Leveraging The Business Through Economic Capital Measurement - Why Adopt Quantitative Risk Measurement. Presentation to IFC Conference - Pakistan

Transcription

1 Leveraging The Business Through Economic Capital Measurement - Why Adopt Quantitative Risk Measurement Presentation to IFC Conference - Pakistan February 2009

2 Economic capital serves as the means for developing tools to navigate the business Supports the objectives of Basel II Ensures appropriate return in order to cover risks for the size and complexity of the bank Establishes a means for evaluating and optimizing portfolio sectors, businesses, and transactions Allows banks to drive incentives and remuneration outcomes Is the vehicle by which risk-return strategies and policies are driven through the organization Supports alignment to market forces Becomes a strategic link to managing credit rating agencies, shareholders and analysts 2 And drive enhanced value for business lines, senior management and shareholders

3 The Board and Senior Management challenge is to balance stakeholder expectations Protect Financial Solvency What is the Bank s overall risk appetite? Does the Bank have enough capital to cover its risks? Can the Bank effectively monitor and control its risks? Optimize Shareholder Profitability Is shareholder s capital invested profitably? Are there ways to redeploy capital to improve overall returns? Is the financial structure and dividend policy effective? Regulators Debt Holders Rating Agencies Customers Shareholders Equity Analysts 3

4 The basic concepts link risk measures to financial management Expected Loss (EL) Anticipated average loss rate Foreseeable cost Reserves and provisions Captured through h charge to Profit & Loss statement Unexpected Loss (UL) Anticipated volatility of loss rate True risk Captured through assignment of economic capital Allocation of equity Provisions and Reserves Capital 4

5 Economic Capital has become the accepted standard for measuring risk Probability of Loss Expected Loss (Mean) Unexpected Loss (STD DEV) Risk Appetite / Target Debt Rating Solvency Standard BBB.1% A.07% AA.03% AAA.01% Reserves Risk Equity /Capital at Risk Amount of Loss Economic Capital 5 Total Capital = Reserves + Equity Uncovered Risk / Mitigate or Hedge Economic capital is generated as a portfolio summary of the components of loss and is dependent on establishing a Risk Appetite

6 What makes implementing economic capital so challenging? Technical Challenges Establishing an appropriate target debt rating, particularly when a bank is limited by its country rating Consolidating different types of risk information Obtaining sufficient data of appropriate quality Establishing a sufficient balance between accuracy, cost, and complexity Cultural Challenges Resistance to change Adoption of measures that provide new levels of transparency Use of measures of capital additional to base regulatory requirements How do we know it s right? Establishing a sufficient balance between accuracy, cost, and complexity 6

7 So, why would we want to do it? Strategic Insight Optimize capital position Plan for capital consumption Manage risk/return trade-offs Evaluate mergers/acquisitions Address equity analysts and credit rating agencies + Operational Excellence Streamline processes to provide faster response and lower cost Optimize pricing to ensure coverage of risk Target and manage customers to reduce costs and focus on most profitable relationships Optimize collections to provide improved returns over shorter periods 7

8 Top institutions world wide actively use economic capital measures to support capabilities at all levels of the organization 8 Source: MOW Survey of Top 100 Banking Institutions 2007

9 An Economic Capital Framework establishes the basis to drive strategy and operational improvements Board & Risk/Capital Committee Performance Measures Remuneration and Incentives Hurdle Rates Capital Planning & Budgeting Allocate Capital Set Risk Appetite Assign Economic Capital Delegated Authorities House / Portfolio limits KRI/Loss Thresholds Position limits Top-Down Control of Risks Assign Limits Check vs. Limits Bottom-Up Measurement of Risks Risk-based pricing Risk-based line management Risk-based approval rules Incorporation into BU strategies t Operational Policies Assign & Strategies Capital Position Assign Capital Taking Measure & Assign Report Capital Risks 9 Strategic Decision Making Operational Execution

10 Risk Appetite is generally described in terms of target credit rating, and should be evaluated with respect to strategic objectives, target businesses, and funding constraints Basel II TARGET DEBT RATING BBB Where Do We Fit? Where Do Our Businesses Fit? AAA Capital Implications: Capital Implications: Higher wholesale funding rate Lower wholesale funding rate Lower economic capital Higher economic capital Higher risk adjusted returns Lower risk-adjusted returns Target Businesses Profile: Retail / Consumer Commoditized Activities : Deposit funding Target Businesses Profile: Finance and Investment activities: Little or no deposit base funding through wholesale markets 10 How much capital will be tied up? How does this affect other investment interests? What businesses will be advantaged or disadvantaged? What other thresholds should we consider? What are the largest single losses we can tolerate? Are they different in different businesses or risk classes?

11 Capitalization rates typically align to credit ratings and sector funding structures 12 Financial Sector Credit Ratings Securities Commercial Banks Diversified Investment Banks Retail Bank Pure Play Retail Credit 2 0 <BBB+ A- A A+ AA- AA AA+ AAA- AAA Many banks are reconsidering their target debt ratings, even en where they are capped by country risk ratings 11

12 Economic capital allocation allows the bank to manage capital and risk adjusted profit at every level Dimension Of Economic Capital Allocation Business Unit Product Holding Company Company Industry Transaction Counterparty Consistency Top-Down / Bottom-Up What Questions Should You Ask? How far do we go? Business lines? Customers? Transactions? What set of measures? How do these relate to limits? What tools and capabilities do we want to develop? What tie to compensation? At what level? What capital basis should we use? What behaviors are we driving? How does this align to shareholder interests? How will we communicate to shareholders? Do we want to externally disclose?

13 RAROC frequently forms the basis by which pricing guidelines, hurdle rates and performance targets are set RAROC Risk Adjusted Return on Economic Capital Revenues (interest & fee income) $$$ - Cost-of-funds (xxx) - Expected loss (xxx) + Capital Benefit xxx - Non-interest expenses (xxx) - Tax (xxx) Risk adjusted return xxx Economic capital capital xxx (credit risk or, market risk risk capital) (operating (operational risk risk capital) RAROC X% Do we utilise as a performance measure? How are we optimising our portfolio? Do we utilise as a hurdle rate? Or as an input to hurdle rate? How does this translate to pricing guidelines? If so, at what level? How do we use it to determine: Which transactions? Which h customer relationships? Which business lines? 13

14 Example: Capital Planning and Performance Reporting Risk-adjusted returns measures provide added value over standard measures Risk Adjusted Performance Assessment Business Commercial Market A Market B Market C ROE 22% Risk Adjusted 8% ROE 23% Risk Adjusted 23% ROE 23% Risk Adjusted 13% Correspondent banking 26% 30% 13% -9% 79% 32% Private banking 7% 3% 3% 4% 49% 64% Retail Corporate finance 20% 62% 23% 69% 4% NA 3% NA 3014% 36% 2770% 42% Total 22% 15% 14% 13% 43% 39% Higher ROE does not always imply better performance

15 Example: Capital Planning and Performance Reporting The bank can then more accurately identify opportunities to increase shareholder value Business Growth And Corporate Value Creation Metrics High Risk-Adjusted Returns (Corporate Value Creation) Harvest Value Driver Auto SME Risk Adjusted Returns Scrutiny Mortgage Mid Reposition Low Credit Card Trading C&I Low Earnings Growth High

16 Example: Capital Planning and Performance Reporting In strategic capital planning, senior management can decide how to re-deploy capital to maximize returns RAROC Which businesses do we grow? Which businesses do we sell or retract? How will new investments affect this picture? Which businesses are linked to others? Which businesses will perform in the future? 20% SME Personal Credit Redeploy this capital to above-hurdle businesses 10% Corporate Lending Credit Card Hurdle Sales & Trading 0% % Economic Capital (N$B) Mortgage Lending 16

17 Example: Customer Management Customer relationships can be targeted and managed based on risk-adjusted value Percentage of Profit (RAROC) 180% 160% 140% 120% 100% Value Eroding Relationships Vl Value Destroying Relationships 80% Value Enhancing Relationships 60% 40% Positive Negative Profits Profits 20% 0% 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% Percentage of Relationships Constructive account management techniques can frequently improve profitability by > 20% 17

18 Examples: Process Steam-lining Credit process efficiencies can be dramatically improved through restructuring using risk-based decision tools and policies Credit Process Efficiencies (RM Time) Annual Monitoring Before Risk-Based Origination Sales 10% Variations Reviews Servicing Reporting Streamlining i 18% 14% 22% 9% & GA 27% After Risk-Based Streamlining Sales 43% Net decrease (37.5%) Annual Monitoring Origination Variations Reviews Servicing Reporting 12% 10% 10% 5% &GA 20% More time and resources allotted to sales, marketing Less time and resources allotted to account administration 18 Improved originations and account management = 15% reduction in NPLs Clearer, slimmer policies i Simpler documentation requirements More efficient reporting, increased automation Easier, more automated account monitoring

19 Examples: Risk-based Pricing Adjusting pricing for risks can ensure improved service to target customers while enhancing profitability Improved Pricing Alignment Average Equity Allocation Risk Grade More attractive pricing for better customers Reduced likelihood of adverse selection Reduce portfolio attrition amongst target customers by 80% n Eq quity Allocatio. Original Price Below average risk overpriced.. Above average risk Under-priced Increased pricing for poorer risks: Increased overall portfolio margin by 8bp Better ability to structure and target: Transactions Customers Products Risk Score

20 What has gone wrong? Regulatory Framework? Credit Rating Agencies? Risk Management Practices? Market Confidence / Perception? Mark-to- Market? 20

21 There was a fundamental breakdown in the risk measurement framework Risk Measurement Rules of Thumb 1. The 80:20 rule works 2. All material risks need to be considered 3. Diversification matters 4. Models need to be managed 5. Adherence to governance frameworks is key 6. Stress testing is not just an exercise 21

22 Models should be transparent, but comprehensive How Did Industry Stack Up? 1. The 80:20 Rule Works Overly complex models lose effectiveness: All material risks need to be considered Diversification matters False sense of security Lack of transparency Dismissed or disregarded However, uncovered risks are 4. Models need to be managed often the source of crises Liquidity Risk 5. Adherence to governance frameworks is key Look through modeling 6. Stress testing is not just an exercise 22

23 Very few banks explicitly consider other risks in their capital regime Pillar 1 Risks Credit Market Operational Econmic Capital Coverage by Banks 0% 20% 40% 60% 80% 100% Pillar 2 Risks IRRBB Liquidity Business/Strategic Equity Insurance Model Goodwill Fixed Assets Software Other Diversification Source: BIS and APRA

24 Many banks became overly reliant on capital markets for liquidity Top 100 Bank Loan/Deposit Ratios as of March % Northern Rock 300% Ratio 160% 140% 120% 100% Citi Wachovia BofA In this group: RBS Lloyds Bradford Bingley Nat City 115 % Loan/Deposit 80% 60% 40% 20% JPM TDBN In this group: State Street BNY-Mellon Northern Trust 0% $0 $2 $4 $6 $8 $10 Cumulative Total Banking Assets ($ trillions) 70 % 24 Note: Analysis excludes HSBC North America Holdings, Utrecht-America Holdings, Barclays Group US, MetLife, and Taunus Corp. Source: Highline Financial Data Services, March 31, 2008

25 Over-concentration leads to material weaknesses How Did Industry Stack Up? 1. The 80:20 Rule Works 2. All material risks need to be considered 3. Diversification matters 4. Models need to be managed 5. Adherence to governance frameworks is key 6. Stress testing is not just an exercise Over-concentration in specific assets: Asset-backed securities (e.g. CDO, CLO, etc.) Sub-prime loans Diversification coefficients were optimistic and did not consider stressed environments or business cycle 25

26 26 Certain institutions became excessively concentrated in subprime over the past few years

27 And similarly, the MBS market grew aggressively CDO Issuance $MM Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q4 CDO s collateralized with high-yield loans grew aggressively to 25% - 30% of the market 27

28 With some investment banks ramping up and taking large positions Leading Players in CDO Issuance Growth in CDO Issuance H vs H Morgan Stanley 75% Lehman Brothers 57% Merrill Lynch & Co 46% Bear Stearns & Co 18% Goldman Sachs 6% Some banks hold > 20% of assets in MBS 28

29 Risk models need to be routinely reviewed and maintained How Did Industry Stack Up? 1. The 80:20 Rule Works 2. All material risks need to be considered 3. Diversification matters 4. Models need to be managed 5. Adherence to governance frameworks is key 6. Stress testing is not just an exercise Many models were not routinely reviewed and recalibrated Long period of benign credit environment led to complacency along with a difficult data environment 29

30 Maintenance of risk monitoring and limits needs to be enforced How Did Industry Stack Up? 1. The 80:20 Rule Works 2. All material risks need to be considered 3. Diversification matters 4. Models need to be managed Reporting was lessened or overlooked in some cases Adherence to governance frameworks is key Stress testing is not just an exercise Risk-adjusted measures were put aside Warnings and signals were ignored 30

31 Scenario analysis needs to consider the range of interconnected activities and risks How Did Industry Stack Up? 1. The 80:20 Rule Works 2. All material risks need to be considered 3. Diversification matters 4. Models need to be managed 5. Adherence to governance frameworks is key 6. Stress testing is not just an exercise Little or no stress-testing and scenario analysis No way to pick-up on uncovered risks (e.g. market perception, reputation risks or extreme scenarios) No notable outcomes from stress tests 31

32 Implementing the right balance is challenging, but can be readily achieved by keeping an eye on the basics 1. The 80:20 rule works 2. All material risks need to be considered 3. Diversification matters Implement simple models and then improve on these as data and experience is accumulated Start with the main risk categories and concentrations, but don t ignore the parts that may seem too hard Make conservative measures and look for ways to divest or diversify

33 Implementing the right balance is challenging, but can be readily achieved by keeping an eye on the basics 4. Models need to be managed Review and up-grade models at least yearly; plan for yearly investment 5. Adherence to governance frameworks is key Establish regular reporting and monitoring that is not over burdensome and stick to it 6. Stress testing ti is not just an Look for ways to create scenarios exercise for inherent weaknesses and act on the outcome 33

34 Ultimately, the objective is to achieve a top-down, bottom up consistency Top Down 1. Set the Bank s risk tolerance in line with its strategic objectives 2. Redeploy capital to activities with the best expected risk- adjusted returns 3. Align capital structure with the Bank s risk and solvency standard Bottom Up 4. Control risk to within the Bank s risk tolerance 5. Price business so the bank is paid for the risk it is taking 6. Reduce risk by improving diversification 34

35 Questions? The ability to simplify means to eliminate the unnecessary so that the necessary may speak. Hans Hoffman 35