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0 Risk Adjusted Performance Measurement - the Economic Profit Concept at Deutsche Bank From Theory to Practise South Korea, June 2001

1 Presentation Overview
The purpose of this presentation is to explain the concept of Deutsche Bank’s Economic Profit Concept and its main constituent, RAROC. Deutsche Bank’s basic business decisions are not replaced by RAROC, although our RAROC concept and measurement tools do support management in achieving their objectives. “Deutsche Bank’s overriding objective is to maximise long term shareholder returns. By focusing on shareholder value we will maintain and improve our ability to prosper in a rapidly intensifying competitive environment.” Contents Presentation Overview Deutsche Bank‘s Heritage Introduction Deutsche Bank‘s Approach Deutsche Bank‘s Infrastructure Issues of Implementation Deutsche Bank‘s Experience Conclusion Deutsche Bank Group Executive Board “The introduction of RAROC is a decisive step towards accomplishing value-based management, which marries our internal business objectives at all levels of decision making together with the expectations of our shareholders.” Deutsche Bank Group Executive Board

2 Deutsche Bank’s Heritage
Founded in 1870, Deutsche Bank has undergone rapid growth and internationalization to become a global player in the financial services industry. 1989 Acquisition of Morgen Grenfell Group 1993 Acquisition of Banco de Madrid S.A. and Banca Popolare di Lecco SpA. 1994 Acquisition of Sharps Pixley Group 1995 Acquisition of ITT Commercial Finance, St. Louis (Missouri, USA) 1996 Foundation of a fund management company in Singapore and a subsidiary in Hungary 1997 Acquisition of a trust bank in Japan and an Australian fund management company, Axiom 1998 Acquisition of Credit Lyonnais Belgium 1999 Acquisition of Bankers Trust More Than 130 Years of History Global Presence Germany % Rest of Europe 24.2 % America % Asia Pacific 7.2 % Africa % Deutsche Bank is represented by more than 1,400 branches in Germany and more than 2,300 worldwide. Customer-oriented Structure Deutsche Bank is one of the leading international financial service providers. With more than 98,000 employees and assets exceeding EUR One Trillion, the bank serves more than 12 million customers in 70 countries world-wide. Deutsche Bank has introduced a new group structure (Feb 2001) focusing on 2 customer-oriented risk groups: Corporate and Investment Banking Group Private Clients and Asset Management Group Credentials - Risk Adjusted Performance When Deutsche Bank acquired Bankers Trust in 1999, it inherited the Risk Adjusted Return On Capital (RAROC) concept. Deutsche Bank continues leads the development RAROC in both methodology and tools.

3 Introduction of Richard Hall
Richard Hall - Bsc(Hons) Mathematics for Business Deutsche Bank, Head of Global Markets Information Technology (IT) Asia and Head of Global Risk Technology (GRT) Asia Deutsche Bank AG, Singapore Global Markets IT provides technology support to the Deutsche Bank dealing rooms covering Foreign Exchange, Money Market, OTC Derivatives, Credit Derivatives, Repo and Fixed Income. Global Risk Technology provides technology solutions across all the major risk measurement categories - Market, Credit, Liquidity, Operational and Regulatory Risk. Bankers Trust Company, London, NY, Tokyo, Hong Kong and Singapore Supported all major trading business in various locations plus the Global Risk Management function in London.

4 Introduction to Deutsche Bank’s Economic Profit Concept
Value-based management This diagram shows that an increase in the institution’s market value can be achieved either by increasing the profitability of the existing business or from growth. RAROC is the main component of value-based management. RAROC allows decisions throughout the bank to be compared on a consistent basis in relation to their returns. Capital Markets (Expectations of shareholders) Economic Profit Concept Strategic Planning / Evaluation Capital market oriented target setting Allocation of Resources Value based Management Decision Levels Group Business divisions / areas % Increase of return Economic Capital should be allocated to those customers, products and divisions generating the highest returns. RAROC Growth Single customer relationships Cost of Capital Economic Capital Products

5 Deutsche Bank’s Approach RAROC aim
How much capital is needed by DB? Protection of Bank ensuring sufficient capitalisation Risk appetite of Deutsche Bank Regulatory capital requirements Economic capital requirements reflecting the risk “run” by DB Efficient resource allocation to maximise shareholder value Which fields of business should be expanded / shrunk? Efficient use of Economic Capital Comparison of business activities on a common basis Risk vs.. Return for divisions, customer relationships, product sets Risk-based transaction pricing How should we reflect risk in prices? Competitive pricing Consider portfolio effects in pricing Exit from non-profitable business (risk / reward relationship)

6 Deutsche Bank’s Approach
RAROC example - Efficient resource allocation to maximise shareholder value Using RAROC as a measure of performance (an economic view), the assessment of a customer can change significantly when compared with a regulatory view such as Return on Equity (ROE). These examples show how the results for two customers with different credit qualities can differ depending on how performance is measured. The result is more objective and reliable customer performance evaluation measurement.

7 Deutsche Bank’s Approach RAROC key elements
The RAROC ratio can be quoted against any time horizon, however the 'standard' is to quote a one year RAROC ratio. The basic RAROC equation is the ratio between Risk Adjusted Return (RAR) and Economic Capital (EC). The top-line (Risk Adjusted Return): Total Revenue minus Total Expenses before any risk provisions. Expected Loss Based on a linear mathematical model of the average expectation of loss within a portfolio. OR The “general” and “specific” risk provisions (sometimes termed as loan loss provisions). Capital Benefit Overall cost of funding is reduced from what it would be on a fully-leveraged basis by the cost of funds multiplied by the amount of capital held. This is the benefit to the bank from holding economic capital.

8 Deutsche Bank’s Approach RAROC in practise
Previously implemented - up to June 2000: RAROC = Risk Adjusted Return / Book Equity Capital Where, Book Equity Capital = Capital Allocation Factor * Total Economic Capital Book Equity Capital takes the Economic Capital process a step further and links the RAROC process to shareholders expectations by establishing a firm relationship between Risk and Book Equity. The bottom-line (Book Equity Capital): Where, Capital Allocation Factor = DB Group Share Book Value / DB Group Total Economic Capital Where, Total Economic Capital = Credit Risk Capital, Market Risk Capital and Business Risk Capital Business Risk was DB’s early approach to address Operational Risk in the RAROC calculation.

9 Total Economic Capital
Deutsche Bank’s Approach Impact of BIS on “Total Economic Capital” calculation DB’s Total Economic Capital now comprises of 3 further risk categories (Transfer Risk, Operations Risk & High Impact/Low Frequency Risk) and reflects methodology changes in Market Risk and Credit Risk. Value at Risk Expected / Unexpected Loss Losses from single events Losses due to Remaining Volatility Total Economic Capital Quantified Risk Market Risk = Market Risk + Private Equity Risk Credit Risk = Counterpart Default Risk + Transfer Risk Operational Risk = Business Risk + Operations Risk + High Impact/Low Frequency Risk

10 Deutsche Bank’s Approach RAROC in use
Creating shareholder value has always been DB’s business driver for RAROC ..but in reality the key management focus is first directed towards achieving the acceptable Core Capital Ratio, which is based on Regulatory Capital. Where management of Risk Weighted Assets (RWA) is key …when DB hits the target Core Capital Ratio, management refocus on creating shareholder value - hence refocus on RAROC RAROC operates at a portfolio level …as such, it provides a measure of the ability of a given portfolio to create capital value

11 Deutsche Bank’s Approach RAROC in use
RAROC also operates at a Counterparty and an individual trade level - where it gives an indication of the relative expected profitability ...and is based on an estimate of the incremental economic capital needed to support that trade …but it is not the only arbiter of whether a trade is acceptable (DB may accept trades that don’t meet hurdle rates, provided they are key to achieving targets on a portfolio) At an individual trade level, RAROC has some weaknesses - it can be very sensitive to the input parameters, many of which are estimates There is considerable discussion about the most appropriate way to look at RAROC on trade level - e.g. Do you reflect only the marginal costs of doing a trade, or do you allocate a portion of total costs?

12 Deutsche Bank’s Approach RAROC in use
Generally, the higher the RAROC, the greater the ability to raise internal capital, and the higher the franchise value ….which helps to boost Market Capitalisation Credit decision making is not binary (yes to “good” risks/no to “bad” risks) - it should be based on Risk/Return decisions …businesses should be paid more for taking more risk! …businesses should not accept transactions that destroy capital value - RAROC is a tool that assists in that process

13 Deutsche Bank’s Approach
RAROC example - Practical advantages in terms of value-based management Using a RAROC Pricing Tool Account managers are able to calculate the profitability of any proposed deals after taking risk into consideration A new deal is evaluated based on its risk/return relationship - if the original RAROC figure is unsatisfactory the deal can be restructured as the collateral, term structure and product type are reflected in the RAROC calculation The stair-shaped marking represents the margin, based on credit quality, required to achieve a certain RAROC hurdle rate of 20% The rating of B+ requires a margin of 1% to reach a RAROC hurdle of 20% Incentives for cross-selling activities can be created RAROC calculations are not restricted to corporate banking but can also be used within private banking and investment banking

14 Deutsche Bank’s Approach RAROC reporting
RAROC: Integrated view Business Unit Reports Special Risk Reports Group MIS Segment Reporting RAROC Reporting Line Risk Controlling, Business Area Controlling, Credit Risk Management Heads of Businesses, Risk Management, Group Executive Board Group Executive Board Public Expected Loss Economic Capital Revenues Costs Receiver Credit Risk Market Risk Operational Risk Transaction/ portfolio level Business area specific Daily/monthly performance reports Daily VaR and monthly control report Aggregated Economic Capital, Expected Loss and RAROC Economic Capital and RAROC per Business Division and for the Group Detail

15 Deutsche Bank’s Infrastructure
Global Risk Technology - Example of internal products and services The aim of Global Risk Technology (GRT) is to provide IT products and services to Global Market Risk Management and Global Risk Controlling. The systems developed by GRT encompass all major risk categories; Market, Credit, Liquidity, Operational and Regulatory. Large global team (covering inputs, systems architecture and key MIS) Due to the global size of Deutsche Bank, GRT has developed a integrated structure (integrated Risk Controlling web site).

16 Deutsche Bank’s Infrastructure
Global Risk Technology - Example of internal products and services The Risk, Performance and Limit (RPL) system has been designed to streamline the way in which global risk related information for all Deutsche Bank regional branches and subsidiaries is reported. Risk related information is reported by recording a statistic and its classification. This allows the system to adapt to changing reporting requirements because the way in which statistics are reported can be controlled by the user.

17 Issues of Implementation Practical impacts on RAROC
Besides income and costs, RAROC is mainly influenced by two elements: One: Accurate capture of customer’s credit quality, collateral and size of exposure The lower the credit quality, the higher the default rate, the higher the Expected Loss, the larger is the required Economic Capital. Result - comparatively lower RAROC The better the collateralisation, the lower the Expected Loss and the Economic Capital. Result - comparatively higher RAROC The higher the exposure or loan equivalent exposure, the higher the Expected Loss and the required Economic Capital due to higher risk concentration. Front View Side View Top View

18 Issues of Implementation Practical impacts on RAROC
Two: Portfolio effects RAROC evaluates any stand-alone deal with respect to the whole portfolio. Here the performance of an individual asset is also dependent on the correlation of that asset’s default rate with that of other assets in the Bank’s portfolio. The model used to assess these correlations should be based on the differentiation of customers in terms of credit quality and macro-economic factors. A new commitment in a country or an industry in which the bank has no particular concentration, will attract relatively low Economic Capital Result: comparatively high RAROC A new commitment to a counterparty to which the Bank already has a large exposure, results in a larger risk contribution and a higher Economic Capital requirement. Result: comparatively low RAROC Front View Side View Top View

19 Issues of Implementation Technical impacts on RAROC
Internal modelling Lack of quality data (standardised data gathering) Structural change (rigorous mapping of new deals) Over modelling ie. portfolio is to small, stability a problem Use of approved risk models, market data source and validation methodology Valuation Multiple future prices (dynamic time period definition) Consistency in valuation models Drill-down to support comprehensive management reporting Input requirements - interface with current systems and customisation of existing MIS Data should come from key processing and reporting applications RAROC figures need to be incorporated into the businesses MIS and become a key component of the business performance measurement. Front View Side View Top View

20 Issues of Implementation Technical impacts on RAROC
Data source - ideally data should come from the accounting or back office system Most vendors work on the pretence that data comes from a structured system, which is in most cases not the fact, ie. deals recorded and settled on a MS Excel spreadsheet Suppression of positions Other departments doing deals - captures complete set of traded transactions Front office using dummy deals Data integrity of computed fields - Consistency between front office models and those used to generate and report P&L is critical. Front View Side View Top View

21 Deutsche Bank’s Experience Existing GRT Products
Risk Pricing Model (RPM) RPM is the standard GRM tool used to analyse risk-adjusted profitability of commercial banking transactions for financial and non-financial corporate customers. RPM incorporates a portfolio-dependent approach to the RAROC calculation by considering the risk/return relationship of proposed lending transactions with the global lending portfolio. RPM handles 3 groups of products encompassing 10 different facility types: Loan Products: Revolving Credit Term Loan Overdraft CP Backup (with guarantee function) Bonds & Guarantees: Standby L/C Performance Bond Bid Bond Trade Finance: Trade L/C Banker’s Acceptance Bills

22 Deutsche Bank’s Experience Existing GRT Products
Risk Trade Evaluator (RTE) The RTE user can input up to 5 trades, at one time, with the following types of trades currently being covered: Vanilla Fixed Rate Agreements Interest Rate Swaps Currency Swaps Caps/Floors Swaptions FX Options FX & Gold Forwards Future development will incorporate non-vanilla products, commodities and equities. However, exotic trade RAROC can still be calculated if the user supplies their own exposure profile.

23 Deutsche Bank’s Experience Ongoing initiatives
Research and develop better risk methodologies. Continuously develop risk management polices and enabling tools. Enhance internal risk training. Improve standards for risk information and reporting. Enhance dialogue with regulators (home and local) to improve the regulatory environment. As the world of banking grows more intertwined, the necessity for banks to anticipate and plan for all types of risk becomes increasingly vital. Moreover, regulators from the Basel Committee on Banking Supervision are focusing on developing capital outlay regulations for operational risk. Deutsche Bank expects to derive two major benefits from its ongoing investment in operational risk initiatives: Improved ability to measure/ model OR losses - which will result in lower regulatory capital charges (Pillar I + II) Improved data/ input integrity into the Market and Credit components of our RAROC model

24 Deutsche Bank’s Experience Ongoing initiatives
Currently, Economic Capital methodology for Operational Risk is a top-down model approach based on external loss data (tailored to Deutsche Bank needs), which is compliant with the current regulatory debate as well as in line with our general model philosophy. One of the goals developing the methodology was “sensitivity to managerial action”. In absence of an Deutsche Bank internal loss data history, we introduced a pragmatic but transparent set of incentive factors which influence the OR Capital charge of a business division. Max. 20 % of the charge could be reduced by applying the incentive factors.

25 Conclusion Understand your profits.
Strategic reallocation of Economic Capital in order to support value-based management throughout the bank. Change Management - RAROC fundamentally changes the bank’s risk culture. Implementation requires strong support from management throughout the organisation and clearly defined accountability. Quality of data underpins the effectiveness of all value-based management - RAROC initiatives. Enhances the ability to target customers and manage the bank’s relationship in the most beneficial manner. Enables the business to view the “risk and reward” by transaction, product or business division. Demonstrate the importance of risk management to the overall profitability of the bank - abolish the “policeman” perception. Risk management is a continuous evolution process.

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