Topics 49-50

Question 1

Properties of a coherent risk measure

Answer 1

The properties are as follows:

1. Monotonicity: A portfolio with greater future returns will likely have less risk.
2. Subadditivity: The risk of a portfolio is at most equal to the risk of the assets within the portfolio.
3. Positive homogeneity: The size of a portfolio will impact the size of its risk.
4. Translation invariance: The risk of a portfolio is dependent on the assets within the portfolio.

Question 2

Within the economic capital implementation framework describe the challenges that appear in defining and calculating risk measures

Answer 2

Prior to defining specific measures, one should be aware of the general characteristics of ideal risk measures. They should be: intuitive, stable, easy to compute, easy to understand, coherent, and interpretable in economic terms. In addition, the risk decomposition process must be simple and meaningful for a given risk measure.

The following section is a summary of challenges encountered when considering the appropriateness of each risk measure.

Standard deviation

• Not stable because it depends on assumptions about the loss distribution.
• Not coherent because it violates the monotonicity condition.
• Simple, but not very meaningful in the risk decomposition process.

VaR (the most commonly used measure)

• Not stable because it depends on assumptions about the loss distribution.
• Not coherent because it violates the subadditivity condition (could cause problems in internal capital allocation and limit setting for sub-portfolios).

Expected shortfall

• May or may not be stable, depending on the loss distribution.
• Not easy to interpret, and the link to the banks desired target rating is not clear.

Spectral and distorted risk measures

• Not intuitive nor easily understood (and rarely used in practice).
• May or may not be stable, depending on the loss distribution.

Question 3

Within the economic capital implementation framework describe the challenges that appear in risk aggregation

Answer 3

There are three items to consider: risk metric, confidence level, and time horizon.

1. Risk metric: Relies on the metrics used in the quantification of different risk types. Must consider whether the metric satisfies the subadditivity condition.
2. Confidence level: Loss distributions for different types of risk are assumed to have different shapes, which implies differences in confidence intervals. The lack of consistency in choosing confidence levels creates additional complexity in the aggregation process.
3. Time horizon: Choosing the risk measurement time horizon is one of the most challenging tasks in risk measurement. For example, combining risk measures that have been determined using different time horizons creates problems irrespective of actual measurement methods used. Specifically, there will be inaccurate comparisons between risk types.

Question 4

Five commonly used aggregation methodologies

Answer 4

There are five commonly used aggregation methodologies. The following is a brief description of them, as well as the challenges associated with using them.

1. Simple summation

• Adding together individual capital components.
• Does not differentiate between risk types and therefore assumes equal weighting. Also, does not take into account the underlying interactions between risk types or for differences in the way the risk types may create diversification benefits. In addition, complications arising from using different confidence levels are ignored.

2. Constant diversification

• Same process as simple summation except that it subtracts a fixed diversification percentage from the overall amount.
• Similar challenges as simple summation.

3. Variance-covariance matrix

• Summarizes the interdependencies across risk types and provides a flexible framework for recognizing diversification benefits.
• Estimates of inter-risk correlations (a bank-specific characteristic) are difficult and costly to obtain, and the matrix does not adequately capture non-linearities and skewed distributions.

4. Copulas

• Combines marginal probability distributions into a joint probability distribution through copula functions.
• More demanding input requirements and parameterization is very difficult to validate. In addition, building a joint distribution is very difficult.

5. Full modeling/simulation

• Simulate the impact of common risk drivers on all risk types and construct the joint distribution of losses.
• The most demanding method in terms of required inputs. Also, there are high information technology demands, the process is time consuming, and it may provide a false sense of security.

The variance-covariance approach is commonly used by banks. Frequently, however, bank-specific data is not available or is of poor quality. As a result, the items in the variance-covariance matrix are completed on the basis of expert judgment. On a related note, banks often use a “conservative” variance-covariance matrix where the correlations are reported to be approximate and biased upward. In order to reduce the need for expert judgment, banks may end up limiting the dimensionality of the matrix and aggregating risk categories so that there are only a few of them, not recognizing that such aggregations embed correlation assumptions. Clearly, a disadvantage of such a practice is that each category becomes less homogenous and therefore, more challenging to quantify.

One potential disadvantage of the more sophisticated methodologies is that they often lead to greater confidence in the accuracy of the output. It is important to consider robustness checks and estimates of specification and measurement error so as to prevent misleading results.

Question 5

Within the economic capital implementation framework describe the challenges that appear in qualitative validation of models

Answer 5

The validation of economic capital models differs from the validation of an IRB (internal ratings based) model because the output of economic capital models is a distribution rather than a single predicted forecast against which actual outcomes may be compared. Also, economic capital models are quite similar to VaR models despite the longer time horizons, higher confidence levels, and greater lack of data.

There are six qualitative validation processes to consider. The following is a brief description of them, as well as the challenges associated with using them (where applicable).

1. Use test

• If a bank uses its measurement systems for internal purposes, then regulators could place more reliance on the outputs for regulatory capital.
• The challenge is for regulators to obtain a detailed understanding of which models properties are being used and which are not.

2. Qualitative review

• Must examine documentation and development work, have discussions with the models developers, test and derive algorithms, and compare with other practices and known information.
• The challenge is to ensure that the model works in theory and takes into account the correct risk drivers. Also, confirmation of the accuracy of the mathematics behind the model is necessary.

3. Systems implementation

• For example, user acceptance testing and checking of code should be done prior to implementation to ensure implementation of the model is done properly.

4. Management oversight

• It is necessary to have involvement of senior management in examining the output data from the model and knowing how to use the data to make business decisions.
• The challenge is ensuring that senior management is aware of how the model is used and how the model outputs are interpreted.

5. Data quality checks

• Processes to ensure completeness, accuracy, and relevance of data used in the model. Examples include: qualitative review, identifying errors, and verification of transaction data.

6. Examination of assumptions—sensitivity testing

• Assumptions include: correlations, recovery rates, and shape of tail distributions. The process involves reviewing the assumptions and examining the impact on model outputs.

Question 6

Within the economic capital implementation framework describe the challenges that appear in quantitative validation of models

Answer 6

There are also six quantitative validation processes to consider. The following is a brief description of them, as well as the challenges associated with using them (where applicable).

1. Validation of inputs and parameters

• Validating input parameters for economic capital models requires validation of those parameters not included in the IRB approach, such as correlations.
• The challenge is that checking model inputs is not likely to be fully effective because every model is based on underlying assumptions. Therefore, the more complex the model, the more likely there will be model error. Simply examining input parameters will not prevent the problem.

2. Model replication

• Attempts to replicate the model results obtained by the bank.
• The challenge is that the process is rarely enough to validate models and in practice, there is little evidence of it being used by banks. Specifically, replication simply by re-running a set of algorithms to produce the same set of results is not considered enough model validation.

3. Benchmarking and hypothetical portfolio testing

• The process is commonly used and involves determining whether the model produces results comparable to a standard model or comparing models on a set of reference portfolios.
• The challenge is that the process can only compare one model against another and may provide little comfort that the model reflects “reality.” All that the process is able to do is provide broad comparisons confirming that input parameters or model outputs are broadly comparable.

4. Backtesting

• Considers how well the model forecasts the distribution of outcomes—comparison of outcomes to forecasts.
• The challenge is that the process can really only be used for models whose outputs can be characterized by a quantifiable metric with which to compare an outcome. Obviously, there will be risk measurement systems whose outputs cannot be interpreted this way. Also, backtesting is not yet a major part of banks’ validation practices for economic purposes.

5. Profit and loss attribution

• Involves regular analysis of profit and loss—comparison between causes of actual profit and loss versus the model’s risk drivers.
• The challenge is that the process is not widely used except for market risk pricing models.

6. Stress testing

• Involves stressing the model and comparing model outputs to stress losses.

Question 7

Within the economic capital implementation framework describe the challenges that appear in dependency modeling in credit risk

Answer 7

In general, dependencies can be modeled using: credit risk portfolio models, models using copulas, and models based on the asymptotic single-risk factor (ASRF) model. With the ASRF approach, banks may use their own estimates of correlations or may use multiple systematic risk factors to address concentrations. Such an approach would result in questioning the method used to calibrate the correlations and the ways in which the bank addressed the infinite granularity and single-factor structure of the ASRF model. ASRF can be used to compute the capital requirement for credit risk under the IRB framework.

In the past, the validity of the following assumptions have been questioned:

• the ASRF Gaussian copula approach,
• the normal distribution for the variables driving default,
• the stability of correlations over time, and
• the joint assumptions of correctly specified default probabilities and doubly-stochastic processes, which suggest that default correlation is sufficiently captured by common risk factors.

In contrast, when banks use a regulatory-type approach, the assumptions of such an approach create other challenges for both banks and regulators:

• Correlation estimates need to be estimated, but there may be limited historical data on which to base the correlation estimates. Also, the assumptions used to generate the correlations may not be consistent with the underlying assumptions of the Basel II credit risk model.
• A banks use of the Basel II risk weight model requires concentration risk to be accounted for by other measures and/or management methods. It will also require regulators to evaluate such measures/methods.

A key challenge to overcome is the use of misspecified or incorrectly calibrated correlations and the use of a normal distribution (which does not replicate the details of the distribution of asset returns). This may lead to large errors in measuring portfolio credit risk and economic capital.

Question 8

Within the economic capital implementation framework describe the challenges that appear in evaluating counterparty credit risk

(Market-risk-related challenges to counterparty exposure at default (EAD) estimation)

Answer 8

Such a task is a significant challenge because it requires: obtaining data from multiple systems, measuring exposures from an enormous number of transactions (including many that exhibit optionality) spanning a wide range of time periods, monitoring collateral and netting arrangements, and categorizing exposures across many counterparties. As a result, banks need to have well-developed processes and trained staff to deal with these challenges.

Market-risk-related challenges to counterparty exposure at default (EAD) estimation.

• Counterparty credit exposure requires simulation of market risk factors and the revaluation of counterparty positions under simulated risk factor shocks, similar to VaR models. Consider the following two challenges that occur when attempting to use VaR model technology to measure counterparty credit exposure.
  
  • Market risk VaR models combine all positions in a portfolio into a single simulation. Therefore, gains from one position may fully offset the losses in another position in the same simulation run. However, counterparty credit risk exposure measurement does not allow netting across counterparties. As a result, it is necessary to compute amounts at the netting set level (on each set of transactions that form the basis of a legally enforceable netting agreement), which increases computational complexity.
  • Market risk VaR calculations are usually performed for a single short-term holding period. However, counterparty credit exposure measurement must be performed for multiple holding periods into the future. Therefore, market risk factors need to be simulated over much longer time periods than in VaR calculations, and the revaluation of the potential exposure in the future must be done for the entire portfolio at certain points in the future.

Question 9

Within the economic capital implementation framework describe the challenges that appear in evaluating counterparty credit risk

(Credit-risk-related challenges to PD and LGD estimation)

Answer 9

• Some material transactions are performed with counterparties with which the bank does not have any other exposures. Therefore, the bank must calculate a probability of default (PD) and loss given default (LGD) for the counterparty and transaction.
• For hedge funds, the measurement challenge occurs when there is little information provided on underlying fund volatility, leverage, or types of investment strategies employed.
• Even for counterparties with which the bank has other credit exposures, the bank still needs to calculate a specific LGD for the transaction.

Question 10

Within the economic capital implementation framework describe the challenges that appear in evaluating counterparty credit risk

(Interaction between market risk and credit risk—wrong-way risk)

Answer 10

• Identifying and accounting for wrong-way risk (exposures that are negatively correlated with the counterparty’s credit quality) is a significant challenge because it requires an understanding of the market risk factors to which the counterparty is exposed. That would be difficult to do in the case of a hedge fund, for example, which would be less transparent.
• It also requires a comparison of those factor sensitivities to the factor sensitivities of the bank’s own exposures to the counterparty.
• The magnitude of wrong-way risk is difficult to quantify in an economic capital model since it requires a long time horizon at a high confidence level.

Question 11

Within the economic capital implementation framework describe the challenges that appear in evaluating counterparty credit risk

(Operational-risk-related challenges in managing counterparty credit risk)

Answer 11

• The challenge is that managing such risk requires specialized computer systems and people. Complicated transactions, such as daily limit monitoring, marking-to-market, collateral management, and intraday liquidity and credit extensions, increase the risk of measurement errors.
• The quantification of operational risks is a significant challenge, especially when it pertains to new or rapidly growing businesses, new products or processes, intraday extensions of credit, and infrequently occurring but severe events.

Question 12

Within the economic capital implementation framework describe the challenges that appear in evaluating counterparty credit risk

(Differences in risk profiles between margined and non-margined counterparties)

Answer 12

• The modeling difference between the two types of counterparties is primarily concerned with the future forecasting period. For margined counterparties, the forecasting period is short, and for non-margined counterparties, it is usually much longer.
• As a result of the difference in time periods, the aggregation of risk between these two types of counterparties is a challenge because the usual procedure is to use a single time period for all positions.

Question 13

Within the economic capital implementation framework describe the challenges that appear in evaluating counterparty credit risk

(Aggregation challenges)

Answer 13

• In general, the challenges are increased significantly when moving from measuring credit risk of one counterparty to measuring credit risk of the firm in general for economic capital purposes.
• When counterparties have both derivatives and securities financing activities, the problem is especially challenging because the systems in place may not be able to handle such aggregation.
• Further aggregation challenges exist when high-level credit risk measures are required to be aggregated with high-level market risk and operational risk measures in order to calculate economic capital.
• Breaking down counterparty credit risk into detailed component parts (as is often done with market risk) is another challenge. The sheer computational complexities and enormous amounts of data required would generally be cost prohibitive to perform on a frequent basis. The challenge still remains for many banks due to outdated or ineffective computer systems.

Question 14

Describe the BIS recommendations that supervisors should consider to make effective use of internal risk measures, such as economic capital, that are not designed for regulatory purposes

Answer 14

There are ten Bank for International Settlements (BIS) recommendations to consider:

1. Use of economic capital models in assessing capital adequacy. The bank should show how such models are used in the corporate decision-making process so as to assess the model’s impact on which risks the bank chooses to accept. In addition, the board should have a basic understanding of the difference between gross (stand alone) and net (diversified) enterprise-wide risk in assessing the bank’s net risk tolerance.
2. Senior management. The economic capital processes absolutely require a significant commitment from senior management. They should understand its importance in the corporate planning process and should ensure that there is a strong infrastructure in place to support the processes.
3. Transparency and integration into decision-making. Economic capital results need to be easy to trace and understand in order to be useful. Careful attention must be given to obtaining reliable estimates on an absolute basis in addition to developing the flexibility to conduct firm-wide stress testing.
4. Risk identification. This is the crucial starting point in risk measurement. The risk measurement process must be very thorough to ensure that the proper risk drivers, positions, and exposures are taken into account in measuring economic capital. That will ensure that there is little variance between inherent (actual) and measured risk. For example, risks that are difficult to quantify should be considered through sensitivity analysis, stress testing, or scenario analysis.
5. Risk measures. No given risk measure is perfect, and a bank must understand the strengths and weaknesses of its chosen risk measures. No one risk measure for economic capital is universally preferred.
6. Risk aggregation. The reliability of the aggregation process is determined by the quality of the measurement risk components, plus the interrelationships between such risks. The aggregation process usually requires consistency in the risk measurement parameters. The aggregation methodologies used should mirror the bank’s business composition and risk profile.
7. Validation. The validation process for economic capital models must be thorough and corroborating evidence from various tests must show that the model “works” as intended. In other words, within an agreed upon confidence interval and time period, the capital level determined must be enough to absorb the (unexpected) losses.
8. Dependency modeling in credit risk. Banks must consider the appropriateness of the dependency structures used within their credit portfolio. Specifically, credit models need to be assessed for their limitations, and such limitations need to be dealt with via appropriate supplementary risk management approaches, such as sensitivity or scenario analysis.
9. Counterparty credit risk. There are trade-offs to be considered in deciding between the available methods of measuring counterparty credit risk. Additional methods, such as stress testing need to be used to help cover all exposures. Measuring such risk is complicated and challenging. Specifically, the aggregation process needs to be vetted prior to a bank having a big picture perspective of counterparty credit risk.
10. Interest rate risk in the banking book. Specifically, financial instruments with embedded options need to be examined closely in order to control risk levels. Certainly, there are trade-offs between using earnings-based versus economic value-based models to measuring interest rate risk. For example, the former has aggregation problems because other risks are measured using economic value. Also, using economic valuebased models could be inconsistent with business practices.

Question 15

Explain benefits and impacts of using an economic capital framework within area of credit portfolio management

Answer 15

Constraints imposed:

• Credit quality of each borrower is determined in a portfolio context, not on a standalone basis.
• A loan’s incremental risk contribution is used to determine the concentration of the loan portfolio.

Opportunities offered:

• The process allows one to determine appropriate hedging strategies to use in reducing portfolio concentration.
• Credit portfolio management becomes a means for protecting against risk deterioration.

Question 16

Explain benefits and impacts of using an economic capital framework within area of risk-based pricing

Answer 16

Constraints imposed:

• Pricing decisions are based on expected risk-adjusted return on capital (RAROC), so deals will be rejected if they are lower than a specific RAROC. The proposed interest rate is determined by the amount of economic capital allocated to the deal.
• Pricing decisions include:
  
  • (1) cost of funding,
  • (2) expected loss,
  • (3) allocated economic capital, and
  • (4) additional return required by shareholders.
• Therefore, a minimum interest rate is determined that will increase shareholder value.

Opportunities offered:

• Can be used to maximize the bank’s profitability. For example, some pricing decisions may need to be overridden because certain customer relationships are more profitable (at a lower price/interest rate) or desirable from a reputational point of view. Of course, such overrides are not taken lightly and require upper management approval, as well as rigorous subsequent monitoring.

Question 17

Explain benefits and impacts of using an economic capital framework within area of customer profitability analysis

Answer 17

Constraints imposed:

• The analysis is complicated in that many risks need to be aggregated at the customer level.
• Customers need to be segmented in terms of ranges of (net) return per unit of risk; the underlying information is difficult to measure and allocate.

Opportunities offered:

• Assuming that the measurement obstacles have been overcome, the analysis can be easily used to determine unprofitable or only slightly profitable customers. Such customers could be dropped and economic capital allocated to the more profitable customers.
• Economic capital is used in maximizing the risk-return trade-off (through relative riskadjusted profitability analysis of customers).

Question 18

Explain benefits and impacts of using an economic capital framework within area of management incentives

Answer 18

Constraints imposed:

• Studies show that compensation schemes are a minor consideration in terms of the actual uses of economic capital measures at the business unit level.

Opportunities offered:

• It is suggested that management incentives is the issue that motivates bank managers to participate in the technical aspects of the economic capital allocation process.

Question 19

Describe best practices and assess key concerns for the governance of an economic capital framework

Answer 19

In order for an economic capital framework to be effective it should include:

• Strong controls for changing risk measurements.
• Comprehensive documentation for measuring risk and allocation approaches.
• Policies for making sure economic capital practices follow outlined procedures.
• View of how economic capital measures apply to daily business decisions.

Best practices for the governance of an economic capital framework cover:

1. Senior management commitment.
2. The business unit involved and its level of expertise.
3. The timing of economic capital measurement and disclosures. Most banks will compute economic capital on either a monthly or quarterly basis. Pillar 3 of the Basel II Accord encourages the disclosure of information about how capital is allocated to risks.
4. Policies and procedures for owning, developing, validating, and monitoring economic capital models. Formal policies and procedures encourage the consistent application of economic capital across the bank. The owner of the economic capital model will usually oversee the economic capital framework.

Key concerns related to governance and the application of economic capital measures involve:

1. Senior management commitment.
2. The role of stress testing. Many banks currently apply stress tests; however, using more integrating stress tests will allow banks to better assess the impact of a stress scenario on certain economic capital measures.
3. Measuring risk on either an absolute or relative basis.
4. Not using economic capital as the only measure that determines required capital. Most banks align economic capital with external credit ratings. Shareholders desire profitability via lower capital levels while rating agencies encourage solvency via higher capital levels.
5. Defining available capital resources. Currently, there is no definition for available capital among banks. Most banks adjust Tier 1 capital to determine available capital resources.
6. Transparency of economic capital measures. Economic capital models are more useful for senior managers when they are transparent. Increased documentation will improve the validity of using the model when making business decisions.

Question 20

Describe the Federal Reserves Capital Plan Rule and explain the seven principles of an effective capital adequacy process for bank holding companies (BHCs) subject to the Capital Plan Rule

Answer 20

Bank holding companies (BHCs) must have adequate and sufficient capital for their survival and growth.

The Federal Reserve maintains its interest in survivability and smooth functioning BHCs through its Capital Plan Rule and the annual Comprehensive Capital Analysis and Review (CCAR). The CCAR is the Federal Reserve’s supervisory program for evaluating capital plans. The Capital Plan Rule mandates that BHCs develop and put in place a capital plan and a process to evaluate and monitor their capital adequacy. The capital plan covers all U.S. domiciled BHCs with total consolidated assets equal to $50 billion or more.

The principles on which the Federal Reserve assesses BHCs for managing and allocating their capital resources is referred to as the capital adequacy process (CAP). The seven principles of the CAP are as follows:

1. Risk management foundation. A BHC has an effective capital risk management plan to encompass all key risk exposures on a firm-wide basis in terms of identification, evaluation, measurement, and control.
2. Resource estimation methods. A BHC has a capital resource estimation plan to clearly define and estimate available capital resources over a stress scenario time horizon.
3. Loss estimation methods. A BHC has a process for estimating potential losses and aggregating them on a firm-wide basis over a given stress scenario time horizon.
4. Impact on capital adequacy. A BHC has a process to evaluate the combined impact on capital adequacy—given loss estimates and capital resources combined—in light of the stated goals with respect to capital level and composition.
5. Capital planning policy. A BHC has a sound capital policy to develop capital goals, determine appropriate capital levels and composition as well as capital distributions (actions) and contingency plans.
6. Internal controls. A BHC has a vigorous internal controls policy in place for independent review, model validation, documentation, and internal audit of the capital adequacy process.
7. Effective oversight. A BHC has a board and senior management responsible for an effective and thorough oversight of multiple dimensions of the internal capital risk plan, including methods, processes, assessments, validations, reviews, documentation, infrastructure, resources, goals, limitations, and approval of capital decisions.

Question 21

Describe practices that can result in a strong and effective capital adequacy process for a BHC in the area of risk identification

Answer 21

• BHCs should have a process in place to identify all risk exposures stemming from numerous sources, including stress conditions, changing economic and financial environments, on-and-off balance sheet items, and their impact on capital adequacy.
• In addition, BHCs should critically scrutinize underlying assumptions regarding risk reduction through risk mitigation or risk transfer techniques.
• Senior management should regularly update and review the risk identification plan with special consideration for how their risk profiles might change under stress scenarios.
• BHCs should integrate the identified risk exposures into their internal capital planning processes.
• Scenario-based stress testing may not capture all potential risks faced by BHCs, some risks are difficult to quantify or they do not fall into the integrated firm-wide scenarios. However, such risks must be included and accounted for in the capital planning processes. These risks are categorized as “other risks,” and their examples include compliance, reputational, and strategic risks.

Question 22

Describe practices that can result in a strong and effective capital adequacy process for a BHC in the area of internal controls

Answer 22

• BHCs should have efficiently running management information systems (MIS) for collecting and analyzing pertinent information set quickly and accurately.
• In addition, BHCs should put in place a detailed and organized documentation system fully encompassing all dimensions of capital planning processes, including risk identification, loss estimation techniques, capital adequacy, and capital decision processes.
• There must be a thorough, independent, and regular review and validation of all models used for internal capital planning purposes, including assessment of conceptual soundness of models and verification of processes.
• BHCs should maintain and update a list of all inputs, assumptions, and adjustments for the models used to generate final projections and estimates, such as income, loss expenses, and capital. These models should be validated for their effective use, not only under normal conditions, but also under stress conditions. BHCs should make full disclosure of their validation process and outcome, and should restrict the use of models which are not validated.

Question 23

Describe practices that can result in a strong and effective capital
adequacy process for a BHC in the area of governance

Answer 23

• BHCs should have boards with sufficient expertise and involvement to fully understand and evaluate the information provided to them by senior management regarding their capital planning processes. Also, the boards should be informed about the stress scenarios and any corrective measure undertaken as a result of stress testing outcomes.
• Under the Capital Plan Rule, the management of BHCs is required to furnish key information to the board for its approval of internal capital adequacy plans.
• Senior management should evaluate the internal capital plan on an ongoing basis, focusing on key weaknesses, strengths, assumptions, scenarios, estimates, and models. In addition, senior management should make appropriate adjustments and remediation to the capital plan if the review process reveals shortcomings in the plan.
• BHCs should maintain detailed minutes of board meetings, describing the issues raised and discussed, as well as the information used and the recommendations made in these meetings.

Question 24

Describe practices that can result in a strong and effective capital adequacy process for a BHC in the area of capital policy

Answer 24

• A capital policy should clearly define the principles and guidelines for capital goals, issuance, usage, and distributions.
• Policies regarding common stock dividends and repurchase agreements should include the following:
  
  • Key metrics influencing the size, timing, and form of capital distributions.
  • Materials used in making capital distribution decisions.
  • Specific scenarios that would cause a distribution to be reduced or suspended.
  • Situations that would cause the BHC to consider replacing common equity with other forms of capital.
  • Key roles and responsibilities of individuals or groups for producing reference materials, making distribution recommendations and decisions, and reviewing analysis.
• BHCs should establish specific goals for both the level and composition of capital under normal as well as stress conditions.
• While setting capital distribution levels, BHCs must take into consideration numerous factors, including future growth plans (including acquisitions) and associated risk, current and future general economic conditions, in particular the impact of macroeconomic and global events during stress conditions, on their capital adequacy.
• BHCs should develop strong contingency planning offering numerous options to deal with contingency situations as well as their effectiveness under stress conditions. Contingency plans should be based on realistic assumptions and contain futuristic outlooks, rather than overly relying on history.

Question 25

Describe practices that can result in a strong and effective capital adequacy process for a BHC in the area of stress testing and stress scenario design

Answer 25

• Scenario design and stress testing should focus on unique situations of BHCs, their asset and liability mix, portfolio composition, business lines, geographical territory, and revenue and loss factors, while taking into consideration the impact of macroeconomic and firm-specific vulnerabilities and risks.
• Also, a BHCs scenario designing and testing should not employ optimistic assumptions benefiting the BHC.
• BHCs should employ both an internal model and expert judgment, an outside expert’s opinion. If only a third-party model is used, it must be tailored to the unique risk profile and business model of a BHC.
• Stress testing models should be based on multiple variables encompassing all the risk exposures faced by BHCs on a firm-wide basis.

Question 26

Describe practices that can result in a strong and effective capital adequacy process for a BHC in the area of estimating losses, revenues, and expenses

(quantitative and qualitative basis)

Answer 26

• BHCs should prefer using internal data to estimate losses, revenues, and expenses. However, in certain situations, it may be more appropriate to use external data. In these instances, it should be ensured that the external data reflects the underlying risk profile of their business lines, and necessary adjustments should be made to data input or output to make the analysis reflect a true picture of the BHCs unique characteristics.
• In addition, BHCs should segment their line of businesses and portfolios utilizing common risk characteristics showing marked differences in past performances.
• Past relationships between losses, revenues, expenses, and underlying driving factors, and their interrelationships may not hold in the future, thus, necessitating employment of sensitivity analysis (to answer “what if” questions) when using models based on historical underlying interactions.
• BHCs sometimes use qualitative methodologies, like expert judgment or management overlay, as a substitute or a complement to quantitative methods. Qualitative techniques should be based on sound assumptions, and an external reviewer should find these approaches logical, reasonable, and clearly spelled out.
• A sensitivity analysis should be used for a qualitative approach as well.
• From a supervisory standpoint, BHCs are expected to use conservative assumptions, not favorable to BHCs, for estimating losses, revenues, and expenses under normal and stress conditions

Question 27

Describe practices that can result in a strong and effective capital adequacy process for a BHC in the area of estimating losses, revenues, and expenses

(Loss Estimation Methods)

Answer 27

• BHCs should use uniform, reputable methods to aggregate losses across various lines of business and portfolios for firm-wide scenario analysis.
• They should also use automated processes, without manual intervention or managerial adjustments showing clear linkage from data sources to loss estimation and aggregation.
• In the case using external data, BHCs should demonstrate that the data reflects their risk exposures, encompassing geographic, industry, and other key dimensions.
• Risk segmentation should be supported by the data capturing the unique characteristics of each risk pool.
• BHCs can use either an economic loss approach (i.e., expected losses) or an a_ccounting-based loss approach_ (i.e., charge-off and recovery) to estimate credit losses.
• For the expected loss approach, BHCs should categorize losses into probability of default (PD), loss given default (LGD), or exposure at default (EAD) and then identify the determinants of each component. Long run averages for PDs, LGDs, and EADs should not be used, as these averages reflect economic downturn and upturn periods not necessarily suitable for scenario testing under stress conditions.
• If BHCs are using rating systems as a key input to estimate expected losses under stress (e.g., on their wholesale portfolios), they should recognize the limitations in rating systems and their data and make necessary adjustments.
• BHCs should utilize a robust time series with sufficient granularity while employing tolerate models to estimate the rate at which delinquent and non-delinquent accounts in the current quarter are expected to roll over into default or delinquent status in the next quarter.
• If using charge-off models (i.e., accounting models), BHCs should include variables which represent the risk characteristics of an underlying portfolio while estimating the statistical relationship between charge-off rates and macroeconomic variables at the portfolio level.

Question 28

Describe practices that can result in a strong and effective capital adequacy process for a BHC in the area of estimating losses, revenues, and expenses

(Operational Risk)

Answer 28

• In order to determine operational risk, many BHCs estimate correlation between operational risk and macroeconomic factors. If they do not discover a statistically significant relationship between the variables, they employ other methods, including scenario analysis utilizing historical data and management input. BHCs should employ a combination of techniques to develop strong loss estimates under stress conditions, including past loss records, future expected events, macro conditions, and firm-specific risks.
• BHCs using regression models to estimate loss frequency and loss severity under stress scenarios should provide statistical support for the period chosen for estimation purposes instead of arbitrary and judgmental selection.
• A modified loss distribution approach (LDA) is also used by BHCs to estimate value at risk (VaR) to estimate operational risk losses at a chosen confidence interval (e.g., 90% or 95%).
• Some BHCs use scenario analyses in case they encounter model or data limitations in order to incorporate a wide range of risks (which is not possible otherwise due to data or model limitations).

Question 29

Describe practices that can result in a strong and effective capital adequacy process for a BHC in the area of e_stimating losses, revenues, and expenses_

(Market Risk and Counterparty Credit Risk)

Answer 29

• In order to estimate the potential loss resulting from market credit interaction, BHCs use probabilistic approaches (which produce a probability distribution of expected portfolio losses) and deterministic approaches (which yield point estimates of an expected portfolio loss).
• BHCs using probabilistic approaches should clearly offer evidence that such methods can yield more severe risk scenarios compared to historical scenarios.
• BHCs using deterministic approaches should demonstrate that they have employed a wide range of scenarios, adequately covering their key risk exposures, including mark-to-market positions in the event of firm-specific or market-wide stress conditions.
• Market shock scenarios do not directly incorporate the default of the counterparty. Some BHCs explicitly incorporate the scenario of default of key counterparties (including key customers) while using some sort of probabilistic approach involving some estimates of the PD, LGD, and EAD of counterparties.
• BHCs also use assumptions about risk mitigation in the future. Such assumptions, if used, should be conservative in nature. In stress scenarios, the ability of BHCs to take desired actions may be limited.

Question 30

Describe practices that can result in a strong and effective capital adequacy process for a BHC in the area of estimating losses, revenues, and expenses

(PPNR Projection Methodologies)

Answer 30

• PPNR is pre-provision net revenue (i.e., net revenue before adjusting for loss provisions). While estimating revenues and expenses over a planning horizon under stressed conditions (the Capital Plan Rule requires forecasts over the next nine quarters), BHCs should not only take into consideration their current situation, but also the possible future paths of business activities and operational environments related to their on- and off-balance sheet risk exposures, underlying assumptions, and assets and liabilities.
• BHCs should also take into consideration the impact of regulatory changes on their performance and ability to achieve their stated targets and goals.
• Net interest income projections are not isolated projections; rather, they are entrenched with other items of a capital adequacy plan.
• Balance sheet assumptions should be consistent while projecting net interest income.
• Net interest income projections should be based on methodologies that incorporate discount or premium amortization adjustments for assets not held at par value that would materialize under different scenarios.
• Additionally, BHCs with trading portfolios should establish a clear link between trading revenue projections to trading assets and liabilities and the compatibility of all the elements of stress scenario conditions.
• BHCs with off-balance sheet business items should demonstrate the linkage between revenue projections and changes in on- and off-balance sheet items.
• Furthermore, BHCs holding mortgage servicing rights assets (MSRAs) should carefully design assumptions regarding default, prepayment, and delinquency rates, ensuring that these assumptions are robust and scenario specific. In addition, BHCs that hedge MSRA risk exposure should generate scenario specific assumptions.
• In addition, BHCs should utilize a wide set of explanatory variables to develop statistical relationships. BHCs should take into consideration the impact of macroeconomic conditions, such as an economic downturn, on their non-interest expense projections. Non-interest expense projections, like all other projections, should be consistent with revenue and balance sheet estimates and should generate the same underlying strategic assumptions.
• If projections assume that a decline in revenue (e.g., due to an increase in credit collection costs in an economic downturn) can be offset by some mitigating strategies, BHCs should then clearly demonstrate the feasibility of such actions. Mitigation actions should not be supported by past relationships and actions only because future financial, macro, and global environments may not be as favorable to execute such strategies, as was the case in the past.

Question 31

Describe practices that can result in a strong and effective capital adequacy process for a BHC in the area of assessing the impact of capital adequacy

Answer 31

• Projecting balance sheet items, such as changes in assets and funding, directly without consideration of underlying drivers (of such changes), would be a weak practice.
• BHCs should incorporate relationships between revenues, expenses, and balance sheet items into their scenario analyses.
• Projections for RWA should be consistent with the projections for risk exposures of on-and off-balance sheet items.
• BHCs with a strong process of implementation should form a centralized group responsible for aggregating loss, revenue, expense, on- and off-balance sheets, and RWA projections for enterprise-wide scenario analysis.
• In addition, BHCs should establish a strong governance structure to critically scrutinize assumptions, methods, and estimates generated in an enterprise-wide scenario analysis and offer needed adjustments.