Advances in Risk Management – Beyond Basel II EY refers to the global organization, and/or one or more of the independent member firms of Ernst & Young.

Advances in Risk Management – Beyond Basel II

EY refers to the global organization, and/or one or more of the independent member firms of Ernst & Young Global Limited

Page 2

Contents

About the Speaker

Pratik Shah,

Ernst & Young LLP, India

Partner- Advisory Services

Leader- Financial Services Risk Management

► Associate Member of the Institute of Chartered Accountants, India, has a Masters of Business Administration from Peter F. Drucker Graduate School

► Sixteen years of professional experience specialising in Governance, Risk & Compliance Assignments

► Expertise:

1. Operational Risk

2. Credit Risk1. Regulatory Compliance2. Capital Management3. Governance Risk4. Enterprise Risk Management

► Key Markets

1. India1. USA2. UK3. Australia4. Switzerland5. Singapore6. Malaysia7. Vietnam

► Key FS Clients

1. SBI Group

2. ICICI Group

3. Credit Suisse

4. ANZ

5. Morgan Stanley

6. GE Capital

7. Zurich Financial Services

Contents

Boubyan Bank, Kuwait3

Content

1 Background and Context Setting

2 Integrated view of Risks

3 Using Risk Management to take Strategic Decisions

4 Linkage to Capital Management and Stress Testing

Page 4

Background and Context Setting

Page 5 PRIVATE & CONFIDENTIAL NOT TO BE SHARED WITH THIRD PARTIES WITHOUT PRIOR WRITTEN CONSENT OF EY

What is ERM and Why do we need it

Silo risk management

Key focus: Safeguard Enterprise Value• Compliance focused• Works with in the boundary of

definition• Focuses on Risk Mitigation &

usually not fully aligned to strategic & operational decisions

Enterprise risk management

Key focus: Maximize Enterprise Value• Value focused• Comprehensive coverage of

risk universe (ex: Strategic, model risk)

• Focuses on emerging risks and core to strategic & operational decisions

Necessary but value addition is limited to risk definition

An organizational capability that drives substantial value Vs

competes

ORCR

MR

ERM in a risk-based approach to managing an enterprise, integrating risk management of Pillar 1 risks, Pillar 2 risks, internal control and strategic planning. It helps to manage risk to be within its risk appetite, to provide reasonable assurance regarding the creation and protection of value for stakeholders.

“It would be a mistake to conclude that the only way to succeed in banking is through ever-greater size and diversity. Indeed, better risk management may be the only truly necessary element of success in banking.”Alan Greenspan


Risk Appetite and Material risk assessment sets the tone for fully functional ERM

ERM Component

Risk Appetite: Risk Appetite is the amount of risk, on a broad level, that an organization is willing to take on in a pursuit of its strategic business objectives

Objective

• Drive range of business decisions including resource allocation, new business opportunities, liquidity and capital planning by incorporating risk perspective

Use

• Improves the way risk is explicitly considered when management makes strategic decisions

• Helps establish meaning reports for senior management and the board.

• Provide focus to risk assessments and stress testing.

Material Risk Assessment:: The Integrated Material Risk Framework provides the board and senior management relevant information concerning the Bank’s risk profile, in a timely and concise manner. Integrated Material Risk Assessment is driven by:

• Provide a top down approach to obtain integrated view of risks across the organization and connect risk profile to approved risk appetite

• Provices synthesized, actionable risk dashboard: Drawn from reports & documents used by top management to provide insights on past, present and future


Sources of risk

Market Risk

Trading book Banking book

VaR ,CVA, PFE,PD, LGD, EAD CCF,ALM, EaR, BEICF score

Risk Assessment

Risk Quantification

Credit Risk

Balance SheetProfit & LossGovernance

Liquidity / IRROperational

Risk

Earnings, Capital, Reputation, GovernanceRisk Appetite

Metrics

Setting risk-adjusted return on equity

Primary capital allocation

• Sub-allocation – BU / Portfolio

• Performance metrics

Performance mgmnt

• Performance Vs original targets

• Portfolio re-allocation

Re-allocationIdentification

of metrics

Analysis of resources & constraints

Business & Financial

objectives

Market & Competition

Vision, Guiding Principles, Stakeholder, Risk Capacity

Basel II Framew

ork

Integrated view of risk basis impact om risk

appetitej

ERM framework builds on Basel- II elements to facilitate the risk informed business decisions

1

KRI Identify and measure indicators for each risk that impacts the risk appetite values

2

1 2Integration of risk an finance Risk based performance management

Page 8

Taking an Integrated view of risks – Beyond Basel II

Risk Appetite – Tool to align the risk the Bank takes is aligned to the strategy

Attributes of Good Risk Appetite

► Linkage to mid to long term strategy

► Benchamrked to Peers / Competes

Linked to Strategy

► RAS should comprehensively cover all fundamental risks the bank faces

► Include quantitative and qualitative statements

Comprehensive Coverage

► Govern decision making across all businesses and risk types

► Allocate group level risk appetite to specific risk categories, lines of business, legal entities etc.

Govern Decision Making

Key Steps

Objective

A practical and simple approach to facilitate financial and business planning through improved understanding and consideration of risk adjusted returns

Identify risk and finance metrics and define tolerances for risk appetite at bank level

Integrate Risk Appetite into major decisions such as capital planning, budgeting, liquidity planning

Establish Risk Appetite Cascade Risk Appetite

Establish monitoring templates that are linked to Risk Appetite but are also relevant to Business Units

Manage & Monitor

Develop reporting dashboards and action tracking mechanism for board and sr. management

Report & Escalate


Driving Strategic Decisions on Capital Allocation through Risk Appetite: Illustrative – RAROC

Risk Adjusted Return on Capital (RAROC): Provides risk based profitability measurement framework for measuring risk adjusted financial performance across the bank. It is calibrated down to business groups, portfolio and borrowers

Illustrative Risk Appetite Statement: The bank should target a risk adjusted return greater than the weighted average cost of capital employed at all times (Hurdle Rate).

Risk Appetite Statement – Risk Adjusted Return on Capital (Illustrative)

• Target RAROC computed based on:• Peer Group Benchmarking• Hurdle rate - Cost of capital i.e capital

based on WACC plus liquidity premium considered as minimum RAROC for the bank

• RAROC Vs ROE i.e RAROC > ROE indicates a significant capital buffer or inefficient use of capital

• Constraints- capital adequacy, priority sector – External; portfolio focus and capability - Internal

• Target RAROC embedded into• Capital utilization• Financial Projections – Asset

growth rate, portfolio diversification and capital generation rate

• Business Strategy- Focus areas based on RWA composition i.e Reduce percentage of Risk Weighted Assets systematically in order to improve ROA

Target RAROC > Hurdle RateUse test – Periodic monitoring and

update

Risk Appetite Implementation

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

14.00%

16.00%

18.00%

20.00%

18.25%

12.34% 12.07%

2.15%

0.71%

10.10%

9.17%9.97% 9.67%

10.20%

RAROC

Weighted Average Cost of Capital

Bank 1 Bank 2 Bank 3 Bank 4 Bank 5


Material Risk Assessment – Tool to distil information and provide integrated view of top risks and big bets shaping Bank’s performance

Attributes of Good MRA framwork:

► Insight on Top risks► Clarity on big bets► Major decisions

supported with risk insights

► Risk dialogue with top management

Risk/ Reward Tradeoff

► Top management involved in risk processes-Oversight

► Critical risk information surfaced in timely manner

Increased Board Involvement

► Exhaustive identification and prioritisation of risks

► Should contain forward looking elements, historical risk metrics may not be good indictors of duture

Robust Risk Management

Key Steps

Objective

Risks by nature are interdependent, major negative outcomes are usually due to convergent of risk factors , so the material risk assessment seeks to measure the these converged impact on earnings, capital, liquidity and reputation and provide an integrated view of risks.

Identify material risks and corresponding metrics aligned to current risks undertaken based on strategy

Shortlist material risks and metrics based on management workshops and data analysis

Identify Metrics Finalize Metrics

Determine thresholds and categorize into low, medium, high based on Risk Appetite of the bank and business strategy

Link to Risk Appetite

Collect data, perform assessment based on defined scales and report results through integrated risk dashboards

Assessment & Reporting


► Risk Dashboard is a periodic snapshot of a top-down assessment of key risks facing the bank – it is presented by the CRO to the Board of the Bank - impact assessment is based on multi-dimensions i.e., earnings, capital, people and reputation – KRIs are used to track the trajectory of risk …

Material Risk Assessment – Illustrative view of risk

Rank(Last

)Risk Group Likely

Impact

Time Horizo

nStatus Owner

Action Plan

Effective

Earnings Capital

PeopleReputati

on

1(x)

Credit Risk Credit HighEar – H Cap - M

NOW ↓ CRO HighPoe - L Rep - L

2(x)

Credit Concentration Risk

Credit HighEar – H Cap - H

NOW ↑ CRO LowPoe - H Rep - H

3(x)

Country Risk Credit Medium

Ear – M Cap - M1 YEAR ↓ CRO High

Poe - L Rep - L

4(x)

Market Risk MarketMediu

m

Ear - M Cap - L

1 YEAR ↑ Treasury

MediumPoe - M

Rep - M

5(x)

Liquidity Risk FinanceMediu

m

Ear – MCap –

M NOW ↑ ALMMediu

mPoe - L Rep - H

6(x)

Operational Risk OperationalMediu

m

Ear - L Cap - L

1 Year ↑ ORM LowPoe - H

Rep - M

7(x)

Compliance Risk OperationalMediu

m

Ear – M Cap – L

1 Year ↑ Compliance High

Poe - MRep -

M

Illustrative


Risk Assessment and ReportingIllustrative – Credit Risk

Definition

Credit Risk • Credit Risk is the current and prospective impact on earnings and capital, arising from the loss to an

entity due to inability or unwillingness of a borrower/counter-party to meet commitments in relation to lending, trading, settlement and other financial transactions or reduction in portfolio value arising from actual or perceived deterioration in credit quality of borrowers/counterparties.

Name of the Entity: Bank xx

Key Risk Driver Description:1. Percentage of unrated exposure to

Total Credit Exposure2. Gross NPA to Gross Advances

Ratio (%)3. Total unsecured credit exposure as

a % of Total Credit Exposure of Entity

4. Ratio of Risk Weighted Assets to Total Assets

5. Average DPD (xx days- YY days) as a % of Total Credit Risk Exposure

1 4 9 16 25Entity Value

Assessment Rating

0-50-10-5

0-40

0-2

5-101-25-15

40-502-4

10-152-3

15-25

50-60

4-6

15-253-5

25-35

60-70

6-8

25 <5 <

35 <

70 <

8 <

122.4

26.4

63

2.4

99

16

16

4

Overall Rating for Credit Risk (Average) 11

Key Performance Driver Description:1. Actual vs Targeted Net Interest

Income (Actual as a percentage of Target)

85 > 85-90 90-110 110-125 125 < 112 16

Legend – Risk Index Low 8 - 14 15 - 22 > 231 - 7 Medium High Critical

Illustrative


Risk Assessment and ReportingIllustrative – Credit Risk

Illustrative

Risk vs Performance Assessment Map

Risk is not commensurate with the return generatedRisk is greater than return generated

Risk is commensurate to the return generated

Legends

Credit Risk

2012 2013 20140.00%

5.00%

10.00%

15.00%11.00%

9.00%12.00%

Unrated Exposure to Total Credit Exposure

Unrated Exposure to Total Credit Ex-posure

2012 2013 20140.00%

1.00%

2.00%

3.00%

4.00%

2.10%2.90%

2.40%

Gross NPA to Gross Advances

Gross NPA to Gross Advances

2012 2013 20141.80%2.00%2.20%2.40%2.60%

2.10%2.20%

2.40%

Past Due Exposure to Total Exposure

SMA Exposure to Total Exposure


Bringing ERM framework to life- An illustration – Credit Risk & RAROC

Source of Risk Banking book

PD, LGD, EAD CCF

Risk Assessment

Risk Quantification

Basel II- Credit Risk

Risk Profile

Target risk-adjusted RAROC


Portfolio RAROC | Re-allocation |Capital Optimization

Performance Management

Credit Risk

Metrics:RAROC

Resources & constraints:

- Cost of Capital- Income &

business mix- Reg capital /

provisions

Risk adjusted profitability

and resource allocation

Volatility, risk free return,

peer returns


12

Integration of risk an finance Risk based performance management

1 2

j

KRI

• Unrated exposure to Total Exposure• Gross NPA to Gross Advances• Past Due to Total Exposure• Interest Expended to Average Liabilities

• Negative • Negative• Negative• Positive

RAROC RelationshipCapital - RAROCRisk Appetite

Metrics


Bringing ERM framework to life- An illustration – Credit Risk

Source of Risk Banking book

PD, LGD, EAD CCF

Risk Assessment

Risk Quantification

Basel II- Credit Risk

Capital - RAROCRisk Appetite

Metrics

Integrated Risk Profile

Setting risk-adjusted RAROC


• Allocation of Capital based on performance of portfolios and BUs

• Portfolio re-allocation

• Capital Optimization

Performance Management

Integration of Risk and Finance Data

Credit Risk

KRI


Identification of metrics

Analysis of resources & constraints

Business & Financial

objectives

Market & Competition


12

Integration of risk an finance Risk based performance management

1 2


RAROC Relationship

KRI




ERM Framework impacts most business processes

Strategic Planning and Corporate Strategy

Risk and Performance Measurement

Target Evaluation and Portfolio Management

Risk and Performance Reporting:

Strategy Identification

Target Setting

Strategy Execution

Monitoring / Disclose

• Identify optimal mix of business strategies

• Medium term aspirations• Provide guidelines• Assess Earnings implications of

strategies• Outline best use of spare

capacity

• Calculate Economic Capital, RAROC/ EVA

• Calculate EaR• BU cascading of limits• Maintain Desired Profile

• Execute contingency planning

• New Business Opportunities

Resource Management and Product Approval

• Efficient utilization of capacity

• Identify acceptable and unacceptable sources of risk

• Manage expectations• Proactive Management• Risk Dashboards• Monitoring of KRIs / KPIs

Page 18

Using Risk Management to take Strategic Decisions – Case: Capital Management


RAROC based capital allocation

Determine Bank-wide cost of capital (WACC)

Determine Bank-wide Target Return (%)

Determine Target Return (%) for the balance portfolio

Step 1: Determine Target Return Step 2: Determine Target Risk Premium above base rate

Step 3: Take Capital Allocation Decisions

Add the mark-up to factor in discounts on Priority Sector DRI, staff loans, etc.

Add the mark-up to factor in overall spread / margin that the bank targets to achieve

Segment

Cost per Rupee Exp

Capital %

Trend of

Interest Income

(%)

Base Rate (%)

Target Income (%)

to meet Target Return

Target Risk

Premium above

base rate Interest

Operating

Provisions

Corporate (above BBB )

1.00%

Corp- (below BBB)

2.00%

PSE 0.25%

MSME – Guaranteed

3.00%

MSME no guarantor

4.00%

Home loan 2.00%

Other Retail 3.50%

….

XX%

Apply market constraints, competitor pricing, relationship / strategic portfolio constraints

Allocate Capital - Prioritize growth

NoCan charge premium to

the customer?

Guarantees

Collateral

On-BS Netting

Ratings

Reduce required

Regulatory Capital

Yes

Can charge premium to

the customer?

No/Less Allocation

No

Yes

Expand business and allocate capital only in those geographies/ sectors/ borrowers who can match the target return , which is determined by the Bank through WACC and other mark - ups

Risk Appetite


Enable senior management monitoring of capital efficiency across the bank

Senior Management• Analyze the

overall Capital Efficiency metrics within the Bank

• Drive strategic decision making

• Support IRM in prioritizing and rolling out key initiatives

RM dept.• Monitor the

Capital Efficiency across the bank, follow up with braches, BUs

• Reporting of key metrics to Senior Management

Region

CostCapital Required

Target Return

(%)

Interest Income

(%)Interest

Operating

Provisions

Overall Bank

Mumbai

Delhi

Chennai

Hyderabad

Pune

EY will develop MIS dashboards for the senior management for strategic decisioning to target/exit portfolios – geographies, products , industries, etc.

Templates provided for RAROC based capital allocation would form an input to the MIS

Segment Capital Efficiency Dashboard

Segment Exposure

RAROC Target Return (%)

NPA (%)

Avg. RW (%)

Corporates

SME

Retail – Personal

Region Avg.

Granular analysis for segments where returns are below the target returns

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Advances in Risk Management – Beyond Basel II EY refers to the global organization, and/or one or more of the independent member firms of Ernst & Young.

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