Active Portfolio Management: Balancing Risk & Opportunity

Ludger Overbeck University of Giessen, Germany Ludger.overbeck@math.uni-giessen.de

GARP 13th Annual Risk Management Convention, New York, February 2012

INTEGRATED APPROACH TO VALUE-BASED MANAGEMENT

Intertwine risk, capital, risk-adjusted performance and business strategy

Risk Of Business

Capital Allocation

Risk-Adjusted Performance

Strategic Planning

Future Risk Taking

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Relationships to single customers

Business divisions/

Business areas

Group

Products

Decision- levels

Capital market- oriented

target

Allocation of

Resources

Strategic Planing/

Evaluation

Economic Capital

RAROC

Expected Return by Investor

% Increase of Return

Growth

Capital market (Expectations of shareholders )

Company value oriented Steering Concept

Value- oriented Steering

Economic Profit

• Economic profit puts a focus on both: growth and profitability.

• Like RAROC it can be applied on all decision levels.

THE VALUE ORIENTED STEERING CONCEPT STRIVES - BY MEANS OF RAROC - ON THE INCREASE OF ECONOMIC PROFIT

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Agenda

We will consider the following questions: What is economic capital and RAROC? Benefits of the RAROC-calculations? Tools and Application. Measurement of EC

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Objectives of Economic Capital Measurement

Objectives of credit portfolio modeling in Financial Institutions

l Computing the portfolio loss distribution Measures: Unexpected Loss, Credit VaR, Economic Capital Capital buffer to protect the institutions against unexpected losses

l Allocation of Economic Capital Distribution of capital to business units to measure performance Distribution to individual transactions to optimize risk/return ratios

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Why risk measurement / management?

Success Successful firms attract

more capital

Risks

Most businesses go along

with risk taking

Capital Risks has to be cushioned

by capital

Capital and Success can be quantified also risks have to be quanitified!

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Objectives of Economic Capital Measurement

• Efficient deployment of capital • Compare performance of business divisions • Risk vs. Return for business areas, customer groups products etc.

• Risk Appetite of bank • Regulatory requirements • Target Rating

• Value creation at origination • Avoid non-profitable transactions (including risk) • Identification of Hedging needs

Efficient allocation of resources to

maximize return

Protection of organization

Risk-adjusted Pricing

Which strategic business areas should

be expanded?

What are the capital requirements

How to determine risk-adjusted prices

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What is economic capital?

EC is the capital needed as a cushion against large losses. l In mathterms:

– Usually: Quantile of a loss distribution minus its expected loss, Quantile (99%)(L) -EL

– Alternative: Expected Shortfall: E[L|L>”Large”], possibly “Large”=Quantile.

l Can be viewed as a insurance or risk premium, that conceputually should be invested in riskless and liquid assets!

l Quantile or “Large” indicated the risk appetite of the institution and depends also on the desired own default probability.

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Loss Distribution

Set Time Horizon Obtain Loss

Distribution Set Level of

Confidence, e.g. 99%-Quantile

Read off Economic Capital

0 0.005 0.01 0.015 0.02 0.025 0.03

0

50

100

150

200

250

Expected Loss Economic Capital

Unexpected Loss

Loss

Probability Density or Frequency of Losses

99%-Quantile Mean

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0

5

10

15

20

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

Year

Cred

it Lo

ss

Objectives of Economic Capital

Expected Loss

Unexpected Loss

95% Quantile

Economic Capital

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Business Concepts for ACPM

Basic Concepts for ACPM

l Credit should be consistently priced l Credit should be transferred to a central portfolio management

unit l Credit should be managed in a portfolio context

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Business Concepts

Separation of Origination and Portfolio Management Origination is responsible for Client Relation PM is responsible for

l Aggregation l Re-distribution l Securisation l Hedging, Investment l Optimisation

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Three stages of Portfolio Management

Risk Controlling/Management l Measurement, Limit setting, ex post

Risk advisory l Measurement, “pricing”, RAROC-approach

Active Risk Management l Measurement and Market pricing l Risk/Return analysis and modeling l Hedging, investing l Strict separation of origination and risk managemt l Transfer pricing

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Stage 1

Risk Controlling, centralized function l First credit portfolio models l Marginal risk contribution drives internal pricing of credits l RAROC-pricing tool l Hurdle rate l Prices are bank specific l Institutional risk aversion is important l Ignores market perception of risk through credit spreads l Different incentives between front, middle and back offices

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Stage 2

Advisory l Centralized function decides about hedges and investments from

a top-down perspective l Often ignores still market pricing l Problem of cost and revenue allocation

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Stage 3

Origination transfers all risk to a portfolio management function against a “transfer fee”

Transfer fee should capture all returns, “opportunities” and the risk costs ( sometimes called “Mark-to-hedge”)

All risk management including capital management is with the portfolio management function

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Sales Capital market ACPM

(Active credit port-

folio management)

Sale at

market price

Buys

&

sells

generates

lending business with

customers

is ”owner of the risk”

– manages credit portfolio

– structures risks

– optimizes RWA application

– improves risk-return ratio

risks on the market

ACPM is the defined interface between sales and credit capital markets

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ACPM What are the targets?

Strengthening pricing sensitivity through transparent credit risk costs Improvement of risk profile Reduction of concentration risks Generation of add-on revenues through active positioning

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ACPM What are the challenges?

Transferring relatively illiquid products into capital markets Integration of market and credit risk and pricing Portfolio modeling Optimization of risk/return profile

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Improvement of Risk Profile

Possible stylized example “Black” =Starting Portfolio “Yellow”= Peak single exposures

hedged l little effect, i.e. no single name

concentration “Blue”=Numerical Optimization

l Major improvement l Basically yielding optimal

industry/regional allocation “Green”= additional qualitative

adjustments based on views towards industries/regions

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Improvement of Risk Profile

Possible stylized example Total improvement of Expected

Loss by 10% Decrease probability of loosing

more than 10% is reduced to a third (from of 7.2% to 2.4%)

Economic Capital reduced by 20% from 5% to 4%.

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- illustrative -

Contributory Economic Capital as a function of industry

EDF: 30 bp R²: 30 %

LGD: 50 %

CTY: Germany

CEC in % Exposure

0.00%

1.00%

2.00%

3.00%

4.00%

5.00%

Chemicals FinanceCompanies

Semi-conductors

Application of RAROC

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EC and RAROC example

As in the EL example: PD=30BP, LGD=50%, EAD=1,500,000, EL=2,250 EC=5% (i.e. Chemical) of exposure=75,000 Assume return (after non-risk cost) of 10,000=0.66% net margin RAROC=(Return-EL)/75,000=7,750/75,000=10.33%

If we could made the same loan in “semi-conductor” industry, EC=2.5%, the

RAROC would double to 20.33% A “RAROC-hurdle”-rate of 20 % would only be reached by the second

transaction. The transaction with the “chemical”, could perhaps sold in the market,

swapped or syndicated. Bank has to much concentration in “chemical”

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Portfolio report

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Active Credit Portfolio Management

In addition to the loan book, ACPM units shouls also have more trading like books l Investments for diversification and yields l Hegde book for single names l Macro Hedges l Rebalancing

l Trading opportunities

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Some quotations

Early as from 1998 (OWC in ERISK)

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Some quotations

Moodys KMV: early mover in ACPM: Kealhofer McQuown Vasicek founded KMV which provided

l EDF-measure: Expected Portfolio l Cited from: A brief History of Active Credit Portfolio Management

– Three principles – Hold credit only if compensated for the marginal risk – Reduce concentration and correlation – Reward liquid products, i.e. consider how liquid a product is.

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Some citations (KMV)

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Citation KMV

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Summary

Active Portfolio Management is a l Holistic approach to risk/return optimization l Considers all transactions in a portfolio level l Wants to avoid concentration in the portfolio

– Since Concentration leads to large „unexpected losses“ – Diversification strategies reduce concentration

l Portfolio view enables to define target portfolio l Might inprove risk opportunity profile by

– Hedging – Investing – Avoiding/limiting transactions with a high concentration risk

– or large risk with respect to return

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Summary

Active Portfolio Management requires

l Consistent and sensible risk adn return measurements l Joint analysis of market and credit risk l Consistent and rigorous pricing of transactions l Identification of hedging, trading and investment opportunities l Positioning in the secondary market l Portfolio view