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Stress Testing / ICAAP / Capital ManagementSoftware solution
Erik Ibron, Director -- Solution Specialist, Moody's Analytics August 2011
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Agenda
1. ICAAP Solution Overview
2. Spreading & Rating stress test
3. Portfolio management
4. From KRI to KPI scenario analysis
5. Balance sheet and Liquidity stress
6. ICAAP enforcement
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ICAAP Solution Overview
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Principles for sound stress testing practices and supervision(Extracts) - What is needed from a software perspective
» The stress testing tool seen as an operational tool versus a pure back-end
» Scenarios should cover the environment and the business strategy – i.e. the response to the environment
» Flexible in order to define multiple & ad-hoc scenarios in addition to the recurring ones
» Discussing requires understanding: consistent and reliable data in a trustable common placeholder, comprehensive dashboards, reports and drill-down
A modular and integrated ERM solution to properly address ICAAP and stress testing
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Spreading & Rating stress test
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Stress test in the context of scoring/spreading
Who would benefit most from scenario features in a software :
» Portfolio managers - to assess the quality of their portfolio, and its robustness under economic stress
» Model builders – to stress, analyze and validate the models and scorecards before they are deployed
» Senior management – to identify the key risk areas that need to be monitored, or the strengths that the institution can play on
Scoring/Rating users would benefit most from:
» Portfolio-level Stress testing capabilities
» Integrated analytical/OLAP reporting and portfolio-level analysis features
» Integration with macroeconomic scenarios, multi-period forecasts…
Institutions require the software to centralize scenarios
» Scenario sharing, template definition, audit/logging & review
» Define and re-use formula, distribution of inputs, following trends
» Integration with macroeconomic data and multi-period forecasts
» Examples:– Optimistic: GDP Growth of 3.2%, U.S. Unemployment 7%, etc.
– Baseline: GDP Growth of 1%, U.S. Unemployment 9%, etc.
– Double-dip Recession: GDP Growth of -0.8%, Unemployment 12%
» …
The software should provide a comprehensive framework to input stressed assumptions
» On any component of a model– For instance, modify any quantitative/qualitative factor of a standard model (ex:
for MM, Sales Growth, Debt ratio…)
» At any level of granularity– For instance, high-level aggregated inputs can be refined with counterparty-by-
counterparty adjustments
The end goal is to compare the new risk rating profiles across multiple scenarios, for your overall portfolio
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Portfolio management
An ICAAP and Stress Testing engine aims at answering critical questions on your global portfolio
» Who are your 10 best customers?» Who are your 10 worst customers and what can you do about them?» Who will be your 10 worst under stressed conditions?» How much economic capital are you consuming? » What is your risk concentration by industry and geography?» How can you use all these outputs for business strategy?
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Understand Which Positions Add or Destroy Value… and Do Something About It
MODEL A TRADE BEFORE YOU MAKE IT- Where will it be?- Spread is about the same…- But one brings more risk to the portfolio
UNDERSTAND WHAT YOU HOLD- Two exposures to Singamas Container in this portfolio- Concentration is relatively low, but high PD (3.98%) andhigh correlation with portfolio mean high risk contribution
- Not being compensated for risk- Time to reduce or eliminate positions?
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Original Portfolio Sold 11 Buy Better 11Exposure - $MM 4,631 4,568 4,631No. of Exposures 2,418 2,407 2,418
Total Spread (bps) 136.5 133.6 139.0Expected Loss (bps) 100.4 92.5 91.7Expected Spread (bps) 36.1 41.1 47.4Unexpected Loss (bps) 114.7 109.2 109.7
Sharpe Ratio 31.5% 37.6% 43.2%
Incremental changes: add exposures with high return/risk and shed or mitigate those with low return/risk. A small number can have a major impact.
In this example, replacing 11 worst exposures with 11 best ones changed return/risk (Sharpe Ratio) from 31% to 43%, about a 33% improvement.
What if scenarios for Portfolio Management Decisions
Stress the portfolio loss distribution
Two principal approaches
» Unconditional
– Change inputs such as PD, LGD, EAD, correlation
– Observe effects on portfolio of stress scenario
» Conditional
– Build loss distribution “conditional” on certain outcomes
– Has the benefit of preserving correlation and other relationships
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From KRI to KPI scenario analysis
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A forward looking governance framework
Governance framework forecasting banking risk and performance measures under plausible or extreme stress scenario:
» Multi year expectations
» Simulate and fine-tune mitigation actions
» Readily available macro-economic scenarios
A parametric approach as an alternative to stochastic simulations:
» For a quick turnaround of ad-hoc scenarios and dashboards
» To integrate with baselines imported from legacy systems
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Holistic approach consolidating incomes, costs and risks components to stress risk and risk-adjusted performance insights
Incomes(Integrated or
imported)
Operating costs
(Integrated or imported)
Expected Loss
(Integrated or imported)
Capital charge(Regulatory or Economic capital or
imported)
RAROC
Scenario Analysis shifts all components within a consistent scenario
GDP up by 10% in ChinaUnemployment rate reaches 9% in Europe
Budget for the next 3 years
Advisory Services
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Scenario can be defined against any dimension: BU, country, industry…A comprehensive data model to maintain reference data » Bank’s dimensions:
– Country, Business Units, product, business Line– Channel, transaction type
» Counterparty dimensions– Client, Business type, industry sector, rating
» Guarantees & Collateral– Collateral type– Guarantee country, rating, business type…
The more granular is the imported data, the wider is the range of available dimensions
User editable timeline» Immediate access to scenario baselines» Analysis of Mitigation effect on following years
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Input granularity
Scenario dimensions and granularity alignment
Macro Eco
Indicators
• Country• Industry
Budget• Business Unit• Product Line
FX, Funding
Cost• Currency
Results are calculatedat the finest level of granularity
Input granularity
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What should be stressed: market factors
• Gross Domestic Product• Unemployment Rate• Housing Index …
Macro Economic Indicators
• Foreign Exchange currencyForeign
exchange rates
• Simple “plus one notch”, “plus two notch”• Transition MatrixCredit grades
• LGDLGD
• Collateral• Guarantee
Collateral valuation
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What should be stressed: Portfolio & Budget
• Product processing costs• Sales and marketing costs• Overhead costs
Costs
• Net interest income• Non Funded Income• Funds transfer income
Revenues
• EAD• Outstanding• Nominal
Business volumes
• Increased draw downs / decreased headroom• Committed/ Uncommited
Facility utilization
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What should be stressed: Governance
• Earning per share target• Capital Ratio TargetRisk Appetite
• % Earnings given as dividendsDividend Policy
• General Provision• Equity Issuance• Bond Issuance
Capital Management
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*Collateral type: RRE = Residential Real Estate ; CASHCOL = Cash collateral ;
EQTCOL = Equity collateral ; CRE = Commercial Real Estate ; NETCOL = Netting collateral
Increase business volume with a given risk profile according to business directions
The system automatically displays the current portfolio baseline
The user can set assumptions across multiple time horizon
The volume can be set over any combination of user-defined dimensions
The user can set an increase at any level of granularity. The new volume will match the existing risk profile breakdown within
the current portfolio
Or the user can refine and set an increase at a finer
level
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Drill-down reporting to understand, discuss and analyze the results
StrategyScenarios
Time HorizonIndicators
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Dashboard for scenarios comparison
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A dashboard for each user or manager profile
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Dashboard View
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Flexibility for the institutions to create and modify theirown dashboard
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A stress test engine should be scalable to derive and stress Key Performance Indicators based on incremental cost and income data
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Performance month evolution for a given scenario
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Balance sheet and Liquidity stress
Banks should monitor short-term and mid to long-term Liquidity risk
Short Term Medium Term
ScopeEnsures that the bank can be financed safely via secured short term funding.
Enable the bank to forecast liquidity requirements to sustain its activity / strategy for the coming months / years.
Calculation Frequency Daily or weekly Monthly
Stress testing scenario
4 scenarios:- on going,- systemic crisis,- specific (downgrade),- specific + systemic crisis
Time Horizon Maturities monitored until 3M Maturities Monitored from 3M to unlimited horizon
Perimeter Consolidated/Entity level
Approach Static approach Dynamic approach
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The main liquidity indicators to report and/or to stress
Liquidity gap and liquidity buffer» Can be generated daily» Based on granular cash-flows or cumulated vision» With user-defined or regulatory defined time-bucketing
Liquidity ratios » Balance-sheet ratios or cash-flow ratios» Short term Assets / Short term Liabilities.
Concentration analysis» Analysis of the diversification of funding sources» Top 20 depositors/lenders including modeling client & bank group structure
Monitoring of these indicators can be performed per:» Group / Legal entity / Business line» Currency
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Static Simulation Components
On market data » Rate
» Inflation
» Volatility
» Foreign exchange rate
» Spread curve
On client behaviour» Amortizing profile for non-maturing deals
» Prepayments
» Renegotiations
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Liquidity risk stress test are mostly driven by regulators
» Marketable Assets» Haircut definition for marketable assets.
» Sell-offs of debt securities and equities
» Early Amortization, Stickiness» Accelerated extinction for loans and deposits
» Delayed extinction for loans and deposits
» Amortization Convention on Undrawn Balances
Indicators
» Liquidity Reserve, Ratio, Survival Period
Portfolio Segmentation Criteria
» Customer Segment, Country, Economic Sectors
» Rating
Term Deposits
-120 000
-100 000
-80 000
-60 000
-40 000
-20 000
0
févr.-
07
mai-0
7
août-
07
nov.-
07
févr.-
08
mai-0
8
août-
08
nov.-
08
févr.-
09
mai-0
9
août-
09
nov.-
09
févr.-
10
mai-1
0
août-
10
Outstanding
Balance Contractual schedule
Early withdrawal
Stickiness
Reserve / Saleability
0
50 000
100 000
150 000
200 000
250 000
300 000
mai-07 août-07 nov-07 févr-08 mai-08 août-08 nov-08 févr-09 mai-09 août-09 nov-09 févr-10
TimeC
ash
Amortizing Profile AaaSaleability for AAAAmortizing Profile Baa1 to Aa1Saleability for Baa1 to Aa1Amortizing Profile B3 to Ba1Saleability for B3 to Ba1Amortizing Profile Non eligibleReserve
Haircuts for AAA securities
Haircuts for securities from Baa1 to Aa1
Haircuts for securities from Ba3 to Ba1
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Dynamic simulations components
Forecast balance-sheet options
» Manually inserted deals
» Volume per period
» Business Volumes Forecast Targets
The new production feature is generated based on
» The diversity and volume of the banks products as observed in recent portfolio
» To the need of other business : the new production deals can be saved and used again
The liquidity stress test engine should generate the regulatory reports as per the local jurisdiction
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ICAAP enforcement
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Limit Setting & Diversification EnforcementEnforce concentration control and diversification strategy, at origination point
Country Analysis Typical Gauge Report, email alerts and escalation procedure
Sectorial Analysis
1
2
3
4
5
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Multiple risk measures are calculated. Each measures has
its own limits
Limit breaches should be monitored with a variety of measurements
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Early warning, Alerts Management and Watchlists
Alerts can be defined for multiple purposes» Counterparties blacklist» Countries under watchlist» Concentration ratios» Multiple thresholds
Alerts framework needs to be flexible» Alerts can be defined at deal
level or aggregated level» A wide range of actions can be
triggered (log, mail, report, limit locking, user workflow...)
Multiple thresholds allow for several levels of alert severity
Actions (emails, workflows,…) are automatically trigger for each level of alert
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ICAAP and stress test for an iterative and active portfolio management cycel
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Q & A
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moodys.com
Moody’s Analytics Singapore6 Shenton Way #14-08DBS Building Tower 2
Singapore 068809
Erik IbronDirector
Solution Specialist
+65 6511.4482 tel+65 9118.7273 [email protected]
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© 2011 Moody’s Analytics, Inc. and/or its licensors and affiliates (collectively, “MOODY’S”). All rights reserved. ALL INFORMATION CONTAINED HEREIN IS PROTECTEDBY COPYRIGHT LAW AND NONE OF SUCH INFORMATION MAY BE COPIED OR OTHERWISE REPRODUCED, REPACKAGED, FURTHER TRANSMITTED, TRANSFERRED,DISSEMINATED, REDISTRIBUTED OR RESOLD, OR STORED FOR SUBSEQUENT USE FOR ANY SUCH PURPOSE, IN WHOLE OR IN PART, IN ANY FORM OR MANNEROR BY ANY MEANS WHATSOEVER, BY ANY PERSON WITHOUT MOODY’S PRIOR WRITTEN CONSENT. All information contained herein is obtained by MOODY’S fromsources believed by it to be accurate and reliable. Because of the possibility of human or mechanical error as well as other factors, however, all information containedherein is provided “AS IS” without warranty of any kind. Under no circumstances shall MOODY’S have any liability to any person or entity for (a) any loss or damage inwhole or in part caused by, resulting from, or relating to, any error (negligent or otherwise) or other circumstance or contingency within or outside the control ofMOODY’S or any of its directors, officers, employees or agents in connection with the procurement, collection, compilation, analysis, interpretation, communication,publication or delivery of any such information, or (b) any direct, indirect, special, consequential, compensatory or incidental damages whatsoever (including withoutlimitation, lost profits), even if MOODY’S is advised in advance of the possibility of such damages, resulting from the use of or inability to use, any such information. Theratings, financial reporting analysis, projections, and other observations, if any, constituting part of the information contained herein are, and must be construed solelyas, statements of opinion and not statements of fact or recommendations to purchase, sell or hold any securities. NO WARRANTY, EXPRESS OR IMPLIED, AS TO THEACCURACY, TIMELINESS, COMPLETENESS, MERCHANTABILITY OR FITNESS FOR ANY PARTICULAR PURPOSE OF ANY SUCH RATING OR OTHER OPINION ORINFORMATION IS GIVEN OR MADE BY MOODY’S IN ANY FORM OR MANNER WHATSOEVER. Each rating or other opinion must be weighed solely as one factor in anyinvestment decision made by or on behalf of any user of the information contained herein, and each such user must accordingly make its own study and evaluation ofeach security and of each issuer and guarantor of, and each provider of credit support for, each security that it may consider purchasing, holding, or selling.