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Moving to a Risk-centric approach in banking business

Prof. Angelo TantazziUniversity of Bologna and Chairman of Prometeia

May 25th 2016

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This document is the base for an oral presentation, without which it is

incomplete and can give rise to misunderstandings

any partial or total reproduction of its content is prohibited without written

consent by Prometeia

Copyright © 2016 Prometeia

Disclaimer

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Establishing a proper “risk culture” across the banking organization is vital, in a nutshell, for three main reasons:

1. The improvement of credit process - through more advanced decision tools and a large availability of information - reduces the volume of non performing loans and provisions, with the effect of optimizing P&L and capital preservation

2. As a side effect of the new paradigm, the “risk culture” creates an increasing positive pressure on Corporate / SME customers to strengthen their balance sheets, reduce their debts and improve their capability to plan their growth in a financially sustainable way

3. The improvement of balance sheet management process - through more advanced ALM, liquidity and market risk tools - reduces the volatility of Net Income and maximizes the risk-adjusted return of new business, thanks to the adoption of Risk-adjusted pricing strategies and performance metrics able to identify the most profitable products / lines of business with a medium/long term horizon

Until now, the relative isolation of Iranian Banking Sector from international financial community may have contained the financial stability risks originated by a weak banking infrastructure. Now, with the opportunity for Iranian banks to enter the international financial markets, sound rules of corporate governance and global BCBS regulation must be adopted according to the industry best practices.

Introduction

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The creation of a new “risk culture” in banks and financial institutions“Risk” is the unifying viewpoint for understanding, interpreting and managing banking activity in today’s world. In emerging countries this sets a challenge that requires not only the development of internal processes, competences and IT infrastructures..

..but also a different mindset and managerial approach in: ü evaluating alternative strategic options in steering the banking business ü allocating internal resources, in particular capital and liquidityü setting targets and internal objectives, both for top and line managers

This means:• Evaluating strategic options not only based on their expected economic return (revenues –

costs) but taking also into consideration their implicit risks (i.e. the “volatility” of such return..)• Allocating internal resources to the businesses / products / customers that show the higher

risk-adjusted profitability with a forward looking perspective• Setting targets (typically KPIs) and internal objectives (for people and business units) with the

goal of achieving the optimal trade-off between profits and related risks

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Prometeia collaborates with banks and financial institutions in over 20 different countries - across Europe, Africa and the Middle East - not only to develop the “risk culture” at top management level..

..but also to re-engineer key business processes under a Risk-centric perspective

2. Origination and Underwriting

1. Pricing Strategies

4. Performance Management &

Control3. ALM & Treasury

Management

Risk-Centric

Approach

In emerging markets, Prometeia projects have contributed to the evolution of key managerial & regulatory processes across the entire organization, including:• Credit & Origination• Risk & Compliance• Finance & Accounting• Planning & Control• Treasury & Investment Functions

Prometeia experience in the field of “Risk-centric Change Management”

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Some concrete examples of recent projects across MENA:1. Review of the product pricing model used for commercial business (Retail, Corporate, SME),

based on forward-looking analysis of the risks originated by each lending or funding transactionDeveloped a framework for Risk-based Benchmark Pricing and Fund Transfer Pricing to support the definition of commercial strategies at Group level (Lebanon)

2. Implementation of a Risk-based loan origination process, by integrating credit risk analysis, portfolio monitoring, limit management, RWA / capital assessment

Developed the Credit Origination platform covering also Credit Risk analysis and Credit Decision Management (Egypt)

3. Design of an Asset Liability Management framework aimed at mitigating the volatility of Net Income generated by maturity transformation and repricing mismatch

Developed the ALM framework with focus on Profit Risk Hedging, Liquidity and Funding Risk Management (Saudi Arabia, Tunisia, Turkey, Egypt)

4. Implementation of a Risk-adjusted Profitability Analysis Model aimed at measuring the contribution of the Treasury and Commercial Business Units to Bank’s Net IncomeContribution to the development of an integrated MIS platform supporting medium-term planning, performance allocation and IFRS9 compliance (HA) (Turkey)

Examples of Prometeia projects aimed at Risk Change Management

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Profit RiskLiquidity Risk

Credit Risk

Op Risk

±

Lending Rate

Cost of Funding

Cost of Expected Loss

Cost of Unexpected Loss

Cost of Operational Risk

Operational Costs

Economic Value Added

++++=

Other costs

Market RiskLiquidity Risk

OLD PARADIGMLending / funding conditions are mostly driven by commercial logics and competition dynamics, with no precise quantification of the risks originated by the new business transactions (market, credit, liquidity and operational) and the related costs

NEW PARADIGM: Lending and funding conditions are consistent with the risks originated by new business transactions

(1) Implementing a new paradigm for Product Pricing Strategies (1/2)

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As a consequence of a Rating Model adoption, areas of loans mispricing become more evident, leaving room for improving overall loan portfolio profitability and a proper definition of risk - driven commercial strategies

The Risk-adjusted pricing approach reduces “cross subsidization” effects among customers and enable the bank to optimize the risk – return tradeoff of relationship lending as a whole

Low protection of prime clients with respect to other potential competitors

structural mispricing, absence of a risk-based pricing

Cross-subsidization effects, good clients support bad clients

Key issues

1

2

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1

(1) Implementing a new paradigm for Product Pricing Strategies (2/2)

Average observed spread vs. risk based fair price

0,0%

1,0%

2,0%

3,0%

4,0%

5,0%

6,0%

7,0%

8,0%

9,0%

10,0%

spre

ad

Rating1 2 3 4 5 6 7 8 9 10 11 12 13

Theoretical risk-adjusted pricePrime clients, low risk, with bad

pricing condition

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Worst clients, high risk, with good pricing condition

Average observed credit

spread

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OLD PARADIGMCredit approval processes are mostly driven by commercial logics, “volume” and competition dynamics, with no precise quantification of their impact in terms of provisioning, capital requirements and risk-adjusted performance

NEW PARADIGM: A robust quantitative framework is developed to improve credit quality and credit control processes

• Electronic Credit Application• Early Warning System

short term mid term

• RWA / Capital Impact Assessment• Credit Limit Risk-Adjusted (expected losses)• Credit Portfolio Optimization: EVA, RORAC

• Credit data collection• Rating calculation

Risk infrastructure

Process management

Risk governance

(2) Implementing a new paradigm for Origination & Underwriting

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OLD PARADIGMDelegation of powers for credit decision are usually related to exposure amount (independently from risk / Expected Loss). This naturally brings inefficiency in the credit allocation process and extends the time length for credit decision on less risky credit requests

NEW PARADIGM: risk based delegation of powers improves time to decision and distribute the workloads in the credit supply chain more efficiently

(2) Risk-based Origination process: implications for delegation of powers

Less time/ reduced costs

Better evaluation performance –EL reduction

Number of credit decisions and risk distribution over 1 Year(Medium bank –Corporate portfolio – Case Study)

Authorized: old limit system

Authorized: new limit system

-+ 2.80%0.08%

-0. 50%

-2.30%

Change in risk (Expected Loss Amount )authorized

0

2000

4000

6000

8000

10000

12000

14000

Branch Area 1 Area 2 Credit Department

Top management

-3.90%

Risk amount almost constant among levels

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OLD PARADIGMCredit monitoring processes are often driven by a one - by -one monitoring procedure without a predictive classification model.All credit officers are focused on every potential deteriorating loan, without risk based differentiation and prioritization of efforts

NEW PARADIGM: use of forward looking classification models permits prioritization and to reduce overall exposure at default and cost of risk

- Early warning – Exposure at Default management- Monitoring loan life cycle -

‘Passive’ management

Loan

exp

osur

e am

ount

Active management

Watchilist High risk classification Non Performing

OPPORTUNITY AREA

Watchlist High Risk Liquidation

Time

(2) Risk-based Origination process: implications for monitoring process

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OLD PARADIGMThe evolution of credit portfolio composition is planned by CFO/CRO department only with targets on loan exposure dynamics with an ‘intuitive’ name and sectorial concentration risk management, with lack of transmission of credit guidelines to the network

NEW PARADIGM: use of value-based active portfolio management permits to improve the overall risk adjusted portfolio performance and better steer the origination processes

Risk

Risk adjusted return

Risk-adjusted performance analysis

High return, low risk

Low return, high risk

Average portfolio risk

As-is Target

Portfolio average risk-

adjusted performance

SME segment

Commercial segment

(2) Risk-based Origination process: implications for portfolio management

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The transformation process of Credit Risk governance follows a series of evolutionary stages triggered by the improvement of Risk models and tools

Bene

fit fo

r the

ban

k

Development of risk governance ( ‘partially regulatory driven’)

1st STAGE

• Judgmental Credit Approval process for Corporate

• Scoring for Retail segment

2nd STAGE• First ‘naive’ rating based approach

for Corporate• Delegation of powers related to risk

3rd STAGE

• Rating-based approachintroduction for allcustomer segments

• Origination driven by a Decision Support System

4th STAGE• Monitoring and Early Warning • Risk Driven Pricing process in

place• Active portfolio management

based on risk adjusted measures

(2) Risk-based Origination process: evolution of Credit Risk Governance

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n Loan pricing differentiated with reference to risk (rating, expected loss…)

n Active credit portfolio management based on risk adjusted key risk indicators

ActionsP&L item

Net profit margin

Benefits (case study in bold)

n Cross subsidization effects reductionn Targeting of commercial actions to improve risk /

return ration Up to 10% of loan interest margin (mostly

from retail segment)

Operational costs n Loan process differentiation among customer segments and with relation to risk

n Risk- based credit authorization limits

n Efficiency improvement (with time and cost reduction) in underwriting and monitoring activity

n Reduction of time to decision of 30% after Electronic credit application process and risk based credit authorization limits

Credit provisions / cost of credit risk

n Enhancement of credit decision process (Rating) and definition of risk- based credit authorization limits

n Pro-active exposure at default management (Early risk detection systems)

n Reduction of defaulted counterparties in credit portfolio and related exposures

n Reduction of up to 30% of cost of riskn 80% of Corporate expected losses

concentrated in only 10% of monitored customers

Improving risk management and risk culture is vital for establish concrete impact on profit & loss, leveraging on state-of-the-art credit risk modelling

(2) Risk-based Origination process: expected benefits from new approach

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OLD PARADIGMTreasury activity is focused only on short term liquidity management, interbank funding and optimization of the securities portfolios, with (very) limited involvement in the active management of balance sheet risk for the mitigation of the Bank NI volatility

ASSET LIABILITY MANAGEMENT

STRUCTURALFUNDING

MANAGEMENT

ACTIVE PROFIT RISK

MANAGEMENT

LIQUID ASSET BUFFER

MANAGEMENT

SHORT TERMLIQUIDITY RISK MANAGEMENT

NEW PARADIGM: The Found Transfer Price mechanism allows an efficient “pooling” of profit and liquidity risk within the Treasury, centralizing all ALM & Funding processes

FTP

(3) Implementing a new paradigm for ALM & Treasury Management

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OLD PARADIGMProfitability Analysis is mostly driven by “volumes” and focused on aggregated numbers (bank level), with no forward-looking perspective and limited consideration for the cost of risk generated by the various business segments

NEW PARADIGM: The MIS is designed to assess the risk-adjusted performance of each business segment, in the M/L term

Segment Reporting View

Full Cost Allocation

Cost of Capital per Segment

EVA / RAROC indicators

Level of integration between risk and performance management

Mul

tidim

ensi

onal

ity o

f the

ana

lysi

s

(4) Implementing a new paradigm for Performance Management & Control

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The development of risk-centric paradigms must be complemented with an increasing emphasis on the role of the Chief Operating Officer and the risk function across the banking organization

Improve the CRO role in the

organization

“A well developed CRO department & Risk Functions is crucial for the enhancement of the risk culture throughout the whole organization (Business lines and Top Management)”

Conclusion: the CRO role in improving the Risk governance

1. Base level 3. Advanced Level2. Improved Level

• No CRO: reports to a business line head

• Reports to a CFO or business line executive

• The CRO is a memberof the executive riskcommitte

• The CRO reports directly to the CEO with direct access to the Supervisory Board

• The CRO is a member of the executive board and has veto-power on relevant risk takingdecision

Evolutionary stages

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