specific issues of economic capital management:economic vs
TRANSCRIPT
Specific Issues of Economic Capital Management:Economic vs. Regulatory Capital and Business Risk
Corinne NealeManaging Director, Capital Management
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Communication of Risks
Active Portfolio Management
Pricing and Performance Analysis
The Pillar 1 Model
Managing IRB Capital
Capturing Real World Risks
Stress Testing
ManagementActions
RegulatoryCapital
EconomicCapital
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LLN
Pillar 1: A Regulatory Model for ERM
The Stylized IRB ModelDefault/No-DefaultASRF (LLN)Hardwired CorrelationSingle Credit Driver
Lines of Credit
CreditCards
Mortgages
Commercial Medium/Small
Commercial Large
Trading BookBanking Book
Financial InstitutionFinancial Institution
Retail
Sectors
Private Firms
Sectors Sectors
Corporates(Public and
Private)
DerivativesCounterparties
Sovereign Bond Issuers
Corporate Bond Issuers
Credit Derivatives
Sectors
LLNLLNLLN
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The IRB Model: Limitations
Many Risks not captured• Concentration risk
• Single name• Sector (industry, geography)
• Losses driven only by defaults,not by ratings migration
One-size-fits-all within eachBasel II-defined asset class (e.g., allresidential mortgages subject to thesame formula / correlation values;new financial products?)
Only considers one confidence level (i.e., the 99.9%)
Thus, does not address stress scenarios nortail risk (i.e., what are potential losses beyond 99.9%)
Rigidity of modeling assumptions createsdisconnect with true economic capital
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Pillar II: Expectations for Risk Management
In a nutshell, the objectivesof Pillar II are to:
Compensate for limitationsof the IRB Model
Promote enterprise-widemeasurement and managementof risk
Evaluate impact of stress scenarios
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The Pillar 1 Model
Managing IRB Capital
Capturing Real World Risks
Stress Testing
RegulatoryCapital
EconomicCapital
Communication of Risks
Active Portfolio Management
Pricing and Performance Analysis
ManagementActions
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ERM: A Model to Evaluate Real World Risks
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Quantifying the Impact of Real World Risks
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0
10000
20000
30000
40000
50000
Economic Capital MacroeconomicDrivers
Correlation Impact Concetration Risk Migration Risk Regulatory Capital Capital Available
Bank ICAAP Results
Source: for this chart
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Banks’ ICAAP Content
Current and Project Capital PositionsRisk Appetite:
• Confidence Interval• Horizon• Scenario the confidence level corresponds to• Risks covered by Capital
Quantification technique for each riskControl process for risks not covered by capitalRisk aggregation techniques used
• Description• Assumptions• Limitations
Details of stress and scenarios appliedControls and ICAAP validation processICAAP and Pillar 1 comparisonsInternal use of ICAAP
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Quantification Issues: Concentration
How concentrated is my portfolio?
Possible answers:• HH Indexes• Ratio of largest to smallest exposures• Ratio of Additive UL to Absolute UL
this is the only one to capture correlation!
Where are the higher-aggregate concentrations?• This requires multi-level results?
How do correlations interact with concentrations?• Only a full EC model can help to articulate this
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LLN
Modeling Single Name Concentration: An Example
Chart 2. A nongranular portfolio containing an infinitely fine-grained subportfolioNote: Entire portfolio (subportfolio A plus B) is nongranular
Source: Bank of Japan Working Paper Series “An Efficient Monte Carlo Method for a Large and Nongranular Credit Portfolio” Hideaki HigoSee: http://www.boj.or.jp/en/type/ronbun/ron/wps/wp06e19.htm
Nongranularsubportfolio A(# of obligors η)
Infinitely fine-grainedsubportfolio B(# of obligors η)
Where you draw the line depends on your accuracyvs performance trade-off
Sampling or FFT
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Sampling SamplingFFT LLN
Lines of Credit
CreditCards
Mortgages
Commercial Medium/Small
Commercial Large
Modeling Single Name Concentration: An Example
CP analysis
DND for derivatives
Full Migration for Bonds
Integrated Market & Credit (Stochastic Exposures)
Netting & Collateral
Impact of Credit Derivatives
CP analysis
Full Migration
Integrated Market & Credit (Stochastic Exposures) or MtM
CP/Sector analysis
DND or Full Migration
MtM Exposures
CLT
Sector analysis
DND
Notional
Financial Institution
Trading BookBanking Book
Financial Institution
Retail
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SamplingFFT LLN CLT
A Model – Basel Granularity Adjustment
Lines of Credit
CreditCards
Mortgages
Commercial Medium/Small
Commercial Large
Financial Institution
Trading BookBanking Book
Financial Institution
Retail
Run 1 = Systemic + SpecificRun 2 = Systemic
Run 1
LLNRun 2 LLN LLN LLN
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Quantification Issues: Sector Concentration
The other form is Sector concentration• “…relates to imperfect diversification across systematic components of risk,
namely sectoral factors…”*• E.g., exposure to the U.S. automobile industry, which might be highly correlated
to other sectors (e.g., energy, aluminum manufacturing, consumer finance, etc.)
Multi-factor modeling enables the full captureof correlations across industry/geographic sectors…
• Identify exposures to highly correlated industriesor geographies that increase portfolio risk
• Likewise, capture diversification benefitsthat mitigate portfolio risk
*Basel Committee on Banking Supervision, “Studies on credit risk concentration”, Working Paper No. 15, Nov 2006
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Multi-Factor Modeling
Illustration: The Multi-Factor Variable – Candidates
General State of the Economy• Composite Leading Indicator• OECD_CLI• Industrial Production Index• Manufacturing Utilization rate
Prices• Producer Price Index• Producer Sales Index• Producer Inventory Index• Imports
Foreign Trade• Exports• Import Price Index• Export Price Index
Foreign Exchange• FX Rate – Euro/USD• FX Rate – Euro/YEN
Money Markets• 3-Year Corporate Bond Yields• Call Rate• Commercial Paper Rate
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Sector / Geography / Business Concentrations
0
50
100
150
200
250
300
Sector 1 Sector 2Sector 3 Sector 4 Sector 5 Sector 6Sector 7 Sector 8 Sector 9 Sector10
Sector11
Sector12
FTSE classification
Million €
0
200
400
600
800
1,000
1,200
EL UL Exposure
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Quantification Issues: Stress Tests
Stress-tests are part of risk management:
• Residual Risk• Marginal Risk• Business Risk• Macro-Economic Risk
• Downturn / Market Event• Liquidity risk• Correlations
What-If?
ExceptionalEvents
• Capital Adequacy• Capital Allocations• Management Actions
Sensitivities
ChangeAssumptions
TailRisk
UnderstandRisk Profile
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Definition:
The risk that, as a result of an external event, some of the bank’s business expenses be not covered by the income expected from that business, resulting in a net loss that needs to be funded with capital:
Business Risk Assessment Through Stress Tests
Scenarios
Sensitivities
Loss Impact
Business Budget(Self Funded)
StressTests
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Shocks toasset correlations
Stress Test 1
Shocks to credit qualitytransition probabilities
Stress Test 2
Other Risk Assessments Through Stress Tests
Illustration:
Shocks to systematic risk
Stress Test 3
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Other Risk Assessments Through Stress Tests
Results:
020406080
100120140160
Stress1
Stress2
Stress3
EC Base
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The Pillar 1 Model
Managing IRB Capital
Capturing Real World Risks
Stress Testing
RegulatoryCapital
EconomicCapital
Communication of Rrisks
Active Portfolio Management
Pricing and Performance Analysis
ManagementActions
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ERM: Tools for Management Analysis and Action
Advanced modeling techniques enable the quantification of real world risks across the portfolio
Quantification, in turn, enables financial executives to unlock value:
• Communication internally, with regulators,and to the market about risk profile;
• Active management of the portfolio;• Pricing decisions and performance analysis; and• …Ultimately, creation of economic value and
profitable business growth
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Communication of Risk
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Branch
Corporate Group
Communicating Risks
Division
Subsidiary
What is my exposure and regulatory capital
for United Airlines ?
What is my exposure and regulatory capital
associated with Brazil ?
What is my regulatory capitalon the tech sector for our
Asian sub ?
Cou
nter
part
y
SIC
Cou
ntry
All
All
What is my regulatory Capital on retail mortgages
For UK division ?
What is my total regulatorycapital requirement
for the bank ?
What is my exposure andregulatory capital on
non-investment grade products ?
Type Gro
up
Gro
up
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Actively Managing the Portfolio
Evaluating risk contributions across quantiles...but:• Which cut of the portfolio (sector, geography, business line)?• Which statistic (e.g., VaR, UL, Expected Shortfall)?• Which quantiles (e.g., 95%, 99.9%, 99.97%)?
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Contact Us
Eric [email protected] (81) 3 5224 4436
Toru [email protected] (81) 3 5224 4437
Corinne [email protected] (65) 6536 7737