Stress Testing and Economic Capital

1. Stress Testing and Economic Capital By T.Y. Lee

2. Table of Contents • Background • Why Stress Testing • About Stress Testing • About Economic Capital • Case Study • Future Improvements

3. Background Why Stress Testing About Stress Testing About Economic Capital Case Study Future Improvements

4. 20090713 Trading Book Proposals Basel II Enhancement Some new Standards 200710 Incremental Default Risk Charge 1996 Basel I Market Risk Amendment (CR+MR) 20080722 Market Risk Incremental Risk Charge Financial Crisis B1 B2 B3 1988 Basel I Capital Adequacy Ratio (Credit Risk) 2006 Basel II 3 Pillars (CR+MR+OpR) 20090116 Trading Book Proposals Basel II Enhancement 20091217 Strengthen Bank Resilience Liquidity Risk

5. BASEL II Structure TRADING BOOK

6. VaR, Stress Loss, Economic Capital and Limits Economic Capital Desired Rating (e.g. AA - 99.97% CL) Statistical loss (at specified CL) Stress loss (scenario- based) Expected loss (mean) Estimated loss in normal market environment Losses in extreme but plausible “tail” events Frequency of loss Severity of loss Subject to VaR & operational limits Subject to stress loss limits Expected loss deducted from revenues Risk appetite

7. Why Stress Testing • About Stress Testing • About Economic Capital • Case Study • Future Improvements

8. Why Stress Testing? • Regulatory Requirements: • Basel II mandates stress-testing around low-probability events to validate capital estimates. • Regulators want similar assurances that portfolios can withstand extended economic downturns. • It became more important after the financial crisis of 2008 • Better Portfolio Management: • Stresses will occur. Planning for them is profitable. • Reactionary management to sudden stresses is costly.

9. Why Stress Testing • About Stress Testing • About Economic Capital • Case Study • Future Improvements

10. About Stress Testing (1/8) • Stress Testing is not unique to financial industry • Auto industry and its regulatory agency crash automobiles to test safety measures as part of standard operation process (SOP)

11. About Stress Testing (2/8) RCA of USA used to drop TV set from high attitudes to see if the TV can withstand falls Now there are commercials dropping iPhones and Samsung Galaxy to see if the phones still function or the screen is OK

12. About Stress Testing (3/8) • Stress Testing has been used in Market Risks for many years as part of risk management • It is applied to Credit Risk as a supplement to Basel II Pillar II process • The idea is to see if a bank can withstand adverse situations with adequate capital • Federal Reserve of U.S.A. has required 19 biggest banks in the U.S. to perform stress tests as a measurement to banks’ health every year after the financial crisis of 2008

13. About Stress Testing (4/8) • Financial authorities of other advanced countries have also ordered banks under their jurisdictions to conduct stress tests • Financial authority in Taiwan has also followed suit • Banks with sound risk management practices usually conduct their own stress test regularly

14. About Stress Testing (5/8) • The key to Stress Testing is designing stress scenarios which are extreme yet plausible • And those scenarios usually required approval from senior management • Sometimes it required the approval of regulators as well • If it is too lenient, regulators may not like it • If it is too tough, senior management or the board of directors may not like it because that may require holding additional capital

15. About Stress Testing (6/8) • Stress Testing Scenarios: • Historical • 1929 Stock Market Crash • 1973-74 Oil Crisis • Hypothetical • U.S. government defaults on its debt • Asteroid hits Earth • Every counterparty in the portfolio got downgraded by two notches • Hybrid

16. About Stress Testing (7/8) • Example • 1960’s anti-nuclear activists in Japan hypothesized a scenario: • A huge earthquake hit Japan, causes • Huge tsunami, which hit the nuclear plant by the shore and causes • Nuclear catastrophe!

17. About Stress Testing (8/8) • Example (cont’d) • They recommended that the government built robots which can be used during nuclear catastrophe • But Japanese government turned down the idea arguing that the action would dim the public confidence in nuclear power • Then we all know what happened in 2011 • And the highly impossible yet plausible hypothetical scenario has become historical scenario

18. Why Stress Testing • About Stress Testing • About Economic Capital • Case Study • Future Improvements

19. About Economic Capital (1/3)

20. Econ. Capital Statistical Loss (specified level of confidence) Stress Loss (scenario based) Expected Loss Estimated loss in typical adverse period Losses in extreme but plausible “tail” events Frequency of Loss Severity of Loss Risk Appetite restricted by Operating Limits Risk Capacity subject to Stress Loss Limits Average loss deducted from revenues About Economic Capital (2/3) • Economic capital can be determined as the cushion required to keep the bank solvent over a specified time horizon with thedefined confidence level (CL). • A typical time horizon is one year. • The confidence level is explicitly linked to the choice of target solvency standard, i.e., the desired rating.

21. About Economic Capital (3/3) • After the financial crisis of 2008, financial authorities in some advanced countries intend to make economic capital the same as regulatory capital • Also, Basel Committee recommended a more strict definition of tier-1 capital, although it later relaxed the definition in fear of slowing down economic growth with less lending

22. Why Stress Testing • About Stress Testing • About Economic Capital • Case Study • Future Improvements

23. Case Study • The framework we developed is based on: • CreditVar concept of Credit Metrics and • Credit Portfolio View (CPV) by McKinsey

24. Road Map of Credit Metrics

25. Algorithm(1/2) – Migration Simulation Step : One Step : Two

26. Algorithm (2/2) – CPV Approach (2008.1~2008.12) Back to Simulation Process

27. Conditional Algorithm – Migration Simulation Step : One Step : Two

28. Why Stress Testing • About Stress Testing • About Economic Capital • Case Study • Future Improvements

29. Future Improvements (1/2)

30. Future Improvements (2/2) • Pair-wise correlation is NOT adequate to measure the degree of inter-connectedness among industries and among financial institutions

31. Q & A