Johannes wernzs bank management and control

government • The increasing debt situation in Europe and especially in the EU, which led toincreased problems within the monetary union Euro • Problems with sovereign bonds according to

Management for Professionals

Management for Professionals

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Johannes Wernz

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These are challenging times for banking Within the last several years, the bankingindustry has changed significantly due to the global financial crisis As a reaction tothe macroeconomic situation, an entire series of governmental and new regulatoryrequirements have been implemented to meet the new developments and previouslyunderestimated risks.

This book focuses on bank management and control in terms of strategy, capital,and risk management in the context of the recent macroeconomic and regulatorydevelopments Such developments include the following:

• The implementation of Basel II (and the corresponding national standards such

as BIPRU in the United Kingdom) in 2006

• The economic and financial crisis that started with the mortgage bubble in theUnited States and spread to Europe and other parts of the world in 2007 and 2008(see Sect.3.9.2)

• The worsening situation regarding public debts in the United States in the earlyyears of the new century and the corresponding downgrading of the U.S federalgovernment by a credit rating agency (the first time that one of the agencies haddowngraded the U.S government)

• The increasing debt situation in Europe and especially in the EU, which led toincreased problems within the monetary union (Euro)

• Problems with sovereign bonds (according to Basel II, BIPRU, and othernational implementations, these were considered as being risk free; therefore,

as a result, banks accumulated lots of government bonds)

• The changes in Basel 2.5 that were first implemented in Switzerland and later inother countries

• The implementation of Basel III – as shortcomings of Basel II were observed inthe economic and financial crisis

The main topics in this book explore management and steering according todesired return, capital planning and capital optimization, and the implementation ofthe Basel Accords Bank management, strategy and capital planning, and riskmanagement are challenged within the perimeters of Basel 2.5 and Basel III.Going forward, there will be shifts in strategy for many banks due to the newregulatory requirements

v

Beginning with the economic and financial crisis in 2007, several banks facedspecific damaging consequences:

• The U.S bank Lehman Brothers crashed in 2008, despite expectations that theU.S government would rescue the bank

• In the United Kingdom, the Halifax Bank of Scotland (HBOS) – a merger ofHalifax plc and the Bank of Scotland – faced serious issues A merger of HBOSand Lloyds TSB under the new name Lloyds Banking Group resulted

• The Royal Bank of Scotland (RBS) also faced big issues As a consequence, in

2013, about 82 % of the RBS is still owned by the U.K government

• Other banks such as Dexia in Belgium and Depfa in Ireland were negativelyimpacted as a result of their refinancing schemes The banks did their refinancingshort term, whereas the lending was long term As interest rates developed totheir disadvantage within the crisis, huge losses were incurred Although Dexiawas bailed out with the help of Belgium’s tax payers, the bank once again facednew difficulties in 2011 because it had accumulated many sovereign bonds

• The bank HRE of Munich, Germany, purchased Depfa, and shortly after thepurchase, the economic and financial crisis hit and the above-mentionedrefinancing scheme resulted in massive problems for HRE HRE could only besaved with the help of Germany’s government and thus Germany’s tax payers

• Many of Germany’s Landesbanken, mostly belonging to German states such asNorth Rhine-Westphalia, Bavaria, or Saxony and to local Sparkassen (thrifts),misjudged the risks associated with securitized products like collateralized debtobligations (CDOs) and faced significant trouble beginning in 2007 TheLandesbank of North Rhine-Westphalia, the Du¨sseldorf-based WestLB, wasparticularly hard hit

• During the crisis of 2007 and in the subsequent years, UBS of Switzerlandrequested help from the Swiss state and the Swiss National Bank (SNB) UBShad misjudged the risks associated with securitized products (CDOs) and facedlarge losses Concentrations within its portfolio (such as securitizations from theUnited States) were detected too late

• In addition, IKB, a Du¨sseldorf-based bank (associated with the German state),which invested massively in securitized products from the United States, alsofaced massive losses

Almost every big bank is internationally invested and therefore is very muchaffected by influences originating from almost any part of the globe If one bankfaces a problem, many other banks are also affected Regulators faced a situation inwhich regulatory requirements were deemed to be insufficient Therefore, regu-latory requirements were adjusted and expanded Depending on the business model

of a bank, adjusting to new regulatory requirements will have a significant influence

on the bank’s capital allocation Thus, the risk/return management of the banks isaffected strongly Regulatory requirements for capital do have the most prominentinfluence on the return these days

Risk modeling has a significant influence on the capital requirement for thecorresponding business segment Risk modeling, therefore, has an impact on thereturn on equity (RoE) of the corresponding business segment It is part of the Basel

II philosophy that incentives are set to implement a good and granular risk agement So the improvement of risk management and the increase of granularitywithin risk management are often rewarded with lower capital charges Generally,the return on equity will be reduced when Basel III goes into effect To partlycompensate for this, many banks will improve their risk management and thecorresponding processes and governance within the next few years But evenexpensive projects aimed at improving the systems are often “highly profitable”

man-as they can have a big influence on the return

This book provides a systematic in-depth overview of all areas that are relevant

to the management of risk and return and therefore to banks’ strategy Thediscussed topics are embedded in the context of the regulatory requirementsrepresented by the Basel Accords (Basel II and Basel III) and the nationalguidelines This book focuses on the advanced approaches within the BaselAccords (see Sect.3.7), as these advanced approaches provide most opportunitiesfor improving risk management and thus for strategic considerations

An overview of the Basel Accords – the regulatory rules specifying therequirements for capital and reporting on risks – is given Also the nationalimplementations of the Basel Accords – such as BIPRU in the United Kingdom,the Rundschreiben in Switzerland, and the Solvabilita¨tsverordnung in Germany –are discussed in Sect.3.7 The philosophy and evolution of the Basel Accords arediscussed and important details of the rules are emphasized

Terms like “Basel,” the “Basel Rules,” and the “Basel Accords” are usedsynonymously in this book

I would like to thank my colleagues and partners for their insightful commentsabout the topics discussed in this book In particular, I would like to thank

• Prof Dr Andreas Blumer,

• Prof Dr Volker Reichenberger, and

• Prof Dr Marc-Oliver Otto

And last but not least, my thanks to Christian Rauscher, Elizabeth Aseritis,Janish Aswin and Barbara Bethke

Psalm 136:1 – O give thanks unto the LORD; for he is good

1 Outline 1

2 Bank Management and Steering 3

2.1 Strategy Planning: Iterative Process 3

2.1.1 Process of Planning 3

2.1.2 Capital Allocation 6

2.2 Strategy Planning: Tools 8

2.2.1 EaR/CaR: Overall Aggregation 9

2.2.2 Scenario Based Assessment/Stress Testing 13

2.3 Capital Optimization 23

3 Banks in Their Regulatory and Economic Environment 25

3.1 Economic and Political Aspects 25

3.2 Types of Banks 26

3.3 Banks in Different Legislations 27

3.4 Role of the Banks’ Credit Rating 28

3.5 Role of Rating Agencies 28

3.6 Role of the International Swaps and Derivatives Association (ISDA) 29

3.7 Regulatory Environment 29

3.7.1 BIS 29

3.7.2 BIS and the Great Depression: History in a Nutshell 30

3.7.3 Basel II 30

3.7.4 Basel 2.5 32

3.7.5 Basel III 32

3.8 Issue Overview 35

3.9 Issue Complexity and Risk Identification 36

3.9.1 Sale- and Lease-Back-Transactions 36

3.9.2 Securitization and Subprime 37

4 Risk Modeling and Capital: Credit Risk (Loans) 39

4.1 Pricing and Expected Loss 39

4.1.1 Adverse Selection 40

4.1.2 Risk Adjusted Pricing and RoE 40

xi

4.2 Loan Loss Provisioning 40

4.3 Capital: Relevant Points 41

4.3.1 Default Definition 42

4.3.2 Maturity 43

4.3.3 Granularity of Rating Engines 45

4.3.4 Classification of Assets 46

4.3.5 Recent Bubbles 48

4.3.6 Downturn PD 49

4.3.7 Missing Values 50

4.4 PD-Rating Tools and LGD-Tools 51

4.5 Rating Tools (PD) 51

4.5.1 Development of Rating Tools 51

4.5.2 Calibration of the Rating Tools 53

4.5.3 Example of a Corporate Rating Tool 55

4.6 LGD-Tools 57

4.6.1 LGD-Tool for Machinery Like Cars, Trucks, Planes, Construction Machines 58

4.6.2 LGD-Tool for Mortgages 60

4.7 Backtesting Within Credit Risk 63

4.7.1 Backtesting Versus Validation 63

4.7.2 Backtesting 63

4.7.3 Backtesting Framework PD 65

4.7.4 Backtesting Framework LGD 67

5 Risk Modeling and Capital: Counterparty Credit Risk (EPE) 69

5.1 Cash Flows and Exposure 69

5.1.1 Consideration of Collateral 71

5.1.2 Parameters Within EPE 72

5.2 American Monte Carlo Simulation/Longstaff-Schwarz-Regression 72

5.3 Wrong Way Risk (WWR) 72

6 Risk Modeling and Capital: Credit Risk (Securitizations) 75

7 Risk Modeling and Capital: Market Risk 77

7.1 Pricing 77

7.2 VaR 77

7.3 Risks Not Covered in VaR 78

7.4 Backtesting 79

8 Risk Modeling and Capital: Operational Risk 81

8.1 AMA Model: Scenarios 81

8.2 AMA Model: Modeling and Simulation 84

8.3 Internal Data/External Data 91

8.4 Controls 91

8.5 Backtesting 92

9 Risk Modeling: Asset Liability Management (ALM) 93

9.1 New Measures LCR and NSFR 93

9.1.1 LCR 94

9.1.2 NSFR 94

9.2 Impact on Liquidity Planning and Business 96

9.3 Impact of the Corporations’ Own Rating 96

10 Appendix: A-IRB Formulas for the Derivation of Risk-Weighted Assets 97

10.1 Residential Mortgage Exposure 97

10.2 Qualifying Revolving Retail Exposures 98

10.3 Other Retail 98

10.4 Corporate, Sovereign, Banks and Financial Institutions 98

10.5 Big Banks and Financial Institutions 99

10.6 Corporate: SME 99

10.7 Specialized Lending 100

10.8 Granularity Adjustment 100

11 Appendix: Credit Portfolio Modeling 101

12 Appendix: Country Risk/Issuer Risk 103

13 Appendix: Settlement Risk and Systemic Risk 105

14 Appendix: Historical Data 107

Abbreviations 111

Glossary 115

Bibliography 119

Outline 1

This book is divided into the following chapters: Chap.2deals with all issues relevantfor bank management and steering, for strategy, and especially for the risk-returnmanagement In this chapter, banking models are examined In Chap.3the economicand political situation is discussed and the regulatory framework and the develop-ment of the philosophy within the Basel Accords are presented Chapters4,5, and6deal with all manifestations of credit risk (loans, trades (EPE) and securitization).Risk and return relevant topics such as risk adjusted pricing and the underlyingparameters are illustrated Risk models are presented Chapter7deals with marketrisk, whereas Chap.8deals with OpRisk In Chap.9asset liability management isdiscussed

Relevant topics such as capital optimization are discussed in greater detail, andthe important issues regarding risk adjusted pricing are addressed in varioussections throughout the book

Bank management and risk-return management are the main topics in this book.Issues that do have a direct impact on risk-return management are thereforehighlighted in grey boxes embedded within the sections

Regarding Capital and Capital Optimization this means…

Bank management and risk-return management are mainly influenced by theregulatory requirements and thus by the changes to capital charges that are requiredthese days The other recurring topic in this book is therefore the Basel Accords(Basel II and Basel III) Topics related to Basel III (Basel III went into effect in2013) are highlighted and outlined in dark grey boxes embedded in the sections

Regarding Basel III this topic is highly relevant, as

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The sample bank described in this book is typically found in banking capitalssuch as London, Zurich or Frankfurt The illustrative bank is a universal full-servicebank; on the one hand it has strong roots in businesses like national retail andcorporate loans (mortgages, consumer loans, loans to SME and big corporations,specialized lending), and on the other hand it also is a strong investment bank wherethere is significant wealth management The example bank recently increased itsactivity within Asia, especially within the wealth management segment.

All presented balance sheet figures, risk weighted assets (RWA) and capitalfigures are realistic vis-a-vis banks based in London, Zurich or Frankfurt

The regulatory capital is calculated according to Basel II and Basel III.Assessments are made according to the discussed macroeconomic scenarios Forthe national bank there are portfolios of mortgages, of consumer loans and loans tosmall and medium enterprises (SMEs) and big corporations; for the investmentbank there are loans to other banks, to governments and also to big multinationals,and there are trading portfolios consisting of all kinds of stock, commodities andderivatives

Bank Management and Steering 2

Appetite, risk appetite – how much of it, with what consequences, with what impact

on the strategy and on the volatility of earnings? This is a fundamental question inbank management

Managers are often tempted by high profits, especially when there are newproducts on the market that promise high profits; the buying pressure is great; onewants to participate Often, the volatility of earnings is disregarded Risk and returnare, however, almost always coupled

How much volatility of earnings (and therefore the probability of a total loss) canone tolerate? Often one chooses a mix For example, one could decide to invest 60 %

of the capital in the investment banking business with the hope of bigger returns andone could invest 40 % of capital in the national desks – especially retail – hoping forstable results there Retail business – for example, mortgage and consumer loans –generally offers a lower return, but there is lower volatility of the results, in the sensethe results are more “stable.” The total return and the overall volatility of thedistribution result from the mix (in this example, 60/40)

To shift the distribution of the business short term is often not possible but can beachieved, for example, by means of an acquisition The acquisition of Postbank bythe Deutsche Bank in 2010 is one such example The Deutsche shifted its strategyand thus the business by its strategic decision toward a higher share of retailbusiness

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assess the potential strategies associated with the risk appetite, and also to assess theconsequences of the strategies (Fig.2.1).

The senior management decides which return on equity and thus which volatility

of the profits is desirable A rather risk-averse bank might decide that a return onequity of 11 % is sufficient There is lower volatility then, so the returns tend to bepretty stable One can expect that the 11 % can be achieved in most years A risk-taking bank possibly decides for a return on equity of 20 % The increased riskappetite and thus the higher return are associated with higher volatility It may bethat in one year the 20 % can be achieved, while the return in the next year goesdown or even is negative

Whatever the decision, the risk appetite needs to be translated into a strategy

In the first case in our example the bank will probably strengthen the lending tosmall and medium enterprises (SMEs); in the second example the bank tendstoward commodities trading or securitization

The strategy has implications for many parts of the bank Finance, treasury andrisk should therefore be involved in the planning process To determine whether thechosen strategy can provide the required return with sufficient planning security,the risks should be assessed with an overall tool This tool considers all divisions/desks, regions and categories of risk The corresponding Value at Risk (VaR) iscalculated by aggregating all these pieces and bits

The VaR is always calculated for a given quantile To each considered quantile arisk capacity is assigned The resulting rules are explained in detail below It makessense to choose one quantile of the overall VaR, which assesses the threats torevenues, and another quantile that assesses the threat to capital The followingmeasures result from these considerations

2 Define Strategy

8 Modify Strategy

3 Determine Earnings and EaR/CaR for the (new) Strategy

4 Determine Capacities for the Strategy

5 If EaR and CaR are within their Capacities 6., else 7.

6 Accept Strategy

1 Define Risk Appetite and RoE

7 Modify RoE Fig 2.1 Iterative process

of the strategy planning

• The “earnings at risk” (EaR) are calculated at a quantile of 95 % The meaning ofthis definition of EaR is that the calculated risks at this quantile manifest once in

20 years

• The “capital at risk” (CaR) is calculated at a quantile of 99.9 %, whichcorresponds to the “regulatory measure” (the Basel measures are mostly calcu-lated at the quantile of 99.9 %) The meaning of this definition of CaR is that thecalculated risks at this quantile manifest once in 1,000 years

To each of the defined risk measures a capacity is assigned Capacity1 isassociated with the measure earnings at risk (earnings at risk are calculated at aconfidence level of 95 %)

Capacity1¼ Income before tax including bonuses and dividends

The condition is as follows:

Capacity1> Earnings at Risk

This condition implies that losses erasing dividends and/or bonuses should occuronly once in 20 years at the maximum

The so-called Capacity2 is assigned to the measure capital at risk (capital at risk

is calculated at a confidence level of 99.9 %)

Capacity2¼ Capacity1 plus capital

The condition is as follows:

Capacity2> Capital at Risk

This condition implies that losses erasing the capital and leading to bankruptcyshould occur only once in 1,000 years at the maximum

Besides the above requirements, the regulatory requirement is always: theremust be enough capital to satisfy the following:capital/RWA> x In the UnitedKingdom x will be increased step by step up to 11.5 % within the next few years; inSwitzerland it will be increased up to 19 %

With the help of earnings at risk and capital at risk and their correspondingcapacities the following example could result:

• With the strategy to increase loans for SME, the return on equity (RoE) can bereached within 19 of 20 years This is a result of the comparison of EaR and thecorresponding Capacity1 (see Fig.2.2)

• With this strategy total losses occur less than once in 1,000 years This is a result

of the comparison of CaR and the corresponding Capacity2 (see Fig.2.3)

So the decision of senior management in this example would presumably be toimplement the discussed strategy

On the other hand perhaps the following example resulted:

• The strategy to increase investments into commodities and securitization impliesthat the desired RoE can only be reached in 12 of 20 years (see Fig.2.4)

• Besides, total losses occur five times within 1,000 years (see Fig.2.5)

Compared to the first discussed strategy potentially higher incomes result (bothcapacity measures are increased) On the other hand risk is increased so much thatthe EaR are bigger than Capacity1 and the CaR is bigger than Capacity2 As aconsequence this strategy should not be implemented, rather it should be modified

2.1.2 Capital Allocation

In the above discussed example the first strategy will be implemented The capitalhas to be allocated to the investment bank and to the national part of the bank.Table2.1shows the overall regulatory capital for the bank according to Basel II.The capital is then also shown as calculated according to CaR Table2.1and thecomparison Basel II vs CaR are discussed in detail in Sect.2.2.1

The desired yields are as follows:

• Sixteen percent for the investment bank – to compensate for the higher risks – and

• Eleven percent for the national part of the bank

7 Dividend and

Recapitalization 4

Bonuses 4

27.7

Earnings 8

The allocation of the capital and the volatility of the results are shown inTable2.2.

There is a total of 17.1 billion for credit risk of which eight billion are allocated

to the national part of the bank (mainly mortgage loans, loans to SME and bigcorporations) and 9.1 billion are allocated to the investment bank (big loans tomultinationals, credit risk in trading (see also Chap.5) and securitization).There is a total of 4.2 billion for market risk Of this amount 3.3 billion areallocated to the investment bank and 0.9 billion to the national part of the bank Thetotal of one billion for investment risk is completely allocated to the investmentbank

12

Dividend and Recapitalization 5

Bonuses 5

27.7

Earnings 10

Fig 2.5 Capacity2 versus CaR – in this case acceptability of risks is not given

The Operational Risk (OpRisk) capital of four billion is distributed in thefollowing way: 2.5 billion are allocated to the investment bank and 1.5 billion tothe national part of the bank Issuer Risk (sovereign bonds) according to Basel forthe most part does not have to be underpinned with capital (when the bonds do have

a good external rating (see Chap.12for Issuer Risk)) Funding Risk and other riskslike pension risk do not have to be underpinned with capital according to Pillar 1

With the help of such tools like

• the overall VaR measures EaR and CaR and

• the overall stress testing,

which are discussed hereafter, the desired strategy is challenged and then assessedwhether it holds from an earnings as well as from a capital point of view

Table 2.1 Capital (Billion EUR) according to Basel II and according to internal models (CaR)

Basel II CaR (internal model)

Table 2.2 Yield and volatility of the results

Capital Yield (%) Volatility of the results (%)

2.2.1 EaR/CaR: Overall Aggregation

Using overall measures like EaR and CaR it can be determined which loss amountcan occur for the desired/chosen strategy Each risk kind is considered andaggregated Within the process of aggregation correlations between differentkinds of risks are a key element The parameters are determined with the help ofdata observed within the last several years These data are the default rates withincredit risk, the historical market movements within market risk and the historicallosses within OpRisk (internal and external data)

In Table2.3Risk Weighted Assets (RWA) according to a typical Pillar 3-Report(ICAAP) for the year 2014 are shown The bold rows show new elements that areimplemented as a result of Basel 2.5

In this example, Credit Risk from trading can be found mainly within the rowsCorporates and Banks The total of the risk weighted assets (RWA) equals a capital

of 39 billion (corresponding to 8 % of the RWA)

As a comparison in Table2.4the results for Basel II and Basel III are shown

Table 2.3 Part of an ICAAP-report

Basel III RWA in billions Thereof Thereof

2.2.1.1 Internal Modeling of EaR/CaR

The measures EaR and CaR are calculated with the help of an overall VaRsimulation The occurring risks (defaults, stock prices, OpRisk incidents .) arepartly influenced by each other These dependencies (or correlations) are given inTable2.5

The correlations are calculated with the help of correlation analyses (taking intoaccount correlations between default rates and stock prices for example)

In Credit Risk Credit Portfolio Models (see Chap.11) are often used A CreditPortfolio Modeling corresponds to a credit VaR modeling Different obligors(coming from different sectors and regions) are coupled to (or influenced by) theoverall economy differently Within market risk the VaR – usually representing atime horizon of 10 days within market risk – must be scaled to a time horizon ofone year Within Operational Risk the modeling is done as outlined in Chap.8.Values for the CaR as shown in Table2.1might result

2.2.1.2 Overall Simulation

Within the overall simulation (Fig 2.6) all the kinds of risks are included Therelevant risks depend on each other as outlined in Table2.5

Table 2.4 Capital according to Basel II and Basel III

Investment risk (%) OpRisk (%)

Issuer risk (%)

Funding risk (%)

Other risks (%)

The less strong the correlations are the more the so-called diversification benefitcan be observed.

Figure 2.7shows the mechanisms of correlation On the left side there is nocorrelation (correlation¼ 0) The value of the second risk factor (for example,stock prices within market risk) is independent of the value of the first risk factor(for example, a default rate within credit risk) In the middle the value of the firstrisk factor influences the value of the second Mathematically, this corresponds to aconvolution

The comparison is discussed in detail in the following Sect.2.2.1.3

Monte Carlo Simulation

Inputs: Gains/Losses/Correlations

Fig 2.6 Monte Carlo simulation and its inputs

RF 1

RF 2

Fig 2.7 Dependency of the risk factors (RF), transmitted by the correlations

2.2.1.3 Comparison Internal Modeling of CaR Versus Basel II

The example given in Table2.6shows the differences that might occur betweenthe regulatory requirements according to Basel II and the internal assessment,calculated with the help of CaR The reasons are discussed hereafter

From a Pillar 2 point of view the resulting 30 billion are sufficient (Table2.6),

as these 30 billion are less than Capacity2 (in our example Capacity2 is 35.7 billion;see also Fig 2.3) All risks are considered; therefore the requirements of Pillar

• Probability of Default (PD) and

• Loss Given Default (LGD),

• Maturity,

• Business volume, and

• To a greater extent the correlations between obligors

Formulas are provided in Chap.10 In the Basel formulas predefined values forthe correlations are implemented, and there is a “hard coding” of these correlations.According to the majority of research papers written on the topic these correlationsare too high and thus quite conservative – at least for few regions and industrialsectors (see Table2.7)

On the other hand during the credit crunch in the United States (beginning in2007) even higher correlations were observed – at least for the sub-prime loans.Analyses of time series for Switzerland lead to the conclusion that the correlationscould be of the magnitude as shown in Table2.8 Values in this table are used inthe internal credit portfolio models (see Chap.11) rather than the Basel values

Table 2.6 Comparison CaR/Basel II

Basel II CaR (internal model)

One interesting observation is that the values provided within these papers differquite drastically In Table2.8the resulting capital charge according to Basel andthe internal model (calculated for the corporate segment of two large Swiss Banks)

is shown

In Table2.9a comparison between the EaR and the CaR values is provided

With the help of scenario based assessments (SBA) and stress testing banks andinsurance companies can assess the upside potential and the downside risk of their

Table 2.7 Asset correlation according to different sources

Moody’s KMV ( 2008 ) Moody’s KMV 1981–2006 7.87–29.98 %

Dietsch and Petey (2004) Coface 1994–2001 0.12–10.72 % Hamerle et al (2003) Standard and Poor’s 1982–1999 0.4–6.04 %

Table 2.8 CaR – depending on the asset correlations

Basel II/Basel III Bank 1 Bank 2

Capital at risk credit risk (99.9 %) X CHF about 1/2 * X CHF about 1/3 * X CHF

Table 2.9 EaR and CaR

EaR (internal model) CaR (internal model)

business as a whole under different future developments As there are manydivisions/desks within the bank and many different sub portfolios it is often difficult

to assess banks’ and insurance companies’ overall chances and risks (over allcountries and regions and over all desks/asset classes) – nevertheless this overallassessment can be done with the help of holistic scenario based assessment andstress testing

The advantage of scenario based assessments and stress testing is that these toolsare not that much influenced by the past, rather these tools are expert based andforward looking Ideally the previously discussed tools like EaR and CaR and thescenario based assessments and stress testing are done in “parallel,” meaning thatthere is a mutual benchmark of the respective results

As mentioned, for scenario based assessments and stress testing there is norestriction due to missing or biased historical data There is no a priori restriction.Also, outside the box thinking can be reflected within the scenarios

One, nevertheless, has to consider certain causes and effects that have to bereflected in modeling the scenarios As an example one can assume that risingunemployment within a country or region causes increasing default rates within thatcountry or region There are few of these causes and effects that should beconsidered in the modeling process

Two detailed scenarios are provided in the following On the one hand arecession scenario and on the other hand a stagflation scenario is shown in detail

By using EaR and CaR and scenario based assessments and stress testing thestrategy of the bank is challenged Different banks put different emphasis on certainscenarios The scenarios provided in this chapter are modeled for big universalfull-service banks; nevertheless others can use the relevant parts of these scenarios.For big universal full-service banks it is important to have holistic parameter setscovering countries and regions worldwide and covering the whole spectrum of riskparameters such as

• Gross Domestic Product (GDP),

• Commodity Prices (Oil, Gold .)

Different locations and subsidiaries and business units/desks apply the relevantparameters provided by the group (holding/parent company) and report back theirspecific results – in terms of P&L impact and capital consumption (see Fig.2.10).Concentrations that are not material to subsidiary and/or business unit levelmight get material on group level One big opportunity of the scenario basedassessments and stress testing is the holistic view it can provide The SBA is able

to identify possible concentrations or wrong way risks at a group level (see Sect.5.3about wrong way risk) It might be that there are concentrations that were notpreviously identified For example few subsidiaries might hold stock in the sameregions of the world (there might be a concentration on a group level) Anotherexample could be that a national subsidiary provided many loans in one regionwhereas the investment bank sold many CDS on firms in this region.

There are primary parameters in these scenarios such as GDP, stock prices andinterest rates (these primary parameters are provided by the experts and economists).And then there are secondary, derived parameters, which are derived from theprimary ones with the help of models and regressions There are IR/FX modelsand regressions of the GDP versus PD for example

In Tables2.10and2.11the primary and secondary parameters of the recessionscenario are provided for three subsequent years The recession scenario ismotivated by the following assumptions:

• There is a recession in the United States, caused by federal, state and localcommunity budget reductions Therefore imports decrease

• Thus the recession spills over to Europe In Europe the increasing sovereigndebts become critical and several banks go down, which has implications on thereal economy (loans are provided more reluctantly)

The holistic parameter set consists of the primary parameters (Table2.10) and thesecondary ones (Table2.11) derived from the primary parameters with the help of themodels and regressions (shown in Fig.2.8)

In Tables2.12and2.13the primary and secondary parameters of the stagflationscenario are provided for 3 subsequent years The stagflation scenario is motivated

by the following assumptions:

• The debt crisis in the United States and Europe lingers on

• Economy stagnates

• The steps taken by the national banks lead to significantly increased inflation.The holistic parameter set consists of the primary parameters (Table2.12) andthe secondary ones (Table2.13) derived from the primary parameters with the help

of the models and regressions (shown in Fig.2.9) Within the stagflation scenarioinflation is a primary parameter (which is not the case for the recession scenario)

In a first step the parameter sets are provided for each division/desk of the bank.Within the divisions and desks the stressed values are determined In a second stepthe aggregation is done on a group level (see Fig.2.10)

To explain the scenarios past crises should also be considered (see Chap.14).Scenarios should be prioritized according to their probability Table2.14shows

an example of stress testing values compared to Basel II values

Table 2.10 Primary set of parameters of the recession scenario

Table 2.11 Secondary set of parameters of the recession scenario

•Commodity Prices: Oil, Gold

Fig 2.8 Process of the determination of parameters within the recession scenario

Table 2.12 Primary set of parameters of the stagflation scenario

2.3 Capital Optimization

There are quite few motivations for capital optimization; an increased return onequity (RoE) is a key motivation This increase is often possible because better riskmanagement and thus awareness is rewarded by the regulator

•Commodity Prices: Oil, Gold

Fig 2.9 Process of the determination of parameters within the stagflation scenario

In the following chapters most issues regarding capital optimization arediscussed The corresponding issues are highlighted in a box These issues can beused as a “checklist.”

Whenever issues regarding capital and thus the return on equity are discussed,they are highlighted by a light grey box summarizing key points

Regarding equity this means…

Table 2.14 Results of stress testing (in terms of capital) compared to the Basel II requirements

Parameters provided to the Divisions (IR, FX to the

Investment Bank; PDs and house prices to the national

Division; IR, FX, own spread to Treasury/Finance)

Calculations within the Divisions/Desks

Aggregation on Group Level

Fig 2.10 Subsequent steps within scenario based assessments and stress testing

Banks in Their Regulatory and Economic

Banks serving as an interface between investors and borrowers are important for theeconomy Banks provide loans and enable private and commercial investment andgrowth Most people buying a house or a flat need a loan Also most companies canhandle larger investments only through loans Lending and the associated riskassessments are key tasks of the banks’ business Money from savers, investorsand from central banks is provided to economy Thus it is important that the bankcan borrow enough money from the central bank, from other commercial banks andfrom savers and that this supply is not interrupted – as it can happen in times of acrisis It should be ensured that the depositors’ money in almost any case is not lost.Confidence in the system – avoiding massive withdrawings of creditors’ money – is

an important element The failure of a bank can trigger a domino effect in thebanking world When banks mistrust each other and reduce lending, the economy isalso affected For many people the bankruptcy of the U.S bank Lehman Brothers in

2008 was a shocking experience, especially for countries and economies in whichthe banking sector plays a dominant role For example in Switzerland, it is a hugedilemma of what to do in such a crisis situation The big banks are just too big; theyare “too big to fail.” One consequence is the current regulatory request that bigbanks should be providing living wills and resolution and recovery planning(see Sect 3.7.5.8) The economic and financial crisis of the recent years tookplace against the background of past political, technological and economicdevelopments and regulatory decisions These are in particular the following:

• In 1986, the British Prime Minister Margaret Thatcher liberalized stock trading.The legislative package was subsequently referred to as the “Big Bang.” Stocktrading became easy and cheap

• U.S president Bill Clinton repealed the Glass-Steagall Act in 1999 This lawfrom the 1930s (which was enacted after the Great Depression) prohibited banksfrom doing traditional lending and investment banking at the same time

J Wernz, Bank Management and Control, Management for Professionals,

DOI 10.1007/978-3-642-40374-3_3, # Springer-Verlag Berlin Heidelberg 2014 25

• The SEC (the U.S Securities and Exchange Commission) in 2001 lowered theminimum tradable amount of 16 cents to 1 cent After which high-speed tradingwas reinforced.

• In 2005, the German government passed a law that allowed corporations to selltheir shares of other corporations tax free The mutual interdependences of theso-called “Germany Inc.” were repealed thus increasing pressure in the firms

• Also in 2005, stock exchanges in the United States introduced e-trading.All these developments must be seen in the context of deregulation and globali-zation starting in the eighties These developments were accompanied by fasttechnological changes

In Germany and Switzerland there are a number of banks that operate almostexclusively within saving and lending; for example, the district savings banks andthe local cooperative banks There are many special banks and numerous car banks

In Switzerland a Cantonal Bank (Kantonalbank) is assigned to each Canton Thethrifts (Bausparkassen) in Germany play a major role in mortgage financing Also,most universal full-service banks have important divisions/desks, which are in thelending business

Investment banks are active in mergers and acquisitions (M&A); they bringtogether investors and borrowers, and they help companies with initial publicofferings (IPOs) Moreover, they are market makers in the pricing of products.They are active in proprietary trading, they do investments in promising businesses(for example for their clients within wealth management) Some investment banksare (or were) Goldman Sachs, Merrill Lynch, Morgan Stanley, Lehman Brothers,Bear Stearns and Salomon Brothers Some of the investment banks went bankrupt,others transformed into more of a universal banking group, and others gave up theirstatus as an investment bank

Banks performing on both the lending business in a particular market as well asasset management and investment banking are considered as universal full-servicebanks here

• In the United Kingdom, Lloyds Banking Group, which is also strong in theinsurance sector, is an important example

• In Switzerland, UBS and Credit Suisse are the two dominant banks They areactive in asset management, domestic and international lending (mortgages andcorporate) and, of course, investment banking

• In France, BNP Paribas, Credit Agricole and Socie´te´ Ge´ne´rale are prominentuniversal full-service banks

• In Germany, the Deutsche Bank is a universal full-service bank The Deutsche is

in the lending business for large corporate clients and also strong in retailbanking (especially since the purchase of Postbank) and it is active in investmentbanking