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CRITICAL SUCCESS FACTORS IN IMA IMPLEMENTATION PHILIPPE CARREL Mumbai, July 21 st 2010

Risk Intelligence: The 21 st Century Frontier of Market Efficiency. CRITICAL SUCCESS FACTORS IN IMA IMPLEMENTATION PHILIPPE CARREL Mumbai, July 21 st 2010. THE ROAD TO SYSTEMATIC RISKS. Number of crisis over time appears to be rising.

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CRITICAL SUCCESS FACTORS IN IMA IMPLEMENTATION PHILIPPE CARREL Mumbai, July 21 st 2010

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  1. Risk Intelligence: The 21st Century Frontier of Market Efficiency CRITICAL SUCCESS FACTORS IN IMA IMPLEMENTATION PHILIPPE CARREL Mumbai, July 21st 2010

  2. THE ROAD TO SYSTEMATIC RISKS Number of crisis over time appears to be rising 370 years of cyclical crises always resulted from decoupling the perception of current risk versus future value

  3. REGULATIONS AIM AT DE-RISKING VITAL ACTIVITIES Idiosyncratic risk stabilised through adjusted through risk adjusted capital reserves Systematic risks through countercyclical prudential supervisory measures. BCBS 164 on strengthening resilience contains proposals for capital buffers to contain leverage and exposure

  4. IDIOSYNCRATIC RISK MANAGEMENT IS TO BALANCE THE CREATION OF VALUE WITH EXPOSURE TO RISK FACTORS Risk is a measure of sensitivity to factors of exposure under scenarios Managing risk is to align the firm’s exposure to the risk factors with its appetite for it

  5. Banking Books Trading Books Markets Portfolios Economy Growth Country Operations Markets Portfolios Economy Growth Country Operations Markets Portfolios Economy Growth Country Operations Operational Risks (PE x LGE) or OpVaR Net RWA a = a - UL ( i , j , ) VaR ( ) EL ( i , j ) Aggregated Loss Distribution EL MANAGED IN SILOS, RISK IS NECESSARILY AGGREGATED BY MODELS Collateral Market Risks (ALM) Credit Risks (EL=PDx[1-LGD]) Market Risks (Haircut) Credit Risks (EAD) Market Risks (VaR) Credit Risks (CVaR, PFE)

  6. Repetitive tail events Scope of Basle II Expected losses Outside the scope of Basle II Interval of confidence Outside the scope of B II But increases exposure to tail risks… ..and to system externalities. A FOCUS ON LOW IMPACT HIGH FREQUENCY EVENTS REDUCES CAPITAL CHARGE… Probability of Loss Event VaR Stressed VaR Catastrophic Scenario Expected Losses Loss Impact

  7. Risk Intelligence CREATE A CULTURE OF RISK MANAGEMENT – KEEP IT ALIVE Restore the balance Capital Efficiency / Risk to align Corporate Governance and Risk Appetite Support Regulatory Compliance with information on market behaviour in addition to statistical analysis No financial instrument is inherently risky Valuation and aggregation methodology (covariance) depend on the nature of tail events Crashes follow booms, but the future is not like the past

  8. Markets Portfolios Economy Growth Country Operations Markets Portfolios Economy Growth Country Operations Valuations Counterparties RECONNECT SENSES TO CREATE A DNA BACKBONE Banking Books Risk Factors Trading Books Markets Portfolios Economy Growth Country Operations

  9. RECONNECT THE BRAINS WITH THE NERVOUS SYSTEM Portfolio view of firmwide risks, limits and triggers Business Line Risk Mgr Net Exposure Sensitivity Max Loss Regional Risk Mgr Product Risk Mgr Portfolio Limits Sensitivity Limits Concentration Limits P/L Limits

  10. CREATING A RISK INTELLIGENT GOVERNANCE AND COMPLIANCE FRAMEWORK • Multiple vendor feed • Internal pricing feed 7 Risk Intelligence 2 Market Intelligence • Exposure • Sensitivity • Max Loss • Cross-silo exposure from: • business lines • products • regions Scenario Simulations Portfolio Intelligence Reverse Stress Test 4 Capital & Liquidity Strategy RISK FACTORS 5 1 8 Intelligent Data • Gaps • Concentrations • Contingencies Liquidity Risk 3 6 • Reference data • Counterparty data • Ratings 5 Enterprise Risk Management Monitor Global Risk Infrastructure Framework CAPITAL & LIQUIDITY SHOULD BE DRIVEN BY RISK INTELLIGENCE NOT ONLY RWA

  11. CREATING RISK INTELLIGENCE GOVERNANCE DRIVEN • Enterprise-wide aggregation (by risk factor) • Sensitivity analysis (portfolio and entity level) • Stress testing • Effective counterparty exposure • Expected Positive Exposure (EPEs) • Credit Value Adjustments (CVAs) COMPLIANCE DRIVEN • Liquidity Risk Management • Stress test ALM & gap analyses • Counterparty driven gap analyses • Collateral liquidity • Valuations of OBS exposure • Limit & Collateral Management • Net counterparty exposure • Risk concentration and sensitivity limits • Leverage ratios and OBS

  12. THE FALLACY OF MODERN FINANCE THEORY Modern finance theory leads to • Measuring expected return as a function of volatility (CAPM) • Diversifying risks through expectations of low covariance • Expressing tail event probabilities as a frequency of occurrence The act of (collectively) observing an area of financial safety makes it risky A. Persaud. Dec 2002

  13. COVARIANCE RELIES ON INVESTORS’ BEHAVIOUR NOT ON HISTORICAL DATA Variables are wrongly assumed to be independent

  14. SPIRIT OF BASLE III(BCBS 164 on Strengthening Resilience) Quality and consistency of capital base T1 Equity only T2 5 year minimum maturity , hybrids phased out T3 abolished Enhanced risk coverage Stressed VaR (includes periods of stress) Credit Value Adjustment (CVA) to represent counterparty risk in market exposure Push on centralised clearing counterparties Wrong-Way risk Leverage ratio Ratio added to Pillar1 calculated with credit conversion factors Focus on off-balance sheet items Counter-cyclical measures Probability of Default (PD) and Exposure At Default (EAD) computed over long term Expected Loss (EL) to replace IAS39 Capital buffers to limit excess credit and leverage Global Liquidity Standard (BCBS 165)

  15. CREATING A RISK INTELLIGENT INDUSTRY GOVERNANCE DRIVEN Liquidity Dynamic gap analysis under scenarios Concentrations on funding sources Stress tests of exposure and collateral COMPLIANCE DRIVEN Counterparty Risks Concentrations and leverage Collateral and margin management (reflect concentrations) Market Risks Concentrations, root risk and indirect exposure Credit and liquidity risk priced in market risk Mark-to-volitilty, mark-to-liquidity Volatility and correlations Potential reverse impact of volatility and concentrations on correlations correlation and market depth

  16. ENHANCE TRANSPARENCY • Attach risk-ratings to ALL instruments including OTC and funds • Rate financial risks, volatility, liquidity, transparency • Adapt valuation frequency to risk ratings (Mark-to-Risk)

  17. MONITOR BEHAVIOURS • Attach risk-ratings to ALL instruments including OTC and funds • Rate financial risks, volatility, liquidity, transparency • Adapt valuation frequency to risk ratings (Mark-to-Risk)

  18. RISK & LIQUIDITY CONCENTRATION BENCHMARKS

  19. AGGREGATED TERM STRUCTURE OF MISMATCHES IN FOREIGN CURRENCIES Banks contribute foreign exchange claims in US$m by 1-Currency 2-Instrument type (fxswap, loan type, asset, liability) 3-Tenor (time bucket) 4-Volatility time bucket (if applicable) 5-Strike bucket (if applicable) 3 Thomson Reuters • Aggregated views foreign exchange claims by time bucket • Gap analysis (Asset/Liability mismatch) • Sensitivity analysis (under scenarios) • Volatility concentration matrices • Strike/Barriers concentration matrices Term Structure of Asset/Liabilities by currency • Central bank gets view of potential bubbles • Regulators can anticipate on funding issues per currency and instrument • Aggregated risk view in GBP • Banks can benchmark their funding risk against industry view. 1 2 Regulators input scenario 1-Interest rates 2-Exchange rate 3-Volatility 4-Correlation • Allow an assessment of firms’ currency liquidity risks and their potential vulnerabilities to a drying up of certain currency swap markets

  20. VARIABLE CAPITAL ADEQUACY RATIOS & CROSS-SYSTEM SIMULATIONS • Combine modeling, human judgment and consensus based consultation • Adjust regulatory policies according to risk intelligence • Anticipate bubbles and eradicate systemic risk

  21. Risk Intelligence is the New Efficient Frontier Regulators’ insights depend on risk intelligence. Data • Equity Prices • Public Company Fundamentals • Evaluated Pricing • Risk Benchmarks • Risk Indices • Risk Ratings • Pricing & Reference data • Valuation Risk Insights Information Post Trade Analytics Stress Tests & Reverse • Monte Carlo VaR • Potential Future Exposure • Stress and Scenario Testing • Beta • Duration • VaR • Binomial Model Analysis Collection Data Management • Single desk / portfolio • Unsophisticated • Multi desk / portfolio • Static post-trade risk aggregation • Portfolio view of firm-wide risk • Dynamic aggregation of contextualized risk Risk Aggregation Risk Intelligence Risk measurements Value Balancing shareholder value versus risk exposure depends on the firm’s assessment of its aggregate sensitivity to risk factors under changing conditions and on its ability to act upon it. 21

  22. Risk Intelligence: The 21st Century Frontier of Market Efficiency CRITICAL SUCCESS FACTORS IN IMA IMPLEMENTATION PHILIPPE CARREL Mumbai, July 21st 2010

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