Value Orientated Risk and Capital Management

Dr. Oliver KaufmannFI Risk & Portfolio Management

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1. Capital vs Risks

2. Regulatory Background

Contents / Agenda

3. Risk Adjusted Portfolio Management

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Equity Capital(= Assets - Liabilities)

Liabilities(Debt Capital)

Assets

Banks balance sheet

• 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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Credit Risk

Unexpected losses due to default of borrowers, counterparties, emittents

e.g.subprime crisis

Operational Risk

ngs Bank,

Unexpected losses due to failures of Systems, processes, human or technical errors, external events and legal processes

e.g. BariSocGen

Market Risk

arket movements of Unexpected losses due to mrisk factors like interest rates, stock and currency prices

e.g.new economy crash

Liquidity Risk

to repay liabilities

costs

to sell assets

Unexpected losses due to:a) unability

b) higher refinancing

c) lacking market depth

Risks of banking business

Risks unavoidable

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

No Risk no Business !

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Capital adequacy

Risks

Risk WeightedAssets (RWA)

covered byadequate equity

capital to survive‚realised‘ risks?

Capital Ratio: Equity/RWA > 8%

Tier 1• Common stakeholders

Equity and minority interests• Retained earnings• Preference shares• Innovative capital

Tier 2• equity reserves / cumulative• preference shares• Subordinated debt

Tier 3• Equity reserves / cumulative• preference shares• Subordinated debt

Equity Capital

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

Credit Risk• Derivatives• Off balance

sheet• Risk weighted

balance sheetassets

Credit Risk

Market /Liquidity Risk

Operational Risk

Tier 1

Tier 2

Tier 3

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

Scenario 1:

Credit Risk: The new Audi S4...

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PD

The Audi S4...

Insurance premium:

10% * 50.000,-€ * 100% = 5.000,-€

EAD LGD EL

Total insurance premium for 10 insured Audis:

10 * 5.000,-€ = 50.000,-€

Loss CompensationTotal premium

PD = Probability of Default EAD = Exposure at defaultLGD = Loss given DefaultEL = Expected Loss

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The Audi S4...

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

Scenario 2:

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PD

The Audi S4...

Insurance premium:

10% * 50.000,-€ * 90% = 4.500,-€

EAD LGD EL

Total insurance premium for 10 insured Audis:

10 * 4.500,-€ = 45.000,-€

LossReplacement

(less 5.000,-€ retention)Total premium

PD = Probability of Default EAD = Exposure at defaultLGD = Loss given DefaultEL = Expected Loss

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Economic capital covers the Unexpected Loss, the Expected Loss is covered by the risk margin

Years / Scenarios

Portfolio loss distribution

Expected Loss(average loss)

Unexpected Loss(loss volatility)

95 % of all cases (19 out of 20)

Economic Capital

Loss

Economic Capital = Expected Loss – Unexpected Loss; level of confidence: 99.9% - 99.98%.

Credit Risk: Expected and Unexpected Losses

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Result

Risk Costs~ Margin

Rating A Rating B

12%

30%

Rating ~ Risk

Expected Loss: Exposure * PD * LGD Expected Costs Risk Provisions

Unexpectecd Loss: Exposure * PD * LGD * „Portfolio effects“

Provide capital to cushion unexpected losses

Capital Costs

(required minimium interest return on capital)

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

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„Basel II“

International„Gentlemen‘s Agreement“

„CRD“

EuropeanCapital

RequirementsDirective

„SolvV“

German regulation

rules

European implementation

National implementation (in vigor since beginning of 2008)

Regulatory View: „BASEL committee“

BIZ

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Regulatory goals

Basel II Goals

• Aligning regulatory capital requirements more closely to the underlying risks

• Incentives to improve internal risk managementmore forward looking

• Risk adequate pricingif higher/lower risk than higher/lower margins

Basel I

is/was not adequate formodern risk situation.

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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

*Organisation for Economic Co-operation and Development

NO credit rating (PD)

NO portfolio effects (diversification/concentration)

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Basel II: Advanced Internal Rating Based Approach (AIRB)

Simple rule:

Capital / Risk Weighted Assets > 8%

Capital = RWA * 8%

~ Exposure * K (PD, LGD, Maturity)

Probability of Default

Still no portfolio effects (diversification/concentration)

but

Loss given Default

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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 !

Internal determination of default riskGeneral approach:

Internal Determination of banks probability of default (PD) and loss given default (LGD):

Capital Adequacy

Asset Structure and Quality

Earnings performance

Liquidity structure of balance sheet

Sensitivity to market risk

Management quality

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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

Pillar 1: Calculation of regulatory capital for• Credit risk (AIRB-Ansatz)• Operational risk (AMA Ansatz)• Market risk (internal GS I model)

Pillar 2: Supervisory review process (SRP)4 principles:• supervisory review process• regulatory advices• regulatory transparency• specific topics within the SRP

Pillar 3: Market disciplineQualitative&quantitative disclosure of:• scope of application• capital structure• adequacy of capital resources• taken risks

Minimum requirementsfor Risk Management(MaRisk = national implementation)

SREP2ICAAP1

1 Internal Capital Adequacy Assessment Process2 Supervisory Review and Evaluation Process

Based on internal parameter estimation

Basel II framework

Regulatory Capital

EconomicCapital

Last year AIRB-Ansatz and AMA-Ansatz sucessfully approved by german regulator

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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

Operational Risk means the risk of loss resulting from inadequateor failed internal processes, people and systems or from externalevents, 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 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

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

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OpRisk Controlling Framework: AMA

Operational Risk Management

Bonus-Malus-Value System

Quantitative Model – Operational Risk Engine: Capital / Risk Calculation

Internal LossData

External LossData

Quality SelfAssessment

Key RiskIndicators

Risk and Control Inventory

Operational Risk Strategy & Regulatory Requirements

Senior Management & Regulatory Reporting

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Credit Risk Operational Risk Market andLiquidity Risk Business Risk

Losses Losses

Market volatility

Losses

Defaults Operational events

Losses

Earningsvolatility

Capital needed to cushion bank against unexpected losses

Economic Capital

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

Economic Capital

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Risk strategy

Pillar 2: Minimum requirements on risk management

Overall responsibility of Board of Directors

Definition of risk taking capability concept

Implementation of reliable risk management system for all risk types

Integration of risk management system in overall bank steering

Implementation of reliable risk reporting and documentation system

and some more …

1.

2.

3.

4.

5.

6.

...

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Risk Committee of supervisory board

Riskstrategy

Independent Control: Internal Revision

RisktypesCredit Risk Market Risk Liquidity Risk

Operational Risk (Legal Risk) Business Risk

Board of managing directors

Common understanding of risk strategyand organisation / processes

Overall responsibility of Board of Directors1.

Risk-quantification

Risk-identi-fication

Risk-minimi-sation

Risk-transparency

Market Side

OperativeCredit RiskFunction

CRO

Riskcommittee

Creditcommittee

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Sufficient Capitalisation according to Target Rating

Risk coveringCapital

EconomicCapital

Definition of risk taking capability concept2.

Tier 1

Reserves

Target Profits

Operational Risk

Market Risk

Credit Risk

Business Risk

Comparison of equity and overall risk profil

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Risk strategy3.• Implementation of risk strategy• Close relation to business strategy• Inclusion of qualitative risk types

Market Risk

Operational Risk

Business Risk

Concentration

Branches

Countries

Segements

Products

Limits forExpected Lossand RiskConcentration

Credit Risk

Σ Market Risk

Σ Operational Risk

Σ Business Risk

Σ Credit Risk

Buffer

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Group

Business Lines

Client/product

Integration into bank management4.

Risk taking capability analyses:

Ecap = Σ Risks < disponible Equity

Ensures survival of bank

Risk-adjusted performance analyses :

RoRaC = Profit / Ecap

Capital allocation

Pricing and Product design

Ensures profitability of bank

Challenge: Management Attention Inclusion into renumeration concept !

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Economic Capital

Comparison RoRaC and RoE

RoRaC=Profit / ECap

RoE=Profit / RegCap

122006

122007

ROE (Avg) (%)

RORAC (%)

Economic Capital Credit

RiskMarket

RiskOp

RiskBusiness

Risk

35 5

ECAP ECAP (Avg)

140 1350100

Reg Capital

(Avg)RO

RACROE(Avg)

ZFI 280 25% 15% 70

Profit

062007

Management Reporting FI Portfolio

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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

Sales Steering Concept

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

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Minimum Margin ~ 1,5 %

Value orientated credit pricing concept

Risk

Price(Gross Margin)

Basel I

Price of Risk

Refinancing costs

Admin / operating costs

Expectes Loss + Capital Costs

Basel II:

AIRB / Economic Capital

Expected Loss = 1,5% * 50%

Unexpected Loss = 16% * (1,8%+0,9%)

Admin costs: 0,3 %

Example:

Minimum requiredReturn on Capital:

Unexpected OpRisk:Unexpected Credit Risk:

PDLGD

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RegCap

ECap

Real Time Tool at Point of Sales

Financial Institutions Value Contribution Margin CalculationThe trade N/A was calculated by Oliver Kaufmann on 16.04.2008 17:03:46.

Client DetailsClient Name/Client NumberClient Rating 3.4Client Masterscale PD 1.500 %VBKDNR New ClientGroup NameGroup City/Country DEGroup LAD 0.0 T€Group EL 0.0 T€

Current Transaction DetailsSign (1=New Credit; -1=Creditsale) 1Product Type 001_Cash credit/Overdraft facilityStart Date 05-2008Lifetime (years) 1.0Currency EURExternal Limit 0.0 T€Drawing 1,000.0 T€Collateral 0.0 T€Guarantee J/N N

IncomesGross 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 TransactionRevenues 13.0 T€- Expected Loss (EL) 4.0 T€- Direct Costs 3.3 T€= Gross Return 5.7 T€- eCap Costs 5.1 T€= Value Contribution Margin 0.6 T€

Transaction IndicatorsRoRaC 17.9 %eCap 32.0 T€Basel II Capital 40.7 T€Risk Concentration 41.9 bp

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PortfolioAnalyses

ScenarioAnalysese.g.Impact of Hedging,True sales,Syndication,New business

Portfolio- and Scenario Analyses (in all risk dimensions)

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-- Country-- Sales Unit-- Segment

2006 2007 Δ in %Revenues 0,0 T € 0,0 T € + 0,0%

- Expected Loss (EL) 0,0 T € 0,0 T € + 0,0%- eCap Costs 0,0 T € 0,0 T € + 0,0%

- Direct Costs 0,0 T € 0,0 T € + 0,0%VCM 0,0 T € 0,0 T € + 0,0%

Country -- Segment -- 24% 61% 6% 3% 6%Region -- ZFI --

2006 2007PQI 0,00 0,00

RoRaC 0,0% 0,0%Ø-PD -- --

CB-Rating -- --Ø CVaR in T€ 0,0 0,0

Comments 38% 50% 8% 3% 2%

0,00 0,00 0,00 0,00 0,000,0 0,0 0,0 0,0 --

/ partnership meets expertise /

Ø CVaR in T€

Group

Revenue share

VCM share

PQI

--

Ranking VCM 2007

Key Performance Indicators

Client Profile--4--

GBKdNrSWIFT CodeVBKdNr

Revenues 2007 - Breakdown by Product Category (in T€)

0,0

20.000,0

40.000,0

60.000,0

80.000,0

100.000,0

-10.000,0

0,0

10.000,0

20.000,0

30.000,0

40.000,0

50.000,0

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

TotalVCM

CashServices

TradeServices

BankingProducts

MarketProducts

Others

TotalRevenues

CashServices

TradeServices

BankingProducts

MarketProducts

Others

Ex-Post Client Profile

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Pillar 3: Market Discipline

Market

Market Discipline:

Indirect pressureto improve Risk

Management and capital adequacy

Bank

Capital Structure,Taken Risks, Adequacy of Capital Resources, Scope of Application

Disclosure

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

Implementation minor technical effort compared to Pillar 1 and 2

Pillar 3 : Issues

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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• Risk policies• Capital ratios• Capital structure• Credit Exposure per products, segments,

regions, rating class• Maturities• Impaired Loans by Portfolio• Development of Loan Provisions

Pillar 3 : Disclosure examples (32 altogether)

• Risk Mitigation• Description and Validation of PD, LGD

estimations• Securitizations• Validation of VaR-Market risk models• Interest rate risk for Banking Book• P&L for equities

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Economic Capital(‚true‘ risk profile)

Economic View:Risk adjusted capital steering

Regulatory Capital(simplified risk profile)

Regulatory View: Stability/SolvencySide condition for capital steering

Equity Capital

View of Investors: Optimisation of RoE

Overall Picture

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Capital Market Informations

Information• Credit Risk• Liqui Risk• Recoverybuthigh volatility

Bond Spreads

Should beequal but theyare not quiteoften

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Capital Market Informations

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Capital Market Informations

Contact Dr. Oliver KaufmannTel.: ++49 (0)69 / 136 22244E-Mail: oliver.kaufmann@commerzbank.com

Thank you for your attention!