stress testing and economic capital by t.y. lee. table of contents background why stress testing...

Stress Testing and Economic Capital

By T.Y. Lee

Table of Contents

• Background

• Why Stress Testing

• About Stress Testing

• About Economic Capital

• Case Study

• Future Improvements

• Background




• Case Study


B1B1

1988

Basel I

Capital Capital Adequacy RatioAdequacy Ratio

(Credit Risk)(Credit Risk)

1996

Basel I

Market Risk Market Risk AmendmentAmendment

(CR+MR)(CR+MR)

B2B2

2006

Basel II

3 Pillars3 Pillars

(CR+MR+OpR)(CR+MR+OpR)

Financial Financial CrisisCrisis

20080722

Market Risk

Incremental Risk Charge

20090116

Trading Book Proposals

Basel II Enhancement

20090713

Trading Book Proposals

Basel II Enhancement

Some new Standards

B3B3

20091217

Strengthen Bank Resilience

Liquidity Risk

200710

Incremental Default Risk

Charge

一

最低資本需求Minimum Capital Requirement

信用風險

標準法 (SA ， Standardized Approach)

風險抵減(CRM)

資產證券化

內部評等法 (IRB ， Internal Ratings Based)

基礎 (FIRB)

進階 (AIRB)

市場風險

標準法

內部模型法 (IMA ， Internal Model Approach)

作業風險

基本指標法 (BIA ， Basic Indicator Approach)

標準法 (SA ， Standardized Approach)

進階衡量法 (AMA ， Advanced Measurement Approach)

二監理檢視（審查） Supervisory Review Process

三市場紀律（公開揭露） Market Discipline

BASEL II Structure

TRADING BOOKTRADING BOOK

Frequency of

loss

Severity of loss

Expected loss deducted from

revenues

VaR, Stress Loss, Economic Capital and Limits

Risk appetite

Subject to stress loss limits

Estimated loss in normal market

environment

Expected loss (mean)

Statistical loss (at specified CL)

Losses in extreme but

plausible “tail” events

Stress loss (scenario-

based)

Subject to VaR & operational limits

Economic Capital Desired Rating

(e.g. AA - 99.97% CL)




• Case Study


Why Stress Testing?

• Regulatory Requirements:– Basel II mandates stress-testing around low-

probability events to validate capital estimates.– Regulators want similar assurances that portfolios can

withstand extended economic downturns.– It became more important after the financial crisis of

2008

• Better Portfolio Management:– Stresses will occur. Planning for them is profitable.– Reactionary management to sudden stresses is

costly.




• Case Study


About Stress Testing (1/8)

• Stress Testing is not unique to financial industry

• Auto industry and its regulatory agency crash automobiles to test safety measures as part of standard operation process (SOP)


• RCA of USA used to drop TV set from high attitudes to see if the TV can withstand falls

• Now there are commercials dropping iPhones and Samsung Galaxy to see if the phones still function or the screen is OK

About Stress Testing (3/8)• Stress Testing has been used in Market

Risks for many years as part of risk management

• It is applied to Credit Risk as a supplement to Basel II Pillar II process

• The idea is to see if a bank can withstand adverse situations with adequate capital

• Federal Reserve of U.S.A. has required 19 biggest banks in the U.S. to perform stress tests as a measurement to banks’ health every year after the financial crisis of 2008


• Financial authorities of other advanced countries have also ordered banks under their jurisdictions to conduct stress tests

• Financial authority in Taiwan has also followed suit

• Banks with sound risk management practices usually conduct their own stress test regularly


• The key to Stress Testing is designing stress scenarios which are extreme yet plausible– And those scenarios usually required

approval from senior management – Sometimes it required the approval of

regulators as well– If it is too lenient, regulators may not like it– If it is too tough, senior management or the

board of directors may not like it because that may require holding additional capital


• Stress Testing Scenarios:– Historical

• 1929 Stock Market Crash• 1973-74 Oil Crisis

– Hypothetical• U.S. government defaults on its debt• Asteroid hits Earth• Every counterparty in the portfolio got downgraded

by two notches

– Hybrid


• Example– 1960’s anti-nuclear activists in Japan

hypothesized a scenario:• A huge earthquake hit Japan, causes• Huge tsunami, which hit the nuclear plant by the

shore and causes• Nuclear catastrophe!


• Example (cont’d)– They recommended that the government built

robots which can be used during nuclear catastrophe

– But Japanese government turned down the idea arguing that the action would dim the public confidence in nuclear power

– Then we all know what happened in 2011– And the highly impossible yet plausible

hypothetical scenario has become historical scenario




• Case Study


About Economic Capital (1/3)CapitalCapital AccountingAccounting RegulatoryRegulatory EconomicEconomic

Def.Def.

• ““ACTUALLACTUALLY Hold”Y Hold” capital

• Listed on the Balance Sheet

• ““MUST MUST Hold”Hold” capital

• Minimum requirement

• ““SHOULD Hold” SHOULD Hold” capital• the buffer of reserves banks hold

to guard against unexpected losses and maintain the financial

stability.

MethodolMethodologyogy

• Accounting rules, such as GAAP, IFRS…

• Regulatory Formulas

• Unable to fully reflect instinct risk

• Risk capital, to ensure that the realistic balance sheet stays solvent over a certain time period with a pre-specified probability.

FunctionaFunctionalitylity

• Peer comparison

• Financial analysis

• Mandatory capital

• Individual level• Focus on

•Safety•Quantity•Passive way

• Bridge to link the risk and business strategy and to measure RAROC

• Focal point of rating agencies and investors

• Focus on•Safety and Efficiency•Quantity and Quality•Proactive way

About Economic Capital (2/3)• Economic capital can be determined as the cushion required to keep

the bank solvent over a specified time horizon with the defined confidence level (CL).

• A typical time horizon is one year.

• The confidence level is explicitly linked to the choice of target solvency standard, i.e., the desired rating.

Frequency of

Loss

Severity of Loss

Average loss deducted from

revenues

Risk Appetite restricted by

Operating Limits

Risk Capacitysubject to

Stress Loss Limits

Estimated loss in typical adverse period

Expected Loss

Statistical Loss (specified level of confidence)

Losses in extreme but plausible “tail”

events

Stress Loss (scenario

based)

Econ. Capital

About Economic Capital (3/3)

• After the financial crisis of 2008, financial authorities in some advanced countries intend to make economic capital the same as regulatory capital

• Also, Basel Committee recommended a more strict definition of tier-1 capital, although it later relaxed the definition in fear of slowing down economic growth with less lending




• Case Study


Case Study

• The framework we developed is based on:– CreditVar concept of Credit Metrics and– Credit Portfolio View (CPV) by McKinsey

Road Map of Credit Metrics

Algorithm(1/2) – Migration Simulation

Simulation Portfolio Risk

<功

能>

Rating 3

Rating 2

Generate Random Number

(0,1)

Obligor 1Obligor 2Obligor 3

.

Divide into

Rating Group

Mapping toMigration

Matrix

RatingMigration

Matrix

Get Migrate Rating

Calculate Loan Present Value

Credit Spread

By Rating

Get discount

Rate

CorporateCustomer

Dataset(ID, Rating,

industry,Outstanding..

Etc.)

Repeat X times

1st Stage:Generate Simulation Data

Simulation Dataset

2nd Stage:Calculate Portfolio Risk

Get New Industry Code

MappingCalculate

Portfolio Risk

Equity Index Correlation

Matrix

Group into Industry

Rating 1


.

.


.

.

Store in Dataset

Dataset

Process

Given data

SIC Code /Industry codemapping tale

Step : One

Step : Two

Algorithm (2/2) – CPV Approach

Back to Simulation Process

Credit Portfolio View Model (CPV-Macro) Flow Chart

<功能

>

1.預測經濟變數: ARMA(p,q)

2.建構Default Rate Proxy:

AR(1)-GARCH(1,1)

3.估計違約機率:Logistic Function

Pt*=1/1+e^-y

4. Generate Risk Sensitivity Factor & Migrate Factor

TSBUnconditional

Migration Matrix(2007.09-2008.09)

TSBHistorical


TSBConditional


5. Adjust Migration Matrix

(2008.1~2008.12)

Algorithm – Migration Simulation

Step : One

Step : Two

Simulation Portfolio Risk

<功

能>

Rating 3

Rating 2


(0,1)


.

Divide into

Rating Group

Mapping toMigration

Matrix

RatingMigration

Matrix

Get Migrate Rating


Credit Spread

By Rating

Get discount

Rate

CorporateCustomer

Dataset(ID, Rating,


Etc.)

Repeat X times


Simulation Dataset



MappingCalculate

Portfolio Risk


Matrix

Group into Industry

Rating 1


.

.


.

.

Store in Dataset

Dataset

Process

Given data


Conditional




• Case Study


Future Improvements (1/2)Simulation Portfolio Risk

<功

能>

Rating 3

Rating 2


(0,1)


.

Divide into

Rating Group

Mapping toMigration

Matrix

RatingMigration

Matrix

Get Migrate Rating


Credit Spread

By Rating

Get discount

Rate

CorporateCustomer

Dataset(ID, Rating,


Etc.)

Repeat X times


Simulation Dataset



MappingCalculate

Portfolio Risk


Matrix

Group into Industry

Rating 1


.

.


.

.

Store in Dataset

Dataset

Process

Given data


Future Improvements (2/2)

• Pair-wise correlation is NOT adequate to measure the degree of inter-connectedness among industries and among financial institutions

stress testing and economic capital by t.y. lee. table of contents background why stress testing...

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