Integrated Risk architecture:Implementation Issues
FICCI - IBA conference on “Global Banking – paradigm shift” on October 5th 2005
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Challenges in Implementing IRM3
Components for implementing IRM
What is Integrated Risk Management
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Three key imperatives for Bank’s Management
Differing requirements from various stakeholders Employees Borrowers Regulators Credit Rating
agencies Counterparty
banks Depositors Investors
Differing requirements from various stakeholders Employees Borrowers Regulators Credit Rating
agencies Counterparty
banks Depositors InvestorsCapital
Adequacy
Growth
Profitability
IRM can assist in managing the three objectives proactively
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Maintenance of Regulatory/ Economic Capital is crucial to business continuity
Economic Capital is the financial cushion that a bank uses to absorb unexpected losses. The purpose of economic capital is to provide confidence to claim holders such as depositors, creditors and other stakeholders.
The development of of sophisticated risk measurement tools offers banks the capability to calculate economic capital.
The proposed New Basel Capital Accord is a major move towards aligning regulatory capital to economic capital.
Economic Capital is the financial cushion that a bank uses to absorb unexpected losses. The purpose of economic capital is to provide confidence to claim holders such as depositors, creditors and other stakeholders.
The development of of sophisticated risk measurement tools offers banks the capability to calculate economic capital.
The proposed New Basel Capital Accord is a major move towards aligning regulatory capital to economic capital.
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Profitability Analysis – Bank ABC
Investments offer the highest contribution p.c.age on assets
Which segment leads to high interest earnings?
The credit function has the largest contribution towards fixed expenses
Which credit segment contributes the highest?
What is the position after allocating costs?
Am I properly pricing for expected Losses?
Investments offer the highest contribution p.c.age on assets
Which segment leads to high interest earnings?
The credit function has the largest contribution towards fixed expenses
Which credit segment contributes the highest?
What is the position after allocating costs?
Am I properly pricing for expected Losses?
Profitability AnalysisCredit Investments Others
Average Assets 51840 35064 10597
Interest Income 7.9% 8.5% 1.5%Interest Expenses 3.6% 3.6% 3.6%Net Interest Margin 4.3% 4.9% -2.1%Other Income 1.9% 1.3%Less: Provisions 1.3% 0.0%Total Contribution 4.9% 6.3% -2.1%Contribution (LKR Mn) 2548 2204 -226
Total Contribution 4526Operating Expenses 3975Share of Profit from subsidiaries 197PBT 749Tax 70PAT 679
• What is the capital required for different business lines?• What is the return provided by different business lines on
capital invested?• What is the expected impact of NPAs/ revaluation? Where
should we grow?• Are we generating enough internal capital to support growth?
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Risk Exposures – Bank ABC
Assets31/12/2003
Cash & Short Term Funds 1739Balances with Central Banks 3305T Bills and other eligible securities 5756Placement with and loans to other banks 10987Bills of Exchange 2493Loans & Advances 44222Lease Rentals receivable within one year 96Lease Rentals receivable after One year 72Dealing Securities 587Equity & others 916Bonds 17664Investment Securities 18580Investment Properties 804Investments in Subsidiaries & Associates 1667Accrued Intt 1073Cheques Purchased 2979Other Assets 3331Other Assets 7382Group balances receivable 503Property Plant & Equipment 1807Total Assets 100000
Liabilities31/12/2003
Deposits from customers 77312Deposits from Banks 188Total Deposits 77500Borrowings 10923Group balances payable 397Deferred Tax Liability 0Tax Payable 26Other Liabilities 4887Subordinated Debentures 520Total Liabilities 94253Shareholders EquityShare Capital 1082Permanent Reserve Fund 609Reserves 4056Total Equity 5747Total Liabilities & Equity 100000
Market RiskCredit Risk Liquidity Risk
The bank runs asset liability mismatches due differing maturity profiles and lending and borrowing rates for credit, investments, deposits and subordinated debentures.
Borrowing/ Lending/ Investing in Foreign Currency gives rise to foreign exchange risk
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How does this affect us?
Credit Risk: Simple credit products (loans normally backed by collateral, few products)
Market Risk: Simple market risk products (dealing in g-sec/ limited corporate bond market/ limited FX market)
Operational Risk: Not a major concern
Credit Risk: Simple credit products (loans normally backed by collateral, few products)
Market Risk: Simple market risk products (dealing in g-sec/ limited corporate bond market/ limited FX market)
Operational Risk: Not a major concern
Increasing Complexity & Size
Current Environment Future Environment
Credit Risk: Credit Derivatives Project Finance
Market Risk: Multiple currencies Investments in securities across
countries Investments in corporate bonds Swaps/ Options other
derivatives
Operational Risk: Increasingly important with
complex systems and processes, operations across time zones and markets
Credit Risk: Credit Derivatives Project Finance
Market Risk: Multiple currencies Investments in securities across
countries Investments in corporate bonds Swaps/ Options other
derivatives
Operational Risk: Increasingly important with
complex systems and processes, operations across time zones and markets
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RAROC - Base for Integrated Risk Management
RAROC 22%
Risk-adjustedNet income
1750
Risk-adjustedAfter tax income
1.75%
AverageLending assets
100,000
Total capital8000
Risk-adjustedNet income
2.20%
Net Tax0.45%
Total capital8.0 %
Risk-adjustedincome5.60 %
Costs 3.40
%
Credit Risk Capital4.40 %
Market Risk Capital1.60 %
Operational Risk Capital 2.00 %
Income6.10 %
ExpectedLoss 0.50 %
RAROC could be carried out for the bank as a whole or a business segment.
RAROC allows a bank to take a comprehensive risk view and forms the base for IRM
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Integrated Risk Management in a Bank
What is Integrated Risk Management?
•Measure, monitor and manage all the risks across the bank.
•Bank wide integrated risk management infrastructure in terms of people, policies and systems
•Common and consistent risk measurement and quantification methodologies across all risk categories
•Aggregation of risks and estimation of economic capital to assist in risk/ return decision making
Compliance
Policies
Culture
Systems& Processes
Peo
ple
Methodologies
Integrated Risk
Management
Organisation
Structure
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Perceived advantages of IRM
Facilitates strategic value creation
Key to regulatory compliance
Mechanism for efficient allocation of economic capital
Enables bank to maximise returns
Lower capital costs
Better decision making due to scenario analysis
Risk adjusted pricing
Loss reduction due to understanding of correlations
Elimination of unwanted exposures
Facilitates strategic value creation
Key to regulatory compliance
Mechanism for efficient allocation of economic capital
Enables bank to maximise returns
Lower capital costs
Better decision making due to scenario analysis
Risk adjusted pricing
Loss reduction due to understanding of correlations
Elimination of unwanted exposures
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Challenges in Implementing IRM3
Components for implementing IRM
What is Integrated Risk Management
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IRM Implementation – Important Facets
IT Infrastructure
Risk Communication and Control
Centralised risk function (analytics and management)
New product assessment
Quantification
Aggregation
Risk-adjusted performance measurement
Controls on Risk takers
Risk reportingRisk Policy
Policy Risk Models Performance Measurment
MIS
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Challenges in Implementing IRM3
Components for implementing IRM
What is Integrated Risk Management
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IRM Challenges – identification of gaps in existing risk management practices
Organisation Structure Organisation Structure
Risk Management Policies Risk Management Policies
Management Information Systems Management Information Systems
Information Technology Systems Information Technology Systems
Top Management Oversight Top Management Oversight
Risk Analytics Risk Analytics
Processes and Systems Processes and Systems
Reviewing and improving existingReviewing and improving existing
Credit RiskCredit Risk
Market RiskMarket Risk
Operational RiskOperational Risk
Basel IIBasel II
ALMALM Business RiskBusiness Risk Reputation RiskReputation Risk
Beyond Basel IIBeyond Basel II
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IRM Challenges - measurement of risks
Credit Risk Probability of Default Loss Given Default Exposure at Default
Market Risk Trading Book (VaR) Interest Rate Risk on Banking Book
Operational Risk (evolving)
Credit Risk Probability of Default Loss Given Default Exposure at Default
Market Risk Trading Book (VaR) Interest Rate Risk on Banking Book
Operational Risk (evolving)
Requires collection of data over time, development of measurement models, back testing of models
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IRM Challenges – Risk Aggregation
Correlations among risk silos
OVERALL ECONOMIC CAPITAL
RISK CATEGORY
RISK SILOCREDIT RISK
Corporate
I
Corporate II
Retail P
ool
CorrelationsAcross
Companies
OPERATIONAL RISK
Business Line 1
Business Line 2
Correlations across
Businesses
MARKET RISK CAPITAL
Interest Rate R
isk
Foreign E
xchange Risk
Com
modity R
isk
Correlations across
Asset classes
Equity R
isk
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IRM Challenges - modelling of correlations across risk categories & risk silos
Modelling correlations requires data and is not easy Fat tails in credit risk create problems
Modelling correlations requires data and is not easy Fat tails in credit risk create problems
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IRM Challenges - Improving IT systems
Internal risk scoring models for credit Portfolio Management Models Models for estimating VaR for Market risk Operational Risk databases Asset Liability Management System Data warehouse having interfaces for
Analytical Modelling Reporting
Internal risk scoring models for credit Portfolio Management Models Models for estimating VaR for Market risk Operational Risk databases Asset Liability Management System Data warehouse having interfaces for
Analytical Modelling Reporting
Options for developing Risk Management Systems In-house Off-the-shelf
Options for developing Risk Management Systems In-house Off-the-shelf
Sizeable investments in IT infrastructure required for implementing Basel II
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Thank youThank you
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