Risk Appetite: A new Menu under Basel 3? Pieter Klaassen (UBS - Firm-wide Risk Control & Methodology) voor het Zanders Risicomanagement Seminar 1 november 2012
Introduction to Entrepreneurship and Characteristics of an Entrepreneur
Risk Appetite: A new Menu under Basel 3? Pieter Klaassen (UBS) voor het Zanders Risicomanagement Seminar 2012
1. Risk Appetite: A new Menu under Basel 3?
Zanders Seminar “Effectief Kapitaalmanagement”
Pieter Klaassen
UBS - Firm-wide Risk Control & Methodology
1 November 2012
2. Agenda
What is this “Risk Appetite”?
UBS Firm-wide Risk Appetite Framework
Basel 3: A Stricter Diet
Risk Appetite under Basel 3
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4. What is this “Risk Appetite”?
Risk Appetite
“The level and type of risk a firm is able and willing to assume in its exposures and business
activities, given its business objectives and obligations to stakeholders.”
“Risk appetite is generally expressed through both quantitative and qualitative means and should
consider extreme conditions, events, and outcomes. In addition, risk appetite should reflect
potential impact on earnings, capital, and funding/liquidity.”
(Senior Supervisors Group, “Observations on Developments in Risk Appetite Frameworks and IT
Infrastructure”, December 23, 2010)
Context
– Papers by the Senior Supervisors Group (SSG) and Institute for International Finance (IIF)
established that a comprehensive firm-wide risk appetite framework covering all types of
risks is now considered essential and not just best practice
– Basel II, Pillar 2:
“The bank’s board of directors has responsibility for setting the bank’s tolerance for risks. It
should also ensure that management establishes a framework for assessing the various risks,
develops a system to relate risk to the bank’s capital level…“
3
5. Risk Appetite: Key Elements
Regulatory Expectations and Industry Best Practices
Comprehensive approach – integrating credit, market, operational, liquidity, and
reputational risks across the firm
– Both quantitative and qualitative elements
Use of multiple methodologies (taking into account technical limitations of risk metrics,
models, and techniques such as VaR) – incorporating, in particular, stress/scenario
testing and consideration of risk concentrations
Translate risk appetite at the top of the house to risk appetite (limits) for individual risk
types and at lower levels of the organization (business units and below)
Link to strategic planning and budgeting process - collaboration among risk
management, finance, and strategy functions
Role of risk culture, ‘tone from the top’
Risk appetite as a continuous, evolutionary, learning process – not
just a one-time exercise
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6. Defining, Challenging and Monitoring Risk Appetite
Firms’ management, boards, risk management departments, and supervisors all
have roles
Management should articulate the firm’s appetite for risk in the context of business
strategy
– They own the risk and are expected to fully understand the firm’s risk position at all times
Boards should
– set basic goals for the firm’s risk appetite and strategy,
– review and affirm management’s articulation of risk appetite, and
– ensure that risks are comprehensively considered and managed
CROs should (and should be empowered to):
– assess and control the firm-wide risk level
– provide an integrated view of the overall risks the firm faces, and
– ascertain that the firm’s risk level is consistent with its risk appetite
Supervisors have a role in assessing and challenging Boards’ and Managements’
achievement of these goals, risk awareness and understanding, and conformance to
(evolving) best practice
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8. Earnings/Capital Waterfall Continuum – at Least in Principle
Capital Criteria Earnings Criteria
Solvency
Regulatory Constraints
View
Rating Change
Positive Earnings, Payment of Dividends
Risk Exposure: Mean Earnings
Deviation from Mean Earnings at:
Risk
Probability
99.9+%
95%
0
Cushion
Capacity /
Earnings
Capital Dividend Earnings Power/Capacity
Event
Earnings/Dividend
Capital Depletion
reduction
7
9. Evolution of Risk Appetite & Experience during the Crisis
Shift to ensuring going concern under stress
Traditionally, focus on:
Solvency perspective
– Consideration of Economic Capital and total (or Tier 1) capital
Dividend paying ability in most years, also in adverse economic situation
Experience during the crisis:
Focus on going-concern capital metrics (e.g., Tier 1 ratio)
– Loss-absorbing capital is what matters
Consider scenario-based stress metrics in addition to statistical metrics
– Look beyond historical experience
Ensure stable funding sources and ample liquid assets
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10. Implications for Risk Appetite
Embedding multiple complementary criteria
Need for complementary criteria (with different time horizons and confidence/severity
levels), representing different points in the financial structure/stakeholder waterfall. E.g.:
– Traditional EC view at a high (99.9+%) confidence level over 1 year and/or multiple years
– Tier 1 ratio or similar view at a lower confidence level over ranges from 1 quarter to multiple
years
– Earnings view at a lower (one in 5-25 year) confidence level over 1 quarter to 1 year time horizon
Focus on high-quality equity capital (convergence to Basel III or similar view)
Multiple severity levels, metrics, and risk horizons
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11. UBS Firm-wide Risk Appetite
Pillars
UBS Risk Appetite Framework
Minimum Tier-1
Earnings Capital Solvency
Earnings should Loss-absorbing Ensure sufficient
cover the risk capital is sufficient total loss-
of losses in to absorbing capital
most years meet regulatory to sustain even an
+ requirements even extreme stress
Avoid repeated if a severe loss event
(large) quarterly event were to
losses occur
Stress Stress Stress Stress Stress
Statistical Scenario Statistical Scenario Statistical
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12. Risk Appetite objectives: Risk Capacity vs Risk Exposure
} Buffer
Taking into account
strategic considerations
Earnings
Credit Risk
Market Risk
Capital
Risk Appetite
Issuer Risk
Investment Risk
Regulatory requirements Funding Risk
and constraints
Country Risk
Pension Risk
Operational Risk
Risk Capacity Risk Exposure
maximum amount of risk a firm is the amount of risk, by whatever
technically able to assume given its metric, actually being taken at a
capital base, liquidity, borrowing point in time, or expected/forecast to 11
capacity, and regulatory constraints be taken
13. Overview of Firm-wide Risk Appetite Framework
The framework encompasses all material risk categories, and plays a key role in the decision-
making processes in the Bank
Firm-wide Risk Appetite Framework
Risk Capacity Risk Exposure
Business
Plans
E@R / C@R Exposure Firm-wide
(projected net Stress
Measures
earnings and
capital) Statistical Stress
Risk Categories Measures Measures
less
Business Risk Operational Credit Country Investment Pension
Risk
Funding Risk Market Risk Issuer Risk LU Risk
(volatility in Risk Risk Risk Risk
earnings)
Consequential Risks Position Risks
Granular Limit Framework
The firm-wide statistical and stress metrics are complemented with
a granular limit framework with portfolio and position limits
Of the various scenarios in the Firm-wide Stress framework, the most relevant /
severe one is used as the ‘binding’ scenario in the Risk Appetite Framework
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14. Risk Exposure: Firm-wide measures
UBS has two complementary approaches – one statistical and one stress based
Statistical measure which allows the aggregation of firm-wide risks using
Earnings-at-Risk / statistical techniques which can then be tied to probabilities / confidence
Capital-at-Risk levels
(E@R / C@R)
A large number of potential outcomes and associated losses is simulated,
rooted in historically observed market changes
More intuitive stress measure which calculates the impact of a scenario on
Firm-wide Scenario the firm-wide portfolio including the causality chain by which losses would
Stress Test arise if the scenario were to unfold
Scenarios enable incorporation of forward-looking views
Under both firm-wide measurement approaches, we model the first order P&L and capital
impacts as well as the consequential capital impacts of downgrades in the Firm's portfolio
and resulting adjustments to RWA
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15. UBS Approach for Firm-wide Stress Testing
Scenario-based stress tests
Risk Factor
P&L impacts
Sensitivities
Macro-economic
and/or OCI impacts Aggregation
scenario
Revaluation
RWA impacts
methodologies
Various global Quantitative and Credit Risk Quarterly time profile of
downturn scenarios qualitative analysis of • P&L (losses, earnings)
historical data about Market Risk
• OCI impacts
defaults, Issuer Risk • Risk Weighted Assets
impairments, write-
downs etc. Investment Risk and ultimately Tier 1 capital
ratio
Funding Risk
Operational Risk Tier 1 Capital Ratio
Pension Risk Critical
threshold
Country Risk
Business Risk
Q1 Q2 Q3 Q4 Q5 Q6 Q7 Q8
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16. UBS Statistical Risk framework
Comprehensive assessment of risks
Position Risks Consequential Risks Business Risks
= Aggregate
Statistical Risk
Market Operational Business Exposure
Issuer Funding
Targeted stress Expecte
Probability
Credit Pension components d
Earnings
Country
Capture special risks
not modeled statistically 0
Investment Earnings
Step One Step Two Step Three
= Copula Aggregation
Aggregate Group Risk Exposure derived from probability distribution of potential earnings shortfalls,
supplemented by targeted stress components.
Diversification between risk types is included at each aggregation step
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19. Basel 3: Increased Minimum Capital Requirements
Following Basel Committee … … and with “Swiss Finish”
BIS Basel 3 Phase-in - Minimum capital requirement FINMA Basel 3 Phase-in - Minimum capital requirement
Global Systemically important Banks (G-SIB) Systemically important Banks (maximum 6% progressive component)
20% 20%
18% 18%
16% 16% 6.00%
5.63%
14% 14% 5.12%
4.50%
12% 2.5%
12%
3.75% 3.00%
1.875% 3.00%
10% 10% 2.875%
1.25% 2.75%
2.0% 2.625%
0.625% 2.0%
2.25%
8% 2.0% 8%
2.0% 1.5% 1.50% 1.75%
1.5% 5.50%
2.5% 2.0% 4.88%
1.5% 1.00% 4.25%
3.5% 6% 3.63%
6% 1.5% 2.5% 2.88%
1.5% 1.875% 2.75%
1.25%
1.5% 0.625% 2.50%
4% 1.0% 4%
2% 4.0% 4.5% 4.5% 4.5% 4.5% 4.5% 2% 4.00% 4.50% 4.50% 4.50% 4.50% 4.50%
3.5% 3.50%
0% 0%
2013 2014 2015 2016 2017 2018 Basel 3- Full 2013 2014 2015 2016 2017 2018 Basel 3- Full
G-SIB additional capital (max) Tier-2 Capital Additional Tier-1 Capital Progressive component (CoCos 5% trigger) Capital Buffer - CoCos 7% Trigger (max)
Capital Conservation Buffer (CET1) Minimum CET1 Capital Buffer - CET1 (min) Minimum CET1
Excludes Countercyclical Capital Buffer (max 2.5%)
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20. Basel 3: Lower Eligible Capital + higher RWA
AV Corr +1.4%
CVA +9.3%
RWA vs +7.6%
Eligible Capital deductions
-16.4%
RWA
-5.0% DTA
+ 18.4%
-3.6% Inv. in Fin
Institutions
-2.0% Items > 15% CET1
Other
-5.8% Source: EBA Basel III monitoring exercise,
deductions
average of Group 1 banks, Sept 2012 19
21. In addition to impact of Basel 2.5
Stress VaR, IRC, CRM, and modified securitisation treatment
increase UBS market risk RWA by 400%
Source: UBS 3Q12 Report 20
23. Basel 3: New items on the menu
Liquidity
Coverage
Leverage Ratio
Ratio
Net Stable
Funding
Ratio
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24. Basel 3: UBS Balance Sheet Development
Influences Leverage Ratio capital requirement
Target reduction of Assets excl PRVs to 600bn in 2015
Source: UBS 4Q11 & 3Q12 Results Presentation 23
26. Basel 3 is estimated to lead to increased product costs
Source: “Basel III and European banking: Its impact, how banks might respond, and the challenges of
25
implementation”. McKinsey & Company, Working Papers on Risk 26, November 2010.
27. Basel 3: Capital Market Businesses are most affected
Structured credit, rates, and equity most affected; FX and cash equities least
Mitigating
actions:
Portfolio
optimization
Model
refinements +
data quality
improvements
Conserving
capital, liquidity
and funding
Operational
enhancements
Source: “Day of reckoning? New regulation and its impact on capital-markets businesses”,
McKinsey & Company, Working Papers on Risk 29, October 2011. 26
28. Basel 3: Considerations for Earnings Objectives
Focus on profitability of Core Businesses
Original objective (2003) was to ensure minimum dividend payment
– Even in adverse situation, with high probability
Since the 2007-2008 financial crisis
– Profits have been used to increase tangible equity instead of paying dividends
– Risk taking has reduced substantially
– Inventory of legacy exposures have been wound down
– Market circumstances have been challenging
Focus on profitability instead of paying dividends
– For Core Businesses - Legacy exposures supported by capital
– Differentiated tolerance for losses in different businesses
New balance to be found between risk and return
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29. Basel 3: Choices for Capital Objectives
Sufficient capital to ensure going-concern after severe stress
Consider Basel 3 CET1 phase-in or fully-applied?
– Regulatory capital based on phase-in
– Analyst focus often already on fully-applied
What minimum CET1 ratio to choose under stress for Tier-1 Capital objectives?
– Impairment of capital buffer requires plan to replenish the buffer
– Impairment of capital buffer can lead to restrictions on shareholder distributions and discretionary
pay – up to imposing measures to increase capital and/or reduce RWA
– Latest point at which FINMA interferes is 8.75% CET1 ratio
– 50% impairment of capital buffer
– Well before triggering high-trigger (7%) CoCos
Maintain Solvency objective
– Loss-absorbing capital as Risk Capacity
Alignment with Recovery and Resolution plans
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30. Potential Extensions of Risk Appetite objectives
Leverage ratio objective
– Satisfying minimum leverage ratio also after a stress event?
– FINMA leverage ratio denominator calculation (“assets”) to be finalized
– Minimum leverage ratio requirement to be reviewed
Establish connection with liquidity framework
– Minimum liquidity and funding requirements after a stress event
– UBS satisfies existing interpretation of LCR and NSFR
Separate (but aligned) objectives for major legal entities
Cascade Risk Appetite objectives to Business Divisions
– Continue to do so through limit framework
– In addition, consideration of business-specific objectives
Balance between comprehensiveness, simplicity & transparency
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