Challenges in Market and Counterparty Risk Management

1. Challenges in Market and Counterparty Risk Management How to solve the critical issues? Solutions that can help. Reinhard Keider; Head of Risk Architecture and Risk Methodologies in Bank Austria ZADAR, 14 May 2011

2. Don´t ever try to understand everything, some things will just never make sense.

3. I guesssomeofyoumightagreewiththissaying. Despitethis I will tryto • Makemybriefpresentationunderstandable • Andhopefullyitmakesensetoyou. ….so let´sstart !

4. AGENDA • Part 1: Market Risk Management • Part 2: Counterparty Credit Risk • Part 3: New regulatory framework (Basel 2.5/3)

5. Part 1: Market Risk Management Market Risk Management must be seen as an integrated approach. Successful Market Risk Management should cover at the least the following topics: • Risk Management Unit to be independent from business unit • Consistent framework where to operate (RM handbook, clear and transparent limit structure, Escalation path in case of limit violation) • Combination of limits: VaR limits, sensitivity limits, options limits • State of the art model for monitoring/steering market risk (internal model internal/external) • Coverage of the relevant instruments/products • Consistent Market data, risk factors and time series • Flexible architecture to include new products fast and efficient • Experienced people within Risk Management Unit

6. Components of MR Management • Dependent on asset classes within the bank a market risk tool needs to cover FX products, Interest Rate Instruments (both linear and non linear ones), Equity and Credit Spread linked instruments. Currently commodity and inflation linked products need to be covered properly. • The number of Risk Factors plays important role to reflect a realistic risk picture (e.g. FX: 75 currencies, 45 IR curves, 5000 EQ, 250 Spread Curves, Vega risk: 2000 risk factors) • State of the art modelling in terms of simulation; Historical simulation, Monte Carlo Simulation for monitoring/steering market risk (internal model internal/external) • Stresstesting: importance still increasing; standard scenarios and macro economic scenarios (e.g. Greece default, inflation, terror attack) • Export /Transfer module and data source module allow fast integration of new requirements • Reporting engine to fullfill various information needs • Backtesting gives answer about to model qualtiy

7. Comparison of current and new Market Risk Capital Requirements for Trading Book Current Approach New Approach Value-at-Riskbased capital charge Value-at-Riskbased capital charge Incremental Risk Charge (IRC) + Specific Risk Surcharge (capture default risk) + Stressed VaR + CRM for correlation trading portfolio + Capital from standardised approach + capital from revised standardised approach +

8. Part 2: Counterparty Credit Risk (CCR)Basic definition, types of CCR • Counterparty Credit Risk (CCR)istheriskthat a counterpartytofinancialcontractsfailstofullfiltheobligations (payments, deliveryofassets) agreed in thecontracts. • Twotypesof CCR aredistinguished • Settlement Risk:The counterparyfails in settelingits due paymentsordeliveries • Presettlement RiskThe counterparydefaultsbeforecontractsettlement Followingproductsaresubjectto CCR: • OTC-derivatives (noexchange-tradedinstruments) • Securities Financing Transactions (SFT) (e.g. securitiesborrowingandlending, repurchaseandreverserepurchaseagreements)

9. Why to introduce an internal model for counterparty credit risk? Key benefits? • Improvement of Internal risk management: • A state-of-the-art model allows realistic assessment of actual counterparty credit risk exposure • Allows efficient use of credit lines by supporting risk mitigating effects: • Full Netting effect • Margining • Portfolio effects • Capital calculation: • Same risk mitigation effects as for internal risk management apply • Usually Significant RWA reduction compared to Current Exposure Method to be expected • Risk adequate pricing: • Unilateral/Bilateral Credit Valuation Adjusments supported, taking full portfolio view into account

10. Counterparty Credit Risk Aspects of Managing Counterparty Credit Risk 10

11. Quantitative measures for CCR Exposure measure and purpose

12. 7.0% 6.0% Limit 5.0% 4.0% EE USD interest rates (%) Exposure 3.0% PFE Reduction) 2.0% 1.0% 0.0% 0 2 4 6 8 10 0 2 4 6 8 10 12 Time Time Internal Counterparty Risk Model Model overview and components Market data Product valuation models Transaction data Counterparty data Risk Management • Spot rates • Yield curves • Volatilities • etc. • Vanilla options (Black Scholes) • Exotic (accrual, extendable) • Barrier (standard, double) • Swaption, cap/floor • etc. • Swap rate • Reference rate • Settlement frequency • Maturity • etc. • Legal agreements • Netting data • Collateral data • Country • etc. • Limit monitoring • Capital requirements • Credit Valuation Adjustment • Reporting • Stresstesting • Validation Market data pre-processing Aggregation Scenario engine Instrument price distributions Output USD interest rates Value of swap (% of notional) Time

13. Part 3: Basel 2.5 and Basel 3 Chapter Title - Chapter Section Title Challenges to the Banking industry in front of new Basel regulations

14. Current situation (Basel II) • VaR based Trading book capital charge calculated using 99% quantile of 10 day loss • Common assumption: • Losses from issuer defaults in trading book positions negligible since • – Mainly high rated issuers in trading book • – Positions are sold in case of downgrading • Financial crisis: • Losses >> trading book capital charge occurred • (e.g. Lehman Brothers) • Particularly positions subject to credit spread risk (cds, cdo,bonds,…) • Significant part of the losses not caused by actual defaults but by • rating migrations

15. Regulatory Response • Basel Committee proposed changes to the capital requirements for the trading book: (mainly for internal model) • Incremental risk charge (IRC), specific risk • Stressed value-at-risk, general risk • Comprehensive risk measure for correlation trading activities • For remaining securitization products the capital charges of the banking book apply Implementation date: 31 Dez. 2011

16. Timeline for Basel 2.5 and 3 Dec. 2010 Basel III ~finalized ‘A global regulatory framework for more resilient banks and banking systems’ Dec. 2009 Basel III first draft, ‚Strengthening the resilience of the banking sector‘ Jan 2013 Initial rise in capital from Basel III Stressed EPE, Market Risk CVA charge,.. Leverage ratio Liquidity ratio .. Final implementation 2019 Dec. 2011 Basel 2.5 goes live IRC, CRM, Stressed VaR,.. …July 2009 Basel 2.5 proposal Finalised June 2010 IRC, CRM, Stressed VaR,..

17. Basel Reform Programme: Focus on Counterparty Credit Risk - Overview A. Capital Base B. Counterparty Risk C. Leverage Ratio D. Procyclicality E. Liquidity Standard Raise quality, consistency and transparency of bank's capital base Strengthen risk coverage, amending July 2009's trading book and securitization reforms by adding capital requirements for counterparty credit risk Introduce a "leverage ratio" as a supplementary measure to the Basel II framework with in order to build up excessive leverage in the banking system Promote measures for building up capital buffers in good times that can be drawn upon in stress periods Promote measures for building up capital buffers in good times that can be drawn upon in stress periods EXAMPLES • Determine capital requirement for counterparty credit risk using effective EPE calculation for a period of stress (similar to 2009' proposal regarding market risk stressed VaR) and • Introduce captial charge for mark-to-market losses (ie credit value adjustment losses = CVA risk) associated with deterioation in the credit worthiness (not necessarily default) of counterparties • Strengthen standards for collateral management and initial margining. Eg banks with large and illiquid derivative exposures will have to apply longer margining periods. • Banks with exposure to central counterparties (of those are meeting some CPSS/IOSCO "strict criteria" only) will qualify for a zero percent risk weight. • Include "wrong-way risk" (cases where the exposure rises when the credit quality of the counterparty deteriorates) into Pillar 1 requirements, enhance stress test requirements, revise model validation standards and issue supervisory guidance for sound backtesting practices of CCR.

18. Additional Market Risk Capital ChargeCredit Valuation Adjustment: Cover MtM of unexpected counterparty risk losses • In addition to the existing capital charge for unexpected losses arising from counterparty defaults (Counterparty Credit Risk RWA) a stand-alone capital charge has been proposed to cover the market risk of potential MtM losses due to spread driven increase of unilateral credit value adjustments (CVA) of OTC portfolios. • Unilateral CVA: Adjustment of the risk-free mark-to-model prices of OTC derivatives for the credit risk of the counterparty (= expected loss). • Calculation of the new CVA capital charge by evaluating the unexpected losses of a portfolio composed of bond-equivalents each describing the OTC exposure to a counterparty and associated hedges. • Applying the applicable regulatory market risk charge (IMOD) to the bond-equivalents (i.e. 99% VaR: general + specific risk including stressed VaR but not IRC). • Liquidation horizon = 10 days • recognises hedges: eligible, single-name CDS / CCDS or other hedging instrument directly referencing the counterparty • Central Counterparties (CCP) and Securities finance transactions (SFT) are excluded • CVAs already recognised by the bank as an incurred write-down, can be used to reduce the Counterparty Default Risk capital charge (no “double counting”)

19. Nowit´suptoyoutodecide: • Was thepresentationunderstandable? • Doesitmakesense ? ….in anycase: itisthe end! 

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