Operationalization of Risk Appetite - balance sheet projections of banks Johan Hedberg Faculty of Engineering, LTH Lund University July 30, 2013 Abstract The financial crisis in 2008 enlightened several shortcomings in the perfor- mance of the banking sector. As a result of this a more rigid regulatory framework, Basel III, has been developed which raises the requirements of banks’capitalandliquiditystructureandinternalcapitaladequacyprocesses. This involves evaluating potential future risks related to the strategy and risk appetite of a bank. Therefore it is crucial that a bank has an understand- ing of how their business plan would affect the balance sheet under different economic scenarios. The goal of this study is therefore to demonstrate how this can be imple- mented by using quantitative projection methods, incorporating important risk factors such as yield curves, credit spreads and default probabilities. The projections involve the development of a deterministic mathematical model, based on credit migrations, under which business plans can be tested and evaluated under scenarios based on historical downturns such as the recent financial crisis. The evaluation is done by incorporating four key risk metrics into the model followed by a study of the results from the risk metrics using balance sheet data from an American bank. These risk metrics are considered under three different scenarios and four proposed business plans. Risk appetite targets and limits are defined where a breach serves as an indication to the bank that the business plan should be revised. The results show potential risks involved in the different business plans and supports a modest growth of the current balance sheet and a sound balance between trading and lending activities in order to stay within limits under severe scenarios. The conclusion is that the model can serve as a base for setting a risk appetite framework at a bank, but in order to validate key assumptionsandrobustnessoftheresultsamorethoroughinvestigationwith access to bank data is needed. Preface This thesis began as a suggestion from the Quantitative Advisory Services (QAS) at EY in Copenhagen. The idea was to work with regulatory require- ments in Basel III and more specifically to develop a capital planning tool which operationalized risk appetite for banks. This sounded like an inter- esting topic with respect to the the current financial climate and with the financial crisis still in mind. During my work at EY I have received great support and I would especially want to thank Richard Hunter for insightful comments and knowledgeable help. Also, I would like to thank Jim Gustafs- son for supporting me extensively throughout the process. I would also like to thank Johanna Carlsson, Anna Silén and Karin Gambe for helping with additional input and comments. Also, I would like to thank Nader Tajvidi at The Division of Mathemati- cal Statistics at the Faculty of Engineering at Lund University for important and rewarding feedback throughout the work process. Johan Hedberg Copenhagen, July 24, 2013 Contents 1. Introduction 1 1.1. Background . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 1.2. Aim of thesis . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 1.3. Outline . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 2. Basel III 4 2.1. Basel Accords - History . . . . . . . . . . . . . . . . . . . . . . 4 2.2. Pillar 1 - Capital requirements under Basel III . . . . . . . . . 4 2.3. Supervisory requirements under Basel III (Pillar 2) . . . . . . 7 2.4. Risk Appetite . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 3. Relevant risks under Basel III 11 3.1. Credit risk under Basel III . . . . . . . . . . . . . . . . . . . . 11 3.2. Market risk under Basel III . . . . . . . . . . . . . . . . . . . 12 3.2.1. Value-at-Risk . . . . . . . . . . . . . . . . . . . . . . . 13 3.2.2. Standardized method and internal model . . . . . . . . 14 3.3. Operational risk under Basel III . . . . . . . . . . . . . . . . . 15 3.3.1. The Basic Indicator Approach (BIA) . . . . . . . . . . 17 3.3.2. The Standardized Approach (TSA) . . . . . . . . . . . 17 3.3.3. The Advanced Measurement Approaches (AMA) . . . 18 3.4. Liquidity risk under Basel III . . . . . . . . . . . . . . . . . . 18 3.4.1. Liquidity Funding Ratio (LCR) . . . . . . . . . . . . . 19 3.4.2. Net Stable Funding Ratio (NSFR) . . . . . . . . . . . 19 4. Balance sheet structure 20 4.1. The balance sheet of a bank . . . . . . . . . . . . . . . . . . . 20 4.2. Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20 4.2.1. Banking book . . . . . . . . . . . . . . . . . . . . . . . 20 4.2.2. Trading book . . . . . . . . . . . . . . . . . . . . . . . 22 4.3. Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22 4.3.1. Shareholders’ Equity . . . . . . . . . . . . . . . . . . . 22 4.3.2. Deposits and Wholesale funding . . . . . . . . . . . . . 23 4.4. Profit & Loss account . . . . . . . . . . . . . . . . . . . . . . . 24 4.4.1. Structure . . . . . . . . . . . . . . . . . . . . . . . . . 25 5. The projections 27 5.1. Projections - main purpose . . . . . . . . . . . . . . . . . . . . 27 5.2. Risk metrics . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28 5.2.1. CET 1 Ratio . . . . . . . . . . . . . . . . . . . . . . . 28 5.2.2. Return on Equity (ROE) . . . . . . . . . . . . . . . . . 29 5.2.3. Leverage ratio . . . . . . . . . . . . . . . . . . . . . . . 29 5.2.4. NSFR . . . . . . . . . . . . . . . . . . . . . . . . . . . 30 5.3. Constructing balance sheet for a simple bank . . . . . . . . . . 31 5.4. Relevant risk factors . . . . . . . . . . . . . . . . . . . . . . . 31 5.4.1. The yield curve . . . . . . . . . . . . . . . . . . . . . . 32 5.4.2. Credit spread of bonds . . . . . . . . . . . . . . . . . . 33 5.4.3. Probability of Default . . . . . . . . . . . . . . . . . . 34 5.4.4. Equity Index . . . . . . . . . . . . . . . . . . . . . . . 37 5.4.5. Exposure,volatilityandcorrelationofyieldcurve,credit spreads and equity . . . . . . . . . . . . . . . . . . . . 37 5.4.6. Loss Given Default (LGD) . . . . . . . . . . . . . . . . 39 5.4.7. Loan rate . . . . . . . . . . . . . . . . . . . . . . . . . 40 5.4.8. Cost of wholesale funding . . . . . . . . . . . . . . . . 42 5.4.9. Deposit rate and growth of deposits . . . . . . . . . . . 43 5.5. Mechanics of the projections . . . . . . . . . . . . . . . . . . . 44 5.5.1. Time horizon . . . . . . . . . . . . . . . . . . . . . . . 44 5.6. Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44 5.6.1. Corporate bonds . . . . . . . . . . . . . . . . . . . . . 44 5.6.2. Government bonds . . . . . . . . . . . . . . . . . . . . 47 5.6.3. Equity . . . . . . . . . . . . . . . . . . . . . . . . . . . 48 5.6.4. Retail loans . . . . . . . . . . . . . . . . . . . . . . . . 48 5.6.5. Old loans . . . . . . . . . . . . . . . . . . . . . . . . . 51 5.6.6. New loans . . . . . . . . . . . . . . . . . . . . . . . . . 53 5.7. Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53 5.7.1. Deposits . . . . . . . . . . . . . . . . . . . . . . . . . . 53 5.7.2. Wholesale funding . . . . . . . . . . . . . . . . . . . . 54 5.7.3. Share capital . . . . . . . . . . . . . . . . . . . . . . . 54 5.7.4. Retained earnings (Profit & Loss account) . . . . . . . 54 5.7.5. Reallocating assets/retained earnings at end of each period . . . . . . . . . . . . . . . . . . . . . . . . . . . 55 5.7.6. Default state . . . . . . . . . . . . . . . . . . . . . . . 56 5.8. Risk-weighted assets . . . . . . . . . . . . . . . . . . . . . . . 56 5.8.1. Market risk for Bank J . . . . . . . . . . . . . . . . . . 56 5.8.2. Credit risk for Bank J . . . . . . . . . . . . . . . . . . 57 5.8.3. Operational risk for Bank J . . . . . . . . . . . . . . . 58 6. Testing business plans under different scenarios 59 6.1. Initial portfolio of Bank J . . . . . . . . . . . . . . . . . . . . 59 6.2. Business plans . . . . . . . . . . . . . . . . . . . . . . . . . . . 59 6.2.1. Plan 1 - Keeping current portfolio structure . . . . . . 60 6.2.2. Plan 2 - Increasing trading portfolio . . . . . . . . . . . 60 6.2.3. Plan 3 - Increasing retail loan portfolio . . . . . . . . . 60 6.2.4. Plan 4 - Aggressive growth agenda . . . . . . . . . . . 60 6.3. Scenarios . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61 6.3.1. Scenario 1 - Base Case Scenario . . . . . . . . . . . . . 61 6.3.2. Scenario 2 - Early 2000’s Recession (2000-2004) . . . . 63 6.3.3. Scenario 3 - Financial Crisis (2005-2009) . . . . . . . . 66 7. Results 69 7.1. Scenario 1 - Base Case Scenario . . . . . . . . . . . . . . . . . 69 7.2. Scenario 2 - Early 2000’s Recession . . . . . . . . . . . . . . . 71 7.3. Scenario 3 - Financial Crisis . . . . . . . . . . . . . . . . . . . 74 8. Conclusions 78 8.1. Scenario 1 - Base Case Scenario . . . . . . . . . . . . . . . . . 78 8.2. Scenario 2 - Early 2000’s Recession . . . . . . . . . . . . . . . 78 8.3. Scenario 3 - Financial Crisis . . . . . . . . . . . . . . . . . . . 79 8.4. Final conclusions . . . . . . . . . . . . . . . . . . . . . . . . . 80 9. Discussion of improvements 81 Appendices 82 A. Volatility and correlation in trading book 82 A.1. Volatility of risk factors in trading book . . . . . . . . . . . . 82 A.2. Correlation between risk factors in trading book . . . . . . . . 83 B. Spread for cost of wholesale funding 84 C. Balance sheet data and mapping rules 85 D. Capital Planning Tool 87 References 93 1 Introduction 1.1 Background The fundamental purpose of a bank is the provision of long term financing to the real economy. This is done through borrowing from customers in the form of deposit taking or from wholesale markets and transforming this short term debt into long term debt by lending to businesses and individuals. By standing in the middle of these transactions the bank takes on credit risk, and by transforming the duration of debt it takes on liquidity risk. In order to balance the level of these risks against the risk capacity of the business it is vital that the bank understands how they will evolve over time and in different economic scenarios and how this evolution can be affected by the business plan. The evaluation of the recent financial crisis in 2008 showed some critical shortagesinthebehaviorofthebankingsector. Onemainreasonforthecrisis was that banks in many countries had built up excessive on- and off-balance sheetleverage. Combinedwithaweakercapitalbaseandinsufficientliquidity buffers, the banking sector was unable to take care of larger exposures of the off-balance sheet and the systemic trading and credit losses that occurred when the crisis was at hand. This led to a degeneration in the market’s trust of the banks and in the end this was transmitted to the whole economy. Due to this turn of events, a new and stricter framework for regulating risks taken by banking institutions was developed in the form of Basel III[1]. The lack of stability in the banking world during the crisis showed the importance of assessing that enough capital is covering the risks of banks. With an uncertain future where many scenarios could potentially undermine thecapitalbaseofabank, itiscrucialtohaveaprocessinplacethatcaptures these issues. This can be done by incorporating business plans into scenario building and stress testing through projections of a bank’s balance sheet[2]. It is an important part of Basel III and is specified under Pillar II. The model developed is deterministic and is based on credit migrations and discounting principles. Through constructing a mathematical model based on credit migrations and through implementing this in a tool where a bank can project its assets and liabilities, this thesis provides a risk appetite framework under which a bank can evaluate and quantify the future risks of its current business plan. 1 1.2 Aim of thesis Thegoalofthisthesisistodemonstratehowquantitativeprojectionmethods can be used to challenge a bank’s business plans and ensure that the risk taking activities of the bank do not exceed its risk capacity. The projection methodology will be to consider asset and liability allocations, incorporating both business plans and the effect of key risk drivers. By considering a number of scenarios, reflected in the projection through stressed risk drivers, we see how risk appetite limits can be used to limit or promote risk taking activities in order to ensure the continuing financial strength of the bank and the fulfillment of the sharpened requirements in Basel III. Key metrics are defined to be used in a risk appetite framework and both tolerances and limits for these metrics are defined. These metrics are projected quarterly over a five year time horizon based on balance sheet and required capital projections across a number of extreme but plausible scenarios. If the limits are breached in any of these scenarios then the risk appetite is considered to be breached and the business plan should be revised to avoid excessive risk in the company. A number of alternate business strategies are investigated, such as an aggressive growth agenda and a focus on trading assets on the balance sheet and show that the performance of the riskmetricsshowsacleardifferentiationbetweentheimpactsofthestrategies on the financial strength of the company in adverse scenarios. 2 1.3 Outline The thesis is structured as follows. Section 2 describes the background and focus of Basel III and the definition and idea behind risk appetite and how it can be operationalized. Section 3 describes some of the most important risks under Basel III. Section 4 describes the structure of a bank’s balance sheet. Section 5 describes how the projections of the balance sheet are done with explanations of chosen risk metrics and risk factors. Section 6 describes different business plans and under which scenarios those are tested. Section 7 shows the results. Section 8 concludes. Section 9 discusses further im- provements. An overview of the different parts and how they are connected can be seen in figure 1. Figure 1: Overview of the different parts of the thesis. 3 2 Basel III 2.1 Basel Accords - History ThefirstBaselaccordwascreatedin1988bytheBaselCommitteeofBanking Supervision, a committee established by the Central Bank Governors of the Group of Ten (G-10) in 1974. With this an important step towards an international minimum capital standard for banks was taken. However, it can be concluded that many of the approaches in Basel I were far too coarse and failed to measure and aggregate risk sufficiently. It also failed in treating the risk of derivatives, at that time a relatively new set of instruments that had quickly gained popularity. The focus in the first accord was on credit risk. A second framework, Basel II, was introduced in 2004, again with focus on credit risk. This time banks were allowed to choose between internally developed approaches and certain defined standard methods to measuring risk. The three-Pillar concept was introduced, with Pillar 1 subject to the calculation of a minimum capital charge. The capital charge was calculated for credit risk, market risk and operational risk. Pillar 2 was introduced as thesupervisoryreviewprocess,whichenhancedtheimportanceofgovernance of the banks’ internal assessments to their overall risk. In other words, that soundmanagementmethodswereinplaceandthatenoughcapital(described in Pillar 1) was allocated to the different risks. Pillar 3 was subject to public disclosure of risk measures with greater insight to the risk management of banks, in order to improve market discipline. During and after the financial crisis in 2008 several shortcomings of Basel II were revealed which led to the development of a third accord, Basel III. Much of the framework of Basel II is the base of Basel III, with some im- portant differences[10]. The structure of Basel III will be described further ahead. An overview of the regulatory framework can be seen in figure 2. 2.2 Pillar 1 - Capital requirements under Basel III One of the key lessons learned from the financial crisis was that many banks had insufficient amounts of high quality capital. It was also revealed that the definition of capital was different across jurisdictions, making it hard to supervise if capital standards of the previous regulation framework, Basel II, were to be appropriately met. In order to deal with these shortcomings Basel III was introduced. The definition and views of the regulatory capital is, as in Basel II, addressed in Pillar 1. Regulatory capital is defined as the minimum requirement of capital that 4
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