Complexity

1
Banks at Cross-Roads
Integrated Risk Management and Performance
Measurement
2
IPM Solution Set - Integrated Performance
Measurement
SVM
EP
RAPM
Economic Capital
Operating Profit
Op. Risk
Cr. Risk
Mkt. Risk
FTP
Cost
Rev.
Risk
Profit Loss
Middleware
Analytical Engines
Data Warehousing
Operational Data Store
General Ledger
3
Current Management Philosophy Is Directed by
Historical Information and Does Not Emphasize
Forward-looking Approaches to Decision Making
It is the completion of a process long since
started in most FIs
4
Risk Measurement Methodologies
5
Risk Management Methodologies
Primary market risks result from movements in
financial markets
Secondary risks capture risks from other market
characteristics
Liquidity risk results from the inability to
receive fair value
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Risk Management Methodologies - Market VaR

• Market Value-at-Risk (VaR)

ƒ

• Future Market Value Distributions
• Position Risk Horizons
• Correlation Between Positions

Market/ Position Risk

n
7
Risk Management Methodologies - Market VaR
Risk Management Methodologies - Market VAR

• Value-At-Risk represents the worst case loss

1 in 40 Loss
VAR
MTM Losses
MTM Gains
83.0 confidence (approximately one standard
deviation)
97.5 confidence (approximately two standard
deviations)
99.5 confidence (approximately three standard
deviations)
8
Risk Management Methodologies - Market Risk
Measurement Techniques
4. Value-At-Risk (VAR) with Correlation
3. Value-At-Risk (VAR) at Instrument Level
2. Basis Point Value (BPV) Approach
Increasing Sophistication
1. Notional Amount at Risk
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Risk Management Methodologies - Market VaR
approaches
Risk Management Methodologies - Market VAR
Approaches to Calculating Value-At-Risk
Monte Carlo Simulation
Mean Covariance Approach
Historical Simulation
What if Analysis
Scenario Based Approaches
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By Product Type..
Value Dashboard
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Risk Management Methodologies
Counterparty Settlement and Pre-settlement Risk
Issuer Risk
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Risk Management Methodologies - Credit VaR

• Credit Value-at-Risk (VaR)

ƒ

• Future Market Value Distributions
• Default Rate Distributions
• Recovery Rate Distributions
• Portfolio Correlation Effects

Expected and Unexpected Credit Losses

n
13
Risk Management Methodologies - Credit VaR
Expected Loss
99th Percentile Loss Level
Economic Capital
Probability
Loss
Covered by pricing and provisioning
Covered by capital and/or reserves
Quantified using scenario analysis and controlled
with concentration limits
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Risk Management Methodologies - Credit VaR
Today's replacement cost, including effect of
accruals

Potential changes in value over remaining life of
transaction
-
Net effect of long and short positions
-
Collateral held to reduce credit exposure

Spot settlements owed or defaulted payments
Credit Exposure
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Risk Management Methodologies - Credit VaR
Maximum Exposure
8
6
Expected Exposure
4
Market Value
2
0
Time
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Risk Management Methodologies - Credit Risk
Measurement techniques
4. Dynamic Approaches (Monte Carlo and Portfolio
Simulations)
3. Mark-to-Market plus a factor
2. Mark-to-Market
Increasing Sophistication
1. Notional Amount at Risk
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Dynamic Approach - Creditmetrics
Exposures
Value-at-Risk Due to Credit
Correlations
User Portfolio
Credit Rating
Seniority
Ratings Series, Equities Series
Credit Spreads
Market Volatilities
Rating Migration Likelihoods
Recovery Rate In Default
Models (e.g., Correlations)
Present Value Bond Revaluation
Exposure Distributions
Standard Deviation of Value Due to Credit Quality
Changes for a Single Exposure
Joint Credit Rating Changes
Portfolio Value at Risk Due to Credit
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By Industry Sector ...
Value Dashboard
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Risk Management Methodologies
Improper Authorization
Inadequate Documentation
Systems Failure
Poor Judgment
Training / Human errors
A special case is event risk, where one or more
extreme external events cause a high,
un-preventable loss.
Fraud
Mis-pricing
Transaction Processing Errors
Under Utilization of Funds
Model Errors
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By Operational Events..
Value Dashboard
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The Solution - Systems Architecture Model
External Communications
External System Interfaces
Front Office/Deal Capture
Client Information Collection
S A L E S T R A D I N G
Documentation Database
Confirms / Notices Payments / Settlements Collat
eral Events Accounting Entries (G/L) Other
External Interfaces
Event Processing
Central Data Repository
Trade Entry and Capture
- Position Tracking - Transaction Details -
Market Data - Economic Details - Transaction
History
Financial Reporting Risk Control
(MIS) Performance Analysis Compliance Other MIS
Financial and Management Reporting
Trade Pricing
Risk Management
Market Risk Analysis
Credit Risk Analysis
Exposures (e.g., Value at Risk) Limits (Available
Credit Lines)
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The IPM Solution Set - Methodologies
SVM
Goal

• Best of Breed
• Methodologies

Op. Risk
Cr. Risk
Mkt. Risk
Cost
Rev.
FTP
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Rewards to Organisations that implement IPM is
tremendous

• We believe there are big rewards for
  organisations that can implement IPM
• Improving earnings stability
• Understanding sensitivity of earnings to external
  and internal factors
• Management of earnings surprises
• Awareness of trends
• Optimising use of capital
• Allocating capital efficiently at enterprise-wide
  level
• Identifying value creating/destroying lines of
  business
• Alignment of capital coverage with risk appetite
• Enhancing operational decision-making
• Embedding risk in the decision making process
• Change from historic to forward-looking
  management
• Decentralized and efficient decision making

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IPM enables senior management to answer strategic
questions and manage the business with a forward
looking approach

• Integrated Performance Management (IPM) is about
  bringing Shareholder Value theory into
  operational reality
• Where is my organization creating / destroying
  value?
• Is our organization aligned with our strategy to
  create value?
• Are we meeting shareholder expectations?
• How do we compare to our competitors?
• What are the areas of future opportunity?
• Are we properly compensated for the risks we are
  taking?
• Am I leveraging my IT investment?
• Is capital invested in the correct business to
  optimize value creation?
• Are we correctly measuring performance?
• Can the business plan and forecast steer the
  correct course?

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An Example Identifying Value Creation or Erosion
in the Enterprise...
Value Dashboard
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Calculation and Allocation of Economic Capital to
Business Units and the Bank by Risk Type
Retail Banking
Customer Finance
Wholesale Banking
Intl Banking
Ins Invstmnts
The Bank
Central Units

18m
54m
56m
Market
660m
137m
137m
Insurance
7m
957m
Credit
533m
3,481m
439m
1,207m
872m
385m
Operational (event)
228m
911m
79m
178m
Operational (business)
116m
323m
103m
120m
851m
86m
80 m
65m
Operational Market Risk dominated
Credit Risk dominated
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Economic Profit is the key element of this
program, integrates profitability and risk and
supports historical and forward-looking analysis
Two Equivalent Definitions of Economic Profit
(EP)
Revenues
-
(RAPM - Cost of Equity) x Economic Capital
Return
Operating Expenses
Accounting Earnings
VaR
-
Taxes
Risk
NOPAT
Growth
(Book Equity
-
x Cost of Equity)
Quality Earnings

Economic Profit

Economic Profit

• Economic Profit sets the performance bar higher
  by forcing managers to meet not only operating
  expenses but also all expenses associated with
  invested capital
• A major issue in financial services in defining
  the capital base
• General approach is to apply our capital-at-risk
  model (consistent with RAPM) to determine the
  capital which is ultimately employed and thus the
  amount by which managers are ultimately held
  accountable

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Value Driver Measurement and Benchmarking Can
Provide Additional Focus for Strategic Direction
EP by Measurement Center
Strategic Assessment by Segment(Business Unit,
Product, Region)
Return-On-Capital - Cost of Capital (R-C Spread)
A
Drives Capital Investment to Add Value
B
C
Attractive
Investment
Consider Growth/EntryOptions
D
E
SegmentAttractiveness
Consider Exit Options
Financial Value Driver Benchmark
Disadvantaged
Advantaged
Competitive Position
Decides How to Invest and Manage Earnings
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Risk-adjusted Capital or Economic Capital
Allocated Revenue Allocated cost data
G/L
Support systems
Income
Allocation systems
Return on Economic Capital
?

Creditrisk Operationalrisk Market
risk Insurancerisk
G/L
_

Economic Capital
EquityProfit
Risk systems
Cost of Equity
Value Contribution to Shareholder
Support systems
?

Economic Capital
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Technology Blueprint
Information Processing and Storage
Information Presentation
Translation Processor (Middleware)
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To integrate and deliver all the information in
an efficient manner, the technology architecture
has to be flexible and scalable

• Flexibility
• Leverage existing investments
• Support plug-in best of breed applications
• accelerated organizational changes due to
  shorter, less costly implementations
• Facilitates integration of new systems (MA)
• Scalability
• Accommodate growth in the organization
• support high volumes of transactions and level of
  detail
• enhance timeliness of delivery due to capacity

Source Data
Information Presentation
Information Processing and Storage
Translation Processor (Middleware)
Traditional IT Process Financial Management
Accounting
External Feeds

Summarized financial postings
Transaction Capture

• Market data
• Credit ratings

Drill down to detail

Discrete Reporting
Operational Systems
Operational Data Store
Translation Mapping

• Fixed income
• Foreign exchange

Transaction detail
Web based report viewer
Business Support Systems
Analytical results
Calculation Engines

• Payroll
• Benefits

Summarization Posting

• Detailed financial postings
• Business events
• Reference data

Non-Automatic Inputs

• Manual entries

Algorithmics Risk Watch
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IPM Solution Set
SVM
EP
RAPM
Economic Capital
Operating Profit
Op. Risk
Cr. Risk
Mkt. Risk
FTP
Cost
Rev.
Risk
Profit Loss
Middleware
Analytical Engines
Data Warehousing
Operational Data Store
General Ledger
33
Building Sound Internal Controls
Integrity and Accuracy of Records and Reports
Effective Operations Reliable Reporting Reconcili
ation Control
Why Internal Controls?
Building the Under- standing in the Bank for
Adequate Oversight
Internal Controls
Testing Risk Management Process periodicaly
External Auditing
Evaluation of the Independence and
Effectiveness of Risk Management Functions
Building Safe systems
Based on the objective of the Sound Internal
Controls to provide strategic as well as
operational decision support, this will be a
major (joint) bank-wide effort.