Risk Management and Capital Allocation in Financial Institutions

• The Economics of Risk Management
• Enterprise-wide Risk Management vs. Silo Approach
• Economic Capital and its Role in Risk Management
• The Capital Allocation Process
• Risk Centre Architecture and Risk Specialization
• Risk-Adjusted Performance Measurement
• Practical Implementation Issues

The objective of this seminar is to give you a good understanding of methods for measuring and controlling aggregate risks in financial institutions and to discuss how these methodologies can be integrated into an economic capital allocation process.

We start with a brief review of recent trends within financial risk management. We trace the progression of risk-management techniques, from “duration management” via ALM to Enterprise-wide Risk Management. We explain why risk integration, increased competition and stakeholder pressures have lead to the need for a more proactive approach to risk management and a more efficient usage of risk capital.

We look at the two prevailing approaches to measuring and managing risks: the “silo” approach, and the ERM, or fully integrated, approach to risk management. We explain how risks are measured at the individual and at the aggregate levels using “Value-at-Risk” and other measures and how these measures translate into regulatory (Basel) and economic capital charges.

Our main focus will be on the use of “Economic Capital” as the foundation for risk management in modern financial institutions. We define the concept of “economic capital”, and we explain in depth a number of approaches to calculating the amount of capital required to maintain a certain solvency level. The use of economic capital is in the very core of good risk management and is an important component of the ICAAP (Internal Capital Adequacy Assessment Process) of Basel II.

Further, we explore how, through the process of capital allocation, an institution can control risk-taking on an ex-ante basis and how this “capital-at-risk” is used as the basis for risk-adjusted performance evaluation. We explain how to manage risks in order to guarantee that firm-wide exposure is consistent with shareholders' risk preferences, how to define limits for individual risk units, and how top management can evaluate performance on a risk-return basis (RAROC).

Finally, we discuss some practical issues related to the implementation of a risk capital allocation system, including the choice risk-centre architecture, the degree of risk specialization, and the type of capital allocation process and its degree of centralization-decentralization.

 

Day One

09.00 - 09.15 Welcome and Introduction

09.15 - 12.00 Trends in Risk Management

• The Changing Assumptions about Risk Management
• The Evolution of Risk Management – from Duration to ERM
• Risk Integration and the Need for more Efficient Capital Allocation
• How Effective Risk Management Can Create Value

Approaches to Measuring and Managing Risks

• Alternative Measures of Risk
• Volatility, VaR, LPM and Extreme VaR
• The “Silo” Approach to Measuring and Managing Risks
  • The Basel II/Solvency II Risk Measurement Frameworks
• Problems with the Silo Approach
  • Loss of Diversification Benefits, System Redundancy, Data Inconsistency
• Enterprise-wide Risk Management
  • Why an Enterprise Risk Management Approach?
  • Core Components of an ERM Framework
  • The COSO Framework for Measuring and Managing Risks
• Small Exercises

12.00 - 13.00 Lunch

13.00 - 16.30 Economic Capital – the Foundation for Modern Risk Management

• Why Economic Capital Planning Has Become Increasingly Important to Overall Competitiveness
• Economic Capital as a “Common Currency” for Risk
• Economic Capital in Banks
  • Differences between VaR and Economic Capital
  • What Risks Should be Included when Calculating EC?
  • How Much Capital Is Need to Support the Bank’s Total Risk?
  • How Much Capital Is Needed to Obtain Target Rating?
  • Using Mathematical Modelling for Measuring Economic Capital
• Economic Capital in other Types of Financial Institutions
  • Calculating “Probability of Ruin”
  • Calculating EC as Amount of Assets Needed to Reduce Probability of Ruin to Acceptable level
• Tie-In of Economic Capital to Regulatory/Rating Agency Capital
  • Historical Ways of Calculating Solvency Levels
  • New Capital Adequacy Models with Greater Regard to Institutions’ Proprietary Models
  • Case Study: S&P’s Dynamic “FPC” Model
• Small Exercises

Day Two

09.00 - 09.15 Brief recap

09.15 - 12.00 Capital Allocation and Risk Adjusted Performance Measurement

• Allocating Capital Across Business Units
  • Making Risk-Return Profiles Comparable Across Business Lines
  • Estimating How Much Risk Each Business Unit Contributes to the Institutions’ Total Risk
  • Determining Major Sources of Concentration and Diversification
  • Deciding Who Gets the Diversification Benefits
  • Deriving Appropriate Limits for All Risks and Business Lines
• Measuring and Evaluating Risk-Adjusted Performance
  • The Origins of Risk-Adjusted Performance Measures
  • From RORAC via RARORAC to RAROC
  • Are Business Units Creating or Destroying Value?
  • Case Study: Measuring RAROC in “NoHope Bank”
• Risk Pricing
  • Measuring the Market Price of Risk
  • Risk-Adjusted Loan Pricing
  • How a Portfolio-Based Approach to Loan Pricing Can Lead to Competitive Advantages
• Small Exercises

12.00 - 13.00 Lunch

13.00 - 16.00  Implementing a Risk Capital Allocation System

• The Internal Capital Adequacy Assessment Process (ICAAP)
• Setting Strategic Risk and Earnings Targets
  • Which Risks to Take, Which Risks to Hedge/Transfer?
  • What Price to Charge for Bearing Risks?
• Integrating Regulatory and Economic Capital Models into an Overall Framework
• Using EC Planning to Realize Benefits Beyond Basel II/Solvency II
• Aligning The Incentives System with the Institution’s Risk and Earnings Targets
• Developing an Organizational Risk Culture
  • Providing Guidance to Advance the Use of a More Corporate and Systematic Approach to Risk Management;
  • Building a “Risk-Smart” Workforce
  • Creating an Environment that Allows for Innovation and Responsible Risk Taking
• Some Practical Issues
  • Obtaining Internal and External Data
  • Data Cleaning, Data Warehousing and Data Processing
  • Risk Control and Reporting
  • Implementing and Testing Controls

Summary, Evaluation and Termination of the Seminar