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Page 1October 19, 2009Group Risk Control
ERSTE GROUP
Challenges inStrategic Risk Management
Andreas WeingesselOctober 2009
Page 2October 19, 2009Andreas Weingessel / Group Risk Control
ERSTE GROUP
In the News
Page 3October 19, 2009Andreas Weingessel / Group Risk Control
ERSTE GROUP
Recipe for Disaster
In the mid-'80s, Wall Street turned to the quants—brainy financial engineers—to invent new ways to boost profits. Their methods for minting money worked brilliantly... until one of them devastated the global economy.
cited from: WIRED MAGAZINE: 17.03http://www.wired.com/techbiz/it/magazine/17-03/wp_q uant
Here's what killed your 401(k) David X. Li's Gaussian copula function as first published in 2000. Investors exploited it as a quick—and fatally flawed—way to assess risk.
Page 4October 19, 2009Andreas Weingessel / Group Risk Control
ERSTE GROUP
Agenda
- Risk Management in Banks- Credit Risk
- Enterprise-wide Risk Management- Operational Risk
Page 5October 19, 2009Andreas Weingessel / Group Risk Control
ERSTE GROUPFundamentals of Banking Business
− Main function of banks to act as intermediaries of fund transfers from liquidity providers (holders) towards liquidity buyers
− Banks within fund transfer activity managing mismatch in tenor and currency of collected liquidity and demanded credit
− As intermediary service provider, the banks are taking the risk of debtors and protecting the creditors
− Main indicator of banks’ solvency is their capital which can first absorb losses together with their profit
Andreas Weingessel / Group Risk Control
ERSTE GROUP
RISK STEERING
� Organization� Capital Allocation� Risk- / Return-
optimization� Risk limits� Diversification� Training
� Hedging ex post
ex a
nte
RISK CONTROLLING
� Quantification� Reporting
RISK IDENTIFICATION
� Where are risks?� Which kind of risks
exist?� How can they be
measured?
RISK MANAGEMENT i.b.s
RISK MANAGEMENT i.n.s.“Risk management is
identification, measurementand steering of risk.”
What is Risk Management?
Page 7October 19, 2009Andreas Weingessel / Group Risk Control
ERSTE GROUP
Classification of Banking Risks (1)
Credit Risk
traditional
Credit Risk
Treasury
Credit Risk
Market Risk
Trading Book
Market Risk
Banking Book
Market Liquidity
Risk
Market Risk
Quantifiable Risks(effect on return < 1 year)
Strategic Risks(effect on return > 1 year)
Enterprise-wide Risk
Operational Risk
Page 8October 19, 2009Andreas Weingessel / Group Risk Control
ERSTE GROUP
Classification of Banking Risks (2)
Enterprise-Wide Risk
Op. risk as
part of credit risk
IT - System
External
Process
Employees
Event Risk
Operational Risk
OwnAssets
Businessrisk
ReputationRisk
EquityRisk
LiquidityRisk
Page 9October 19, 2009Andreas Weingessel / Group Risk Control
ERSTE GROUP
What is Basel II ?> Overview of components
► Risk adequate capital
► All specific bank risksand other risks capital
► Credit risk
► Market risk in the trading book
► Operational risk
Basel IIPillar 1
Minimum Capital Requirements
► Continuous riskmanagement process
► Evaluation of bank's internal capital adequacyassessment process(ICAAP )
► Definition of bank's individual solvability-coefficients
Pillar 2Supervisory Review Process
► Enhanced disclosure
► Better assessment formarket participants of capital adequacy of banks
► Increase of marketdiscipline
Pillar 3Market Discipline
Page 10October 19, 2009Andreas Weingessel / Group Risk Control
ERSTE GROUP
Agenda
� Risk Management in Banks
- Credit Risk- Enterprise-wide Risk Management- Operational Risk
Page 11October 19, 2009Andreas Weingessel / Group Risk Control
ERSTE GROUP
Internal Rating
− Estimates credit worthiness of a client
− Relative ranking (client A is “better” than client B) vs.
− Absolute ranking − Probability of default (PD)
vs.− Expected Loss (EL)
Page 12October 19, 2009Andreas Weingessel / Group Risk Control
ERSTE GROUP
Internal Rating
− Different methods for different exposure classes− Rating Factors− Economic Information− Behavioral Scoring− Soft Facts− External Information
− System components− Online rating (rating if necessary)− Batch rating (monthly automated update)− Application rating (at loan application)
Page 13October 19, 2009Andreas Weingessel / Group Risk Control
ERSTE GROUP
Internal Rating
− Mapping of clients into discrete number of rating classes− Mapping of rating classes into PDs
− Database: Historical time series of client information (input factors, default definition)
− Logistic regression leading to score values
Page 14October 19, 2009Andreas Weingessel / Group Risk Control
ERSTE GROUP
Usage of Ratings
− Loan Decision− Pouvoir− Pricing of Loan− Risk Provisions− Forecast− Internal Capital Calculation− External Capital Calculation (Basel II)
Page 15October 19, 2009Andreas Weingessel / Group Risk Control
ERSTE GROUP
Internal Rating - Challenges
− Distinguish “good” (=non-risky) clients from “bad” (=“risky”) clients− Discriminatory power
− Predict Probability of Default− Point-in-Time vs. Through-the-Cycle− Choice of Rating Scale− Choice of Homogenous Segments− Client vs. Product View− Country Risk
Page 16October 19, 2009Andreas Weingessel / Group Risk Control
ERSTE GROUP
Credit Risk Parameter
*) implicit treatment for corporates with reported sales and total assets of less than € 500 Mio
Foundation IRB
Advanced IRB
Exposure at Default (EAD)(Credit Conversion Factor - CCF)
supervisory valuesbank's own estimation
Probability of Default (PD)bank's own estimation
bank's own estimation
Loss Given Default (LGD) supervisory valuesbank's own estimation
Maturity implicit treatmentbank's own
estimation *)
Page 17October 19, 2009Andreas Weingessel / Group Risk Control
ERSTE GROUP
Risk Parameter - Challenges
− Quality of Time Series− Consistent definition and use of default events…− Structural Changes
− Understanding of the Operative Credit and Workout Process− Treatment of open lines− “Revival” of defaulted clients
Page 18October 19, 2009Andreas Weingessel / Group Risk Control
ERSTE GROUP
Agenda
� Risk Management in Banks� Credit Risk
- Enterprise-wide Risk Management- Operational Risk
Page 19October 19, 2009Andreas Weingessel / Group Risk Control
ERSTE GROUPFrom Rating to CapitalRiskweights *)
PD0%
50%
100%
150%
200%
250%
300%
0% 20% 40% 60% 80% 100%
4 different risk weight functions:�Corporates, Banks and Sovereigns; LGD = 45%, Maturity = 2.5 Yr�SME-Corporates (between. € 5 and 50 m turnover); LGD = 45%, Maturity = 2.5 Yr�Risk weights of claims secured by residential property; internal LGD = 20%�Remaining Retail-claims und SME-Retail; internal LGD = 25%
Page 20October 19, 2009Andreas Weingessel / Group Risk Control
ERSTE GROUP
❚ Advantages❚Comparison between different risk categories = higher risk transparency
❚ Portfolio View
❚ Widely used in the banking world
❚ Basis for risk-adjusted Performance measurement, risk bearing capacity calculation, risk efficient capital allocation
Internal Risk Models (VaR)
❚ Disadvantages❚“Normal distribution – Concept”
❚ Not sub-additive � Expected Shortfall
❚ Tail behavior
❚ Wrong sense of safety
Page 21October 19, 2009Andreas Weingessel / Group Risk Control
ERSTE GROUP
Risk-Bearing Capacity Calculation –Goals
� Ensure the survival of the bank by avoiding risks which exceed the risk-bearing capacity
� Assessment of an adequate capital size from risk management perspective
� Basis for setting an overall bank limit
� Framework for establishment of risk appetite
� Create awareness for the relation between risk and risk-bearing capacity
Page 22October 19, 2009Andreas Weingessel / Group Risk Control
ERSTE GROUP
Risk-Bearing Capacity Calculation –Algorithm
1) Calculation of the Risk
2) Determination of coverage potential
3) Comparison between coverage potential and risk
Page 23October 19, 2009Andreas Weingessel / Group Risk Control
ERSTE GROUPMeasurement of “all” material risk types
Correlation / Copulas
Economic Capital
Credit-VaRCredit-VaR
Volatility of Credit losses
Market-VaRMarket-VaR
Volatility of Market price
Operational-VaROperational-VaR
Volatility of operational loss
events
Other RiskOther Risk
Page 24October 19, 2009Andreas Weingessel / Group Risk Control
ERSTE GROUPCoverage Potential
Divide Total Capital into Coverage Potentials based on
�Availability of Capital
�Triggering of Default Event
Page 25October 19, 2009Andreas Weingessel / Group Risk Control
ERSTE GROUP
Risk-Bearing Capacity Calculation: Risk vs. Capital
Diversi-fication
Diversi-fication
Economic Capital
Economic Capital
Op.risk
Op.risk
Creditrisk
Creditrisk
Marketrisk
Marketrisk
Centralcapitalreserve
risk capital
Coverage Potential I
Coverage Potential II
Coverage Potential III
Coverage Potential IV
Coverage Potential V
Page 26October 19, 2009Andreas Weingessel / Group Risk Control
ERSTE GROUPPro-cyclicality in Basel II
Cap
ital
Req
uire
men
ts
Economic Cycle
Advanced IRB Approach� Individual validation of all parameters
leads to highest responsiveness to market changes
Foundation IRB Approach� Individual validation limited to
probability of default� LGD and CCF are predetermined and
constant� Subsequent lower reflection of
adverse market developments
Standard Approach� Impact from economical downturn due
to application of external ratings but which are smoothened based on its though the cycle approach
Banks applying the Advanced IRB Approach face the h ighest impactfrom economical downturns on their Basel risk expos ure
Page 27October 19, 2009Andreas Weingessel / Group Risk Control
ERSTE GROUP
Stress Tests
− Statistical Models used to calculate Capital or VaR are based on historical data
− Evaluate sensitivity of models with respect to changes in input parameters− Stress input parameters to reflect a (realistic) worst case scenario
− Determine P&L and capital ratio in scenario
− Set measures accordingly
Page 28October 19, 2009Andreas Weingessel / Group Risk Control
ERSTE GROUP
Agenda
� Risk Management in Banks� Credit Risk� Enterprise-wide Risk Management
- Operational Risk
Page 29October 19, 2009Andreas Weingessel / Group Risk Control
ERSTE GROUP
Operational Risk -Definition
““ The risk of loss resulting from inadequate or The risk of loss resulting from inadequate or failed internal processes, people and systems failed internal processes, people and systems
or from external events.or from external events. ””
Excluded:❚ Reputation risk❚ Strategic risk
Included:❚ Legal risk
Definition according to Basel II:
Page 30October 19, 2009Andreas Weingessel / Group Risk Control
ERSTE GROUP
Operational Risk Framework
Page 31October 19, 2009Andreas Weingessel / Group Risk Control
ERSTE GROUP
OpRisk Model
The theory: A simple approach
Model frequency and severity separately, then compute convolution
Assumptions
− given N=n, X1,X2,...,Xn are iid.− given N=n, the distribution of X1,X2,...,Xn is
independent from n.
− Distribution of N is independent of X1,X2,...,Xn
NXXXS +++= ...21
Page 32October 19, 2009Andreas Weingessel / Group Risk Control
ERSTE GROUP
OpRisk Model
The practice
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