interest rate risk modeling day sun_gard_ambit banking
Post on 19-Oct-2014
2.068 views
DESCRIPTION
A draft presentation on balance sheet management practices and asset-liability management.TRANSCRIPT
3/20/2011
1
SunGard BankingIRR Modeling and Management
[Business or Company that Needs to Know More aboutBalance Sheet Management] – ask me to come help
DATELOCATION
1
Standard Disclaimer and Ground Rules
The views, expressions and ideas of this presentation are those of the author and do not necessarily reflect the views and opinions of Ambit or SunGard.
Thank you to the [COMPANY] SunGard and all
2
Thank you to the [COMPANY], SunGard and all the participants and organizers of this conference.
Ground rules: Network: Make friends and stay in touch
Engage: Ask many questions
Apply: How do we make a difference tomorrow when on-site?
Who is SunGard?
3
Financial ServicesFinancial Services
3/20/2011
2
Ambit Risk Academy: Bio of Speaker
Thomas DaySunGard Ambit – Risk & PerformanceDirector, Risk & Policy(617) 780-4140 – [email protected]
Role at SunGard:Tom Day is the Managing Director of Risk Solutions and Policy at SunGard Ambit, where he is a key source of thought leadership for the company and its financial institution clients. Leveraging an extensive twenty-year career in banking, risk management and bank supervision, Mr. Day assists clients in navigating through diverse market challenges, regulatory policy
4
changes and business opportunities. His overall technical knowledge across bank balance sheets, capital management and enterprise-risk is comprehensive, and Mr. Day is well known for practical solutions to financial problems from a best-practice, business, accounting and strategic perspective.
Background prior to SunGard:Prior to re-joining SunGard, Mr. Day was Senior Risk and Policy Advisor within the US Treasury Department. In this role, Mr. Day oversaw the TARP program for various chartered institutions and was a member of the interagency review committee that recommended billions of dollars of capital investments into banks and financial institutions. He has also served in senior roles at the Office of the Comptroller of the Currency, the Federal Reserve Board of Governors, AmSouth Bancorporation, SouthTrust Bancorp and Barnett Bank. He previously served as the SVP and head of product management and development at SunGard BancWare, one of the world’s leading providers of risk management software.
Mr. Day has a BS in Economics from Auburn University and is a Commissioned National Bank Examiner and a Commissioned Federal Bank and Financial Holding Company Examiner. He is on the Board of the Professional Risk Managers’ International Association (PRMIA), the Regional Director of the D.C. Chapter of PRMIA, a frequent speaker at various industry conferences and events, a routinely published writer, and an avid fan of American football (particularly the SEC).
Ambit Risk & Performance: ALM, Capital/Stress-Testing, Liquidity, Budgeting, Planning, and FTP
Basel 3
Systemic Risk
European Systemic Risk Board
Ambit Risk Academy Advice, Tools, and SMEs for a Changing Financial Landscape
The Dodd-Frank ActCEBS
Too Big to Fail
Incurred v Expected Losses
SIFI and G-SIFIBalance Sheet Management: Never More Critical
Interest Rate and Liquidity Risk ManagementCapital Buffers
Incentive Compensation and Performance Measurement
G-20 and FSB
Financial Stability Oversight Council
International Harmonization
Cross-Border ResolutionInterconnectedness
Incurred v. Expected Losses
Stress-Testing and Capital Planning
http://www.centerforcapitalmarkets.com/resources/dodd-frank-wall-street-reform-and-consumer-protection-act-of-2010-regulatory-authority/
3/20/2011
3
Impact of Financial Reform on Risk Management?
• Risk Management Impact?
• Full employment at:
7
p y Deloitte, KPMG, PwC, BAH,
Promontory Have regulatory experience,
will hire• Major areas of need:
Infrastructure issues ERM is “for keeps” Massive need for education Cultural challenges Regulatory challenges
Major Areas of Impact: Balance Sheet Management
Agenda: Interest Rate Risk Modeling and Measurement
Supervisory and Business Expectations
ALM5 Capabilities and Limitations
Using the Tool: Risk versus Compliance
IRR Architecture and Key Issues
Summary Review and Conclusions
Sungard Account Management
3/20/2011
4
Agenda: Interest Rate Risk Modeling and Measurement
Supervisory and Business Expectations
ALM5 Capabilities and Limitations
Using the Tool: Risk versus Compliance
IRR Architecture and Key Issues
Summary Review and Conclusions
Sungard Account Management
Convergence: Balance Sheet and Enterprise-Wide Risk Management
Gap Analyses
Duration Analysis
NII Simulation
Economic Value Analysis
Dynamic Simulation Techniques
Fair Value Accounting / Credit Adjustment
Integration of
1970s 1980s 1990s 2000s
Value-at-Risk (VaR)
Sensitivity Analysis
Stress Tests
Monte-Carlo-VaR
Integration ofRisk Management
Black-Scholes, Greeks
Basel I RiskMetrics Basel II
The ALM Risk Domain
Supervisors expect that IRRM will cover: SHORT-TERM RISK to EARNINGS:
Risk to margin, net interest income (NII), and net income
Includes base-runoff cash-flows and new business projections
LONG-TERM RISK to VALUE: Often called “economic value of equity” (EVE); may be other
Sungard Account Management
Often called economic value of equity (EVE); may be other approaches that are acceptable
Bank supervisors (and others) often forget ALM should also encompass: Liquidity
FTP, profitability, performance and budget
Certain aspects of credit risk
Certain aspects of operational risk
3/20/2011
5
BS&R Expectations and Examination Requirements
With regard to interest rate risk management, BS&R should be as interested in the risk-management process as the model (i.e., 80/20 rule)
SunGard has considerable experience with the all regulatory groups and many examiners are familiar with ALM5ALM5
Consistent with SR 95-51, SR 96-13, and the January 6, 2010 Advisory, the regulators should be looking at: Board and senior management oversight
Policies, procedures and limits Not just ALM and IRR
Model risk management, investment portfolio and liquidity
Risk monitoring systems, controls and infrastructure
Internal and external audit, reporting and disclosure13
Good Starting Point: Pragmatic Approach
Models are analytical approximations, or abstractions, of reality that i lif l h d l ti hi i t th ti l
“No matter how good the theory, the first question any good quant should ask of a model: Under what conditions will it fail. The
second: When will it occur? You see, your organization needs to be aware that your models are wrong. Some people use the word
mis-specified, but I don’t like that because there is no obvious Platonic specification of the financial world.” - Emmanual Derman
simplify complex phenomena and relationships into the essential elements that drive risk.
Models are designed to solve or provide direction towards the solution of a particular problem.
What is model risk? The risk that is derived from using assorted variables and mathematical specifications within a model class to produce estimates, forecasts and solutions that do not conform to real world outcomes.
The impact of such risk is felt by an organization when decision-makers make economic commitments based on the results of such output.
Sungard Account Management
Summary of Key Guidance
Sungard Account Management
3/20/2011
6
The Evolution of IRR Supervisory Guidance
The Federal Deposit Insurance Corporation Improvement Act of 1991
• Section 305
• Focus on “Capital Charge”
• OTS adopts a unique approach
• Internal Models Approach (all other Agencies)
Earnings versus Value Debate
• NII forecast
Sungard Account Management
• EVE (beauty is in the eye of the beholder)
Interagency Policy Statement (1996)
• The Board should…
• Senior management should…
• Treasury management should…
• Reporting processes should…
• Rate risk systems should…
• Internal audit should…
The January 2010 Guidance on IRR
Corporate Governance Regular, timely, broad range of participation
Policies and Procedures No mention of credit spreads: value and earnings impacts
Measurement and Monitoring of IRR Input data, cash-flow, aggregation, forecast horizon (5-7 year issue), p , , gg g , ( y ),
dynamic and “static” simulations
Stress-Testing Broader range of scenarios, call for deterministic scenarios
Assumptions Sensitivity analysis, special attention around behavioral models
Risk-mitigation
Internal Controls and Validation
Sungard Account Management
Agenda: Interest Rate Risk Modeling and Measurement
Supervisory and Business Expectations
ALM5 Capabilities and Limitations
Using the Tool: Risk versus Compliance
IRR Architecture and Key Issues
Summary Review and Conclusions
Sungard Account Management
3/20/2011
7
Accrual Book Maturity Model: Maturity Map
• End-state target environment• Governance excellence• Consolidated and
comprehensive on-and off-balance sheet coverage
• Numerous stress, sensitivity, ctic
e
Leadership Quadrant
Proactive Quadrant
What Does Maturity Mean?
Leadership Target
Accrual Book IRR: Maturity Map
2011 ( l)
Sungard Account Management
, y,and strategy scenarios: earnings and value
• Decision-support/ computational speed
• Monthly builds/ model “weight”
• FTP method ownership• Integrated liquidity analysis• Resource strength (human
and technical)• Validation and control
Firm-Level Maturity
Ind
ust
ry B
est
Pra
c
Early-stages Reactive Quadrant
20092010
2011 (goal)
Strategic Balance Sheet Management
1
ALM Process • Import position and market data• Calculate risk measures (income and value)
• Generate ALM report package (min frequency
monthly)
Analyze Reports• EVE sensitivities
(contractual cash flows)• Standard EVE
Risk Committees• Active balance sheet risk
management • Enhance risk/return profile• Modify plans – tactical and
t t i • MVPE• DV01/KRD
• NII Simulation• Re-pricing Gap analysis
2
strategic
4
3
What-if Simulation• Analyze risk exposure – forecast and stress• Measure impact of hedging strategy• Measure sensitivity to key assumptions• Understand behavioral dynamics
Governance: Critical Success Factor
Organizational Design is critical to effective process management
• Effective governance drives the entire balance sheet management process
• ALCO is the action-vehicle
• Treasury must have a clear mandate with well articulated policies and procedures
• Line of business buy-in and cooperation is essential
• Modeling is designed to support the governance process; anything else is /ancillary/secondary
• Reporting and feedback align various components
• Enforce accountability
• Create action items, e.g. hedging
• Value-added, e.g. pricing optimization, elimination of expensive options, funding optimization
All players must understand roles and responsibilities
• Education/Qualification of resources
• Creation of risk management culture
3/20/2011
8
Governance Framework
• Governance
o Comprehensive oversight
o ALCO is action vehicle
• Organizational Structure and Responsibilities
o ERM sponsorship
o Treasury ownership
o LOB cooperation
• Data and Assumptions
o Ownership
o Quality Assurance/Control
• Risk Models
o Design
o Efficiency/Usability vs. Granularity
o Consistent management/analysis across all line models
• Reporting
o Comprehensive presentation of risk limits and exposures
o Actionable information
Effective Business-Level ALM: Communication
ompe
titiv
e P
ositi
onin
g
Risks and OpportunitiesP
lans and ForecastsALM/
F ti
3rd Parties
Retail
A t Fi
Subsidiaries On-going Communication
catio
n
On-going C
omm
u
Str
ateg
ic F
ocus
and
Co
ForecastingUnit
Auto Finance
CRE
Leasing/Factoring
C&I
Investment BankingOn-going Communication
On-
goin
g C
omm
unic
unication
ALM is the “huddle” that brings all business activities together into an overall picture of balance sheet strength and weakness. Ultimately, ALM is an enterprise-risk function
Range of Practice at Large Banks
3/20/2011
9
Range of Practice at Large Banks (continued)
Range of Practice at Large Banks (continued)
Some Interest in Stochastic NII
• Produce a range of NII outcomes based on sampling around the tails rather than the mean.
• Interesting practice for stress-testing; however, terribly difficult to interpret and communicate the usefulness given business
Sungard Account Management
usefulness given business contingencies and other factors.
• Ambit encourages a wide-range of approaches with the goal of establishing a range of views as to the impact of rate and spread movements on the firm’s overall structural position risk.
3/20/2011
10
Agenda: Interest Rate Risk Modeling and Measurement
Supervisory and Business Expectations
ALM5 Capabilities and Limitations
Using the Tool: Risk versus Compliance
IRR Architecture and Key Issues
Summary Review and Conclusions
Sungard Account Management
ALM5 is a dynamic balance sheet income simulation and valuation model Can fully meet all business and regulatory requirements
Can scale to meet any size and complexity requirements
Embeds best-of-breed analytics, access to third-party prepayment and structure models, and valuation technologies
Used to ensure consistency between risk, budgeting/planning, FTP, and liquidity risk management groups. Increasingly used for macro credit
l i
How ALM5 is Used within Financial Organizations
analysis.
The model is used to create multiple market scenarios to ascertain sensitivity to all sources of IRR Repricing, Basis, Yield Curve, and Options Risk
Is used to understand sensitivities to business plan, spread, prepayment, funding and customer behavioral risks
Drives better business decisions through precision of cash flow calculations
Common Use Case: Defined More Clearly
$
CP$
New Business Roll
Forecast Growth
Static balance sheet (a.k.a., flat balance
Forecast error. Ties to budget and planning.
Net Interest Income from this point is typical “risk” measure from S0 to/against S1, S2, Sn
27%
”X”%
Valuation from this point is the typical “risk” measure from Scenario0 (S0) against S1, S2, Sn
t0 t12
Baserunoffsheet)
ALM5 can measure all of these risk components. The manner in which cash flows are modeled (from both an income and valuation view) requires a wide range of assumptions related to the market environment, data, calculations, and risk measures (i.e., output).
t3 t6 t9
73%What is “VaR” at this future point? Forward looking risk measures. T12 or any Tn
3/20/2011
11
Pragmatism in ALM: Necessary, but not Sufficient
ALM5 is a forward-looking, state-of-the-art risk management system used to identify and understand risk → A/L management is not an accounting exercise.
Future balances and behavioral assumptions are forecast with uncertainty, but must foot to plan.
There is a tradeoff between granularity and efficiency.
Too much granularity (i.e. not enough aggregation) will hinder efficiency and slow-down effective decision-making.
The trade-off between accuracy and risk-management pragmatism is an art, but best practices exist as well as supervisory/regulatory expectations. Need to reinforce each other.
Treasury and Risk Management Organization
Implementing improvements in data workflows, ownership of assumptions, and utilization of industry leading practice risk measures will support an organization’s ALCO Process, linking risk groups and decisions in a practical and efficient manner.
This will also successfully address regulatory requirements for adequacy of IRR management.adequacy of IRR management.
ALM5 has all necessary capabilities to support an enterprise-wide ALCO and balance-sheet management process.
It is critical that staff – bank and supervisory – understand that the processes that surround the balance sheet management process are as (often more) important than the model itself. Too many get trapped on the vendor model rather than internal
resourcing, staffing, policies and procedures
All income and all valuation scenarios Spot and future
Static and new business
Daily versus monthly
Integrated liquidity risk management Deposit shock scenarios
What can ALM5 do?(and a side-note about ALM6)
Integration of Contingency Funding Plan
Haircuts to pledged and non-pledged assets
Designed to be actively used Not a compliance tool, but a decision-making tool
Rapid compute times are a priority. Scales linearly with number of CPUs added to analytical server farm
Be adjusted to accommodate unique business problems and needs; designed to be an “open” system
3/20/2011
12
Agenda: Interest Rate Risk Modeling and Measurement
Supervisory and Business Expectations
ALM5 Capabilities and Limitations
Using the Tool: Risk versus Compliance
IRR Architecture and Key Issues
Summary Review and Conclusions
Sungard Account Management
Risk Tensions
Senior Management and ALM goals often can conflict with each other
Sr. Mgt: Give me more earnings. NOW!
Sungard Account Management
ALM: No problem. Here is some more risk.
Sr. Mgt: Wait a minute. Give me less risk!
ALM: No problem. Here is less earnings.
The Role of ALCO: Process is Important
To manage the structure of the bank’s balance sheet and the level of banking book market risk(s)
Ensure effective measurement and reporting systems
Include heads of all major LOBs May also include marketing and investor relationsy g
Balance LOB optimism on business plans with practical financial realities (i.e., a forum for debate across LOBs)
Ensure Treasury’s “discretionary” actions are in alignment with core banking plans and activities
When using correspondent services, all of the above are even more critical for the examiner to review
3/20/2011
13
Key Risks Traditional Covered by IRRM
INTEREST-RATE RISK
E i B d M
Maturity and Repricing Mismatch
The risk that “gaps” between maturity or repricing dates will affect earnings and value.
Yield-curve RiskBasis RiskEarnings-Based Measures
Economic-Based Measures
The risk to changes in the slope of the yield-curve
The risk that the correlations between rates upon which my assets and liabilities are based will move in a fashion which is detrimental to an organization’s earnings and value
Options Risk
The risk that embedded and explicit options present to an organization
Volatility?
Dimensions of Risk
Static Risk How do changes to risk factors impact my inherent risk position? EXAMPLE:
Economic value of equity, as traditionally applied, is a static risk measure Gap reporting, as traditionally applied, is a static risk measure
Dynamic Risk How do changes in risk factors – over time – impact my risk position –
over time? Note: risk factors are moving AND my risk position is moving This is equivalent to a holding period measure of risk where position
risk is likely changing relative the movement of the risk factors EXAMPLE:
Net interest income simulation is a dynamic measure of risk wherein the risk factors AND the position risk is changing over the holding period
Typical Model Data Flow
Balance sheet data and aggregation, repricing
Specific rate forecasts, future Interest Rate Risk
Loan
Systems
Investmnt
Systems
Other
Systems
General
Ledger
Deposit
System
Earnings gg g , p ginformation and other inputs and assumptions
,growth assumptions and other key inputs
Model
Beginning Balance Sheet
Month 1 Balance Sheet
Month 2 Balance Sheet
Etc. Ending Balance Sheet
Performance for Month 1
Performance for Month 2
Periodic Performance
Etc.
Simulations
Value
Simulations
3/20/2011
14
Interest Rate Risk Management Concepts
1. Repricing Gap
2. Net Income Simulation and Earnings at Risk (EaR)
3. Economic Value of Equity (EVE)3. Economic Value of Equity (EVE)
4. Scenario/Sensitivity Analysis
5. Data Integrity and Assumptions
6. Limits and Controls
Sungard Account Management
Repricing Gap Analysis
Repricing Gap provides a simple, yet limited, view of re-pricing mismatches along the yield curve. Best Practices
Availability of re-pricing details on all balance sheet instruments
Significant granularity of re-pricing cash flow, e.g. 0-3, 3-6, 6-9, 9-12 months, 1, 2, 3, 4, 5, 6-10, 11-15, 16-20, 21-30 years
Multiple shock scenarios in order to observe mismatch volatility
Critical Assumptions Distribution of non-maturity deposit balances should be consistent with
FTP process; risk management and incentive comp should be aligned
Limitations Analysis is limited to current balance sheet; ignores future business
Inadequate for capturing impact of optionality, e.g. caps, floors, swaptions, convexity, etc.
Levered vs. Unlevered
Sungard Account Management
Example: Repricing Gap Report
Sungard Account Management
3/20/2011
15
Interest Rate Risk Management Concepts
1. Repricing Gap
2. Net Income Simulation and Earnings at Risk (EaR)
3. Economic Value of Equity (EVE)3. Economic Value of Equity (EVE)
4. Scenario/Sensitivity Analysis
5. Data Integrity and Assumptions
6. Limits and Controls
Sungard Account Management
Net Interest Income (NII) Simulation
NII simulation provides an estimate of near-term earnings sensitivity to changes in market interest rates. Intuitive and easily understood by ALCO and Exec. Management
Best Practices Dynamic balance sheet derived from LOB forecasts of future business
LOB ownership of key model assumptions
Sensitivity analysis to key model assumptions, e.g. deposit re-pricing, y y y p , g p p g,prepayment speeds, credit performance
Large number of rate scenarios including shocks, ramps, twists
Analysis of below-the-margin line items in order to achieve a NI or EPS sensitivity measure
Regular model validation and back-testing of near-term projections
Critical Assumptions Static versus dynamic balance sheet
Flat versus forward curve
Static (constant speeds) versus dynamic prepayment functions (ADCo)Sungard Account Management
Net Interest Income (NII) Simulation (cont’d)
Limitations Short term in nature; common practice is 1-2 year horizon
Misses impact of options that are beyond model horizon, e.g. mortgage prepay/extension risk, long-term FHLB optionality, TRuP options
Longer term, e.g. 5-7 years, horizons are recommended by regulators, but become very assumption driven
Ignores changes in value of MTM instruments (and potential earnings impact of impairment charges), e.g. trading book, MTM hedging portfolio
Deterministic vs Probability-based Yield Curve evolution Traditional methods rely upon single path rate scenarios
More current methods utilize stochastic yield curve models to derive a range of earnings estimates Provides more granular analysis of cash flow variability
Sungard Account Management
3/20/2011
16
Example: Net Interest Income Report
Sungard Account Management
Example: Net Interest Income Report
Sungard Account Management
Interest Rate Risk Management Concepts
1. Repricing Gap
2. Net Income Simulation and Earnings at Risk (EaR)
3. Economic Value of Equity (EVE)3. Economic Value of Equity (EVE)
4. Scenario/Sensitivity Analysis
5. Data Integrity and Assumptions
6. Limits and Controls
Sungard Account Management
3/20/2011
17
Economic Value of Equity (EVE) Measures
EVE analysis provides an estimate of the sensitivity of the “economic value” of balance sheet equity to changes in market interest rates Captures all cash flows associated with current balance sheet
Better captures exposure to optionality risk
Inconsistent views across regulatory authorities FDIC prefers LT income simulation over EVE FDIC prefers LT income simulation over EVE
OCC somewhat ambivalent about EVE; have been known to give a “pass” to some LFIs on EVE in lieu of long-term income simulation
FRB more interested in EVE
12 CFR § 3.10 provides that national banks can be assessed higher minimum capital ratios based on significant exposures to declines in the economic value of its capital.
Proposed new accounting rules may make EVE considerably more important as it will translate directly into reported earnings volatility
Sungard Account Management
Economic Value of Equity (EVE) Measures (cont’d)
Best Practices Stochastic interest rate model
Dynamic prepayment functionality
Two-factor yield curve models
Incorporates credit-spread volatility
Unique credit spreads for different asset classes
Limitations Does not translate/correlate directly to an intuitive earnings-based
measure of risk
Does not translate/correlate directly to market cap sensitivity
Does not indicate optimal hedging strategies
Ignores the impact of future business
All of the above lead to difficulty in limit setting
Requires significant computing power
Not all balance sheet instruments can be valued accurately with a single type model
Sungard Account Management
Other Valuation Based Measures
DV01 Dollar value impact of 1 bp move in an interest rate
Common risk measure in fixed-income portfolio management
Not as common in balance sheet management
Key Rate Duration Measures the effect of a change in the yield curve that is localized at
a particular maturity point
Necessary for development of detailed hedging strategies
Mitigates risk to changes in curve shape
OAS In contrast to the simple “yield curve spread" measurement of bond
premium over a pre-determined cash-flow model, the OAS describes the market premium over a model including two types of volatility: variable interest rates and variable prepayment rates.
Sungard Account ManagementCONFIDENTIAL – FOR INTERNAL USE ONLY
3/20/2011
18
Example Reports: EVE and NII Scenario Dashboard
Sungard Account Management
Example Reports: EVE
Sungard Account Management
Interest Rate Risk Management Concepts
1. Repricing Gap
2. Net Income Simulation and Earnings at Risk (EaR)
3. Economic Value of Equity (EVE)3. Economic Value of Equity (EVE)
4. Scenario/Sensitivity Analysis
5. Data Integrity and Assumptions
6. Limits and Controls
Sungard Account Management
3/20/2011
19
Scenario/Sensitivity Analysis
In addition to establishing and monitoring standard risk limits for the impact of changes in market interest rates, sensitivity analysis to key model assumptions must be performed periodically, e.g. interest rate sensitivity and balance decay functions on non-maturity deposits Sensitivity analysis tests a model’s parameters without relating those
changes to an underlying event or real world outcome
Additional business scenarios, e.g. rapidly growing balance sheet, de-levering balance sheet, economic recession, corporate credit event, need to be periodically modeled Scenario analysis uses the model to predict a possible future
outcome given an event or series of events
Other Matters
The use of IRR models for balance sheet management, e.g. corporate forecasting, strategic analysis, M&A support, adds considerably to a firm’s credibility with regulatory authorities. If a model is used only for IRR management, the question arises as
to its credibility/veracity.
On January 6, 2010, the financial regulators issued an advisory to remind institutions of supervisory expectations regarding soundremind institutions of supervisory expectations regarding sound practices for managing interest rate risk (IRR). “In the current environment of historically low short-term interest
rates, it is important for institutions to have robust processes for measuring and, where necessary, mitigating their exposure to potential increases in interest rates.”
Regulators fear banks going out the curve (and funding short) in the quest for yield. Post credit-crisis, regulators do not want banks immediately increasing risk along another dimension.
Sungard Account Management
Interest Rate Risk Management Concepts
1. Repricing Gap
2. Net Income Simulation and Earnings at Risk (EaR)
3. Economic Value of Equity (EVE)3. Economic Value of Equity (EVE)
4. Scenario/Sensitivity Analysis
5. Data Integrity and Assumptions
6. Limits and Controls
Sungard Account Management
3/20/2011
20
Data Issue Overview: The High-Altitude View
There has been a significant increase in the use of technology to increase efficiencies over the last two decades (you never “arrive”, but are always in the process of “arriving”) Banks have gotten bigger, risk-taking got more “scientific” (models)
Funding liquidity seemed endless (pre-crisis)
Products became more complex
Competition, globally, became more intense
Economies-of-scale seemed to “rule” and “diseconomies” of scale were “inconceivable” in banking
Our experience indicates: Multiple source systems
Legacy data problems
Inability to pull current position balance sheets together
Inability to evaluate, plan and budget over such a large book
Governance by volume and performance, not by risk
Key Assumptions: Income Simulation
1. Starting Balance Sheeta) Data preparation and maintenance is often > 60% of the challengeb) Some institutions are unable to compile complete starting position in a
timely basis (possible red flag)
2. Selection of rate scenarios and driver ratesa) +100, +200, +300, non-parallel, ramps, forward curve, etcb) How many driver rates? How to correlate? Manage?b) How many driver rates? How to correlate? Manage?
3. New business (e.g., roll-rates)a) How will new business “roll” onto books? When? With what
characteristics? How to source these assumptions? Maintain?
4. Repricing attributesa) Important for models not at instrument level
5. Core deposit behavior – earnings and valuation6. Prepayment assumptions
Key Assumptions: EVE
Discount rates utilized
Spreads used, if any Maybe 1) OAS, 2) credit, and/or 3) other
Core deposit average lives and valuation method(s) Core deposit average lives and valuation method(s) Are the same base runoff cash flows used for valuation and for
income simulation?
How are loans of similar type aggregated and evaluated?
How are embedded options valued? How do methods differ across the chart-of-account(s)?
3/20/2011
21
Data Integrity and Assumptions
Documentary support for derived assumptions used in the model: Core deposit assumptions – rate betas and lags (for NII) and decay
rates/durations (for EVE)
Deposit behaviors for risk management should be similar/identical as those for FTP
LOB sponsorship/ownership of pro forma inputs/estimates
Synchronization of pro forma prepayment speeds with historicalSynchronization of pro forma prepayment speeds with historical experience
Data limitations do exist and large, complex institutions will have to strike a balance between a quality process and overload. Sensitivity analysis should be used to test exposures resulting from poor data
quality, data aggregation as well as imperfect model assumptions, e.g. core deposit rate betas.
Sungard Account Management
Data Integrity and Assumptions
"Best in Class" ALM process Frequency: Complete monthly reporting of all risk limits; constant analysis of
model assumptions, data quality and accuracy of output
Data aggregation: As little as possible w/o sacrificing compute efficiency For static scenario models, data granularity can be maximized while data
aggregation (pooling) can be minimized.
For stochastic models, data aggregation needs to be maximized in order to get compute results in a timely manner. Granularity, and hence accuracy, will be p y y, y,sacrificed to some extent. Period (quarterly or annual) analysis using more granular inputs can be used to ballpark errors associated with efficiency in regular process.
Regular LOB involvement in validation of model assumptions and results
Modeling effort that demonstrably drives corporate balance sheet management process
Sungard Account Management
Interest Rate Risk Management Concepts
1. Repricing Gap
2. Net Income Simulation and Earnings at Risk (EaR)
3. Economic Value of Equity (EVE)3. Economic Value of Equity (EVE)
4. Scenario/Sensitivity Analysis
5. Data Integrity and Assumptions
6. Limits and Controls
Sungard Account Management
3/20/2011
22
Policies, Procedures and Limits
Policy comprehensiveness is critical Is it Board approved annually?
Overall policy objectives and IRRM philosophy are well articulated
Outlines major drivers of IRR and liquidity risk for the entity(ies)
Details responsibilities and authorities
Board
ALCO(s)( )
Management processes and procedures
Establishes risk appetite (how?) and tolerance
NII and EVE and exposure of each to major IRR sources (m,y,o,b)
Re-pricing GAP misses many risk factors and is not largely used
Exceptions to policy (process for escalation and remediation)
Relationship to capital, dividend, off-balance sheet, derivatives, investment and accounting policies
Has it been “benchmarked” against peer?
Sungard Account Management
Limit Structures
Limits need to be developed based on a risk appetite analysis, or similar “threshold” exercise
Most large banks place limits to several baseline scenarios for dynamic income simulation NII (over 12 and 24 month horizons) and static Economic-Value of Equity (EVE) ) q y ( )analyses Not uncommon to have ramps, stair-steps or shock-based NII limits
EVE is by nature a shock-based (instantaneous) measure
January 2010 Interagency “advisory” made some suggested changes to the 1996 statement, but is only an advisory
Sungard Account Management
Difference between limits and robust “analysis”
Measuring risk against policy limits is a 1st-order expectation; numerous additional scenarios need to be performed Net interest income
Exposure to yield curve, basis and options (volatility) risk
Exposure to spread risks
Economic value of equity
Exposure to credit spread (should be a MVPE baseline, not EVE)
Not uncommon for a separate model to be run for EVE analysis
Quant, R&D and market-data sourcing (prices and spreads) is a critical element (can have organizational design impacts)
Migration over time to a full-blown OAS method, but most banks are not at this stage yet
Sungard Account Management
3/20/2011
23
Policies, Procedures and Limits
Policy comprehensiveness is critical Is it Board approved annually?
Overall policy objectives and IRRM philosophy are well articulated
Outlines major drivers of IRR and liquidity risk for the entity(ies)
Details responsibilities and authorities
Board
ALCO(s)( )
Management processes and procedures
Establishes risk appetite (how?) and tolerance
NII and EVE and exposure of each to major IRR sources (m,y,o,b)
Re-pricing GAP misses many risk factors and is not largely used
Exceptions to policy (process for escalation and remediation)
Relationship to capital, dividend, off-balance sheet, derivatives, investment and accounting policies
Has it been “benchmarked” against peer?
Sungard Account Management
Limit Structures
Limits need to be developed based on a risk appetite analysis, or similar “threshold” exercise
Most large banks place limits to several baseline scenarios for dynamic income simulation NII (over 12 and 24 month horizons) and static Economic-Value of Equity (EVE) ) q y ( )analyses Not uncommon to have ramps, stair-steps or shock-based NII limits
EVE is by nature a shock-based measure
January 2010 Interagency “advisory” made some suggested changes to the 1996 statement, but is only an advisory
Sungard Account Management
Internal Controls and Model Validation
There is an expectation that Internal or Corporate Audit Staff play a role in the IRR model review process In a decentralized model, various check-points and procedures will
need to be established and flow-through to the annual corporate audit report(ing)
The IRR element plays a significant role in the CAMELS rating process of the banks, and the RFI/C rating for the BHC/FHC.process of the banks, and the RFI/C rating for the BHC/FHC.
Model Validation Various policy statements: OCC 2000-16 and FHFA recent policies
are valuable reference points
Model validations needs to be conducted by quant personnel, independent from modeling crew. The validation needs to be coordinated with audit. Needs to be rigorous. Elements of the Jan 2010 statement need to be incorporated.
Sungard Account Management
3/20/2011
24
Agenda: Interest Rate Risk Modeling and Measurement
Supervisory and Business Expectations
ALM5 Capabilities and Limitations
Using the Tool: Risk versus Compliance
IRR Architecture and Key Issues
Summary Review and Conclusions
Sungard Account Management
Model Architecture: Account Level Detail
1. Ideally, you want to limit the number of accounts you model at the group or pool level and maximize the number of accounts you model at the transaction level.
2. Some accounts you may simply have to model at the
Sungard Account Management
group or pool level using weighted average attributes
Model Architecture
• These constitute the “end-nodes” of your chart-of-account (COA) structure
• Varies from vendor to vendor• Such structure can allow for dynamic
dimensions
e.g., COA “end-nodes”Business Banking:London:CRE:Fixed:Business Banking:London:CRE:Libor3M:Business Banking:Hong Kong:C&I:Libor3MBusiness Banking:New York:Mtg:Treasury12M:
3/20/2011
25
Model Architecture
Model Architecture (continued)
Key Issues: Inputs
Identify model vendor and version number of data transformation engine; note specific modules or add-ons
Identify and assess ETL (extract, transform, and load) process, e.g. BDI, Access, Excel, SQL, etc.
Determine data sources, data owners, availability and control environment
Determine reconciliation process for product balances
Determine extent of data transformation and pooling logic
Select sample of records for testing (will follow through computational engine)p g ( g p g )
Review and test pooling logic
Review data filling routines
Review behavioral overrides in data
Review data record (from source system) granularity (accuracy vs. efficiency)
Review pool record (feed to computational engine) granularity (accuracy vs. efficiency)
Review USD and FX market spot rate and curve inputs (and consistency across models)
Review USD and FX internal spot rate and curve inputs (and consistency across models)
3/20/2011
26
Key Issues: Assumptions and Compute Engine
Identify and review key behavioral assumptions, e.g. prepayments and deposit decay rates; determine source, ownership, review and revision procedures
Review and test model rate generation processes, e.g. stochastic and forward curves
Review and document chart of accounts and key behavioral settings
Select sample of accounts for testing [sampling methodology TBD]
Verify cash flows for sample accounts, including principal and II/IE
Review new business chart of accounts, key behavioral settings
Determine assumption sources and validation methodologies for new business Determine assumption sources and validation methodologies for new business
Determine market value methodologies, e.g. static or stochastic
Review setup and calibration of stochastic rate model used for EAR or EVE calculations
Review EVE discounting (flat or with spread?). Basis for assumptions. Support.
Review key rate and DV01 methodologies
Outputs: Reporting
Review ALCO policy to identify risk limits
Review existing interest rate risk reports
Review GAP report construction, including balance sheet line-item inclusion/exclusion criteria
Review NIM forecast
Review analysis and measurement of mismatch basis yield Review analysis and measurement of mismatch, basis, yield curve, and options risk
Review funding/hedging recommendations
Review economic forecast and recommending balance sheet strategies
Determine if IRR reporting is appropriate given size and complexity of organization’s balance sheet
Sungard Account Management
Governance: Internal Routine and Control
Review model operating procedures
Review back-testing of NIM and synchronization with budget or FP&A forecast
Review analytical reports/studies used to verify model results
Review stress testing
Review “what-if” scenarios
Review business line analysis of model results
Review disclosure of key behavioral assumptions, e.g. prepayments and deposit decay ratesdecay rates
Review model documentation for disclosures around model use and limitations
Review model documentation for discussions of model theory
Review change control procedures
Review recent audit findings for model/modeling process
Review model validation policy
Review previous model validation findings
Determine testing and approval process prior to model deployment
Sungard Account Management
3/20/2011
27
Agenda: Interest Rate Risk Modeling and Measurement
Supervisory and Business Expectations
ALM5 Capabilities and Limitations
Using the Tool: Risk versus Compliance
IRR Architecture and Key Issues
Summary Review and Conclusions
Sungard Account Management
Summary
Governance as much as the model Policies and Limits
Committees and active senior management and board oversight
Routine validations and accountability mechanisms in place
Break down silos. Use the model to drive business, not compliance
Robust stress-testing and sensitivity analysisg y y Non-parallel curve shifts critical in today’s environment
Duration and convexities are critical in today’s environment
Validation, Assumption management and Version control
Resources – does the bank have sufficient internal resources?
Income and value measures
Create a network of experts you can lean on when needed
Sungard Account Management
Q&A?
Any questions or comment?
Sungard Account Management
3/20/2011
28
SunGard BankingIRR Modeling and Management
[NAME]
THANK YOU [email protected]@dcprmiahttp://linkd.in/DC_PRMIA_LI (DC PRMIA LinkedIn Community)
82