Stress Testing and Economic Capital By T Y
Stress Testing and Economic Capital By T. Y. Lee
Table of Contents • • • Background Why Stress Testing About Economic Capital Case Study Future Improvements
• • • Background Why Stress Testing About Economic Capital Case Study Future Improvements
200710 1996 Incremental Default Risk Charge Basel I Market Risk Amendment 20080722 Market Risk Trading Book Proposals Incremental Risk Charge Basel II Enhancement (CR+MR) B 1 20090713 Some new Standards B 2 Financial Crisis B 3 1988 2006 20090116 20091217 Basel II Capital Adequacy Ratio 3 Pillars Trading Book Proposals Strengthen Bank Resilience (Credit Risk) (CR+MR+Op. R) Basel II Enhancement Liquidity Risk
BASEL II Structure 標準法(SA，Standardized Approach) 一 最低資本需求 Minimum Capital Requirement 信用 內部評等法 風險 (IRB，Internal Ratings Based) 風險抵減 (CRM) 基礎 (FIRB) 進階 (AIRB) 資產證券化 市場 標準法TRADING BOOK 風險 內部模型法(IMA，Internal Model Approach) 基本指標法(BIA，Basic Indicator Approach) 作業 標準法(SA，Standardized Approach) 風險 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
Va. R, Stress Loss, Economic Capital and Limits Economic Capital Expected loss (mean) Frequency of loss Statistical loss (at specified CL) Estimated loss in normal market environment Stress loss (scenariobased) Desired Rating (e. g. AA 99. 97% CL) Losses in extreme but plausible “tail” events Severity of loss Expected loss deducted from revenues Subject to Va. R & operational limits Subject to stress loss limits Risk appetite
• • • Why Stress Testing About Economic Capital Case Study Future Improvements
Why Stress Testing? • Regulatory Requirements: – Basel II mandates stress-testing around lowprobability 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.
• • • Why Stress Testing About Economic Capital Case Study Future Improvements
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)
About Stress Testing (2/8) • RCA of USA used to drop TV set from high attitudes to see if the TV can withstand falls • Now there are commercials dropping i. Phones 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
About Stress Testing (4/8) • 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
About Stress Testing (5/8) • 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
About Stress Testing (6/8) • 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
About Stress Testing (7/8) • 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!
About Stress Testing (8/8) • 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
• • • Why Stress Testing About Economic Capital Case Study Future Improvements
About Economic Capital (1/3) Capital Accounting Regulatory Economic • “SHOULD Hold” capital Def. • “ACTUALLY • “MUST • the buffer of reserves banks hold Hold” capital to guard against unexpected • Listed on the • Minimum Balance Sheet requirement losses and maintain the financial stability. • Regulatory • Risk capital, to ensure that the • Accounting Formulas realistic balance sheet stays Methodol rules, such as • Unable to fully solvent over a certain time period GAAP, ogy reflect instinct IFRS… with a pre-specified probability. risk • Peer Functiona comparison • Financial lity 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. Expected Loss Statistical Loss (specified level of confidence) Estimated loss in typical adverse period Frequency of Loss Average loss deducted from revenues Risk Appetite restricted by Operating Limits Stress Loss (scenario based) Econ. Capital Losses in extreme but plausible “tail” events Risk Capacity subject to Stress Loss Limits Severity of Loss
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
• • • Why Stress Testing About Economic Capital Case Study Future Improvements
Case Study • The framework we developed is based on: – Credit. Var concept of Credit Metrics and – Credit Portfolio View (CPV) by Mc. Kinsey
Road Map of Credit Metrics
Algorithm(1/2) – Migration Simulation Step : One Step : Two
Algorithm (2/2) – CPV Approach (2008. 1~2008. 12) Back to Simulation Process
Algorithm – Migration Simulation Step : One Step : Two Conditional
• • • Why Stress Testing About Economic Capital Case Study Future Improvements
Future Improvements (1/2)
Future Improvements (2/2) • Pair-wise correlation is NOT adequate to measure the degree of interconnectedness among industries and among financial institutions
Q & A
- Slides: 31