1
Integrated Risk Management and Performance Measurement
Banks at Cross-Roads
2IPM Solution Set - Integrated Performance Measurement
Pro
cess
Ree
ngin
eeri
ng Project M
anagement
Technical Infrastructure
SVM
EconomicCapital
OperatingProfit
Risk Profit & Loss
OperationalData Store
GeneralLedger
AnalyticalEngines Data
Warehousing
Middleware
Op.Risk
Cr.Risk
Mkt.Risk FTP Cost Rev.
EP
RAPM
3
1980s
Focus on Revenue and Cost Management
Mark-to-market
Activity-basedcosting
Transferpricing
1990s
Focus on Risk Control
Historic Focus
Value at risk
Risk-adjustedperformance
Portfoliomanagement
2000+
Bring togethermanagement of
profitabilityand risk under thecommon objective
of generatingShareholder Value
Fully integratedprofitability andrisk information
Forward-looking,not just static,
management tools
This is what mostUniversal Bankswant to achieve
It is the completion of a process long since started in most FIs
Current Management Philosophy Is Directed by Historical Information and Does Not Emphasize Forward-looking Approaches to Decision Making
4
Risk Measurement
Operational Risk
Credit Risk
Market Risk
Risk Measurement Methodologies
5
Secondary risks capture risks from other market characteristics
Primary market risks result from movements in financial markets
Liquidity risk results from the inability to receive fair value
Market Risk
Risk Management Methodologies
6
Market/ Position Risk = ƒ • Future Market Value
Distributions
• Position Risk Horizons
• Correlation Between Positions
Risk Management Methodologies - Market VaR
Market Value-at-Risk (VaR)
n
7Risk Management Methodologies - Market VAR
VAR
MTM Losses MTM Gains
“1 in 40 Loss”
99.5% confidence (approximately three standard deviations)
97.5% confidence (approximately two standard deviations)
83.0% confidence (approximately one standard deviation)
Risk Management Methodologies - Market VaR
Value-At-Risk represents the “worst case” loss
8
Increasing Sophistication
Increasing Sophistication
1. Notional Amount at Risk
2. Basis Point Value (BPV) Approach
3. Value-At-Risk (VAR) at Instrument Level
4. Value-At-Risk (VAR) with Correlation
Risk Management Methodologies - Market Risk Measurement Techniques
9Risk Management Methodologies - Market VAR
Approaches to Calculating Value-At-Risk
Mean Covariance Approach
Mean Covariance Approach
Historical SimulationHistorical Simulation
“What if”Analysis“What if”Analysis
Monte Carlo
Simulation
Monte Carlo
Simulation
Scenario Based Approaches
Risk Management Methodologies - Market VaR approaches
10
Value Dashboard
By Product Type…..
(000) 1994 1995 1996 1997 1998 YTD 99
Market VaR by Product
Loans 563,169 643,554 601,654 850,206 788,767 1,148,911 Bonds 2,252,675 2,574,216 2,406,614 3,400,825 3,155,069 4,595,644 FX 1,126,337 1,287,108 1,203,307 1,700,413 1,577,534 2,297,822 Derivatives 1,689,506 1,930,662 1,804,961 2,550,619 2,366,302 3,446,733 Equity 1,055,941 1,206,664 1,128,100 1,594,137 1,478,939 2,154,208 Diversification Ben. 351,980 402,221 376,033 531,379 492,980 718,069
Market VaR by Product
-
500,000
1,000,000
1,500,000
2,000,000
2,500,000
3,000,000
3,500,000
4,000,000
4,500,000
5,000,000
1994 1995 1996 1997 1998 YTD 99
Loans
Bonds
FX
Derivatives
Equity
11
Direct Lending Risk
Counterparty Settlement and Pre-settlement Risk
Issuer Risk
Credit Risk
Risk Management Methodologies
12
Expected and Unexpected
Credit Losses=ƒ • Future Market Value Distributions
• Default Rate Distributions
• Recovery Rate Distributions
• Portfolio Correlation Effects
Risk Management Methodologies - Credit VaR
Credit Value-at-Risk (VaR)
n
13
Expected Loss
99th PercentileLoss LevelEconomic Capital
Pro
bab
ilit
y
Loss
Covered by pricing and provisioning
Covered by capital and/or reserves
Quantified using scenario analysis and controlled with concentration limits
Risk Management Methodologies - Credit VaR
14
Actual exposure
Potential Exposure
Collateral
Settlements
Credit Exposure
+
+
-
Today's replacement cost, including effect of accruals
Potential changes in value over remaining life of transaction
Collateral held to reduce credit exposure
Spot settlements owed or defaulted payments
Netting
-
Net effect of long and short positions
Risk Management Methodologies - Credit VaR
15
8
6
4
2
0
Time
Mar
ket
Val
ue
Maximum Exposure
Expected Exposure
Risk Management Methodologies - Credit VaR
16
Increasing Sophistication
Increasing Sophistication
1. Notional Amount at Risk
2. Mark-to-Market
3. Mark-to-Market plus a ‘factor’
4. Dynamic Approaches (Monte Carlo and Portfolio Simulations)
Risk Management Methodologies - Credit Risk Measurement techniques
17
Exposures Value-at-Risk Due to Credit Correlations
User Portfolio
Market Volatilities
ExposureDistributions
Credit Rating
Rating Migration Likelihoods
Standard Deviation of Value Due to Credit Quality Changes for a Single Exposure
Seniority
Recovery Rate In Default
Portfolio Value at Risk Due to Credit
Ratings Series, Equities Series
Joint Credit Rating Changes
Models (e.g., Correlations)
Credit Spreads
Present Value Bond Revaluation
Dynamic Approach - Creditmetrics
18
Value Dashboard
By Industry Sector ...
(000) 1994 1995 1996 1997 1998 YTD 99
Credit VaR by Industry
Financial Institution 3,123,027 3,568,800 3,336,442 4,714,781 4,374,073 6,371,234 Agriculture 153,591 175,515 164,087 231,874 215,118 313,339 High Tech 409,577 468,039 437,566 618,332 573,649 835,572 Utility 819,154 936,079 875,132 1,236,664 1,147,298 1,671,143 Retail 307,183 351,029 328,175 463,749 430,237 626,679 Manufacturing 204,789 234,020 218,783 309,166 286,824 417,786 Diversification Ben. 102,394 117,010 109,392 154,583 143,412 208,893
Credit VaR by Industry
-
1,000,000
2,000,000
3,000,000
4,000,000
5,000,000
6,000,000
7,000,000
1994 1995 1996 1997 1998 YTD 99
Financial Institution
Agriculture
High Tech
Utility
Retail
Manufacturing
19
Improper Authorization
Inadequate Documentation
Systems Failure
Poor Judgment
Training / Human errors
Fraud
Mis-pricing
Transaction Processing Errors
Under Utilization of Funds
Model Errors
A special case is event risk, where one or more extreme external events cause a
high, un-preventable loss.
Operational Risk
Risk Management Methodologies
20
Value Dashboard
By Operational Events…..
Op. VaR by Event Class(000) 1994 1995 1996 1997 1998 YTD 99
Mismanagement 917,282 1,048,213 979,966 1,384,806 1,284,735 1,871,332 Human Resources 825,554 943,392 881,969 1,246,325 1,156,261 1,684,199 Unauthorized trading 1,100,739 1,257,856 1,175,959 1,661,767 1,541,681 2,245,599 Sales Practice 733,826 838,570 783,973 1,107,845 1,027,788 1,497,066 Other Criminal Activities 1,192,467 1,362,677 1,273,956 1,800,248 1,670,155 2,432,732 Theft and Fraud 642,098 733,749 685,976 969,364 899,314 1,309,933 Errors and Omisssions 1,284,195 1,467,498 1,371,952 1,938,728 1,798,628 2,619,865 Disasters 550,369 628,928 587,980 830,883 770,841 1,122,799 Technology 1,375,924 1,572,319 1,469,949 2,077,209 1,927,102 2,806,999 Externalities 458,641 524,106 489,983 692,403 642,367 935,666 Total Op. Risk 9,081,096 10,377,309 9,701,664 13,709,578 12,718,872 18,526,191
19
94
19
96
19
98
Mismanagement
Sales Practice
Errors and Omisssions
Externalities
-
500,000
1,000,000
1,500,000
2,000,000
2,500,000
3,000,000
Op. VaR by Event ClassMismanagement
Human Resources
Unauthorized trading
Sales Practice
Other Criminal Activities
Theft and Fraud
Errors and Omisssions
Disasters
Technology
Externalities
21
Front Office/Deal Capture
Credit RiskAnalysis
Market RiskAnalysis
Event Processing
External Communications
TradeEntry andCapture
ClientInformationCollection
TradePricing
SALES
&
TRADING
Central Data Repository
- Position Tracking- Transaction Details- Market Data- Economic Details- Transaction History
Documentation Database
Risk Management
External System
Interfaces
Financial and Management
Reporting
Confirms / Notices
Payments / Settlements
Collateral Events
Accounting Entries (G/L)
Other External Interfaces
Financial Reporting
Risk Control (MIS)
Performance Analysis
Compliance
Other MIS
Exposures (e.g., Value at Risk)Limits (Available Credit Lines)
Valuation Models-Standard Calculator- Risk Algorithms
The Solution - Systems Architecture Model
22The IPM Solution Set - Methodologies
Op.Risk
Cr.Risk
Mkt.Risk FTP Cost Rev.
““Best of Breed”Best of Breed” MethodologiesMethodologies
Risk Profit & Loss
Traditional Traditional MeasurementsMeasurements
SVM GoalGoal
EconomicCapital
OperatingProfit
EP
RAPM
Key MetricsKey Metrics
23Rewards to Organisations that implement IPM is tremendous
We believe there are big rewards for organisations that can implement IPM:
Improving earnings stability– Understanding sensitivity of earnings to external and internal factors
– Management of earnings ‘surprises’
– Awareness of trends
Optimising use of capital– Allocating capital efficiently at enterprise-wide level
– Identifying value creating/destroying lines of business
– Alignment of capital coverage with risk appetite
Enhancing operational decision-making– Embedding risk in the decision making process
– Change from historic to forward-looking management
– Decentralized and efficient decision making
24
IPM enables senior management to answer strategic questions and manage the business with a forward looking approach
Integrated Performance Management (IPM) is about bringing Shareholder Value theory into operational reality
• Where is my organization creating / destroying value?
• Is our organization aligned with our strategy to create value?
• Are we meeting shareholder expectations?
• How do we compare to our competitors?
• What are the areas of future opportunity?
• Are we properly compensated for the risks we are taking?
• Am I leveraging my IT investment?
• Is capital invested in the correct business to optimize value creation?
• Are we correctly measuring performance?
• Can the business plan and forecast ‘steer’ the correct course?
25
Value Dashboard
An Example …Identifying Value Creation or Erosion in the Enterprise...
RAPM vs Hurdle Rate
0.00%
2.00%
4.00%
6.00%
8.00%
10.00%
12.00%
14.00%
1994 1995 1996 1997 1998 YTD 99
RAPM
Hurdle Rate
1994 1995 1996 1997 1998 YTD 99
Total Net Income (000) 3,721,275 4,205,041 4,751,696 5,369,416 6,067,440 6,856,208
RAPM 10.00% 11.00% 10.00% 11.00% 10.75% 10.75%Hurdle Rate 12.00% 12.00% 12.50% 12.75% 13.00% 13.25%Economic Profit Rate -2.00% -1.00% -2.50% -1.75% -2.25% -2.50%
Economic Capital (000) 37,212,748 38,227,641 47,516,958 48,812,875 56,441,305 63,778,675
Economic Profit (744,255) (382,276) (1,187,924) (854,225) (1,269,929) (1,594,467)
26
Calculation and Allocation of Economic Capital to Business Units and the Bank by Risk Type
872m
323m
80 m
178m851m120m
86m 65m
103m
228m
116m
911m
385m
79m
7m
957m
1,207m 3,481m439m
137m137m
54m 18m
660m
533m
56m
Credit Risk dominated Operational & Market Risk dominated
Market
Credit
Operational (event)
Insurance
Retail Banking
Customer Finance
Wholesale Banking
Intl Banking
Ins & Invstmnts
The Bank
Central Units
Operational (business)
27
RevenuesOperating ExpensesTaxesNOPAT
(Book Equity
x Cost of Equity)
--
-
=
Accounting Earnings
(RAPM
- Cost of Equity)
x Economic Capital
Two Equivalent Definitions of Economic Profit (EP):
VaR Return
Growth
Economic Profit = Economic Profit
Risk
Economic Profit is the key element of this program, integrates profitability and risk and supports historical and forward-looking analysis
• Economic Profit sets the performance bar higher by forcing managers to meet not only operating expenses but also all expenses associated with invested capital
– A major issue in financial services in defining the capital base
– General approach is to apply our capital-at-risk model (consistent with RAPM) to determine the capital which is ultimately employed and thus the amount by which managers are ultimately held accountable
Quality Earnings
28
EP by Measurement Center
Return-On-Capital - Cost of Capital
(R-C Spread)
% Investment
Strategic Assessment by Segment(Business Unit, Product, Region)
SegmentAttractiveness
Attractive
Disadvantaged Advantaged
Competitive Position
Consider Growth/EntryOptions
Consider Exit Options
BA
C
DE
Drives Capital
Investment to Add Value
Decides How to Invest and
Manage Earnings
Financial Value Driver Benchmark
Value Driver Measurement and Benchmarking Can Provide Additional Focus for Strategic Direction
Peer Peer Peer Peer Peer PeerBank A Bank B Bank C Bank D Bank E Bank F
Fiscal Year End Dec-97 Sep-97 Mar-98 Dec-97 Dec-97 Dec-97
Revenue 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%Net Interest Margin 90.0% 39.9% 95.1% 48.3% 97.2% 98.2%Non-Interest Income 9.1% 60.1% 4.9% 51.7% 2.8% 1.8%
Operating Expenses 5.1% 13.0% 1.5% 21.3% 21.3% 7.7%Loan Loss Provision 0.0% 9.0% 0.6% 2.5% 0.2% 0.2%Other Expense 1.6% 11.1% 0.8% 15.8% 1.6% -0.4%Cash Operating Taxes 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%Operating Margin 2.4% 26.9% 2.0% 12.1% -12.1% -5.7%
Market VaR Capital 0.4% 0.7% -0.7% 0.9% 0.7% -0.7%Credit VaR Capital 0.4% 8.4% 1.0% 28.6% 1.8%Operating VaR Capital 0.8% 9.0% 0.3% 29.5% 1.1% 1.1%
RAPM 1.6% 17.9% 1.7% -17.4% -6.8% -6.8%
EP -9.8% 6.1% -10.0% -5.4% -19.8% -19.8%
Economic Profit $MMs 19.20 20.70 8.00 (24.00) (16.40)
29Risk-adjusted Capital or Economic Capital
Cost of
Equity
_
EquityProfit
=
Income
Economic Capital
Return on Economic
Capital=
Economic Capital
=
Value Contribution to
Shareholder
G/L
Support systems
Allocation systems
G/L
Risksystems
Support systems
Allocated Revenue
Allocated cost data
Creditrisk
Operationalrisk
Market risk
Insurancerisk
30
Translation Processor(Middleware)
Translation & Mapping
Transaction Capture
Summarization & Posting
Source Data
External Feeds
Operational Systems• Front office• Middle office• Back office
Business Support Systems
• HR• Benefits
Non-Automatic Inputs
Information Presentation
Information Processing and
Storage
Traditional ERP Financial &
Management Accounting
Discrete Reporting
Integrated Reporting
Blended Reporting
Ad hoc Reporting
Technology Blueprint
Operational Data Store
Analytical Engines
31
Source Data Information Presentation
Information Processing and Storage
Translation Processor(Middleware)
External Feeds
Operational Systems
Business Support Systems
Non-Automatic Inputs
Translation & Mapping
Transaction Capture
Traditional IT Process Financial & Management Accounting
Operational Data Store
Calculation Engines
Summarization & Posting
• Fixed income• Foreign
exchange
• Market data• Credit ratings
• Payroll • Benefits
• Manual entries
Summarized financial postings
• Detailed financial postings
• Business events
• Reference data
Drill down to
detail
Transaction detailAnalytical
results
AlgorithmicsRisk Watch
Discrete Reporting
Integrated Reporting
Blended Reporting
Ad hoc Reporting
Flexibility• Leverage existing
investments• Support plug-in
best of breed applications
• accelerated organizational changes due to shorter, less costly implementations
• Facilitates integration of new systems (M&A)
Scalability• Accommodate
growth in the organization
• support high volumes of transactions and level of detail
• enhance timeliness of delivery due to capacity
Web
bas
ed r
epo
rt v
iew
er
To integrate and deliver all the information in an efficient manner, the technology architecture has to be flexible and scalable
32IPM Solution Set
Pro
cess
Ree
ngin
eeri
ng Project M
anagement
Technical Infrastructure
SVM
EconomicCapital
OperatingProfit
Risk Profit & Loss
OperationalData Store
GeneralLedger
AnalyticalEngines Data
Warehousing
Middleware
Op.Risk
Cr.Risk
Mkt.Risk FTP Cost Rev.
EP
RAPM
33
Effective OperationsReliable Reporting
Reconciliation Control
InternalControls
Testing Risk Management Process
periodicaly
Evaluation of the Independence and
Effectiveness of RiskManagement Functions
“Building” the Under-standing in the Bank
for Adequate Oversight
Integrity and Accuracyof Records and Reports
Based on the objective of the Sound Internal Controls to provide strategic as well as operational decision support, this will be a major (joint) bank-wide effort.
Why Internal
Controls?
External
Auditing
Building
Safe
systems
Building Sound Internal Controls
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