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Royal Bank of Canada
BUS 419 – Advanced Derivatives Securities
Heng I (Miki) Pun
Jeff Chan
Macau Chan
Nathan Yau
Agenda
• Industry Overview
• Regulations
• Overview of RBC
• Financial Statement Analysis
• Risk Management Structure
• Major Risks of RBC
• Risk Management Strategies
Industry Overview
Number of Banks Operating in Canada
• 29 domestic banks
• 24 foreign bank subsidiaries
• 27 full-service foreign bank branches
• 3 foreign bank lending branches
Major Players
• Toronto-Dominion (TD) Bank – 21.9%
• Royal Bank of Canada – 20.6%
• Canadian Imperial Bank of Commerce (CIBC) – 16.4%
• Scotiabank – 14.1%
• Bank of Montreal – 13.4%
Products and Services Segmentation
Major Market Segmentation
Key External Drivers
• Consumer Confidence Index - measures consumer optimism about the
current macroeconomic environment and is strongly correlated with
aggregate household debt levels.
• Overnight Rate - the interest rate at which major financial institutions can
borrow and lend short-term funds to each other. It is strongly correlated
with interest rates charged by industry operators on lending products.
• Corporate profit - Corporate clients are anticipated to account for 20.2% of
total industry revenue in 2015. Changes in corporate profit tend to dictate
demand for credit from this market segment.
• Regulations - improve the reputations of Canadian banks on a global scale,
yet temper lending and increase compliance costs, to the detriment of
industry profit.
Regulations
Bank Act
• Schedule I Banks are domestic banks and are allowed to accept
deposits, which makes them eligible to receive, hold and enforce
a special security interest
• Schedule II banks are also allowed to accept deposits and are
subsidiaries of foreign banks, but they are excluded from the
Back Act security
• Schedule III banks are permitted to operate in Canada, but are
not incorporated under the Bank Act, which limits their range of
banking activities
The Basel Committee
• Established in 1930 in Basel, Switzerland
• Created by the central bank Governors of the Group Ten nations in 1974 and
meets four times a year at the Bank for International Settlements (BIS) in Basel
Switzerland
• A forum to promote discussion and policy analysis among central banks and
within the international financial community
• Objective: To enhance understanding of key supervisory issues and improve the
quality of banking supervision worldwide
Basel I – The Basic Capital Accord
• Published in 1988
• Established a set of minimum capital requirements for banks
with the goal of minimizing credit risk
• Banks that operate internationally were required to maintain a
minimum capital ratio of capital to risk-weighted assets of 8% to
be implemented by the end of 1992
Basel II - The New Capital Framework
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•
•
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Initially published in 2004 – built on the work of Basel I, especially in the areas of risk and
capital
Designed to improve the way regulatory capital requirements reflect underlying risks and
to better address the financial innovation that had occurred in recent years
Aimed at rewarding and encouraging continued improvements in risk measurement and
control
Comprised three pillars:
 Minimum capital requirements, which sought to develop and expand the standardised
rules set out in Basel I;
 Supervisory review of an institution's capital adequacy and internal assessment
process; and
 Effective use of disclosure as a lever to strengthen market discipline and encourage
sound banking practices
• Provided 3 tiers of capital
Basel III
•
•
•
•
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Originally published in December 2010 in response to the global financial crisis and
is expected to be phased in between 2013 and 2019
To strengthen the regulation, supervision and risk management of the banking
sector
Raises both the quality and quantity of required regulatory capital bases
Improve the banking sector's ability to absorb shocks arising from financial and
economic stress
Enhances the risk coverage of the Basel II capital framework to capture on- and offbalance sheet risks
Also strengthens the consistency and transparency of the capital base for
commercial banks by defining and limiting the types of capital instruments they
use
Tier 1 Capital
• Under Basel III, need to be subordinated to depositors and
general creditors, have fully discretionary non-cumulative
dividends or coupons and have neither a maturity date nor an
incentive to redeem
• Common shares and non-cumulative, perpetual preferred shares
would be compliant with the new rules
• The “innovative instruments” issued by the Canadian banks
which currently qualify as Tier 1 capital would not be compliant
with Basel III
Tier 2 & Tier 3 Capital
• Will be simplified – there will be only one set of Tier 2 capital
(rather than Tier 2A and Tier 2B under the current rules)
• Will need to meet the minimum standard of being subordinated
to depositors and general creditors and have an original maturity
of at least five years
• Subordinated debt issuances will not be compliant where they
contain a step-up feature, other incentives to redeem, or provide
for redemption in the first five years
• Tier 3 capital will be eliminated
Basel Ratios of RBC
Overview of RBC
Company Background
• Banking Industry contributes $51 billion for Canada (3.1% of the GDP)
• The second largest bank in Canada
• Currently based in Toronto and was founded in Halifax in 1864
• Operates in Canada, the US, and other 44 countries
•
1,372 bank branches and 4,973 ATMs
• Has over 78,000 employees serving over 16 million clients
• Bank of the Year for Canada in 2014
Industry Leader
• Royal bank is leading the
industry in terms of total
assets, only ranking
after TD bank.
Market share
Management Team
Dave Mckay - CEO and President
•
Joined RBC in 1988
Education:
•
•
Bachelor of Mathematics from the University of Waterloo
MBA from the Richard Ivey School of Business at University of Western
Ontario
Doug McGregor - Chairman and CEO of RBC Capital Market
•
Joined Marcil Trust in 1983, which was later acquired by RBC Capital
Markets in 1990.
Education:
•
•
Honours BA (Business) from the University of Western Ontario
MBA from the University of Western Ontario
Management Team
Janice Fukakusa - Chief Financial Officer
•
Joined RBC in 1985
Education:
•
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Bachelor of Arts from University of Toronto
Master of Business Administration from Schulich School of Business.
Mark Hughes - Chief Risk Officer
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Joined RBC in 1981
Education:
•
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MBA (Finance) from Manchester Business School
LL.B from Leeds University in England
Corporate Governance Structure
• Risk Committee’s
Responsibilities
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•
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Oversee risk management
Balance risk and rewards
Make recommendation to the
board
SWOT Analysis
Vision and Goals
• Vision – Always earning the right to be our clients’ first choice.
• Three Strategic Goals:
•
•
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In Canada, to be the undisputed leader in financial services;
Globally, to be a leading provider of capital markets, investor and wealth management
solutions; and
In targeted markets, to be a leading provider of select financial services complementary
to our core strengths.
Major Products and Services
• There are 5 profit segment:
• Personal $ Commercial Banking
• Wealth Management
• Insurance
• Investors and treasury services
• Capital markets
Major Products and Services
11 % increase
Lucrative!!!
Stock Trend
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•
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TD - $52.20
BMO - $73.60
Scotia Bank – 63.62
Financial Analysis
Balance Sheet
9.3% of Total Asset
Balance Sheet Cont.
10 % of Liabilities
94 % is Liabilities
Income Statement
Hedging Purpose
Income Statement Cont.
Comprehensive Income
Cash Flows
Cash Flows Cont.
$1,673 Net Cash Flow
Summary of Derivative Income
Fair Value of Derivative Instrument
Growth and Strength of the Last Three Years
Comparison of ROE of RBC & Global Peer
Second highest
among Global
Peer Group.
Risk Management Structure
Risk Philosophy
• Seeking to ensure that business activities and transactions
provide an appropriate balance of return for the risks assumed
and remain within our Risk Appetite through adherence to our
Enterprise Risk Appetite Framework.
Enterprise Risk Management Framework
• Provides an overview of our enterprise-wide programs for
identifying, assessing, measuring, controlling, monitoring and
reporting on the significant risks that face the organization.
Risk Conduct
Risk Appetite
Risk
Management
principles
Risk
Governance
Risk
Measurement
Risk Control
Risk Conduct
• A shared set of behavioral norms that sustain the core values, protect their
clients, safeguard the shareholders’ value, and support market integrity and
stability from undue risk.
• Four key components:
• Tone at the top and middle management
• Accountability, which is shared across all businesses and employees
• Incentives
• Effective challenge
Risk Appetite
• The amount and type of risk they are able and willing in the pursuit of our
business objective.
Define Risk Capacity
Identify regulatory constraints
Establish Risk Appetite
The Enterprise Risk
Appetite Framework
Self-Imposed Constraints & Drivers
Set Risk Limits and Tolerances
Ensure that risk-taking activities are within Risk Appetite
Measure Risk Profile
Ensure appropriate action is taken prior Risk Profile surpassing Risk Appetite
Risk Management Principles
• The following principles guide our enterprise-wide management of risk:
Effective balancing of risk and reward
Shared responsibility for risk management
Based on an understanding of risk
Avoid activities that are not consistent with values
Focus on clients
Use of judgment and common sense
Risk Governance
First Line of Defense (Risk owners)
• Provided by employees across
business and support functions
embedded in the businesses
• Alignment of business and
operational strategies with Risk
Conduct and Risk Appetite
Reporting of
risk
Identification
Monitoring
Assessment
Mitigation
Second Line of Defense (Risk Oversight)
• Provided by areas with independent
oversight accountabilities residing in
functions.
Risk Guidance
Oversight of First
Line Risk
management
Monitor level of
risk
Third Line of Defense (Independent Assurance)
• Provided by internal audit
• Provides independent assurance to senior management and
the Board of Directors.
Risk Measurement
• Expected losses: Losses that are statistically expected
to occur in the normal course of business in a given
period of time. (Earning at risk)
• Unexpected losses: Losses that are statically
estimated of the amount by which actual losses
can exceed expected losses. (Capital at risk)
• Unexpected = Actual - Expected
Expected losses
Unexpected losses
Stress testing
Back-testing
Validation of measurement
models
Risk Measurement
• Stress testing: Examines potential impacts arising
from adverse events.
• Ongoing enterprise-wide stress tests
• Risk specific stress testing programs
• Ad-hoc stress tests
• Reverse stress tests
Expected losses
Unexpected losses
Stress testing
Back-testing
Validation of measurement
models
Risk Measurement
• Back-testing: Ensure the credit risk parameters remain
appropriate for use in capital calculations.
• Preformed by comparing the realized value to
beginning estimates
Expected losses
Unexpected losses
• Validation of measurement models:
• Ensure the model incorporate current market
developments and industry trends.
• Ensure that all material underlying model
risk are identified and mitigated
Stress testing
Back-testing
Validation of measurement
models
Risk Control
• Enable the optimization of risk and return on both a portfolio and a
transactional risk
Level 2
Level 3
Level 4
Level 5
Business
Segments and
Corporate
Support
Specific
“Multi-risk”
Enterprise
Risk Policies
Enterprise
Risk Policies
Risk-Specific
Frameworks
Level 1
Enterprise Risk
Management
Framework
General
Risk Pyramid
• Identify and categorize the principal risks in new
and existing businesses, products or initiatives,
acquisitions and alliances
Major Risks of RBC
• Credit Risks
• Market Risks
• Liquidity & Funding Risks
• Insurance Risks
• Regulatory Compliance Risk
Credit Risks
• Credit risk is the risk of loss that an obligor’s inability or reluctant to follow
Issuer
Debtor
Counterparty
Borrower
Policyholder
Secondary Obligors
Primary Obligors
the contractual obligations.
Guarantor
Reinsurer
Credit Risk Measurement
• Both individual obligor and port folio level risks are quantified
• Expected credit loss and minimize unexpected losses management
• Limit earning volatility
• Two approaches:
• Internal Ratings Based Approach (IRB)
• Standard Approach
• Key parameters:
• Probability of default
• Exposure at default
• Loss given default
Credit Risk Measurement: Wholesale Risk
• Wholesale portfolio comprises of:
• Business
• Sovereigns
• Public sector entities
• Banks and other financial institutions
• Certain individuals and small businesses
Credit Risk Measurement: Wholesale Risk
(Cont)
• Wholesale credit risk rating system
•
Borrower Risk Rating (BBR) and PD
Credit Risk: Retail Risk
• The retail portfolio is comprised of:
• Residential mortgages
• Personal loans
• Credit Card loans
• Small business loans
Credit Risk: Retail Risk
• Primary Risk Rating System: Credit Scoring
• For acquisition of new clients
• Management of existing clients
• Pool Exposures for risk quantification
• Based on credit risk parameters
Credit Risk Control
• Minimum requirements for management of credit risk:
• Credit risk assessment
• Credit risk concentration
• Credit risk mitigation
• Structuring of transactions
• Collateral
• Credit derivatives
Gross Credit Risk Exposure by Portfolio and
Sector
Provision for (recovery of) Credit Losses
Gross Impaired Loans (GIL)
Market Risk
• The impact of market prices upon the financial condition of the firm
• Including:
• Potential gains or loss due to changes in market determined variables
• Credit spreads, equity prices, commodity prices, foreign exchange
rates and implied volatilities.
Market Risk Measurement
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Positions whose revaluation gains and losses are reported in Revenue
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Hedge ineffectiveness
Changes in the fair value of AFS securities
Changes in the Canadian dollar value of investments in foreign subsidiaries
Re-measurements of employee benefit plans
CET1 Ratio
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Impairment on available-for-sale (AFS) securities
CET1 capital
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Changes in the fair value of instruments classified or designated as at fair value through profit and loss
Changes in risk-weighted assets (RWA) resulting from changes in traded market risk factors
Changes in the Canadian dollar value of RWA due to foreign exchange translation
Economic value of the bank
•
Changes in the value of other non-trading positions whose value is a function of market risk factors
Market Risk Control
• Value-at-Risk (VaR)
• A statistical measure of potentia loss of a financial portfolio computed at
the 99th percentile confident level over one day holding period
• Stressed Value-at-Risk (SVaR)
• Same as VaR but it is computed using a fixed historical one year period
of extreme volatility and its inverse rather than the most recent two year
VaR and SVaR
Trading Revenue and VaR
Liquidity and Funding Risk
• Risk that RBC may be unable to generate or obtain sufficient cash or its
equivalent in a timely and cost-effective manner to meet the commitment
as they come due
Liquidity and Funding Risk Measurement
• Structural (Long term) Liquidity Risk
• Cash capital and other structural metric
• Tactical (Shorter-term) Liquidity Risk
• Apply net cash flow limits in CAD and other currencies for key shortterm time horizons
• Assign a risk-adjusted limit to pledging exposure
• Contingency Liquidity Risk
• Liquidity Contingency Plan
• Liquidity Contingency Team
Liquidity and Funding Risk Control
• Policies
• Define risk tolerance parameters.
• Authorities and limits
• Funding Strategy
Insurance Risk
• Potential financial loss that may arise where the amount, timing and/or
frequency of benefit payments under insurance and reinsurance contracts
are different than expected.
• Measurement:
• Insurance Risk Framework
• Insurance risk policies and procedures
Regulatory Compliance Risk
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Risk of potential non-conformance with laws, rules, regulations, prescribed
practices, contracts or ethical standards in any jurisdiction in which we operate.
Develop Regulatory Compliance Management Framework for Risk Measurement:
Five Elements:
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Use regulatory compliance programs in business activities and operations.
Ensure regulatory compliance risks are identified and assessed appropriately
Design and implementation of specific controls.
Monitoring and oversight of the effectiveness of the controls
Other Risks of RBC
• Optional Risk
• Strategic Risk
• Reputation Risk
• Legal and regulatory environment risk
• Competitive risk
• Systemic risk
Risk Management Strategies
Derivatives Instrument
• Financial Derivatives: Financial contracts whose value is derived from an
underlying interest rate, foreign exchange rate, credit risk, and equity.
Credit Derivatives
Forward contracts
Futures contracts
Swaps
Options
Other Derivatives
Products
• Non-financial Derivatives: Contracts whose value is derived from precious
metal and commodity derivative contracts in both OTC and exchange markets.
Derivatives issued for trading purpose
• Sales Activities: Structuring and marketing of derivative products to clients
to enable them to transfer, modify or reduce current or expected risks.
• Trading Activities:
Market-making
Arbitrage
activities
Positioning
Trading
Activities
Trading Activities
• Market-making - involves quoting bid and offer prices to other
market participants with the intention of generating revenue
based on spread and volume
• Positioning - involves managing market risk positions with the
expectation of profiting from favourable movements in prices,
rates or indices
• Arbitrage activities - involve identifying and profiting from price
differentials between markets and products
Hedging Strategies
Interest rate
swaps
Cross currency
swaps
Foreign exchange
forward contracts
Foreign exchange
swaps
Credit derivatives
Derivative-related credit risk
• Generated by the potential for the counterparty to default on its
contractual obligations when transactions have a positive market
value to the Bank.
• Represented by the positive fair value of the instrument.
• Normally a small fraction of the contract’s notional amount.
Risk Control Techniques
• Evaluate the creditworthiness of counterparties.
• Manage the size, diversification and maturity structure of the portfolio.
• Compare the credit utilization for all products with established limits on a
continual basis.
• Use of master netting agreement - provides for a single net settlement of all
financial instruments covered by the agreement in the event of default.
• Use of collateral – includes the mark-to-market provisions in agreements, which
then provide the right to request the counterparty pay down or collateralize the
current market value of its derivatives positions when the value passes a specified
threshold amount.