Workshop on Risk Management in Commercial Banks

1. Workshop 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 society’s 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

3. Banking Sector Agenda In East Asia Source: East Asia Finance, The Road to Robust Markets, World Bank, 2006

4. Why Risk Management? Banking Instability

5. Framework for Banking Stability

6. Why 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

7. Why Risk Management? • Increase in bankruptcy in most economies as markets become more competitive --- globalization and domestic liberalization • “Winner’s 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.

8. Why Risk Management: Economic Rationale

9. Why 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

10. Why 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.

11. Traditional 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

12. New 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)

13. Measuring 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)

14. INTEGRATED 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.

15. 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 Risk Management System

16. Risk 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 • Basel’s Capital Rules • Assessing Basel capital • Basel II implementation process in banks

17. Basics Tasks in Credit Risk Management Professional Risk Manager’s 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?

18. Basic Tasks in Credit Risk Management (Cont’d) • 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?

19. RISK METHODS AND ANALYTICS FUNCTIONS Source: Evan Picoult, Citigroup October, 2006

20. Definition 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 year’s time • Typically, banks aim to have a high (e.g., 99.9%) probability of remaining solvent

21. Economic 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

22. Thinking 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

23. Use 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

24. Risk Adjusted Return on Capital

25. Stress 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

27. Basel 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

28. Basel II Scope of Application • Insurance entities • Generally, deduct bank’s 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

29. Basel 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

30. Basel 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)

31. Basel 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

32. Summary 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 bank’s 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.

33. Credit 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 CRA’s 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.

34. Role 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?

35. Perspectives 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

36. Perspectives on Supervision and Regulation • Safety Net Arrangements • Liquidity Assistance • Insolvent institutions • Crisis Resolution • Market Integrity • Institutional Structure of FinancialRegulation • Fragmented or Integrated

37. Why 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

38. Risk 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

39. Why 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

40. Cross- 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

41. Thank You