3 - Basel II and Economic Capital-pdf

GFSRM Managers Academy
Basel II and Economic Capital

Jörg Behrens
©2004 Ernst & Young LLP. All rights reserved.

This material is proprietary, confidential, and for internal use only.
Unauthorized distribution or reproduction of this program or its contents violates firm policy and copyright laws.
“House Rules”
Allowed is:
• To interrupt the speaker
• To ask “stupid questions” (that do not exist anyway)
• Almost everything else…
“House Rules”
Allowed is:
• To interrupt the speaker
• To ask dumb questions (that do not exist
anyway)
• Almost everything else…
But please do not:

• Make phone calls
• Fall asleep (I am tired, too…)
Content
• What is Economic Capital?
• What is Regulatory Capital?
• Why is it highly relevant?
• What is our service offering?

What is Economic Capital?

• Economic Capital is a buffer against large
portfolio losses.

portfolio losses.
• It is based on a loss distribution.
Loss distribution
Number
Number of
of losses
losses
Loss
Loss amount
amount
Loss distribution
Number
Number of
of losses
losses
Loss
Loss amount
amount
Loss distribution
Number
Number of
of losses
losses
Loss
Loss amount
amount
Loss distribution
Number
Number of
of losses
losses
Loss
Loss amount
amount
Loss distribution
Number
Number of
of losses
losses
Loss
Loss amount
amount
50% 97%
Loss distribution
Number
Number of
of losses
losses
Loss
Loss amount
amount
Loss distribution
Number
Number of
of losses
losses
Loss
Loss amount
amount
EL UL Quantile
Loss distribution
Number
Number of
of losses
losses
Loss
Loss amount
amount
EL UL ES
Loss distribution
Future Portfolio Loss Histogram
0.60%
99th percentile loss

0.50% Expected loss
0.40%
Frequency
0.30%
0.20%
0.10%
0.00%
0 200 400 600 800 1000 1200 1400
Potential portfolio losses (M GBP)


portfolio losses.
• Economic Capital helps to make different risks
comparable.
Comparing things
+ = ??
Comparing things
+ = ??
Value of + value of = ?? !!
Comparing things
+ = ??
Value of + value of = 1 GBP
Market Risk + Credit Risk = ???

Comparing things
+ = ??
Value of + value of = 1 GBP
Market Risk + Credit Risk = ???

(We
(We will
will come
come back
back to
to that
that later...)
later...)

portfolio losses.
• Economic Capital helps to make different risks
comparable.
• Therefore it is the basis for performance
measurement.

Talking about performance measurement:
Who’s jumping higher, a frog or a horse?

What is Regulatory Capital?

• A rule to estimate Economic Capital.
What is Regulatory Capital?

• A rule to estimate Economic Capital.
Well, almost…
Basel II goals
• Risk based regulatory capital ⇒reduce capital arbitrage
• Incentives for good risk management
• Different levels of sophistication
• Recognition of hedges
Basel II goals
• Risk based regulatory capital ⇒ reduce capital arbitrage
• Level playing field
• Regulatory model close to best industry practice
Basel II goals
• …
• After all: Less systemic risk
Basel II goals & delivery

• …
• After all: Less systemic risk
Basel II building blocks

Basel II
Pillar 1 Pillar 2 Pillar 3

Minimum Capital Qualitative Review Market Discipline
Operational
Market Risk Credit Risk
Risk
Standard IRBA IRBA Basic Standard

AMA
Approach “foundation” “advanced” Indicators Approach
BII Credit Capital Formula

Capital = 8%
8% x Credit
Creditrisk
risk
“Base Portfolio
Portfolio
“Baseline”
line” +
adjustment
adjustment
Claim
Claim - Guarantees
Guarantees
Risk
RiskWeight
Weight x Exposure
Exposure
PD LGD BRW
BRW
PD LGD
Basel II vs. Economic Capital

So what is regulatory Capital =
8%
8%
x Credit risk
Credit risk
+ Portfolio
capital? “Base line”
“Base line”
- Guarantees
Portfolio
adjustment
adjustment
Claim
Claim Guarantees
Risk Weight x Exposure
Risk Weight Exposure
PD LGD BRW
PD LGD BRW
Future Portfolio Loss Histogram Basically a mechanism to

compute capital charges on
0.60%
0.50% Expected loss 99th percentile loss

Frequency
0.40%
0.30%
a generalized single
0.20%
0.10%
exposure basis.
0.00%
0 200 400 600 800 1000 1200 1400
Potential portfolio losses (M GBP)
Solvency II
• Solvency II = “Basel II for insurers”
• EU initiative with implementation plan for 2007
• Implementation in UK by FSA PSB requirements 2005
• Implementation in CH by BPV requirements till end of 2005
(Field Test 2004)
• Focus on 3 pillars as for Basel II
• Critical role of fair value valuation

Why is ECAP highly relevant?

• Any ideas?

• Capital is a scarce resource

• Economic Capital is at the heart of many
regulatory initiatives: Basel II, Solvency II,
PSB…

• Economic Capital is at the heart of many
regulatory initiatives: Basel II, Solvency II,
PSB…
• Capital allows to compare different risks and as
such is a fundament of risk management.
(But you know that by now…)

Our Services
• Integrate pieces into a Central Capital Model
IntegratedGroup-wide
Capital Model
capital model
FREQ
CaR
Expected Shortfall
LOSS
Expected loss Unexpected Loss Ruin?
0.03
LossDistribution
Dependency Model 0.03
Lo ss D istribution
0.03
Lo ss D istribution
0. 01 8
0.025 99%quantileq = 42.79 0.025 99% quantile q = 42.79 0.025 99% quantile q = 42.79
α α α
0. 01 6
0. 01 4 0.02
0.02 0.02
0. 01 2
0.015 0.015 0 .0 1 0.015
0. 00 8
0.01 0.01 0. 00 6
0.01
0. 00 4
0.005 0.005 0.005

0. 00 2
0
-1 0 -8 -6 -4 -2 0 2 4 6 8 10 0
0 0 0 10 20 30 40 50 60
0 10 20 30 40 50 60 0 10 20 30 40 50 60
OR risk
Insurance risk Market risk Credit risk
loss distribution
loss distribution loss distribution loss distribution
Dependency Model
Internal
Data losses
Loss Distribution
0.03
Loss Distribution
LDA Engine Loss

aggregation
0.03
0.025 0.025 99% quantile=q42.79

99% quantile=q42.79 α
α
Basel 2 DB
0.02 0.02
0.015 0.015
0.01 0.01
0.005
risk
0.005
External
0 0
0 10 20 30 40 50 60 0 10 20 30 40 50 60
Loss Distribution
0.03
events /
0.025 99% quantile=q42.79
α
losses
0.02
0.015
0.01
busines Key Risk

0.005
0
0 10 20 30 40 50 60
Loss Distribution
0.03
Loss Distribution
0.03
s lines Indicators
0.025 99% quantile=q42.79
α
0.025 99% quantile=q42.79
α
0.02
0.02
Scorecard Model
0.015
0.015
0.01
0.01
0.005
0.005
0
0 10 20 30 40 50 60
0
0 10 20 30 40 50 60
Our Services
• Design an Economic Capital Model for internal
capital assessment and stress/scenario testing
Economic Capital & Stress Model

Distributions Operational Retail Corporate Insurance Market
Loss
dependencies
dependencies
-
-
Our Services
• Design an Economic Capital Model for internal
capital assessment and stress/scenario testing
• Strategic Risk Tool for Board or Audit
Committee level
Strategic Risk Management

Ideal
Ideal Set-Up:
Set-Up: Board
Risk
Risk appetite
appetite defined
defined at
at
Board
Board level.
level.
Risk
Risk limits
limits allocated
allocated top-
top- Bus Line 1 Bus Line 2 Bus Line 3
down.
down. Limit 1 Limit 2 Limit 3
OL 3 OL 3 OL 3
OL 2 OL 2 OL 2
OL 1 OL 1 OL 1
R e tu rn s
0.04
BL I
0.03 B L II
Prob.
0.02
0.01
0
-1 -0 . 8 -0 . 6 -0 . 4 -0 . 2 0 0.2 0.4 0 .6 0.8 1
R e t u rn p e r y e a r
R e q u ir e d c a p ita l p e r B L
0.01
BL I
0 .0 0 8 B L II
0 .0 0 6
Prob.
0 .0 0 4
9 9 % q u a n tile q = 2 .8 3
α
0 .0 0 2
9 9 % q u a n tile q = 3 .3 6
α
0
0 0.5 1 1 .5 2 2.5 3 3.5 4 4.5 5
L o s s e s (1 y e a r)

Ideal
Ideal Set-Up:
Set-Up: Board
Risk
Risk appetite
appetite defined
defined at
at
Board
Board level.
level.
Risk
Risk limits
limits allocated
allocated top-
down.
Typical
Typical Set-Up:
Set-Up: OL 3 OL 3 OL 3
OL 2 OL 2 OL 2
OL 1 OL 1 OL 1
Risk
Risk limits
limits defined
defined at
at
Business
Business level.
level.
Overall
Overall risk
risk limit
limit agreed
agreed
as
as the
the aggregated
aggregated 0.04
R e tu rn s
BL I
business
business risk
risk limits.
B L II
limits.
0.03
Prob.
0.02
0.01
0
-1 -0 . 8 -0 . 6 -0 . 4 -0 . 2 0 0.2 0.4 0 .6 0.8 1
0.01
BL I
0 .0 0 8 B L II
0 .0 0 6
Prob.
0 .0 0 4
9 9 % q u a n tile q = 2 .8 3
α
0 .0 0 2
9 9 % q u a n tile q = 3 .3 6
α
0
0 0.5 1 1 .5 2 2.5 3 3.5 4 4.5 5

Ideal
Ideal Set-Up:
Set-Up: Board
Risk
Risk appetite
appetite defined
defined at
at
Board
Board level.
level.
Risk
Risk limits
limits allocated
allocated top-
down.
Typical
Typical Set-Up:
Set-Up: OL 3 OL 3 OL 3
OL 2 OL 2 OL 2
OL 1 OL 1 OL 1
Risk
Risk limits
limits defined
defined at
at
Business
Business level.
level.
Overall
Overall risk
risk limit
limit agreed
agreed EY
EY Solution:
Solution:
as
as the
the aggregated
aggregated 0.04
R e tu rn s
BL I Strategic
Strategic Economic
Economic or or
business
business risk
risk limits.
B L II
limits.
0.03
actuarial
actuarial Capital
Capital Model
Model
Prob.
0.02
0.01
to
to link
link risk
risk limits
limits to
to global
0
global
-1 -0 . 8 -0 . 6 -0 . 4 -0 . 2 0 0.2 0.4 0 .6 0.8 1
0.01
BL I
0 .0 0 8 B L II
risk
risk appetite
appetite and
and toto study
study
0 .0 0 6
Prob.
0 .0 0 4
9 9 % q u a n tile q = 2 .8 3
α
0 .0 0 2
9 9 % q u a n tile q = 3 .3 6
α
impact
impact of of stress
stress events.
events.
0
0 0.5 1 1 .5 2 2.5 3 3.5 4 4.5 5
Any questions?
Break Out Session: Case Studies

• Economic Capital client meeting:
– Table 1: Investment Bank
– Table 2: Asset Manager
– Table 3: Retail Bank
– Table 4: (Re-)Insurance Firm
• What is our proposition to sell ECAP?
• Whom would we want to present our services to?
• How can one leverage Basel II investments?
Summary
• A buffer for unexpected losses and also a risk measure
suitable for measuring and reporting risk at various
levels.
Why is it highly relevant?
• It makes risk comparable (“apples to apples…”) and is
the fundament for performance measurement.
What is our service offering?
• We review and improve existing frameworks, extend
regulatory capital systems (e.g. Basel II) or develop
strategic risk management capabilities.

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GFSRM Managers Academy

Basel II and Economic Capital

©2004 Ernst & Young LLP. All rights reserved.

But please do not:

• What is Economic Capital?

What is Economic Capital?

What is Economic Capital?

99th percentile loss

Potential portfolio losses (M GBP)

What is Economic Capital?

Value of + value of = 1 GBP

Market Risk + Credit Risk = ???

Value of + value of = 1 GBP

Market Risk + Credit Risk = ???

What is Economic Capital?

What is Economic Capital?

• What is Economic Capital?

What is Regulatory Capital?

What is Regulatory Capital?

Basel II goals & delivery

Basel II building blocks

Pillar 1 Pillar 2 Pillar 3

Standard IRBA IRBA Basic Standard

BII Credit Capital Formula

Basel II vs. Economic Capital

Future Portfolio Loss Histogram Basically a mechanism to

0.50% Expected loss 99th percentile loss

• What is Economic Capital?

Why is ECAP highly relevant?

Why is ECAP highly relevant?

Why is ECAP highly relevant?

Why is ECAP highly relevant?

• What is Economic Capital?

0.015 0.015 0 .0 1 0.015

0.005 0.005 0.005

LDA Engine Loss

0.025 0.025 99% quantile=q42.79

busines Key Risk

Economic Capital & Stress Model

Strategic Risk Management

Strategic Risk Management

Strategic Risk Management

Break Out Session: Case Studies

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