Risk Management for Banks: Challenges and Opportunities Corporate Governance Program for Directors of Indian Banks Mumbai, India December 16, 2005. Mark Lawrence, Ph.D. Former Chief Risk Officer, Australia and New Zealand Banking Group, Melbourne, Australia [email protected] ANZ.
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Corporate Governance Program for
Directors of Indian Banks
December 16, 2005
Mark Lawrence, Ph.D.
Former Chief Risk Officer, Australia and New Zealand Banking Group, Melbourne, Australia
Source:“The ANZ Risk Management Framework”, CRO presentation to investors, 27 July 2004 http://www.anz.com/aus/shares/presentations/speeches/2004.asp
Performance, Losses, Competition
Market Scrutiny, Technology
Take Uneconomic Risks
Drive Growth Aggressively
Incur Large Losses
Lose Market Share/Profits
Clamp Down on Lending/Risk Taking
Forego Economic Risks
Since the future is uncertain, you can’t generate returns
without taking risk:
There is a limit to the level of risk a commercial bank can take
To be successful, banks must remain successful and viable at every point on the economic cycle…
Note:Culture is a dominant factor in risk outcomes, including incentives/compensation
*** Strong leadership from the top on risk matters is essential, to ensure a strong “risk culture”
5 - 25%
50 - 65%
Operational and Business Risks
10 - 30%
Significantlyimproved ability to manage credit risk on a portfolio basis by more sophisticated banks
But data limitations are significant in many markets
Deregulation & globalisation of financial services
Activities of Banks (& their risk profiles) more diverse & complex
Growing sophistication of financial technology
Whichever way you look, operationally we are becoming more complex and inter-dependent….
Economic, Cultural & Political
Partnering, alliances, outsourcing & JVs
…resulting in greater focus on Operational Risk by financial services providers, government & others…
…and a consensus definition of Operational Risk financial services providers, government & others…
Risk Governance Example: financial services providers, government & others…Board and Executive Risk Committee Structure
Board Risk Management Committee
Principal Executive Risk Committees
Credit & Trading
Asset & Liability
Project & Initiative
Risk Governance Example ( financial services providers, government & others…Cont.)
* See example RMC Charter at:http://www.anz.com/australia/aboutanz/corporateinformation/corpgovpolicy/
Risk Management Functional Model financial services providers, government & others…(Example)
- Internal Credit Rating Tools
- Expected Loss + Economic Capital models (all risks)
** Key Q: where should Risk “Shared Services” be located?** Cultural considerations will drive the outcome here! Why go to the Centre?- Centre of Excellence- Efficiency/avoid duplicationWhy go to the Business Units?- BU Ownership and Accountability- BU control over Cost? (vs cost allocation from centre)
Example: financial services providers, government & others… Central Risk Management Structure
How is this effective? financial services providers, government & others…
Group Risk Management
Banks hold Economic Capital for “Unexpected Loss” financial services providers, government & others…
Potential catastrophic ‘unexpected loss’
against which it is too expensive to hold capital
Expected level of loss (cost of doing business)
for which capital
should be held
The “risk spectrum” financial services providers, government & others…
ECONOMIC CAPITAL FOR ALL THESE RISKS ?
Cost of Funds 6.00% Funds Transfer Pricing Systems
Provision 0.53% Credit Risk Models
Direct Expense 0.15%
Indirect Expense 0.15% Product Cost Accounting Systems
Total charges beforecapital charge 6.93%Capital Charge 0.45%
Total Required “Breakeven”
Loan Rate 7.38%
Allocated equity/loan = 6.7%
Opportunity cost of equity = 12% (“hurdle rate”)
FTP Benefit = 6%
After tax capital charge = 0.067x (0.12 - 0.06) = 0.4%
Tax Rate (imputation-adjusted) = 0.108
Pre-tax capital charge = 0.4%/0.892 = 0.45%
Balancing Risk and Return financial services providers, government & others…
The key is to find the right balance between
risk and return:
The Role of the Chief Risk Officer (CRO) financial services providers, government & others…
The Opportunity… financial services providers, government & others…
To create and position Risk Management in our organisations as a source of distinction and competitive advantage, underpinning sustainable performance and growth
Agenda (II): Basel II financial services providers, government & others…
Basel II - what is it? financial services providers, government & others…
The 1988 Basel Accord – “Basel I” financial services providers, government & others…
The Impact of Basel I financial services providers, government & others…
Basel II: The Three Pillars financial services providers, government & others…
Basel II consists of three mutually reinforcing pillars:
Pillar 1: Minimum Capital Requirements
Pillar 1 provides the calculation methods that will be used to determine the minimum amount of regulatory capital a bank must hold in the three major types of risks a banking operation faces - credit risk, market risk and operational risk.
A menu of approaches is available to measure:
Credit Risk (Standardised, Foundation internal ratings based approach and Advanced internal ratings based approach - the latter two requiring the application of sophisticated and rigorous credit risk modelling capabilities)
Operational Risk (Basic Indicator, Standardised and Advanced measurement approaches). The requirement to hold regulatory capital for operational risk is a material new requirement.
Market Risk (Standardised and Internal models approach). This element is almost completely unchanged in the new framework following its overhaul in 1996.
Basel II: The three Basel Pillars (cont.) financial services providers, government & others…
Pillar 2: The Supervisory Review Process
Pillar 2 requires regulators to ensure each bank has sound internal processes in place to assess the adequacy of its capital (based on a thorough evaluation of the risks), with the supervisor placing considerable emphasis on the effectiveness and robustness of a bank’s internal risk management capability.
Pillar 3: Market Discipline
Pillar 3 aims to bolster market discipline through enhanced disclosure of risk information to the market. More detail will be disclosed to the market on the types of loans a bank carries, the rate at which loans default and how well credit rating tools predict these defaults.
Market participants will have more information to better understand bank risk profiles and the adequacy of bank capital positions.
Credit Risk Capital
Internal Rating Based (IRB) - Advanced
Internal Ratings Based (IRB) - Foundation
Allows application of internally developed rating systems (default probabilities) with greater recognition of physical collateral.
Minor modifications to the current (Basel I) Accord, allowing the use of external ratings and some collateral recognition.
Internally determined default probabilities, loss given default and exposure at default factors can be used, subject to very stringent criteria.
Operational Risk Capital
Basic Indicator Approach
Standardised Approach for Operational Risk
Advanced Measurement Approaches
A range of advanced capital assessment techniques will be allowed, subject to a set of stringent qualifying criteria.
A similar calculation based on a % of gross income using distribution factors across eight Basel-defined business lines.
A coarse calculation based upon a straight percentage (15%) of gross income.
Key changes in Basel II Capital
Remainder eg Personal/ Corporates
Risk weight sensitive to borrower’s credit risk
Increasing default risk
Operational Risk Capital Capital
* The magnitude of this shift illustrates the difficulty of the measurement challenge!
“Let a thousand flowers bloom…”!!
Basel II: Pillar 3 requirements Capital
Table 6: Credit risk – disclosures for portfolios subject to IRB approaches
Effective dialogue between the industry and supervisor is essential for success!