Integrated Risk architecture:Implementation Issues

FICCI - IBA conference on “Global Banking – paradigm shift” on October 5th 2005

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Challenges in Implementing IRM3

Components for implementing IRM

What is Integrated Risk Management

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Three key imperatives for Bank’s Management

Differing requirements from various stakeholders Employees Borrowers Regulators Credit Rating

agencies Counterparty

banks Depositors Investors

Differing requirements from various stakeholders Employees Borrowers Regulators Credit Rating

agencies Counterparty

banks Depositors InvestorsCapital

Adequacy

Growth

Profitability

IRM can assist in managing the three objectives proactively

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Maintenance of Regulatory/ Economic Capital is crucial to business continuity

Economic Capital is the financial cushion that a bank uses to absorb unexpected losses. The purpose of economic capital is to provide confidence to claim holders such as depositors, creditors and other stakeholders.

The development of of sophisticated risk measurement tools offers banks the capability to calculate economic capital.

The proposed New Basel Capital Accord is a major move towards aligning regulatory capital to economic capital.

Economic Capital is the financial cushion that a bank uses to absorb unexpected losses. The purpose of economic capital is to provide confidence to claim holders such as depositors, creditors and other stakeholders.

The development of of sophisticated risk measurement tools offers banks the capability to calculate economic capital.

The proposed New Basel Capital Accord is a major move towards aligning regulatory capital to economic capital.

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Profitability Analysis – Bank ABC

Investments offer the highest contribution p.c.age on assets

Which segment leads to high interest earnings?

The credit function has the largest contribution towards fixed expenses

Which credit segment contributes the highest?

What is the position after allocating costs?

Am I properly pricing for expected Losses?

Investments offer the highest contribution p.c.age on assets

Which segment leads to high interest earnings?

The credit function has the largest contribution towards fixed expenses

Which credit segment contributes the highest?

What is the position after allocating costs?

Am I properly pricing for expected Losses?

Profitability AnalysisCredit Investments Others

Average Assets 51840 35064 10597

Interest Income 7.9% 8.5% 1.5%Interest Expenses 3.6% 3.6% 3.6%Net Interest Margin 4.3% 4.9% -2.1%Other Income 1.9% 1.3%Less: Provisions 1.3% 0.0%Total Contribution 4.9% 6.3% -2.1%Contribution (LKR Mn) 2548 2204 -226

Total Contribution 4526Operating Expenses 3975Share of Profit from subsidiaries 197PBT 749Tax 70PAT 679

• What is the capital required for different business lines?• What is the return provided by different business lines on

capital invested?• What is the expected impact of NPAs/ revaluation? Where

should we grow?• Are we generating enough internal capital to support growth?

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Risk Exposures – Bank ABC

Assets31/12/2003

Cash & Short Term Funds 1739Balances with Central Banks 3305T Bills and other eligible securities 5756Placement with and loans to other banks 10987Bills of Exchange 2493Loans & Advances 44222Lease Rentals receivable within one year 96Lease Rentals receivable after One year 72Dealing Securities 587Equity & others 916Bonds 17664Investment Securities 18580Investment Properties 804Investments in Subsidiaries & Associates 1667Accrued Intt 1073Cheques Purchased 2979Other Assets 3331Other Assets 7382Group balances receivable 503Property Plant & Equipment 1807Total Assets 100000

Liabilities31/12/2003

Deposits from customers 77312Deposits from Banks 188Total Deposits 77500Borrowings 10923Group balances payable 397Deferred Tax Liability 0Tax Payable 26Other Liabilities 4887Subordinated Debentures 520Total Liabilities 94253Shareholders EquityShare Capital 1082Permanent Reserve Fund 609Reserves 4056Total Equity 5747Total Liabilities & Equity 100000

Market RiskCredit Risk Liquidity Risk

The bank runs asset liability mismatches due differing maturity profiles and lending and borrowing rates for credit, investments, deposits and subordinated debentures.

Borrowing/ Lending/ Investing in Foreign Currency gives rise to foreign exchange risk

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How does this affect us?

Credit Risk: Simple credit products (loans normally backed by collateral, few products)

Market Risk: Simple market risk products (dealing in g-sec/ limited corporate bond market/ limited FX market)

Operational Risk: Not a major concern

Credit Risk: Simple credit products (loans normally backed by collateral, few products)

Market Risk: Simple market risk products (dealing in g-sec/ limited corporate bond market/ limited FX market)

Operational Risk: Not a major concern

Increasing Complexity & Size

Current Environment Future Environment

Credit Risk: Credit Derivatives Project Finance

Market Risk: Multiple currencies Investments in securities across

countries Investments in corporate bonds Swaps/ Options other

derivatives

Operational Risk: Increasingly important with

complex systems and processes, operations across time zones and markets

Credit Risk: Credit Derivatives Project Finance

Market Risk: Multiple currencies Investments in securities across

countries Investments in corporate bonds Swaps/ Options other

derivatives

Operational Risk: Increasingly important with

complex systems and processes, operations across time zones and markets

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RAROC - Base for Integrated Risk Management

RAROC 22%

Risk-adjustedNet income

1750

Risk-adjustedAfter tax income

1.75%

AverageLending assets

100,000

Total capital8000

Risk-adjustedNet income

2.20%

Net Tax0.45%

Total capital8.0 %

Risk-adjustedincome5.60 %

Costs 3.40

%

Credit Risk Capital4.40 %

Market Risk Capital1.60 %

Operational Risk Capital 2.00 %

Income6.10 %

ExpectedLoss 0.50 %

RAROC could be carried out for the bank as a whole or a business segment.

RAROC allows a bank to take a comprehensive risk view and forms the base for IRM

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Integrated Risk Management in a Bank

What is Integrated Risk Management?

•Measure, monitor and manage all the risks across the bank.

•Bank wide integrated risk management infrastructure in terms of people, policies and systems

•Common and consistent risk measurement and quantification methodologies across all risk categories

•Aggregation of risks and estimation of economic capital to assist in risk/ return decision making

Compliance

Policies

Culture

Systems& Processes

Peo

ple

Methodologies

Integrated Risk

Management

Organisation

Structure

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Perceived advantages of IRM

Facilitates strategic value creation

Key to regulatory compliance

Mechanism for efficient allocation of economic capital

Enables bank to maximise returns

Lower capital costs

Better decision making due to scenario analysis

Risk adjusted pricing

Loss reduction due to understanding of correlations

Elimination of unwanted exposures

Facilitates strategic value creation

Key to regulatory compliance

Mechanism for efficient allocation of economic capital

Enables bank to maximise returns

Lower capital costs

Better decision making due to scenario analysis

Risk adjusted pricing

Loss reduction due to understanding of correlations

Elimination of unwanted exposures

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Challenges in Implementing IRM3

Components for implementing IRM

What is Integrated Risk Management

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IRM Implementation – Important Facets

IT Infrastructure

Risk Communication and Control

Centralised risk function (analytics and management)

New product assessment

Quantification

Aggregation

Risk-adjusted performance measurement

Controls on Risk takers

Risk reportingRisk Policy

Policy Risk Models Performance Measurment

MIS

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Challenges in Implementing IRM3

Components for implementing IRM

What is Integrated Risk Management

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IRM Challenges – identification of gaps in existing risk management practices

Organisation Structure Organisation Structure

Risk Management Policies Risk Management Policies

Management Information Systems Management Information Systems

Information Technology Systems Information Technology Systems

Top Management Oversight Top Management Oversight

Risk Analytics Risk Analytics

Processes and Systems Processes and Systems

Reviewing and improving existingReviewing and improving existing

Credit RiskCredit Risk

Market RiskMarket Risk

Operational RiskOperational Risk

Basel IIBasel II

ALMALM Business RiskBusiness Risk Reputation RiskReputation Risk

Beyond Basel IIBeyond Basel II

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IRM Challenges - measurement of risks

Credit Risk Probability of Default Loss Given Default Exposure at Default

Market Risk Trading Book (VaR) Interest Rate Risk on Banking Book

Operational Risk (evolving)

Credit Risk Probability of Default Loss Given Default Exposure at Default

Market Risk Trading Book (VaR) Interest Rate Risk on Banking Book

Operational Risk (evolving)

Requires collection of data over time, development of measurement models, back testing of models

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IRM Challenges – Risk Aggregation

Correlations among risk silos

OVERALL ECONOMIC CAPITAL

RISK CATEGORY

RISK SILOCREDIT RISK

Corporate

I

Corporate II

Retail P

ool

CorrelationsAcross

Companies

OPERATIONAL RISK

Business Line 1

Business Line 2

Correlations across

Businesses

MARKET RISK CAPITAL

Interest Rate R

isk

Foreign E

xchange Risk

Com

modity R

isk

Correlations across

Asset classes

Equity R

isk

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IRM Challenges - modelling of correlations across risk categories & risk silos

Modelling correlations requires data and is not easy Fat tails in credit risk create problems

Modelling correlations requires data and is not easy Fat tails in credit risk create problems

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IRM Challenges - Improving IT systems

Internal risk scoring models for credit Portfolio Management Models Models for estimating VaR for Market risk Operational Risk databases Asset Liability Management System Data warehouse having interfaces for

Analytical Modelling Reporting

Internal risk scoring models for credit Portfolio Management Models Models for estimating VaR for Market risk Operational Risk databases Asset Liability Management System Data warehouse having interfaces for

Analytical Modelling Reporting

Options for developing Risk Management Systems In-house Off-the-shelf

Options for developing Risk Management Systems In-house Off-the-shelf

Sizeable investments in IT infrastructure required for implementing Basel II

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Thank youThank you

CRISIL Investment & Risk Management ServicesCRISIL Investment & Risk Management ServicesCRISIL LimitedCRISIL Limited dravishankar@crisil.comPh.no: 91 22 56537371Ph.no: 91 22 56537371