Presentation on theme: "Enterprise Risk Management- A closer look at the issues Mr. Ravi Varadachari November 18, 2008."— Presentation transcript:
Enterprise Risk Management- A closer look at the issues Mr. Ravi Varadachari November 18, 2008
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Estimate the “Right” amount of capital Capital depends on various factors including: Exposure to type of asset class - corporate, bank, sovereign and the like Country of incorporation of the exposures Credit ratings/Credit Score Term of exposure – short term or long term Collateral Policy, processes and systems for risk management
ERM and Capital can i mpact growth ambitions and funding cost Impact on Growth: Asset growth would require additional capital Additional capital required depends on growth in “risk weights” and not just asset growth Cost of Funds: Lower wholesale deposit rates for banks that demonstrate good risk management systems and adequate capital No substantial impact on retail deposit rates
and also profitability … Capital10 Borrowings90100110120 Total assets100110120130 Average cost of borrowings 4% Average yield on loans 7% Average costs1% Interest Income7.07.78.49.1 Interest Expenses 3.64.04.44.8 Other Expenses1.01.11.21.3 Net Income188.8.131.52.0 Return on Equity24%26%28%30%
14 The “Risk Management” Value Chain Source: i-flex study based on various surveys Risk Identification Identification of risks and Go - No Go Decision Risk Management Collateral, Guarantees, Covenants Capital Allocation Capital estimation commensurate with risk Risk Based Pricing Pricing takes into account capital charge apart from expenses Stage IStage IIStage IIIStage IV
15 Regulatory, Economic and Book Capital Regulatory Capital : Capital that banks are required to hold by their regulator “The amount of capital a bank must have to stay in business” Under the Basel II framework – computed based on a prescriptive formula for credit risk Economic Capital : Capital that is required commensurate with the risk profile of the bank “The amount of capital a bank should have” Various models to estimate economic capital - stochastic view Endeavor is to use it for business decisions Book Capital : Capital that a prudent bank would choose to hold “The amount of capital a bank that a bank has on its book” Economic book value – different from accounting concept of book value Concept of risk appetite
16 The meaning of capital- different when perceived in the context of risk management Regulators are now trying to align regulatory capital with economic capital… Regulatory Capital : Capital that banks are required to hold by their regulator “The amount of capital a bank must have” Economic Capital : Capital that a prudent bank would choose to hold – commensurate with the risk of the bank “The amount of capital a bank should have” = To maintain Capital Adequacy Ratio = Capital/ Risk Weighted Assets >= 8% Capital depends on the risk profile of the bank’s portfolio
The “Stochastic” Representation Risk ExpectedBest Market0% or Bid/AskPrice% CreditAverage Loss%0 Loss% OperationalAverage Error%0 Error% Worst Price% Unexpected Loss% Unexpected Error% SET LIMITS Probability Distribution WorstExpected Best
Economic Capital for Credit Risk EC = Coverage against “unexpected” losses at desired confidence level Probability of Loss Amount of Loss ($) Unexpected Loss Expected Loss MeanConfidence Level ECONOMIC CAPITAL Typically 99.96% to 99.98% denoting risk appetite
The Black Swam Phenomenon “No amount of observations of white swans can allow the inference that all swans are white, but the observation of a single black swan is sufficient to refute that conclusion.” What is a Black Swam? It is an Event Hard to predict based on historical data After the event – many people saw it coming Stress testing models must assume black swan events to ensure greater predictive power.
The London “Millennium Bridge” Incident Source: http://www.urban75.org/london/
The London “Millennium Bridge” Incident London Bridge – Architect Lord Norman Foster Source: http://www.urban75.org/london/
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