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