basel ii and economic capital (mr. kaufmann)
TRANSCRIPT
Value Orientated Risk and Capital Management
Dr. Oliver KaufmannFI Risk & Portfolio Management
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1. Capital vs Risks
2. Regulatory Background
Contents / Agenda
3. Risk Adjusted Portfolio Management
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Equity Capital(= Assets - Liabilities)
Liabilities(Debt Capital)
Assets
Banks balance sheet
• 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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Credit Risk
Unexpected losses due to default of borrowers, counterparties, emittents
e.g.subprime crisis
Operational Risk
ngs Bank,
Unexpected losses due to failures of Systems, processes, human or technical errors, external events and legal processes
e.g. BariSocGen
Market Risk
arket movements of Unexpected losses due to mrisk factors like interest rates, stock and currency prices
e.g.new economy crash
Liquidity Risk
to repay liabilities
costs
to sell assets
Unexpected losses due to:a) unability
b) higher refinancing
c) lacking market depth
Risks of banking business
Risks unavoidable
Challenge: Detect, measure and manage true risks adequately to prevent unexpected losses !!
No Risk no Business !
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Capital adequacy
Risks
Risk WeightedAssets (RWA)
covered byadequate equity
capital to survive‚realised‘ risks?
Capital Ratio: Equity/RWA > 8%
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
Equity Capital
Regulator: Cover risks by adequate Equity capital to ensure solvency Capital Ratio
Credit Risk• Derivatives• Off balance
sheet• Risk weighted
balance sheetassets
Credit Risk
Market /Liquidity Risk
Operational Risk
Tier 1
Tier 2
Tier 3
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Original price 50.000,- € EAD = 50.000,-Accident frequency 1 out of 10 PD = 10%Cost sharing 0,- € LGD = 100%
Scenario 1:
Credit Risk: The new Audi S4...
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PD
The Audi S4...
Insurance premium:
10% * 50.000,-€ * 100% = 5.000,-€
EAD LGD EL
Total insurance premium for 10 insured Audis:
10 * 5.000,-€ = 50.000,-€
Loss CompensationTotal premium
PD = Probability of Default EAD = Exposure at defaultLGD = Loss given DefaultEL = Expected Loss
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The Audi S4...
Original price 50.000,- € EAD = 50.000,-Accident frequency 1 out of 10 PD = 10%Retention 5.000,- € LGD = 90%
Scenario 2:
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PD
The Audi S4...
Insurance premium:
10% * 50.000,-€ * 90% = 4.500,-€
EAD LGD EL
Total insurance premium for 10 insured Audis:
10 * 4.500,-€ = 45.000,-€
LossReplacement
(less 5.000,-€ retention)Total premium
PD = Probability of Default EAD = Exposure at defaultLGD = Loss given DefaultEL = Expected Loss
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Economic capital covers the Unexpected Loss, the Expected Loss is covered by the risk margin
Years / Scenarios
Portfolio loss distribution
Expected Loss(average loss)
Unexpected Loss(loss volatility)
95 % of all cases (19 out of 20)
Economic Capital
Loss
Economic Capital = Expected Loss – Unexpected Loss; level of confidence: 99.9% - 99.98%.
Credit Risk: Expected and Unexpected Losses
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Result
Risk Costs~ Margin
Rating A Rating B
12%
30%
Rating ~ Risk
Expected Loss: Exposure * PD * LGD Expected Costs Risk Provisions
Unexpectecd Loss: Exposure * PD * LGD * „Portfolio effects“
Provide capital to cushion unexpected losses
Capital Costs
(required minimium interest return on capital)
Margin should be calculated considering ‚true‘ risk costs !!
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„Basel II“
International„Gentlemen‘s Agreement“
„CRD“
EuropeanCapital
RequirementsDirective
„SolvV“
German regulation
rules
European implementation
National implementation (in vigor since beginning of 2008)
Regulatory View: „BASEL committee“
BIZ
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Regulatory goals
Basel II Goals
• Aligning regulatory capital requirements more closely to the underlying risks
• Incentives to improve internal risk managementmore forward looking
• Risk adequate pricingif higher/lower risk than higher/lower margins
Basel I
is/was not adequate formodern risk situation.
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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
*Organisation for Economic Co-operation and Development
NO credit rating (PD)
NO portfolio effects (diversification/concentration)
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Basel II: Advanced Internal Rating Based Approach (AIRB)
Simple rule:
Capital / Risk Weighted Assets > 8%
Capital = RWA * 8%
~ Exposure * K (PD, LGD, Maturity)
Probability of Default
Still no portfolio effects (diversification/concentration)
but
Loss given Default
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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 !
Internal determination of default riskGeneral approach:
Internal Determination of banks probability of default (PD) and loss given default (LGD):
Capital Adequacy
Asset Structure and Quality
Earnings performance
Liquidity structure of balance sheet
Sensitivity to market risk
Management quality
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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
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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 disciplineQualitative&quantitative disclosure of:• scope of application• capital structure• adequacy of capital resources• taken risks
Minimum requirementsfor Risk Management(MaRisk = national implementation)
SREP2ICAAP1
1 Internal Capital Adequacy Assessment Process2 Supervisory Review and Evaluation Process
Based on internal parameter estimation
Basel II framework
Regulatory Capital
EconomicCapital
Last year AIRB-Ansatz and AMA-Ansatz sucessfully approved by german regulator
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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
Operational Risk means the risk of loss resulting from inadequateor failed internal processes, people and systems or from externalevents, 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 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
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
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OpRisk Controlling Framework: AMA
Operational Risk Management
Bonus-Malus-Value System
Quantitative Model – Operational Risk Engine: Capital / Risk Calculation
Internal LossData
External LossData
Quality SelfAssessment
Key RiskIndicators
Risk and Control Inventory
Operational Risk Strategy & Regulatory Requirements
Senior Management & Regulatory Reporting
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Credit Risk Operational Risk Market andLiquidity Risk Business Risk
Losses Losses
Market volatility
Losses
Defaults Operational events
Losses
Earningsvolatility
Capital needed to cushion bank against unexpected losses
Economic Capital
Should reflect ‚true‘ risk profile of bank Consideration of all quantifiable risks
Economic Capital
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Risk strategy
Pillar 2: Minimum requirements on risk management
Overall responsibility of Board of Directors
Definition of risk taking capability concept
Implementation of reliable risk management system for all risk types
Integration of risk management system in overall bank steering
Implementation of reliable risk reporting and documentation system
and some more …
1.
2.
3.
4.
5.
6.
...
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Risk Committee of supervisory board
Riskstrategy
Independent Control: Internal Revision
RisktypesCredit Risk Market Risk Liquidity Risk
Operational Risk (Legal Risk) Business Risk
Board of managing directors
Common understanding of risk strategyand organisation / processes
Overall responsibility of Board of Directors1.
Risk-quantification
Risk-identi-fication
Risk-minimi-sation
Risk-transparency
Market Side
OperativeCredit RiskFunction
CRO
Riskcommittee
Creditcommittee
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Sufficient Capitalisation according to Target Rating
Risk coveringCapital
EconomicCapital
Definition of risk taking capability concept2.
Tier 1
Reserves
Target Profits
Operational Risk
Market Risk
Credit Risk
Business Risk
Comparison of equity and overall risk profil
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Risk strategy3.• Implementation of risk strategy• Close relation to business strategy• Inclusion of qualitative risk types
Market Risk
Operational Risk
Business Risk
Concentration
Branches
Countries
Segements
Products
Limits forExpected Lossand RiskConcentration
Credit Risk
Σ Market Risk
Σ Operational Risk
Σ Business Risk
Σ Credit Risk
Buffer
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Group
Business Lines
Client/product
Integration into bank management4.
Risk taking capability analyses:
Ecap = Σ Risks < disponible Equity
Ensures survival of bank
Risk-adjusted performance analyses :
RoRaC = Profit / Ecap
Capital allocation
Pricing and Product design
Ensures profitability of bank
Challenge: Management Attention Inclusion into renumeration concept !
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Economic Capital
Comparison RoRaC and RoE
RoRaC=Profit / ECap
RoE=Profit / RegCap
122006
122007
ROE (Avg) (%)
RORAC (%)
Economic Capital Credit
RiskMarket
RiskOp
RiskBusiness
Risk
35 5
ECAP ECAP (Avg)
140 1350100
Reg Capital
(Avg)RO
RACROE(Avg)
ZFI 280 25% 15% 70
Profit
062007
Management Reporting FI Portfolio
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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
Sales Steering Concept
PricingImplementation of Ex-Ante pricing tool at point of sales• Results of Transaction: Value Contribution Margin• Transaction Indicators: RoRaC, eCap, Basel II Capital, Risk Concentration
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Minimum Margin ~ 1,5 %
Value orientated credit pricing concept
Risk
Price(Gross Margin)
Basel I
Price of Risk
Refinancing costs
Admin / operating costs
Expectes Loss + Capital Costs
Basel II:
AIRB / Economic Capital
Expected Loss = 1,5% * 50%
Unexpected Loss = 16% * (1,8%+0,9%)
Admin costs: 0,3 %
Example:
Minimum requiredReturn on Capital:
Unexpected OpRisk:Unexpected Credit Risk:
PDLGD
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RegCap
ECap
Real Time Tool at Point of Sales
Financial Institutions Value Contribution Margin CalculationThe trade N/A was calculated by Oliver Kaufmann on 16.04.2008 17:03:46.
Client DetailsClient Name/Client NumberClient Rating 3.4Client Masterscale PD 1.500 %VBKDNR New ClientGroup NameGroup City/Country DEGroup LAD 0.0 T€Group EL 0.0 T€
Current Transaction DetailsSign (1=New Credit; -1=Creditsale) 1Product Type 001_Cash credit/Overdraft facilityStart Date 05-2008Lifetime (years) 1.0Currency EURExternal Limit 0.0 T€Drawing 1,000.0 T€Collateral 0.0 T€Guarantee J/N N
IncomesGross Interest Margin 1.40 %Committment Fee p.a. 0.00 %Provision Credit p.a. 0.00 %Transaction Upfront Fee 0.00 %Transaction Upfront Fee 0.00 T€Liquidity costs % 0.05 %
Results of TransactionRevenues 13.0 T€- Expected Loss (EL) 4.0 T€- Direct Costs 3.3 T€= Gross Return 5.7 T€- eCap Costs 5.1 T€= Value Contribution Margin 0.6 T€
Transaction IndicatorsRoRaC 17.9 %eCap 32.0 T€Basel II Capital 40.7 T€Risk Concentration 41.9 bp
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PortfolioAnalyses
ScenarioAnalysese.g.Impact of Hedging,True sales,Syndication,New business
Portfolio- and Scenario Analyses (in all risk dimensions)
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-- Country-- Sales Unit-- Segment
2006 2007 Δ in %Revenues 0,0 T € 0,0 T € + 0,0%
- Expected Loss (EL) 0,0 T € 0,0 T € + 0,0%- eCap Costs 0,0 T € 0,0 T € + 0,0%
- Direct Costs 0,0 T € 0,0 T € + 0,0%VCM 0,0 T € 0,0 T € + 0,0%
Country -- Segment -- 24% 61% 6% 3% 6%Region -- ZFI --
2006 2007PQI 0,00 0,00
RoRaC 0,0% 0,0%Ø-PD -- --
CB-Rating -- --Ø CVaR in T€ 0,0 0,0
Comments 38% 50% 8% 3% 2%
0,00 0,00 0,00 0,00 0,000,0 0,0 0,0 0,0 --
/ partnership meets expertise /
Ø CVaR in T€
Group
Revenue share
VCM share
PQI
--
Ranking VCM 2007
Key Performance Indicators
Client Profile--4--
GBKdNrSWIFT CodeVBKdNr
Revenues 2007 - Breakdown by Product Category (in T€)
0,0
20.000,0
40.000,0
60.000,0
80.000,0
100.000,0
-10.000,0
0,0
10.000,0
20.000,0
30.000,0
40.000,0
50.000,0
Value Contribution Margin 2007 - Breakdown by Product Category (in T€)
TotalVCM
CashServices
TradeServices
BankingProducts
MarketProducts
Others
TotalRevenues
CashServices
TradeServices
BankingProducts
MarketProducts
Others
Ex-Post Client Profile
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Pillar 3: Market Discipline
Market
Market Discipline:
Indirect pressureto improve Risk
Management and capital adequacy
Bank
Capital Structure,Taken Risks, Adequacy of Capital Resources, Scope of Application
Disclosure
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Additional Disclosures for IRB-Ansatz (Price for using IRB-Ansatz)
Implementation minor technical effort compared to Pillar 1 and 2
Pillar 3 : Issues
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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• Risk policies• Capital ratios• Capital structure• Credit Exposure per products, segments,
regions, rating class• Maturities• Impaired Loans by Portfolio• Development of Loan Provisions
Pillar 3 : Disclosure examples (32 altogether)
• Risk Mitigation• Description and Validation of PD, LGD
estimations• Securitizations• Validation of VaR-Market risk models• Interest rate risk for Banking Book• P&L for equities
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Economic Capital(‚true‘ risk profile)
Economic View:Risk adjusted capital steering
Regulatory Capital(simplified risk profile)
Regulatory View: Stability/SolvencySide condition for capital steering
Equity Capital
View of Investors: Optimisation of RoE
Overall Picture
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Capital Market Informations
Information• Credit Risk• Liqui Risk• Recoverybuthigh volatility
Bond Spreads
Should beequal but theyare not quiteoften
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Capital Market Informations
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Capital Market Informations
Contact Dr. Oliver KaufmannTel.: ++49 (0)69 / 136 22244E-Mail: [email protected]
Thank you for your attention!