s1 Risk EC Overview

8/4/2019 s1 Risk EC Overview

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Introduction to Risk Managementand Economic Capital

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Germn Creamer

Risk Management Mission

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Drive Profitable Growth

Without Surprises

While Providing an OutstandingCustomer Experience


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Types of Risk

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CreditRisk

There are three types of risk a typical financial services

business faces.

MarketRisk

OperationalRisk

Net exposurethat the owner ofa financial asset

has to anadverse change

in its marketvalue or saleable

price.

The risk of not achieving

business objectives dueto failed process, people,or information systems,

or from the externalenvironment.Risk that

debtor willdefault onpayment

obligation.

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Financial Risks

Market Risk: changes in the prices of financial assets and liabilities.

Credit Risk: risk of default of an obligor.

Operational Risk: potential losses due to inadequate systems, management failure

fraud

technology risk


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Capital allocation & risk

Essence of any business: manage risk and trade-off with profits.

Types of capital:

Economic capital (EC): estimate of the level of capital that a firm requiresto operate itsbusiness with a desired target solvency level.

Reflect fair market value differential between assets and liabilities

Institution specific: based on internal models

Regulatory capital (RC): capital that a bank is required to hold byregulators to cover potential losses.

Proxy for economic capital.

Book capital (BC): actual physical capital held: equity capital + other assetslikeliquid debt or hybrid instruments (accounting concept)

Banks capital is normally larger than the regulatory capital.

Corporate credit rating: measure of capital adequacy.

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Primary role of capital in a bank:

Assure that total risk taken is less than ability to absorb worst case losses.

Protect depositors and other claim holders;

Provide enough confidence to external investors and rating agencies onthe financial health and viability of the firm (going concern)

During 1970s, financial deregulation & search for larger profits led todecrease banks economic capital increased level of risk

Basel (Basel Committee on Banking Supervision) I: 1993: establish capitalrequirements for financial institutions

Basel II: 1998 new standards.

Align regulatory capital requirements more closely to the underlying risks

that banks face.Promote a more forward-looking approach to capital supervision:

encourages banks to identify the risks they may face, today and in thefuture, and to develop or improve their ability to manage those risks.

More flexible and adjusted to advances in markets and risk managementpractices.


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Capital as a Management Tool

Risk aggregation: Economic Capital as a an aggregator of different types ofrisks in different business units and/or products.

Performance measurement: use risk to adjust returns:

Risk adjusted performance measurement (RAPM): consistent metric that spansall asset and risk classes.

Asset and business allocation: RAPM as a capital allocation tool

Risk Management Evolution

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Control

Enterprise-WideRisk Management

Profit Optimization

Lets trace the evolution of Credit Risk Management:


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Key Points

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Two analytical considerations that yield effective risk management are

given below:

Profit Based Decisioningrather than cost per loanor credit loss focusedcontrol Fact Based

Prediction usingCustomer spendingor corporatefinancial statementsand paymentbehavior, andexternalinformation.

Profit Drivers Revenues & Expenses of Credit Risk Decisions

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The overall profitability of eachdecision must also take intoaccount the potential costs,including:

Interest Revenue

Discount Revenue

Other Revenue

Loan Fees

Operating Expense

Interest Expense

Credit and Fraud

Advertising


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Equity Capital

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150139Assets

Equity

Liabilities

Assuming that a company finances its business model with Debt and Equity:

$ Billion

Shareholders own the company solong as Assets are greater thanLiabilities and Equity is greater than 0

If Equity turns negative (e.g., due tolarge losses), then Liabilities willexceed Assets and bankruptcy will bevery likely

In other words, Equity protects againstrisk of bankruptcy due to adversepretax income (PTI) volatility

Corporate credit rating and cost ofdebt depend on how good thisprotection is

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Volatility and Shareholders' Capital

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Time

Illustrative P&L of a company

0

1) Fundamental reason a company

needs Shareholders' Capital is toprotect it against bankruptcy incase of large losses

3) The higher the expectedpretax income (PTI), the lesscapital is needed

2) The higher the volatility of lossesand revenues, the higher the

volatility of PTI and the morecapital is required


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Default loss distribution

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Capital requirement iscalculated at certain

confidence level

(Econ. Capital)

VaR - The ConceptVaR technique is based on statistical distributions, standard deviation, and

confidence intervals.

VaR is also known as 'Risk Dollars Concept'.

VaR answers the question - "How much a firm can lose with X% probability overa given horizon."

Suppose a portfolio manager has a daily VaR equal to $1 million at 1%. Thismeans that there is only one chance in 100 that a daily loss bigger than $1million occurs under normal market conditions.

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Graphical Representation of VaR

A portfolio whose one-month 95% VaR is $10 million, would be expected to loseless than $10 million during 95 months out of 100, based on its currentcomposition and recent market behavior. In other words, the portfolio isexpected to lose at least $10 million in 5 months out of 100.

The portfolio's one-month 95% VaR is found by locating that point on the x-axissuch that 95% of the probability falls to the right of the point. This representsthe upper bound on a 95% confidence interval for the amount that the portfoliomight lose.

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Capital Requirement and Confidence Level

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95% 99% 99.9% 99.97%Confidence level

Odds of bankruptcy 1:20 1:100 1:1,000 1:3,300

100%

None

Credit rating B+ BB+ A+ AA US Government

Higher Credit Rating

= Better Protection= Higher Confidence Level

More

Capital

"Once in a thousand years" = Over 10 years one A-rated out of 100 goes bankrupt(Bear Stearns, Enron)


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Risk Based Capital

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Expected Catastrophic

80Expenses

100Revenues

Pre-Tax Income 100 10 80 = 10

Write-offs 10

70

60

60 30 70 = -40

10+20 = 30

Ending capital Starting Capital +10 Starting Capital - 40

Starting capital needed to avoid bankruptcy = 40

However, if Starting Capital =40 then in Pessimistic scenario the endingcapital will be 40-5=35 - not enough for the next year!

Hence to ensure the company remain going concern, Starting Capitalneeds to be 40+5 = 45

Pessimistic

75

90

90 20 75 = -5

10+10 = 20

Starting Capital - 5

Scenarios for the next year's performanceIllustrative

Definition of Economic Capital

Economic Capital is the amount of capital required to ensure that the probabilityof bankruptcy remains below the target level with the desired confidence level

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Target level for probabilityof bankruptcy depends ofeach company (i.e. 0.1%)

For a company with acredit rating of A+,

desired level to avoiddowngrade is 97.5%

This assures this company retains its target credit rating of A+


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Different Types Of Capital

Regulatory capital required by regulators tobe allowed to stay in business

Rating agency capital - required by ratingagencies (e.g., S&P, Moodys) to qualify for atarget credit rating

Economic capital required to withstand worstcase scenarios (as defined by confidence level)specific to the business model

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Required Capital Available Capital

Equity market capitalization not well suitedas protection against large losses (it is likely tofall exactly when the losses strike); explicitlyexcluded by regulators

Book equity capital amount of capital likelyto be available in times of hardship (dependson accounting standards, such as GAAP,Statutory)

Capital to protect against losses

Available capital mustexceed required capital!

How much do we need? How much do we have?

s1 Risk EC Overview

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