Filename

Integrated Risk Management in aFinancial Conglomerate

Til Schuermann*Federal Reserve Bank of New York

World Bank Risk Management WorkshopCartagena, ColombiaFebruary 17, 2004

* Any views expressed represent those of the author only and not necessarily those of the Federal Reserve Bank of New York or the Federal Reserve System.

Filename 2

What Is a Financial Conglomerate?

Joint Forum definition (2001)

“Any group of companies under common control whose exclusive or predominant activities consists of providing significant services in at least two different financial sectors (banking, securities, insurance)”

Virtually all of the large, internationally active multinational financial institutions are, to some degree, financial conglomerates

– Strict “3 of 3” or weaker “2 of 3” definitions

Filename 3

Market Context

Rapid growth in scope of large, multi-line financial institutions

– Consolidation

– Financial deregulation

– Globalization

Not just bigger, also (much) more complex

Major advances in risk measurement and capital management practices across the industry

Capital regulation still largely based around single business lines or ‘silo’ approach

Filename 4

What Is the Regulatory Issue?

Banks, securities firms and insurance companies all conduct trading business with

– Many of the same instruments and

– Many of the same counterparties, but . . .

. . . subject to very different regulatory capital charges

Differences are profound and pervasive

– Differences in regulatory objectives

– Differences in definition of regulatory capital

– Differences in regulatory capital charges

Filename 5

Philosophical Differences About What Should Count as Capital

Differing assumptions about how to deal with a faltering firm– Securities regulators: liquidate without loss to customers or

recourse to bankruptcy proceedings, emphasis on subordinated claims

– Bank regulators: want time to detect and remediate, emphasis on patient money

– Insurance regulators: ring-fence for protection of customers, emphasis on adequacy of technical reserves

Evident in capital ratios– Securities firms: ~5%– Banks: ~ 10%– Insurers

• Life: ~8%• P&C: ~25%

Filename 6

Differing Definitions of Capital

Net Worth: similarities more apparent than real

– Mark to market accounting in securities firm

– Mix of mark to market & book value in banks

– Statutory accounting in insurance companies

Filename 7

Example of Different Treatments

Banking Regulation

• Treat as commercial loan

• BIS 1: 8% Capital

• BIS 2: 2% Capital

EU Credit Insurance

• Treat as credit insurance paying credit insurance premium of 1% pa.

• Solvency capital = 15% of premiums 0.16% of outstandings

EU Life Insurance

• Treat as investment

• Implicit asset charge = 3% of outstandings

Consider a credit exposure to an ‘A’ rated counterparty

Filename 8

Key Questions and Approach

1. How should assessments of capital adequacy take into account diversification or concentration of activities within a conglomerate?

2. What are the implications for regulating the solvency of a multi-line financial conglomerate?

Our Approach– Adopt a top-down economic perspective– Focus on unique problems of risk aggregation within a

conglomerate– Initially, make simplistic assumption that all risk types

have multivariate normal distribution– Risk is taken to be 99% VaR

Filename 9

Risk Types and Distributions

Credit Market P&C CAT P&C Experience Business Event

Operating RiskAsset Risk Liability Risk

RISK

Life

AA-

How to Aggregate?

Filename 10

Risk Types and Modeling Approaches

Risk Type Modeling Approach

Risk Type Modeling Approach

Market / ALM

VaR, scenario analysis

CAT Simulation, Exceedence Prob. Curves

Credit EL, UL; Simulation

Non-CAT P&C

Frequency Severity; Loss Triangles

Life Surplus Testing Operational Simulation, EVT

There is a large variety of measurement and modeling approaches

Filename 11

Risk Management in a Financial Conglomerate

Financial HoldingCompany

Financial HoldingCompany

CorrelationCorrelation

Very HighVery Low

ALM

Non-LicensedSubsidiary

Market

Credit

Insurance

Operating

P&C InsuranceCompany

Life InsuranceCompany

Insurance

UniversalBank

Market

Credit

ALM

Operating

ALM

Market

Credit

Insurance

Operating

Credit

Market

Insurance

ALM

Operating

Filename 12

Levels of Risk Aggregation in a Financial Institution

LEVEL 1Within a

Risk TypeCommercial

Credit

Consumer International

LEVEL 2Within a

Subsidiary

+

Market

+

Operating

LEVEL 3Across

Subsidiaries+

Bank Insurance

Filename 13

Diversification: Size of “Portfolio” and Degree of Correlation

Typical Market vs. Credit Risk Correlation

0%

20%

40%

60%

80%

100%

# of Positions

= 40%

= 2%

10050 150

Geographic Diversification

100%

78%

70%

45%

US US + UK US + UK +Germany

Global

Level 1

Filename 14

Diversification Across Risk Types

0%

20%

40%

60%

80%

100%

Standalone Diversified

Market/ALM: 20%

Credit 55%

Operat'l 25%

79%

Within Universal Bank

Level 2

Across Bank & Insurance

Bank + Insurance Diversified Across Business

100% 90%

Level 3

Filename 15

Diversification Across Risk Types: Financial Conglomerate

0%

2%

4%

6%

8%

10%

12%

Bank P&C-lite Bank Life-lite Bank-P&C Life Bank-lite Mixed

Div

ersi

fica

tio

n B

enef

it

Conservative Average

Filename 16

Summary of Results so Far

Diversification effects typically decrease at successive levels in an organization: Level 1 > Level 2 > Level 3

Provided standalone risks are correctly measured, incremental diversification benefits across banking and insurance fall into an expected range of 5-10%

Diversification effects are greatest when businesses are of similar size

Combining a bank with a P&C company produces the greatest diversification benefit because P&C and credit risks predominate and are uncorrelated

Filename 17

Alternative Interpretations

Naive View

• HCCAP Univ-BankCAP + InsCAP

• Level 3 diversification unimportant

• BIS 2 approach (deconsolidation) is right

Counter View

• Result only valid if regulatory measures at Levels 1 and 2 fully reflect diversification

• Existing measures are inherently limited:

– ‘Lowest common denominator’

– Assume ‘average’ correlation for many risk types at Level 1

– Ignore cross-factor diversification at Level 2

BUT

Risk Aggregation at Level 3 Can Only Be as Good as the Standalone Measures on Which It Is Based

Filename 18

Level 2: A More Sophisticated Approach Goal was to model market, credit and operational risk of a typical large,

internationally active bank

Market and credit risk distributions from market data

Operational risk distribution from industry (proprietary) database of operational risk events

Compare different ways of computing total risk distribution– Add-VaR: add-up marginal VaR to arrive at total

• Effectively BIS 2– Normal-VaR: assume joint normality– Copula-VaR: use copulas to arrive at total risk distribution– Hybrid approach: assume elliptical distribution (not as strict as joint

normal but almost as easy)

Risk is taken to be 99.9% VaR

Filename 19

Marginal Risk Distributions

Market risk distribution

0.000

0.001

0.002

0.003

0.004

0.005

0.006

0.007

-1.50% -1.06% -0.62% -0.19% 0.25% 0.69% 1.13% 1.56% 2.00%

Return (as % of trading book)

De

ns

ity

Credit risk distribution

0.000

0.002

0.004

0.006

0.008

0.010

0.012

-1.50% -1.06% -0.62% -0.19% 0.25% 0.69% 1.13% 1.56% 2.00%

Return (as % of lending book)

De

ns

ity

Operational risk distribution

0.000

0.020

0.040

0.060

0.080

0.100

0.120

0.140

0.160

0.180

-1.50% -1.06% -0.62% -0.19% 0.25% 0.69% 1.13% 1.56% 2.00%

Return (as % of total assets)

Den

sity

Market Credit Operational

Total risk distribution(default holding and correlation, normal copula)

0.000

0.002

0.004

0.006

0.008

0.010

0.012

0.014

0.016

loss -1.09% -0.88% -0.66% -0.44% -0.22% -0.01% 0.21% 0.43%

Return (as % of total book)

De

ns

ity

Total

Filename 20

Characteristics of Risk Distributions

Market

Credit

Operational

Highest volatility Lowest skewness Slightly fat tails

Moderate to high volatility Skewed Moderately fat-tailed

Low volatility Very skewed Very fat-tailed

Filename 21

Impact of Correlation at 99.9% VaR

-1.0%

-0.8%

-0.6%

-0.4%

-0.2%

0.0%

0.0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8

Rho

To

tal

risk (

%o

f b

oo

k)

Add-VaR

Hybrid-VaR

Copula-VaR

Normal-VaR

(market,credit) = 50% vary to operational risk

Filename 22

Bottom Line Consistent ordering of approaches

– Add-VaR > Hybrid-VaR > Copula-VaR > Normal-VaR– Add-VaR biggest: imposes perfect inter-risk correlation– Normal-VaR smallest since it imposes thinnest tails– The Hybrid approach is strikingly close to copula-VaR

• Use volatility multiples from marginals• Incorporates correlation

Diversification benefits at 99.9% VaR can be substantial– Depending on correlations, 10% to 35%

As business mix or correlation shifts towards operational risk (very fat-tailed and skewed), 99.9% VaR increases dramatically

– Normal-VaR fails especially here– Hybrid approach can handle this well (sensitive to tail

shape of marginals)

Filename 23

What Has Been the Market Response?

Risk Measurement

• Economic capital increasingly being adopted as “common currency” for risk across financial businesses

• Migration of methodologies from banking to insurance

• Diversification effects captured at successive levels

• Customized models sensitive to business mix

Risk Management

• Conglomerates building up centralized risk and capital management units

• Dominant approach “hub and spoke” system

• Hub responsible for overseeing Group risk and capital planning (Level 3)

• Spokes responsible for risk management and transaction decisions within businesses (Levels 1 and 2)

Filename 24

Filename 25

Thank You!

http://nyfedeconomists.org/schuermann/

Filename 26

Limitations of ‘Silo’ Regulation

Inconsistency

• Capital requirements dependent on where risk is booked

• Boundaries breaking down due to product innovation

• Increasing demand/potential for regulatory arbitrage

Aggregation

• Concentration of risks across legal boundaries

• Diversification across risk classes within a legal entity

• Diversification of risks across business activities and operating companies

Incompleteness

• Capital requirements of unlicensed operating companies

• Capital requirements/funding structure of holding company

• ‘Strategic’ investments in non-financial companies