Title: Workshop on Risk Management in Commercial Banks
1Workshop on Risk Management in Commercial Banks
- Organizing For Risk Control
June 18-20, 2008 Asia-Pacific Finance and
Development Center World Bank Institute
2 Risk Control and Banking Stability
- Banking systems
- Mobilize savings (economies of scale)
- Allocate and monitor the use of societys savings
- Facilitate risk amelioration and trading
- Well-Functioning Banking systems
- Improve capital allocation and economic growth.
- Reduce income inequality
- Lower poverty Inequality
- Consequences of Banking Failures
- Economic growth suffers --- output declines,
entrepreneurship gets thwarted. - Fiscal burden diverts resources from essential
public goods and public investments
3Banking Sector Agenda In East Asia
Source East Asia Finance, The Road to Robust
Markets, World Bank, 2006
4Why Risk Management? Banking Instability
5Framework for Banking Stability
6Why Risk Management?
- Banks often have
- Liquidity problems
- Large open currency positions of private banks
- Significant holdings of government debt
- Low asset quality
- Risk assessment and management systems weak
- Lack of good corporate governance
- Major macroeconomic instability
- High public sector deficit
- Systemic distortions created by weak banks
- Weak financial disclosure rules and oversight
arrangements
7Why Risk Management?
- Increase in bankruptcy in most economies as
markets become more competitive --- globalization
and domestic liberalization - Winners Curse. More creditworthy firms have
direct access to debt markets. Banks make more
loans to borrowers without access to credit
markets average loan quality has deteriorated. - Volatile Values of Collateral
- More competitive financial markets ---Interest
margins have declined - The growth of derivatives all have credit
exposures - Thus worsening of the risk-return tradeoff
- BIS Risk-Based Capital Requirements Links
capital charges to external credit ratings or
internal model of credit risk.
8Why Risk Management Economic Rationale
9Why Risk Management?
- Macro-financial Rationale
- Procyclicality of bank lending is a widespread
phenomenon and not confined to specific episodes - Shocks to capital result in a reduction of bank
loan supply (both in and outside crises and
independent of structure) - The effect of initial capital is stronger in
crisis times - Loan losses have the potential to exacerbate
macroeconomic fluctuations, that is, financial
instability may have real effects (even outside
of crises and absent bank defaults). - Financial and monetary stability are not
disjoint. - Monetary policy can have powerful effects in
exacerbating or alleviating financial
instability. Banks balance sheet characteristics
affect their lending activity banks with higher
provisions tend to extend less credit than their
stronger competitors - The impact of provisions on bank loan supply is
stronger for banks that are poorly capitalized. - Bank capital matters more in times of low
economic growth - Source Bank weakness and bank loan supply ,
Erlend Nier and Lea Zicchino, 2004, Bank of
England
10Why Risk Management? Corporate Rationale
- Risks arising from provision of financial
services such as - Market risk
- Credit risk
- Operational risk
- Cross border risk
- To set performance incentives that are not
perverse and better align growth and stability - Measure economic capital
- Allocate resources more efficiently
- Apply risk based pricing
- Customer selection and product development
- Active management of portfolio risk
- Establish an integrated risk management system to
ensure consistent risk measurements / policies
for each type of risk, across all businesses.
11Traditional Approaches to CreditRisk Management
- Character reputation, repayment history
- Capital equity contribution, leverage.
- Profitability earnings volatility.
- Collateral Seniority, market value volatility
of market value of collateral. - Economic cycle and market conditions.
- Problems of consistency and subjectivity
12New Approaches to Risk Management
- Role of Credit Risk Models
- Support tactical credit risk management
- Support decision making at the strategic level
- Understand better lending implications
- Credit Risk Modeling Framework
- Definition of default
- Aggregation of credit risk
- Recovery
- Exposure
- Types of Models (Econometric, Equity Based,
Actuarial)
13Measuring Risks
- All measurements of risk incorporate not only
quantitative but also qualitative elements. - Even with good data and tools, uncertainty exists
- Estimation error always exists, often difficult
to quantify - Need to combine with qualitative tools and
judgment - Use of sensitivity analysis, stress testing, and
scenario analysis - For analyzing potential effects not captured by
static quantitative tools - To inform use of baseline measure
- When data are scarce or tools are lacking,
baseline measure should use more sensitivity
analysis and qualitative factors - Should cover the major risk types (credit,
market, operational)
14INTEGRATED RISK MANAGEMENT
- THREE RELATED ASPECTS
- Integrated risk management as having consistent
policies and methods of measurement of risk
through-out the firm. - Integrated risk management as the integration of
risk measurements, particularly economic capital,
as a component, into all aspects of business
decisions. - Integrated risk management as the process of
centralizing certain key risk architecture
functions, to ensure consistency in measurement
and reporting of risk.
15Risk Management System
- Risk Management Functions
- Approve and monitor risk limits.
- Approve limit exceptions.
- Approve new forms of transactions
- Function as eyes and ears of senior management
with regard to risk taking of business.
- Risk Architecture Functions
- Build and maintain risk infrastructure of firm
- Develop methods to measure and analyze risks,
including economic capital. - Develop risk policies.
- Develop comprehensive risk reports.
- Develop IT based risk systems
16Risk Management
- Risk Models for Individual Assets
- Regression model and using simulation model
- Portfolio Risk Models for Economic Capital
- The Conceptual Framework Economic Capital
- Types of Portfolio models
- Assessing economic capital
- Basel II Capital
- Basels Capital Rules
- Assessing Basel capital
- Basel II implementation process in banks
17Basics Tasks in Credit Risk Management
- Professional Risk Managers International
Association - Review strategic credit positions
- Any changes to largest exposures (net of
collateral)? - How about changes to counterparty ratings?
- Any significant credits to be approved by chief
credit officer or board? - Credit limits and provisions
- Any limit excesses?
- Limits to be reviewed?
- Provisions still up to date?
- All concentrations within limits?
- Credit exposure
- All exposures covered and correctly mapped?
- Any Wrong way position?
18Basic Tasks in Credit Risk Management (Contd)
- Credit reporting
- All significant risks covered in credit report?
- Report distributed to all relevant parties?
- Any significant credits that must be discussed at
top management/board level? - Stress and scenario analysis
- Any surprises from stress and scenario analysis
at portfolio or global level? - Anything not covered by current set of scenarios?
- Provisions
- Any past or anticipated changes in general loss
provisions? - Any changes to specific provisions?
- Documentation
- Full documentation in place for all transactions?
- Break clauses and rating triggers fully
recognized? - Credit protection
- Credit protection utilized and understood?
- Any further possibility to exploit credit
protection?
19RISK METHODS AND ANALYTICS FUNCTIONS
Source Evan Picoult, Citigroup October, 2006
20Definition of Economic Capital
- Capital is held to ensure that a bank is likely
to remain solvent, even if it suffers unusually
large losses - Available economic capital
- The amount by which the value of all assets
currently exceeds the value of all liabilities - Required economic capital
- The amount by which the value of all assets
should exceed the value of all liabilities to
ensure that there is a very high probability that
the assets will still exceed the liabilities in
one years time - Typically, banks aim to have a high (e.g., 99.9)
probability of remaining solvent
21Economic Capital
- EC is the amount of capital to be held to protect
against low probability losses - The building blocks of EC
- PD, LGD, EAD, correlation, (M)
- The key parameters describing the Credit Loss PDF
- EL and UL
- Capital as percentile of PDF
- Basel Capital is a stylized version of EC
- A single correlation is assumed
- A single systematic risk factor
- Infinite granularity, no large loans or
concentrations - No uncertainty in LGD
22Thinking about Economic Capital
- Given the random amount of losses we suffer each
year, how much could we lose if we are unlucky? - Capital as an unexpected loss percentile
- Capital percentile of PDF
- How much could we expect to lose in a recession?
- Capital as expected loss conditional on severe"
draw of systematic risk factor - Uncertainty in LGD and EAD assumed to be
idiosyncratic, so - Conditional EAD and conditional LGD are equal to
their expected values, respectively - Capital conditional default probability x LGD x
EAD
23Use of Economic Capital RAROC
- Capital decisions
- General provisions, reserves, capital allocation
- Portfolio allocation decisions
- Identification of opportunities and problems
- Pricing and profitability decisions
- RAROC Risk-Adjusted Return On Capital
- Boosting high RAROC business lines
- Loan pricing
- Margin EL H x Capital OpRisk OpCost
24Risk Adjusted Return on Capital
25Stress Testing
- What is Stress Test? Techniques used by financial
firms to gauge their vulnerability to
exceptional, but plausible, events. - How do you identify a plausible, stressful
scenario? - Use a historical scenario
- Develop a hypothetical scenario
- What is likely to be stressed?
- The earnings, reserves, and capital adequacy of
the individual banks - Stress test should cover loans and other parts of
the balance sheet as well as the income statement
26 Principles vs. Rules based Standards for
Governance
- Rules-based detailed, rigid with little
discretion, but intention can be circumvented - Principles-based broad principles with little
structure to guide, flexible and responsive to
changes, as judgment is guided by
spirit/intention - Objectives-based principles where objectives
are clearly defined, sufficient detail and
structure is given so that standard can be
operationalized and applied on consistent basis - Economies can adopt standards to reorganize
bureaucracy for transparent and effective
delivery of services, with accountability. These
operational standards ensure that processes
minimizes self-serving behaviour, turf fights and
silo mindsets, and promote collaboration and
unity of purpose in delivery of public services - Hence, institutional reform involves not only
performance and conformance, but also
transformance into a socially accountable growth
27Basel II
Much more complex and risk sensitive First Pillar
Minimum capital Second Pillar Supervisory
review Third Pillar Market discipline Treats
exposures very unequally depending on exposure
characteristics Treats banks very unequally
depending on sophistication of risk management
systems
Will profoundly alter bank behavior
28Basel II Scope of Application
Insurance entities Generally, deduct banks
equity and other capital investments in insurance
subsidiaries However, some G10 countries will
retain current risk weighting treatment (100 for
standardized banks) for competitiveness reasons
Supervisors may permit recognition by bank of
excess capital invested in insurance subsidiary
over required amount Commercial entities
generally deducted significant investments in
commercial entities above materiality thresholds
Significant investments in commercial entities
below materiality thresholds risk weighted 100
Applied on consolidated basis to internationally
active banks All banking and other financial
activities (whether or not regulated) captured
through consolidation Financial activities do
not include insurance Majority-owned
subsidiaries not consolidated deduct equity and
capital investments Significant minority
investments without control deduct equity and
capital investments Deduction of investments 50
from tier 1 and 50 from tier 2 capital
29Basel II Three Pillars
Minimum Capital Charges Minimum capital
requirements based on market, credit and
operational risk to (a) reduce risk of failure by
cushioning against losses and (b) provide
continuing access to financial markets to meet
liquidity needs, and (c) provide incentives for
prudent risk management.
First Pillar
Supervisory Review Qualitative supervision by
regulators of internal bank risk control and
capital assessment process, including supervisory
power to require banks to hold more capital than
required under the First Pillar
Second Pillar
Third Pillar
Market Discipline New public disclosure
requirements to compel improved bank risk
management
30Basel II Capital Components
- Credit risk charges
- Revised
- To ensure capital charges are more sensitive to
risks of exposures in banking book - Enhancements to counterparty risk charges also
applicable to trading book exposures - Operational risk charges
- New
- To require capital for operating risks (fraud,
legal, documentation, etc.) - Market risk charges
- Initially unchanged, but Basel/IOSCO review has
proposed changes to specific risk calculations
and Second Pillar stress testing - To require capital for exposures in trading book
- Rules in Market Risk Amendment (1996)
31Basel II Types of Banks
- Measure credit risk pursuant to fixed risk
weights based on external credit assessments
(ratings) - Least sophisticated capital calculations
generally highest capital burdens
Standardized
- Measure credit risk using sophisticated formulas
using internally determined inputs of probability
of default (PD) and inputs fixed by regulators of
loss given default (LGD), exposure at default
(EAD) and maturity (M). - More risk sensitive capital requirements
Foundation IRB
- Measure credit risk using sophisticated formulas
and internally determined inputs of PD, LGD, EAD - Most risk-sensitive (although not always lowest)
capital requirements - Transition to Advanced IRB status only with
robust internal risk management systems and data
Advanced IRB
32Summary of Main Changes in the BCP
- More emphasis placed on governance, transparency
and accountability of supervisory agencies, and
reaffirming supervisory independence and adequacy
of resources and legal protections. - Bank governance given more attention to ensure
that there is effective control over a banks
entire business. More details are provided on
board and senior management responsibilities, set
clear strategies and accountabilities. - Strengthened guidance on risk management
practices. While some areas were already covered
in the former BCP, these have now been brought
under standalone CPs including (i) an
integrated approach to risk management, (ii)
liquidity risk (iii) operational risk and (iv)
interest rate risk in the banking book. - The importance of greater disclosure to enable
market discipline to supplement official
supervision is reinforced. New criteria have been
added specifying that the supervisor require
disclosure and not just promote it, as
formulated earlier. - The know-your-customer (KYC) principle expanded
to better capture issues pertaining to the abuse
of financial services firms by criminal elements
as reflected in the revised FATF standards as far
as relevant for bank supervisors.
33Credit Rating Agencies
- Role of Credit Rating Agencies (CRAs) is vital
- CRAs assess the credit risk of banks
- CRAs attempt to make sense of the vast amount of
information available regarding a bank, its
market and its economic circumstances - They give investors, lenders to banks, and to
regulators a better understanding of banking
system and banking institution risks. - A credit rating, typically, is a CRAs opinion of
how likely a bank will mange its financial
obligation and operations in a timely and
efficient manner. - Under Basel II they have a special role.
34Role of Credit Rating Agencies
- What Credit Rating Agencies Do for Banks?
- What is the Rating Process?
- What are the Rating Methodologies?
- How transparent is the ratings process public
dissemination of ratings and market timing? - How do they manage Conflicts of Interest?
35Perspectives on Supervision and Regulation
- Objectives of regulation and supervision
- Systemic Stability
- Safety and Soundness
- Consumer Protection
- Consumer Confidence
- Universal functions
- Prudential regulation
- Prudential supervision
- Systemic Stability
- Conduct of Business Regulation and Supervision
36Perspectives on Supervision and Regulation
- Safety Net Arrangements
- Liquidity Assistance
- Insolvent institutions
- Crisis Resolution
- Market Integrity
- Institutional Structure of Financial Regulation
- Fragmented or Integrated
37Why Cross-Border Supervision?
- Waves of large intra-nation bank mergers over the
past decade have created banks of unprecedented
size - Japan credit quality problems have resulted in
consolidation partially the result of government
policy - US Drive to have truly national banks ---merger
wave among larger regional banks - Europe Intra- market mergers created national
champions often with government encouragement
38Risk Based Approach In Regulatory Institutions
Issues and Actions
- Involvement of Senior Staff
- Improve communication with banks
- Clearer Guidances
- Clearer explanation of assessments
- Training and Guidance for Supervisors
- Use of IT
39Why Cross-Border Supervision?Implications of
Banking Industry Globalization
- Global banks may be key players in markets that
are not key to the bank - National borders provide tax/regulatory arbitrage
opportunities but provide little other benefit to
the bank - Reputation/political risk may be as important as
potential financial impact of adverse outcomes in
the host country
40Cross- Border Banking Supervision
- Basel II attempts to better promote international
harmonization of regulatory environment. Goals
include - Improve soundness and stability of the
international banking system - Insure capital is not a source of competitive
inequality - Encourage stronger risk management
- Home-Host Coordination
- Better Knowledge of Subsidiary Activities
- Home-Host Supervisory Challenges
- Better Knowledge of Subsidiary Activities
- Home-Host Supervisory Challenges Objectives,
Implementation and Expectations, Incentives
Capabilities
41Thank You