Download Why Risk Management

Workshop on Risk Management in
Commercial Banks
Organizing For Risk Control
June 18-20, 2008
Asia-Pacific Finance and Development Center
World Bank Institute
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Risk Control and Banking Stability
Banking systems
– Mobilize savings (economies of scale)
– Allocate and monitor the use of society’s savings
– Facilitate risk amelioration and trading
Well-Functioning Banking systems
– Improve capital allocation and economic growth.
– Reduce income inequality
– Lower poverty & Inequality
Consequences of Banking Failures
– Economic growth suffers --- output declines, entrepreneurship
gets thwarted.
– Fiscal burden diverts resources from essential public goods
and public investments
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Banking Sector Agenda In East Asia
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Source: East Asia Finance, The Road to Robust Markets, World Bank, 2006
Why Risk Management? Banking Instability
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Framework for Banking Stability
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Why Risk Management?
Banks often have
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Liquidity problems
Large open currency positions of private banks
Significant holdings of government debt
Low asset quality
Risk assessment and management systems weak
Lack of good corporate governance
Major macroeconomic instability
High public sector deficit
Systemic distortions created by weak banks
Weak financial disclosure rules and oversight
arrangements
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Why Risk Management?
Increase in bankruptcy in most economies as markets become
more competitive --- globalization and domestic liberalization
“Winner’s Curse”. More creditworthy firms have direct access to
debt markets. Banks make more loans to borrowers without access
to credit markets average loan quality has deteriorated.
Volatile Values of Collateral
More competitive financial markets ---Interest margins have
declined
The growth of derivatives : all have credit exposures
Thus worsening of the risk-return tradeoff
BIS Risk-Based Capital Requirements: Links capital charges to
external credit ratings or internal model of credit risk.
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Why Risk Management: Economic Rationale
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Why Risk Management?
Macro-financial Rationale
Procyclicality of bank lending is a widespread phenomenon and not confined to
specific episodes
Shocks to capital result in a reduction of bank loan supply (both in and outside
crises and independent of structure)
The effect of initial capital is stronger in crisis times
Loan losses have the potential to exacerbate macroeconomic fluctuations, that
is, financial instability may have real effects (even outside of crises and absent
bank defaults).
Financial and monetary stability are not disjoint.
Monetary policy can have powerful effects in exacerbating or alleviating
financial instability. Banks’ balance sheet characteristics affect their lending
activity: banks with higher provisions tend to extend less credit than their
stronger competitors
The impact of provisions on bank loan supply is stronger for banks that are
poorly capitalized.
Bank capital ‘matters’ more in times of low economic growth
Source: Bank weakness and bank loan supply , Erlend Nier and Lea Zicchino, 2004, Bank of England
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Why Risk Management? Corporate Rationale
Risks arising from provision of financial services such as
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Market risk
Credit risk
Operational risk
Cross border risk
To set performance incentives that are not perverse and better
align growth and stability
Measure economic capital
Allocate resources more efficiently
Apply risk based pricing
Customer selection and product development
Active management of portfolio risk
Establish an integrated risk management system to ensure
consistent risk measurements / policies for each type of risk, across
all businesses.
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Traditional Approaches to Credit
Risk Management
Character – reputation, repayment history
Capital – equity contribution, leverage.
Profitability – earnings volatility.
Collateral – Seniority, market value &
volatility of market value of collateral.
Economic cycle and market conditions.
Problems of consistency and subjectivity
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New Approaches to Risk Management
Role of Credit Risk Models
– Support tactical credit risk management
– Support decision making at the strategic level
– Understand better lending implications
Credit Risk Modeling Framework
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Definition of default
Aggregation of credit risk
Recovery
Exposure
Types of Models (Econometric, Equity Based,
Actuarial)
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Measuring Risks
All measurements of risk incorporate not only
quantitative but also qualitative elements.
– Even with good data and tools, uncertainty exists
– Estimation error always exists, often difficult to quantify
– Need to combine with qualitative tools and judgment
Use of sensitivity analysis, stress testing, and scenario
analysis
– For analyzing potential effects not captured by static
quantitative tools
– To inform use of baseline measure
– When data are scarce or tools are lacking, baseline measure should
use more sensitivity analysis and qualitative factors
– Should cover the major risk types (credit, market, operational)
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INTEGRATED RISK MANAGEMENT
THREE RELATED ASPECTS
– Integrated risk management as having consistent
policies and methods of measurement of risk
through-out the firm.
– Integrated risk management as the integration of risk
measurements, particularly economic capital, as a
component, into all aspects of business decisions.
– Integrated risk management as the process of
centralizing certain key risk architecture functions, to
ensure consistency in measurement and reporting of
risk.
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Risk Management System
Risk Management
Functions
Approve and monitor risk
limits.
Approve limit exceptions.
Approve new forms of
transactions
Function as eyes and ears
of senior management
with regard to risk taking
of business.
Risk Architecture
Functions
Build and maintain risk
infrastructure of firm:
Develop methods to
measure and analyze
risks, including economic
capital.
Develop risk policies.
Develop comprehensive
risk reports.
Develop IT based risk
systems
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Risk Management
Risk Models for Individual Assets
– Regression model and using simulation model
Portfolio Risk Models for Economic Capital
– The Conceptual Framework: Economic Capital
– Types of Portfolio models
– Assessing economic capital
Basel II Capital
– Basel’s Capital Rules
– Assessing Basel capital
Basel II implementation process in banks
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Basics Tasks in Credit Risk Management
Professional Risk Manager’s International
Association
Review strategic credit positions:
– Any changes to largest exposures (net of collateral)?
– How about changes to counterparty ratings?
– Any significant credits to be approved by chief credit officer or board?
Credit limits and provisions:
– Any limit excesses?
– Limits to be reviewed?
– Provisions still up to date?
– All concentrations within limits?
Credit exposure:
– All exposures covered and correctly mapped?
– Any Wrong way position?
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Basic Tasks in Credit Risk Management
(Cont’d)
Credit reporting:
– All significant risks covered in credit report?
– Report distributed to all relevant parties?
– Any significant credits that must be discussed at top management/board level?
Stress and scenario analysis:
– Any surprises from stress and scenario analysis at portfolio or global level?
– Anything not covered by current set of scenarios?
Provisions:
– Any past or anticipated changes in general loss provisions?
– Any changes to specific provisions?
Documentation:
– Full documentation in place for all transactions?
– Break clauses and rating triggers fully recognized?
Credit protection:
– Credit protection utilized and understood?
– Any further possibility to exploit credit protection?
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RISK METHODS AND ANALYTICS FUNCTIONS
Risk Methods and Analytics
Operational Risk Analytics
Credit Risk Analytics
Counterparty Risk Analytics
Source: Evan Picoult, Citigroup October, 2006
Market Risk Analytics
Model Validation
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Definition of Economic Capital
Capital is held to ensure that a bank is likely to remain
solvent, even if it suffers unusually large losses
– Available economic capital:
– The amount by which the value of all assets currently exceeds
the value of all liabilities
Required economic capital:
– The amount by which the value of all assets should exceed the
value of all liabilities to ensure that there is a very high
probability that the assets will still exceed the liabilities in one
year’s time
Typically, banks aim to have a high (e.g., 99.9%)
probability of remaining solvent
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Economic Capital
EC is the amount of capital to be held to protect against
low probability losses
The building blocks of EC
– PD, LGD, EAD, correlation, (M)
The key parameters describing the Credit Loss PDF
– EL and UL
– Capital as percentile of PDF
Basel Capital is a stylized version of EC
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A single correlation is assumed
A single systematic risk factor
“Infinite granularity”, no large loans or concentrations
No uncertainty in LGD
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Thinking about Economic Capital
Given the random amount of losses we suffer each
year, how much could we lose if we are unlucky?
– Capital as an unexpected loss percentile
– Capital = percentile of PDF
How much could we expect to lose in a recession?
– Capital as expected loss conditional on “severe" draw of
systematic risk factor
– Uncertainty in LGD and EAD assumed to be idiosyncratic, so
– Conditional EAD and conditional LGD are equal to their
expected values, respectively
– Capital = conditional default probability x LGD x EAD
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Use of Economic Capital & RAROC
Capital decisions
– General provisions, reserves, capital allocation
Portfolio allocation decisions
– Identification of opportunities and problems
Pricing and profitability decisions
– RAROC: Risk-Adjusted Return On Capital
Boosting high RAROC business lines
Loan pricing
– Margin = EL + H x Capital + OpRisk + OpCost
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Risk Adjusted Return on Capital
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Stress Testing
What is Stress Test? Techniques used by
financial firms to gauge their vulnerability to
exceptional, but plausible, events.
How do you identify a plausible, stressful
scenario?
– Use a historical scenario
– Develop a hypothetical scenario
What is likely to be stressed?
– The earnings, reserves, and capital adequacy of the
individual banks
– Stress test should cover loans and other parts of the
balance sheet as well as the income statement
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Principles vs. Rules based Standards for
Governance
Rules-based: detailed, rigid with little discretion, but intention can
be circumvented
Principles-based: broad principles with little structure to guide,
flexible and responsive to changes, as judgment is guided by
spirit/intention
Objectives-based: principles+ where objectives are clearly defined,
sufficient detail and structure is given so that standard can be
operationalized and applied on consistent basis
Economies can adopt standards to reorganize bureaucracy for
transparent and effective delivery of services, with accountability.
These operational standards ensure that processes minimizes selfserving behaviour, turf fights and silo mindsets, and promote
collaboration and unity of purpose in delivery of public services
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Hence, institutional reform involves not only performance and
conformance, but also transformance into a socially accountable
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growth
Basel II
Much more complex and risk sensitive
First Pillar – Minimum capital
Second Pillar – Supervisory review
Third Pillar – Market discipline
Treats exposures very unequally depending on exposure
characteristics
Treats banks very unequally depending on sophistication of
risk management systems
Will profoundly alter bank behavior
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Basel II Scope of Application
Insurance entities
Applied on consolidated basis to
Generally, deduct bank’s equity and
internationally active banks
other capital investments in insurance
All banking and other financial activities
subsidiaries
(whether or not regulated) captured
However, some G10 countries will
through consolidation
retain current risk weighting treatment
Financial activities do not include
(100% for standardized banks) for
insurance
competitiveness reasons
Majority-owned subsidiaries not
Supervisors may permit recognition by
consolidated: deduct equity and
bank of excess capital invested in
capital investments
insurance subsidiary over required
Significant minority investments
amount
without control: deduct equity and
Commercial entities generally deducted
capital investments
Deduction of investments 50% from significant investments in commercial
entities above materiality thresholds
tier 1 and 50% from tier 2 capital
Significant investments in commercial
entities below materiality thresholds
risk weighted 100%
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Basel II – Three Pillars
First Pillar
Second Pillar
Third Pillar
Minimum Capital Charges: Minimum capital
requirements based on market, credit and operational
risk to (a) reduce risk of failure by cushioning against
losses and (b) provide continuing access to financial
markets to meet liquidity needs, and (c) provide
incentives for prudent risk management.
Supervisory Review: Qualitative supervision by
regulators of internal bank risk control and capital
assessment process, including supervisory power to
require banks to hold more capital than required
under the First Pillar
Market Discipline: New public disclosure
requirements to compel improved bank risk
management
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Basel II – Capital Components
Credit risk charges
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To ensure capital charges are more sensitive to risks of exposures in banking book
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Enhancements to counterparty risk charges also applicable to trading book exposures
Operational risk charges
– New
– To require capital for operating risks (fraud, legal, documentation, etc.)
Market risk charges
– Initially unchanged, but Basel/IOSCO review has proposed changes to specific
risk calculations and Second Pillar stress testing
– To require capital for exposures in trading book
– Rules in Market Risk Amendment (1996)
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Basel II – Types of Banks
• Measure credit risk pursuant to fixed risk weights
Standardized
based on external credit assessments (ratings)
• Least sophisticated capital calculations; generally
highest capital burdens
• Measure credit risk using sophisticated formulas
Foundation IRB
using internally determined inputs of probability of
default (PD) and inputs fixed by regulators of loss
given default (LGD), exposure at default (EAD)
and maturity (M).
•More risk sensitive capital requirements
•Measure
Advanced IRB
credit risk using sophisticated formulas
and internally determined inputs of PD, LGD, EAD
•Most risk-sensitive (although not always lowest)
capital requirements
•Transition to Advanced IRB status only with
robust internal risk management systems and data
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Summary of Main Changes in the BCP
More emphasis placed on governance, transparency and accountability of
supervisory agencies, and reaffirming supervisory independence and
adequacy of resources and legal protections.
Bank governance given more attention to ensure that there is effective
control over a bank’s entire business. More details are provided on board
and senior management responsibilities, set clear strategies and
accountabilities.
Strengthened guidance on risk management practices. While some areas
were already covered in the former BCP, these have now been brought
under “standalone” CPs including (i) an integrated approach to risk
management, (ii) liquidity risk (iii) operational risk and (iv) interest rate risk
in the banking book.
The importance of greater disclosure to enable market discipline to
supplement official supervision is reinforced. New criteria have been added
specifying that the supervisor “require” disclosure and not just “promote” it,
as formulated earlier.
The “know-your-customer” (KYC) principle expanded to better capture
issues pertaining to the abuse of financial services firms by criminal
elements as reflected in the revised FATF standards as far as relevant for
bank supervisors.
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Credit Rating Agencies
Role of Credit Rating Agencies (CRAs) is vital
– CRAs assess the credit risk of banks
– CRAs attempt to make sense of the vast amount of
information available regarding a bank, its market
and its economic circumstances
– They give investors, lenders to banks, and to
regulators a better understanding of banking system
and banking institution risks.
– A credit rating, typically, is a CRA’s opinion of how
likely a bank will mange its financial obligation and
operations in a timely and efficient manner.
– Under Basel II they have a special role.
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Role of Credit Rating Agencies
What Credit Rating Agencies Do for Banks?
What is the Rating Process?
What are the Rating Methodologies?
How transparent is the ratings process
public dissemination of ratings and market
timing?
How do they manage Conflicts of Interest?
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Perspectives on Supervision and Regulation
Objectives of regulation and supervision
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Systemic Stability
Safety and Soundness
Consumer Protection
Consumer Confidence
Universal functions
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Prudential regulation
Prudential supervision
Systemic Stability
Conduct of Business: Regulation and Supervision
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Perspectives on Supervision and Regulation
– Safety Net Arrangements
– Liquidity Assistance
– Insolvent institutions
– Crisis Resolution
– Market Integrity
Institutional Structure of Financial Regulation
– Fragmented or Integrated
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Why Cross-Border Supervision?
Waves of large intra-nation bank mergers over
the past decade have created banks of
unprecedented size
– Japan credit quality problems have resulted in
consolidation partially the result of government
policy
– US – Drive to have truly national banks ---merger
wave among larger regional banks
– Europe – Intra- market mergers created “national
champions” – often with government encouragement
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Risk Based Approach In Regulatory
Institutions Issues and Actions
Involvement of Senior Staff
Improve communication with banks
– Clearer Guidances
– Clearer explanation of assessments
Training and Guidance for Supervisors
Use of IT
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Why Cross-Border Supervision?
Implications of Banking Industry Globalization
Global banks may be key players in
markets that are not key to the bank
National borders provide tax/regulatory
arbitrage opportunities but provide little
other benefit to the bank
Reputation/political risk may be as
important as potential financial impact of
adverse outcomes in the host country
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Cross- Border Banking Supervision
Basel II attempts to better promote international
harmonization of regulatory environment. Goals include:
– Improve soundness and stability of the international banking
system
– Insure capital is not a source of competitive inequality
– Encourage stronger risk management
Home-Host Coordination
Better Knowledge of Subsidiary Activities
Home-Host Supervisory Challenges
Better Knowledge of Subsidiary Activities
Home-Host Supervisory Challenges: Objectives,
Implementation and Expectations, Incentives
Capabilities
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Thank You
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