Presentation on theme: "Presentation Overview"— Presentation transcript:
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.”ContentsPresentation OverviewDeutsche Bank‘s HeritageIntroductionDeutsche Bank‘s ApproachDeutsche Bank‘s InfrastructureIssues of ImplementationDeutsche Bank‘s ExperienceConclusionDeutsche 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 Group1993 Acquisition of Banco de Madrid S.A. and Banca Popolare diLecco SpA.1994 Acquisition of Sharps Pixley Group1995 Acquisition of ITT Commercial Finance, St. Louis (Missouri, USA)1996 Foundation of a fund management company in Singaporeand a subsidiary in Hungary1997 Acquisition of a trust bank in Japanand an Australian fund management company, Axiom1998 Acquisition of Credit Lyonnais Belgium1999 Acquisition of Bankers TrustMore Than 130 Years of HistoryGlobal PresenceGermany %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 StructureDeutsche 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 GroupPrivate Clients and Asset Management GroupCredentials - Risk Adjusted PerformanceWhen 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 BusinessDeutsche Bank, Head of Global Markets Information Technology (IT) Asia and Head of Global Risk Technology (GRT) AsiaDeutsche Bank AG, SingaporeGlobal 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 SingaporeSupported 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 managementThis 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 ConceptStrategicPlanning /EvaluationCapital marketorientedtarget settingAllocation ofResourcesValue basedManagementDecisionLevelsGroupBusinessdivisions / areas%Increase of returnEconomic Capital should be allocated to those customers, products and divisions generating the highest returns.RAROCGrowthSingle customerrelationshipsCost of CapitalEconomic CapitalProducts
5 Deutsche Bank’s Approach RAROC aim How much capital is needed by DB?Protection of Bank ensuring sufficient capitalisationRisk appetite of Deutsche BankRegulatory capital requirementsEconomic capital requirements reflecting the risk “run” by DBEfficient resource allocation to maximise shareholder valueWhich fields of business should be expanded / shrunk?Efficient use of Economic CapitalComparison of business activities on a common basisRisk vs.. Return for divisions, customer relationships, product setsRisk-based transaction pricingHow should we reflect risk in prices?Competitive pricingConsider portfolio effects in pricingExit from non-profitable business (risk / reward relationship)
6 Deutsche Bank’s Approach RAROC example - Efficient resource allocation to maximise shareholder valueUsing 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 Expensesbefore any risk provisions.Expected LossBased on a linear mathematical model of the average expectation of loss within a portfolio.ORThe “general” and “specific” risk provisions (sometimes termed as loan loss provisions).Capital BenefitOverall 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 CapitalWhere,Book Equity Capital = Capital Allocation Factor * Total Economic CapitalBook 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 CapitalWhere,Total Economic Capital = Credit Risk Capital, Market Risk Capital and Business Risk CapitalBusiness Risk was DB’s early approach to address Operational Risk in the RAROC calculation.
9 Total Economic Capital Deutsche Bank’s ApproachImpact of BIS on “Total Economic Capital” calculationDB’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 RiskExpected / Unexpected LossLosses from single eventsLosses due to Remaining VolatilityTotal Economic CapitalQuantified RiskMarket Risk = Market Risk + Private Equity RiskCredit Risk = Counterpart Default Risk + Transfer RiskOperational 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 RAROCRAROC 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 estimatesThere 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 CapitalisationCredit 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 managementUsing a RAROC Pricing ToolAccount managers are able to calculate the profitability of any proposed deals after taking risk into considerationA 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 calculationThe 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 createdRAROC 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 viewBusiness Unit ReportsSpecial Risk ReportsGroup MISSegment ReportingRAROCReporting LineRisk Controlling, Business Area Controlling, Credit Risk ManagementHeads of Businesses, Risk Management, Group Executive BoardGroup Executive BoardPublicExpected LossEconomic CapitalRevenuesCostsReceiverCredit RiskMarket RiskOperational RiskTransaction/ portfolio levelBusiness area specificDaily/monthly performance reportsDaily VaR and monthly control reportAggregated Economic Capital, Expected Loss and RAROCEconomic Capital and RAROC per Business Division and for the GroupDetail
15 Deutsche Bank’s Infrastructure Global Risk Technology - Example of internal products and servicesThe 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 servicesThe 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 exposureThe lower the credit quality, the higher the default rate, the higher the Expected Loss, the larger is the required Economic Capital.Result - comparatively lower RAROCThe better the collateralisation, the lower the Expected Loss and the Economic Capital.Result - comparatively higher RAROCThe higher the exposure or loan equivalent exposure, the higher the Expected Loss and the required Economic Capital due to higher risk concentration.Front ViewSide ViewTop View
18 Issues of Implementation Practical impacts on RAROC Two: Portfolio effectsRAROC 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 CapitalResult: comparatively high RAROCA 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 RAROCFront ViewSide ViewTop View
19 Issues of Implementation Technical impacts on RAROC Internal modellingLack of quality data (standardised data gathering)Structural change (rigorous mapping of new deals)Over modelling ie. portfolio is to small, stability a problemUse of approved risk models, market data source and validation methodologyValuationMultiple future prices (dynamic time period definition)Consistency in valuation modelsDrill-down to support comprehensive management reportingInput requirements - interface with current systems and customisation of existing MISData should come from key processing and reporting applicationsRAROC figures need to be incorporated into the businesses MIS and become a key component of the business performance measurement.Front ViewSide ViewTop View
20 Issues of Implementation Technical impacts on RAROC Data source - ideally data should come from the accounting or back office systemMost 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 spreadsheetSuppression of positionsOther departments doing deals - captures complete set of traded transactionsFront office using dummy dealsData integrity of computed fields - Consistency between front office models and those used to generate and report P&L is critical.Front ViewSide ViewTop 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 CreditTerm LoanOverdraftCP Backup (with guarantee function)Bonds & Guarantees: Standby L/CPerformance BondBid BondTrade Finance: Trade L/CBanker’s AcceptanceBills
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 currentlybeing covered:Vanilla Fixed Rate AgreementsInterest Rate SwapsCurrency SwapsCaps/FloorsSwaptionsFX OptionsFX & Gold ForwardsFuture development will incorporate non-vanilla products, commodities and equities.However, exotic trade RAROC can still be calculated if the user supplies their ownexposure 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.