Financial Integrity, Oversight and

Broadened Capital Markets

Risk Management Review

May 1, 2007
 Outline for today’s discussion
z Introductions
z Review of objectives of risk management sub-
component and specific tasks
z Overview of Risk Management
¾ Definitions and terminology
¾ CreditRisk
¾ Operational Risk
z Discussion of your ideas and objectives
z Next steps
 Sarah (“Sally”) W. Hargrove
z Native of North Carolina
z Wharton MBA, CFA
z Thirty years of experience in investment and commercial
banking in NY, NC and PA
z Top bank regulator in Commonwealth of PA for banks,
savings institutions, licensed lenders
z Consulting for past 12 years in primarily emerging markets
(technical assistance and training in bank appraisals, risk
management and corporate governance)
z Worked with CBJ on risk management, early warning
system, and corporate governance
General objectives of risk
management sub-component
z Address practical issues for implementation
of risk management systems for BIS II
compliance
z Build risk management capacity in Jordanian
banks by providing useful tools and solutions
to practical problems
z Provide roadmap for evolution to IRB
(Foundation) in 2012
Objectives for first phase of risk
management sub-component
z Conduct kick-off session to identify practical
problems in implementing risk management
and BIS II
z Follow up with private interviews
z Work with interested banks to develop
methodology for standardized risk rating
system
z Conduct risk management diagnostics
Today is a kick-off

z Provide general overview of risk and risk

management
z Establish a baseline of risk knowledge,
common terminology and understanding of
BIS requirements
z Provide overview of different credit rating/risk
measurement approaches
z Hear from you
Follow-up individual or group
meetings as requested
z Develop methodology for creating a
standardized internal risk rating system
z Conduct individual bank diagnostics
¾ Gap analysis
¾ Focus on policies and procedures
¾ Reports for monitoring
¾ Organizational structure
Certain principles rule financial
intermediation in free markets
z Supply and demand
¾ Interest rate as the “clearing price”
¾ Opportunity cost of consumption/investment

z Rational investors
¾ Risk averse
¾ Maximize return/Minimize risk

z Efficient markets
¾ Allocation of resources
¾ Information impounded in prices
¾ Competition
Perceived risk is based on
historical or expected volatility
160
140
120
100
Series1
80
Series2
60
40
20
0
1 2 3 4 5 6 7 8 9 10
Universally risk is defined by
volatility
Features
Features

ƒ Normal distribution
ƒ Skewed distribution
ƒ Range
ƒ Variance
ƒ Standard deviation

Tail Probability =
2.5%

Distribution of actual or expected occurrences

The higher the risk, the higher the
required rate of return
z Required rate of return determines the price
¾Current income stream
¾Capital appreciation
z Perceived risk determines the required return
¾The greater the historical volatility the greater the
risk
¾The greater the uncertainty the greater the risk
¾The longer the horizon the greater the risk
Risk is priced by the discount
rate: absolute and relative
MV=PV = Σ C + TV
t=0-n (1+r)t (1+r)t
Rate of Return
CCC
Common Stock
B
Risk BB Conv. Preferred
Premium Preferred Stock
BBB Income Bonds
A
Subordinated Debentures
AA 2nd Mortgage Bonds
AAA First Mortgage Bonds
Treasury Bonds
Risk Free
Rate
Level of Risk
Risk measurement allows us to
make a trade-off with return
Expected Return C

B
A

Risk/Standard Deviation
There is risk-reward trade-off
inherent in financial intermediation

z Short-term vs longer-term
z Liquidity
z Floating vs fixed rates
z Credit
z Leverage

Risk is defined as volatility in earnings

and/or capital
Capital needs to support major
risks in financial institutions
On and off balance sheet
Credit Risk credit exposures

Interest rate and equity

risk in trading book; FX
Market Risk and commodity risks in
banking and trading books

Primarily failed
processes or event risk
Operational risk (not strategic or
reputational risk)
So how much capital does a
financial institution need?

“Enough…but not too

much.”
What is enough capital?
z Capital protects depositors and creditors
¾Safety and soundness
¾Supports growth
¾Is a buffer against losses
¾Can be in the form of non-equity

z Equity capital represents owners’ interests

¾Last creditors to be paid in liquidation
¾Requires a return in cash income and appreciation
¾Retained earnings are a good source of capital
 What is too much capital?
z Capital is a non-interest bearing source of funds
¾ Equity capital is the most expensive source of funds
¾ Must earn a required rate of return (ROE)
¾ Is a scarce resource

z Management’s goal is to maximize risk-adjusted

returns
¾ Competes with risk-free rate and alternative
investments
¾ Affects pricing and competitive position if too much
Capital adequacy is in the eyes
of the beholder
Focusisishistorical
Focus historicalcost
costof
of
z Accounting capital assetsand
assets andrecognition
recognitionof of
impairment(fair
impairment (fairvalue)
value)

Focusisisincome,
Focus income,the
the
z Market capital market’sexpectations
market’s expectations
andrequired
and requiredreturn
return

Focusisismarket
Focus marketvalue
value
(PVof
(PV ofcash
cashflows)
flows)ofof
z Economic capital assets/liabilities
assets/liabilities

Focusisisbalance
Focus balancesheet
sheet
andincome
and incomerisk
riskand
and
z Regulatory capital capitalcomponents
components
capital

BIS II attempts a more precise calibration of economic and

regulatory capital
In a perfect market the different
capital values would be equal
z Book values represent present values of future
cash flows discounted at current required rates
of return
z Market values of capital stock reflect net present
values
z Economic capital is the same as net book value
z Regulatory capital would be a realizable value
of assets in excess of liabilities
Capital requirements can be a
competitive advantage
Japanese Bank US Bank

Loan USD 100 million USD 100 million

Net interest margin .6% 1.25%
Income USD 600,000 USD 1,250,000

Capital 2% 6%

USD 2 million USD 6 million

ROE 30% 20.8%
BIS II permits banks to customize
capital adequacy assessment

z Align regulatory capital requirements more

closely with underlying risk
z Emphasis is on banks’ risk management and
economic capital allocations
z There is flexibility in assessing capital
adequacy: standardized vs. IRB approaches
Capital must be allocated to
support major banking risks
Credit Risk
• Standardized Approach
• IRB Approach
• Foundation
• Advanced

Minimum
Market Risk 8% of Capital to
• Standardized Approach Risk-Weighted
• Internal Models Approach Assets

Operational Risk
• Basic Indicator Approach
• Standardized Approach
• Internal Measurement Approach
Capital adequacy is a function of
three pillars
Pillar 1: Minimum Capital
• Internal capital assessment process
and control environment
• Capital f (how sound the process is)
Mutually
reinforcing
Pillar 2: Supervisory Review factors that
• Review assessment process determine capital
• Evaluate IRR in banking book adequacy

Pillar 3: Market Discipline

• Formal disclosure policy
• Describe risk profile, capital levels, risk
management process and capital
adequacy
Ultimately the financial market is
the harshest regulator
Quantitative Requirement Qualitative Requirement

Minimum Capital Supervisory

Requirement Review Process

•• Manyplayers
Many players

•• Selfinterested,
Self interested,
rational
Market Discipline rational
• • Independent
Independent

• • Real
Realtime
time

Public Disclosure
Capital required is a function of
the quality of information
z The less the history, the less reliable the
data
z The less certain or transparent, the greater
the risk
z The more the risk, the more capital needed
z All the above implies higher capital levels
for some institutions in less mature markets
Capital absorbs unexpected
losses and supports growth

“Capital is not a substitute for inadequate

control or for risk management
processes.”
- Bank for International Settlements
Assumption of risk is the raison
d’etre of banking

ƒ Banks make money by assuming risk

ƒ Banks lose money by not managing risk or

by not getting paid for the risk assumed

ƒ Banks manage what they measure

A formalized risk management
framework is best practice

Risk Management is the deliberate

acceptance of risk for profit – making
informed decisions on the trade-offs
between risk and reward and using
various financial and other tools to
maximize risk-adjusted returns
within pre-established limits.
A Risk Management facilitates
informed decision-making

Identify

Measure

Manage

Monitor
Risk Management is now basic
to financial management

“The nature of Risk Management in banks is changing

fundamentally. Until recently, it has been an exercise
in damage limitation. Now it is becoming an
important weapon in the competitive struggle
between financial institutions.

Those who can manage and control their risks best

will be the most profitable, lowest priced producers.
Those who misjudge or mis-price will be out on their
ear.”
The Risk Game
The Economist, Survey of
International Banking (1996)
Risk management permits risk-
reward trade-offs

The primary objective is to minimize the

volatility of earnings and capital (hence the
risk as perceived by investors) and at the
same time earn a ROE to maintain the value
of the common equity.
Risk management permits better
performance measurement
TRADITIONAL RISK-ADJUSTED
PERFORMANCE MEASURES PERFORMANCE MEASURES

•• Asset
Asset volume/growth
volume/growth •• Contribution
Contribution net
net of
of expected
expected
losses
losses
•• Revenues
Revenues
•• RAROC
RAROC
•• Contributions
Contributions
•• EVA
EVA or
or SVA
SVA
•• ## New
New customers/clients
customers/clients

•• Growth
Growth in
in poor
poor quality
quality loans
loans •• Booking
Booking of of low
low grade
grade assets
assets
only
only ifif compensated
compensated with
with
•• “Adverse
“Adverse selection”
selection” higher
higher margins
margins
•• Thin/insufficient
Thin/insufficient margins
margins •• Focus
Focus on
on risk/reward
risk/reward ratios
ratios
The focus is on management…
not control
Risk Control Risk Management

• Avoid •Absorb/reserve

• Decrease •Hedge/Transfer

• Limit •Sell/share

•Insure

•Price for

•Limit
Emphasis is on Quantity of risk
and Quality of management
What risks, how much and
What risks and how much how well managed

•• Loan
Loan Rating
Rating •• Loan
Loan Rating
Rating
•• VaR
VaR reporting
reporting •• Value
Value at
at Risk
Risk analysis
analysis
•• Mark
Mark to
to Market
Market •• Risk
Risk self
self assessments
assessments
•• Portfolios
Portfolios •• Operating
Operating risk
risk analogs
analogs

Historical Analysis Historical Analysis and

Forward modeling
Benefits of integrated risk
management
z Promotes and strengthens a consistent risk culture
z Clear, consistent position on risk enhances market image
z Supports the efficient use of financial and human
resources for maximum risk-adjusted returns
z Facilitates the dissemination of multi-dimensional risk
knowledge and expertise to where it makes a difference
z Provides corporate level overview of risks and risk trends
for strategic and business planning
z Enables performance evaluation on a risk-adjusted basis
Elements of integrated risk
management
z Common language
z Consistent measurement and methodologies
z Integrated processes
z Clear roles and responsibilities
z Excellent training and communications
z Technology supported-MIS a key driver
z Not bureaucratic—enabling, not controlling
Risk management philosophy
z Manage risks at source: Primary responsibility
for risk decisions are at the businesses
z Within businesses, segregation of responsibility
for risk management and for customer
profitability
z Risk management is a culture issue:
volunteerism
z Risk management policies and practices should
support business goals
Ownership of risk is a key driver to
assuring all risks are managed

“Every risk needs an owner”

Risk management framework
integrates several areas

Internal Audit

Credit Risk Management

ALM Treasury
Management
 Management decisions are
iterative and continuous
Business Set Policies and Objectives (including FTP rules)
strategy &
credit policy

Gather Develop and Collect and

External Assess Analyze
Interest Rates
Information Scenarios Internal data
FX rates
Economy
Competition

Set Set Set Set investment

Liquidity Interest FX and earnings
Policy rate Exposure management
position position guidelines

Execute

Drives strategy and credit risk management

Source: Booz-Allen & Hamilton

Good risk policies address all
identified risks
z Assign responsibilities and duties
z Define risk measures
z Set risk limits
z Specify how to handle exceptions to limits
z Set times for review and revision
z Set how and when the process should be
audited
z Receive Board of Directors’ approval
Critical success factors for good
risk management
z Executive level commitment and leadership
z Education and communication
z Clear roles and responsibilities
z Risk management must support business
activities and goals—managing risks for
rewards
z Information-based decisions
z Understandable measurements
Risk management is an integrated
process
Systems
• Data extraction
• Data transfer links
• Data mapping
• MIS support

Policies & Methodologies

Processes Risk • Grading / Scoring
• Approval Management
• Limits / Control • Calculators
• Reports • Capital attribution
• Disclosure
Organization
• Independence
• Audit
• Education
• Performance Evaluation
RAROC drives BIS Pillar 1
RAROC: Risk-adjusted return on capital

Revenue less funding and Predictable losses are

other costs expensed

Profit _ Provisions
RAROC =
Economic Capital

The cushion needed to

support Unexpected Losses
RAROC allows management to make
proper risk-reward trade-offs
Loan/Product/Branch Pricing guidelines

Interest
Interestand
andfee
feeincome
income xxx
xxx FTP
Less
Lesscost-of-funds
cost-of-funds (xxx)
(xxx)
Net
Net interestincome
interest income xxx
xxx
Less
Less “expectedloss”
“expected loss” (xxx)
(xxx) Credit analysis
Less
Less non interestexpenses
non interest expenses (xxx)
(xxx)
Pretax
Pretaxincome
income xxx
xxx Direct and allocated
Less
Lesstaxtax (xxx)
(xxx) indirect costs
xxx
xxx

Divided
Dividedby
byEconomic
Economic xxx
xxx Allocated capital
Capital
Capital

RAROC
RAROC X%
X%
Applied to hurdle rate
Capital assessments must be
consistent with how operate
Return RAROC

Efficient
Frontier

• Business Units,
Sub-Portfolios,
• Transactions
•

Risk
•
Free
Rate

Risk
One of the most difficult aspects of
RAROC is the assignment of EC

z RAROC uses a bank’s own allocation

z RORAC uses BIS assigned weights
z The more the capital the more the perceived
risk of the asset….but more conservative and
less risky the bank
z The more the capital the higher the required
return from the asset
Credit risk rating system
provides RAROC input

z Standardized Approach
z Internal Ratings Based Approach
¾ Foundation

¾ Advanced
What is credit risk?
“The risk that a borrower will not pay what we lent – in full
and on time”

The potential that a bank borrower or counterparty will fail

to meet its obligations in accordance with agreed terms
“Principles for the Management of Credit Risk” - BIS 1999

Must also include all threats to value, in a probability / net

present value sense; e.g. deterioration in quality
throughout the life of the loan is a credit risk in itself
Credit risk affects both capital and
earnings
Foregone Interest and provisions
And mark-to-market losses

The primary objective is to minimize the volatility

of earnings and capital (hence the risk as
perceived by investors) and at the same time earn
a ROE to maintain the value of the common
equity.

Losses in economic capital

Good credit risk management a
competitive advantage

Identify

Measure And price appropriately!

Manage

Monitor
Credit risk measurement takes
different forms
z Expert systems
z Credit scoring models
z Rating systems
¾ CAMELS
¾ Pass, OLEM, Substandard, Doubtful, Loss
¾ Public bond ratings
 Credit rating methodologies are
on a continuum
Judgment Template Scoring Model

Final ratings are Graders are Grades are

Grades are set ultimately provided a derived purely
judgmentally judgmental, but “scoresheet” mechanically,
against a set graders are which combines a with no role for
of qualitative provided with a set of objective subjective inputs
guidelines “template” of characteristics
quantitative with subjective
benchmarks for factors in a
each rating predetermined
category manner
Altman Z score is one of earliest
credit models
RATIO FORMULA WEIGHT FACTOR WEIGHTED RATIO
Earnings Before Interest and
Taxes
Return on Total Assets ---------------------------------------- x. 3.3 -4 to +8.0
-
Total Assets
Net Sales
----------------------------------------
Sales to Total Assets x 0.999 -4 to +8.0
-
Total Assets
Market Value of Equity
----------------------------------------
Equity to Debt x 0.6 -4 to +8.0
-
Total Liabilities
Working Capital
Working Capital to Total ----------------------------------------
x 1.2 -4 to +8.0
Assets -
Total Assets
Retained Earnings
Retained Earnings to Total ----------------------------------------
x1.4 -4 to +8.0
Assets -
Total Assets
Credit analysis drives the credit
risk assessment of all methods

Both the ability and the

willingness to pay are key
There are two basic elements
of credit risk
z Standalone risks
¾ Default probability
¾ Loss given default
¾ Migration risk

z Portfolio risks
¾ Default correlations
¾ Exposure

Credit risk management means

diversifying and transferring risk
 Industry sector

Competitive position

Mgmt. / organization

Financial strength
depends on many factors
Standalone creditworthiness

Cash flow/ debt serv.

Data drives the credit analysis
Category Data Required Data Sources

Industry ♦ Industry profile -- 3 years ♦ Internal

◊ Size, growth ◊ Files
◊ Concentrations ◊ Research department
◊ Cyclicality/seasonality ◊ Other managers familiar with industry
◊ Explanation of trends ♦ Third parties
♦ Industry outlook ◊ Ministries
♦ Profiles of key competitors (top two) ◊ Multilateral agencies -- World Bank,
♦ Regulatory profile -- current, recent changes, IADB, etc.
expected changes ◊ Other government organizations
♦ Borrower’s strategy ◊ Trade associations
♦ Key alliances: ◊ Other banks
◊ With government ◊ Other companies in industries
◊ With private sector ♦ External -- customer calls
◊ With other influential players ♦ Business press

Financial ♦ Company financials -- 3 years ♦ Internal

Condition ◊ Profit & loss statements, balance ◊ Files
sheets ◊ Other managers familiar with borrower
◊ Supplementary statements -- ♦ Issuer
reconciliation of net worth, fixed assets\ ◊ In person calls
◊ Audited where possible ◊ Site visits
♦ Creditor facilities
◊ Banks amounts and condition
◊ Suppliers of facilities

s
example
SAMPLE DATA COLLECTION
 Quantitative modeling provides
the basis of the analysis

Input Calculation Output

Economic
Economic Individual
Individual Aggregation
Aggregation to
to Calibrated
Calibrated
Raw
Raw data
data Interpretation
Interpretation Scores
Scores overall
overall Score
Score Rating
Rating (PD)
(PD)

• Financials • Ratios • Scale • Weights fixed • Calibration

• Assessment of comparable (e.g. linear fixed
qualitative for all factors algorithm)
Factors

May be different by segment

(size, state -owned /private, industry, available information)
There are two major factors to
consider…

What is the likelihood a borrower will default?

Probability [%]

If the borrower defaults, how much are we likely to lose?

Amount [JOD or %]
BIS II has led to a new generation
of statistical rating models
z Three measures for credit risk
¾ Standardized using external ratings for risk weights
¾ IRB: Foundation and Advanced

z IRB uses banks’ own rating systems with

required features
z Provisions should equal expected loss where
EL = PD * LGD * EAD
z Capital must be held for UL
Probability of Default (PD) is
based on historical experience
X Corporate Loans
Y Credit Cards

Standard
-4 -3 -2 -1 0 1 2 3 4 Deviation

X = 2% X = 4%
Y = 4% Y = 5%
Databases of historical defaults
are maintained by ECAIs
• S&P
• Moody’s
• Fitch
• Dun & Bradstreet
• Others
Supervisors assign ratings to
risk weights for standardized

S & P RATING MOODY’S DEFAULT PROBABILITY

EQUIVALENT (SUBSEQUENT YEAR)
AAA Aaa 0.01%
AA Aa3/A1 0.03%
A As/A3 0.10%
BBB Baa2 0.30%
BB Ba1/Ba2 0.81%
B Ba3/B1 2.21%
CCC B2/B3 6.00%
CC B3/Caa 11.68%
C Caa/Ca 16.29%
Hindsight is perfect….but how
do we predict default?
Data lets us generalize about a
similar population

Example: Life insurance company

How we can we classify

individuals into broad risk bands
to manage our actuarial risk?

?
How do we discern the predictive
risk variables?
Example: Life insurance company

Set
hypothesis
• Age
Examine • Male / female
experience • Smoker / non-smoker
• Obesity
• Family history
Select
variables

Test
predictability

Test and
Calibrate
Analysis of the data
Risk factor: Obesity
Set
100
hypothesis 80

60

40

Examine 20

experience 40 k 60 k 80 k 100 k 120 k 140 k 160 k 180 k

90

Select 80
70

variables 60

50
40
30

20

Test 10
0
40 k 60 k 80 k 100 k 120 k 140 k 160 k 180 k

predictability
90

80
70

Test and 60
50

Calibrate 40
30
20
10

0
40 k 60 k 80 k 100 k 120 k 140 k 160 k 180 k
Larger populations and more
reliable data = more confident
The most reliable are consumer
credit scoring models
:
Example s
ard
Credit C
100
80 100
60 80 100
40 60 80 100
20 40 60 80 100
0 20 40 60 80
1 2 3 4 100
5 6 7 8 9 10
0 20 40 60 100
1 2 3 480 5 6 7 8 9 10
0 20 40
60 80
1 2 3 4 5 6 7 8 9 10
0 20
40 60
1 2 3 4 5 6 7 8 9 10
0 20 40
1 20
2 3 4 5 6 7 8 9 10
0
10 2 3 4 5 6 7 8 9 10
1 2 3 4 5 6 7 8 9 10

Examples of
predictive factors
for credit cards
Not surprisingly, such models can
drive the whole credit process
100
80 100
60 80 100
40 60 80 100
20 40 60 80 100
0 20 40 60 80
1 2 3 4 100
5 6 7 8 9 10
0 20 40 60 100
1 2 3 480 5 6 7 8 9 10
0 20 40
60 80
1 2 3 4 5 6 7 8 9 10
0 20
40 60
1 2 3 4 5 6 7 8 9 10
0 20 40
1 20
2 3 4 5 6 7 8 9 10
0
10 2 3 4 5 6 7 8 9 10
1 2 3 4 5 6 7 8 9 10

• Planning
• Marketing
• Approval
• Pricing
• Monitoring
• Collections
• Provisioning
Design, integrity, maintenance, and
validity of the model is the core
100
80 100
60 80 100
40 60 80 100
20 40 60 80 100
0 20 40 60 80
1 2 3 4 100
5 6 7 8 9 10
0 20 40 60 100
1 2 3 480 5 6 7 8 9 10
0 20 40
60 80
1 2 3 4 5 6 7 8 9 10
0 20
40 60
1 2 3 4 5 6 7 8 9 10
0 20 40
1 20
2 3 4 5 6 7 8 9 10
0
10 2 3 4 5 6 7 8 9 10
1 2 3 4 5 6 7 8 9 10

zBacktesting

zStress testing
zValidation
Potential losses should be priced
in our rates

Expected
loss = ?

How much we expect to lose (probability) on a credit or group of credits

May be expressed as a per cent or an absolute number

Often abbreviated as “EL” – also known as “ROL” (risk of loss)

Expected loss is a function of
three variables

Expected Probability Loss given Exposure

loss = of default
x default
x at default
Let’s calculate a simple example

Expected Probability Loss given Exposure

loss = of default
x default
x at default

Rating PD % LGD % EaD %

1 0.01 0 100
2 0.03
10
3 0.05
25
4 0.25
5 0.70 50
6 1.50
75
7 6.00
8 20.0 100

9 50.0
10 100.0
In per cent…

Expected
.03 or 3% Probability
.06 Loss.50
given Exposure
1.00
loss = of default
x default
x at default

Rating PD % LGD % EaD %

So if the credit is JOD
7,000, EL for that 1credit0.01
is 0 100
JOD 210 (3% x 7,000)2 0.03
10
3 0.05
25
4 0.25
5 0.70 50
6 1.50
75
7 6.00
8 20.0 100

9 50.0
10 100.0
… or in numbers

3%210
JOD .06 .50 JOD
1.00
7,000
= x x

Rating PD % LGD % EaD %

1 0.01 0 100
2 0.03
10
3 0.05
25
4 0.25
5 0.70 50
6 1.50
75
7 6.00
8 20.0 100

9 50.0
10 100.0
The standalone EL’s can be
aggregated for the whole portfolio
100
90
80
100 70
90 60
80 50
70 40
60 30
20
50
10
40
100 0
90
30
1 2 3 4 5 6 7 8 9 10
80 20
70 10
60
50
0
40 1 2 3 4 5 6 7 8 9 10
30
20
10
0 90
1 2 3 4 5 6 7 8 9 10 80
70
60
50
40
Probability 30
20
10
0
1 2 3 4 5 6 7 8 9

Losses
Over time actual can be
compared to expected losses
100
90
80
100 70
90 60 100
80 50 90
70 40 80
60 30 70
20 60
50
10 50
40
100 0 40
30 100
90 1 2 3 4 5 6 7 8 9 10
20 30 90
80

?
70 10 20 80
60 10 70
0
50
1 2 390 4 5 6 7 8 9 10 0 60
40
1 2 3 4 5 6 7 8 9 10
30
80 50
20
70 40
10
0 60 30
1 2 3 4 5 6 50 7 8 9 10 20
40 10
30 0
20 1 2 3 4 5 6 7 8 9 10
10 100

0 80
1 2 3 4 5 6 7 8 9
60

40

20

1 2 3 4 5 6 7 8 9
EL are “predictable” – UL losses
(i.e. volatility) represent true risk
Expected
Expected Loss
Loss (EL)
(EL)
•• Anticipated
Anticipated average
average loss
loss
rate
rate
•• Foreseeable
Foreseeable “cost”
“cost”
•• Charged
Charged through
through
income statement
income statement

Unexpected
Unexpected Loss
Loss (UL)
(UL)
•• Anticipated
Anticipated volatility
volatility of
of
loss rate
loss rate
•• True
True “risk”
“risk”
•• Captured
Captured through
through
assignment
assignment of
of capital
capital
The greater the variance, the
more capital required
Unexpected Loss Requires capital support - as a cushion

Mean “expected” Loss

Probability
of Loss
Unexpected Loss
(Standard Deviation)

Amount of
Loss
The amount of capital depends
on target debt rating

Mean “expected” Loss

Unexpected Loss
( 1 Standard
Deviation) Required Capital

Solvency
Standard
BBB A AA AAA
.03 .01 .003 .001

Total “Economic” Capital = Reserves + Equity Uncovered Risk

Credit analysis drives the PD but is
only one component of risk
Based on Feedback
Credit Analysis
analysis & identified loop and Structuring Feedback process:
comparative standards annual review &
experience

Risk Rating:
Borrower and Facility Loss Given Default

A function of
analysis and
structuring

Probability Exposure
of Default at Default

Based on
historical risk
rating data Expected Loss

EL=PD x LGD x EAD

Credit risk analysis is an
evolving field
z Quantitative modeling includes
structural and reduced form models
z Credit risk management means
diversifying and transferring risk
z Research continues to integrate new
asset classes and correlations
The Control Environment is an
important part of risk management
Control Environment

Internal Audit Internal Control

Independent review to Management control of day-to-

ensure controls working as day activities including:
intended, risks are controlled •Policies and procedures
and operational inefficiencies
are identified during: •Segregation of duties

•On-site reviews •Authorities and approval limits

•Off-site reviews •Checking procedures

•Supervision of transactions and
Enforces recording
•Budget controls
Operational risks are classified as
either “event” or “business” risks
z All non-credit and non-market risks
¾“Routine processes”
¾Payments/Settlements
¾Documentation
¾IT, regulatory, legal, fraud
¾Strategy and planning
z Managed by organizational and other internal
controls
¾Segregation of duties and dual controls
¾Internal audit scope, procedures, findings and
responses
¾Self-assessment process
Communications is key!

“An effective internal control system requires

effective channels of communication to ensure
that all staff fully understand and adhere to
policies and procedures affecting their duties and
responsibilities and that other relevant information
is reaching the appropriate personnel.”

Bank for International Settlements, Framework for Internal Control

Systems in Banking Organizations
Internal audit is an important
component

z Third line of defense

z Business partner not adversary
z Separate from risk management oversight
z Responsible to ensure that controls and
limits are working
Next steps

z Individual interviews
z Diagnostic reviews
z Standardized risk rating system
¾Individual
¾Workshop ?
z Sarah (Sally) Hargrove
[email protected]
[email protected]
Tel: 550 3069 Ext. 149