Bara ERM v2

© Oliver Wyman | SIN-ZAK05401-017

ENTERPRISE RISK MANAGEMENT – TOWARDS SHAREHOLDER VALUE CREATION

DECEMBER 2016

Eric M. Pascal, CPA, CMA, CFA, ACMA, FRM, CGMA Partner Finance and Risk

CONFIDENTIALITY

Our clients’ industries are extremely competitive. The confidentiality of companies' plans and data is obviously critical. will protect the confidentiality of all such client information.

Similarly, management consulting is a competitive business. We view our approaches and insights as proprietary and therefore look to our clients to protect 's interests in our presentations, methodologies and analytical techniques. Under no circumstances should this material be shared with any third party without the written consent of .

Copyright ©

Agenda

1. Introduction

2. Why risk-adjusted analyses is an important part of ERM

3. Setting the Risk Appetite statement

4. Embed Risk Appetite in Annual planning

5. Necessary central capabilities

6. Closing remarks

Introduction 1

4 4 © Oliver Wyman | SIN-ZAK05401-017

A best practice Enterprise Risk Management (ERM) planning and allocation framework in our view incorporates the following four elements

Available capital Current capital requirements (=capital attribution)

Capital buffer Risk appetite Performance measurment New business allocation

0%

5%

10%

15%

20%

25%

30%

35%

0% 100%

RoE

Share of capital

Asset Mgmt.

Fin. Markets

PF

I F

Lending

PE

Organic growth

Inorganic growth

• How much capital is required to cover all risks?

• How can we attribute capital requirements to business units?

• What buffer do we need to protect against adverse economic conditions, model risks, etc.?

• Is the business plan within our preset risk appetite

• How can we understand where it will be most profitable to allocate capital to profit centers?

• How can we budget capital to achieve a profitable portfolio with stable earnings and efficient use of capital?

100

40

25

35 35

Corp lending

Fin. Markets

Inv. Banking

Retail

CL

FM

IB Retail

Acquisition

Risk-adjusted performance measurement

Setting risk appetite Risk measurement and capital attribution 1 2 3 Capital

budgeting and monitoring 4

Illustrative example


The combined economic and regulatory environment means that Banks have to strive to maximise the efficiency of financial resources

• +200 bps

– Through more coherent approach to financial resource strategy and balance sheet management

• +200 bps

– Through effective allocation of financial resources during planning process

• >+100 bps

– Through clean up of financial resource consumption

Estimated Return on Equity uplift potential for average bank

Financial Resource Management levers

• “Strategic balance sheet” that aligns – Corporate strategy – Financial resource strategy – Risk appetite

• Integrated resource planning – Alignment of funding supply and

asset activity – Financial resources treated with same rigour

as the P&L – Central guidance and aggregation

• Dynamic resource deployment – Clear governance and accountability – Clear targets and effective

performance management – Filtering and discipline at origination

Planning

Execution

Strategy

Enterprise risk management has become an integral component of the performance agenda


Financial performance management has evolved from volume-based to risk-based metrics

Sales/revenue

Risk adjusted

return

Return on capital

Key considerations for best practice performance management

Profits Returns adjusted for risk

and compared with capital consumed

Volume Value

Metrics • Sales • Market share

• Profit margin • RoE

• Economic Profit (EP) • Risk Adjusted Return on

Capital (RAROC)

Definition of “risk”

• Not taken into account

• Actual risk-costs (backward looking)

• Forward-looking, cycle-neutral risk costs

• Simplified versions may be used at RM or Account levels

Definition of “capital”

• Not taken into account

• Book or regulatory capital • Regulatory or Economic capital

Periodic view • 1 year • 1 year • 1 year, can be transformed into NPV view

In Europe the conduct risk agenda means that firms are grappling with aligning financial measures with behavioural measures of performance


Strategic Planning Risk Appetite

Financial Resource

Management Compensation

and reward Performance management

Shar

ehol

der a

lignm

ent

Strategy

Performance metrics

Operating decisions

Vision Overarching vision/ mission of the organization

How the vision will be achieved – including performance targets and risk appetite

Articulating the strategy in concrete terms and consistent metrics down through the organisation

Embedding performance metrics into key management processes

Aligning business decision- making processes with the key management processes

Risk-adjusted performance management (RAPM) frameworks have the goal of cascading a consistent message through the organisation

Management processes


Economic measures of value are designed to align with shareholder interests

Volume

Revenue

Profit

Returns (e.g. ROC)

RAROC

Economic Profit

Incr

easi

ng in

form

atio

n

Increasing alignment with shareholder value

Captures activity growth

+ average sales price

+ expenses and tax

+ capital

+ risk-adjustment + cost of capital

Value-based metrics Spectrum and “evolution” of financial performance metrics


There are many other levers Risk has to help align the business plan to shareholder value creation

Examples include:

• Drive the articulation of Risk Appetite – Ensure no surprises to shareholders – go/ no go areas – Set limits on the volatility of earnings – helping provide a smooth and stable earnings stream – Risk appetite consideration of all new business opportunities

• Holistic stress and scenario testing – Understand the interconnected drivers and magnitude of stress events – Help identify early warning indicators and mitigate the impact of stress scenarios – Identify new risks through reverse stress testing

• Comparison of Economic vs. Regulatory risk – Where simple regulatory measures used, help identify the underlying risk drivers

Why risk-adjusted analyses is important How do we look at returns?

2


RAROC = Revenues – Operating Costs – Expected Loss

Economic or Regulatory Capital

Credit risk

• Rating tools

• Default definition

• BIS II

• Allocating credit risk

• LGD, EAD

• Portfolio model

Market risk

• Metrics

• BIS II

• Calibration of tools

Operational risk

• Review existing framework

• BIS II developments

• Methodology must ensure confidence in RAROC measure

Other risks

• IRRBB risk

• Business risk

• Liquidity risk

• Metrics

• Cross selling

• Allocation of revenue

• Consistent data

• Cost allocation

• Funding costs

• Average losses

• Substitutes for actual losses and provisions

RAROC and Economic Profit are core components of a risk-adjusted performance framework

EP = Revenues – Operating Costs – Expected Loss – charge for Economic or Regulatory Capital


In a resource constrained world, banks need to more actively manage risk-return, right from portfolio level…

Example of a peer ASEAN bank “2020 project” Shift in profit pools by fully charging for resources

23% 30%

4%

9% 23%

23%

27% 17%

15% 5%

3% 6%

5% 9%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Accounting profits Economic profit*

Transaction Bkg FIG TreasuryCorporate SME, Commercial Private bankingRetail

• Shifts in profit pools when fully charged for capital and liquidity

• An ‘Economic profit’ view for annual planning process would result in a different ‘resource prioritisation’ vis-a-vis an ‘Accounting profit’ view

• RAROC, RoRWA and other related metrics exhibit similar impact

• Shareholder value contribution for Corporate

banking and Treasury lower (22%) than what was considered during the planning process (42%)

• Boost for fee and deposit related businesses (retail, private banking, transaction banking)

* Economic profit reflects charging for capital and liquidity costs to the accounting profits. In Addition, Expected loss is considered instead of accounting provisions


…down to the customer and RM level

Revenue vs. risk-adjusted view of customers for Commercial banking

-500

-300

-100

100

300

500

700

900

-100 400 900 1,400 1,900Revs (000s)

EP (000s) Avg. Revenue/

customer

Avg. EP/ customer

“Sustain and Improve” (Continue focus)

“Grow accounts” (Target/invest)

“Restructure accounts” (Cross sell/re-price)

“Review accounts” (Replace/exit)

Example of a peer ASEAN bank “Portfolio performance review” project

• Customers traditionally considered high value (high revenues) but actually destroying shareholder value

• Need to review accounts – either restructure or exit accounts


As business mix shifts, it is important to continue testing the relevance of performance metrics – most remain mainly in the lending based space

Type of business Typical businesses covered Example performance metric Comments Lending Based “standard”

Consumer banking (mortgage, cards, personal loans) Commercial and Corporate Banking (trade and non-trade loans)

• Economic Profit (EP) • RoRWA, • RAROC

• Significant credit risk taken • Risk adjusted metrics considered as primary

performance metric

Multi-year asset-based lending

Project Finance, IPRE • SVA (discounted EP) • Significant credit risk taken • Risk-adjusted metric need to reflect multi-year

‘value-add’

Trading Based Rates, FX, FX Option, Fixed income, Cross market

• EP • Total Returns

• Significant market risk taken • Principal-based: requires capital commitments • Combination of risk adjusted and profitability

measures

Success Based Strategic investments; Treasury trading balance sheet

• SVA (discounted EP) • Single year RAROC /

RoRWA

• Equity Investments • PE like multi-year businesses

Fee Based Investment banking Asset Management Private Banking

• Earning’s volatility and its drivers

• Shadow reports of EP / RoRWA / RAROC

• Incorporating “Earnings volatility” as a metric to adjust for risk

• Commission/margin based businesses • Flow products require short-term principal risk • Low capital consumption

Cascading is based on cash-flow and value driver models alongside RoRWA and other classic risk-adjusted performance metrics


The existing capabilities of many banks fall short for strategic decision support in a resource constrained world

Siloed, fragmented approach across bank functions and planning exercises (e.g. Risk/Finance/Strategy; Holding/Countries/BUs)

Disconnected budgeting/strategic planning/RAS/ICAAP exercises; often using inconsistent assumptions and resulting in inconsistent/contradictory projections

Resistance to embed risk-adjusted measures in decision making (at all levels from planning down to pricing)

Low transparency: Lack of understanding of outputs from complex risk models and their underlying drivers

Limited capabilities to quickly forecast results for alternate economic or strategic scenarios - resulting in strategic decisions making based on “gut-feeling”

Organization/ approach

Capabilities

Budgeting vs. Strategy vs.

RAS vs. ICAAP

Embedding risk

Transparency

Whilst under much less regulatory pressure, ASEAN leaders are catching up with global developments in anticipation of a potential downturn


Indu

stria

l Offi

ces

Res

iden

tial

deve

lopm

ent

Oth

ers

Ret

ail

Mix

ed u

se

Vac

ant l

and

Unc

oded

-10%

0%

10%

20%

30%

40%

0% 20% 40% 60% 80% 100%

Segm

ent R

ARO

C M

ay 0

8

Drill down – management often use ‘feed-starve’ charts to depict value creation and for a focus point for senior challenge

Ret

ail

Offi

ces

Mix

ed u

se

Indu

stria

l

Res

iden

tial d

evel

opm

ent

Oth

ers

Unc

oded

Vac

ant l

and

0%

5%

10%

15%

20%

25%

30%

0% 20% 40% 60% 80% 100%

Segm

ent R

ARO

C

% of Segment Ecap

CoE = 15.0%

Ret

ail

Mix

ed u

se

Offi

ces

Oth

ers

Res

iden

tial

deve

lopm

ent

Indu

stria

l

Vac

ant l

and

0%

10%

20%

30%

40%

0% 20% 40% 60% 80% 100%Segm

ent R

ARO

C M

ay 0

8

Offi

ces R

esid

entia

l de

velo

pmen

t

Ret

ail

Mix

ed u

se

Oth

ers

Indu

stria

l

Vaca

nt la

nd

Unc

oded

-5%0%5%

10%15%20%25%30%35%

0% 20% 40% 60% 80% 100%Segm

ent R

AR

OC

May

08

Region 1

Region 2

Region 3

Property finance RAROC vs. capital consumption (all regions)


Case study: Effective risk-based centralised challenge process adding 20% to planned EP

Plan optimisation Opportunity evaluation Profit pool analysis 1 2 3

-50

0

50

100

150

2010 2015 2020Economic Profit Cost of CapitalExpected loss Cost

Regional profit pools Region X Banking Revenues 2010–2020E ($BN)

Existing Business profit pools Economic Profit by Business Line

Resource availability

Financial targets

Performance Risk appetite

Valuation Resource generation/

consumption

Portfolio rebalancing

Economic profit Cost of Capital Tax Expected Loss Cost

0%

20%

40%

60%

80%

100%

Wealth & Asset Mgmt. Deposits

Corporate Banking

Business Banking

SME Card

Consumer Finance Private

Bank Mortgages

Result • Planned EP increased by 20%

• NSFR improved by 7%

• Clear optimisation targets tailored by business against Volumes, Price, Risk & Costs

Capital re-allocation by BU for 2013 Capital by BU (BN)

Current Capital Capital 2013 (initial proposal) Capital 2013 (optimised)

0

1

2

3

4

5

6

Bus

ines

s B

anki

ng

Cor

pora

te

Ban

king

SM

E

Dep

osits

Wea

lth &

A

sset

Mgm

t. P

rivat

e B

anki

ng.

Car

d

Con

sum

er

Fina

nce

Mor

tgag

es

Invest Scale back

Setting Risk Appetite What is the ‘right’ capital target?

Section 3


Banks should set their capital targets based on their Risk Appetite and strategic needs

Tier 1 + Tier 2

Minimum Pillar 1

requirements

Pillar 2 add ons

Buffers

Strategic

Downturn

Minimum regulatory

requirements

Average of peer group

Target required capital

• Outside-in target setting demands judgemental application of benchmark analyses to take into account the “signalling” effect to external stakeholders (e.g. analysts, investors, regulator)

• Conducted through benchmarking with a group of peer banks

• Inside-out analysis provides an analytics-based target, subject to analytical assumptions

• Based on stress tests for credit, market and other loss in income

Outside-in benchmarking

Capital target

Inside-out analysis


Risk Appetite is fundamentally about articulating, governing and cascading an overall risk tolerance into operational actions/controls…

FHC-level risk indicators

FHC-level risk metrics

Business-level and risk metrics and limits

FHC -level risk tolerance

• Key measure of risk levels which serve as levers that can be used to manage the risk profile of the bank/holding company across risk types

• Key measures to be monitored that provide early warning if the risk appetite may be breached

• Explicit limits and guidance provide to business and risk managers cascaded from the desired risk profile for the bank/holding company

• “Inviolate” limits given a choice, particularly if the risk appetite has been communicated to the public

Note: FHC = Financial Holding Company, or Group


…which needs to be inter-linked with the institution’s strategic goals

Strategy Risk appetite

RoE

Profitability/ Efficiency

Asset growth

Revenue growth

Market share/ penetration

Solvency

Liquidity

Business mix

Franchise

Earnings volatility

Requirements

• What do you need to achieve your strategy?

• What outcomes would not be acceptable?

Limitations

• How do these constrain the business plan?

• What do we need to track/stress test?


When setting targets, banks consider different definitions of capital…

Regulatory capital Agency driven capital Economic capital Actual capital

Definition • Amount of capital required to protect the Group against statutory insolvency over a one-year time-frame

• Amount of capital the rating agencies expect in order to feel comfortable giving a “AA” rating

• Amount of capital required to protect the Group against economic insolvency over a one-year time-frame

• Amount of equity capital or Embedded Value actually held to protect the Group against economic and statutory insolvency over a one-year time-frame

Purpose • Designed to protect policy holders and creditors

• Acts as a floor, which triggers takeover by the regulators

• Designed to test and communicate capital adequacy warranting the target debt rating based on the rating agency metrics and models

• Designed to be a tool for management

• Designed to communicate accounting solvency and profitability to outside constituents

Measurement • Based on undifferentiated rules of thumb that do not reflect the real economic risks of the business and usually based on (relatively) public information

• Based on relatively undifferentiated rules of thumb (bank), and/or simple models (insurance)

• Not formulaic – other factors such as quality of management and likelihood of Government bail-out are also considered

• Reflects real risks taken in the sense of unexpected movements in the value of assets and liabilities and on the confidence interval management wishes to tolerate

• Accounting result; expanded definition includes hidden reserves

Bare minimum capital you must have

Capital you are expected to have

Capital you ought to have

Capital you actually have

Economic capital provides an internal measure of risk-based capital requirements and hence forms an important component of ICAAP


…as well as its internal strategic objectives

Range of strategic objectives

Option for aggressive growth

Strategic objective Relevance under stress Further considerations/notes Survival: Batten down the hatches, i.e. keep buffer for survival

Under a stress scenario, the bank may also want to have this buffer for idiosyncratic events e.g. single name events

N/A

Dividend: Ensure that the bank can pay a dividend without restrictions from regulators

Under a stress scenario, the bank may still want to maintain ability for dividend payment

• Dependent on dividend pay-out ratio

External rating: Look relatively better than other banks in the market

Under a stress scenario, the bank may want to benefit from a “flight to safety” effect

• Hygiene factor for certain parts of the business

• Dependence on internationalization strategy

• Delta in funding costs by rating grade

Growth: Support organic growth

Under stress, there may be opportunities to grow as the bank emerges from stress scenario

• Given range of potential objectives, this requirement under stress may place onerous demands on capital requirements Growth:

Support inorganic growth (M&A opportunities)

Under a stress scenario, there may be opportunistic transactions to benefit from low valuations

Survival


Stress testing typically plays an important role in informing capital targets and buffer levels

Credit Risk Credit Risk

ALM

Pillar 1 Minimum Capital as of specific balance sheet date

(Credit, Market and Operational risk)

Pillar 2 – Defining Minimum Capital Level to

Propose to Regulator

Market risk

Credit Concentration

Broader stress testing to guide “cushion” (and manage regulator and rating agency)

• Identify major loss scenarios, that could impair capital base

Market risk

Operational risk Operational risk

Other Often no extra capital required, unless risks larger than for competitors/benchmark

Capital adequacy Role of stress testing

“Cushion”

• Compare Pillar 1 requirements with actual magnitude of Pillar 1 risks at the bank, using Economic Capital

• Determine relative importance of non-Pillar 1 risks to Pillar 1 risks and benchmark to peer banks – Judge if Pillar 1 capital is enough – Judge if other risks require more attention than

at other banks

The trend globally is to define capital targets both under stress and business-as-usual circumstances


Client example: Framework for assessing trade-off between growth, return, external rating and solvency requirements

• What are the Bank’s strategic objectives with respect to growth, ability to pay dividends and external ratings?

• What are the relevant regulatory considerations, e.g. – increase in regulatory

minimums – implementation of capital

conservation buffer (CCB)

• Based on the strategic and regulatory considerations, what are the minimum solvency ratios that the Bank needs to protect? – Under BAU – Under Stress

Implication on returns

Minimum solvency ratios required

Bank’s strategic objectives and regulatory considerations 1 2 3

• Based on the minimum solvency ratios required to satisfy strategic and regulatory objectives, how does this impact overall Group Return on Equity (RoE)?

• Further, what is the effect of Basel III liquidity and funding rules on RoE going forward?

Loop back if needed

Disguised client example


However, capital targets cannot be set in isolation, because RAS sets multi-dimensional constraints, within which management needs to optimise returns

Risk Appetite dimensions

Solvency

Earnings

Liquidity

Franchise

Return optimisation

space

Concentration constraints (region, country, product)

Asset growth > X%

Funding constraints

RegCap growth < XX%

EaR < revenue

Return is optimized within constraints, the tightness of which will depend on business unit profiles and comfort levels, leaving the

trade-off decisions to business management

X If BU needs to

release constraints mid-plan, they can

request it provided the

Group approves

This raises key questions regarding the set of RAS chosen in terms of • Comprehensiveness:

Do we have the right set of statements and metrics covering all risks that are important to the Board?

• Consistency: Can the various targets be achieved at the same time in non-stressed conditions?

• Sensitivity to changes in drivers/ components How sensitive are individual RAS to changes in underlying components? E.g. how will a capital increase impact my EPS targets?

• Hierarchy of RA statements: If we cannot meet all targets in a stress situation, which one are we sacrificing first?

Illustrative


Embedding into other processes

(at all levels of the organisation)

Senior Management (i.e. Exec Risk Committee)

Board Risk Appetite

Sec

tor e

xpos

ure

Trad

ing

desk

Linking to limit frameworks

BU2 BU3 BU4 BU5 Etc. BU1

Allocate Group Risk Appetite to BU level

Link to limit frameworks

1

2

3 Linking to annual planning process – Metrics translated into a planning factor

(e.g. credit exposure, ECap, etc.) – Allocated to BUs based on previous

growth projections and management discretion

– Planning process redesigned to incorporate risk input and guidance

– Initial Risk Appetite guidance for each BU communicated through Budget Guidance

– Taken into account during planning process, discussions in case of breach

• Linking to existing limit frameworks – Working closely with respective BUs

(e.g. Corporate, SME, Capital Markets) to align/develop existing limit frameworks and monitoring processes

• Embedding into other processes – For “qualitative” Risk Appetite

statements/metrics (e.g. rating agency communication, Op. Risk management, ethical conduct policies, etc.)

1

2

3

Three linking mechanisms for Risk Appetite

To make it all work in practice, capital targets and other RAS need to be cascaded into an institution’s decision making, processes and governance frameworks

Risk-return considerations in planning and business decisions

4


To succeed, banks need a consistent framework to make clear risk-return trade-offs during planning and then embedding this in business execution

Make forward looking risk-return trade-offs during planning

Embed risk-return trade-offs into how the business executes

Ensure business is aligned to risk-return behavior

RAS Strategic planning Budgeting

Scenario planning

Portfolio optimisation

RAS cascading

Capital allocation

Allocation framework

RWA optimisation

Liquidity management

Liquidity charge

Performance management and Incentives RAPM framework

Compensation models

Processes Analytics

A

B

C Effectively monitor performance* Reporting mechanism and framework

MIS

Feedback framework D * Not addressed in detail in this presentation


How much capital do we need?

What and how much risk

should we take?

Where should we place our

strategic bets?

How should we allocate

resources for sustainable

growth?

Risk Appetite (Risk)

Strategic Planning (Strategy/Finance)

Capital Management (Finance/Treasury)

This will require a step-change in collaboration between Strategy, Risk, Finance, and subsequent support from HR

• Best practices articulate a process that ensures that implications of strategic decisions are informed from a risk and capital perspective

• Specifically, articulating a trade-off reflections contribute to ensure that

– Capital adequacy targets are met under certain strategic scenarios

– Risk-return analysis are considered

– Capital is efficiently allocated

– Risk appetite is not breached and is consistent with strategic targets

• From an implementation perspective, entities

– Articulate a trade-off debate prior to the planning exercise

– Account for high level analytical sensitivities to a set of strategic decisions

– Count with a formalised governance, with clearly defined leaders and challengers

A. Make forward looking risk-return trade-offs during planning


Banks have developed integrated annual planning process to embed risk-return considerations Example: Peer ASEAN bank

Phase 1 (Aug)

Phase 2 (Sept – Oct)

Phase 3 (Nov – Dec)

Phase 4 (Jan – Mar)

Board

Senior Management

Finance

Risk

Strategy

Capital Management

Business Units / Legal Entities

HR

Creation of high-level

SBU and legal entity plans

C Budget

creation and submission

H

Plan approval

N

Debate and challenge

G

Capital and funding plans

I

Finalized plans

M

Detailed RWA

forecasting

J

Iterative process

High level funding and capital plan

F

Annual RAS refresh

A

Annual strategic planning

B

Monthly reporting of EP/RAROC

O B

Monthly monitoring of capital, funding

P B

ICAAP Q

Aggregation

K Scenario analysis

D

RWA forecast

E

Revise plans

L

Revise plans

Compensation models R



Analytics – Scenario planning An integrated scenario planning framework allows the bank to analytically assess trade-offs between capital, funding and P&L


Which bank strategies will provide an optimal risk-adjusted return for the bank? 2 Are we meeting the internal (RAS) and external (Regulatory) constraints in the chosen ‘strategic’ scenario?

3 What are the best mitigating strategies and/or changes in strategy to each scenario? 4

What is the financial impact of each bank strategy or macro-economic scenario? 1

Inputs

Financial statements • P&L • Balance sheet

Balance sheet strength • Capital position • Funding position

Portfolio snapshot • Exposure breakdown • Risks

Key value drivers • Group-wide • Major divisions/BUs

Forecasting

Capital adequacy • Regulatory view • Economic View

P&L and Balance Sheet • P&L • Key B/S items

Funding • Asset liability gap • Funding profile

Valuation • Group-wide • Key divisions/BUs

External factors Macro scenarios • Chief economist

assumptions • User specified scenarios

Market developments • Banking sector • Peers

Internal levers Strategies • Group-wide • Major divisions/BUs • Products

Levers • Growth • Pricing • Risk

Integrated planning framework… … focused on addressing key concerns of senior management


Mitigating actions: attractiveness map

Feas

ibili

ty o

f app

licat

ion

Financial Impact

Variable costs 5

Δ Credit spreads 2

Δ Commissions (unitary) 3

Business/Geo mix 6-7

Credit deleverage 1

Δ Deposits vols 4

+

- +

Δ Strategic divestments 8

ROE Solvency EP Liquidity

1 Deleverage in customer loans

2 Increase in credit spreads

3 Increase in unitary commissions

4 Increase in Retail funding

5 Efficiency ratio improvements

6 Change in geographic mix

7 Change in product mix

8 Strategic Portfolio divestments

Analytics – Scenario planning …enabling impact analyses to support informed board discussions on portfolio optimisation decisions

Illustrative A. Make forward looking risk-return trade-offs during planning


Analytics – Scenario planning Example: Assessing segment attractiveness under multiple macroeconomic scenarios


1. Based on Economic Department’s macroeconomic scenarios

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

Consumerfinancial services

Credit cards Commercial Corporate Markets Investmentbanking

AssetManagement

International

RO

RW

A

Positive Current Base Mild High stress

RRWA under four scenarios

Structurally attractive

Selective segments will be attractive

Value preservation using downside protection

Positive case

• 10 year interest rate peaks at 8.8%

• Home price inflation slows down to ~ 6% for one year

Base case


• Home price inflation slows down to ~ 0% for one year

Mild stress (1:4)


• Home prices drop by 10% (30% real)

High stress (1:10)


• Home prices drop to -20% (40% real)

Illustrative


Analytics – Portfolio optimisation Banks formulate a “fair” account of shareholder value creation across the portfolio to make business-level strategic decisions

A. Make forward looking risk-return trade-offs during planning Illustrative

Home Loans

TradingBusiness Banking

Credit Cards

Imperial

VAF

Retail Deposit

Small businesses

PF Lending

Personal Loans

Corporate Banking

Capital - Banking

Bancassurance & Wealth

-15%

-10%

-5%

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

50%

55%

60%

65%

(700) (350) - 350 700

Capital production vs. RAROC: Client example

Capital

Producing

Cap

ital

Con

sum

ing

Challenge: Gain margin at expense

of volume

RAROC

Challenge: Maintain Challenge: Grow

faster

Challenge: Continue improving returns


Process To embed the risk-return considerations in business decision, resources need to be suitably charged - the level of sophistication may vary by banks

B. Embed into how the business executes

Basis of charge FTP and Capital charge

FTP, EL and Capital Charge

FTP, EL, Capital and Liquidity charge (LCR, NSFR)

FTP only

Comparison of charging regimes

Charging by risk types

Pillar 1 RWAs (Credit, market and operational)

ECap equivalent (Internal calculation)

Full regulatory capital (Pillar 1 and 2)

Pillar 1 RWAs (Credit only)

Granularity of charging

Business unit (e.g. Rates)

Desk (e.g. Govies)

Trade level Division (e.g. Fixed income)

Mechanism of charging

Cha

rge

leve

l (bp

s)

Leverage

Cha

rge

leve

l (bp

s)

Leverage

Average or target

leverage

Cha

rge

leve

l (bp

s)

Leverage

Average or target

leverage

Cha

rge

leve

l (bp

s)

Leverage

Stepped charge Progressive charge Contingent charge Flat charge

1

2

3

4


Analytics – Capital RWA optimisation remains firmly on the agenda for banks with the aim to maximise the scarce resources

Typical RWA optimisation areas

Main areas Example initiatives

Methodology improvement

• Data quality refinement • Improvement of guarantees eligibility • Models and parameters refinement • Best utilization of regulatory freedom

Business initiatives

• Tactical: headroom, uncommitted lines, collateral optimization,… • Product features: Limits, early prepayment options,… • Strategic: reprioritisation of new business, revisiting of capital management capabilities • Incentivatisation (allocation of RWAs to engender desired behaviour)

Financial Optimization

• Traditional distribution • Alternative distribution • Hedging

Market and Counterparty Risk Optimization

• Drafting and use of netting and collateral agreements • Elimination of infragroup exposures • Maximisation of VaR and IMM model adoption

Buffer Management • Improvement of stress testing methodologies • Optimal consideration of cyclicality in the calculation of risk parameters

Active RWA controlling • Setup of a unit dedicated to ongoing RWA monitoring and implementation of optimisation initiatives

Incr

easi

ng c

ompl

exity



Analytics - Liquidity Thorough Balance Sheet reviews, institutions maximise return on long-term funding and liquidity both from a tactical and strategic point of view

Source: Oliver Wyman analysis. * Return defined as risk adjusted revenues for each segment.

Return on liquidity and funding balance by client segment Universal bank example

Retail

Asset Management

Private Banking

Factoring

Consumer finance

Portfolio in run off Public Financing

Markets

Small business

Micro business

Leasing

Average position

Average position

Examine options of securitization

Investigate opportunity to issue bonds

• Stabilization of liquidity utilisation

Reduction of liquidity needs and monitoring of off-balance sheet positions

Increase profitability profile

Capitalize on existing client base to increase deposits

Accelerated disengagement of activities in run off

0

Ret

urn

on L

ong-

term

fund

ing

Net long-term funding consumption

Structured Finance Corporate lending


Trigger

• Reduced availability of long-term wholesale funding putting limits on growth of the balance sheet

• Economics of different businesses changed dramatically by post-Lehman funding reality


Process Performance management processes are applied at different levels of the organization in order to cascade, monitor and measure risk-adjusted metrics

KPI Management tools

Operational level

BU level

ExCo level

Risk costs Operating costs

Revenues Costs

Lead metric by business

Extra-ordinary revenues

Revenues from

operations

Capital costs

Main-tenance

costs …

Credit risk

costs

Other risk

costs

Invest-ment rev.

… Product rev. … …

• Risk-adjusted performance tool • Capital planning tool • Budget projection model • Portfolio level risk models • Stress testing models • Target setting and incentives models

• Ex-ante models • Target setting models • Limit setting models • Value at Risk models • Simulation tools

Models differentiated by BU/Sub-BU • Pricing models • Wallet sizing models • Valuation models • Customer value and propensity

models

KPI cascading and management example

C. Ensure business is aligned to risk-return behavior


Analytics The incentive framework should also have a clear linkage between risk-adjusted performance and compensation to ensure aligned behavior

“Knock-out” factor values 0x 0,5x 1x • Unauthorised breach of “Hard” VaR limit • Breach of “Hard” compliance requirements • Dealing in non-approved products

Ex a

nte

Ex p

ost

Attributable Revenues

Direct/Indirect Costs Cost of allocated capital

Risk adjusted cost of funds Cost of leverage

Quality of earnings adjustments

Risk-adjusted

profit - =

Risk-adjusted profit

BonusR$ Flex

-Collaboration with other areas-Operational quality-Role-specific KPIs

-Efficiency/ Cost management

-Final score

-Risk & ComplianceScoreWeightPerf. Indicators

-Collaboration with other areas-Operational quality-Role-specific KPIs

-Efficiency/ Cost management

-Final score

-Risk & ComplianceScoreWeightPerf. Indicators

Employee XX

Calculated bonus Year 0 Year +1 Year +2 Year +3

“At risk” for senior management and major risk takers

Financial performance of individual/desk measured on directly-influenceable

risk-adjusted results

I

Non-linear payout function flexed for

non-financial performance

II

Knock-outs for serious breaches of risk and

compliance requirements

IV

Bonus partly deferred on pre-set bands and “at risk” – clawback if

negative results

V

Financial resources

incorporated either in financial

performance or in non-financial

scorecard

Example of emerging post-crisis remuneration framework

C. Ensure business is aligned to risk-return behavior


A robust capital planning and allocation process, coupled with successful capital management will lead to the following benefits

1 2 3 4 Reduced capital resources More efficient

allocation/structure of available capital resources

Increased business efficiencies

Improved external perception

• Better understanding of the drivers and dynamics of the excess buffer

• Manage regulatory and rating agency expectations through demonstration of sophistication and ability to actively manage capital

• Help steer scarce capital to sources of value creation

• Optimise capital structure (levels, instruments, entities etc.)

• Better dialogue and steering in business unit planning round

• More forward looking approach to capital planning helping to put in place contingencies before things become expensive

• More focused external communications

• Appearance of “leading edge” sophistication


This is so easy to use, you don’t need instructions

Integrated reporting to senior management should be made iPad compatible

Graphical user interfaces are designed by professional graphic

layout designers

D. Reporting and monitoring

Necessary central capabilities 5


Solutions range from narrow measurement improvement to a fundamental shift in the performance model

• Adjust for risk to encourage good credit/pricing decisions

• Include cross-channel success to promote co-operation

• Avoid volume metrics that encourage mis-selling

Align interests (Better measures)

Create transparency (Better targeting)

Create motivation (Better model)

Quick fixes (Easy, low impact)

Structural change (Hard, big impact)

• Adjust for local market potential

• Strip out uncontrolled events (e.g. margin impact)

• Adjust for service quality and other strategic goals

• Strip out legacy income and allocated costs

• Build local plan/process to promote new revenue growth

• Create steep team incentive for success


Strategy process

Performance monitoring and compensation

Budgeting and resource allocation

Aggregation, challenge

and debate

BU-level planning

Top-down group and

BU planning

• Strong focus on the identification and prioritisation of changes in the environment, and strategic thrusts

• Provides qualitative and quantitative input into the target setting process

• Targets and high-level plans developed based on a variety of inputs

• Group allocates capital to each BU based on:

• Performance projections, (e.g. net income, EP and RAROC)

• Consumption of all risk resources

• Overall group strategy – i.e. where do we want to be?

• BU-level plans developed using fast, easy to use tools and based on top-down targets and strategy – not a detailed budgeting process

• Performance and risk consumption under multiple strategies/ scenarios is analysed and shared with Group Finance and other BUs

• BU plans aggregated and compared to Group plan – “planning gap” quantified

• BU plans challenged by other BUs and Group Finance

• Group ExCo evaluates the BU-level plans and plays out needed resource allocations which are needed to maximize return

• Plans are iterated until the planning gap is closed and ExCo signs off

• Detailed budgeting process occurs after BU-level planning and challenge and debate

• Only a single iteration required by Group, although the BUs may choose to drill down to the detail at any time

• Tolerances for KPI’s set based on the final plan

• Performance against these KPI’s is tracked on a monthly basis

• Performance vs. KPI’s is tied directly to remuneration at an appropriate level in the organisation

To have an impact, risk-adjusted performance measures need to be well embedded into strategic processes


Questioning, debating and resource allocation

Business planning Business guidelines

Strategy Guidelines Business segment strategy

Planning detailing

Resource allocation

Aggregation, questioning,

debating

Budgeting, action

planning

Requirements • Clear up-front guidance, informed from the

strategic balance sheet – Financial resource strategy considered

from the outset – Supply of funding as constraint to

asset-side activity

• Financial resources treated with the same rigour as the P&L – Granularity – Challenge

• Strong central team – Analytical capability to rapidly aggregate and

stress developing plans – Regular feedback and support to businesses

to structure plans

Leading banks have an integrated resource planning process, with Risk playing a crucial role

Vision of the group • Clearly formulated vision of

the future of the business segments, defined through consensus

• Clarity about the expected contribution of the business segments to the accomplishment of the vision of the future

• Strategic balance sheet

Risk strategy • Risk tolerance • Target-risk profile

Approving risk • Final check of plans with respect to risk

tolerance and limits

Risk effects • Review the risk on the group

level and the risk of diversification effects

• Stress scenarios

Business segment contract • Profit objectives, limits,

resource allocation • Responsibility of

management (e.g. product/market)

• Management initiatives • Value drivers/KPIs • Personal goals and

compensation • Agenda for

performance evaluation Approval of capital and financing • Approval of capital and financing • Derivation of capital and financing plans

Capital and financing effects • Coupling of asset and

liability plans • Assessing requirements with

available resources

Capital and financing strategy • Efficiency of capital

and financing • Consideration of capital

market circumstances


Strong central capabilities are needed to effectively engage with the businesses across the planning cycle

Group Risk

Treasury

Investor Relations

Group Finance

Translate targets into internal measures and

issue planning guidelines

Executive/Board

Identify performance targets (EPS, RoE

etc.)

Divisions

Aggregate plans

Feedback to divisions

Develop initial business plans Refine plans

Stress test and assess aggregate capital implications

Risk parameters/ assumptions

Prov

ide

assi

stan

ce

Prov

ide

assi

stan

ce

Rec

omm

enda

tions

for c

apita

l al

loca

tion

Capital allocation and

budgets

Input on risk appetite and measurement

issues

Input on capital structure issues/

specify info required for capital mgmt

Capital plan sign-off ALCO reporting

Develop Group capital plan

- Forecasting and stress testing

- Confirm risk appetite - Contingency planning - Structure optimisation

Market input on dividend policy etc

Update capital plan

Structuring and execution of one-off

transactions

Interaction for one-off transactions

Execution of capital plan

Monitoring, Reporting and

analysis

Reporting Execution of plans

Detailed information to support planning

Aggregate reporting

Divisional target setting

Input on market perception/appetite

etc

Measurement support

Market input on dividend policy etc

Input from Strategy, Finance, Risk, Treasury, Divisions

Preparation of ICAAP

Clear up-front guidance

• Informed by analysis – Group-level targets – Resource availability – Risk appetite – Key watchpoints – Etc.

• Includes key planning dimensions , KPIs and constraints

Aggregation & support

• ‘Helpdesk’ & BU feedback

• Aggregation of plans to ensure Group issues reflected

• Scenario testing of business portfolio

• Refinement of guidance as appropriate

Challenge & allocation

• Central confidence in numbers

• Decision informed by – Cross BU comparison – Portfolio rebalancing

exercise

• Clear performance targets agreed

Monitoring & re-allocation

• Monitoring of BU consumption and efficiency

• Re-balancing options regularly updated

• ‘Shaking the tree’ for resources in between planning period


Today’s context of high P&L uncertainty and market & regulatory pressure has led many firms to improve scenario-based planning capabilities

Regulatory & market pressure • Increased regulatory requirements

impacting performance – Higher capital requirements defined by

BIS3/EBA incorp. into local regulation • Recurrent stress-testing exercises

and increased regulatory scrutiny – Periodic Stress Testing exercises for

EBA/BoS/FSA w potential market impact generate additional pressure to generate/control forecasts

• Changes in local regulation (e.g. Provisions in Spain; Liikanen; ICB)

• High market sensitivity to entity results

High P&L and market uncertainty • Macroeconomic environment

(global and local) • Financial Services

– Bankruptcy risk from sovereigns and financial institutions

– Competitive pressure in key markets (E.g. Spain deposits war)

• Bank specific – E.g. – Revenue generation – Funding costs – Trading book volatility – RWA sensitivity to risk – International expansion / contraction

Scenario- based

planning

Objectives

• Better understand key strategic “bets and threats” and overall P&L, B-S and Solvency impacts

• Embed risk and scenario-based considerations into strategic planning (vs. one base case)

• Evaluate/challenge the real feasibility of business plan projections and performance levers

• Real-time impact evaluation (incl. mitigation strategies) supporting informed management discussions

• Enhanced consistency, transparency and transversality across individual risk drivers and stakeholders involved in the strategic planning value chain

1 2 3 4 5


A model of the bank can help provide Group and businesses with an understanding of scenario impacts on financial performance

Transversal view Scenarios & Inputs Sensitivity modelling Financial impact

Macro-scenarios Research Department

Bank strategy Planning / BUs

Scenarios

Inputs

Budget/Plan Finance / Risk / Capital

Parameters

Scenario results

Profit and Loss

Balance Sheet

Solvency

Other KPIs (ROE, CIR…)

Modular projections

Net Interest Income

Commisions

Expenses

Expected Loss

Capital requirements

Business Volumes

Available capital

Provisions

• Top-down modelling of key performance drivers • Reconciliation mechanisms ensure bottom-up coherence

• Synthetic reporting of key P&L/ B-S/Capital items aligned w AR

• Sourced from Bank MIS & bottom-up models

Client model overview


• Home price inflation slows down to ~6% for one year


• Home price inflation slows down to ~0% for one year


• Home prices drop by 10% (30% real)


• Home prices drop to -20% (40% real)

-5-4-3-2-101234567

Banc-assurance

&Wealth

RetailDeposit

Smallbusinesses

Capital -Banking

CreditCards

Trading² BusinessBanking

PersonalLoans

HomeLoans

CorporateBanking

PFLending

VAF

EP B

N

Positive Current Base Mild High stress

Structurally attractive

Selective segments will be attractive

Value preservation using downside protection

Market EP under four scenarios

Positive case Base case Mild stress (1:4) High stress (1:10)

The capability to run central scenarios can assist the management of earnings volatility

2) Trading here means Market Corporate Sales

Closing remarks 6


Example structure of a successful program

1 Annual Planning process

2 Allocation

3 Performance management

4 Reporting

Bank-wide RAS

Scenario planning/ top-down stress testing capabilities

Annual planning upgrade (linkage to RAS, scenario planning)

Capital management (Capital allocation framework)

Liquidity management

RAPM framework RAPM cascading Linkage to Pricing strategy

Risk-adjusted compensation models

Reporting framework (including risk elements)

RAS Cascading

2-4 months 3-5 months 2-4 months 3-5 months 2 months Duration

Exact sequence and duration would vary based on the existing capabilities of a bank


Closing remarks

• Regulation is making the efficient utilisation of financial resources increasingly important

• Risk-adjusted performance management can be a key tool to assist this, enabling management to compare diverse portfolios on a like for like basis

• As with any single approach, RAPM has its limitations – management should not over-rely on the power of a single number

• In an increasingly volatile financial world, stress and scenario testing capabilities are vital

• Risk, Finance and the Business have a crucial role to play in steering the organisation to maximise shareholder value

QUALIFICATIONS, ASSUMPTIONS AND LIMITING

CONDITIONS

This report is for the exclusive use of the client named herein. This report is not intended for general circulation or publication, nor is it to be reproduced, quoted or distributed for any purpose without the prior written permission of . There are no third party beneficiaries with respect to this report, and does not accept any liability to any third party.

Information furnished by others, upon which all or portions of this report are based, is believed to be reliable but has not been independently verified, unless otherwise expressly indicated. Public information and industry and statistical data are from sources we deem to be reliable; however, we make no representation as to the accuracy or completeness of such information. The findings contained in this report may contain predictions based on current data and historical trends. Any such predictions are subject to inherent risks and uncertainties. accepts no responsibility for actual results or future events.

The opinions expressed in this report are valid only for the purpose stated herein and as of the date of this report. No obligation is assumed to revise this report to reflect changes, events or conditions, which occur subsequent to the date hereof.

All decisions in connection with the implementation or use of advice or recommendations contained in this report are the sole responsibility of the client. This report does not represent investment advice nor does it provide an opinion regarding the fairness of any transaction to any and all parties.

Bara ERM v2

Documents

Transcript of Bara ERM v2