Why do we need a Systemic View of Default and Market Risk?

Dear community members,
Some days ago I was discussing with a friend about the concept of Risk, about its nature.

In a classic view, common on most of the Financial Institutions, Market Risk and Default Risk are different entities with some common characteristics. From that perspective they have traditionally been managed separately.

In my humble opinion, with the globalization of the Financial System and the increasing complexity of the traded Financial Instruments a wider approach covering Market and Default Risk in a systemic view is necessary.

Let’s look at a very simple example; as a Financial Institution giving a Mortgage Loan, typically we can require a Real Estate collateral for Default Risk Mitigation purposes.
Unfortunately as the recent Real Estate bubble has taught us, the default risk related to the Loan has not been mitigated but, at least partially, transferred to the Market Risk representing the value of the collateral. So basically, what we see is that Default and Market Risk are deeply related.

Another example could be the evaluation of the market risk of an issued Bond backed by a pool of debts in a securitization process; the market risk associated to that bond is deeply related to the default risk of the debts backing the bond.

Also, if we look to the derivatives market, by buying an exchange rate swap, we could try to mitigate the market (exchange rate) risk of a specific investment by paying a premium. But in fact, we’re not fully making the market risk disappear, as part of it, maybe tiny, has been transferred to the default risk of the counterpart. The influence of the OTC derivatives on the last Financial Crisis could be an interesting example.

If Market and Default Risk are so intimately related, that in many cases we can observe transfers from one to the other, as different manifestations of the same reality, a complete view should look at them together with a systemic approach.

Looking forward to read your thoughts.

Kindest Regards.

Ferran.

November 21, 2009

The Capital Factory.

Dear SAP Banking Community,

As we all know, we’re sadly in the middle of a very painful recession, the Financial System has suffered an enormous stress and the situation is still serious.

Looking at the media we see very often that the Banks need to be recapitalized, without capital there’s no credit, and credit is the fuel of the economy.

Jean Claude Trichet, President of the European Central Bank said yesterday (January 14th 2010); “Banks should use the improved funding conditions to strengthen further their capital bases and where necessary take advantage of government measures.”

http://www.bloomberg.com/apps/news?pid=newsarchive&sid=adKklreVp8JI

But Capital is an expensive resource…

Is there an IT answer to the requirement?

According to Basel II and IFRS regulation, we have some techniques for Risk Mitigation and Profit Generation; let me give you some simple examples.

Netting Assets and Liabilities Positions.- All the Banks and Financial Institutions have crossed investments; Bank A borrows money from Bank B and the other way around.

Basel II agreement and local regulations gives the possibility of Netting those Assets and Liabilities, or OTC-Derivative Positions, so reduce the exposures, consequently the Risk Weighted Assets and Finally the Regulatory
Capital.

So we get “Free Capital”.

IFRS recognizes the Risk Mitigation Opportunity of Hedge Accounting, and permits the Valuation Adjustments of Financial Instruments. Those Adjustments bring additional Profit and “Generate” Capital in the Balance Sheet.

The difficulty here is that we must fulfill some strict legal requirements for proving the legal Netting Agreements and the Effectiveness of our Hedge Relationships.

Proving that we fulfill those requirements requires a Structured Data Model and efficient Risk Calculators on our Information System, and very powerful Reporting Tools.

Once again; “Disclosure is the Word”.

Looking forward to read your views.

Kindest Regards.

Ferran.

January 15, 2010

Counter-Cycle Provisions System. Chapter 4.

Dear SAP Banking Community members.

On the previous posts of this topic we discussed about the convenience of using a Counter-Cycle Provisions system in terms of supporting Financial Stability, by limiting the risk exposures on the expansion phase and reducing the losses on the recession phase.

We also discussed about the main difficulty of building a systematic Counter-Cycle provision system. Especially if we consider that, by definition of the model, we have to evaluate non-visible failed loans, and we can not let the system to make “arbitrary” provisions.

As I commented already, the IRB approach of the Basel II agreement is an excellent candidate for making a systematic model for counter-cycle provisions creation, and additionally gives an opportunity for reconciling the solvency and accounting regulation (Basel II and IFRS).

The key points of the model are:

1) Measure the Loss Identification Period (LIP), which as we discussed is not the same for the whole Bank Loans Portfolio, se we need to split it in micro-portfolios and evaluate the Loss Identification Period on each of them.

2) Have a system with a coherent and homogeneous approach for the evaluation of the IRB Approach parameters (Credit Risk-Solvency) and Provisions Creation (Accountancy-Financial Instruments Valuation).

In my opinion Bank Analyzer fulfills those two critical requirements.

On one hand it offers the possibility of calculating the IRB Parameters on micro-portfolios divided by the combination of values of the descriptive characteristics of the Source Data Layer, and store the results also divided by micro-portfolios on the Results Data Layer.

Additionally, and for me it’s a great competitive advantage, the Integrated Financial and Risk Architecture of the Bank Analyzer system it’s the best approach for supporting the necessary reconciliation of the Solvency and Accounting requirements that this method requests.

Looking forward to read your opinions.

Kindest Regards.

Ferran.

Counter-Cycle Provisions System. Chapter 3.

Dear community members,

On our last post we commented the main difficulty for building a counter-cycle provisions system is measuring non-visible failed loans.

As we must evaluate non-visible failed loans, the provisions cannot be specific (we don’t know to what loan the provision belongs) but generic, trying to measure the failed loans in the portfolio without having to identify them univocally.

But determining the value of the generic provisions required is a difficult and risky task, as it can create arbitrary postings which affect the Bank result.

The International Financial Reporting Standards require to the Banks create provisions for covering the losses on their portfolio due to events which have already happened and will affect future cash flows.

Part of those losses described by the accounting rules are the non visible failed loans that we described at the beginning.

For determining the losses on those failed loans that we’re aware that exist in the portfolio but we haven’t detected yet, we have to evaluate the whole portfolio and adjust its value globally. That’s the main difference between a Generic and a Specific provision, as in the second we’ve identified the failed loan and it can be evaluated individually.

A very interesting approach for the evaluation of the generic provisions utilizes the IRB Approach of the Credit Risk Calculation (Basel II) as a basis for the determination of the generic provisions.

For the IRB Credit Risk Calculation we have to evaluate the several components; the Probability of Default (PD), the Loss Given Default (LGD), the Exposure at Default (EAD) and the maturity of the contracts (M).

Additionally, the IRB approach let us calculate the expected losses of the portfolio (EL), which is the expected loss for every loan that we can calculate with the following the formula:

EL=PD*LGD*EAD

But we must be careful as the IRB approach definition of Expected Losses is different of the concept of Incurred Losses of the IFRS.

The Expected Losses of the IRB approach is the average flow of losses that the internal rating calculation methods forecasts that is going to materialize in one year, while the Incurred Losses of the IFRS is the stock of existing losses of the portfolio at any given time, due to events in the past which will generate losses in the future.

Both, Incurred Losses and Expected Losses are different from the yearly manifested losses (flow of yearly defaults) and consequently the yearly flow of specific provisions.

Nevertheless, we can calculate the Incurred Losses according to the IFRS by estimating the yearly flow of expected losses and the time from the event which makes the loan failed and the time when the failed loan becomes visible. This period between both events is called Loss Identification Period (LIP).

For instance if the obligor losses his job and as a consequence he will be incapable of fulfilling his payment obligations 18 months later, the Loss Identification Period would be 18 months.

Consequently if we know both magnitudes (the Expected Losses and the Loss Identification Period) we can estimate the Incurred Losses multiplying both.

For example, if the calculated Expected Losses of our portfolio (IRB Approach) are 45 million dollars/year and the average Loss Identification Period is 2 years, that means the Incurred Loss in our portfolio is 90 million dollars.

Incurred Losses (IFRS) = Expected Losses (IRB Approach) * Loss Identification Period

On the expansion phase of the economic cycle the Loss Identification Period is longer due to the easiness for refinancing policies supported but the good economic conditions.

And according to the formula the longer Loss Identification Period will make the Incurred Losses higher during the expansion phase.

So we will get the counter-cycle behavior on the provisions for losses that we are searching.

What do you think?

Cheers.

Ferran

Counter-Cycle Provisions System. Chapter 2.

Dear SAP Banking Community members,

Some days ago, I made some comments about the advantages of adding Counter-Cycle Generic Provisions to the currently used system, based on the generation of specific provisions recognizing losses on failed loans.

Nevertheless, there’re some big difficulties on the implementation of a Counter-Cycle Provisions System.

First; we need a method to determine the volume of the provisions in a way that represents the real (fair) value of the portfolio.

Additionally the system must be consistent in the both phases of the economical cycle for avoiding any danger of arbitrary interpretations of it, but it also must have the counter-cycle behavior for which it has been designed, accumulating provisions on the expansion phase that will be consumed on the recession phase.

The basic idea is to implement the model under the hypothesis that failed assets are usually failed before they are actually “recognized” or “visible” as failed.

In my opinion, from that hypothesis we can build the counter cycle behavior.

We must assume that on the expansion cycle we have a number of loans which are actually failed, but they’re not visible as failed, as the economic conditions, and even the optimistic feeling of the whole financial system during the expansion cycle, prevents the failed loan to be made visible.

On the contrary, during the recession cycle, that optimism is over; and both, the failed loans generated on the recession phase, and those failed loans generated on the expansion phase are all made visible (that in fact generates the pro-cycle behavior of the current system).

If we build the provisions model using as the trigger of the provisions the failed loans generated in the two phases of the economical cycle and not only the “visible” failed loans, we’re closer to the Counter-Cycle Provisions System we must achieve.

The difficulty is how to build a system which measures the non-visible failed loans.

What do you think?

Kindest Regards.

Ferran.

Counter-Cycle Provisions System.

Dear SAP Banking Community members.

As several studies have proved, the specific provisions and capital requirements regulation implemented for protecting the depositors of a bank from the default risk of the banking activity, produces some pain on the economic system due to its pro-cycle behavior.

As the economy moves to the recession phase of the economic cycle the Default Risk increases and with it the Capital Requirements and Provisions grow.

That of course, limits the resources available for offering new loans or refinancing contracts, and finally generates a “Credit Crunch”, which increases the damage on the economy.

In fact the whole process works as a vicious cycle in which increasing the default risk, limits the lending capacity of the Financial System, ending in a Credit Crunch which pushes the economy in a deeper recession.

As the economic situation becomes worse the Default Risk increases and also the required provisions, starting the cycle again.

With the discussions of the new regulation for the Financial System, one of the proposals under consideration is the introduction of “Counter-cycle” Provisions in addition to some modification on the Capital Requirements.

In my opinion, banking activity behaves with a clear pro-cycle pattern, especially regarding the quality of their assets. When the economy is doing well, bank’s clients pay on time their loans. On the contrary when the economy falls into recession banks have to recognize losses and make higher provisions.

On the other hand, during the expansion phase of the economic cycle, some Banks, driven by the objective of increasing their market share, can make risky investments which will be the source of future losses.

The pro-cycle behavior of the provisions obeys to the risk perception itself.

The common view is that the risk is a consequence of the recession cycle, when the clients start to fail on their payment obligations. In my opinion a more realistic thinking should consider that the risk is a component of the Banking activity and it exists during the two phases of the cycle, but unfortunately it’s much more visible on the recession phase.

The basic description of a counter-cycle provisions model would work according to the following pattern:

- During the expansion phase of the economic cycle, when the “specific” provisions are small, the “generic” counter-cycle provisions should be high, recognizing the difference between the expected losses through the full economic cycle and the “specific” provisions of every year.

- During the recession phase, when the specific provisions are high, the bank will use the resources stored by the “generic” provisions during the expansion phase, limiting the credit crunch described at the beginning of this post.

Finally I think that the implementation of a counter-cycle provision model requires an integrated Risk and Capital Management System which permits the analysis of the origin of the risk during the whole economic cycle.

The described system should offer sophisticated reporting tools for supporting the bank managers on the evaluation and tracking of the provisions generation during the whole economic cycle; and specially how the resources stored by the generic provisions are utilized later by the specific provisions.

Looking forward to read your opinions.

Cheers.

Ferran.

Bank Analyzer Complexity, Business Content, Audit, Regulation and Flexibility.

Dear friends,
Some days ago I was discussing with a colleague about the difficulty of implementing SAP Banking, and Bank Analyzer in particular.
According to him, and I would say it's a common view on the market, Bank Analyzer is too complex and customers prefer other solutions "more flexible" than SAP.
Before discussing if that view is correct or not, maybe we should discuss first what does flexible mean.
Let's look at the Business Content of Bank Analyzer for AFI (it's just an example but it could be valid for other modules). Under the customizing layers of the BA Business Content, we have the standard calculations for valuation of Financial Instruments encapsulated in function modules or badis. Most of the common "Business Transactions" can be evaluated with the standard business content, but for some particular Business Transactions we have to enhance the calculation capabilities of Bank Analyzer.
It's true that enhance the business content with the necessary Calculation Procedures, Steps, Item Types, etc is not an easy task, but I honestly think it's a necessary one.
By following the structure of the Business Content, we have several advantages. Amongst others we have the possibility of reusing and documenting the elements of the calculation in an structure which let us identify easily what's standard and what's new, limiting the modification to what's strictly necessary and supporting the necessary tasks of auditing. With the new legal requirements for controlling the way in which risk is managed and valuations are done in Banks, making the systems auditable is an important asset, and the Business Content is an excellent tool for supporting a detailed audit of the system.
But, even if the implementation project resources are so limited that we cannot afford to enhance the Business Content, we can use "external" systems (including ABAP developments) for making the valuation and incorporate it to the standard calculations of Bank Analyzer by feeding the Results Data Layer with those data, before we transfer the results to the Analytics Layer.
Obviously, by following this scenario we lose most of Bank Analyzer advantages, but then, complexity and lack of resources shouldn't be an excuse, and we still keep a strong and auditable system for most of the Bank products covered by the standard Business Content. As new releases of Bank Analyzer Business Content will cover new requirements, we'll be able of replacing the external calculations by the standard ones.

What do you think?
Kind Regards.

Ferran.