Thinking beyond Basle
fa
risk management
Even as the Basle committee's proposals on BIS II compliance catapulted the issue
of capital adequacy back into the headlines of the world's financial press, Rl was
busy rolling-out its own BIS II compliant Credit Risk Portfolio Management (CRPM)
project based on economie capital theory. We asked two of the people responsible
for keeping Rl ahead of the regulators to bring What's NewS up to date on develop-
ments in the fast changing world of credit risk management. First Harkirat Singh
talks us through the theory of modern risk management, and over the page
Adriaan Kukler details the implementation of the CRPM project
Basic measures
Sophisticated approach
Counterparty risk methodology
Protecting capital
Active management
Correct correlations
What'sNewS Issue 1 January/February 200 7
From today's perspective, the Basle
c
committee's 1988 attempt to ensure
banks have sufficiënt capital to cover the
risk of losses looks hopelessly inadequate.
The Basle accord (BIS I) stipulation that
all internationally operating banks hold
physical capital (TIER I and II) of at least
8% of their risk weighted assets for coun
terparty, market and country risk, has
been rendered virtually obsolete by a
global market willing to trade in any risk
that can be separately modelled and
priced. To capture the complexity of to
day's market requires a new model of cap
ital, explains Harkirat Singh, special advi-
sor to the Board and general manager in
London.
'The notion of solvency underpinning the
original Basle Accord is basically a bal-
ance sheet management and allocation
tooi rather than a true measure of return
on risk capital,' says Singh. 'It works as a
multiplier by limiting the capital gearing
through the concept of risk weighted as-
sets. Hence it ignores rating implications -
a bank with less than 8% capital ade
quacy is considered undercapitalized, a
bank with more than 8% seems to be op
erating with "slack" in the system.'
To develop a model of capital capable of
working as a true risk measurement and
management tooi means moving away
from the concept of solvency to one of
economie capital. Or, put another way,
from a simplistic capital adequacy equa-
tion compromised by 'operational feasibil-
ity' to one based on qualitative differentia-
tion of counterparty, market, country and
operational risks. 'To date the goal of sol
vency management has been to increase
the return on sol
vency and hence
maximize earnings,'
Singh explains.
'From now on we
will be taking a more
sophisticated ap
proach, and looking
to safeguard the
shareholder's long
term interests by pur-
suing the optimum
revenues consistent
with preservation of
the bank's capital
over time.'
Harkirat Singh explains the new model
Making the move from solvency to eco
nomie capital requires a new emphasis on
the quantification of risk. In place of the
4-bucket product and counterparty risk
classification system used to calculate risk
weighted assets, comes a new, statistically-
based methodology which - by multiply-
ing expected and maximum counterparty
default probability, exposures and loss
percentages with defaulted counterparties
- anticipates expected and unexpected
losses to determine provisioning and risk
capital allocation respectively. Once loss
figures have been calculated they are then
assigned to all product transactions with
the counterparty - not just the obvious
candidates.
Singh elaborates: 'It also becomes possible
to stipulate that the net profit from a
client/transaction should at least cover all
the expected losses to arrivé at the risk ad-
justed result and to further stipulate that
the unexpected losses be provided with a
balance sheet cushion of "economie"
capital. We can then ask "what return
does the bank expect on this capital?"'
Deducting the capital cost from the above
risk adjusted result gives the economie
value add (EVA). A positive EVA result
means the bank's capital is increasing in
the long term. A negative figure suggests,
despite current earnings, that capital is be-
ing destroyed. 'Simply put,' he continues,
'this is the basic concept of economie capi
tal. By impiementing these measurement
tools we can begin to manage risk on the
business origination side by looking at all
transactions/ clients and asking "does this
produce a positive or
negative EVA?"'
Alongside the use of eco
nomie capital for more
accurate risk adjusted
pricing, these credit risk
measures also work on
the aggregation of indi-
vidual risks into portfo-
lios for risk/return profil-
ing which enables a more
sophisticated approach
to distribution. 'Unex
pected loss is a function
of expected loss and the
loss correlation across
assets,' explains Singh. 'The portfolio
manager should, logically, reduce name
and industry concentrations and increase
geographic diversification. Active portfo
lio diversification is, therefore, the logical
route to reducing economie capital at risk
and enhancing RAROC - Risk Adjusted
Return on Capital - but diversification
without the use of correlation analysis can
lead to a false sense of security.'
Take, for example, a bank with housing
loans and telecom exposures in its portfo
lio. While it might seem that risk is dimin-
ished by selling telecoms assets and buying
exposure to commercial property, in real-
ity the risk may have been increased. If in
that country the housing and commercial
property markets have a very high correla
tion, a crash in one would have a multi
plier effect on the other. 'Through correla
tion methodology we can identify classes
of assets with high or low estimated corre
lations,' says Singh. 'This allows us to de
velop optimal portfolio diversification
strategies to achieve a lower total
continued on page 4
