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Value Orientated Risk and Capital

Management

Dr. Oliver Kaufmann


FI Risk & Portfolio Management
Contents / Agenda

1. Capital vs Risks

2. Regulatory Background

3. Risk Adjusted Portfolio Management

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Banks balance sheet

Liabilities
(Debt Capital)
Assets
Equity Capital
(= Assets - Liabilities)

• Optimise return on equity capital: RoE as key indicator for investors and shareholders

• Limitations from regulator: Minimum required equity capital compared to business activities
- Solvency
- Stable financial systems, protection of local depositors

Main internal steering factor: Optimisation of limited resource equity capital

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Risks of banking business

Risks unavoidable No Risk no Business !

Challenge: Detect, measure and manage true risks adequately to prevent unexpected losses !!

Credit Risk Operational Risk Market Risk Liquidity Risk

Unexpected losses due Unexpected losses due Unexpected losses due Unexpected losses
to default of borrowers, to failures of Systems, to market movements of due to:
counterparties, processes, human or risk factors like interest a) unability to repay
emittents technical errors, external rates, stock and liabilities
events and legal currency prices b) higher refinancing
e.g. processes costs
subprime crisis e.g. c) lacking market depth
e.g. Barings Bank, new economy crash to sell assets
SocGen

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Capital adequacy

Regulator: Cover risks by adequate Equity capital to ensure solvency Capital Ratio

Risks Equity Capital

Tier 1
• Common stakeholders
Operational Risk Equity and minority interests
• Retained earnings
• Preference shares
Risk Weighted Tier 1 • Innovative capital
Market / Assets (RWA)
Liquidity Risk covered by
adequate equity
Credit Risk
• Derivatives capital to survive‚ Tier 2
• Off balance realised‘ risks? • equity reserves / cumulative
sheet Tier 2 • preference shares
• Risk weighted
Credit Risk • Subordinated debt
balance sheet Tier 3
assets Tier 3 • Equity reserves / cumulative
• preference shares
• Subordinated debt

Capital Ratio:
Equity/RWA > 8%

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Credit Risk: The new Audi S4...

Scenario 1:
Original price 50.000,- € EAD = 50.000,-
Accident frequency 1 out of 10 PD = 10%
Cost sharing 0,- € LGD = 100%

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The Audi S4...

Insurance premium:

10% * 50.000,-€ * 100% = 5.000,-€


PD = Probability of Default
EAD = Exposure at default
PD EAD LGD EL LGD = Loss given Default
EL = Expected Loss

Total insurance premium for 10 insured Audis:

10 * 5.000,-€ = 50.000,-€

Loss Total premium Compensation

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The Audi S4...

Scenario 2:
Original price 50.000,- € EAD = 50.000,-
Accident frequency 1 out of 10 PD = 10%
Retention 5.000,- € LGD = 90%

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The Audi S4...

Insurance premium:

10% * 50.000,-€ * 90% = 4.500,-€


PD = Probability of Default
EAD = Exposure at default
PD EAD LGD EL LGD = Loss given Default
EL = Expected Loss

Total insurance premium for 10 insured Audis:

10 * 4.500,-€ = 45.000,-€

Replacement
Loss Total premium (less 5.000,-€ retention)

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Credit Risk: Expected and Unexpected Losses

Portfolio loss distribution

Loss
95 % of all cases
(19 out of 20)

Unexpected Loss
(loss volatility)
Economic Capital
Expected Loss
(average loss)

Years / Scenarios

Economic capital covers the Unexpected Loss,


the Expected Loss is covered by the risk margin
Economic Capital = Expected Loss – Unexpected Loss; level of confidence: 99.9% - 99.98%.

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Result

Expected Loss: Risk Costs


Exposure * PD * LGD Æ Expected Costs Æ Risk Provisions ~ Margin
Unexpectecd Loss:
Exposure * PD * LGD * „Portfolio effects“

30%

Provide capital to cushion unexpected losses


12%

Rating A Rating B Rating


Capital Costs
~ Risk
(required minimium interest return on capital)

Margin should be calculated considering ‚true‘ risk costs !!

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Regulatory View: „BASEL committee“

„Basel II“

International
„Gentlemen‘s
Agreement“
BIZ

„SolvV“

German National implementation (in vigor since beginning of 2008)


regulation
rules

„CRD“

European
European implementation
Capital
Requirements
Directive

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Regulatory goals

Basel I Basel II Goals

is/was not adequate for • Aligning regulatory capital requirements more closely to
modern risk situation. the underlying risks
• Incentives to improve internal risk management
more forward looking
• Risk adequate pricing
if higher/lower risk than higher/lower margins

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Credit Risk development: Basel I and Basel II Standardansatz

Simple rule:

Capital / Risk Weighted Assets > 8%

Capital = RWA * 8%

~ Exposure * Weighting Factor

e.g. 20% for OECD* countries

NO credit rating (PD)

NO portfolio effects (diversification/concentration)

*Organisation for Economic Co-operation and Development

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Basel II: Advanced Internal Rating Based Approach (AIRB)

Simple rule:

Capital / Risk Weighted Assets > 8%

Capital = RWA * 8%

but ~ Exposure * K (PD, LGD, Maturity)

Probability of Default Loss given Default

Still no portfolio effects (diversification/concentration)

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Internal determination of default risk
General approach:

Capital Adequacy
Asset Structure and Quality
Management quality
Earnings performance
Liquidity structure of balance sheet
Sensitivity to market risk
Internal Determination of banks probability of default (PD) and loss given default (LGD):

Analysis of balance sheet (quantitative model)

Analysis of historical defaults and crisis in the banking sector (quantitive model)

Qualitative Analysis by relationship manager and credit risk analysts to adjust quantitative model

Key Indicator: Probability of support by shareholders and/or government !

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Credit Risk Portfolio Model

Capital F ( Exposure, PD, LGD, Maturity, Concentration)

Credit Value at Risk = CVaR

Issues:

Different portfolio models on the market

Measurement of reliable concentration effects (default


correlations)

Allocation to single loan

Basel III
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Basel II framework

BASEL II

Pillar 1: Pillar 2: Pillar 3:


Calculation of regulatory capital for Supervisory review process (SRP) Market discipline
• Credit risk (AIRB-Ansatz) 4 principles: Qualitative&quantitative disclosure of:
• Operational risk (AMA Ansatz) • supervisory review process • scope of application
• Market risk (internal GS I model) • regulatory advices • capital structure
• regulatory transparency • adequacy of capital resources
• specific topics within the SRP • taken risks

Based on internal parameter estimation

ICAAP1 SREP2

Regulatory Capital
Economic Minimum requirements
Capital for Risk Management
(MaRisk = national implementation)
1 Internal Capital Adequacy Assessment Process
2 Supervisory Review and Evaluation Process
Last year AIRB-Ansatz and AMA-Ansatz
sucessfully approved by german regulator
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Operational Risk

Operational risk has always been there and lies at the heart of a lot of high losses and
even bankrupticies Barings Bank, SocGen…

Operational Risk means the risk of loss resulting from inadequate


or failed internal processes, people and systems or from external
events, and includes legal risk

Enough losses to care about it!

Benefits from optimising processes, efficient controls and transparent loss and risk
analyses are not just prevention of catastrophic losses but also leads to lower costs in
the normal business running

Regulator forces it now with OpRisk calculation requirements under Basel II

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Methods to calculate OpRisk capital charges

The Basic Indicator Approach


• Simplest of the three approaches
• Default option for smaller banks
• Straightforward calculation based on the firms' income

The Standardized Approach


• Calculations based on Income
• Different Percentages applying accross different business lines
• Standardized Approach banks have to meet certain qualifying criteria to be able to take the
advantages of the approach

The Advanced Measurement Approach


• Highest capital relief and highest positive impact on bank processes but inevidable more complex.
• Under this approach each bank calculates own capital requirements, by developing and applying
its own internal risk measurement system
• Bank must meet certain qualifying criteria
• Risk measurement system must be validated by the regulator

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OpRisk Controlling Framework: AMA

Operational Risk Management

Senior Management & Regulatory Reporting

Bonus-Malus-Value System

Quantitative Model – Operational Risk Engine: Capital / Risk Calculation

Quality Self Key Risk


Assessment Indicators
Internal Loss External Loss
Data Data

Risk and Control Inventory

Operational Risk Strategy & Regulatory Requirements

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Economic Capital

Capital needed to cushion bank against unexpected losses

Should reflect ‚true‘ risk profile of bank Consideration of all quantifiable risks

Economic Capital

Market and
Credit Risk Operational Risk Business Risk
Liquidity Risk

Market
Operational events volatility Earnings
Defaults volatility

Losses Losses Losses Losses

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Pillar 2: Minimum requirements on risk management

1. Overall responsibility of Board of Directors

2. Definition of risk taking capability concept

3. Risk strategy

4. Integration of risk management system in overall bank steering

5. Implementation of reliable risk management system for all risk types

6. Implementation of reliable risk reporting and documentation system

... and some more …

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Overall responsibility of Common understanding of risk strategy
1. Board of Directors and organisation / processes

Risk Committee of supervisory board


Board of managing directors

Riskstrategy

Risk-
quantification CRO

Risk- Risk- Operative


Market
identi- minimi- Credit Risk
Side
fication sation Function

Risk-
transparency Risk Credit
committee committee

Risktypes
Credit Risk Market Risk Liquidity Risk
Operational Risk (Legal Risk) Business Risk

Independent Control: Internal Revision


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Comparison of equity and
2. Definition of risk taking capability concept
overall risk profil

Risk covering Economic


Capital Capital

Target Profits Business Risk

Reserves Credit Risk

Market Risk

Tier 1 Operational Risk

Sufficient Capitalisation according to Target Rating

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• Implementation of risk strategy
3. Risk strategy • Close relation to business strategy
• Inclusion of qualitative risk types

Buffer

Market Risk Σ Market Risk

Operational Risk Σ Operational Risk

Business Risk Σ Business Risk

Credit Risk Σ Credit Risk

Concentration

Branches
Limits for
Countries Expected Loss
and Risk
Segements Concentration

Products

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4. Integration into bank management

Group
Risk taking capability analyses:
Ecap = Σ Risks < disponible Equity

Ensures survival of bank

Business Lines
Risk-adjusted performance analyses :
RoRaC = Profit / Ecap

Capital allocation

Client/product
Pricing and Product design
Ensures profitability of bank

Challenge: Management Attention Inclusion into renumeration concept !

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Management Reporting FI Portfolio
Comparison RoRaC and RoE

RoRaC=
Profit / ECap

RoE=
Profit / RegCap

RORAC (%)

12 06 12 ROE (Avg) (%)


2006 2007 2007

Economic Capital
Reg
Credit Market Op Business ECAP Capital RO ROE
Economic Capital Risk Risk Risk Risk ECAP (Avg) (Avg) RAC (Avg) Profit
ZFI 100 0 35 5 140 135 280 25% 15% 70

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Sales Steering Concept

Pricing
Implementation of Ex-Ante pricing tool at point of sales
• Results of Transaction: Value Contribution Margin
• Transaction Indicators: RoRaC, eCap, Basel II Capital, Risk Concentration

Reporting
Implementation of Ex-Post Client Profiles
• Key Performance Indicators: Portfolio Quality Index, RoRaC, Ø-PD, CB-Rating, ØCVaR in T€
• Breakdown by Product Category and Client: Revenues, EL, eCap-Costs, OpRisk-Costs, Direct Costs,
VCM

Steering
• Consideration of risk/return key indicators in individual target objectives and renumeration scheme

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Value orientated credit pricing concept

Example:
Price
(Gross Margin) Expected Loss = 1,5% * 50%

PD
LGD
Capital
el II: omic
Bas / Econ Unexpected Loss = 16% * (1,8%+0,9%)
Basel I AIRB
Price Minimum required
Return on Capital:
of Risk
Unexpected Credit Risk:
Expectes Loss + Capital Costs
Unexpected OpRisk:
Admin / operating costs
Admin costs: 0,3 %

Refinancing costs

Minimum Margin ~ 1,5 %


Risk
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Real Time Tool at Point of Sales

Financial Institutions Value Contribution Margin Calculation


The trade N/A was calculated by Oliver Kaufmann on 16.04.2008 17:03:46.
Client Details
Client Name/Client Number
Client Rating 3.4
Client Masterscale PD 1.500 %
VBKDNR New Client
Group Name
Group City/Country DE
Group LAD 0.0 T€
Group EL 0.0 T€
Current Transaction Details
Sign (1=New Credit; -1=Creditsale) 1
Product Type 001_Cash credit/Overdraft facility
Start Date 05-2008
Lifetime (years) 1.0
Currency EUR
External Limit 0.0 T€
Drawing 1,000.0 T€
Collateral 0.0 T€
Guarantee J/N N
Incomes
Gross Interest Margin 1.40 %
Committment Fee p.a. 0.00 %
Provision Credit p.a. 0.00 %
Transaction Upfront Fee 0.00 %
Transaction Upfront Fee 0.00 T€
Liquidity costs % 0.05 %
Results of Transaction
Revenues 13.0 T€
- Expected Loss (EL) 4.0 T€
- Direct Costs 3.3 T€
= Gross Return 5.7 T€
- eCap Costs 5.1 T€ ECap
= Value Contribution Margin 0.6 T€
Transaction Indicators
RoRaC 17.9 %
eCap 32.0 T€
Basel II Capital 40.7 T€
Risk Concentration 41.9 bp
RegCap

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Portfolio- and Scenario Analyses (in all risk dimensions)

Scenario
Analyses
e.g.
Impact of
Hedging,
True sales,
Syndication,
New business

Portfolio
Analyses

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Ex-Post Client Profile

Client Profile
GBKdNr -- Country --
SWIFT Code -- Sales Unit 4 Revenues 2007 - Breakdown by Product Category (in T€)
VBKdNr -- Segment --
100.000,0
Group --
80.000,0

60.000,0
2006 2007 Δ in %
Revenues 0,0 T€ 0,0 T€ + 0,0% 40.000,0
- Expected Loss (EL) 0,0 T€ 0,0 T€ + 0,0%
20.000,0
- eCap Costs 0,0 T€ 0,0 T€ + 0,0%
- Direct Costs 0,0 T€ 0,0 T€ + 0,0% 0,0
VCM 0,0 T€ 0,0 T€ + 0,0% Total Cash Trade Banking Market Others
Revenues Services Services Products Products

Ranking VCM 2007 Country -- Segment -- Revenue share 24% 61% 6% 3% 6%


Region -- ZFI --
Value Contribution Margin 2007 - Breakdown by Product Category (in T€)

50.000,0

Key Performance Indicators 40.000,0


30.000,0
2006 2007 20.000,0
PQI 0,00 0,00
10.000,0
RoRaC 0,0% 0,0%
Ø-PD -- -- 0,0
CB-Rating -- -- -10.000,0
Ø CVaR in T€ 0,0 0,0 Total Cash Trade Banking Market Others
VCM Services Services Products Products

Comments VCM share 38% 50% 8% 3% 2%

PQI 0,00 0,00 0,00 0,00 0,00


Ø CVaR in T€ 0,0 0,0 0,0 0,0 --

/ partnership meets expertise /

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Pillar 3: Market Discipline

Bank

Capital Structure,Taken Risks, Adequacy of


Capital Resources, Scope of Application

Market
Discipline:
Indirect pressure
Disclosure
to improve Risk
Management and
capital adequacy

Market

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Pillar 3 : Issues

Additional Disclosures for IRB-Ansatz (Price for using IRB-Ansatz)

Implementation minor technical effort compared to Pillar 1 and 2

Frequency?
Disclosure = Transparency ?
Disclosure of proprietary informations ?
Benefit from Pillar 3 ?

Working Group of german banks and supervisor recommends disclosure framework:


www/bundesbank.de/download/bankenaufsicht/pdf/anwendungsbeispiel_saeule_3.pdf

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Pillar 3 : Disclosure examples (32 altogether)

• Risk policies • Risk Mitigation


• Capital ratios • Description and Validation of PD, LGD
• Capital structure estimations

• Credit Exposure per products, segments, • Securitizations


regions, rating class • Validation of VaR-Market risk models
• Maturities • Interest rate risk for Banking Book
• Impaired Loans by Portfolio • P&L for equities
• Development of Loan Provisions

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Overall Picture

Equity Capital

View of Investors: Optimisation of RoE

Regulatory Capital Economic Capital


(simplified risk profile) (‚true‘ risk profile)

Regulatory View: Stability/Solvency Economic View:


Side condition for capital steering Risk adjusted capital steering

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Capital Market Informations

Information
• Credit Risk
• Liqui Risk
• Recovery
but
high volatility

Bond
Spreads
Should be
equal but they
are not quite
often

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Capital Market Informations

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Capital Market Informations

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Thank you for your attention!
Contact Dr. Oliver Kaufmann
Tel.: ++49 (0)69 / 136 22244
E-Mail: oliver.kaufmann@commerzbank.com

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