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Risk Management Review521
Risk Management Review521
Risk Management Review521
Today is a kick-off
Provide general overview of risk and risk management Establish a baseline of risk knowledge, common terminology and understanding of BIS requirements Provide overview of different credit rating/risk measurement approaches Hear from you
Rational investors
Risk averse Maximize return/Minimize risk
Efficient markets
Allocation of resources Information impounded in prices Competition
The higher the risk, the higher the required rate of return
Required rate of return determines the price
Current income stream Capital appreciation
B A
Risk/Standard Deviation
Market Risk
Interest rate and equity risk in trading book; FX and commodity risks in banking and trading books
Operational risk
Market capital
Economic capital
Regulatory capital
Operational Risk Basic Indicator Approach Standardized Approach Internal Measurement Approach
Pillar 2: Supervisory Review Review assessment process Evaluate IRR in banking book Pillar 3: Market Discipline
Formal disclosure policy Describe risk profile, capital levels, risk management process and capital adequacy
Market Discipline
Public Disclosure
Capital is not a substitute for inadequate control or for risk management processes.
- Bank for International Settlements
Banks make money by assuming risk Banks lose money by not managing risk or by not getting paid for the risk assumed Banks manage what they measure
The primary objective is to minimize the volatility of earnings and capital (hence the risk as perceived by investors) and at the same time earn a ROE to maintain the value of the common equity.
Growth in poor quality loans Growth in poor quality loans Adverse selection Adverse selection Thin/insufficient margins Thin/insufficient margins
Booking of low grade assets Booking of low grade assets only if compensated with only if compensated with higher margins higher margins Focus on risk/reward ratios Focus on risk/reward ratios
Historical Analysis
ALM
Treasury Management
Execute Drives strategy and credit risk management Source: Booz-Allen & Hamilton
Organization
Independence Audit Education Performance Evaluation
Profit RAROC =
Provisions
Economic Capital
The cushion needed to support Unexpected Losses
Credit analysis
Allocated capital
Efficient Frontier
Risk
The potential that a bank borrower or counterparty will fail to meet its obligations in accordance with agreed terms
Principles for the Management of Credit Risk - BIS 1999
Must also include all threats to value, in a probability / net present value sense; e.g. deterioration in quality throughout the life of the loan is a credit risk in itself
The primary objective is to minimize the volatility of earnings and capital (hence the risk as perceived by investors) and at the same time earn a ROE to maintain the value of the common equity.
Final ratings are ultimately judgmental, but graders are provided with a template of quantitative benchmarks for each rating category
Graders are provided a scoresheet which combines a set of objective characteristics with subjective factors in a predetermined manner
Grades are derived purely mechanically, with no role for subjective inputs
x 0.999
-4 to +8.0
Equity to Debt
x 0.6
-4 to +8.0
x 1.2
-4 to +8.0
x1.4
-4 to +8.0
Portfolio risks
Default correlations Exposure
Credit risk management means diversifying and transferring risk
Industry sector
Competitive position
Mgmt. / organization
Data Required Industry profile -- 3 years Size, growth Concentrations Cyclicality/seasonality Explanation of trends Industry outlook Profiles of key competitors (top two) Regulatory profile -- current, recent changes, expected changes Borrowers strategy Key alliances: With government With private sector With other influential players Company financials -- 3 years Profit & loss statements, balance sheets Supplementary statements -reconciliation of net worth, fixed assets\ Audited where possible Creditor facilities Banks amounts and condition Suppliers of facilities
Data Sources Internal Files Research department Other managers familiar with industry Third parties Ministries Multilateral agencies -- World Bank, IADB, etc. Other government organizations Trade associations Other banks Other companies in industries External -- customer calls Business press Internal Files Other managers familiar with borrower Issuer In person calls Site visits
Industry
Financial Condition
s example
SAMPLE DATA COLLECTION
Ratios
May be different by segment (size, state -owned /private, industry, available information)
If the borrower defaults, how much are we likely to lose? Amount [JOD or %]
IRB uses banks own rating systems with required features Provisions should equal expected loss where EL = PD * LGD * EAD Capital must be held for UL
-4
-3
-2
-1
Standard Deviation
X = 2% Y = 4%
X = 4% Y = 5%
MOODYS EQUIVALENT
Aaa Aa3/A1 As/A3 Baa2 Ba1/Ba2 Ba3/B1 B2/B3 B3/Caa Caa/Ca
How we can we classify individuals into broad risk bands to manage our actuarial risk?
10 9 8 7 10 9 8 10 9 10
Not surprisingly, such models can drive the whole credit process
100 80 100 60 40 20 0 80 100 60 40 20 1 0 80 100 60 40 2 20 1 0 80 100 60 80 3 4 100 6 7 8 9 10 5 40 60 80 100 2 3 4 5 6 7 8 9 10 20 40 60 80 1 2 3 4 5 6 7 8 9 10 0 20 40 60 1 2 3 4 5 6 7 8 9 0 20 40 1 20 3 4 5 6 7 8 2 0 1 0 2 1 3 2 4 3 5 4 6 5 7 6
10 9 8 7 10 9 8 10 9 10
10 9 8 7 10 9 8 10 9 10
How much we expect to lose (probability) on a credit or group of credits May be expressed as a per cent or an absolute number Often abbreviated as EL also known as ROL (risk of loss)
Probability of default
Exposure at default
Exposure at default
EaD % 100
In per cent
Expected .03 or 3% loss Probability .06 of default
Rating So if the credit is JOD PD % 7,000, EL for that 1 credit0.01 is 2 JOD 210 (3% x 7,000) 0.03 3 4 5 6 7 8 9 10 0.05 0.25 0.70 1.50 6.00 20.0 50.0 100.0
or in numbers
3% JOD 210 .06
.50
Rating 1 2 3 4 5 6 7 8 9 10
PD % 0.01 0.03 0.05 0.25 0.70 1.50 6.00 20.0 50.0 100.0
LGD % 0 10 25 50 75 100
EaD % 100
100 90 80 70 60 50 40
100 90 80 70 60 50 40 30 20 10 0 1 2 3 4 5 6 7 8 9 10
70 60 50 40 30 20 10 0 1 2 3 4 5 6 7 8 9 10
30 20 10 0 1 2 3 4 5 6
10
90 80 70 60 50 40 30 20 10 0 1 2 3 4 5 6 7 8 9
Probability
Losses
100 90 80 70 60 50 40
100 90 80 70 60 50 40 30 20 10 0 1 2 3 4 5 6
70 60 50 40 30 20 10 0 1 2 3 4 5 6 7 8 9 10
100 90 80 70 60 50 40 30 20 10 0 1 2 3 4 5
30 20 10 0 1 2 3 90
80 70 60 50 7 40 30 20 10 0 1 2 3
8 9 10
100 90 80 70 60 6 50 40 30 20 10 0 1
100 80
10
?
8 9
10
10
60 40 20 0 1 2 3 4 5 6 7 8 9
Anticipated average loss Anticipated average loss rate rate Foreseeable cost Foreseeable cost Charged through Charged through income statement income statement
Anticipated volatility of Anticipated volatility of loss rate loss rate True risk True risk Captured through Captured through assignment of capital assignment of capital
Probability of Loss
Amount of Loss
Uncovered Risk
Probability of Default
Based on historical risk rating data
Exposure at Default
Expected Loss
Internal Control
Management control of day-today activities including: Policies and procedures Segregation of duties Authorities and approval limits Checking procedures Supervision of transactions and recording Budget controls
Communications is key!
An
effective internal control system requires effective channels of communication to ensure that all staff fully understand and adhere to policies and procedures affecting their duties and responsibilities and that other relevant information is reaching the appropriate personnel.
Bank for International Settlements, Framework for Internal Control Systems in Banking Organizations
Next steps
Individual interviews Diagnostic reviews Standardized risk rating system Individual Workshop ? Sarah (Sally) Hargrove swhargrove@nc.rr.com swhargrove@yahoo.com Tel: 550 3069 Ext. 149