Post on 21-Jan-2016
transcript
Stress Testing and Economic Capital
By T.Y. Lee
Table of Contents
• Background
• Why Stress Testing
• About Stress Testing
• About Economic Capital
• Case Study
• Future Improvements
• Background
• Why Stress Testing
• About Stress Testing
• About Economic Capital
• Case Study
• Future Improvements
B1B1
1988
Basel I
Capital Capital Adequacy RatioAdequacy Ratio
(Credit Risk)(Credit Risk)
1996
Basel I
Market Risk Market Risk AmendmentAmendment
(CR+MR)(CR+MR)
B2B2
2006
Basel II
3 Pillars3 Pillars
(CR+MR+OpR)(CR+MR+OpR)
Financial Financial CrisisCrisis
20080722
Market Risk
Incremental Risk Charge
20090116
Trading Book Proposals
Basel II Enhancement
20090713
Trading Book Proposals
Basel II Enhancement
Some new Standards
B3B3
20091217
Strengthen Bank Resilience
Liquidity Risk
200710
Incremental Default Risk
Charge
一
最低資本需求Minimum Capital Requirement
信用風險
標準法 (SA , Standardized Approach)
風險抵減(CRM)
資產證券化
內部評等法 (IRB , Internal Ratings Based)
基礎 (FIRB)
進階 (AIRB)
市場風險
標準法
內部模型法 (IMA , Internal Model Approach)
作業風險
基本指標法 (BIA , Basic Indicator Approach)
標準法 (SA , Standardized Approach)
進階衡量法 (AMA , Advanced Measurement Approach)
二 監理檢視(審查) Supervisory Review Process
三 市場紀律(公開揭露) Market Discipline
BASEL II Structure
TRADING BOOKTRADING BOOK
Frequency of
loss
Severity of loss
Expected loss deducted from
revenues
VaR, Stress Loss, Economic Capital and Limits
Risk appetite
Subject to stress loss limits
Estimated loss in normal market
environment
Expected loss (mean)
Statistical loss (at specified CL)
Losses in extreme but
plausible “tail” events
Stress loss (scenario-
based)
Subject to VaR & operational limits
Economic Capital Desired Rating
(e.g. AA - 99.97% CL)
• Why Stress Testing
• About Stress Testing
• About Economic Capital
• Case Study
• Future Improvements
Why Stress Testing?
• Regulatory Requirements:– Basel II mandates stress-testing around low-
probability events to validate capital estimates.– Regulators want similar assurances that portfolios can
withstand extended economic downturns.– It became more important after the financial crisis of
2008
• Better Portfolio Management:– Stresses will occur. Planning for them is profitable.– Reactionary management to sudden stresses is
costly.
• Why Stress Testing
• About Stress Testing
• About Economic Capital
• Case Study
• Future Improvements
About Stress Testing (1/8)
• Stress Testing is not unique to financial industry
• Auto industry and its regulatory agency crash automobiles to test safety measures as part of standard operation process (SOP)
About Stress Testing (2/8)
• RCA of USA used to drop TV set from high attitudes to see if the TV can withstand falls
• Now there are commercials dropping iPhones and Samsung Galaxy to see if the phones still function or the screen is OK
About Stress Testing (3/8)• Stress Testing has been used in Market
Risks for many years as part of risk management
• It is applied to Credit Risk as a supplement to Basel II Pillar II process
• The idea is to see if a bank can withstand adverse situations with adequate capital
• Federal Reserve of U.S.A. has required 19 biggest banks in the U.S. to perform stress tests as a measurement to banks’ health every year after the financial crisis of 2008
About Stress Testing (4/8)
• Financial authorities of other advanced countries have also ordered banks under their jurisdictions to conduct stress tests
• Financial authority in Taiwan has also followed suit
• Banks with sound risk management practices usually conduct their own stress test regularly
About Stress Testing (5/8)
• The key to Stress Testing is designing stress scenarios which are extreme yet plausible– And those scenarios usually required
approval from senior management – Sometimes it required the approval of
regulators as well– If it is too lenient, regulators may not like it– If it is too tough, senior management or the
board of directors may not like it because that may require holding additional capital
About Stress Testing (6/8)
• Stress Testing Scenarios:– Historical
• 1929 Stock Market Crash• 1973-74 Oil Crisis
– Hypothetical• U.S. government defaults on its debt• Asteroid hits Earth• Every counterparty in the portfolio got downgraded
by two notches
– Hybrid
About Stress Testing (7/8)
• Example– 1960’s anti-nuclear activists in Japan
hypothesized a scenario:• A huge earthquake hit Japan, causes• Huge tsunami, which hit the nuclear plant by the
shore and causes• Nuclear catastrophe!
About Stress Testing (8/8)
• Example (cont’d)– They recommended that the government built
robots which can be used during nuclear catastrophe
– But Japanese government turned down the idea arguing that the action would dim the public confidence in nuclear power
– Then we all know what happened in 2011– And the highly impossible yet plausible
hypothetical scenario has become historical scenario
• Why Stress Testing
• About Stress Testing
• About Economic Capital
• Case Study
• Future Improvements
About Economic Capital (1/3)CapitalCapital AccountingAccounting RegulatoryRegulatory EconomicEconomic
Def.Def.
• ““ACTUALLACTUALLY Hold”Y Hold” capital
• Listed on the Balance Sheet
• ““MUST MUST Hold”Hold” capital
• Minimum requirement
• ““SHOULD Hold” SHOULD Hold” capital• the buffer of reserves banks hold
to guard against unexpected losses and maintain the financial
stability.
MethodolMethodologyogy
• Accounting rules, such as GAAP, IFRS…
• Regulatory Formulas
• Unable to fully reflect instinct risk
• Risk capital, to ensure that the realistic balance sheet stays solvent over a certain time period with a pre-specified probability.
FunctionaFunctionalitylity
• Peer comparison
• Financial analysis
• Mandatory capital
• Individual level• Focus on
•Safety•Quantity•Passive way
• Bridge to link the risk and business strategy and to measure RAROC
• Focal point of rating agencies and investors
• Focus on•Safety and Efficiency•Quantity and Quality•Proactive way
About Economic Capital (2/3)• Economic capital can be determined as the cushion required to keep
the bank solvent over a specified time horizon with the defined confidence level (CL).
• A typical time horizon is one year.
• The confidence level is explicitly linked to the choice of target solvency standard, i.e., the desired rating.
Frequency of
Loss
Severity of Loss
Average loss deducted from
revenues
Risk Appetite restricted by
Operating Limits
Risk Capacitysubject to
Stress Loss Limits
Estimated loss in typical adverse period
Expected Loss
Statistical Loss (specified level of confidence)
Losses in extreme but plausible “tail”
events
Stress Loss (scenario
based)
Econ. Capital
About Economic Capital (3/3)
• After the financial crisis of 2008, financial authorities in some advanced countries intend to make economic capital the same as regulatory capital
• Also, Basel Committee recommended a more strict definition of tier-1 capital, although it later relaxed the definition in fear of slowing down economic growth with less lending
• Why Stress Testing
• About Stress Testing
• About Economic Capital
• Case Study
• Future Improvements
Case Study
• The framework we developed is based on:– CreditVar concept of Credit Metrics and– Credit Portfolio View (CPV) by McKinsey
Road Map of Credit Metrics
Algorithm(1/2) – Migration Simulation
Simulation Portfolio Risk
<功
能>
Rating 3
Rating 2
Generate Random Number
(0,1)
Obligor 1Obligor 2Obligor 3
.
Divide into
Rating Group
Mapping toMigration
Matrix
RatingMigration
Matrix
Get Migrate Rating
Calculate Loan Present Value
Credit Spread
By Rating
Get discount
Rate
CorporateCustomer
Dataset(ID, Rating,
industry,Outstanding..
Etc.)
Repeat X times
1st Stage:Generate Simulation Data
Simulation Dataset
2nd Stage:Calculate Portfolio Risk
Get New Industry Code
MappingCalculate
Portfolio Risk
Equity Index Correlation
Matrix
Group into Industry
Rating 1
Obligor 1Obligor 2Obligor 3
.
.
Obligor 1Obligor 2Obligor 3
.
.
Store in Dataset
Dataset
Process
Given data
SIC Code /Industry codemapping tale
Step : One
Step : Two
Algorithm (2/2) – CPV Approach
Back to Simulation Process
Credit Portfolio View Model (CPV-Macro) Flow Chart
<功能
>
1.預測經濟變數: ARMA(p,q)
2.建構Default Rate Proxy:
AR(1)-GARCH(1,1)
3.估計違約機率:Logistic Function
Pt*=1/1+e^-y
4. Generate Risk Sensitivity Factor & Migrate Factor
TSBUnconditional
Migration Matrix(2007.09-2008.09)
TSBHistorical
Migration Matrix(2005.03-2007.03)
TSBConditional
Migration Matrix(2007.09-2008.09)
5. Adjust Migration Matrix
(2008.1~2008.12)
Algorithm – Migration Simulation
Step : One
Step : Two
Simulation Portfolio Risk
<功
能>
Rating 3
Rating 2
Generate Random Number
(0,1)
Obligor 1Obligor 2Obligor 3
.
Divide into
Rating Group
Mapping toMigration
Matrix
RatingMigration
Matrix
Get Migrate Rating
Calculate Loan Present Value
Credit Spread
By Rating
Get discount
Rate
CorporateCustomer
Dataset(ID, Rating,
industry,Outstanding..
Etc.)
Repeat X times
1st Stage:Generate Simulation Data
Simulation Dataset
2nd Stage:Calculate Portfolio Risk
Get New Industry Code
MappingCalculate
Portfolio Risk
Equity Index Correlation
Matrix
Group into Industry
Rating 1
Obligor 1Obligor 2Obligor 3
.
.
Obligor 1Obligor 2Obligor 3
.
.
Store in Dataset
Dataset
Process
Given data
SIC Code /Industry codemapping tale
Conditional
• Why Stress Testing
• About Stress Testing
• About Economic Capital
• Case Study
• Future Improvements
Future Improvements (1/2)Simulation Portfolio Risk
<功
能>
Rating 3
Rating 2
Generate Random Number
(0,1)
Obligor 1Obligor 2Obligor 3
.
Divide into
Rating Group
Mapping toMigration
Matrix
RatingMigration
Matrix
Get Migrate Rating
Calculate Loan Present Value
Credit Spread
By Rating
Get discount
Rate
CorporateCustomer
Dataset(ID, Rating,
industry,Outstanding..
Etc.)
Repeat X times
1st Stage:Generate Simulation Data
Simulation Dataset
2nd Stage:Calculate Portfolio Risk
Get New Industry Code
MappingCalculate
Portfolio Risk
Equity Index Correlation
Matrix
Group into Industry
Rating 1
Obligor 1Obligor 2Obligor 3
.
.
Obligor 1Obligor 2Obligor 3
.
.
Store in Dataset
Dataset
Process
Given data
SIC Code /Industry codemapping tale
Future Improvements (2/2)
• Pair-wise correlation is NOT adequate to measure the degree of inter-connectedness among industries and among financial institutions
Q & A