1. 4th SEACEN-
ABAC/ABA/PECC
Public-Private Dialogue
The Credit Risk Economic
Capital
-Concept
-Applications
-Challenge
Experience Sharing
2008/08/18
Eric Kuo

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Myself and my contact.
Myself … My contact
l Eric is a credit portfolio manager at l 886-2-2722-2002 Ext : 1492
Chinatrust bank and responsible for the
credit portfolio management. l Kaiyuan.kuo@chinatrust.com.tw
l He has experiences on implementation
of EC and its applications.
l Eric also acts as lead contact and
participates in IACPM (International
Association of Credit Portfolio
Managers) activities.
Eric (Kai-yuan) Kuo
l Before taking on his current role, Eric
was involved in the strategic planning,
databased marketing and
datawarehouse.
l Prior to joining Chinatrust bank in 1999,
Eric worked for credit scoring model
and cash card product development at
one major retail bank in Taiwan.
2008 Prepared by Eric — CTCB Confidential
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Banks hold ‘Economic Capital’ (or “Risk” Capital) to protect against
“Unexpected Loss”.
AGENDA OF TODAY
1. What is Credit Economic capital is estimated to gauge the ‘Unexpected
EC ? Loss’ of a bank’s credit portfolio.
Economic capital is wildly utilized in all aspects of bank’s
management. Three key management applications :
l Risk governance
2. What is EC for
l External communication
l Internal management
To promote and encourage the use of EC requires both of the
3. Our experience
encouragement and continuous communication with regulators,
and challenges rating agencies and equity analysts.
Create value through manage credit portfolio to sustain through
4.Beyond EC ‘economic cycle’.
‘Delivering a Stable and Sustainable profit growth’ for investors.
2008 Prepared by Eric — CTCB Confidential
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Bank capital is reserved as a cushion to absorb unexpected loss.
Conceptual
Generate risk parameters (PD,LGD,EAD) Bank capital (risk or economic capital)
from historical loss data. is prepared as cushion to absorb the
The expected loss estimation is the cost unexpected credit losses.
of doing loan business.
Target
Capital is used to rating 1. Basel
cover these Credit loss generates a
Credit Loss extraordinary loss
general form of
Risk Appetite formula to
proxy the
Bank’s actual loss
Risk
‘unexpected
experience Unexpec-
Average ted loss Capital loss’ and as
credit loss capital
requirement.
2. It might over or
EL under
estimated the
Time Probability
risk.
Note : Expected Loss = PD*LGD *EAD
EL doesn’t necessary equal to the historical loss experience, due to the portfolio component may change. Prepared by Eric — CTCB Confidential
2008
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Economic capital takes ‘diversification’ and ‘concentration’ effects into
consideration to gauge the level of ‘UNEXPECTED LOSS’.
Illustrative
Total = 30 Total = 27
5
2
Credit
Regulatory Capital
Regulatory Diversification Concentration - Economic Bank’s current
Capital Effect- Benefit Punishment , due Capital available
Requirement from correlation to concentrated on capital
certain name ,
industry…
Regulatory capital is the EC is the maximum amount of unexpected losses
Definition minimum amount of capital to potentially arising from all sources that could be
meet regulator’s request absorbed while remaining solvent, with a given level
of confidence over a given time horizon.
2008 Prepared by Eric — CTCB Confidential
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Economic Capital has been evolved into many banking management
applications.
AGENDA OF TODAY
1. What is Credit Economic capital is estimated to gauge the ‘Unexpected Loss’ of a
bank’s credit portfolio.
EC ?
Economic capital is wildly utilized in all aspects of
bank’s management. Three key management
applications :
2. What is EC for l Risk governance
l External communication
l Internal management
To promote and encourage the use of EC requires both of the
3. Our experience
encouragement and continuous communication with regulators,
and challenges rating agencies and equity analysts.
Create value through manage credit portfolio to sustain through
‘economic cycle’.
4.Beyond EC
‘Delivering a Stable and Sustainable profit growth’ for investors.
2008 Prepared by Eric — CTCB Confidential
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Although there are many applications of Economic Capital developed in the
past decade, we consider the key management applications are as follows:
Key applications
The most common
applications of economic 1 Risk Governance : Determine risk appetite of a
capital are as following : bank
1 l Demonstrate the desire rating of a bank which shows
Risk Governance : the risk appetite…
l …and therefore, determine the amount of Economic
Determine risk Capital that required to hold for protecting ‘Unexpected
appetite of a bank loss’ .
2 Internal Capital Adequacy Assessment
2 3 Process : Pillar 2 compliance
Internal
Capital l Utilize the EC to compare with the regulatory capital
Communi- and to illustrate the sufficiency of solvency.
Adequacy
Access- cate with
3 Communicate with Rating agency
menet Rating
l Capital ratio doesn’t have a direct link to bank’s rating.
Process agency
l Rating agency welcome more information to
– Pillar 2 demonstrate the transparency of the risk.
compliance
4 Performance & investors communication
4 l RAPM :To gauge the return over the risk of line of
Internal Performance business
Management & l Use a basis of capital allocation and strategic decision
process.
investor communication l Limit Setting / Pricing
2008 Prepared by Eric — CTCB Confidential
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1 Risk Governance of a bank : Determine risk appetite of a bank
The amount of EC held by a bank reflects the risk appetite of a bank.
Illustrative
EC link to bank‘s
Probability of target rating
loss
‘A’ rating ‘AA’ rating
Loss Distribution :Confidence of :Confidence of
=99.9% =99.97%
Better rating requires
increased capital
holding and
demonostrates the
appetite of a bank
Credit
Losses
0 Loss
Tail Risk
Expected Unexpected loss
loss = Economic Capital
Regulator Capital is also used to cover
unexpected loss.The Basel Comittee uses a
general form of formula to proxy the UL
2008 Prepared by Eric — CTCB Confidential
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Aiming at better rating, requires more capital and shows bank’s risk
appetite.
Bank’s Loss Distribution
Frequency of Loss
9%
EL may be Target Rating
8% sufficient to =A
7% cover the loss
within 1 year PD=0.1%Target Rating
6% at 64% of =A+
5% probability PD=0.04%
Target
4%
Rating =AA Max loss with 0.01%
3% PD=0.02% of possibility,
happen once in
2% 10,000 years
1%
$ of
0% Loss
300 E Amount
EL EC = 100 Tail risk
Regulator Capital 120
EC = is also used to cover
unexpected loss.The Basel Comittee uses a
EC = 130
general form of formula to proxy the UL
2008 Prepared by Eric — CTCB Confidential
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Risk appetite makes explicit how much risk the institution is willing to
take.
Winterthur
Link to its target rating The bank’s current available
capital is sufficient to cover
99.7% is equal to ‘AA’ 99.97% ‘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 — CTCB Confidential
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Banks need to design a process to demonstrate their capital adequacy
under the pillar 2.
Pillar I Pillar II
•Capital calculation’s primary purpose Principle 1: Banks should have a process for
is for regulatory minimum, not bank assessing their overall capital adequacy in
relation to their risk profile and a strategy for
capital planning and risk
maintaining their capital levels.
management minimum.
Principle 2: Supervisors should review and
•Pillar 1 not tailored to institution’s evaluate banks’ internal capital adequacy
business mixes, strategies and risk assessments and strategies, as well as their
appetites. ability to monitor and ensure their compliance
with regulatory capital ratios. Supervisors should
•Taiwan regulator considers the IRB take appropriate supervisory action if they are
bank should develop EC not satisfied with the result of this process.
Note: some banks or regulators are considered EC as Pillar 1. 2008 Prepared by Eric — CTCB Confidential
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2 Internal Capital Adequacy Assessment Process
Capital adequacy is typically shown from a regulatory perspective and
by comparing EC with available book equity.
Illustrative
Example of Credit Suisse
n Breakdown of economic capital by risk type, showing diversification benefit
n Historical comparison shows like-for-like evolution
Sources: Credit Suisse annual report 2005 2008 Prepared by Eric — CTCB Confidential
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3 Communicate with Rating agency
Rating agencies welcome EC disclosure.
Higher capital ratio doesn’t necessary lead to a better rating.
Tier 1 capital ratio by S&P rating Observation
Capital ratio is one of the rating criteria. Higher ratio
doesn’t necessary rated a better grades. • Capital ratios are only one of multiple
factors taken into consideration by rating
Tier 1 ratio agencies
Some A+ rating
13%
banks have higher • Agencies reward EC disclosure :
12% tier 1 ratio than Moody’s* has revised their rating
AAA’s methodology and welcome the disclosure
11% of economic capital, stress testing and
10%
earning volatility.
9% • Historically, capital ratios have been
inversely correlated to ratings – with
8%
highly rated banks being more leveraged
7% Upper quartile than lower rated banks.
6% Average • Factors that rating considers important :
5%
Wider range of 1. Extensive franchise
Lower quartile
Tier 1 Ratio
4% 2. Diversified business mix
AAA AA+ AA AA- A+ A A- BBB+ BBB
3. Strong risk management
Source :Mercer Oliver Wyman analysis based on a sample of 160 banks in
2003 obtained from Bankscope
4. Stable, predictable earnings
* : Moody’s Special Comment: Risk Disclosures of Banks and
Securities Firms, May 2006 2008 Prepared by Eric — CTCB Confidential
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Bank can leverage EC to demonstrate the potential unexpected loss and its
related probability to the loss.
Illustrative
Bank’s Loss Distribution
Frequency of Loss
9%
EL may be
8% sufficient to
cover the loss Current S & P
7%
within 1 year Rated bank as
6% at 64% of ‘A’…
5% probability
.. But given Bank’s
4% current available
3%
capital, it is
sufficient to AA
2% rating
1%
$ of
0% Loss
Amount
EL Economic Tail risk
Capital
AIRB Capital
Bank Available Capital
2008 Prepared by Eric — CTCB Confidential
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4 Performance & investors communication
RAROC and Economic Profit extend the traditional ROE measure by
incorporating risk.
RAROC Economic Profit
Interest Income Interest Income
– Funds transfer price – Funds transfer price
+ Non-Interest Income + Non-Interest Income
– Operating Expenses – Operating Expenses
– Expected Loss* – Expected Loss
Economic Capital
Attributed in
Risk-adjusted profit Risk-adjusted profit
relation to risk
÷ Economic Capital – EC × Hurdle Rate
Hurdle Rate
= RAROC (%) Bank’s minimum
= EP ($)
Return on Capital
*Risk-Adjusted Return on Capital EC = Economic Capital
* : Some banks have implemented credit transfer pricing and utilize the CDS price to
hedge the credit risk. If it is fully hedged through CDS or similar instruments the EC
will be zero. 2008 Prepared by Eric — CTCB Confidential
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The disclosure of RAROC to investors and to demonstrate the return of
taking risk and as part of business planning.
n Return on economic capital and return on n Demonstrate target income growth rate and
invested capital shown by business segment RAROC..
n Allows investors to distinguish between different n ..to balance growth and return and as business
risk-return profiles planning
Note: Citigroup ‘s investor’s presentation. 2008 Prepared by Eric — CTCB Confidential
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Use of ‘Economic Capital’ requires time to build the confidence internally
and encouragement from externally as well.
AGENDA OF TODAY
1. What is Credit Economic capital is estimated to gauge the ‘Unexpected Loss’ of a
bank’s credit portfolio.
EC ?
Economic capital is wildly utilized in all aspects of bank’s
management. Three key management applications :
2. What is EC for l Risk governance
l External communication
l Internal management
To promote and encourage the use of EC requires both
3. Our experience
of the encouragement and continuous communication
and challenges
with regulators, rating agencies and equity analysts.
Create value through manage credit portfolio to sustain through
‘economic cycle’.
4.Beyond EC
‘Delivering a Stable and Sustainable profit growth’ for investors.
2008 Prepared by Eric — CTCB Confidential
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Our experience shows that the EC is lower than AIRB credit capital…
Illustrative
Capital Comparison*
Unit : %
100 15 9
91
20
65
RC Corporate Retail - Retail - Diversifica- Credit Bank’s
(AIRB**) Banking Secured Unsecured tion EC**** Available
effect *** Capital
* Illustrative only, the figures show here not represent for the actual information or current situation.
** Chintrust internal aim at 10% of BIS Ratio.
*** Diversification effect comes form correlation-different classes of asset won’t default together.
****While estimating the EC, Chinatrust bank target at Global ‘A’ for EC calculation. 2008 Prepared by Eric — CTCB Confidential
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..also utilize the ECap to identify the concentration risk .
Illustrative
Industry Concentration
The chart exhibits the
industry concentration risk.
EC = RC
If the EC is equal to the EC > RC illustrates the
demonstrates the risk For the industries that EC
AIRB Cap which means the higher risk or
is properly expressed > RC, Banks need to dig
risk is properly identified by concentration risk in UL
under Basel 2 into further to understand
using the Basel 2 capital context.
formula. the
formula, as shown in the ‘B’
industry. -Profitability
A
Higher EC than RC, for -Industry outlook
EC > RC Zone
example the ‘A’ industry, B
-Relationship
illustrates the the AIRB
capital is under-estimate the Economic
Require -Business strategy
capital and also is an good to
Capital before taking action.
Reduce Opportunity
illustration of ‘Concentration
risk to Increase
Risk’. exposure risk For those industries that
The causes of the exposure EC<RC:
concentration effect may Banks can consider
result from :
expansion after consider
•Larger ‘exposure’
EC < RC stands for -Industry outlook
•Rating the UL is lower than
•Recovery rate of collaterals Basel 2‘s . -Market size
•Net interest income AIRB Capital -Cross-sell opportunity
•Correlation
…of certain industries 2008 Prepared by Eric — CTCB Confidential
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We are currently leveraging the AIRB Capital as risk adjusted measure
instead of EC.
RAROC* Economic Profit
Interest Income Interest Income
– Funds transfer price – Funds transfer price
+ Non-Interest Income + Non-Interest Income
– Operating Expenses – Operating Expenses
– Expected Loss – Expected Loss
AIRB Capital
Attributed in
Risk-adjusted profit Risk-adjusted profit
relation to risk
÷ AIRB Capital – RCap × Hurdle Rate
Hurdle Rate
= RAROC (%) Bank’s minimum
= EP ($)
Return on Capital
*Risk-Adjusted Return on Capital RC = AIRB Capital
2008 Prepared by Eric — CTCB Confidential
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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 Lending business will inevitable faces industry
risk adjusted profit, banks require to cross sell concentration, though, bank need to balance the
more fee-based income to compensate the risk risk and return.
taking activities.
Share of total
RAROC
25%
Share of loan
20% Share of capital
A
X-Sell
Cost of Capital 15%
A
24% of 100% of Capital 10%
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 — CTCB Confidential
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..on the other hand, economic profit reflects the size of the value
contribution.
Risk Adjusted Return On Capital Economic Profit Illustrative
•RAROC estimates the return over the invested •One advantage of economic profit or SVA over RAROC
capital and gives picture if the return exceed bank’s is that SVA reflects the size of the value contribution.
hurdle rate (Chinatrust bank uses cost of capital).
•Some transactions or segments may have large EP
•Some transactions or segments may have higher transactions and businesses even though they may not
RAROC but limited investment opportunities. have the highest RAROC values.
Not the highest
RAROC
RAROC but contributed
the most of the EP
A
A
Cost of Cap
100% of Capital
80 % of Cap 80%
Total EP
of Cap
Note : some uses the phrase SVA(Shareholder Value Added) instead of EP.
EP = (RAROC – Cost of capital) * Invested capital 22
2008 Prepared by Eric — CTCB Confidential

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Furthermore, the RAROC measure is utilized to identify if the obligors
added value to our shareholder.
Example
Cross-Sell RAROC
CoC
Miss-Pricing Zone
CoC
Credit RAROC
Note: CoC = Cost of Capital. 2008 Prepared by Eric — CTCB Confidential
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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 High Observation
Capital usage
High •Usually the capital heavy users
y = -0.1515Ln(x) + 3.5837 don’t outperform the peers.
R2 = 0.6642 •Higher the capital usage lower the
RAROC, though the RAROC still
Contributed exceed the cost of capital (hurdle
majority of Risk- rate)
adjusted profit
RAROC
Action can be taken :
•Invest in high RAROC segments
Average RAROC of and increase return on the capital
portfolio
heavy users.
Challenge may face
•Limited opportunities in high
Cost of Capital RAROC segments
•Strong bargaining power in the
Low
capital heavy users.
Average allocated capital
2008 Prepared by Eric — CTCB Confidential
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Internal capital management and performance management and based on
RC to align with external compliance.
Issues Description
•Require tailored made of correlation for consumer
banking. Other
Measurement
•EC model is complex
Challenges
•Difficult to validate the EC figure, due to historical loss
experience is not longer enough.
Accuracy of the
EC measure
•Capital attribution and performance measurement based
Management on RC to align the external compliance.
•Line of business tends to embrace EC when there is Lower the EC the
diversification effect exists, decline to recognize EC better ?
when concentration effect occurs .
Concentration
Diversification effect
effect Do investors
Situation care about
may faces EC?
when
implement
EC
Regulatory EC with EC with
Capital 2008 Prepared by Eric — CTCB Confidential
diversification concentration
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1 Accuracy of the EC measure
Understand your MODEL and what is the ASSUMPTION before further
application.
Findings from credit portfolio management study in 2004 Comments
1. Different models may have
Which models are used? different results.
CSFB Credit Risk+ 6% • Each vendor model has
his own features.
In-house Credit Metric 6%
Vendor • Understand what are you
developed
model doing when using
44 % MKMV 42%
66% vender’s model.
2. Longer the tenor, usually,
Macro Model 2%
requires more EC.
• Common practice is
How long of the tenor is applying in estimating the EC? apply 1 year horizon to
estimate the EC.
1- year Full Banks need to understand what
horizon maturity methods are you using in
54% 46% estimating EC and gain confidence
internally before communicating
with regulator.
Source: IACPM -Survey of CPM practices 2004 2008 Prepared by Eric — CTCB Confidential
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2 The lower the EC the better ?
EC largely depends on the target rating a bank is aiming at.
Moreover, EC alone doesn’t illustrate the RETURN by taking RISK.
What Return is generated is
Aiming at better Rating requires to hold more EC
more important
Probability of Global Rating = ‘AA’
loss 1. Combine with the return
(99.97% of confidence interval)
information, banks can :
Global Rating = ‘A’
(99.9% of confidence interval) • Measure risk-adjusted
business unit
Global Rating = BBB
(99.85% of confidence interval) profitability to gauge the
portfolio performance.
• Demonstrate efficient
usage of shareholder
funds
2. However, it is difficult to
Loss compare with peers, due to
EL Economic Capital
• Model may be different
BBB
• Target rating may be
A
different
AA
2008 Prepared by Eric — CTCB Confidential
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3 Do investors care EC
Inevitably, investors look at simple indicator.
Requires time to communicate with and to promote the use of RAPM .
Inevitably, investors look at simple indicator when Require time to communicate
choosing stock. with and to promote EC .
Traditionally, Equity analyst and investor look at EPS.. 1. Provide EC and Risk Adjusted
Performance Measures
demonstrate a bank
P/E Ratio = Stock Price
• Knows RISK well
EPS • Examine if bank added
value to shareholders
..the RAROC doesn’t have a direct link to stock price 2. It may not have a direct link to
stock price, however , in my
Net Income Capital Return on Capital opinion, gradually, the effect will
reflect on the P/E ratio, due to
Return
RC 100 10% • Transparency of bank risk
on RC
disclosure
10
=
• Alternative indicator for
EC 50 Return 20% investors to measure the
on EC management team’s
performance.
2008 Prepared by Eric — CTCB Confidential
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In sum, to encourage the use of EC requires continuous communication
externally and internally.
Reason of use Challenge may face
l Measure the risk capital l Know your model
– Link to bank’s target rating – Assumption of the model
– Consider the diversification and – Parameters that you put into the
EC as risk
concentration effects model
measurement l Basel 2 may not be appropriate to gauge – Interpret the results carefully
risk in emerging market l Build confidence
– The Basel 2 capital may not capture/ – EC is not a regulator requirement
reflect the risk in Emerging market.. – Explanation of the difference
– …it may over or under estimate the risk. between RC and EC
l Risk appetite l Require continuous communication
– Link to bank’s target rating – There is little comparability across
EC as risk
l ICAAP firms in EC approaches –
management – Requirement of Pillar 2 therefore numbers have to be
l Rating communication taken with a pinch of salt
– Encourage the EC disclosure
l Investors communication – Accounting metrics are still
– Generally more information, especially on dominant to investors.
risk, is welcomed. – Internal communication to
l Performance and compensation develop the confidence and clear
– Gauge the performance of line of up doubts.
business l Market competition
l Limit setting / Portfolio stress testing
l Capital allocation and planning – May not be able to price based on
2008 Prepared by Eric — CTCB Confidential
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We cannot direct the wind but can adjust the sail.
Face the unpreventable risk.
AGENDA OF TODAY
1. What is Credit Economic capital is estimated to gauge the ‘Unexpected Loss’ of a
bank’s credit portfolio.
EC ?
Economic capital is wildly utilized in all aspects of bank’s
management. Three key management applications :
2. What is EC for l Risk governance
l External communication
l Internal management
To promote and encourage the use of EC requires both of the
3. Our experience encouragement and continuous communication with regulators,
and challenges rating agencies and equity analysts.
Create value through manage credit portfolio to sustain
through ‘economic cycle’.
4.Beyond EC
‘Delivering a Stable and Sustainable profit growth’ for
investors.
2008 Prepared by Eric — CTCB Confidential
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Traditional commercial banking model relies on lending as ‘Entry product’
and aims at cross selling to deeper relationship with clients.
Conceptual
Facing the same down-side risk but the up-side is totally
Traditional model of commercial banking different that makes the stock investment – an attractive
investment.
Obligor
Return Stock
Deposit Loan
With
Bank possibility
Different compensation of ‘high’
return
n Banker as the intermediary – Cross-sell profit
collecting deposit and providing
Credit income
loans that were held to maturity
– Loan consumed ‘Capital’ With high
0 possibility of
– Regulatory legislation ‘constant’
watch BIS ratio and NPL return
– Bank focuses on bi-lateral
relationships But faces the
same down
- 100 % side loss with
n This model has been under low possibility
pressure for the past 40 years Facing the same loss
2008 Prepared by Eric — CTCB Confidential
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Usually the low possibility of ‘Large unexpected loses’ not only wiped out
the profits but also results in significant market cap decline…
XX Bank
l In addition to
putting in danger
bank’s target
credit rating,
large losses can
erode
shareholder
confidence
l Implications for
• XX Bank lost a total of market
perhaps $0.5 billion in the
capitalization can
course of Enron meltdown. Yet,
as events unfolded, far exceed actual
shareholders lost confidence losses
and share price plummeted to
all time low
• XX Bank’s share price fell from
about $40-$15 dollars,
destroying about $50 billion of
market cap
2008 Prepared by Eric — CTCB Confidential
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..and the credit crisis tends to be a cyclic event…
Examples of losses by financial institutions Too many
$ Millions No downgrades banks
triggered by these
Loss size* losses
1,025
826
Too many losses
531 451
260 247
U.S. AmEx – Fleet JP BONY – Capital Sub-Prime Crisis
Bancorp – high Boston – Morgan telecom One –
airline yield Argentina Chase – loans and subprime
exposure bonds bonds Enron bonds lending
after 9/11
2001 2002 2007
Loss/ book
7% 7% 3% 1% 4% 7%
equity**
* Pretax
** Assuming book equity in 2003
Source: Literature searches; 2008 Prepared by Eric — CTCB Confidential
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..that explains why the outcome of credit portfolio is asymmetric – A small
number of bad loan may wipe your capital out - ’Once in a blue moon’ ?
Probability
of loss
The game of credit portfolio
• Asymetric risk return
pay-off.
It rare happens
but once it does , • Long tail and
you are
concentration –
‘Sayonara’
‘Once in a blue
Reserve Capital moon’ is more
common than we
Potential “unexpected” think.
Zero Expected Potential “unexpected” losses against which it
losses level of loss losses for which capital would be too
should be held expensive to hold
capital
0% Loss 100%
rate
2008 Prepared by Eric — CTCB Confidential
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EC estimation only exhibits the Unexpected Loss of a bank’s credit risk,
but the risk won’t disappear away by itself.
Illustrative
Banks tend to have deeper relationship with well-
established or public listed corporations.
Most banks face concentration risk, resulting from small portion EC indicates the potential risk
of obligors (or industries, geographic) account for majority of
income or exposure… (UL), but risk won’t disappear
…also consume most of the bank’s capital. away by itself.
Non-Public
Listed / other 40 Remedy
50 50
industries 60
1. Diversified your credit
90 portfolio
Public listed 2. Active manage your
corporations /
60 portfolio through
Star 50 50
industries 40
- Risk mitigation
10
- Risk transfer
# of Exposure Regulatory Economic Revenue
Obligor Capital Capital
2008 Prepared by Eric — CTCB Confidential
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Banks require to develop a mechanism to transfer risk and manage bank
capital.
Illustrative
Traditional credit management Active credit portfolio management approach
•Loan
Credit
selling
Origination Management Origination
•CDS
Relationship Monitor Relationship
Active •CDS
Primary Management Workout Primary Management Credit Secon-
Index
Portfolio dary
Market Market •CLO
Manage- Market
ment •Insuranc
Credit Credit e
Approval / Approval / •Portfolio
Rating Rating Trading
Source : ERisk,
2008 Prepared by Eric — CTCB Confidential
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A new business model emerges through Credit portfolio management.
Illustrative
•Create More Business Opportunities.
•RM Focuses on Relationship
•Support BU / Client growth.
Capital Market Collaboration Framework Within Chinatrust Current Customers
Trade & SELL BUY & SELL & Control
Capital Market FINANCIAL GROUP BU
• Alternative mean of •Support Business Loan
Bank 1 Trader capital raising Growth
Bank 2 CDS 1 CDS 2
•Control RWA. •Reduced EL/
•Utilize Capital more
CapCost Obligors
efficient
Structur CREDIT PORTFOLIO
CLN 2 ed CLN 1 • Control • Minimize
Concentration risk Unexpected Loss
Finance
Investors CLO2 CLO1 •Reduce credit risk •Optimize Economic
Capital
2008 Prepared by Eric — CTCB Confidential
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Portfolio theory suggests us that we can enhance portfolio performance by
re-weighting, and banks finally can adopt the theory into practice.
Conceptual
Portfolio Performance Enhancement
12% 1 Hedge : Reduce risk / uncertainty
-Tool : Buy CDS, Loan Sell,
Insurance, Securitization
Efficient
10%
Frontier
2 Enhance Yield : Invest in High Yield
Return
given the same ‘risk’
8% 4
2 -Tool : Secondary loan, Sell
3 CDS, CDS Index, securitization.
Current Portfolio
6% 3 Swap Asset
4 Synthetics : Reduce risk and utilize the
4% free up capital to invest in credit.
5% 15% 25% 35%
Risk
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Portfolio Improvement is achieved by both reweighing existing exposure
holdings and by hedging unwanted risk.
Risk-Return Optimization Conceptual
Same Risk Portfolio Efficient Frontier
The efficient frontier for
the portfolio is calculated
by optimizing within the
Current Portfolio
portfolio. The frontier can
be moved by expanding
the portfolio assets to
Same Return Portfolio
include diversifying
Optimal Sharpe Ratio exposures.
By introducing new exposures that diversify the portfolio risk-return
tradeoff will improve, allowing for the construction of optimal portfolios .
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..also aiming at improve the single-name credit risk management.
3 LGD and Fee
2 Fee Incr
5 EDF Decr
1 LGD Decr
4 Commit
Expected Spread
Initial
Risk Reducing/Return Enhancing Scenarios:
–Scenario 1: Risk mitigation – reduce LGD from 35% to 15%
–Scenario 2: Increase usage fee from 3.49% to 5.50%
–Scenario 3: Reduce LGD and increase usage fee
–Scenario 4: Reduce commitment to $20 mil
–Scenario 5: Assume terms remain the same, but EDF drops from 11% to 9%
Risk Contribution
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Our ultimate goal is to ‘Deliver a Stable and Sustainable profit growth for
investors and to sustain through ‘economic cycle’.
Learn our lesson from recent credit crisis.. •..and create our own blue ocean strategy
EPS l Managing concentration
risk.
Bank l Diversifying portfolio
through Buy & Sell credit.
Max Return l Becoming Market Maker
Other in Taiwan Credit market
Banks Min Risk
l Support both of client’s &
CTCB’s business growth.
l Ensuring business
growth with good credit
Time quality
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The International Association of Credit Portfolio Manager established in
2001 to further promote the practice of credit exposure management .
Who We Are and What We Are About Share ideas and exchange experiences
•Established in 2001 .
•Promote the practice of credit exposure
management by providing an forum to
exchange ideas on topics of common interest.
•There are 87 financial institutions worldwide
that are members of the IACPM…
•..and from 14 countries and include many of
the world’s largest commercial wholesale
banks, investment banks and insurance
companies, as well as a number of asset
managers.
•Represents its members before legislative
and administrative bodies.
•Conducts research on the credit portfolio
management field.
Note: Free document in IACPM web site, www.iacpm.org. 2008 Prepared by Eric — CTCB Confidential
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Participants not only from commercial banks .
Aareal Bank DZ Bank National City Bank
ABN AMRO Bank Euler Hermes Group Natixis
Allianz AG Export Development Canada Nationwide Insurance
Atradius Fifth Third Bank NIBC Bank
Australia and New Zealand Banking Group FirstRand Bank PB Capital
Bank of America Fortis PNC
Bank of Ireland Goldman, Sachs Primus Asset Management
Bank of Montreal HSBC RaboBank
Bank of New York Mellon HSH Nordbank Royal Bank of Canada
Bank of Tokyo-Mitsubishi UFJ Hypovereinsbank Royal Bank of Scotland
Barclays Capital IKB Deutsche Industriebank Scotiabank
Bear Stearns ING Capital SEB
BNP Paribas Intesa Sanpaolo Shinsei Bank
Bluecrest Capital JPMorgan Chase Société Générale
BP KBC Bank Standard Bank of South Africa
Calyon KeyBank Standard Chartered
Capital One KfW Sumitomo Mitsui Banking Corporation
CIBC World Markets KfW IPEX-Bank SunTrust Banks
Citigroup Landesbank Baden Wurttemberg Swiss Re
Citizens Financial Group Lloyds TSB Bank TD Securities
Chinatrust Financial Holding Manulife Financial Corporation TIAA-CREF
Commercial Industrial Finance Corp. Merrill Lynch UBS AG
Commerzbank MetLife U.S. Bancorp
Commonwealth Bank of Australia Mizuho Corporate Bank Wachovia Corporation
Credit Suisse Monte Dei Paschi Di Siena Wells Fargo Bank
DEPFA Bank plc Morgan Stanley WestLB
Deutsche Bank Munich Reinsurance Westpac Banking Corporation
Dexia SA National Australia Bank WGZ Bank
Dresdner Kleinwort National Bank Financial XL Capital 2008 Prepared by Eric — CTCB Confidential
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In sum, credit risk need to be accurate estimated, managed and
transferred.
TAKE AWAYS OF TODAY
Bank holds ‘Economic Capital’ to protect ‘Unexpected
Loss’.
1. What is EC l Not for the regulatory compliance purpose
l But to know what is ‘True Risk’
Economic capital is wildly utilized in all aspects of bank’s
management. Three key management applications :
2. What is EC for l Risk governance
l External communication
l Internal management
To promote the use of EC requires time to build confidence
3. Our experience internally and both of the encouragement and continuous
and challenges communication externally.
Knowing risk without action to offload risk won’t prevent
bank from risk.
4.Beyond the EC
To deliver a Stable and Sustainable growth to shareholders,
bank need to well managed and take actions.
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