Credit Stress LossAlexandre KurthWM&SB Risk Control

22 October, 2009

1

Alphabet of Credit Risk Measures

frequ

ency

of l

osse

s

expectedcredit risk

costs

ExpectedLoss

cost of economic capital directcosts

mean:Expected Loss

amount of loss

Confidence-level ofeconomiccapital

Economic Capital

Standarddeviation

Risk Measure:UnexpectedLoss

Stress Lossesunacceptable risks

Statistical Loss,e.g. Expected Shortfall,CoC

absorbed by revenues absorbed by capital

2

What is Stress Testing About?

♦ Principles for sound stress testing practices and supervision; Basel Committee on Banking Supervision Consultative Document, issued for comment March 13, 2009

♦ Quote: Stress testing is an important risk management tool that is used by banks as part of their internal risk management and, through the Basel II capital adequacy framework, is promoted by supervisors. Stress testing alerts bank management to adverse unexpected outcomes related to a variety of risks and provides an indication of how much capital might be needed to absorb losses should large shocks occur. Moreover, stress testing is a tool that supplements other risk management approaches and measures. It plays a particularly important role in:– providing forward-looking assessments of risk;– overcoming limitations of models and historical data;– supporting internal and external communication;– feeding into capital and liquidity planning procedures;– informing the setting of a banks’ risk tolerance; and– facilitating the development of risk mitigation or contingency plans across a range

of stressed conditions.

3

Overview of Stress LossThree mutually reinforcing Pillars

MINIMUM CAPITALREQUIREMENTS

Combined bank-wide stress test

SUPERVISORY REVIEW OFCAPITAL ADEQUACY

Portfolio specific stress tests

MARKET DISCIPLINE

Reverse stress test

NEW BASEL CAPITAL ACCORDMeasure, monitor

and control risk under stress conditions

Reports, Limits, Planning

4

Credit Stress Testing Landscape

Lombard, Securities FinancingReal Estate Corporate Clients

Credit Portfolio WM&SB

Scenario Analyses

Concentration Analyses

Swiss Real Estate Scenario (Replication 90ies-crisis)

Market risk scenarios (e.g. liquidity and epicenter

scenarios:

Collateral Concentration: (Issuer Group, Hedge Funds, Mutual Funds,

Country)Top Client List: Expected Tail Loss, limit, exposure,

expected Loss

Industry concentrationIndustry concentration

Reverse Stress Testing

Define hypothetical bank-breaking scenarios, e.g. leading to a predefined target loss, not based on PDs, EADs, LGDs, not using a history based model [cf. Principles

for sound stress testing practices and supervision, Par. 9]

Global macro-economic scenariosScenarios: Factor model to forecast

PDs and LGDs

sticky portfolio which is managed in longterm

view

liquid portfolio which can be managed on short-

term basis

majority of portfolio cannot be managed on

short-term basis

5

Applications of EL, Credit VaR, Stress Loss, Loss Forecast

Credit VaRExpected Loss

Risk Measures

Appl

icat

ions

*

Stress Losses

Risk Control

Portfolio Thresholds / Triggers

CLLP

RWA Basel II Capital

Strategy

PricingPerformance Measurement

Basel II ICAAP (Pillar II)Business Plan

*) Applications are not exclusively driven by these measures; but they are influenced; there may be others as well.

…there is no one-size-fits-all measure

General Provisioning

Pool

Influence from risk measures on risk relevant applications…

Actual Loss ForecastNotional

6

Uncertainty of Stress Losses

current EL

stress loss

distribution of credit losses conditional on the

stressed economic situation

♦ The stress loss measure does not suggest the worst possible outcome

♦ Even if the economy turns out to be as assumed in the stress scenario, the loss outcome may significantly vary around the expected value (stress loss) alternative measure for stress loss could be a quantile or ETL of the distribution or confidence interval

ABSCHNITT 1

Lombard Stress

8

Collateral Concentration

♦ Portfolio concentrations of exposures collateralized by marketable assets (e.g. Lombard) are measured by 'single' shocks

10-d

ay p

rice

drop

for s

elec

ted

hist

oric

ev

ents

Proposed shocksMerck

Netscape

Yahoo!

SGX Pharmaceuticals

ABB

Ahold

Parmalat

Worldcom

Enron

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

Accounting fraud, June 02

Accounting fraud / insolvency, Dec 03

Grounding, Oct 01

Share price manipulation, Jan 06

Accounting fraud / insolvency, Dec 01

Accounting fraud / CEO resignation, Feb 03

Failed strategy / asbestos risk, Oct 02

Failed clinical trial, Sep 06

Accounting and civil fraud, June 02

Legal issues, July 06

Dot.com bubble, Oct 00

General company crisis, Aug 98

Dot.com bubble, May 00

Accounting problems, Jan 04

Vioxx, Oct 04

Adecco

Qualcomm

Bet and win

Livedoor

Swissair

Tyco

Even without a general market downturn, idiosyncratic, event-driven shocks proved disastrous in the past.

9

Example of Collateral Concentration

Title MV LV exposureTitle A 15 6Title B 2 1.2Title C 3 1.8Total 20 9 6

All figures in CHF Mio

5 3

Loss: CHF 1 Mio

XX X

X Total

10

Collateral Concentration Analysis ResultsCollateral concentration of issuer groups

illustrative figures

CHF mio Volatility Adtv McapIssuer Group Issuer Rating May09 Feb09

1 (1) Issuer A 100 105 86 [1664]

Equity 25% 315 86'716 26

Debt A1 8

Fiduciary 67

Structured products 0

2 (2) Issuer B 65 90 1 [314]

Equity 28% 384 112'354 65

Debt Aa2 0

Fiduciary

Structured products 0

3 (4) Issuer C 27 28 1 [99]

Equity 46% 753 37'946 27

Debt A2 0

Fiduciary

Structured products 0

95% ShockStress exposure Eff [actual]

# stress exp.

11

Market Scenario Stress Testing in Credit

TradedProducts

Client relationship

Collateralmarket value

BankingProducts

Equities

Fixed Income

Precious Metals

Cash

Hedge FundsMutual FundsStruct.

Products

other

Exposure

Before stress event

Stress ex.

Additional unsecured exposure following a market stress event

Exposure

TradedProducts

BankingProducts

Collateralmarket value

EquitiesFixed Inc.P. Metals

Cash

H. FundsM. Funds

St. Prod.

other

Stress exposure

After stress event

Scenarios / market stress events

10-day risk factor shocks for ♦ Equity indices ♦ FX rates ♦ Interest rates ♦ Country spreads♦ Credit spreads

Shock transmission

♦ Risk factor shocks are translated into product-specific shocks

♦ Exposure side only receives FX shock to account for currency mismatches

12

Stress Test Scenario Description for Securities FinancingThe scenario suite consists of selected Group market stress as well as portfolio-specific scenarios

Equ

ity in

dex

shoc

ksC

urre

ncy

shoc

ks

vs. C

HF

Libo

r rat

e sh

ocks

in b

p

Note that the above charts only contain the most relevant risk factors.

Scenario 1All markets down

Scenario 2EM crisis (pegs break)

Scenario 3Credit crunch

Scenario 4FX shocks only

Scenario 5specific scenario

Scenario 6specific scenario

Market Risk Stress Test Scenario Portfolio specific Scenarios

EU

RG

BP

GB

P

HK

DS

GD

RU

BB

RL

US

DE

UR

GB

PJP

YH

KD

SG

DR

UB

BR

L

EU

RG

BP

JPY

HK

DS

GD

RU

BB

RL

EU

R

JPY

US

D

US

D

US

DE

UR

JPY

HK

DS

GDR

UB

BR

L

US

D

GB

P

HK

DS

GD

RU

BB

RL

JPY

EUR

US

D

GB

PJP

YH

KD

SG

D

BR

LR

UB

CH

FE

UR

US

DG

BP

JPY

HK

DS

GD

CH

FE

UR

US

DG

BP

JPY

HK

DS

GD

SG

DH

KD

JPYG

BPUSDEURC

HF

SG

DH

KD

JPY

US

D

CH

FEUR

GBP

SG

DH

KD

JPY

GBP

USDEURCHF

SG

DH

KD

JPY

GB

PU

SD

EU

RC

HF

SM

IS

&P

500FTS

E 100

DA

XC

AC

Topix

CA

CD

AX

FTSE

100S

&P

500S

MI

Topix

CA

CD

AX

FTSE

100S

&P

500S

MI

CA

CD

AX

S&

P500

SM

I

SM

IS

&P

500FTS

E 100

DA

XC

AC

Topix

Topix

Hang S

eng

Hang S

eng

TopixH

ang Seng

CA

C

FTSE

100

Hang S

eng

Hang S

eng

Hang S

engTopix

SM

IS

&P

500FTS

E 100

DA

X

13

Stress Scenario Results

♦ Stress results show portfolio exposition against a scenario

♦ Stress results are not a forecast

♦ Significant increase of Stress Exposure during the subprime crisis until November 2008

♦ Continuous decrease of Stress Exposure since November 2008

Total Stress Exposure

1.001.78

0.87 0.82 1.27 1.33 1.712.54

3.31 3.02 3.24 3.412.37 2.18

1.45 1.39 1.26

4.81

0

1

2

3

4

5

6

Mar06

May06

Aug06

Nov06

Feb07

May07

Aug07

Nov07

Feb08

May08

Aug08

Nov08

Feb09

Mar09

Apr09

May09

Jun09

Jul09

Stre

ss E

xpos

ure

in C

HF

mill

ion

(inde

xed

Mar

06)

illustrative figures

ABSCHNITT 2

Macro-economic Stress Testing

15

SensitivitiesDrivers

Use sensitivities to forecast future PDs and LGDs for stress scenarios defined in terms of drivers, e.g. PD=f(IR, GDP growth, RE prices,…)

Identify macroeconomic factors for each segment which impact the default rate, i.e. Interest Rate IR, GDP growth, RE prices, FX rate EUR/CHF

Sensitivities Analyse historic time series to estimate how a change in a driver impacts the default rate resp. LGD, e.g. IR up 1% => PD up by x%, i.e. default rate for services (1.00%) changes by 1.00%*39% to 1.39%, if IR goes up by 1%

Forecast

Sensitivities for various economic drivers are estimated on portfolio relevant segmentation:

e.g.Energy intensiveFinancial ServicesManufacturingServicesReal Estate ConstructionRestaurant Hotels…

Lombard, Securities FinancingReal Estate Corporate Clients

private mortgagesIPRE

private clientsmarket stress

16

Macro-economic Stress Testing Methodology Explained♦ Sensitivities to macroeconomic variables estimated based on internal history of

impairment data Main drivers: GDP growth, interest rates, FX rate EUR/CHF, House Price changes

♦ Application to given macroeconomic scenario

02

46

8%

1995

q1

1996

q1

1997

q1

1998

q1

1999

q1

2000

q1

2001

q1

2002

q1

2003

q1

2004

q1

2005

q1

2006

q1

2007

q1

2008

q1

2009

q1

2010

q1

time

Illustrative example

Upper confidence bound

Lower confidence bound

Fitted Values / Forecasts under stress scenario

2008

q1

2009

q1

2010

q1

Current Average

PD in Portfolio segment

Application

Stressed Default Rate Levels

Future stress scenario, specifying GDP, interest rates, FX-rates, etc.

Past time-series of default rates, used to derive sensitivities to macro-variables like GDP, interest rates … 20

09q1

2010

q1

2011

q1

εββββ +++++= KKVolatilitytesInterestRaGDPgrowthPD ...22110

ABSCHNITT 3

Real Estate Stress

18

A New Swiss Real Estate Crisis

♦ Starting point: favorable economic environment in Swiss real estate market

♦ Inflation picks up throughout the country

Loss RateBankruptcy RateBooked Losses

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004Replication of the Swiss real estate bubble from the 90ies

♦ Property prices go up, too, resulting in a general bubble

♦ SNB is forced to react and raises interest rates sharply

♦ The economy markedly slows down, unemployment starts to grow, the property markets show first signs of correction

♦ A widespread fall of property prices follows

Illustration –sample figures

19

Credit Risk Drivers in Real Estate Portfolio

Affordability

Equi

ty

Portfolio Slice along LtV and Affordability for private mortgages

Affordability = _____________________________costs (mortgage, maintenance)

income (corrected by 2nd homes)

Loan-to-Value

LGD

Default

Red AreaLosses expected due to- limited equity buffer- stressed affordability

Orange AreaNo losses expected because of - very good affordability and - limited or missing loss potential

20

Impact of Scenarios

Affordability

Equi

ty Shift to upper areas

Real Estate Price Decline

Interest Rate Increase

Unemployment Rate Increase

Shift to right area

0.1% 0.35%

Increase of Default Rates

21

Market Activity Map for Swiss Owner-occupied Properties

Market activity map is based on Swiss real estate market variables such as prices, construction activity; and macro-economic variables such as unemployment rate, tax rates and population (change, forecast)

Market activity map for Swiss Owner-occupied Properties based on MS segmentation (mobilité spaciale)

22

Real Estate Scenario Cockpit

♦ Price forecast of price index per MS region (mobilité spaciale) auf Basis based on macro-economic parameters and scenarios

♦ Forecasts per MS-Region for– SFH– Condominiums– MFH– Office Buildings ♦ The Real Estate Scenario Cockpit supports

– the visualization of the (long-term) sensitivity of the Swiss real estate market based on normal scenarios

– stress loss calcuation based on various stress scenarios

Real Estate Scenario Cockpit

ABSCHNITT 4

Reverse Stress Testing

24

The "Reverse" part of Stress Testing Current scenarios ask "what happens if" whereas reverse stress testing asks "what needs to happen that we lose x"

Define scenario mainly based on history in terms of macroeconomic variables, e.g. GDP, IR, etc.

Apply model based on internal risk measures parameters and historic time series

Obtain stress loss figures, usually in a severe but not (necessarily) bank breaking dimension

Define outcomes which threaten the viability of the whole firm, e.g. target loss breaking regulatory capital ratios

Find hypothetic trigger events which could cause such an effect

Find out which (sub-) portfolio would be affected to which extent, NOT on the basis of historic time series

Conventional stress test

Reverse stress test

Principles for sound stress testing practices and supervision; Basel Committee on Banking Supervision Consultative Document, issued for comment March 13, 2009 (cf. Principle 9, p.18)