1 integrated risk management and performance measurement banks at cross-roads

1

Integrated Risk Management and Performance Measurement

Banks at Cross-Roads

2IPM Solution Set - Integrated Performance Measurement

Pro

cess

Ree

ngin

eeri

ng Project M

anagement

Technical Infrastructure

SVM

EconomicCapital

OperatingProfit

Risk Profit & Loss

OperationalData Store

GeneralLedger

AnalyticalEngines Data

Warehousing

Middleware

Op.Risk

Cr.Risk

Mkt.Risk FTP Cost Rev.

EP

RAPM

3

1980s

Focus on Revenue and Cost Management

Mark-to-market

Activity-basedcosting

Transferpricing

1990s

Focus on Risk Control

Historic Focus

Value at risk

Risk-adjustedperformance

Portfoliomanagement

2000+

Bring togethermanagement of

profitabilityand risk under thecommon objective

of generatingShareholder Value

Fully integratedprofitability andrisk information

Forward-looking,not just static,

management tools

This is what mostUniversal Bankswant to achieve

It is the completion of a process long since started in most FIs

Current Management Philosophy Is Directed by Historical Information and Does Not Emphasize Forward-looking Approaches to Decision Making

4

Risk Measurement

Operational Risk

Credit Risk

Market Risk

Risk Measurement Methodologies

5

Secondary risks capture risks from other market characteristics

Primary market risks result from movements in financial markets

Liquidity risk results from the inability to receive fair value

Market Risk

Risk Management Methodologies

6

Market/ Position Risk = ƒ • Future Market Value

Distributions

• Position Risk Horizons

• Correlation Between Positions

Risk Management Methodologies - Market VaR

Market Value-at-Risk (VaR)

n

7Risk Management Methodologies - Market VAR

VAR

MTM Losses MTM Gains

“1 in 40 Loss”

99.5% confidence (approximately three standard deviations)

97.5% confidence (approximately two standard deviations)

83.0% confidence (approximately one standard deviation)

Risk Management Methodologies - Market VaR

Value-At-Risk represents the “worst case” loss

8

Increasing Sophistication


1. Notional Amount at Risk

2. Basis Point Value (BPV) Approach

3. Value-At-Risk (VAR) at Instrument Level

4. Value-At-Risk (VAR) with Correlation

Risk Management Methodologies - Market Risk Measurement Techniques

9Risk Management Methodologies - Market VAR

Approaches to Calculating Value-At-Risk

Mean Covariance Approach

Mean Covariance Approach

Historical SimulationHistorical Simulation

“What if”Analysis“What if”Analysis

Monte Carlo

Simulation

Monte Carlo

Simulation

Scenario Based Approaches

Risk Management Methodologies - Market VaR approaches

10

Value Dashboard

By Product Type…..

(000) 1994 1995 1996 1997 1998 YTD 99

Market VaR by Product

Loans 563,169 643,554 601,654 850,206 788,767 1,148,911 Bonds 2,252,675 2,574,216 2,406,614 3,400,825 3,155,069 4,595,644 FX 1,126,337 1,287,108 1,203,307 1,700,413 1,577,534 2,297,822 Derivatives 1,689,506 1,930,662 1,804,961 2,550,619 2,366,302 3,446,733 Equity 1,055,941 1,206,664 1,128,100 1,594,137 1,478,939 2,154,208 Diversification Ben. 351,980 402,221 376,033 531,379 492,980 718,069

Market VaR by Product

-

500,000

1,000,000

1,500,000

2,000,000

2,500,000

3,000,000

3,500,000

4,000,000

4,500,000

5,000,000

1994 1995 1996 1997 1998 YTD 99

Loans

Bonds

FX

Derivatives

Equity

11

Direct Lending Risk

Counterparty Settlement and Pre-settlement Risk

Issuer Risk

Credit Risk


12

Expected and Unexpected

Credit Losses=ƒ • Future Market Value Distributions

• Default Rate Distributions

• Recovery Rate Distributions

• Portfolio Correlation Effects

Risk Management Methodologies - Credit VaR

Credit Value-at-Risk (VaR)

n

13

Expected Loss

99th PercentileLoss LevelEconomic Capital

Pro

bab

ilit

y

Loss

Covered by pricing and provisioning

Covered by capital and/or reserves

Quantified using scenario analysis and controlled with concentration limits


14

Actual exposure

Potential Exposure

Collateral

Settlements

Credit Exposure

+

+

-

Today's replacement cost, including effect of accruals

Potential changes in value over remaining life of transaction

Collateral held to reduce credit exposure

Spot settlements owed or defaulted payments

Netting

-

Net effect of long and short positions


15

8

6

4

2

0

Time

Mar

ket

Val

ue

Maximum Exposure

Expected Exposure


16



1. Notional Amount at Risk

2. Mark-to-Market

3. Mark-to-Market plus a ‘factor’

4. Dynamic Approaches (Monte Carlo and Portfolio Simulations)

Risk Management Methodologies - Credit Risk Measurement techniques

17

Exposures Value-at-Risk Due to Credit Correlations

User Portfolio

Market Volatilities

ExposureDistributions

Credit Rating

Rating Migration Likelihoods

Standard Deviation of Value Due to Credit Quality Changes for a Single Exposure

Seniority

Recovery Rate In Default

Portfolio Value at Risk Due to Credit

Ratings Series, Equities Series

Joint Credit Rating Changes

Models (e.g., Correlations)

Credit Spreads

Present Value Bond Revaluation

Dynamic Approach - Creditmetrics

18

Value Dashboard

By Industry Sector ...

(000) 1994 1995 1996 1997 1998 YTD 99

Credit VaR by Industry

Financial Institution 3,123,027 3,568,800 3,336,442 4,714,781 4,374,073 6,371,234 Agriculture 153,591 175,515 164,087 231,874 215,118 313,339 High Tech 409,577 468,039 437,566 618,332 573,649 835,572 Utility 819,154 936,079 875,132 1,236,664 1,147,298 1,671,143 Retail 307,183 351,029 328,175 463,749 430,237 626,679 Manufacturing 204,789 234,020 218,783 309,166 286,824 417,786 Diversification Ben. 102,394 117,010 109,392 154,583 143,412 208,893

Credit VaR by Industry

-

1,000,000

2,000,000

3,000,000

4,000,000

5,000,000

6,000,000

7,000,000

1994 1995 1996 1997 1998 YTD 99

Financial Institution

Agriculture

High Tech

Utility

Retail

Manufacturing

19

Improper Authorization

Inadequate Documentation

Systems Failure

Poor Judgment

Training / Human errors

Fraud

Mis-pricing

Transaction Processing Errors

Under Utilization of Funds

Model Errors

A special case is event risk, where one or more extreme external events cause a

high, un-preventable loss.

Operational Risk


20

Value Dashboard

By Operational Events…..

Op. VaR by Event Class(000) 1994 1995 1996 1997 1998 YTD 99

Mismanagement 917,282 1,048,213 979,966 1,384,806 1,284,735 1,871,332 Human Resources 825,554 943,392 881,969 1,246,325 1,156,261 1,684,199 Unauthorized trading 1,100,739 1,257,856 1,175,959 1,661,767 1,541,681 2,245,599 Sales Practice 733,826 838,570 783,973 1,107,845 1,027,788 1,497,066 Other Criminal Activities 1,192,467 1,362,677 1,273,956 1,800,248 1,670,155 2,432,732 Theft and Fraud 642,098 733,749 685,976 969,364 899,314 1,309,933 Errors and Omisssions 1,284,195 1,467,498 1,371,952 1,938,728 1,798,628 2,619,865 Disasters 550,369 628,928 587,980 830,883 770,841 1,122,799 Technology 1,375,924 1,572,319 1,469,949 2,077,209 1,927,102 2,806,999 Externalities 458,641 524,106 489,983 692,403 642,367 935,666 Total Op. Risk 9,081,096 10,377,309 9,701,664 13,709,578 12,718,872 18,526,191

19

94

19

96

19

98

Mismanagement

Sales Practice

Errors and Omisssions

Externalities

-

500,000

1,000,000

1,500,000

2,000,000

2,500,000

3,000,000

Op. VaR by Event ClassMismanagement

Human Resources

Unauthorized trading

Sales Practice

Other Criminal Activities

Theft and Fraud

Errors and Omisssions

Disasters

Technology

Externalities

21

Front Office/Deal Capture

Credit RiskAnalysis

Market RiskAnalysis

Event Processing

External Communications

TradeEntry andCapture

ClientInformationCollection

TradePricing

SALES

&

TRADING

Central Data Repository

- Position Tracking- Transaction Details- Market Data- Economic Details- Transaction History

Documentation Database

Risk Management

External System

Interfaces

Financial and Management

Reporting

Confirms / Notices

Payments / Settlements

Collateral Events

Accounting Entries (G/L)

Other External Interfaces

Financial Reporting

Risk Control (MIS)

Performance Analysis

Compliance

Other MIS

Exposures (e.g., Value at Risk)Limits (Available Credit Lines)

Valuation Models-Standard Calculator- Risk Algorithms

The Solution - Systems Architecture Model

22The IPM Solution Set - Methodologies

Op.Risk

Cr.Risk


““Best of Breed”Best of Breed” MethodologiesMethodologies

Risk Profit & Loss

Traditional Traditional MeasurementsMeasurements

SVM GoalGoal

EconomicCapital

OperatingProfit

EP

RAPM

Key MetricsKey Metrics

23Rewards to Organisations that implement IPM is tremendous

We believe there are big rewards for organisations that can implement IPM:

Improving earnings stability– Understanding sensitivity of earnings to external and internal factors

– Management of earnings ‘surprises’

– Awareness of trends

Optimising use of capital– Allocating capital efficiently at enterprise-wide level

– Identifying value creating/destroying lines of business

– Alignment of capital coverage with risk appetite

Enhancing operational decision-making– Embedding risk in the decision making process

– Change from historic to forward-looking management

– Decentralized and efficient decision making

24

IPM enables senior management to answer strategic questions and manage the business with a forward looking approach

Integrated Performance Management (IPM) is about bringing Shareholder Value theory into operational reality

• Where is my organization creating / destroying value?

• Is our organization aligned with our strategy to create value?

• Are we meeting shareholder expectations?

• How do we compare to our competitors?

• What are the areas of future opportunity?

• Are we properly compensated for the risks we are taking?

• Am I leveraging my IT investment?

• Is capital invested in the correct business to optimize value creation?

• Are we correctly measuring performance?

• Can the business plan and forecast ‘steer’ the correct course?

25

Value Dashboard

An Example …Identifying Value Creation or Erosion in the Enterprise...

RAPM vs Hurdle Rate

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

14.00%

1994 1995 1996 1997 1998 YTD 99

RAPM

Hurdle Rate

1994 1995 1996 1997 1998 YTD 99

Total Net Income (000) 3,721,275 4,205,041 4,751,696 5,369,416 6,067,440 6,856,208

RAPM 10.00% 11.00% 10.00% 11.00% 10.75% 10.75%Hurdle Rate 12.00% 12.00% 12.50% 12.75% 13.00% 13.25%Economic Profit Rate -2.00% -1.00% -2.50% -1.75% -2.25% -2.50%

Economic Capital (000) 37,212,748 38,227,641 47,516,958 48,812,875 56,441,305 63,778,675

Economic Profit (744,255) (382,276) (1,187,924) (854,225) (1,269,929) (1,594,467)

26

Calculation and Allocation of Economic Capital to Business Units and the Bank by Risk Type

872m

323m

80 m

178m851m120m

86m 65m

103m

228m

116m

911m

385m

79m

7m

957m

1,207m 3,481m439m

137m137m

54m 18m

660m

533m

56m

Credit Risk dominated Operational & Market Risk dominated

Market

Credit

Operational (event)

Insurance

Retail Banking

Customer Finance

Wholesale Banking

Intl Banking

Ins & Invstmnts

The Bank

Central Units

Operational (business)

27

RevenuesOperating ExpensesTaxesNOPAT

(Book Equity

x Cost of Equity)

--

-

=

Accounting Earnings

(RAPM

- Cost of Equity)

x Economic Capital

Two Equivalent Definitions of Economic Profit (EP):

VaR Return

Growth

Economic Profit = Economic Profit

Risk

Economic Profit is the key element of this program, integrates profitability and risk and supports historical and forward-looking analysis

• Economic Profit sets the performance bar higher by forcing managers to meet not only operating expenses but also all expenses associated with invested capital

– A major issue in financial services in defining the capital base

– General approach is to apply our capital-at-risk model (consistent with RAPM) to determine the capital which is ultimately employed and thus the amount by which managers are ultimately held accountable

Quality Earnings

28

EP by Measurement Center

Return-On-Capital - Cost of Capital

(R-C Spread)

% Investment

Strategic Assessment by Segment(Business Unit, Product, Region)

SegmentAttractiveness

Attractive

Disadvantaged Advantaged

Competitive Position

Consider Growth/EntryOptions

Consider Exit Options

BA

C

DE

Drives Capital

Investment to Add Value

Decides How to Invest and

Manage Earnings

Financial Value Driver Benchmark

Value Driver Measurement and Benchmarking Can Provide Additional Focus for Strategic Direction

Peer Peer Peer Peer Peer PeerBank A Bank B Bank C Bank D Bank E Bank F

Fiscal Year End Dec-97 Sep-97 Mar-98 Dec-97 Dec-97 Dec-97

Revenue 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%Net Interest Margin 90.0% 39.9% 95.1% 48.3% 97.2% 98.2%Non-Interest Income 9.1% 60.1% 4.9% 51.7% 2.8% 1.8%

Operating Expenses 5.1% 13.0% 1.5% 21.3% 21.3% 7.7%Loan Loss Provision 0.0% 9.0% 0.6% 2.5% 0.2% 0.2%Other Expense 1.6% 11.1% 0.8% 15.8% 1.6% -0.4%Cash Operating Taxes 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%Operating Margin 2.4% 26.9% 2.0% 12.1% -12.1% -5.7%

Market VaR Capital 0.4% 0.7% -0.7% 0.9% 0.7% -0.7%Credit VaR Capital 0.4% 8.4% 1.0% 28.6% 1.8%Operating VaR Capital 0.8% 9.0% 0.3% 29.5% 1.1% 1.1%

RAPM 1.6% 17.9% 1.7% -17.4% -6.8% -6.8%

EP -9.8% 6.1% -10.0% -5.4% -19.8% -19.8%

Economic Profit $MMs 19.20 20.70 8.00 (24.00) (16.40)

29Risk-adjusted Capital or Economic Capital

Cost of

Equity

_

EquityProfit

=

Income

Economic Capital

Return on Economic

Capital=

Economic Capital

=

Value Contribution to

Shareholder

G/L

Support systems

Allocation systems

G/L

Risksystems

Support systems

Allocated Revenue

Allocated cost data

Creditrisk

Operationalrisk

Market risk

Insurancerisk

30

Translation Processor(Middleware)

Translation & Mapping

Transaction Capture

Summarization & Posting

Source Data

External Feeds

Operational Systems• Front office• Middle office• Back office

Business Support Systems

• HR• Benefits

Non-Automatic Inputs

Information Presentation

Information Processing and

Storage

Traditional ERP Financial &

Management Accounting

Discrete Reporting

Integrated Reporting

Blended Reporting

Ad hoc Reporting

Technology Blueprint

Operational Data Store

Analytical Engines

31

Source Data Information Presentation

Information Processing and Storage

Translation Processor(Middleware)

External Feeds

Operational Systems

Business Support Systems

Non-Automatic Inputs

Translation & Mapping

Transaction Capture

Traditional IT Process Financial & Management Accounting

Operational Data Store

Calculation Engines

Summarization & Posting

• Fixed income• Foreign

exchange

• Market data• Credit ratings

• Payroll • Benefits

• Manual entries

Summarized financial postings

• Detailed financial postings

• Business events

• Reference data

Drill down to

detail

Transaction detailAnalytical

results

AlgorithmicsRisk Watch

Discrete Reporting

Integrated Reporting

Blended Reporting

Ad hoc Reporting

Flexibility• Leverage existing

investments• Support plug-in

best of breed applications

• accelerated organizational changes due to shorter, less costly implementations

• Facilitates integration of new systems (M&A)

Scalability• Accommodate

growth in the organization

• support high volumes of transactions and level of detail

• enhance timeliness of delivery due to capacity

Web

bas

ed r

epo

rt v

iew

er

To integrate and deliver all the information in an efficient manner, the technology architecture has to be flexible and scalable

32IPM Solution Set

Pro

cess

Ree

ngin

eeri

ng Project M

anagement

Technical Infrastructure

SVM

EconomicCapital

OperatingProfit

Risk Profit & Loss

OperationalData Store

GeneralLedger

AnalyticalEngines Data

Warehousing

Middleware

Op.Risk

Cr.Risk


EP

RAPM

33

Effective OperationsReliable Reporting

Reconciliation Control

InternalControls

Testing Risk Management Process

periodicaly

Evaluation of the Independence and

Effectiveness of RiskManagement Functions

“Building” the Under-standing in the Bank

for Adequate Oversight

Integrity and Accuracyof Records and Reports

Based on the objective of the Sound Internal Controls to provide strategic as well as operational decision support, this will be a major (joint) bank-wide effort.

Why Internal

Controls?

External

Auditing

Building

Safe

systems

Building Sound Internal Controls

1 integrated risk management and performance measurement banks at cross-roads

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