CRITICAL SUCCESS FACTORS IN IMA IMPLEMENTATION

PHILIPPE CARRELMumbai, July 21st 2010

Risk Intelligence: The 21st Century Frontier of Market Efficiency

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

REGULATIONS AIM AT DE-RISKING VITAL ACTIVITIES

CAPITAL

Credit Risk Weighted Assets + [12.5 x (Mkt Cap Charge + Ops Cap Charge)]CAPITAL

Credit Risk Weighted Assets + [12.5 x (Mkt Cap Charge + Ops Cap Charge)]

Systematic risks through countercyclical prudential supervisory measures.

BCBS 164 on strengthening resilience contains proposals for capital buffers to contain leverage and exposure

Idiosyncratic risk stabilised through adjusted through risk adjusted capital reserves

IDIOSYNCRATIC RISK MANAGEMENT IS TO BALANCE THE CREATION OF VALUE WITH EXPOSURE TO RISK FACTORS

Corporate Strategy Funding Strategy

Risk Appetite

• Exposure

• Sensitivity

• Maximum Loss

Shareholders Debt, Bond holders

Corporate Strategy Funding StrategyCorporate Strategy Funding Strategy

Risk Appetite

• Exposure

• Sensitivity

• Maximum Loss

Shareholders Debt, Bond holders

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

Market Risks (VaR)Credit Risks (CVaR, PFE)

Markets

Portfolios

Economy

Growth

Country

Operations

MANAGED IN SILOS, RISK IS NECESSARILY AGGREGATED BY MODELSBanking Books Trading Books

Market Risks (ALM)Credit Risks (EL=PDx[1-LGD])

Collateral

Market Risks (Haircut)Credit Risks (EAD)

Operational Risks (PE x LGE) or OpVaR

NetRWA

Markets

Portfolios

Economy

Growth

Country

Operations

Markets

Portfolios

Economy

Growth

Country

Operations

),()(),,( jiELVaRjiUL VaR

confidence level

VaR

confidence level

Aggregated Loss Distribution EL

A FOCUS ON LOW IMPACT HIGH FREQUENCY EVENTS REDUCES CAPITAL CHARGE…

Probabilityof Loss

Event

Expected Losses

VaR Catastrophic Scenario

Loss Impact

But increases exposure to tail risks…

Repetitive tail events

Stressed VaR

Outside the scope of B II

Scope of Basle II

Expected losses Outside the

scope of Basle II

..and to system externalities.

Interval of confidence

CREATE A CULTURE OF RISK MANAGEMENT – KEEP IT ALIVE

Risk Intelligence

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

Restore the balance Capital Efficiency / Risk to alignCorporate Governance and Risk Appetite

Support Regulatory Compliance with information onmarket behaviour in addition to statistical analysis

Banking Books Trading Books

Markets

Portfolios

Economy

Growth

Country

Operations

Markets

Portfolios

Economy

Growth

Country

Operations

MarketsPortfoliosEconomyGrowthCountry

Operations

Valuations Counterparties

RECONNECT SENSES TO CREATE A DNA BACKBONE

Risk Factors

RECONNECT THE BRAINS WITH THE NERVOUS SYSTEM

Portfolio view of firmwide risks, limits and triggers

Business Line Risk Mgr

Product Risk Mgr

Regional Risk Mgr

Net ExposureSensitivityMax Loss

Portfolio LimitsSensitivity Limits

Concentration LimitsP/L Limits

CAPITAL & LIQUIDITY SHOULD BE DRIVEN BY RISK INTELLIGENCE NOT ONLY RWA

Global Risk Infrastructure Framework

Market Intelligence

PortfolioIntelligence

Intelligent Data

RISK FACTORS

Cross-silo exposure from:• business lines• products• regions

• Multiple vendor feed• Internal pricing feed

• Reference data• Counterparty data• Ratings

ScenarioSimulations

RiskIntelligence

Liquidity Risk

Capital & Liquidity Strategy

• Exposure• Sensitivity• Max Loss

ReverseStress Test

• Gaps• Concentrations• Contingencies

Enterprise Risk Management Monitor

1

2

3

45

8

7

6

5

CREATING A RISK INTELLIGENT GOVERNANCE AND COMPLIANCE FRAMEWORK

• 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)

GOVERNANCE DRIVEN

• Liquidity Risk Management• Stress test ALM & gap analyses• Counterparty driven gap analyses

• Collateral liquidity• Valuations of OBS exposure

CREATING RISK INTELLIGENCE

• Limit & Collateral Management• Net counterparty exposure• Risk concentration and sensitivity limits• Leverage ratios and OBS

COMPLIANCE DRIVEN

THE FALLACY OF MODERN FINANCE THEORYModern 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

Rs = i + (Rm-i) + Rs = Expected return on the security

i = risk-free return

Rm= Expected return on the market

= Cov(s,m)Var(m)

Rs = Expected return on the security

i = risk-free return

Rm= Expected return on the market

= Cov(s,m)Var(m)

i

Expectedreturn

a

b

Efficient frontierEfficient frontier

10

Mkt index

COVARIANCE RELIES ON INVESTORS’ BEHAVIOUR NOT ON HISTORICAL DATA

Correlation Matrix

Values Absolute Interval Weekly StartDate 02 Aug09 EndDate 18 Jul10

Threshold1: 0.5 Threshold2: 0 Threshold3: -0.5

is 0.5

GBP= EUR= INR= JPY= CNY= XAU= CLc1GBP= 1.0000 0.9050 0.4909 0.1027 0.2596 -0.7041 -0.2368EUR= 0.9050 1.0000 0.3198 -0.0021 0.3808 -0.6835 -0.0901INR= 0.4909 0.3198 1.0000 0.0066 0.0667 -0.6296 -0.8099JPY= 0.1027 -0.0021 0.0066 1.0000 0.4666 -0.3922 0.1233CNY= 0.2596 0.3808 0.0667 0.4666 1.0000 -0.4171 -0.0595XAU= -0.7041 -0.6835 -0.6296 -0.3922 -0.4171 1.0000 0.3961CLc1 -0.2368 -0.0901 -0.8099 0.1233 -0.0595 0.3961 1.0000

CorrelationColor CodesList Setup

Hide If Correlation above

Currency

Calculate

Variables are wrongly assumed to be independent

SPIRIT OF BASLE III(BCBS 164 on Strengthening Resilience)

Quality and consistency of capital baseT1 Equity onlyT2 5 year minimum maturity , hybrids phased outT3 abolished

Enhanced risk coverageStressed VaR (includes periods of stress)Credit Value Adjustment (CVA) to represent counterparty risk in market exposurePush on centralised clearing counterpartiesWrong-Way risk

Leverage ratioRatio added to Pillar1 calculated with credit conversion factorsFocus on off-balance sheet items

Counter-cyclical measuresProbability of Default (PD) and Exposure At Default (EAD) computed over long termExpected Loss (EL) to replace IAS39Capital buffers to limit excess credit and leverage

Global Liquidity Standard (BCBS 165)

GOVERNANCE DRIVEN

CREATING A RISK INTELLIGENT INDUSTRY

COMPLIANCE DRIVEN

Counterparty RisksConcentrations and leverageCollateral and margin management (reflect concentrations)

LiquidityDynamic gap analysis under scenariosConcentrations on funding sourcesStress tests of exposure and collateral

Market RisksConcentrations, root risk and indirect exposureCredit and liquidity risk priced in market riskMark-to-volitilty, mark-to-liquidity

Volatility and correlationsPotential reverse impact of volatility and concentrations on correlations correlation and market depth

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)

Market Duration class Short/Medium/Long/Extended Coupon Fixed/Variable/Minimum guaranteed Participation Multiple/Full/Partial/Variable Principal Protection None/Partial/Full Convertibility Auto/Dynamic/Periodic/Synthetic Path dependence Callable/Auto/Barriers Legal Supervisory body Bank/Securities/Exchange/Others Regulatory Region EU/US/Other OECD/Others

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)

Price Risk Class Rating A: Depth/Liquidity 0 to 5 B: Quotation frequency 0 to 5 C Typical Slippage 0 to 5 D: Spread/Price Volatility 0 to 5 E: News/Data Availability 0 to 5

RISK & LIQUIDITY CONCENTRATION BENCHMARKS

Banks contribute foreign exchange claims in US$m by1-Currency2-Instrument type (fxswap, loan type, asset, liability)3-Tenor (time bucket)4-Volatility time bucket (if applicable)5-Strike bucket (if applicable)

RISK AGGREGATOR

Term Structure of Asset/Liabilities

by currency

Regulators input scenario1-Interest rates2-Exchange rate3-Volatility4-Correlation

o Aggregated views foreign exchange claims by time bucketo Gap analysis (Asset/Liability mismatch)o Sensitivity analysis (under scenarios)o Volatility concentration matriceso Strike/Barriers concentration matrices

o Central bank gets view of potential bubbleso Regulators can anticipate on funding issues per currency and instrumento Aggregated risk view in base currencyo Banks can benchmark their funding risk against industry view.

1

2

3

Banks contribute foreign exchange claims in US$m by1-Currency2-Instrument type (fxswap, loan type, asset, liability)3-Tenor (time bucket)4-Volatility time bucket (if applicable)5-Strike bucket (if applicable)

RISK AGGREGATOR

Term Structure of Asset/Liabilities

by currency

Regulators input scenario1-Interest rates2-Exchange rate3-Volatility4-Correlation

o Aggregated views foreign exchange claims by time bucketo Gap analysis (Asset/Liability mismatch)o Sensitivity analysis (under scenarios)o Volatility concentration matriceso Strike/Barriers concentration matrices

o Central bank gets view of potential bubbleso Regulators can anticipate on funding issues per currency and instrumento Aggregated risk view in base currencyo Banks can benchmark their funding risk against industry view.

1

2

3

AGGREGATED TERM STRUCTURE OF MISMATCHES IN FOREIGN CURRENCIES

Banks contribute foreign exchange claims in US$m by1-Currency2-Instrument type (fxswap, loan type, asset, liability)3-Tenor (time bucket)4-Volatility time bucket (if applicable)5-Strike bucket (if applicable)

Thomson Reuters

Term Structure of Asset/Liabilities

by currency

Regulators input scenario 1-Interest rates2-Exchange rate3-Volatility4-Correlation

o Aggregated views foreign exchange claims by time bucketo Gap analysis (Asset/Liability mismatch)o Sensitivity analysis (under scenarios)o Volatility concentration matriceso Strike/Barriers concentration matrices

o Central bank gets view of potential bubbleso Regulators can anticipate on funding issues per currency and instrumento Aggregated risk view in GBPo Banks can benchmark their funding risk against industry view.

1

2

3

• Allow an assessment of firms’ currency liquidity risks and their potential vulnerabilities to a drying up of certain currency swap markets

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

Liquidity riskBasis risk

Liquidity riskLiquidity riskBasis riskBasis risk

Risk concentrations

Risk Risk concentrationsconcentrations

Asset/Liab benchmarks

Liquidity mismatches

Identify Asset Bubble

AssessRisks

Industry representativesRegulators

Policy makersPrevisionists

MEASUREIMBALANCES

SIMULATESHOCKS

CONSULT

ADJUST• Variable CAR• Pro/Counter Cyclical• Update instrument risk factors• Communicate policies• Recommandations

MarketCredit

LiquidityDefaults

COMMUNICATE

Liquidity riskBasis risk

Liquidity riskLiquidity riskBasis riskBasis risk

Risk concentrations

Risk Risk concentrationsconcentrations

Asset/Liab benchmarks

Liquidity mismatches

Identify Asset Bubble

AssessRisks

Industry representativesRegulators

Policy makersPrevisionists

MEASUREIMBALANCES

SIMULATESHOCKS

CONSULT

ADJUST• Variable CAR• Pro/Counter Cyclical• Update instrument risk factors• Communicate policies• Recommandations

MarketCredit

LiquidityDefaults

COMMUNICATE

Regulators’ insights depend on risk intelligence.

•Single desk / portfolio•Unsophisticated

Data ManagementData Management

CollectionCollectionRisk

Aggregation

Risk

Aggregation

•Portfolio view of firm-wide risk•Dynamic aggregation of contextualized risk

•Multi desk / portfolio•Static post-trade risk aggregation

21

Risk Intelligence is the New Efficient Frontier

Risk IntelligenceRisk IntelligenceRisk measurements Risk measurements

ValueValue

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.

•Equity Prices•Public Company Fundamentals

•Pricing & Reference data

•Valuation RiskInformationInformation

DataData•Evaluated Pricing

•Risk Benchmarks•Risk Indices•Risk Ratings

InsightsInsights

AnalysisAnalysisStress Tests

&Reverse

Stress Tests&

Reverse •Beta•Duration

•Monte Carlo VaR

•Potential Future Exposure

•VaR•Binomial Model

•Stress and Scenario Testing

Post Trade

Analytics

Post Trade

Analytics

CRITICAL SUCCESS FACTORS IN IMA IMPLEMENTATION

PHILIPPE CARRELMumbai, July 21st 2010

Risk Intelligence: The 21st Century Frontier of Market Efficiency