Economic & Regulatory Capital

Basel II and Financial Stability Seminar Bali, 21 September 2006

Christian Duesterberg RCM Risk Analytics & Instruments

Risk & Capital Management

Agenda

1. Economic Capital Overview 2. EC Methodology - Credit Risk Example 3. Regulatory Requirements 4. Comparison EC and RC

RCM RAI Christian Duesterberg page 2

Risk & Capital Management

Economic Capital What is it?

Economic Capital (EC) is the amount of capital needed to cover accumulated excess (unexpected) losses over a fixed time period with a set confidence level
Motivation
protects the banks assets against extreme events - stakeholder view protects the banks assets against systematic shock - regulatory view a measure of the amount of capital that a firm believes is needed to support its business activities or set of risks management & shareholder view
reflecting the banks risk appetite enabling business decisions on a risk/return basis
expected loss value at risk

EC

RCM RAI Christian Duesterberg page 3

Risk & Capital Management

Economic Capital How is it used in Banks ?

Credit Risk Market Risk Operational Risk Business Risk

Counterparty defaults

Market movements

Adverse operational events

P&L volatility

Unifying risk measure concept for aggregating different risk types

Performance evaluation of

Business units
Client relationships Portfolio strategies
RCM RAI Christian Duesterberg page 4

Steering of banks risk & capital profile on

Transaction level
Portfolio level

Risk & Capital Management

Economic Capital Benefits for Banking System Stability

Bank specific risk measure including
Concentration risk Systematic drivers Stress testing capabilities Scenario analysis Ex-post performance evaluation Ex-ante relevance for pricing, portfolio management and capitalisation

Sound economic capital methodology provides a good measure of any banks risk in relation to its stated targets => individually healthy banks: stable banking system

RCM RAI Christian Duesterberg page 5

Risk & Capital Management

Economic Capital - Allocation

Q quantile

Expected Shortfall Allocation: EC Contribution of a Business Unit to the Economic Capital of the Bank Average loss of the Business Unit in the tail of the portfolio loss distribution
cec cec cec cec cec

probability

99.98% quantile

portfolio loss

EC Allocation

Expected Shortfall Allocation: Contribution of a Business Unit to the Economic Capital of the Bank = Average loss of the Business Unit in the tail of the portfolio loss distribution
RCM RAI Christian Duesterberg page 6

Portfolio: ESFQ = E[Lportfolio | Lportfolio > quantileQ (Lportfolio)], Business Unit: ESF(BU) = E[LBU | Lportfolio > quantileQ (Lportfolio)]

Risk & Capital Management

Agenda

1. Economic Capital Overview 2. EC Methodology - Credit Risk Example 3. Regulatory Requirements 4. Comparison EC and RC

RCM RAI Christian Duesterberg page 7

Risk & Capital Management

EC for Credit Risk

Borrower Risk Quantification Facility Risk Quantification

Expected Loss

Probability of Default (PD) (%)

Risk rating

Loss Given Default (LGD) (%)

Seniority

Exposure at Default (EAD)

Utilisation of commitment Facility structure Market risk drivers

Collateral type/ value

PD Economic Capital

Industry,

LGD EAD

Country,

Public or Private Entity

Industry + Country indices, Portfolio composition

Client specific
RCM RAI Christian Duesterberg page 8

Portfolio specific

Risk & Capital Management

EC for Credit Risk

Economic Capital Loss Threshold Probability Value at Risk Unexpected Loss

Expected Shortfall
Average

Expected Loss Portfolio Loss

Expected Loss: amount of Portfolio Losses expected in the following year Unexpected Loss: volatility of Portfolio Losses (measured in Standard Deviations) Value at Risk: defined as a quantile Confidence Level: derived from Target Rating Economic Capital: (Value at Risk) minus (Expected Loss) Expected Shortfall: average of large Portfolio Losses (large defined by threshold)

RCM RAI Christian Duesterberg page 9

Risk & Capital Management

EC for Credit Risk

Definition of Portfolio Loss The Loss of Credit Portfolio is a random variable M

Source of Randomness

LP = li LGDi 1( Di )
i =1

1(Di) =

1 if i-th loan defaults 0 otherwise

Rating Country Industry Recovery Collateral

LGDi: Loss-Given-Default li: Exposure-at-Default Limit Outstanding Netting

Time Horizon: Equal to the planning horizon 1 year

RCM RAI Christian Duesterberg page 10

Risk & Capital Management

EC for Credit Risk

Histogram of a Portfolios Total Losses

20

95 % of all cases (19 out of 20)

15
15

12
10

8 6 5
5

Economic Capital
7 6 4 3 2 4 3 2 1
17 18 19 20

4 3 2 2

Expected Loss
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16

Years / Scenarios

RCM RAI Christian Duesterberg page 11

Risk & Capital Management

EC for Credit Risk

Generation of asset return for all counterparties correlated via the factor model

Loss Distribution from Monte-Carlo Simulation

No default

Default

Next counterparty

Add exposure of counterparty to loss after last counterparty Portfolio loss in simulation

Empirical loss distribution

Next simulation after last simulation

Loss distribution (after last simulation)

RCM RAI Christian Duesterberg page 12

Risk & Capital Management

EC for Credit Risk

Correlations
Asset value Obligor 2

Defaults happen if an ability-to-pay of a firm falls below a threshold Default correlations are driven by correlations of Ability-to-Pay processes decomposed into systematic part (correlated to industry
and country factors) specific part
Asset value Obligor 1
Default Threshold 2

Default Threshold 1

Correlations between systematic risk factors are calibrated using equity data

Today

Planning horizon

corr > 0

A= R

weight
j =1

factorj + 1 R
2

CP A

CP B

systematic part (country & industry)

specific part

corr > 0

corr > 0

R2 quantifies the fraction of systematic risk in the counterparty: most important driver of correlation of an obligor
RCM RAI Christian Duesterberg page 13

Factor

Risk & Capital Management

EC for Credit Risk

Correlations: Impact on Loss Distribution

Low systematic risk, e.g. Retail Average systematic risk High systematic risk, e.g. Corporates
[ 1%] [ 10 % ] [ 30 % ] EC(2BP) = 0.51 % of Exp. EC (2BP)= 4.00 % of Exp. EC (2BP)= 16.38 % of Exp.

. 0 0.2

EL

0.4

0.6

0.8

RCM RAI Christian Duesterberg page 14

Risk & Capital Management

EC for Credit Risk

Rating Migration
Two-State
Simulate default state at horizon Loss value in default state

Multi-State

Simulate rating state at horizon

Loss value in rating state

AAA AA

VREF -VAAA VREF -VAA VREF -VA VREF -VBBB VREF -VBB VREF -VB VREF -VCCC VREF -VDef

No Defaul t Loss = 0 2 2 Default Loss = LGD*EAD Today: rating R0 Planning horizon Value with rating R0: VREF

A BBB BB B CCC Default

Default probability depends on initial rating Value in default/no default state

depends only on EAD and LGD

Rating migration depends on initial rating & a migration matrix Value in rating class at horizon depends on cash flow valuation:
dependence on EAD and LGD dependence on maturity, default curve, interest rates

RCM RAI Christian Duesterberg page 15

WP1 Risk & Capital Management

EC for Credit Risk

Vendor Models Similarities and Differences

CreditRisk+ (Credit Portfolio Manager Suisse Financial (KMV) Products) Default losses Downgrade/ Default No Factors through assets values Constant Standard multivariate Random (beta distribution) Simulation Default losses Default No Default rates N/A N/A Loss given default (constant) Analytic

CreditMetrics (Risk Metrics) Definition of Risk Credit Events Includes interest rate risk Risk drivers Transition Probabilities Market value Downgrade/ Default No Country and industry factors

Constant Standard Correlation of credit events multivariate Random (beta Recovery rates distribution) Numerical approach Simulation

RCM RAI Christian Duesterberg page 16

Slide 16 WP1 Please insert / convert to table -needs to be updated corrected.

Wilfried Paus, 8/25/2006

Risk & Capital Management

Agenda

1. Economic Capital Overview 2. EC Methodology - Credit Risk Example 3. Regulatory Requirements 4. Comparison EC and RC

RCM RAI Christian Duesterberg page 17

Risk & Capital Management

Regulatory Requirements
Risk Sensitivity Transparency Simplicity Benchmarking

RCM RAI Christian Duesterberg page 18

Risk & Capital Management

Regulatory Requirements: Credit Risk Parameters

Probability of Default (PD), Loss Given Default (LGD), and Exposure at Default (EAD) are essential for Expected Loss (EL), Economic Capital (EC) and Basel II capital calculation

EL

PD EAD LGD

PD LGD EAD
1 1+ (M 2.5) b(PD) R RWA= 12.5 EAD LGD N N 1(PD) + N 1(0.999) PD 1 R 11.5 b(PD) 1 R

EC

IRBA

RCM RAI Christian Duesterberg page 19

Risk & Capital Management

Regulatory Requirements: Basel II RWA Calculation under IRB Advanced Approach

Exposure at Default Loss Given Default Probability of Default B2 parameter (set by Regulators) Maturity

1 1+ (M 2.5) b(PD) R = R R 1 1 N (PD)+ N (0.999) PD RWA= 12.5 EAD LGD N 1 R 11.5 b(PD) 1 R
2 Basel II DB's internal model

formula displayed is valid for large corporates, banks, sovereigns

Regulatory capital for credit risk = 8%* RWA*SF + Shortfall Basel II underlying model is a single global factor with identical weight 1 for all counterparts Parameter R reflects the asset correlation between counterparts being a function of PD (R decreases with increasing PD differing by asset class) In the limit of reducing DBs factor model to a single factor model, relation between the Basel II defined asset correlation R and the R2 parameter used in DBs capital model:

R
RCM RAI Christian Duesterberg page 20

Basel II

R 2 DB 's

internal

model

Risk & Capital Management

IRB AA: Regulatory Capital Calculation for Credit Risk

Large_Corporate_Banks_Sovereign_with_EL Large_Corporate_Banks_Sovereign_without_EL
600.00%

200,00% 190,00%

Rating
AA A

Maturity Adjustments

500.00%

400.00%

Basel II Capital requirement = IRB AA Capital + EL + provisions

180,00% 170,00% 160,00% 150,00% 140,00%

BBB

BB

CCC

Risk weight

300.00%

130,00% 120,00% 110,00%

CC

200.00%

100,00% 90,00%

100.00%

80,00% 70,00%

0.00%
85 .0 3% 50 .0 3% 55 .0 3% 30 .0 3% 25 .0 3% 10 .0 3% 15 .0 3% 20 .0 3% 40 .0 3% 35 .0 3% 45 .0 3% 60 .0 3% 65 .0 3% 70 .0 3% 75 .0 3% 80 .0 3% 90 .0 3% 95 .0 3% 0. 03 % 5. 03 %

60,00% 50,00% 1 1,25 1,5 1,75 2 2,25 2,5 2,75 3 3,25 3,5 3,75 4 4,25 4,5 4,75 5

PD

Maturity

EL is removed from RWA calculation

Banks have to compare EL with the total amount of provisions that they have made Shortfall amounts are deducted from Tier I and II capital Introduction of scaling factor

Regulatory capital reduction (increase) for loans with maturity under (above) 2.5 years depending on the creditworthiness of the customer Regulatory capital reduction for SMEs (corporates with annual sales up to EUR 50mn) by a firm-size adjustment

RCM RAI Christian Duesterberg page 21

Risk & Capital Management

Agenda

1. Economic Capital Overview 2. EC Methodology - Credit Risk Example 3. Regulatory Requirements 4. Comparison EC and RC

RCM RAI Christian Duesterberg page 22

Risk & Capital Management

Economic Capital vs Basel II Regulatory Capital - Credit Risk

Internal model
Multi - factor model (countries & industries) Competition of different modeling approaches Capital allocated to each borrower reflects risks across the whole portfolio Capital allocation is the result of a default simulation based on:
PD, LGD, EAD, Maturity Correlation with country & industry factors

Basel II
Single factor model for different asset classes (corporates, sovereigns, retail, SMEs) One size fits all model Capital allocated to each borrower in isolation Capital allocation is given by a function of :
PD, LGD, EAD, Maturity Customer type (-> asset correlation)

Risk sensitive capital allocation, i.e. increased capital assignment upon credit downgrade

Full recognition of diversification according to country/industry correlation Penalties for sector or name concentration

Limited recognition of diversification, e.g. no diversification between corporate and retail portfolios Increased procyclicality, e.g., systematic amplification of the economic cycle

RCM RAI Christian Duesterberg page 23

Risk & Capital Management

Dual Management of Regulatory and Economic Capital

Assumptions cause RC to Be too crude a risk measure Exceed EC almost surely => Bank is managed via EC subject to RC constraint Implications for
Transaction pricing Risk assessment Planning Performance dilution

Procyclicality

RCM RAI Christian Duesterberg page 24

Risk & Capital Management

Convergence of Regulatory and Economic Capital

RC and EC Gap reconciliation? Examples for Alignment Potential
Asset correlation parameter R: replace PD by size dependency Diversification: Introduce a basic correlation model across geographical regions and customer types Maturity adjustment: mitigate its conservative effect on long term transactions Confidence Level: give regulatory bodies more flexibility

RCM RAI Christian Duesterberg page 25

Economic & Regulatory Capital

Basel II and Financial Stability Seminar Bali, 21 September 2006

Christian Duesterberg RCM Risk Analytics & Instruments