challenges in strategic risk management -...

October 19, 2009Group Risk Control

ERSTE GROUP

Challenges inStrategic Risk Management

Andreas WeingesselOctober 2009

October 19, 2009Andreas Weingessel / Group Risk Control

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In the News


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Recipe for Disaster

In the mid-'80s, Wall Street turned to the quants—brainy financial engineers—to invent new ways to boost profits. Their methods for minting money worked brilliantly... until one of them devastated the global economy.

cited from: WIRED MAGAZINE: 17.03http://www.wired.com/techbiz/it/magazine/17-03/wp_q uant

Here's what killed your 401(k) David X. Li's Gaussian copula function as first published in 2000. Investors exploited it as a quick—and fatally flawed—way to assess risk.


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Agenda

- Risk Management in Banks- Credit Risk

- Enterprise-wide Risk Management- Operational Risk


ERSTE GROUPFundamentals of Banking Business

− Main function of banks to act as intermediaries of fund transfers from liquidity providers (holders) towards liquidity buyers

− Banks within fund transfer activity managing mismatch in tenor and currency of collected liquidity and demanded credit

− As intermediary service provider, the banks are taking the risk of debtors and protecting the creditors

− Main indicator of banks’ solvency is their capital which can first absorb losses together with their profit

Andreas Weingessel / Group Risk Control

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RISK STEERING

� Organization� Capital Allocation� Risk- / Return-

optimization� Risk limits� Diversification� Training

� Hedging ex post

ex a

nte

RISK CONTROLLING

� Quantification� Reporting

RISK IDENTIFICATION

� Where are risks?� Which kind of risks

exist?� How can they be

measured?

RISK MANAGEMENT i.b.s

RISK MANAGEMENT i.n.s.“Risk management is

identification, measurementand steering of risk.”

What is Risk Management?


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Classification of Banking Risks (1)

Credit Risk

traditional

Credit Risk

Treasury

Credit Risk

Market Risk

Trading Book

Market Risk

Banking Book

Market Liquidity

Risk

Market Risk

Quantifiable Risks(effect on return < 1 year)

Strategic Risks(effect on return > 1 year)

Enterprise-wide Risk

Operational Risk


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Classification of Banking Risks (2)

Enterprise-Wide Risk

Op. risk as

part of credit risk

IT - System

External

Process

Employees

Event Risk

Operational Risk

OwnAssets

Businessrisk

ReputationRisk

EquityRisk

LiquidityRisk


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What is Basel II ?> Overview of components

► Risk adequate capital

► All specific bank risksand other risks capital

► Credit risk

► Market risk in the trading book

► Operational risk

Basel IIPillar 1

Minimum Capital Requirements

► Continuous riskmanagement process

► Evaluation of bank's internal capital adequacyassessment process(ICAAP )

► Definition of bank's individual solvability-coefficients

Pillar 2Supervisory Review Process

► Enhanced disclosure

► Better assessment formarket participants of capital adequacy of banks

► Increase of marketdiscipline

Pillar 3Market Discipline


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Agenda

� Risk Management in Banks

- Credit Risk- Enterprise-wide Risk Management- Operational Risk


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Internal Rating

− Estimates credit worthiness of a client

− Relative ranking (client A is “better” than client B) vs.

− Absolute ranking − Probability of default (PD)

vs.− Expected Loss (EL)


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Internal Rating

− Different methods for different exposure classes− Rating Factors− Economic Information− Behavioral Scoring− Soft Facts− External Information

− System components− Online rating (rating if necessary)− Batch rating (monthly automated update)− Application rating (at loan application)


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Internal Rating

− Mapping of clients into discrete number of rating classes− Mapping of rating classes into PDs

− Database: Historical time series of client information (input factors, default definition)

− Logistic regression leading to score values


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Usage of Ratings

− Loan Decision− Pouvoir− Pricing of Loan− Risk Provisions− Forecast− Internal Capital Calculation− External Capital Calculation (Basel II)


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Internal Rating - Challenges

− Distinguish “good” (=non-risky) clients from “bad” (=“risky”) clients− Discriminatory power

− Predict Probability of Default− Point-in-Time vs. Through-the-Cycle− Choice of Rating Scale− Choice of Homogenous Segments− Client vs. Product View− Country Risk


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Credit Risk Parameter

*) implicit treatment for corporates with reported sales and total assets of less than € 500 Mio

Foundation IRB

Advanced IRB

Exposure at Default (EAD)(Credit Conversion Factor - CCF)

supervisory valuesbank's own estimation

Probability of Default (PD)bank's own estimation

bank's own estimation

Loss Given Default (LGD) supervisory valuesbank's own estimation

Maturity implicit treatmentbank's own

estimation *)


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Risk Parameter - Challenges

− Quality of Time Series− Consistent definition and use of default events…− Structural Changes

− Understanding of the Operative Credit and Workout Process− Treatment of open lines− “Revival” of defaulted clients


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Agenda

� Risk Management in Banks� Credit Risk

- Enterprise-wide Risk Management- Operational Risk


ERSTE GROUPFrom Rating to CapitalRiskweights *)

PD0%

50%

100%

150%

200%

250%

300%

0% 20% 40% 60% 80% 100%

4 different risk weight functions:�Corporates, Banks and Sovereigns; LGD = 45%, Maturity = 2.5 Yr�SME-Corporates (between. € 5 and 50 m turnover); LGD = 45%, Maturity = 2.5 Yr�Risk weights of claims secured by residential property; internal LGD = 20%�Remaining Retail-claims und SME-Retail; internal LGD = 25%


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❚ Advantages❚Comparison between different risk categories = higher risk transparency

❚ Portfolio View

❚ Widely used in the banking world

❚ Basis for risk-adjusted Performance measurement, risk bearing capacity calculation, risk efficient capital allocation

Internal Risk Models (VaR)

❚ Disadvantages❚“Normal distribution – Concept”

❚ Not sub-additive � Expected Shortfall

❚ Tail behavior

❚ Wrong sense of safety


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Risk-Bearing Capacity Calculation –Goals

� Ensure the survival of the bank by avoiding risks which exceed the risk-bearing capacity

� Assessment of an adequate capital size from risk management perspective

� Basis for setting an overall bank limit

� Framework for establishment of risk appetite

� Create awareness for the relation between risk and risk-bearing capacity


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Risk-Bearing Capacity Calculation –Algorithm

1) Calculation of the Risk

2) Determination of coverage potential

3) Comparison between coverage potential and risk


ERSTE GROUPMeasurement of “all” material risk types

Correlation / Copulas

Economic Capital

Credit-VaRCredit-VaR

Volatility of Credit losses

Market-VaRMarket-VaR

Volatility of Market price

Operational-VaROperational-VaR

Volatility of operational loss

events

Other RiskOther Risk


ERSTE GROUPCoverage Potential

Divide Total Capital into Coverage Potentials based on

�Availability of Capital

�Triggering of Default Event


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Risk-Bearing Capacity Calculation: Risk vs. Capital

Diversi-fication

Diversi-fication

Economic Capital

Economic Capital

Op.risk

Op.risk

Creditrisk

Creditrisk

Marketrisk

Marketrisk

Centralcapitalreserve

risk capital

Coverage Potential I

Coverage Potential II

Coverage Potential III

Coverage Potential IV

Coverage Potential V


ERSTE GROUPPro-cyclicality in Basel II

Cap

ital

Req

uire

men

ts

Economic Cycle

Advanced IRB Approach� Individual validation of all parameters

leads to highest responsiveness to market changes

Foundation IRB Approach� Individual validation limited to

probability of default� LGD and CCF are predetermined and

constant� Subsequent lower reflection of

adverse market developments

Standard Approach� Impact from economical downturn due

to application of external ratings but which are smoothened based on its though the cycle approach

Banks applying the Advanced IRB Approach face the h ighest impactfrom economical downturns on their Basel risk expos ure


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Stress Tests

− Statistical Models used to calculate Capital or VaR are based on historical data

− Evaluate sensitivity of models with respect to changes in input parameters− Stress input parameters to reflect a (realistic) worst case scenario

− Determine P&L and capital ratio in scenario

− Set measures accordingly


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Agenda

� Risk Management in Banks� Credit Risk� Enterprise-wide Risk Management

- Operational Risk


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Operational Risk -Definition

““ The risk of loss resulting from inadequate or The risk of loss resulting from inadequate or failed internal processes, people and systems failed internal processes, people and systems

or from external events.or from external events. ””

Excluded:❚ Reputation risk❚ Strategic risk

Included:❚ Legal risk

Definition according to Basel II:


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Operational Risk Framework


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OpRisk Model

The theory: A simple approach

Model frequency and severity separately, then compute convolution

Assumptions

− given N=n, X1,X2,...,Xn are iid.− given N=n, the distribution of X1,X2,...,Xn is

independent from n.

− Distribution of N is independent of X1,X2,...,Xn

NXXXS +++= ...21


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OpRisk Model

The practice

challenges in strategic risk management -...

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