Integrated Risk architecture: Implementation Issues

FICCI - IBA conference on Global Banking paradigm shift on October 5th 2005

What is Integrated Risk Management

Components for implementing IRM

Challenges in Implementing IRM

Three key imperatives for Banks Management

Growth

Capital Adequacy

Profitabilit y

Differing requirements from various stakeholders Employees Borrowers Regulators Credit Rating agencies Counterparty banks Depositors Investors

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.

Profitability Analysis Bank ABC

Profitability Analysis Average Assets Interest Income Interest Expenses Net Interest Margin Other Income Less: Provisions Total Contribution Contribution (LKR Mn) Total Contribution Operating Expenses Share of Profit from subsidiaries PBT Tax PAT Credit Investments 51840 35064 7.9% 3.6% 4.3% 1.9% 1.3% 4.9% 2548 8.5% 3.6% 4.9% 1.3% 0.0% 6.3% 2204 4526 3975 197 749 70 679 Others 10597 1.5% 3.6% -2.1%

-2.1% -226

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?

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?
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Risk Exposures Bank ABC

Liabilities Deposits from customers Deposits from Banks Total Deposits Borrowings Group balances payable Deferred Tax Liability Tax Payable Other Liabilities Subordinated Debentures Total Liabilities Shareholders Equity Share Capital Permanent Reserve Fund Reserves Total Equity Total Liabilities & Equity 31/12/2003 77312 188 77500 10923 397 0 26 4887 520 94253 1082 609 4056 5747 100000

Assets Cash & Short Term Funds Balances with Central Banks T Bills and other eligible securities Placement with and loans to other banks Bills of Exchange Loans & Advances Lease Rentals receivable within one year Lease Rentals receivable after One year Dealing Securities Equity & others Bonds Investment Securities Investment Properties Investments in Subsidiaries & Associates Accrued Intt Cheques Purchased Other Assets Other Assets Group balances receivable Property Plant & Equipment Total Assets 31/12/2003 1739 3305 5756 10987 2493 44222 96 72 587 916 17664 18580 804 1667 1073 2979 3331 7382 503 1807 100000

Credit Risk

Market 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

How does this affect us?

Increasing Complexity & Size
Current Environment

Future Environment

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: 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

RAROC - Base for Integrated Risk Management

RAROC allows a bank to take a comprehensive risk view and forms the base for IRM
Risk-adjusted After tax income 1.75% Risk-adjusted Net income 2.20% Net Tax 0.45%

Risk-adjusted income 5.60 % Costs 3.40 %

Income 6.10 % Expected Loss 0.50 %

Risk-adjusted Net income 1750

RAROC 22%

Average Lending assets 100,000 Credit Risk Capital 4.40 % Total capital 8.0 %

Total capital 8000

Market Risk Capital 1.60 %

Operational Risk Capital 2.00 %

RAROC could be carried out for the bank as a whole or a business segment.
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Integrated Risk Management in a Bank

What is Integrated Risk Management?

Organisation Structure

Measure, monitor and manage all the risks across the bank.
Bank wide integrated risk management infrastructure in terms of people, policies and systems

Integrated Risk Manageme nt

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
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Compliance

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

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What is Integrated Risk Management

Components for implementing IRM

Challenges in Implementing IRM

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IRM Implementation Important Facets

Policy Risk Models
Aggregation

Performance Measurment
Controls on Risk takers

MIS

Risk Policy

Centralised risk function (analytics and management)

Quantification

Risk-adjusted performance measurement

Risk reporting

New product assessment

IT Infrastructure

Risk Communication and Control

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What is Integrated Risk Management

Components for implementing IRM

Challenges in Implementing IRM

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IRM Challenges identification of gaps in existing risk management practices Reviewing and improving existing

Information Technology Systems

Risk Analytics Organisation Structure

Basel II Credit Risk

Market Risk
Risk Management Policies Management Information Systems Top Management Oversight Processes and Systems

Operational Risk Beyond Basel II ALM Business Risk Reputation Risk

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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)

Requires collection of data over time, development of measurement models, back testing of models
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IRM Challenges Risk Aggregation

Foreign Exchange Risk

Interest Rate Risk

Commodity Risk

Business Line 1

Business Line 2

Corporate II

Equity Risk

Retail Pool

Corporate I

RISK CATEGORY

Correlations across Asset classes

Correlations Across Companies

Correlations across Businesses

MARKET RISK CAPITAL

CREDIT RISK
Correlations among risk silos

OPERATIONAL RISK

RISK SILO

OVERALL ECONOMIC CAPITAL

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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
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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 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 you
CRISIL Investment & Risk Management Services CRISIL Limited dravishankar@crisil.com Ph.no: 91 22 56537371

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