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Risk Management and Basel II: Bank Alfalah Limited
Risk Management and Basel II: Bank Alfalah Limited
Javed H Siddiqi
Risk Management Division
Knowledge has to be improved, challenged and increased constantly or it vanishes Peter Drucker
Javed H. Siddiqi
Agenda
What is Risk ? Types of Capital and Role of Capital in Financial Institution Capital Allocation and RAPM Expected and Unexpected Loss Minimum Capital Requirements and Basel II Pillars Understanding of Value of Risk-VaR Basel II approach to Operational Risk management Basel II approach to Credit Risk management Credit Risk Mitigation-CRM, Simple and Comprehensive approach. The Causes of Credit Risk Best Practices in Credit Risk Management Correlation and Credit Risk Management. Credit Rating and Transition matrix. Issues and Challenges Summary
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What is Risk?
Risk, in traditional terms, is viewed as a negative. Websters dictionary, for instance, defines risk as exposing to danger or hazard. The Chinese give a much better description of risk >The first is the symbol for danger, while >the second is the symbol for opportunity, making risk a mix of danger and opportunity.
Risk Management
Risk management is present in all aspects of life; It is about the everyday trade-off between an expected reward an a potential danger. We, in the business world, often associate risk with some variability in financial outcomes. However, the notion of risk is much larger. It is universal, in the sense that it refers to human behaviour in the decision making process. Risk management is an attempt to identify, to measure, to monitor and to manage uncertainty.
Type of Capital
Economic Capital (EC) or Risk Capital.
An estimate of the level of capital that a firm requires to operate its business.
to operate.
Economic Capital
Economic capital acts as a buffer that provides protection against all the credit, market, operational and business risks faced by an institution. EC is set at a confidence level that is less than 100% (e.g. 99.9%), since it would be too costly to operate at the 100% level.
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Probability
EL
Cost
UL
Economic Capital = Difference 2,000
2,500
Total Loss incurred at x% confidence level
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And
Risk Management
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History
COUNTRY YEAR
199495 1997 1998 1999 200102 200102
NATURE
Exchange rate crisis Bank run crisis Interest rate crisis. Currency crisis Interest rate instability Debt crisis
RESULTS
Budget deficit increased leading to massive government borrowing. The resultant money supply expansion pushed up prices. Capital flight. Bank run crises and currency run crises latter in 1999. Huge rise in budget deficit. Currency depreciated by 66.3% against the US dollar. Overnight interbank interest rate increased by 1700%. Domestic interest rate reached 60%. Domestic stock market crashed. Default on public debt.
Mexico
Turkey Argentina
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Comparison
Basel I
Focus on a single risk measure
Basel 2
More emphasis on banks internal methodologies, supervisory review and market discipline Flexibility, menu of approaches. Provides incentives for better risk management Introduces approaches for Credit risk and Operational risk in addition to Market risk introduced earlier. More risk sensitivity
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Objectives
The objective of the New Basel Capital accord (Basel II) is:
1. To promote safety and soundness in the financial system 2. To continue to enhance completive equality 3. To constitute a more comprehensive approach to addressing risks 4. To render capital adequacy more risk-sensitive 5. To provide incentives for banks to enhance their risk measurement capabilities
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1&2
3 4 5
8%
9% 10% 12%
Pillar I
Minimum Capital Requirements
Pillar II
Supervisory Review Process
Pillar III
Market Discipline
Establishes minimum standards for management of capital on a more risk sensitive basis: Credit Risk Operational Risk Market Risk
Increases the responsibilities and levels of discretion for supervisory reviews and controls covering: Evaluate Banks Capital Adequacy Strategies Certify Internal Models Level of capital charge Proactive monitoring of capital levels and ensuring remedial action
Bank will be required to increase their information disclosure, especially on the measurement of credit and operational risks. Expands the content and improves the transparency of financial disclosures to the market.
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Objectives
Continue to promote safety and soundness in the banking system
Market disclosure
Issue
Better align regulatory capital with economic risk Evolutionary approach to assessing credit risk - Standardised (external factors) - Foundation Internal Ratings Based (IRB) - Advanced IRB Evolutionary approach to operational risk - Basic indicator - Standardised - Adv. Measurement
Internal process for assessing capital in relation to risk profile Supervisors to review and evaluate banks internal processes Supervisors to require banks to hold capital in excess of minimum to cover other risks, e.g. strategic risk Supervisors seek to intervene and ensure compliance
Effective disclosure of: - Banks risk profiles - Adequacy of capital positions Specific qualitative and quantitative disclosures - Scope of application - Composition of capital - Risk exposure assessment - Capital adequacy
Principle
Pillar 1
Pillar 2
Score Card
Standardized Approach Advanced Measurement Approach (AMA)
Standardized Approach
Foundation
Internal Ratings Based (IRB)
Advanced
Standard Model
Internal Model
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Operational risk
Background
Description Operational risk is defined as the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. This definition includes legal risk, but excludes strategic and reputation risk
Three methods for calculating operational risk capital charges are available, representing a continuum of increasing sophistication and risk sensitivity: (i) the Basic Indicator Approach (BIA) (ii) The Standardised Approach (TSA) and Available approaches (iii) Advanced Measurement Approaches (AMA) BIA is very straightforward and does not require any change to the business TSA and AMA approaches are much more sophisticated, although there is still a debate in the industry as to whether TSA will be closer to BIA or to AMA in terms of its qualitative requirements AMA approach is a step-change for many banks not only in terms of how they calculate capital charges, but also how they manage operational risk on a day-to-day basis
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Convergence of Economies Easy and faster flow of information Skill Enhancement Increasing Market activity Leading to Increased Volatility Need for measuring and managing Market Risks Regulatory focus Profiting from Risk
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Value-at-Risk
Value-at-Risk is a measure of Market Risk, which measures the maximum loss in the market value of a portfolio with a given confidence VaR is denominated in units of a currency or as a percentage of portfolio holdings For e.g.., a set of portfolio having a current value of say Rs.100,000- can be described to have a daily value at risk of Rs. 5000- at a 99% confidence level, which means there is a 1/100 chance of the loss exceeding Rs. 5000/considering no great paradigm shifts in the underlying factors. It is a probability of occurrence and hence is a 27 statistical measure of risk exposure
Features of RMD VaR Model Yields Duration Multiple Portfolios Incremental VaR
VaR
Portfolio Optimization
Variancecovariance Matrix
Stop Loss Helps Facility For For For picking in Identifying of aiding optimizing Return multiple up insecurities Analysis cutting and methods portfolio isolating losses for which and in aiding Risky during the portfolios gel given in well and volatile trade-off set in safe in the of single securities periods constraints portfolio model
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Value at Risk-VAR
Value at risk (VAR) is a probabilistic method of measuring the potentional loss in portfolio value over a given time period and confidence level. The VAR measure used by regulators for market risk is the loss on the trading book that can be expected to occur over a 10-day period 1% of the time The value at risk is $1 million means that the bank is 99% confident that there will not be a loss greater than $1 million over the next 10 days.
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Value at Risk-VAR
VAR (x%) = Zx%
VAR(x%)=the x% probability value at risk Zx% = the critical Z-value = the standard deviation of daily return's on a percentage basis
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VAR(x%)= VAR(x%)1-dayJ
Daily VAR: 1 day Weekly VAR: 5 days Monthly VAR: 20 days Semiannual VAR: 125 days Annual VAR: 250 days
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other time
Assume that a risk manager has calculated the daily VAR(10%) dollar basis of a particular assets to be $12,500.
VAR(10%)5-days(weekly) = 12,500 5= 27,951 VAR(10%)20-days(monthy) = 12,500 20= 55,902 VAR(10%)125-days = 12,500 125= 139,754 VAR(10%)250-days = 12,500 250= 197,642
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Credit Risk
Credit risk refers to the risk that a counter party or borrower may default on contractual obligations or agreements
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(Long Term)
PACRA AAA AA+ AA AAA+ A ABBB+ BBB BBBBB+ BB BBB+ B BCCC+ and below
Unrated
ECA Scores
JCR-VIS AAA AA+ AA AAA+ A ABBB+ BBB BBBBB+ BB BBB+ B BCCC+ and below
Unrated
50%
100%
100%
5,6
150%
6
Unrated
7
Unrated
150%
100%
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PACRA
1
2 3 4
S1
S2 S3 S4
A-1
A-2 A-3 Other
A-1
A-2 A-3 Other
20%
50% 100% 150%
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Short-Term Rating
Short term rating may only be used for short term claim. Short term issue specific rating cannot be used to riskweight any other claim.
e.g. If there are two short term claims on the same counterparty. 1. Claim-1 is rated as S2 2. Claim-2 is unrated
Claim-1 rated as S2 Claim-2 unrated
Risk -weight
50%
100%
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150%
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Basel II: Risk Sensitive Framework RWA (PSO) = Risk Weight * Total Outstanding Amount = 20 % * 10 M =2M 100 % * 10 M = 10 M
Total RWAs =
2 M + 10 M
=12 M
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Customer Title
PAKISTAN STATE OIL DEWAN SALMAN FIBRE LIMITED
Rating
AAA A
Outstanding Balance
100 100 100 100
Risk Weight
20% 50% 100% 150%
Total:
400
320
25.6
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e.g.
Suppose that an Rs 80 M exposure to a particular counterparty is secured by collateral worth Rs 70 M. The collateral consists of bonds issued by an A-rated company. The counterparty has a rating of B+. The risk weight for the counterparty is 150% and the risk weight for the collateral is 50%.
The risk-weighted assets applicable to the exposure using the simple approach is therefore: 0.5 X 70 + 1.50 X 10 = 50 million Risk-adjusted assets = 50 M Comprehensive Approach: Assume that the adjustment to exposure to allow for possible future increases in the exposure is +10% and the adjustment to the collateral to allow for possible future decreases in its value is -15%. The new exposure is: 1.1 X 80 -0.85 X 70 = 28.5 million A risk weight of 150% is applied to this exposure: Risk-adjusted assets = 28.5 X 1.5 =42.75 M
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Foundation
RWA based on internal models for:
Probability of Default (PD)
Advanced
RWA based on internal models for
Probability of Default (PD) Exposure At Default (EAD) Loss Given Default (LGD)
Limited recognition of credit risk mitigation & supervisory treatment of collateral and guarantees
Limited recognition of credit risk mitigation & supervisory treatment of collateral and guarantees
Internal estimation of parameters for credit risk mitigation guarantees, collateral, credit derivatives
Basel II provides a tailored or evolutionary approach to banks that is sensitive to their credit 49 risk profiles
COLLATERAL / WORKOUT
Exposure at Default
Expected amount of loan when default occurs Expected tenor based on prepayment, amortization, etc.
Exposure Term
MATURITY GUIDELINES
Relationship to other assets within the portfolio Exposure size relative to the portfolio
Relative Concentration
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Risk Management
.
Strategic
Macro
Micro Level
On-line risk performed by individual who on behalf of bank take calculated risk and manages it at their best, eg front office or loan originators.
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Increased reliance on objective risk assessment Credit process differentiated on the basis of risk, not size Investment in workflow automation / back-end processes Align Risk strategy & Business Strategy Active Credit Portfolio Management
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Credit organisation - Independent set of people for Credit function & Risk function / Credit function & Client Relations Set Limits On Different Parameters Separate Internal Models for each borrower category and mapping of scales to a common scale Ability to Calculate a Probability of Default based on the Internal Score assigned
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Credit Risk
Industry Risk
Industry Characteristics Industry Financials
Business Risk
Market Position Operating Efficiency
Management Risk
Track Record
Financial Risk
Existing Fin. Position
Credibility
Payment Record
Others
Accounting Quality
Internal factors Scored for each borrowing entity by the concerned credit officer
RMD provides well structured ready to use value statements to fairly capture and mirror the Rating officers risk asses sment under each specific risk factor as part of the Internal Rating Model 56
Credit Rating System consists of all of the methods, processes, controls and data collection and IT systems that support the assessment of credit risk, the assignment of internal risk ratings and the quantification of default and loss estimates.
The New Basle Capital Accord Appropriate rating system for each asset class
Multiple methodologies allowed within each asset class (large corporate , SME) CORPORATE/ BANK/ SOVEREIGN EXPOSURES Each borrower must be assigned a rating Two dimensional rating system Risk of borrower default Transaction specific factors (For banks using advanced approach, facility rating must exclusively reflect LGD) RETAIL EXPOSURES Each retail exposure must be assigned to a particular pool The pools should provide for meaningful differentiation of risk, grouping of sufficiently homogenous exposures and allow for accurate and consistent estimation of loss characteristics at pool level
Minimum of nine borrower grades for non-defaulted borrowers and three for those that have defaulted
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ONE DIMENSIONAL
Risk Grade I II III IV V X X X X X X VI VII
The Facility grade explicitly measures LGD. The rater would assign a facility to one of several LGD grades based on the likely recovery rates associated with various types of collateral, guarantees or other factors of the facility structure.
Differs from the two dimensional system portrayed above in that it records LGD rather than EL as the second grade. The benefit of 58 this approach is that raters LGD judgment can be evaluated and refined over time by comparing them to loss experience.
Portfolio
CREDIT CAPITAL
The portfolio approach to credit risk management integrates the key credit risk components of assets on a portfolio basis, thus facilitating better understanding of the portfolio credit risk. The insight gained from this can be extremely beneficial both for proactive credit portfolio management and credit-related decision making.
1. It is based on a rating (internal rating of banks/ external ratings) based methodology. 2. Being based on a loss distribution (CVaR) approach, it easily forms a part of the Integrated risk management framework.
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Expected (EL)
Unexpected (UL)
Loss (L)
Credit Capital models the loss to the value of the portfolio due to changes in credit quality over a time frame
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CREDIT VaR
97.75%
98.07%
99.35%
99.67%
96.15%
96.47%
97.43%
98.39%
95.19%
95.51%
95.83%
Source: S&P
Confidence level
98.71%
99.03%
96.79%
97.11%
99.99%
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100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0%
Correlation
Probability of Default
Finan Build
Chem High tech Insur Leisure Real Est. Telecom Trans Utility
0.67 2.68
3.65 3.11 0.67 2.06 2.40 7.04 3.56 2.39
0.83 2.36
1.60 1.69 0.52 2.01 6.03 2.49 2.56 1.31
-0.50 -0.49
0.94 0.75 0.75 -1.63 -0.20 -0.44 -0.28 0.05
1.39 1.54
0.52 0.73 -0.03 1.88 6.27 -0.04 1.03 0.67
1.54 3.81
2.09 2.78 0.41 3.64 7.32 3.85 3.29 1.78
0.52 2.09
3.50 2.34 0.41 2.12 0.91 5.21 2.61 1.30
0.73 2.78
2.34 3.01 0.47 2.45 3.83 4.63 2.82 1.67
-0.03 0.41
0.41 0.47 96.00 0.10 0.46 0.50 1.08 0.22
1.88 3.64
2.12 2.45 0.10 4.07 9.39 3.51 3.40 1.48
6.27 7.32
0.91 3.83 0.46 9.39 13.15 -1.14 4.78 2.21
-0.04 3.85
5.21 4.63 0.50 3.51 -1.14 16.72 5.63 4.33
1.03 3.29
2.61 2.82 1.08 3.40 4.78 5.63 3.85 1.99
0.67 1.78
1.30 1.67 0.22 1.48 2.21 4.33 1.99 2.07
Corr(X,Y)=xy=Cov(X,Y)/std(X)std(Y)
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From the historical correlation data of industries, the firm-to-firm correlations are found. Large no. of Simulations (Monte Carlo) of Portfolio the asset value thresholds preserving the correlation structure using Cholesky Loss Distribution Spot & Forward Curve Recovery Rates Decomposition is carried out. Asset value thresholds are converted to simulated ratings for the portfolio for each of the for each grade simulation runs. Valuation STEP 2 Migration Default Calculate asset value thresholds for entire transition matrix. This is done assuming that given current rating, the asset values have Exposure to move up/down by certain amounts (which can be read off a Standard Normal distribution) for it to be upgraded /downgraded.
Step 3
Simulated Credit Scenarios Monte Carlo simulation Return Thresholds Correlations
STEP 4 Step 2 Step 1 Using the forward yield curve (rating wise) and recovery data suitable valuation of each of the instruments in the portfolio is done for each simulation run. The distribution of portfolio values is subtracted from the original value to generate the loss Industry Correlation distribution. Average variability explained by each industry
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Transition rates
What is RAROC ?
Revenues -Expenses -Expected Losses + Return on economic capital + transfer values / prices
RAROC
Risk Adjusted Capital or Economic Capital
The concept of RAROC (Risk adjusted Return on Capital) is at the heart of Integrated Risk Management.
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Risk-adjusted income 5.60 % Risk-adjusted Net income 2.20% Net Tax 0.45% Costs 3.40 %
Risk-adjusted
RAROC 22%
Credit Risk Capital 4.40 % Total capital 8.0 % Market Risk Capital 1.60 % Operational Risk Capital 2.00 %
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Interest Rate Risk Spread Risk Default Risk Credit Default Swap Total Return Swap Basket Credit Swap Securitization
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of migrating to another rating within one year as a percentage) Credit Rating One year in the future
AA 10.93 88.23 1.59 1.89 A 0.45 7.47 89.05 5.00 BBB 0.63 2.16 7.40 84.21 BB 0.12 1.11 1.48 6.51 B 0.10 0.13 0.13 0.32 CCC 0.02 0.05 0.06 0.16 Defaul t 0.02 0.02 0.03 0.07
C U R R E N T
CREDIT
R A T I N G
BB
B CCC
0.08
0.21 0.06
2.91
0.36 0.25
3.29
9.25 1.85
5.53
8.29 2.06
74.68
2.31 12.34
8.05
63.89 24.86
4.14
10.13 39.97
1.32
5.58 18.60
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Credit culture refers to an implicit understanding among bank personnel that certain standards of underwriting and loan management must be maintained. Strong incentives for the individual most responsible for negotiating with the borrower to assess risk properly Sophisticated modelling and analysis introduce pressure for architecuture involving finer distinctions of risk Strong review process aim to identify and discipline among relationship managers
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Modernize and innovate Islamic financial system within Shariah boundary to meet customers demand
Continuously review regulatory and legal framework to suit Shariah requirements Develop and standardize global Islamic banking practices promote uniformity to facilitate cross border transaction and global convention equivalent to ISDA, UCP
Conduct in depth research and find solution on Shariah issues relating to risk mitigation, liquidity management and hedging Address shortage of talents in particular financial savvy Shariah Scholars and Shariah savvy financial practitioners Continuous adaptation of Islamic financial products - is it sustainable?
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To Summarise.
Effective Management of Risk benefits the bank..
Efficient allocation of capital to exploit different risk / reward pattern across business Better Product Pricing Early warning signals on potential events impacting business Reduced earnings Volatility Increased Shareholder Value
No Risk
No Gain!
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