risk appetite: a new menu under basel 3? pieter klaassen (ubs) voor het zanders risicomanagement...
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Risk Appetite: A new Menu under Basel 3?
Zanders Seminar “Effectief Kapitaalmanagement”
1 November 2012
Pieter Klaassen
UBS - Firm-wide Risk Control & Methodology
1
Agenda
What is this “Risk Appetite”?
UBS Firm-wide Risk Appetite Framework
Basel 3: A Stricter Diet
Risk Appetite under Basel 3
Section 1
What is this “Risk Appetite”?
3
What is this “Risk Appetite”?
Risk Appetite
“The level and type of risk a firm is able and willing to assume in its exposures and business
activities, given its business objectives and obligations to stakeholders.”
“Risk appetite is generally expressed through both quantitative and qualitative means and should
consider extreme conditions, events, and outcomes. In addition, risk appetite should reflect
potential impact on earnings, capital, and funding/liquidity.”
(Senior Supervisors Group, “Observations on Developments in Risk Appetite Frameworks and IT
Infrastructure”, December 23, 2010)
Context
– Papers by the Senior Supervisors Group (SSG) and Institute for International Finance (IIF)
established that a comprehensive firm-wide risk appetite framework covering all types of
risks is now considered essential and not just best practice
– Basel II, Pillar 2:
“The bank’s board of directors has responsibility for setting the bank’s tolerance for risks. It
should also ensure that management establishes a framework for assessing the various risks,
develops a system to relate risk to the bank’s capital level…“
4
Risk Appetite: Key Elements
Comprehensive approach – integrating credit, market, operational, liquidity, and
reputational risks across the firm
– Both quantitative and qualitative elements
Use of multiple methodologies (taking into account technical limitations of risk metrics,
models, and techniques such as VaR) – incorporating, in particular, stress/scenario
testing and consideration of risk concentrations
Translate risk appetite at the top of the house to risk appetite (limits) for individual risk
types and at lower levels of the organization (business units and below)
Link to strategic planning and budgeting process - collaboration among risk
management, finance, and strategy functions
Role of risk culture, ‘tone from the top’
Regulatory Expectations and Industry Best Practices
Risk appetite as a continuous, evolutionary, learning process – not
just a one-time exercise
5
Defining, Challenging and Monitoring Risk Appetite
Management should articulate the firm’s appetite for risk in the context of business
strategy
– They own the risk and are expected to fully understand the firm’s risk position at all times
Boards should
– set basic goals for the firm’s risk appetite and strategy,
– review and affirm management’s articulation of risk appetite, and
– ensure that risks are comprehensively considered and managed
CROs should (and should be empowered to):
– assess and control the firm-wide risk level
– provide an integrated view of the overall risks the firm faces, and
– ascertain that the firm’s risk level is consistent with its risk appetite
Supervisors have a role in assessing and challenging Boards’ and Managements’
achievement of these goals, risk awareness and understanding, and conformance to
(evolving) best practice
Firms’ management, boards, risk management departments, and supervisors all
have roles
Section 2
UBS Firm-wide Risk Appetite Framework
7
Capital Criteria Earnings Criteria
Solvency
Positive Earnings, Payment of Dividends
Rating Change
Regulatory Constraints
Mean Earnings
Earnings
Pro
bab
ilit
y
Risk Exposure:
Deviation from Mean Earnings at:
Earnings Power/Capacity
0
Dividend
95%
Capital Depletion Earnings/Dividend
reduction
Ev
ent
Cap
acity
/
Cu
shio
n
Risk
V
iew
99.9+%
Capital
Earnings/Capital Waterfall Continuum – at Least in Principle
8
Evolution of Risk Appetite & Experience during the Crisis
Traditionally, focus on:
Solvency perspective
– Consideration of Economic Capital and total (or Tier 1) capital
Dividend paying ability in most years, also in adverse economic situation
Experience during the crisis:
Focus on going-concern capital metrics (e.g., Tier 1 ratio)
– Loss-absorbing capital is what matters
Consider scenario-based stress metrics in addition to statistical metrics
– Look beyond historical experience
Ensure stable funding sources and ample liquid assets
Shift to ensuring going concern under stress
9
Implications for Risk Appetite
Need for complementary criteria (with different time horizons and confidence/severity
levels), representing different points in the financial structure/stakeholder waterfall. E.g.:
– Traditional EC view at a high (99.9+%) confidence level over 1 year and/or multiple years
– Tier 1 ratio or similar view at a lower confidence level over ranges from 1 quarter to multiple
years
– Earnings view at a lower (one in 5-25 year) confidence level over 1 quarter to 1 year time horizon
Focus on high-quality equity capital (convergence to Basel III or similar view)
Embedding multiple complementary criteria
Multiple severity levels, metrics, and risk horizons
10
UBS Firm-wide Risk Appetite
Pillars
Earnings
Earnings should
cover the risk
of losses in
most years
+
Avoid repeated
(large) quarterly
losses
Minimum Tier-1
Capital
Loss-absorbing
capital is sufficient
to
meet regulatory
requirements even
if a severe loss
event were to
occur
Solvency
Ensure sufficient
total loss-
absorbing capital
to sustain even an
extreme stress
event
UBS Risk Appetite Framework
Stress
Scenario
Stress
Statistical
Stress
Scenario
Stress
Statistical
Stress
Statistical
11
Risk Appetite objectives: Risk Capacity vs Risk Exposure
Earnings
Capital
Regulatory requirements
and constraints
Buffer
Risk Capacity
maximum amount of risk a firm is
technically able to assume given its
capital base, liquidity, borrowing
capacity, and regulatory constraints
Risk Exposure
the amount of risk, by whatever
metric, actually being taken at a
point in time, or expected/forecast to
be taken
Credit Risk
Country Risk
Funding Risk
Operational Risk
Investment Risk
Pension Risk
Market Risk
Issuer Risk
} R
isk A
ppetite
Taking into account
strategic considerations
12
Overview of Firm-wide Risk Appetite Framework
Firm-wide Risk Appetite Framework
Business
Plans
(projected net
earnings and
capital)
less
Business Risk
(volatility in
earnings)
Firm-wide
Stress
Operational
Risk Funding Risk
Pension
Risk Market Risk Issuer Risk
Credit
Risk
Exposure
Measures
E@R / C@R
Statistical
Measures Stress
Measures Risk Categories
Risk Capacity Risk Exposure
Country
Risk
The firm-wide statistical and stress metrics are complemented with
a granular limit framework with portfolio and position limits
Investment
Risk
The framework encompasses all material risk categories, and plays a key role in the decision-
making processes in the Bank
LU Risk
Consequential Risks Position Risks
Of the various scenarios in the Firm-wide Stress framework, the most relevant /
severe one is used as the ‘binding’ scenario in the Risk Appetite Framework
Granular Limit Framework
13
Risk Exposure: Firm-wide measures
UBS has two complementary approaches – one statistical and one stress based
Earnings-at-Risk /
Capital-at-Risk
(E@R / C@R)
Firm-wide Scenario
Stress Test
Statistical measure which allows the aggregation of firm-wide risks using
statistical techniques which can then be tied to probabilities / confidence
levels
A large number of potential outcomes and associated losses is simulated,
rooted in historically observed market changes
More intuitive stress measure which calculates the impact of a scenario on
the firm-wide portfolio including the causality chain by which losses would
arise if the scenario were to unfold
Scenarios enable incorporation of forward-looking views
Under both firm-wide measurement approaches, we model the first order P&L and capital
impacts as well as the consequential capital impacts of downgrades in the Firm's portfolio
and resulting adjustments to RWA
14
UBS Approach for Firm-wide Stress Testing
Credit Risk
Country Risk
Funding Risk
Business Risk
Investment Risk
Risk Factor
Sensitivities
and/or
Revaluation
methodologies
Macro-economic
scenario
Operational Risk
P&L impacts
OCI impacts
RWA impacts
Aggregation
Pension Risk
Quantitative and
qualitative analysis of
historical data about
defaults,
impairments, write-
downs etc.
Various global
downturn scenarios
Quarterly time profile of
• P&L (losses, earnings)
• OCI impacts
• Risk Weighted Assets
and ultimately Tier 1 capital
ratio
Q1 Q2 Q3 Q4 Q5 Q6 Q7 Q8
Tier 1 Capital Ratio
Critical
threshold
Market Risk
Issuer Risk
Scenario-based stress tests
15
UBS Statistical Risk framework
Aggregate Group Risk Exposure derived from probability distribution of potential earnings shortfalls,
supplemented by targeted stress components.
Diversification between risk types is included at each aggregation step
Comprehensive assessment of risks
Earnings
Pro
ba
bili
ty
0
Expecte
d
Earnings
Market
Issuer
Credit
Country
Investment
Operational
Funding
Pension
Business
Position Risks Consequential Risks Business Risks
Targeted stress
components
Capture special risks
not modeled statistically
Aggregate
Statistical Risk
Exposure
=
Step One Step Two Step Three = Copula Aggregation
Section 3
Basel 3: A Stricter Diet
17
Too-Big-To-Fail
Sylvan Wegmann
18
Basel 3: Increased Minimum Capital Requirements
3.50% 4.00% 4.50% 4.50% 4.50% 4.50% 4.50%
2.50%2.75%
2.88%3.63%
4.25%4.88%
5.50%
1.00%
1.75%
2.25%
2.625%
2.875%3.00%
3.00%
1.50%
2.75%
3.75%
4.50%
5.12%
5.63%
6.00%
0%
2%
4%
6%
8%
10%
12%
14%
16%
18%
20%
2013 2014 2015 2016 2017 2018 Basel 3- Full
FINMA Basel 3 Phase-in - Minimum capital requirementSystemically important Banks (maximum 6% progressive component)
Progressive component (CoCos 5% trigger) Capital Buffer - CoCos 7% Trigger (max)
Capital Buffer - CET1 (min) Minimum CET1
3.5% 4.0% 4.5% 4.5% 4.5% 4.5% 4.5%
0.625%1.25%
1.875%2.5%
1.0%
1.5%1.5%
1.5%1.5%
1.5%1.5%
3.5%2.5% 2.0%
2.0%2.0%
2.0%2.0%
0.625%
1.25%
1.875%
2.5%
0%
2%
4%
6%
8%
10%
12%
14%
16%
18%
20%
2013 2014 2015 2016 2017 2018 Basel 3- Full
BIS Basel 3 Phase-in - Minimum capital requirementGlobal Systemically important Banks (G-SIB)
G-SIB additional capital (max) Tier-2 Capital Additional Tier-1 Capital
Capital Conservation Buffer (CET1) Minimum CET1
Excludes Countercyclical Capital Buffer (max 2.5%)
Following Basel Committee … … and with “Swiss Finish”
19
Basel 3: Lower Eligible Capital + higher RWA
DTA
Inv. in Fin
Institutions
Items > 15% CET1
Other
deductions
Eligible Capital
-16.4%
RWA vs
deductions
CVA
AV Corr
-5.8%
-2.0%
-3.6%
-5.0% RWA
+ 18.4%
+7.6%
+9.3%
+1.4%
Source: EBA Basel III monitoring exercise,
average of Group 1 banks, Sept 2012
20
In addition to impact of Basel 2.5
Source: UBS 3Q12 Report
Stress VaR, IRC, CRM, and modified securitisation treatment
increase UBS market risk RWA by 400%
21
Basel 3: UBS RWA Targets
Source: UBS 3Q12 Results Presentation
22
Basel 3: New items on the menu
Leverage
Ratio
Liquidity
Coverage
Ratio
Net Stable
Funding
Ratio
23
Basel 3: UBS Balance Sheet Development
Source: UBS 4Q11 & 3Q12 Results Presentation
Influences Leverage Ratio capital requirement
Target reduction of Assets excl PRVs to 600bn in 2015
Section 4
Risk Appetite under Basel 3
25
Basel 3 is estimated to lead to increased product costs
Source: “Basel III and European banking: Its impact, how banks might respond, and the challenges of
implementation”. McKinsey & Company, Working Papers on Risk 26, November 2010.
26
Basel 3: Capital Market Businesses are most affected
Portfolio
optimization
Model
refinements +
data quality
improvements
Conserving
capital, liquidity
and funding
Operational
enhancements
Source: “Day of reckoning? New regulation and its impact on capital-markets businesses”,
McKinsey & Company, Working Papers on Risk 29, October 2011.
Structured credit, rates, and equity most affected; FX and cash equities least
Mitigating
actions:
27
Basel 3: Considerations for Earnings Objectives
Original objective (2003) was to ensure minimum dividend payment
– Even in adverse situation, with high probability
Since the 2007-2008 financial crisis
– Profits have been used to increase tangible equity instead of paying dividends
– Risk taking has reduced substantially
– Inventory of legacy exposures have been wound down
– Market circumstances have been challenging
Focus on profitability instead of paying dividends
– For Core Businesses - Legacy exposures supported by capital
– Differentiated tolerance for losses in different businesses
New balance to be found between risk and return
Focus on profitability of Core Businesses
28
Basel 3: Choices for Capital Objectives
Consider Basel 3 CET1 phase-in or fully-applied?
– Regulatory capital based on phase-in
– Analyst focus often already on fully-applied
What minimum CET1 ratio to choose under stress for Tier-1 Capital objectives?
– Impairment of capital buffer requires plan to replenish the buffer
– Impairment of capital buffer can lead to restrictions on shareholder distributions and discretionary
pay – up to imposing measures to increase capital and/or reduce RWA
– Latest point at which FINMA interferes is 8.75% CET1 ratio
– 50% impairment of capital buffer
– Well before triggering high-trigger (7%) CoCos
Maintain Solvency objective
– Loss-absorbing capital as Risk Capacity
Alignment with Recovery and Resolution plans
Sufficient capital to ensure going-concern after severe stress
29
Potential Extensions of Risk Appetite objectives
Leverage ratio objective
– Satisfying minimum leverage ratio also after a stress event?
– FINMA leverage ratio denominator calculation (“assets”) to be finalized
– Minimum leverage ratio requirement to be reviewed
Establish connection with liquidity framework
– Minimum liquidity and funding requirements after a stress event
– UBS satisfies existing interpretation of LCR and NSFR
Separate (but aligned) objectives for major legal entities
Cascade Risk Appetite objectives to Business Divisions
– Continue to do so through limit framework
– In addition, consideration of business-specific objectives
Balance between comprehensiveness, simplicity & transparency
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