This action might not be possible to undo. Are you sure you want to continue?
Javed H Siddiqi
Risk Management Division
BANK ALFALAH LIMITED
“Knowledge has to be improved, challenged and increased constantly or it vanishes” Peter Drucker
Risk Management and Basel II
Risk Management Division Bank Alfalah Limited
Javed H. Siddiqi
Managing Risk Effectively: Three Critical Challenges
Y GY G LO LO NO NO CH CH TE TE
GL O B AL IS M
Management Challenges for the 21st Century CHANGE
The Causes of Credit Risk Best Practices in Credit Risk Management Correlation and Credit Risk Management. Issues and Challenges Summary 4 .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. Credit Rating and Transition matrix. Simple and Comprehensive approach.
What is Risk? •Risk. is viewed as a ‘negative’. making risk a mix of danger and opportunity. in traditional terms. defines risk as “exposing to danger or hazard”. 5 . Webster’s dictionary. while >the second is the symbol for “opportunity”. for instance. •The Chinese give a much better description of risk >The first is the symbol for “danger”.
It is about the everyday trade-off between an expected reward an a potential danger. However. We. to monitor and to manage uncertainty. often associate risk with some variability in financial outcomes. to measure. in the business world. It is universal. Risk management is an attempt to identify. 6 . in the sense that it refers to human behaviour in the decision making process. the notion of risk is much larger.Risk Management Risk management is present in all aspects of life.
risk-adjusted performance measurement and optimal decision making through capital allocation. The main calculations principles in the Basel II the current Basel II Accord. 7 . The use of economic capital as a management tool for risk aggregation. The definition and mechanics of economic capital. The key concepts and objective behind regulatory capital.Capital Allocation and RAPM The role of the capital in financial institutions and the different type of capital.
Role of Capital in Financial Institution Absorb large unexpected losses Protect depositors and other claim holders Provide enough confidence to external investors and rating agencies on the financial heath and viability of the institution. 8 .
Capital (RC). Capital (EC) or Risk Capital. An estimate of the level of capital that a firm requires to operate its Regulatory operate. The capital that a bank is required to hold by regulators in order to Bank Capital (BC) The actual physical capital held 9 .Type of Capital Economic business.
since it would be too costly to operate at the 100% level.Economic Capital Economic capital acts as a buffer that provides protection against all the credit. 10 . operational and business risks faced by an institution. EC is set at a confidence level that is less than 100% (e. market.9%). 99.g.
Expected and Unexpected Loss The Expected Loss (EL) and Unexpected Loss (UL) framework may be used to measure economic capital Expected Loss: the mean loss due to a specific event or combination of events over a specified period Unexpected Loss: loss that is not budgeted for (expected) and is absorbed by an attributed amount of economic capital Determined by confidence level associated with targeted rating Losses so remote that capital is not provided to cover them. Reserves 2. EL ytili babor P Cost UL Economic Capital = Difference 2.Risk Measurement.000 0 500 Expected Loss.500 Total Loss incurred at x% confidence level 11 .
Minimum Capital Requirements Basel II And Risk Management 12 .
History COUNTRY 13 .
menu of approaches.Comparison Basel I Focus on a single risk measure Basel 2 More emphasis on banks’ internal methodologies. supervisory review and market discipline Flexibility. More risk sensitivity 14 One size fits all Operational risk not considered Broad brush structure . Provides incentives for better risk management Introduces approaches for Credit risk and Operational risk in addition to Market risk introduced earlier.
The objective of the New Basel Capital accord (“Basel II) is: To promote safety and soundness in the financial system To continue to enhance completive equality To constitute a more comprehensive approach to addressing risks To render capital adequacy more risk-sensitive To provide incentives for banks to enhance their risk measurement capabilities 15 . 2. 5. 3. 4.Objectives 1.
2005 8% 9% 10% 12% 31st Dec..MINIMUM CAPITAL REQUREMENTS FOR BANKS (SBP Circular no 6 of 2005) IRAF Rating Required CAR effective from Institutional Risk Assessment Framework (IRAF) 31st Dec. 2006 and onwards 8% 10% 12% 14% 16 1&2 3 4 5 .
Overview of Basel II Pillars The new Basel Accord is comprised of ‘three pillars’… Pillar I Minimum Capital Requirements Establishes minimum standards for management of capital on a more risk sensitive basis: • Credit Risk • Operational Risk • Market Risk Pillar II Supervisory Review Process Pillar III Market Discipline Increases the responsibilities and levels of discretion for supervisory reviews and controls covering: • Evaluate Bank’s 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. 17 .
Measurement • Effective disclosure of: .Capital adequacy • Ensure capital adequacy is sensitive to the level of risks borne by banks Principle • Constitute a more comprehensive approach to addressing risks • Continue to enhance competitive equality Pillar 3 18 Pillar 1 Pillar 2 . e.Standardised (external factors) .Risk exposure assessment .g.Standardised .Adv. strategic risk • Supervisors seek to intervene and ensure compliance Objectives • Continue to promote safety and soundness in the banking system Market disclosure • What and how should banks disclose to external parties? Issue • How is capital adequacy measured particularly for Advanced approaches? • Better align regulatory capital with economic risk • Evolutionary approach to assessing credit risk . monitor and ensure capital adequacy? • 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.Adequacy of capital positions • Specific qualitative and quantitative disclosures .Basic indicator .Advanced IRB • Evolutionary approach to operational risk .Development of a revised capital adequacy framework Components of Basel II The three pillars of Basel II and their principles Basel II Minimum capital requirements Supervisory review process • How will supervisory bodies assess.Scope of application .Banks’ risk profiles .Foundation Internal Ratings Based (IRB) .Composition of capital .
Overview of Basel II Approaches (Pillar I) Basic Indicator Basic Indicator Approach Approach Operational Risk Capital Score Card Standardized Standardized Approach Approach Advanced Advanced Measurement Measurement Approach (AMA) Approach (AMA) Loss Distribution Internal Modeling Total Regulatory Capital Credit Risk Capital Standardized Standardized Approach Approach Foundation Internal Ratings Internal Ratings Based (IRB) Based (IRB) Advanced Market Risk Capital Standard Standard Model Model Internal Internal Model Model Approaches that can be followed in determination of Regulatory Capital under Basel II 19 .
It is also recognized that the capital buffer related to credit risk under the current Accord implicitly covers other risks. i.e. It is dealt with in every pillar of Accord. supervisory review and disclosure requirements. minimum capital requirements. 20 .Operational Risk and the New Capital Accord Operational risk is now to be considered as a fully recognized risk category on the same footing as credit and market risk..
but excludes strategic and reputation risk 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 Available approaches 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.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. but excludes strategic people and systems or from external events. This definition includes legal risk. This definition includes legal risk. but also how they manage operational risk on a day-to-day basis 21 . 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. Operational risk is defined as the risk of loss resulting from inadequate or failed internal processes.
8 V lu o “ re k ”a s p rv o imo e a e f G e s re u e is ry p s d 22 . Basic Indicator Approach: Capital Charge = alpha X gross income * alpha is currently fixed as 15% Standardized Approach: Capital Charges = ∑beta X gross income (g s in o efo b s e slin =i= .2 . 2. … ) ro s c m r u in s e 1 .The Measurement methodologies 1.3 .
The Measurement methodologies
1. 2. 3. 4. 5. 6. 7. 8.
Business Lines Beta Factors Corporate Finance 18% Trading & Sales 18% Retail Banking 12% Commercial Banking 15% Payment and Settlement 18% Agency Services 15% Asset Management 12% Retail Brokerage 12%
The Measurement methodologies
Under the Advanced Measurement Approaches, the regulatory capital requirements will equal the risk measure generated by the bank’s internal measurement system and this without being too prescription about the methodology used. This system must reasonably estimate unexpected losses based on the combined use of internal loss data, scenario analysis, bank-specific business environment and internal control events and support the internal economic capital allocation process by business lines.
Understanding Market Risk
It is the risk that the value of on and offbalance sheet positions of a financial institution will be adversely affected by movements in market rates or prices such as interest rates, foreign exchange rates, equity prices, credit spreads and/or commodity prices resulting in a loss to earnings and capital.
Why the focus on Market Risk Management ? • 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 26 .
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.5 108. It is a probability of occurrence and hence is a statistical measure of risk exposure 27 Value at Risk .9 4.considering no great paradigm shifts in the underlying factors. 5000.Measure..6 Certainty is 95.5 2.000 1.3 5.011 . a set of portfolio having a current value of say Rs.100.g.7 216.2 0 .022 ..can be described to have a daily value at risk of Rs.005 .000.at a 99% confidence level.016 . Monitor & Manage – Value at Risk Value-at-Risk Value-at-Risk is a measure of Market Risk.6 to +Infinity 7. 5000/. which means there is a 1/100 chance of the loss exceeding Rs.0 433 324.00% from 2.
Features of RMD VaR Model Multiple Portfolios Yields Duration Incremental VaR VaR VaR Portfolio Optimization Variancecovariance Matrix Stop Loss Helpspicking up securities which portfolios inofperiods Facility ofReturn Analysis forinRiskywell setthe constraints For in aiding in cutting losses duringand in single model For Identifying and isolating the given safe securities For optimizing methods and gel involatile portfolio multiple portfolio aiding trade-off 28 .
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. 29 .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.
Value at Risk-VAR VAR (x%) = Zx% σ VAR(x%)=the x% probability value at risk Zx% = the critical Z-value σ = the standard deviation of daily return's on a percentage basis VAR (x%)dollarbasis VAR (x%) decimlbasis a = X asset value 30 .
430 31 .4 percent and the asset has a current value of $5.3 million calculate the VAR(5%) on both a percentage and dollar basis.0231X5.32 VAR(5%) = -1. Critical Z-value for a VAR(5%)= -1.28.31% or $122.300.430 Interpretation: there is a 5% probability that on any given day. the loss in value on this particular asset will equal or exceed 2.65(.65. VAR(10%)=-1.31% VAR (x%)dollar basis= VAR (x%) decimal basis X asset value VAR (x%)dollar basis= -.65(σ) = -1.Example: Percentage and dollar VAR If the asset has a daily standard deviation of returns equal to 1. VAR(1%)=-2.000 = $-122.014) = -2.
Time conversions for VAR VAR(x%)= VAR(x%)1-day√J Daily VAR: 1 day Weekly VAR: 5 days Monthly VAR: 20 days Semiannual VAR: 125 days Annual VAR: 250 days 32 .
642 33 .500.754 = 12.500 √20= 55.902 = 12.500 √5= 27. VAR(10%)5-days(weekly) VAR(10%)20-days(mnthy) o VAR(10%)125-days VAR(10%)250-days = 12.951 = 12.Converting daily VAR to bases: other time Assume that a risk manager has calculated the daily VAR(10%) dollar basis of a particular assets to be $12.500 √250= 197.500 √125= 139.
Credit Risk Management Risk Management Division Bank Alfalah 34 .
Credit Risk Credit risk refers to the risk that a counter party or borrower may default on contractual obligations or agreements 35 .
1 PACRA AAA AA+ AA AAA+ A ABBB+ BBB BBBBB+ BB BBB+ B BCCC+ and below Unrated JCR-VIS AAA AA+ AA AAA+ A ABBB+ BBB BBBBB+ BB BBB+ B BCCC+ and below Unrated Risk Weight (Corporate) 20% 2 2 50% 3 3 100% 4 4 100% 5 5.Standardized Approach (Credit Risk) The Banks are required to use rating from External Credit Rating Agencies (ECAIS). (Long Term) SBP Rating Grade 1 ECA Scores 0.6 150% 6 Unrated 7 Unrated 150% 100% 36 .
Short-Term Rating Grade Mapping and Risk Weight External grade (short term claim on banks and corporate) SBP Rating Grade PACRA JCR-VIS Risk Weight 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% 37 .
Methodology Calculate the Risk Weighted Assets Solicited Rating Rating Unsolicited Banks may use unsolicited ratings (if solicited rating is not available) based on the policy approved by the BOD. 38 .
1. Claim-1 is rated as S2 2. e. Claim-2 is unrated Claim-1 rated as S2 Claim-2 unrated Risk -weight 50% 100% 39 .Short-Term Rating Short term rating may only be used for short term claim.g. Short term issue specific rating cannot be used to risk-weight any other claim. If there are two short term claims on the same counterparty.
2. Claim-1 is rated as S4 Claim-2 is unrated Claim-1 rated as S4 Claim-2 unrated Risk -weight 150% 150% 40 . 1.Short-Term Rating (Continue) e. If there are two short term claims on the same counterparty.g.
Banks are not allowed to “cherry pick” the assessments provided by different ECAIs 41 .Ratings and ECAIs Banks Rating Disclosure must disclose the ECAI it is using for each type of claim.
Basel I v/s Basel II Basel: No Risk Differentiation Capital Adequacy Ratio = Regulatory Capital / RWAs (Credit + Market) 8% = Regulatory Capital / RWAs RWAs (Credit Risk) = Risk Weight RWAs = 100 % 8% * Total Credit Outstanding Amount * 100 M = 100 M = Regulatory Capital / 100 M Basel II: Risk Sensitive Framework RWA (PSO) = Risk Weight * Total Outstanding Amount = 20 % * 10 M =2M 100 % * 10 M = 10 M =12 M 42 RWA (ABC Textile) = Total RWAs = 2 M + 10 M .
0 12.6 4.6 43 .RWA & Capital Adequacy Calculation (In Million) Customer Title PAKISTAN STATE OIL DEWAN SALMAN FIBRE LIMITED Rating AAA A Outstanding Balance 100 100 100 100 Risk Weight 20% 50% 100% 150% RWA = RW * Total Capital CAR (%) Outstanding Required 20 50 100 150 8% 8% 8% 8% 1.0 8.0 RELIANCE WEAVING MILLS (PVT) LTD BBB+ RUPALI POLYESTER LIMITED B Total: 40 0 32 0 25.
Meets the eligibility criteria and Minimum requirements. 44 .Credit Risk Mitigation (CRM) Where a transaction is secured by eligible collateral. Banks are allowed to reduce their exposure under that particular transaction by taking into account the risk mitigating effect of the collateral.
Comprehensive Approach 1. 45 .Adjustment for Collateral: There are two approaches: Simple Approach 2.
A) Under the S. 46 . the risk weight of the counterparty is used. the risk weight of the counterparty is replaced by the risk weight of the collateral for the part of the exposure covered by the collateral. Collateral must be pledged for at least the life of the exposure. Collateral must be revalued at least every six months.Simple Approach (S. For the exposure not covered by the collateral. A.
47 . And adjust the value of collateral downwards to allow for possible decreases in the value of the collateral.Comprehensive Approach (C. A new exposure equal to the excess of the adjusted exposure over the adjusted value of the collateral. counterparty's risk weight is applied to the new exposure. banks adjust the size of their exposure upward to allow for possible increases.A) Under the comprehensive approach.
The risk weight for the counterparty is 150% and the risk weight for the collateral is 50%.e. The counterparty has a rating of B+.5 =42.5 X 70 + 1. Suppose that an Rs 80 M exposure to a particular counterparty is secured by collateral worth Rs 70 M.5 million A risk weight of 150% is applied to this exposure: Risk-adjusted assets = 28.50 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.g.5 X 1.75 M 48 .1 X 80 -0. The collateral consists of bonds issued by an A-rated company. The risk-weighted assets applicable to the exposure using the simple approach is therefore: 0.85 X 70 = 28.
Credit risk Basel II approaches to Credit Risk Evolutionary approaches to measuring Credit Risk under Basel II Internal Ratings Based (IRB) Approaches Standardised Approach • RWA based on externally provided: – Probability of Default (PD) – Exposure At Default (EAD) – Loss Given Default (LGD) 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) • RWA based on externally provided: – 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. credit derivatives Increasing complexity and data requirement Decreasing regulatory capital requirement 49 Basel II provides a ‘tailored’ or ‘evolutionary’ approach to banks that is sensitive to their credit risk profiles . collateral.
amortization.Credit Risk – Linkages to Credit Process CREDIT POLICY Probability of Default Likelihood of borrower default over the time horizon Economic loss or severity of loss in the event of default RISK RATING / UNDERWRITING COLLATERAL / WORKOUT Transaction Credit Risk Attributes Loss Given Default Exposure at Default Expected amount of loan when default occurs Expected tenor based on prepayment. LIMIT POLICY / MANAGEMENT Exposure Term MATURITY GUIDELINES Default Correlation Portfolio Credit Risk Attributes Relationship to other assets within the portfolio INDUSTRY / REGION LIMITS BORROWER LENDING LIMITS Relative Concentration Exposure size relative to the portfolio 50 . etc.
51 .The causes of credit risk The underlying causes of the credit risk include the performance health of counterparties or borrowers. Unanticipated changes in economic fundamentals. Changes in regulatory measures Changes in fiscal and monetary policies and in political conditions.
Middle management or unit devoted to risk reviews 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. 52 .Risk Management Risk Management activities are taking place simultaneously RM performed by Senior management and Board of Directors .
Deploy Best Practices framework 3. Adopt RAROC as a common language 8. Architecture for Internal Rating 5. Measure.Best Practices in Credit Risk Management 1. Explore quantitative models for default prediction 9. Scientific approach for Loan pricing 7. Create Credit culture 53 . Rethinking the credit process 2. Design Credit Risk Assessment Process 4. Use Hedging techniques 10. Monitor & Manage Portfolio Credit Risk 6.
not size Investment in workflow automation / back-end processes Align “Risk strategy” & “Business Strategy” Active Credit Portfolio Management 54 .1. Rethinking the credit process Increased reliance on objective risk assessment Credit process differentiated on the basis of risk.
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 55 .2. Deploy Best Practices framework Credit & Credit Risk Policies should be comprehensive Credit organisation .
Position Future Financial Position Financial Flexibility Accounting Quality • External factors • Scored centrally once in a year • 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 officer’s risk assessment under each specific risk factor as part of the Internal Rating Model 56 .3. Design Credit Risk Assessment Process Credit Risk Industry Risk Industry Characteristics Industry Financials Business Risk Market Position Operating Efficiency Management Risk Track Record Credibility Payment Record Others Financial Risk Existing Fin.
grouping of sufficiently homogenous exposures and allow for accurate and consistent estimation of loss characteristics at pool level 57 . controls and data collection and IT systems that support the assessment of credit risk. Architecture for Internal Rating Credit Rating System consists of all of the methods.4. the assignment of internal risk ratings and the quantification of default and loss estimates. facility rating must exclusively reflect LGD) •Minimum of nine borrower grades for non-defaulted borrowers and three for those that have defaulted RETAIL EXPOSURES •Each retail exposure must be assigned to a particular pool •The pools should provide for meaningful differentiation of risk. 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. processes. The New Basle Capital Accord • Appropriate rating system for each asset class • Multiple methodologies allowed within each asset class (large corporate .
Architecture for Internal Rating…contd. LGD SEPARATELY Client Rating Risk Grade Industry Business Management Financial Client Grade I II III IV V X X X X X VI Facility Rating VII Risk Grade Facility Structure Collateral LGD Grade I X II X X III IV V VI VII The Facility grade explicitly measures LGD.4. ONE DIMENSIONAL Risk Grade Industry Business Management Financial Facility Strucure Security Combined I II III IV V X X X X X X X VI VII Rating reflects Expected Loss R RMD’s modified TWO DIMENSIONAL approach CONCEPTUALLY SOUND INTERNAL RATING MODEL – CAPTURES PD. 58 . The rater would assign a facility to one of several LGD grades based on the likely recovery rates associated with various types of collateral. Differs from the two dimensional system portrayed above in that it records LGD rather than EL as the second grade. The benefit of this approach is that rater’s LGD judgment can be evaluated and refined over time by comparing them to loss experience. guarantees or other factors of the facility structure.
The insight gained from this can be extremely beneficial both for proactive credit portfolio management and credit-related decision making. thus facilitating better understanding of the portfolio credit risk.5. 2. 1. 59 . it easily forms a part of the Integrated risk management framework. It is based on a rating (internal rating of banks/ external ratings) based methodology. Measure. Monitor & Manage Credit Risk Portfolio ‘CREDIT CAPITAL’ The portfolio approach to credit risk management integrates the key credit risk components of assets on a portfolio basis. Being based on a loss distribution (CVaR) approach.
PORTFOLIO CREDIT VaR Priced into the product (risk-based pricing) Covered by capital reserves (economic capital) Probability 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 60 .
11% 96.71% 99.15% 96.47% 96.67% 97.83% Confidence level 98.39% 95.19% 95.ARE CORRELATIONS IMPORTANT RELATIVE CONTRIBUTION OF CORRELATIONS AND PROBABILITY OF DEFAULT IN CREDIT VaR CREDIT VaR 97.75% 98.35% 99.03% 99.99% 61 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Correlation Large impact of correlations Probability of Default .43% 98.07% 99.79% 97.51% Source: S&P 95.
65 3.Y)=ρxy =Cov(X.01 0.03 0.15 -1.05 0.84 2.61 2.29 1.60 1.85 5.27 7.39 1.54 0.56 1.30 1.39 3.48 2.78 Hi tech 3.09 2.44 -0.39 Energ 1.14 4.81 1.40 4.51 3.75 -0.56 2.63 4.94 0.75 -1.3-Year Default Correlations Auto Auto Cons Energ Finan Build Chem High tech Insur Leisure Real Est.03 3.63 1.64 7.01 -1.54 3.06 2.11 0.83 2.99 2.08 3.64 2.39 13.56 2.52 2.91 5. 2.12 0.34 0.69 0.75 0.82 1.00 0.94 0.52 0.81 2.49 -0.40 7.65 1.31 0.41 2.11 1.27 -0.57 0.67 2.07 9.78 2.67 0.73 -0.41 3.67 2. Telecom Trans Utility Cons 4.60 0.10 4.40 1.31 Finan 1.20 -0.41 0.49 2.22 R.67 0.68 3.83 0.21 Trans 7.50 1.03 1.36 1.83 -0.33 Utility 3.34 3.78 2.28 0.04 3.41 4.50 -0.04 3.45 3.20 6.99 2.78 0.84 1.28 1.03 0.21 2.30 Insur 3.50 3.06 2.75 0.44 -0.63 0.E.09 3.08 0.22 1.78 1.12 2.33 1.69 0.Y)/std(X)std(Y) 62 .63 -0.21 4.51 -1.63 2.04 2.52 0.61 1.88 6.41 0.57 -1.29 2.32 3.05 Build 0.07 Corr(X.67 0.36 -0.50 1.41 0.91 3.72 5.32 0.04 1.63 3.47 2.73 2.56 -0.01 6.67 Chem 2.46 0.14 16.51 -1.74 -0.45 0.46 9.67 1.03 0.88 3.85 3.78 5.10 0.82 1.67 Leisure 0.52 2.03 2.47 96.39 1.49 0.48 Tele 2.49 1.85 1.68 2.21 4.83 4.50 2.40 6.
Valuation STEP 2 Migration Default Calculate asset value thresholds for entire transition matrix. Current Rating . the firm-to-firm correlations are found. This is done assuming that given current rating. The distribution of portfolio values is subtracted from the original value to generate the loss Industry Correlation distribution. of correlation (Monte Carlo) of Portfolio Loss Distribution the asset value thresholds preserving the Spot & Forward Curve Recovery Rates carried out. correlation structure using Cholesky Large no.RMD’s approach ‘CREDIT CAPITAL’ Overall Architecture From the historical Simulationsdata of industries. Step 41 STEP 3 Step Step 3 Simulated Credit Scenarios Monte Carlo simulation Return Thresholds Correlations STEP 4 Step 2 (rating wise) and recovery data suitable valuation of each of the 1 Step instruments in the portfolio is done Using the forward yield curve for each simulation run. 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. Average variability explained by each industry 63 Transition rates Tenor of Evaluation. Asset value thresholds are converted to simulated ratings for the portfolio for each of the Decomposition is for each grade simulation runs.
64 . Adopt RAROC as a common language What is RAROC ? Risk Adjusted Return Revenues -Expenses -Expected Losses + Return on economic capital + transfer values / prices Capital required for •Credit Risk •Market Risk •Operational Risk RAROC Risk Adjusted Capital or Economic Capital The concept of RAROC (Risk adjusted Return on Capital) is at the heart of Integrated Risk Management.7.
00 % Cost of capital 18% Average Lending assets 100 000 65 .RAROC Profitability Tree – an illustration Risk-adjusted income 5.60 % Risk-adjusted Net income 2.45% Net income 1750 Average Lending assets 100 000 RAROC 22% EVA 310 Total capital 8000 Total capital 8.10 % Expected Loss 0.40 % Market Risk Capital 1.40 % Income 6.50 % Risk-adjusted After tax income 1.60 % Operational Risk Capital 2.0 % Capital Charge 1440 Credit Risk Capital 4.20% Costs 3.75% Risk-adjusted Net Tax 0.
8. relating it to equity value and volatility Calculate Distance to Default Calculate default point (Debt liabilities for given horizon value) Simulate the asset value and Volatility at horizon Calculate Default probability (EDF) Relating distance to default to actual default experience Calculate Default probability based on Financials Arrive at a combined measure of Default using both . default statistics. Capital Structure & Equity Prices. volatility for each companyyear Solving for firm Asset Value & Asset Volatility simultaneously from 2 eqns. Explore quantitative models for default prediction Corporate predictor Model is a quantitative model to predict default risk dynamically Model is constructed by using the hybrid approach of combining Factor model & Structural model (market based measure) The inputs used include: Financial ratios. Use QRM & Transition Matrix 66 . The present coverage include listed & ECAIs rated companies The product development work related to private firm model & portfolio management model is in process The model is validated internally Derivation of Asset value & volatility Calculated from Equity Value .
9. Use Hedging techniques Credit Portfoli o Risks Different Hedging Techniques Interest Rate Risk Spread Risk Default Risk Credit Default Swap Total Return Swap Basket Credit Swap Credit Spread Swap . as we go along. . . the extensive use of credit derivatives would become imminent 67 .
36 0.25 A 0.10 0.59 1.14 C U R R E N T CREDIT Default 0.32 5.13 39.31 12.16 4.40 84.27 1.02 0.05 0.25 1.85 BBB 0.05 5.63 2.86 CCC 0.97 68 .89 2.12 1.07 1.84 0.05 63.29 2.06 R A T I N G 10.00 3.06 BB 0.02 0.93 88.34 B 0.29 9.48 6.74 0.68 2.45 7.53 8.Sample Credit Rating Transition Matrix ( Probability of migrating to another rating within one year as a percentage) Credit Rating One year in the future AAA AA 10.06 0.21 5.84 0.51 74.58 18.91 0.16 7.11 1.60 AAA AA A BBB BB B CCC 87.13 0.21 0.02 0.13 0.03 0.08 0.89 24.47 89.32 8.23 1.
10. Create Credit culture “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 69 .
Confront and resolve issues \ •Fast evolution of Islamic financial system •Rising competition from well established and emerging financial centres •Untapped potential in the industry 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.Issues and Challenges. Given that...is it sustainable? 70 . 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 ... There is this need to.. UCP Conduct in depth research and find solution on Shariah issues relating to risk mitigation..
Risk Management and Image of a Financial Institution. its culture. “ The way that risk is managed in any particular institution reflects its position in the marketplace. above all. “ 71 . the products it delivers and perhaps.
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! 72 .To Summarise….
This action might not be possible to undo. Are you sure you want to continue?
We've moved you to where you read on your other device.
Get the full title to continue reading from where you left off, or restart the preview.