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ICAAP is a supervisory process mandated under Pillar 2…
..in Taiwan, FSC has designed the guideline for banks to comply with..
Indicators
Principle
Risk Appetite
Principle 1 行 略
High
•
略 行 度 度
行 利 利 略
•
Principle 2 行 度 略
行 略 立 •
Risk Based Pricing
行 聯 量
•
Limit Setting
行 易
•
Principle 4 行 了
易
易
Level
易
•
行 易 易 立
Principle 5 行 行
•
行 易
不 行
•
行 行
Portfolio Concentration Risk Management
行 行
• …..
行 立 理
Principle 12
行 不 降
•
Stress Testing
行 來
Principle 13
力
Low 不利
度 行 行
暴 度 力
列 2008 Prepared by Eric
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… here I’d like to share some of my ideas regarding the important components in
ICAAP. As I am more focus on credit risk discipline, I ‘d use credit risk as illustration.
Risk identification &
1. Type of risk a bank is facing
measurement
• Business risk
• Economics risk
• Liquidity risk
Risk Capital
• Interest rate risk
Estimation
• Reputation risk
Risk governance
• Market risk
& organization
• Operational risk
Stress testing
• Country risk
• Concentration risk
• ….
Risk appetite 2. Here, I am referring to the measurement of credit risk
• PD
• LGD
• EAD
Risk management &
control • Correlation among industries , countries, products or
obligors
Reporting &
monitoring
Capital management
2008 Prepared by Eric
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Basel committee generates a general form of unexpected loss formula for banks to
calculate the capital. –”a simplified version of EC”.
Risk identification &
1. Rudimentary capital estimation approach
measurement
• Basel II Standard approach
• FIRB approach
Subtract EL
• AIRB approach
Risk Capital based
Correlation
Estimation provision
Risk governance
⎡ ⎤
⎡ ⎤
& organization
0. 5
⎛R⎞
⎢ LGD × N ⎢(1 − R ) × G (PD ) + ⎜ ⎟ × G (0.999 )⎥ − PD × LGD ⎥
− 0.5
⎝1− R ⎠
Stress testing ⎢ ⎥
⎢ ⎥
K= ⎣ ⎦
⎢ ⎥
⎣ ⎦
× (1 − 1 .5 × b ) × [1 + (M − 2 .5 ) × b ]
−1
Risk appetite
Tenor adjustment
Risk management &
RWA = K * 12.50 * EAD
control
Reporting &
Capital = RWA * BIS Ratio
monitoring
Capital management
2008 Prepared by Eric
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EC can be leveraged to prove internal capital adequacy, risk appetite, portfolio stress
testing, capital allocation and limit management… EC has become a core of modern
banking management.
Risk identification &
2. Sophistication approach refers to the economic capital estimation
measurement
Loss Distribution
10%
Risk Capital
9% Target Rating =A
Estimation
Cumulative
8%
Risk governance
Frequency 4.4% of probability
& organization
possibility result
of Loss =99.9%
7%
Stress testing in a ‘800’
potential loss
6%
within 1 year
5%
Risk appetite
4%
0.1% of possibility
3% the loss will exceed
2,000
Risk management &
2%
control
1%
0%
Reporting &
0
100
200
300
400
500
600
700
800
900
1000
1100
1200
1300
1400
2000
2200
monitoring
$ of Loss Amount
500
Capital management EL Unexpected Loss = 2,000-500 =1,500
= Economic Capital
2008 Prepared by Eric
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Stress testing is a process to identify and quantify potential low frequency with high
impact stress scenarios for testing bank capital adequacy.
Risk identification &
1. Identification of potential risk sensitivities and vulnerabilities
measurement
based on the comprehensive assessment of the bank’s risk
exposures:
• – By risk types
Risk Capital
• – By activities
Estimation
2. Development, selection and prioritization of relevant stress
Risk governance
scenarios for testing and reporting based on identified risk
& organization
sensitivities, vulnerabilities and cross-risk/activity linkages.
Stress testing
3. Quantifying the likelihood and severity of each scenario, and
hence total risk. Classification and alignment of risks with
business strategy. Benchmarking potential losses against capital
Risk appetite adequacy.
4. Sophisticated macro-economy regression or econometric models
are less intuitive and difficult to implement, due to
• Data availability
Risk management &
control • Model complexity
• Difficult to explain internal and externally
• ..however it is a ‘goal’ to achieve.
Reporting &
monitoring
Capital management
2008 Prepared by Eric
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The Development Process of Stress Testing involves external data collection.
Interest Rate on New Loans of
Macroeconomi Five Leading Banks
House Price
c
Index Lag3
Index
Consumer
Stock Price Unemployment
Confidence
Index HPI
Rate
Index
Lag3
Lag1
House House
Demand Index Supply Index
• Third Stage
• First Stage • Second Stage
To execute stepwise regression
Take the mortgage’s NPL% as
To collect relative
analysis,find primary macroeconomic
observation variable to derive the
macroeconomic data for variables Interest Rate on New
correlation between NPL% and
mortgage,quarterly data Loans of Five Leading Banks —lag3
macroeconomic’s change rate(the
Unemployment Rate—lag1
same/lag1/lag2…etc)
and monthly data.
CTCB HPI—lag3 .
2008 Prepared by Eric
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Expected result is to predict the potential credit loss.
Business Environment - changes in unemployment rate(Lag1)
Consumer Burden --- changes in Interest rate on new loans of Five Leading
changes in NPL
Banks(Lag3)
Housing Prosperity --- changes in CTCB HPI(Lag3)
Mortgage actual NPL%
Mortgage Actual NPL% v.s Predict NPL%
Predict NPL%
6%
4%
2%
0%
2008 Prepared by Eric
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Frequent requested methods are event driven – what if the past events happen again.
Asian
Recent low
Financial Dual card crisis
SARS
of the stock
Crisis
market
Recent
China bottom of the
Missile Test housing
331
market
earthquake
921
earthquake
10% 16
14.57%
14
8%
12
10
6%
3.86% 8
4% 6
2.42%
4
2%
2
1.72%
0% 0
1
3
1
3
1
3
1
3
1
3
1
3
1
3
1
3
1
3
1
3
1
3
1
3
Q
Q
Q
Q
Q
Q
Q
Q
Q
Q
Q
Q
Q
Q
Q
Q
Q
Q
Q
Q
Q
Q
Q
Q
95
95
96
96
97
97
98
98
99
99
00
00
01
01
02
02
03
03
04
04
05
05
06
06
2008 Prepared by Eric
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Portfolio stress testing refers to the change of risk parameters and utilize the
economic capital model to estimate the stressed economic capital.
Simulation Approach - Illustrative
CRE loss distribution output
Risk Parameters Loss simulation model
% of scenarios
PD
50%
In individual scenarios, for
bps
each entity 45% Tail of the
20
distribution
Determine if defaults 40%
15
LGD If defaults, calculate loss as 35%
10
LGD * Exposure 30%
5
Sum across entities to 25%
0
determine portfolio loss 1.1 1.3 1.5 1.7 1.9 2.1 2.3 2.5
20%
CRE losses $ BN
15%
Correlations Repeat scenario 20,000x
10%
PD – PD, PD - 5%
Bank losses $MM
LGD
0%
EAD 0 400 800 1200 1600 2000 2400
Build loss distribution
2008 Prepared by Eric
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The amount of EC held by a bank reflects the risk appetite of a bank. Identification of
risk appetite is a considered as risk governance of a bank.
Risk identification &
1. Bank hold economic capital to protect against unexpected loss.
measurement
EC links to bank‘s
Probability of target rating
Risk Capital loss
‘AA’ rating
Estimation
‘A’ rating :Confidence of
Loss Distribution :Confidence of =99.97%
Risk governance
& organization
=99.9%
Stress testing
Better rating
requires increased
capital holding and
Risk appetite demonostrates the
appetite of a bank
Credit
Risk management &
Losses
control
0 Loss Tail Risk
Expect Unexpected loss
Reporting &
ed loss = Economic Capital
monitoring
Regulator Capital is also used to
cover unexpected loss.The Basel
Comittee uses a general form of
Capital management
formula to proxy the UL
2008 Prepared by Eric
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Risk appetite makes explicit how much risk the institution is willing to take.
Winterthur
Illustrative
The bank’s current available
Link to its target rating
capital is sufficient to cover 99.97%
99.7% is equal to ‘AA’ ‘s potential unexpected loss.
The possibility of loss amount exceeds
the current available capital is 0.03%
Sources: Credit Suisse analyst day presentation 2006 2008 Prepared by Eric
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Identify the ‘RISK APPETITE ‘ means to ask ‘what is the maximum amount of loss
that senior management team can endure’.
Risk appetite metrics
Metric Illustrative Definition Management options
We target a Moody’s rating of ‘A’ on Granular measurement of
Target debt
1 our senior debt, at all times staying ECAP
rating
above ‘A-‘ Top down decision
Defines ECAP requirements
Do not miss consensus earnings Quantitative stress testing of
Earnings
forecast by more than 10% at a 99% business plans
2 volatility
confidence level
We will aim to consistently target
dividend of 2 dollars
We do not wish to see a loss more Bottom up risk measurement
Maximum
3
than 50 Billion at the 99%
loss
confidence interval
2008 Prepared by Eric
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Stress testing is wildly used by best practices and serves as an important factor to
decide risk appetite and also bank should demonstrate the financial health under
stress scenarios.
2008 Prepared by Eric
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Credit risk appetite is about to managing the risk/return trade off... A important
decision of C-Level managers.
Source: ANZ report
2008 Prepared by Eric
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Key management tools includes Limit management, RAPM, capital allocation..
..that also link to risk appetite identification.
Risk identification &
1. Limit management
measurement
Bank can set portfolio limit based on stress testing results, the selection
Risk Capital process is called risk appetite.
Estimation
Risk governance
Estimated Profit/(Loss)
& organization
Scenario ‘Extra loss’ Capitalization
Likelihood after stress
Stress testing
, 量行
Major economic
Unexpected loss
crisis in the ,
Risk appetite 行 BIS Ratio
1 in 20 years
PRC, prompting
a general
7 BN -2.7BN
economic 9.4%
20年
Risk management & downturn across
control the economy
Stressed
scenarios
Real Estate
Reporting & 1 in 20 years 5.7BN -1.4BN 9.8%
Collapse
monitoring
Joint large group
defaults – 99th
1 in 100 years 7.3BN -2.9BN 9.4%
percentile
Capital management
2008 Prepared by Eric
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Applying the stress testing skill to find out the max loss tolerance and use this
figure as the max loss tolerance...and the final decision will become ‘limit
boundary’.
Illustrative
.. and stress the loss under different scenario to figure our
the how much ‘extra EL‘ it may occur.
Key to find a appropriate loss
tolerance need to understand the Compare whether if the ‘extra EL’ can be absorbed by the
current P&L… profit within 1 year or cumulative years of profits.
Stress scenario and loss impact for Mortgage
Mortgage Product P&L
Limit Loss Tolerance
Scenario Parameter Current Cumulative Profit
Product Life Long EL 18.1 Implied a ‘0’
• Current market conditions Basel :3.5
Risk Adjusted Profit Total profit in 3
Extra EL -
consecutive
Based • Ave. PD increases EL 22.88
year
2007 3.5 26%
• Conservative outlook
Basel : 7
• 1 in 3 Year Recession Extra EL 4.77
• Ave. LGD EL 29.3
• Worse case
Basel : 31.5
increases
• 1 in 10 Year Extra EL 11.2
• Ave. PD LGD EL 31.3
• 921 Earthquake
Basel : 66.5
increases
• 1 in 20 Year Extra EL 13.1
2008 Prepared by Eric
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Through the stress testing , we will have a picture on how much amount of loss will
occur at what level of probability. The risk appetite is to ask if senior management can
tolerant of. If they can then it become limit.
Probability of
loss
BIS =10%
1 in 3
1 in 10
1 in 20
Scenario 1 4.7
Scenario 2 11.2
Scenario 3 13.1
Unexpected loss
Expected loss Tail Risk
Current Capital Consumption
xxxx
18.1 89.9
Total Asset = xxxx
2008 Prepared by Eric
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RAROC and Economic Profit extend the traditional ROE measure by incorporating
risk.
Risk identification &
1. RAPM is a core to understand the bank performance.
measurement
RAROC* Economic Profit
Risk Capital
Estimation
Interest Income Interest Income
Risk governance
& organization
– Funds transfer price – Funds transfer price
Stress testing
+ Non-Interest Income + Non-Interest Income
Risk appetite
– Operating Expenses – Operating Expenses
– Expected Loss – Expected Loss
Risk management &
control Risk-adjusted profit Risk-adjusted profit
Capital – Cap Hurdle Rate
Reporting &
monitoring
= RAROC (%) = EP ($)
Capital management Capital can be Economic Capital or
*Risk-Adjusted Return on Capital
AIRB Regulatory Capital
2008 Prepared by Eric
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RAROC is an important performance measurement for assessing if the risk /
return is justified…
Illustrative
Return & Capital allocation Concentration Analysis-Industry
Most of the lending business rarely can deliver risk Lending business will inevitable faces industry
adjusted profit, banks require to cross sell more fee- concentration, though, bank need to balance the risk
based income to compensate the risk taking and return.
activities.
Share of total
RAROC
25%
Share of loan
Share of capital
20%
A
X-Sell
15%
Cost of Capital
A
10%
24% of 100% of Capital
total
capital
5%
RAROC-Credit Asset
RAROC-Incorporate Cross-Sell 0%
A B C D E F G H I
Note: Industry classification is based on Moodys’ classification.
Reason of industry concentration risk: GDP of a country is usually relies on certain industry. 2008 Prepared by Eric
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..on the other hand, economic profit reflects the size of the value contribution.
Illustrative
Risk Adjusted Return On Capital Economic Profit
•RAROC estimates the return over the invested capital •One advantage of economic profit or SVA over RAROC is
and gives picture if the return exceed bank’s hurdle rate that EP reflects the size of the value contribution.
(Chinatrust bank uses cost of capital).
•Some transactions or segments may have large EP
•Some transactions or segments may have higher RAROC transactions and businesses even though they may not have
but limited investment opportunities. the highest RAROC values.
Not the highest RAROC
RAROC
but contributed the most B
B
of the EP
A
A
Cost of Cap
100% of Capital
80%
80 % of Cap
Total EP
of Cap
Note : some uses the phrase SVA(Shareholder Value Added) instead of EP.
EP = (RAROC – Cost of capital) * Invested capital 2008 Prepared by Eric
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Understand current pricing based on rating is the first step to boost profitability.
Average Breakeven Basis Point
Average Pricing Analysis
EP Hurdle Rate EL EL+OP Cost
Margin
Minimum pricing for EP =0
EL+OP Cost+ hurdle rate
avg
RAROC Hurdle Rate
Minimum pricing for RAROC =0
Cross-Sell Margin
Cost of Capital
OP Cost
Annualized
Credit Spread
Expected
Loss
Rating
2008 Prepared by Eric
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Fast and transparency allows C-level to quick respond to the economic turbulence.
Risk identification &
1. Reporting is a matter or efforts or database and MIS
measurement
2. Once a bank has this capability, bank can conduct data mining to
explore the behavior of obligor and use these information to
design strategy
Risk Capital
Estimation
Risk governance
& organization
Stress testing
Risk appetite
Risk management &
control
Reporting &
monitoring
Capital management
2008 Prepared by Eric
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Ultimately, capital management will converge to risk management.
Risk identification &
1. A mechanism of annual review for the risk budgeting can
measurement
facilitate the communication between FiCon ,Credit and BU.
Risk Capital
BU Credit FiCon
Estimation
Risk governance
Assess the Business Plan
& organization
Business Plan on Estimate
on
Stress testing
•Where to grow •RAROC for Pillar 2
•Limit control review
•Expected EAD •AP
•Expected EAD
Risk appetite •Expected PD, LGD •Capital usage
•Expected PD, LGD
•Expected NII, Fee •Capital budgeting
•AIRB Economic capital
Risk management &
estimation
control
Based on available capital
Consolidate the view on
Reporting &
monitoring 1. Industry view for industry limit 1. Target EPS
control
2. Capital raising ?
2. Stress testing to identify ‘risk
3. If provision is enough to
appetite’
Capital management support BU expansion?
3. Past performance
2008 Prepared by Eric
4. Future profitability 24
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The management team will have a better picture on how to re-allocate the limited
capital through analyzing the relationship between RAROC and capital
consumption. Illustrative
= Industry or Line of Business
Low Observation
High
Capital usage
High •Usually the capital heavy users don’t
y = -9E-11x + 0.5702
outperform the peers.
R2 = 0.6437
•Higher the capital usage lower the
RAROC, though the RAROC still
exceed the cost of capital (hurdle rate)
Contributed majority
of Risk-adjusted
Action can be taken :
profit
•Invest in high RAROC segments and
RAROC
increase return on the capital heavy
Average RAROC of users.
portfolio
Challenge may face
•Limited opportunities in high RAROC
segments
•Strong bargaining power in the capital
Cost of Capital
heavy users.
Low
Average allocated capital
2008 Prepared by Eric
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The disclosure of RAROC to investors and to demonstrate the return of taking
risk has become common. Moreover, it is an important part of future business
planning .
Return on economic capital and return on invested Demonstrate target income growth rate and
capital shown by business segment RAROC..
Allows investors to distinguish between different risk- ..to balance growth and return and as business
return profiles planning
Target Income growth rate
Hurdle rate or
cost of capital
Note: Citigroup ‘s investor’s presentation. 2008 Prepared by Eric
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ICAAP involve cross organization collaboration… and this is the ‘Risk
governance and risk organization’
Illustrative
Loss Distribution
Responsibility
Target Rating
A
CEO
Board Member decides Risk
Risk Appetite appetite based on the CSO
EL
bottom up information ..
UL=Capital = Risk Appetite
RBG Overseas
..Senior management CFO Industry/
Capital / Resource
decides resource allocation CSO
Allocation Product
based on risk appetite… CBG
CRO
Limit Cap
(Credit Risk) ..BU review Limit by
CCO
Industry/Products based on
Limit Setting BU
allocated resource…..
Capital Industry/
..Portfolio manager Manage the
Portfolio as % of Product/
Concentration Risk to prevent CCO
Management
Total
from catastrophe ... Produc
..through structured credit
Return
instruments, such as
Hedge Hedge / Securitize
Securitization Loan sell/CDS/Securitization.
CCO
Policy
Must have decision process and
Risk
policy 2008 Prepared by Eric
27
