Stress Testing / ICAAP / Capital ManagementSoftware solution

Erik Ibron, Director -- Solution Specialist, Moody's Analytics August 2011

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Agenda

1. ICAAP Solution Overview

2. Spreading & Rating stress test

3. Portfolio management

4. From KRI to KPI scenario analysis

5. Balance sheet and Liquidity stress

6. ICAAP enforcement

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ICAAP Solution Overview

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Principles for sound stress testing practices and supervision(Extracts) - What is needed from a software perspective

» The stress testing tool seen as an operational tool versus a pure back-end

» Scenarios should cover the environment and the business strategy – i.e. the response to the environment

» Flexible in order to define multiple & ad-hoc scenarios in addition to the recurring ones

» Discussing requires understanding: consistent and reliable data in a trustable common placeholder, comprehensive dashboards, reports and drill-down

A modular and integrated ERM solution to properly address ICAAP and stress testing

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Spreading & Rating stress test

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Stress test in the context of scoring/spreading

Who would benefit most from scenario features in a software :

» Portfolio managers - to assess the quality of their portfolio, and its robustness under economic stress

» Model builders – to stress, analyze and validate the models and scorecards before they are deployed

» Senior management – to identify the key risk areas that need to be monitored, or the strengths that the institution can play on

Scoring/Rating users would benefit most from:

» Portfolio-level Stress testing capabilities

» Integrated analytical/OLAP reporting and portfolio-level analysis features

» Integration with macroeconomic scenarios, multi-period forecasts…

Institutions require the software to centralize scenarios

» Scenario sharing, template definition, audit/logging & review

» Define and re-use formula, distribution of inputs, following trends

» Integration with macroeconomic data and multi-period forecasts

» Examples:– Optimistic: GDP Growth of 3.2%, U.S. Unemployment 7%, etc.

– Baseline: GDP Growth of 1%, U.S. Unemployment 9%, etc.

– Double-dip Recession: GDP Growth of -0.8%, Unemployment 12%

» …

The software should provide a comprehensive framework to input stressed assumptions

» On any component of a model– For instance, modify any quantitative/qualitative factor of a standard model (ex:

for MM, Sales Growth, Debt ratio…)

» At any level of granularity– For instance, high-level aggregated inputs can be refined with counterparty-by-

counterparty adjustments

The end goal is to compare the new risk rating profiles across multiple scenarios, for your overall portfolio

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Portfolio management

An ICAAP and Stress Testing engine aims at answering critical questions on your global portfolio

» Who are your 10 best customers?» Who are your 10 worst customers and what can you do about them?» Who will be your 10 worst under stressed conditions?» How much economic capital are you consuming? » What is your risk concentration by industry and geography?» How can you use all these outputs for business strategy?

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Understand Which Positions Add or Destroy Value… and Do Something About It

MODEL A TRADE BEFORE YOU MAKE IT- Where will it be?- Spread is about the same…- But one brings more risk to the portfolio

UNDERSTAND WHAT YOU HOLD- Two exposures to Singamas Container in this portfolio- Concentration is relatively low, but high PD (3.98%) andhigh correlation with portfolio mean high risk contribution

- Not being compensated for risk- Time to reduce or eliminate positions?

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Original Portfolio Sold 11 Buy Better 11Exposure - $MM 4,631 4,568 4,631No. of Exposures 2,418 2,407 2,418

Total Spread (bps) 136.5 133.6 139.0Expected Loss (bps) 100.4 92.5 91.7Expected Spread (bps) 36.1 41.1 47.4Unexpected Loss (bps) 114.7 109.2 109.7

Sharpe Ratio 31.5% 37.6% 43.2%

Incremental changes: add exposures with high return/risk and shed or mitigate those with low return/risk. A small number can have a major impact.

In this example, replacing 11 worst exposures with 11 best ones changed return/risk (Sharpe Ratio) from 31% to 43%, about a 33% improvement.

What if scenarios for Portfolio Management Decisions

Stress the portfolio loss distribution

Two principal approaches

» Unconditional

– Change inputs such as PD, LGD, EAD, correlation

– Observe effects on portfolio of stress scenario

» Conditional

– Build loss distribution “conditional” on certain outcomes

– Has the benefit of preserving correlation and other relationships

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From KRI to KPI scenario analysis

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A forward looking governance framework

Governance framework forecasting banking risk and performance measures under plausible or extreme stress scenario:

» Multi year expectations

» Simulate and fine-tune mitigation actions

» Readily available macro-economic scenarios

A parametric approach as an alternative to stochastic simulations:

» For a quick turnaround of ad-hoc scenarios and dashboards

» To integrate with baselines imported from legacy systems

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Holistic approach consolidating incomes, costs and risks components to stress risk and risk-adjusted performance insights

Incomes(Integrated or

imported)

Operating costs

(Integrated or imported)

Expected Loss

(Integrated or imported)

Capital charge(Regulatory or Economic capital or

imported)

RAROC

Scenario Analysis shifts all components within a consistent scenario

GDP up by 10% in ChinaUnemployment rate reaches 9% in Europe

Budget for the next 3 years

Advisory Services

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Scenario can be defined against any dimension: BU, country, industry…A comprehensive data model to maintain reference data » Bank’s dimensions:

– Country, Business Units, product, business Line– Channel, transaction type

» Counterparty dimensions– Client, Business type, industry sector, rating

» Guarantees & Collateral– Collateral type– Guarantee country, rating, business type…

The more granular is the imported data, the wider is the range of available dimensions

User editable timeline» Immediate access to scenario baselines» Analysis of Mitigation effect on following years

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Input granularity

Scenario dimensions and granularity alignment

Macro Eco

Indicators

• Country• Industry

Budget• Business Unit• Product Line

FX, Funding

Cost• Currency

Results are calculatedat the finest level of granularity

Input granularity

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What should be stressed: market factors

• Gross Domestic Product• Unemployment Rate• Housing Index …

Macro Economic Indicators

• Foreign Exchange currencyForeign

exchange rates

• Simple “plus one notch”, “plus two notch”• Transition MatrixCredit grades

• LGDLGD

• Collateral• Guarantee

Collateral valuation

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What should be stressed: Portfolio & Budget

• Product processing costs• Sales and marketing costs• Overhead costs

Costs

• Net interest income• Non Funded Income• Funds transfer income

Revenues

• EAD• Outstanding• Nominal

Business volumes

• Increased draw downs / decreased headroom• Committed/ Uncommited

Facility utilization

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What should be stressed: Governance

• Earning per share target• Capital Ratio TargetRisk Appetite

• % Earnings given as dividendsDividend Policy

• General Provision• Equity Issuance• Bond Issuance

Capital Management

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*Collateral type: RRE = Residential Real Estate ; CASHCOL = Cash collateral ;

EQTCOL = Equity collateral ; CRE = Commercial Real Estate ; NETCOL = Netting collateral

Increase business volume with a given risk profile according to business directions

The system automatically displays the current portfolio baseline

The user can set assumptions across multiple time horizon

The volume can be set over any combination of user-defined dimensions

The user can set an increase at any level of granularity. The new volume will match the existing risk profile breakdown within

the current portfolio

Or the user can refine and set an increase at a finer

level

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Drill-down reporting to understand, discuss and analyze the results

StrategyScenarios

Time HorizonIndicators

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Dashboard for scenarios comparison

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A dashboard for each user or manager profile

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Dashboard View

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Flexibility for the institutions to create and modify theirown dashboard

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A stress test engine should be scalable to derive and stress Key Performance Indicators based on incremental cost and income data

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Performance month evolution for a given scenario

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Balance sheet and Liquidity stress

Banks should monitor short-term and mid to long-term Liquidity risk

Short Term Medium Term

ScopeEnsures that the bank can be financed safely via secured short term funding.

Enable the bank to forecast liquidity requirements to sustain its activity / strategy for the coming months / years.

Calculation Frequency Daily or weekly Monthly

Stress testing scenario

4 scenarios:- on going,- systemic crisis,- specific (downgrade),- specific + systemic crisis

Time Horizon Maturities monitored until 3M Maturities Monitored from 3M to unlimited horizon

Perimeter Consolidated/Entity level

Approach Static approach Dynamic approach

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The main liquidity indicators to report and/or to stress

Liquidity gap and liquidity buffer» Can be generated daily» Based on granular cash-flows or cumulated vision» With user-defined or regulatory defined time-bucketing

Liquidity ratios » Balance-sheet ratios or cash-flow ratios» Short term Assets / Short term Liabilities.

Concentration analysis» Analysis of the diversification of funding sources» Top 20 depositors/lenders including modeling client & bank group structure

Monitoring of these indicators can be performed per:» Group / Legal entity / Business line» Currency

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Static Simulation Components

On market data » Rate

» Inflation

» Volatility

» Foreign exchange rate

» Spread curve

On client behaviour» Amortizing profile for non-maturing deals

» Prepayments

» Renegotiations

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Liquidity risk stress test are mostly driven by regulators

» Marketable Assets» Haircut definition for marketable assets.

» Sell-offs of debt securities and equities

» Early Amortization, Stickiness» Accelerated extinction for loans and deposits

» Delayed extinction for loans and deposits

» Amortization Convention on Undrawn Balances

Indicators

» Liquidity Reserve, Ratio, Survival Period

Portfolio Segmentation Criteria

» Customer Segment, Country, Economic Sectors

» Rating

Term Deposits

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Outstanding

Balance Contractual schedule

Early withdrawal

Stickiness

Reserve / Saleability

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mai-07 août-07 nov-07 févr-08 mai-08 août-08 nov-08 févr-09 mai-09 août-09 nov-09 févr-10

TimeC

ash

Amortizing Profile AaaSaleability for AAAAmortizing Profile Baa1 to Aa1Saleability for Baa1 to Aa1Amortizing Profile B3 to Ba1Saleability for B3 to Ba1Amortizing Profile Non eligibleReserve

Haircuts for AAA securities

Haircuts for securities from Baa1 to Aa1

Haircuts for securities from Ba3 to Ba1

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Dynamic simulations components

Forecast balance-sheet options

» Manually inserted deals

» Volume per period

» Business Volumes Forecast Targets

The new production feature is generated based on

» The diversity and volume of the banks products as observed in recent portfolio

» To the need of other business : the new production deals can be saved and used again

The liquidity stress test engine should generate the regulatory reports as per the local jurisdiction

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ICAAP enforcement

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Limit Setting & Diversification EnforcementEnforce concentration control and diversification strategy, at origination point

Country Analysis Typical Gauge Report, email alerts and escalation procedure

Sectorial Analysis

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Multiple risk measures are calculated. Each measures has

its own limits

Limit breaches should be monitored with a variety of measurements

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Early warning, Alerts Management and Watchlists

Alerts can be defined for multiple purposes» Counterparties blacklist» Countries under watchlist» Concentration ratios» Multiple thresholds

Alerts framework needs to be flexible» Alerts can be defined at deal

level or aggregated level» A wide range of actions can be

triggered (log, mail, report, limit locking, user workflow...)

Multiple thresholds allow for several levels of alert severity

Actions (emails, workflows,…) are automatically trigger for each level of alert

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ICAAP and stress test for an iterative and active portfolio management cycel

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Q & A

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moodys.com

Moody’s Analytics Singapore6 Shenton Way #14-08DBS Building Tower 2

Singapore 068809

Erik IbronDirector

Solution Specialist

+65 6511.4482 tel+65 9118.7273 mobileerik.ibron@moodys.com

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