Risk-Focused Supervision. How is Risk Defined?

1. Risk-Focused Supervision.How is Risk Defined? Financial Stability Institute and the Committee of Banking supervisors of West and Central Africa 8-12 April 2002 Jean-Philippe Svoronos Basel Committee on Banking Supervision

2. Overview • Risks in Banking: proportions • Risks in Banking: definitions. • Risk Factors: The Example of Credit Risk • Risk management: Credit Risk

3. 1. Risks in Banking • A bank that doesnot take risk isnot a bank • Banks survive by accepting risks and prosper by managing them adequately • Risk taking is banks‘ crucial economic role and the reason for their existence • But “adequate” management of risks has, over time, become more difficult and complex

4. 1. Risks in Banking: proportions • Banking risks • Credit Risk • Default risk • Country Risk • Settlement risk • Market Risks • Liquidity Risk • Interest Rate Risk • Operational risk • Reputational Risk

5. 1. Why is Credit Risk So Important? • Credit risk continues to be the primary source of problems at banks • Implying that most banks that have “gone under” were hit by credit risk • The effective management of credit risk is essential to the long-term success of any bank

6. 2. Risks in banking: what is Credit Risk? • Credit risk is most simply defined as the potential that a bank’s borrower or counterparty will fail to meet its obligations in accordance with agreed terms. • Credit risk exists throughout the activities of a bank • Loans are the largest and most obvious source • Credit risk exists in both the banking and trading book • Credit risk exists on and off balance sheet

7. 2. Risks in Banking: What is Market Risk? • Risk of losses in on-balance sheet and off-balance-sheet positions arising from movements in market prices. • Examples • Interest rate risk • Foreign exchange risk • Equity position risk • Commodity position risk

8. Credit risk and market risk comparedReturn distributions • Market risk is significantly different in nature from credit risk • Credit returns are skewed, with a long fat tail • Market returns are normally distributed (bell-shaped) • Market risks • Often highly correlated • Can be reduced through hedges • Can only be slightly reduced through diversification • Credit risk • Less correlated • Can be reduced though diversification • Hedges (i.e. credit derivatives) still in state of development

9. Typical Distribution of Credit Returns Gains Losses

10. Typical Distribution of market returns Losses Gains

11. 2. Risks in Banking: What is Liquidity Risk? • The ability for a bank to fund increases in assets and meet obligations/payments as they come due. • Sound liquidity management: one of the most important activities conducted by a bank • The importance of liquidity transcends the individual bank: a liquidity shortfall at a single institution can have system-wide repercussions.

12. 2. Risks: Overall Interest Rate Risk? • The interest rate risk of a bank resulting from its global position. • Such a position is the result of aggregating all the individual positions that a bank takes when entering into transactions, whether on balance-sheet (assets and liabilities) or off-balance sheet. • Its management is sometimes associated with managing liquidity, although the risks are not the same.

13. 2. Risks in Banking: Operational risk • An area of risk on which both banks and supervisors are increasingly focusing because of its relative importance. • No single definition available. • Definition of New Basel Accord is partial: „risk of loss resulting from inadequate or failed internal processes, people and systems or from external events.“ • The definition does include legal risk but however does not include systemic risk, strategic/business risk and reputational risk.

14. 3. Risk factors: Measurement of Credit Risk • The basic measurement is empirical: a loan is supposedly priced according to how much risk it involves. • The measurement of such risk implies assessing the borrower’s creditworthiness. • Three main components enter into the measurement of credit risk: size of exposure, default probability of borrower and loss probability once the borrower has defaulted. • When generalized to the whole bank, the institution relate its economic capital for credit risk to its portfolio‘s probability density function of credit losses

15. Probability Density Function of Credit Losses Economic capital Frequency of loss Stress loss  Expected loss Unexpected loss 0 Amount of loss • Large number of small losses • Few occasions with severe losses

16. 3. Probability Density Function (PDF) • Expected credit loss • Amount of credit loss a bank expects to experience on its credit portfolio over the chosen time horizon • Ideally, provisions should cover expected losses • Unexpected credit losses • Amount by which actual losses exceed expected loss • (Economic) capital should cover unexpected losses • A risky portfolio is one whose PDF has a relatively long and fat tail

17. 3. Definition of Loss • Credit loss arises only if a borrower defaults • Inputs • Default rates Obligor‘s internal credit risk rating • Default horizon Typically 1 year • Exposure Exposure at default • Recovery rate 1-recovery rate = Loss-given default • Correlations Correlation between credit losses

18. 3. But what is a Default? • Different definitions possible: • Firm is unlikely to pay its debt obligations • Credit loss event associated with any other obligation of the firm • Firm is past due more than 90 days (or more?) • Firm has filed for bankruptcy or similar protection

19. 3. Probability of Default - Measurement • Within most internal rating systems, key criterion is internal credit risk rating • Bank establishes set of grades with specific probability of default • Banks assign risk rating to each customer by using • Financial and other characteristics of customer • Vendor-supplied commercial credit scoring model • Internally developed credit scoring model • Often banks relate internal rating to external rating standards • Bank places customer into predefined risk rating category

20. 3. Slotting of Loans into PD Grades Loan A Loan B Loan C Loan D PD 0.02 PD 0.15 PD 0.68 PD 15

21. 3. Time horizon for monitoring credit risk • One-year horizon reflects the typical interval over which e.g. • New capital could be raised • Loss mitigation action could be taken • Internal budgeting, capital planning and accounting statements are prepared

22. 3. Correlations between Credit Events • Not all obligors will default at once • But financial conditions of firms in the same industry or within the same country may reflect similar factors • Assessing such correlations is still quite limited • The importance of such a risk has been traditionally recognized in banking: it is closely related to risk concentration and diversification of exposures • It has become more difficult to assess because of globalization/inter-actions: concentrations can be to one borrower or related borrowers, one sector or related sectors, one country or geographical area.

23. 4. Credit Risk management: Guidance provided by the Basel Committee • Core Principles for Effective Banking Supervision (1997) • Core Principles Methodology Paper (1999) • Principles for the Management of Credit Risk (2000)

24. 4. Credit Risk Management • Banks need to manage the credit risk inherent in the entire portfolio as well as the risk in individual credits or transactions • Banks should also consider the relationship between credit risk and other risks • Sound credit risk management practices should be applied in conjunction with sound practices related to the assessment of asset quality, the adequacy of provisions and reserves, and the disclosure of credit risk

25. 4. Credit Risk Management Process • Establishing an appropriate credit risk environment • Operating under a sound credit granting process • Maintaining an appropriate credit administration and monitoring process • Ensuring adequate controls over credit risk • Role of Supervisors in the process.