity/RWA > 8% 5/41
Credit Risk: The new Audi S4...
Scenario 1: Original price
50.000,- €
EAD = 50.000,-
Accident frequency
1 out of 10
PD = 10%
Cost sharing
0,- €
LGD = 100%
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The Audi S4... Insurance premium: 10% * 50.000,-€ * 100% = 5.000,-€ PD
EAD
LGD
EL
PD = Probability of Default EAD = Exposure at default LGD = Loss given Default EL = Expected Loss
Total insurance premium for 10 insured Audis: 10 * 5.000,-€ = 50.000,-€
Loss
Total premium
Compensation
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The Audi S4...
Scenario 2: Original price
50.000,- €
EAD = 50.000,-
Accident frequency
1 out of 10
PD = 10%
Retention
5.000,- €
LGD = 90%
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The Audi S4... Insurance premium: 10% * 50.000,-€ * 90% = 4.500,-€ PD
EAD
LGD
EL
PD = Probability of Default EAD = Exposure at default LGD = Loss given Default EL = Expected Loss
Total insurance premium for 10 insured Audis: 10 * 4.500,-€ = 45.000,-€
Loss
Total premium
Replacement (less 5.000,-€ retention)
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Credit Risk: Expected and Unexpected Losses Portfolio loss distribution Loss 95 % of all cases (19 out of 20)
Unexpected Loss (loss volatility) Economic Capital Expected Loss (average loss)
Years / Scenarios
Economic capital covers the Unexpected Loss, the Expected Loss is covered by the risk margin Economic Capital = Expected Loss – Unexpected Loss; level of confidence: 99.9% - 99.98%.
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Result Expected Loss: Exposure * PD * LGD Æ Expected Costs Æ Risk Provisions
Risk Costs ~ Margin
Unexpectecd Loss: Exposure * PD * LGD * „Portfolio effects“ 30% Provide capital to cushion unexpected losses 12% Capital Costs (required minimium interest return on capital)
Rating A
Rating B
Rating ~ Risk
Margin should be calculated considering ‚true‘ risk costs !!
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Regulatory View: „BASEL committee“ „Basel II“ International „Gentlemen‘s Agreement“ BIZ
„SolvV“ German regulation rules
National implementation (in vigor since beginning of 2008)
„CRD“ European Capital Requirements Directive
European implementation
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Regulatory goals
Basel I
Basel II Goals
is/was not adequate for modern risk situation.
• Aligning regulatory capital requirements more closely to the underlying risks • Incentives to improve internal risk management more forward looking • Risk adequate pricing if higher/lower risk than higher/lower margins
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Credit Risk development: Basel I and Basel II Standardansatz Simple rule: Capital / Risk Weighted Assets > 8% Capital = RWA * 8% ~ Exposure * Weighting Factor
e.g. 20% for OECD* countries
NO credit rating (PD) NO portfolio effects (diversification/concentration) *Organisation for Economic Co-operation and Development
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Basel II: Advanced Internal Rating Based Approach (AIRB) Simple rule: Capital / Risk Weighted Assets > 8% Capital = RWA * 8%
but
~ Exposure * K (PD, LGD, Maturity)
Probability of Default
Loss given Default
Still no portfolio effects (diversification/concentration)
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Internal determination of default risk General approach:
Capital Adequacy Asset Structure and Quality Management quality Earnings performance Liquidity structure of balance sheet Sensitivity to market risk Internal Determination of banks probability of default (PD) and loss given default (LGD): Analysis of balance sheet (quantitative model) Analysis of historical defaults and crisis in the banking sector (quantitive model) Qualitative Analysis by relationship manager and credit risk analysts to adjust quantitative model Key Indicator: Probability of support by shareholders and/or government !
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Credit Risk Portfolio Model Capital
F ( Exposure, PD, LGD, Maturity, Concentration) Credit Value at Risk = CVaR
Issues: Different portfolio models on the market Measurement of reliable concentration effects (default correlations) Allocation to single loan
Basel III 17/41
Basel II framework BASEL II Pillar 1: Calculation of regulatory capital for • Credit risk (AIRB-Ansatz) • Operational risk (AMA Ansatz) • Market risk (internal GS I model)
Pillar 2: Supervisory review process (SRP) 4 principles: • supervisory review process • regulatory advices • regulatory transparency • specific topics within the SRP
Pillar 3: Market discipline Qualitative&quantitative disclosure of: • scope of application • capital structure • adequacy of capital resources • taken risks
Based on internal parameter estimation ICAAP1
SREP2
Regulatory Capital Economic Capital
Minimum requirements for Risk Management (MaRisk = national implementation)
1 2
Internal Capital Adequacy Assessment Process Supervisory Review and Evaluation Process
Last year AIRB-Ansatz and AMA-Ansatz sucessfully approved by german regulator
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Operational Risk Operational risk has always been there and lies at the heart of a lot of high losses and even bankrupticies Barings Bank, SocGen…
Operational Risk means the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events, and includes legal risk
Enough losses to care about it! Benefits from optimising processes, efficient controls and transparent loss and risk analyses are not just prevention of catastrophic losses but also leads to lower costs in the normal business running Regulator forces it now with OpRisk calculation requirements under Basel II
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Methods to calculate OpRisk capital charges The Basic Indicator Approach • Simplest of the three approaches • Default option for smaller banks • Straightforward calculation based on the firms' income
The Standardized Approach • Calculations based on Income • Different Percentages applying accross different business lines • Standardized Approach banks have to meet certain qualifying criteria to be able to take the advantages of the approach
The Advanced Measurement Approach • Highest capital relief and highest positive impact on bank processes but inevidable more complex. • Under this approach each bank calculates own capital requirements, by developing and applying its own internal risk measurement system • Bank must meet certain qualifying criteria • Risk measurement system must be validated by the regulator
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OpRisk Controlling Framework: AMA
Operational Risk Management
Senior Management & Regulatory Reporting
Bonus-Malus-Value System Quantitative Model – Operational Risk Engine: Capital / Risk Calculation
Quality Self Assessment Internal Loss Data
Key Risk Indicators
External Loss Data Risk and Control Inventory
Operational Risk Strategy & Regulatory Requirements
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Economic Capital Capital needed to cushion bank against unexpected losses Should reflect ‚true‘ risk profile of bank
Consideration of all quantifiable risks
Economic Capital Credit Risk
Defaults
Losses
Operational Risk
Operational events
Losses
Market and Liquidity Risk Market volatility
Losses
Business Risk
Earnings volatility
Losses 22/41
Pillar 2: Minimum requirements on risk management 1.
Overall responsibility of Board of Directors
2.
Definition of risk taking capability concept
3.
Risk strategy
4.
Integration of risk management system in overall bank steering
5.
Implementation of reliable risk management system for all risk types
6.
Implementation of reliable risk reporting and documentation system
...
and some more …
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1.
Overall responsibility of Board of Directors
Common understanding of risk strategy and organisation / processes
Risk Committee of supervisory board Board of managing directors Riskstrategy
Riskquantification Riskidentification
CRO Operative Credit Risk Function
Riskminimisation
Risktransparency
Risk committee
Market Side
Credit committee
Risktypes Credit Risk Operational Risk
Market Risk (Legal Risk)
Liquidity Risk Business Risk
Independent Control: Internal Revision 24/41
2.
Definition of risk taking capability concept
Comparison of equity and overall risk profil
Risk covering Capital
Economic Capital
Target Profits
Business Risk
Reserves
Credit Risk Market Risk
Tier 1
Operational Risk
Sufficient Capitalisation according to Target Rating
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3.
• Implementation of risk strategy • Close relation to business strategy • Inclusion of qualitative risk types
Risk strategy
Buffer
Market Risk Operational Risk Business Risk Credit Risk
Σ Market Risk Σ Operational Risk Σ Business Risk Σ Credit Risk
Concentration Branches Countries Segements
Limits for Expected Loss and Risk Concentration
Products
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4.
Integration into bank management
Group
Risk taking capability analyses: Ecap = Σ Risks < disponible Equity Ensures survival of bank
Business Lines
Risk-adjusted performance analyses : RoRaC = Profit / Ecap Capital allocation
Client/product
Pricing and Product design Ensures profitability of bank
Challenge: Management Attention
Inclusion into renumeration concept !
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Management Reporting FI Portfolio Comparison RoRaC and RoE RoRaC= Profit / ECap RoE= Profit / RegCap RORAC (%) 12 2006
06 2007
ROE (Avg) (%)
12 2007
Economic Capital
Economic Capital ZFI
Credit Risk
Market Risk
Op Risk
Business Risk
100
0
35
5
ECAP
ECAP (Avg)
Reg Capital (Avg)
RO RAC
ROE (Avg)
Profit
140
135
280
25%
15%
70
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Sales Steering Concept Pricing Implementation of Ex-Ante pricing tool at point of sales • Results of Transaction: Value Contribution Margin • Transaction Indicators: RoRaC, eCap, Basel II Capital, Risk Concentration
Reporting Implementation of Ex-Post Client Profiles • Key Performance Indicators: Portfolio Quality Index, RoRaC, Ø-PD, CB-Rating, ØCVaR in T€ • Breakdown by Product Category and Client: Revenues, EL, eCap-Costs, OpRisk-Costs, Direct Costs, VCM
Steering • Consideration of risk/return key indicators in individual target objectives and renumeration scheme
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Value orientated credit pricing concept Example:
Price (Gross Margin)
Basel I
Expected Loss = 1,5% * 50%
el II: Bas / Econ AIRB
pital a C omic
Price of Risk Expectes Loss + Capital Costs
PD LGD
Unexpected Loss = 16% * (1,8%+0,9%) Minimum required Return on Capital: Unexpected Credit Risk: Unexpected OpRisk:
Admin / operating costs Admin costs: 0,3 % Refinancing costs
Risk
Minimum Margin ~ 1,5 % 30/41
Real Time Tool at Point of Sales Financial Institutions Value Contribution Margin Calculation The trade N/A was calculated by Oliver Kaufmann on 16.04.2008 17:03:46. Client Details Client Name/Client Number Client Rating Client Masterscale PD VBKDNR Group Name Group City/Country Group LAD Group EL Current Transaction Details Sign (1=New Credit; -1=Creditsale) Product Type Start Date Lifetime (years) Currency External Limit Drawing Collateral Guarantee J/N Incomes Gross Interest Margin Committment Fee p.a. Provision Credit p.a. Transaction Upfront Fee Transaction Upfront Fee Liquidity costs % Results of Transaction Revenues - Expected Loss (EL) - Direct Costs = Gross Return - eCap Costs = Value Contribution Margin Transaction Indicators RoRaC eCap Basel II Capital Risk Concentration
3.4 1.500 % New Client DE 0.0 T€ 0.0 T€ 1 001_Cash credit/Overdraft facility 05-2008 1.0 EUR 0.0 T€ 1,000.0 T€ 0.0 T€ N 1.40 % 0.00 % 0.00 % 0.00 % 0.00 T€ 0.05 % 13.0 T€ 4.0 T€ 3.3 T€ 5.7 T€ 5.1 T€ 0.6 T€ 17.9 % 32.0 T€ 40.7 T€ 41.9 bp
ECap
RegCap 31/41
Portfolio- and Scenario Analyses (in all risk dimensions)
Scenario Analyses e.g. Impact of Hedging, True sales, Syndication, New business
Portfolio Analyses
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Ex-Post Client Profile Client Profile GBKdNr SWIFT Code VBKdNr Group
Country Sales Unit Segment
-----
-4 --
Revenues 2007 - Breakdown by Product Category (in T€) 100.000,0 80.000,0
2006 Revenues - Expected Loss (EL) - eCap Costs - Direct Costs VCM
2007 0,0 0,0 0,0 0,0 0,0
Ranking VCM 2007 Country Region
T€ T€ T€ T€ T€ ---
0,0 0,0 0,0 0,0 0,0 Segment ZFI
T€ T€ T€ T€ T€ ---
Δ in % + 0,0% + 0,0% + 0,0% + 0,0% + 0,0%
60.000,0 40.000,0 20.000,0 0,0 Total Revenues
Cash Services
Revenue share
24%
Trade Services
61%
Banking Products
6%
Market Products
3%
Others
6%
Value Contribution Margin 2007 - Breakdown by Product Category (in T€) 50.000,0
Key Performance Indicators
40.000,0 30.000,0
PQI RoRaC Ø-PD CB-Rating Ø CVaR in T€
Comments
2006 0,00 0,0% --0,0
2007 0,00 0,0% --0,0
20.000,0 10.000,0 0,0 -10.000,0 Total VCM
Cash Services
Trade Services
Banking Products
Market Products
Others
VCM share
38%
50%
8%
3%
2%
PQI Ø CVaR in T€
0,00 0,0
0,00 0,0
0,00 0,0
0,00 0,0
0,00 --
/ partnership meets expertise /
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Pillar 3: Market Discipline Bank Capital Structure,Taken Risks, Adequacy of Capital Resources, Scope of Application Market Discipline: Indirect pressure to improve Risk Management and capital adequacy
Disclosure
Market
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Pillar 3 : Issues Additional Disclosures for IRB-Ansatz (Price for using IRB-Ansatz)
Implementation minor technical effort compared to Pillar 1 and 2
Frequency? Disclosure = Transparency ? Disclosure of proprietary informations ? Benefit from Pillar 3 ?
Working Group of german banks and supervisor recommends disclosure framework: www/bundesbank.de/download/bankenaufsicht/pdf/anwendungsbeispiel_saeule_3.pdf
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Pillar 3 : Disclosure examples (32 altogether)
• Risk policies
• Risk Mitigation
• Capital ratios
• Description and Validation of PD, LGD estimations
• Capital structure • Credit Exposure per products, segments, regions, rating class
• Securitizations
• Maturities
• Interest rate risk for Banking Book
• Impaired Loans by Portfolio
• P&L for equities
• Validation of VaR-Market risk models
• Development of Loan Provisions
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Overall Picture
Equity Capital
View of Investors: Optimisation of RoE
Regulatory Capital (simplified risk profile) Regulatory View: Stability/Solvency Side condition for capital steering
Economic Capital (‚true‘ risk profile) Economic View: Risk adjusted capital steering
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Capital Market Informations
Information • Credit Risk • Liqui Risk • Recovery but high volatility
Bond Spreads Should be equal but they are not quite often
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Capital Market Informations
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Capital Market Informations
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Thank you for your attention! Contact
Dr. Oliver Kaufmann Tel.: E-Mail:
++49 (0)69 / 136 22244
[email protected]
