Transcript Financial Risk Management: Status and Issues

Overview on Risk Management
Presentation to the Government Association of
Certified Public Accountants during the 31st
Annual National Convention
Risk and Capital Management
► Illustrative Applications
of Risk
Management (Learning from the
Financial Service Industry)
Page 2
Fundamental Risk Management Process
Monitor
Identify
Updating and reporting
of relevant information
Risk
Management
Process
Manage
What should we do
about our risks?
Page 3
What risks do we have?
What are the sources of
these risks?
Measure
How much risk do we have?
Governance and Control environment
Transparent
governance
structure
Understanding risk
• Does senior management
understand the risks faced both
internal and external?
• How does management decide on
the business’s risk appetite?
• How does management incorporate
their understanding of risk into
strategy?
• How does management
communicate this to the rest of the
business?
Controlling risk
• What controls are in place to assess
and manage risk?
• What is the quality of the controls in
place and how are they tested?
• How clear are policy documentation?
(ie, roles & responsibility)
• How does management ensure
policies are being implemented?
• How does management deal with
conflicts of interests & independent
controls and reviews?
Governance
& Control
Prudent conduct of
business
Reporting
• How appropriate is the internal
reporting process (ie, do people
receive the necessary information)?
• How clear is it that management use
internal reporting for decision
making?
• What information does management
receive to give them comfort on
implementation?
• How clear are reporting lines within
the structure?
Decision making
Risk based decision
making
Page 4
• How does the controls environment
need to change?
• Is management comfortable with their
risk appetite?
• How does management seek to raise
capital?
• What is the quality of capital needed?
• Does the risk infrastructure support the
business strategy
• Does the firms strategy need to change
to maximize opportunities from risks in
the business?
Monitoring and
periodic reviews
Fundamental Risk Management Process
Monitor
Updating and reporting
of relevant information
Risk
Management
Process
Manage
What should we do
about our risks?
Identify
What risks do we
have? What are
the sources of
these risks?
(tough part)
Measure
How much risk do we have?
(tougher part)
Page 5
Sample Application in Credit Risk Management
• Risk differentiation possible through a rating system
• A credit rating system (e.g., for developer lending) is
essential for credit approval, risk management and
internal capital allocation
Credit Risk
Modelling
Credit Risk
Assessment
Marketing
Overarching
Governance
Credit Risk
Monitoring
Product
Development /
Amendments
Loan
balances
(in billions)
PD
(high quality)
0
0%
2
2
1%
3
85
3%
4
18
4%
5
23
7%
6
46
12%
7
52
29%
8
15
46%
9
32
78%
12
100%
RATING
CLASS
1
10
Default &
Collections
(default)
Total
285
Note: illustrative numbers only
Page 6
• Property of
monotonocity –
credit quality
declines (as
reflected by PD)
as one goes
down the rating
scale
Credit Risk Rating System
After ‘expansive lending’
Before
RATING
CLASS
Loan
balances
(in billions)
Loan
balances
(in billions)
1
1
(high
quality)
0
(high
quality)
0
2
2
2
7
3
85
3
35
4
18
4
26
5
23
5
37
6
46
6
72
7
52
7
158
8
15
8
92
9
32
9
44
(default)
Total
• A risk rating model facilitates riskbased pricing
• Rating system will depend on
criteria developed
• Risk rating system not a
substitute for a sound and wellinformed credit judgment
10
10
Page 7
RATING
CLASS
12
285
(default)
Total
62
533
Note: illustrative numbers only
Credit Risk Management Should be Designed to
Address Common Mistakes in Lending
FOCUSES
ADDRESSES
Portfolio Protection
 Credit Extension Criteria
 Collateral Security Requirements
 Documentation Requirements
 Facility Structuring
 Approval Authorities
 Limits
 Industry
 Customer
 Group
 Classification
Eight Common Mistakes
1.
Portfolio Over-Concentration
X
2.
The “Lemming” Complex
(or Me “Too-ism”)
X
3.
Over-Reliance On Collateral As
A “Way-Out” (asset-based lending)
4.
Continued Lending Into A
Depressed Business Cycle
5.
Retrospective Risk
Assessment (Not Prospective)
6.
Under-Pricing Risk
7.
Lack Of Accountability and Basis
For Credit Decisions
‘Profitability’ or Sustainability




Risk Return Profile and Mandate
Customer Risk Categorization
Loan Pricing Methodology
Industry Risk Rankings
Policy Design
 Policy Direction
 Policy Execution
 Policy Control
Page 8
X
X
X
X
8.
Failing To Enforce Established
Procedures When Times Are Good
X
X
Value-at-Risk
VaR Illustration
•
Portfolio Return Distribution
Assuming 99% confidence level and a 1-day horizon, a VaR
of Php11 million implies that the FI can expect that, with a
probability of 99%, the value of the asset or portfolio will
decrease by Php11 million or less during one day.
1
0.8
0.6
1%
0.4
VaR
0.2
Profit/Loss
-3
Page 9
-2
-1
1
2
3
Value-at-Risk
Question
What is the correct interpretation of a P4M overnight VaR figure with 99% confidence level? The FI
a)
b)
c)
d)
Page 10
can be expected to lose at least P4M in 1 out of next 100 days
can be expected to lose at least P4M in 95 out of next 100 days
can be expected to lose at most P4M in 1 out of next 100 days
can be expected to lose at most P8M in 2 out of next 100 days
VaR when improperly applied
VaR Illustration
Portfolio Return Distribution
1
0.8
0.6
• What about this region?
1%
0.4
VaR
0.2
Profit/Loss
-3
Page 11
-2
-1
1
2
3
Expected and unexpected losses
0.2
Probability distribution of
credit losses
• If there is cap on pricing, and costs
are increasing because of higher
expected losses (to reflect increasing
credit risk), Fund’s profits and capital
would be dissipated
0.1
0.0
Expected loss
Provisions and margin
Unexpected loss
Capital
Expected loss
The average loss of entity due to borrowers’ defaults
Unexpected loss
The maximum loss exceeding the expected loss with a given
confidence level
Page 12
• Theoretically, expected losses are
covered by margins from pricing and
provisioning
Basel II Framework
Pillar I
Minimum Capital Charge
Credit
Pillar II
ICAAP and SREP
Internal Capital Adequacy
Assessment
Public Disclosure of risk
information
Operational
Market
Page 13
Pillar III
Disclosure
Supervisory Review &
Evaluation Process
Minimum Capital Requirement
Following the definition of regulatory capital under BSP
► BSP issued Circular 538 for banks to set up minimum capital adequate to meet credit,
market, and operational risk exposures. This is measured by the Capital Adequacy Ratio
(CAR) with the following formula:
CAR =
Page 14
Capital
Sum of Credit Risk Weighted Assets + [ (Market Risk Capital Charge
+ Operational Risk Capital Charge) * 10]
Definition of Capital – Accounting? Regulatory?
Economic?
Core Capital (‘Tier 1’)
► Equity capital
► Surplus
Supplementary Capital (‘Tier 2’)
► Revaluation reserves
► General provisions
► Hybrid debt capital
► Subordinated term debt
Short-term subordinated debt (‘Tier 3’)
Page 15
► Concept
of ‘capital
tiering’ concept is based
on the banking industry
► What
is the capital
structure of the Fund?
Basel II Framework
Pillar I
Minimum Capital Charge
Credit
Pillar II
ICAAP and SREP
Internal Capital Adequacy
Assessment
Public Disclosure of risk
information
Operational
Market
Page 16
Pillar III
Disclosure
Supervisory Review &
Evaluation Process
Additional Capital
Requirements
Independent Review and Additional Capital
Requirements (Basel II Framework)
Governance
Individual capital
guidance
General controls
Quality of ICAAP
It is crucial that functions performing
independent review are fully geared up with
respect to resources and skill sets to
ensure the “additional capital requirements”
is kept to a minimum.
PILLAR 2
PILLAR 1
BASE CAPITAL
Capital planning & stress testing
Pillar 2 risk
Pillar 2 controls
Credit risk
Credit risk controls
Operational risk
Operational risk
controls
Market risk
Market risk controls
Minimum capital
Low
Page 17
Medium/Low
Medium
Medium/high High
ICAAP Overview: Building Blocks (Basel II
Framework)
Block 1
Pillar I
Risks
Block 2
Risks not fully
covered by
Pillar I
Block 3
Block 4
Risks not in
Pillar I
External factors
Stress testing
Credit
Residual
Interest rate
Business
Market
Securitization
Concentration
Strategy
Operational
Model Risk
Liquidity
Environment
Settlement
Reputation
Strategic
Underwriting
Pension
Transfer
Page 18
Capital Amount
Need for an Integrated Asset-Liability
Management Plan
Strategy
• Reflect all significant aspects
• Need to consider changes or ‘shifts’
• Need to relate with other risks
Wider Environment
Environment
Markets
Political/Regulations
Broader economy
►
►
►
►
Integrated Risk Modelling (Liquidity
and Other Material Risks)
600
400
400
200
200
0
0
-200
-200
-400
-400
-600
-600
-800
-800
12
11
►
on
th
9
8
Possible actions
Sources of funds
Behavior of other
counterparties
►
M
on
th
on
th
10
M
M
7
on
th
M
6
on
th
M
on
th
5
Liabilities
M
4
on
th
M
on
th
3
Assets
M
2
on
th
M
on
th
M
on
th
M
W
W
W
ee
k4
-1200
ee
k3
-1000
-1200
ee
k2
-1000
Contingency Planning
Axis Title
800
600
W
ALM
1000
800
ee
k1
USD m
1000
Required Funding
►
►
►
Liquidity reserve
Mismatch
Asset composition
Stress Testing
►
►
►
Data sources
Data integrity
MIS needs
1000
1000
500
500
0
0
-500
-500
-1000
-1000
-1500
-1500
-2000
-2000
-2500
-2500
-3000
-3000
Page 19
12
11
on
th
M
on
th
9
Required Funding
M
8
10
on
th
M
7
on
th
M
6
on
th
M
on
th
5
Liabilities
M
4
on
th
M
on
th
3
Assets
M
2
on
th
M
ee
k4
on
th
M
ee
k3
on
th
M
W
W
ee
k2
-3500
W
W
ee
k1
-3500
Axis Title
►
Data and Systems
USD m
Profile
Illustrative Oversight Structure – Risk Management
Board of Trustees
Risk Committee
President & CEO
RM Executive Committee
1
Chief Risk Officer 2
MRM
CRM
ALM
Operating Units
Page 20
ORM
Abbreviations:
MRM – Market Risk Management
CRM – Credit Risk Management
ALM – Asset Liability Management
ORM – Operations Risk Management
Note:
1 Can reside in management committees
2 In other governance models, certain risks reside
in other departments (e.g., strategic risks),
operating units (e.g., operational risks), or
specialized committees (e.g., ALM)
Enterprise Risk Management as an Imperative for
Economic Capital and ALM
Make Our Business Better
COORDINATED APPROACH TO RISK
Revenue and
Market Share
Reputation
and Brand
Coverage
Strategic
Assess
Operations
Improve
Financial
Monitor
Compliance
Product
Development
Finance and
Accounting
Marketing/
Sales
IT
Underwriting
Operations/
Admin/ IT
Transactions
Claims
Management
HR
Asset
Management
Legal and
Other
ALIGNED TO BUSINESS DRIVERS
Keep Us Out of Trouble
Page 21
Tax
Oversight
Corporate Risk Functions
Earnings and
Operating
Margins
Approach
Support Functions
Business Strategy
Executive Management
Asset
and Capital
Management
Risks
Operations and Business Units
Business Drivers
and Initiatives
Internal
Audit
Executive
Management
Compliance
Function
Board
Internal
Controls
Group
Audit
Committee
Other Risk
Functions
Risk
Committee
Achieve
Objectives
Enterprise View
Financial Service Industry
Illustrative Risk Radar (Top 10 Risks)

The credit crunch
1)
Regulation and compliance
2)
Deepening recession
3)
Radical greening
4)
Non-traditional entrants
5)
Cost cutting
6)
Managing talent
7)
Executing alliances and transactions
8)
Business model redundancy
9)
Reputation risks
Page 22
Risk and Capital Management
► The
Financial Service Industry
serves as laboratory for risk and
capital management developments
►
Page 23
It is also a ‘graveyard’ where lessons
can be learned
Agenda
► Indications
of risk management
being required based on
disclosures in IFRS (and soon
IPSAS)
Page 24
IFRS 7, Financial Instruments:
Disclosures
(Effective January 1, 2007)
Page 25
IFRS 7
►
►
►
►
►
Page 26
Overview
Balance Sheet Disclosures
Income Statement and Equity Disclosures
Other Disclosures
Risk Disclosures
Risks arising from financial instruments
Types of typical risks arising from financial instruments
credit risk
liquidity risk
interest rate risk
share price
Page 27
commodities price
currency risk
recovery risk
market risk
other price risks
risk of premature
redemption
Risks arising from financial instruments
Nature and extent of risks arising from financial instruments
qualitative disclosures
►
►
Page 28
quantitative disclosures
The disclosures shall enable the reader of the entity‘s financial
statement to evaluate the nature and extent of the risks arising
from financial instruments to which the entity is exposed at
reporting date.
The disclosures focus on the risks that arise from financial
instruments and how they have been managed.
Sample risk disclosures
►
►
►
►
►
Qualitative disclosures
Quantitative disclosures - general
Quantitative disclosures - credit risk
Quantitative disclosures - liquidity risk
Quantitative disclosures - market risk
Page 29
Qualitative disclosures
IFRS 7.33
For each type of risk arising from financial instruments, the entity shall
disclose:
a) the exposures to risk and how they arise;
b) its objectives, policies and processes for managing the risk and the
methods used to measure the risk; and
c) any changes in (a) or (b) from the previous period.
Page 30
Qualitative disclosures
Qualitative disclosures may include the following narrative
description:
-
Risks the entity is exposed to and how they arose,
Strategies and Processes concerning the taking, the assessment, the
supervision and the control of risks. This can include:
►
►
►
►
►
Page 31
Structure and organization of the entity‘s risk management function(s)
Field of application and type of the risk reporting or risk measurement systems,
The entity‘s strategies for risk hedging or risk reduction
The entity’s strategies and processes for the supervision of a continuous effectiveness
concerning risk hedging or risk reduction, and
The entity’s strategies and processes for avoidance of excessive risk-concentrations
Implementation considerations
►
Concentration of risk
►
►
Page 32
Risk management policies for avoiding excessive risk concentrations
Concentration risk includes all financial instruments and is not limited to loan
exposures
Sample disclosure:
Qualitative disclosure
Source: MBTC December 31, 2007 Consolidated Financial Statements
Page 33
Sample disclosure:
Qualitative disclosure
Source: Philippine Airlines March 31, 2008 Financial Statements
Page 34
Sample disclosure:
Qualitative disclosure
Source: Ayala Corporation Consolidated Financial Statements
Page 35
Sample disclosure:
Qualitative disclosure
Continued
Source: Ayala Corporation Consolidated Financial Statements
Page 36
Sample Disclosure:
Qualitative – Credit risk
Source: MBTC December 31, 2007 Consolidated Financial Statements
Page 37
Sample Disclosure:
Qualitative – Credit risk
Continued
Source: MBTC December 31, 2007 Consolidated Financial Statements
Page 38
Sample Disclosure:
Qualitative – Credit risk
Source: Philippine Airlines March 31, 2008 Financial Statements
Page 39
Sample Disclosure:
Qualitative – Market risk
Source: MBTC December 31, 2007 Consolidated Financial Statements
Page 40
Sample Disclosure:
Qualitative – Market risk
Source: Philippine Airlines March 31, 2008 Financial Statements
Page 41
Sample Disclosure:
Qualitative – Liquidity risk
Source: MBTC December 31, 2007 Consolidated Financial Statements
Page 42
Risk disclosures - General
►
►
►
►
►
Qualitative disclosures
Quantitative disclosures - general
Quantitative disclosures - credit risk
Quantitative disclosures - liquidity risk
Quantitative disclosures - market risk
Page 43
Quantitative disclosures
IFRS 7.34
For each type of risk arising from financial instruments, the
entity shall disclose:
a) summary quantitative data about its exposure to that risk at the
reporting date. This disclosure shall be based on the information
provided internally to key management personnel of the entity (as
defined in PAS 24), for example the entity’s board of directors and
chief executive officer
b) the disclosures required by paragraphs IFRS 7.36-42, to the extent
not provided in (a), unless the risk is not material
c) concentrations of risk if not apparent from (a) and (b).
Page 44
Risk disclosures - Credit risk
►
►
►
►
►
Qualitative disclosures
Quantitative disclosures - general
Quantitative disclosures - credit risk
Quantitative disclosures - liquidity risk
Quantitative disclosures - market risk
Page 45
Quantitative disclosures - Credit risk
IFRS 7.36
The entity shall disclose by class of financial instrument:
a)
b)
c)
d)
Page 46
the amount that best represents its maximum exposure to credit risk
at the reporting date without taking account of any collateral held or
other credit enhancements (eg netting agreements that do not qualify
for offset in accordance with PAS 32) ;
in respect of the amount disclosed in (a), a description of collateral
available as security and other credit enhancements;
information about the credit quality of financial assets that are neither
past due nor impaired; and
the carrying amount of financial assets that would otherwise be past
due or impaired whose terms have been renegotiated.
Sample disclosure:
Credit risk: Maximum exposure
Source: Ayala Corporation Consolidated Financial Statements
Page 47
Implementation considerations
Credit quality of good financial assets
►
►
►
Linkage to internal credit risk management
External credit rating can be adopted
For unrated assets, internal rating can be used
►
►
Page 48
High grade, standard grade, and sub standard grade
Assumptions used for internal ratings is disclosed
Quantitative disclosures - Credit risk
IFRS 7.37
Financial assets that are either past due or impaired
The entity shall disclose by class of financial asset:
a)
b)
c)
Page 49
an analysis of the age of financial assets that are past due as at the
reporting date but not impaired;
an analysis of financial assets that are individually determined to be
impaired as at the reporting date, including the factors the entity
considered in determining that they are impaired; and
for the amounts disclosed in (a) and (b), a description of collateral
held by the entity as security and other credit enhancements and,
unless impracticable, an estimate of their fair value.
Sample disclosure:
Credit risk: Aging analysis
Source: Ayala Corporation Consolidated Financial Statements
Page 50
Sample disclosure:
Credit risk: Credit quality
Source: Ayala Corporation Consolidated Financial Statements
Page 51
Sample disclosure:
Credit risk: Credit quality
Continued
Source: Ayala Corporation Consolidated Financial Statements
Page 52
Quantitative disclosures - Credit risk
IFRS 7.38
Collateral and other credit enhancements obtained
When an entity obtains financial or non-financial assets during
the period by taking possession of collateral it holds as
security or calling on other credit enhancements (eg
guarantees), and such assets meet the recognition criteria in
other Standards, an entity shall disclose:
a)
b)
Page 53
Nature and carrying amount of the assets obtained; and
When assets not readily convertible into cash, policies for disposal or
use of such assets
Sample disclosure:
Credit risk: Credit enhancements
Source: Philippine Airlines March 31, 2008 Financial Statements
Page 54
Risk disclosures - Liquidity risk
►
►
►
►
►
Qualitative disclosures
Quantitative disclosures - general
Quantitative disclosures - credit risk
Quantitative disclosures - liquidity risk
Quantitative disclosures - market risk
Page 55
Quantitative disclosures - Liquidity risk
IFRS 7.39
The entity shall disclose:
a)
b)
Page 56
a maturity analysis for financial liabilities that shows the remaining
contractual maturities; and
a description of how it manages the liquidity risk inherent in (a).
Sample disclosure:
Liquidity risk
Source: Ayala Corporation Consolidated Financial Statements
Page 57
Sample disclosure:
Liquidity risk
Source: Philippine Airlines March 31, 2008 Financial Statements
Page 58
Risk disclosures - Market risk
►
►
►
►
►
Qualitative disclosures
Quantitative disclosures - general
Quantitative disclosures - credit risk
Quantitative disclosures - liquidity risk
Quantitative disclosures - market risk
Page 59
Quantitative disclosures - Market risk
A sensitivity analysis for each type of market risk is mandatory
A separate sensitivity analysis
for each market risk
A sensitivity analysis
reflecting interdependencies
Each type of market risk is to
be analyzed separately
Example: Value-at-Risk
The reporting entity can choose the type of sensitivity analysis
An entity may provide different types of sensitivity analyses
for different classes of financial instruments
Page 60
Quantitative disclosures - Market risk
IFRS 7.40
Sensitivity analysis
Unless the entity complies with IFRS 7.41, The entity shall
disclose:
a)
b)
c)
Page 61
a sensitivity analysis for each type of market risk to which the entity is
exposed at the reporting date, showing how profit or loss and equity
would have been affected by changes in the relevant risk variable that
were reasonably possible at that date;
the methods and assumptions used in preparing the sensitivity
analysis; and
changes from the previous period in the methods and assumptions
used, and reasons for such changes.
Quantitative disclosures - Market risk
What is ‘reasonably possible change’?
a)
b)
c)
Page 62
Consideration of the economic environment in which the entity operates –
‘worst-case’ scenarios or ‘stress tests’ are not included
The entity should consider what changes are reasonably possible over the next
reporting period
The entity need not re-assess reasonably possible change if the rate of change
of the variable is stable
Quantitative disclosures - Market risk
IFRS 7.41
If an entity prepares a sensitivity analysis, such as value-at-risk,
that reflects interdependencies between risk variables (eg interest
rates and exchange rates) and uses it to manage financial risks, it
may use that sensitivity analysis in place of the analysis specified in
paragraph 40. The entity shall also disclose:
a)
b)
Page 63
an explanation of the method used in preparing such a sensitivity analysis,
and of the main parameters and assumptions underlying the data provided;
and
an explanation of the objective of the method used and of limitations that may
result in the information not fully reflecting the fair value of the assets and
liabilities involved.
Quantitative disclosures - Market risk
IFRS 7.42
When the sensitivity analyses disclosed in accordance with IFRS
7.40-41 are unrepresentative of a risk inherent in a financial
instrument (for example because the year-end exposure does not
reflect the exposure during the year), does the entity disclose that
fact and the reason it believes the sensitivity analyses are
unrepresentative.
Page 64
Sample disclosure:
Market risk
Source: Philippine Airlines March 31, 2008 Financial Statements
Page 65
Sample disclosure:
Market risk – FX Risk
Source: Philippine Airlines March 31, 2008 Financial Statements
Page 66
Sample disclosure:
Market risk – FX Risk
Continued
Source: Philippine Airlines March 31, 2008 Financial Statements
Page 67
Sample disclosure:
Market risk – FX Risk
Continued
Source: Philippine Airlines March 31, 2008 Financial Statements
Page 68
Sample disclosure:
Market risk – Cash flow interest rate risk
Source: Philippine Airlines March 31, 2008 Financial Statements
Page 69
Sample disclosure:
Market risk – Price interest rate risk
Source: Philippine Airlines March 31, 2008 Financial Statements
Page 70
Sample disclosure:
Market risk – Equity price risk
Source: Philippine Airlines March 31, 2008 Financial Statements
Page 71
Sample disclosure:
Market risk – Value-at-risk (VaR)
Source: Philippine Airlines March 31, 2008 Financial Statements
Page 72
Risk and Capital Management
►
But how will risk management be applied in the
public sector?
►
Page 73
Issue on mandate versus commercial purpose –
should there be a conflict?
Risk and Capital Management
►
Sustainability as the foundation for public sector
risk management
►
Page 74
Measures to apply
Risk and Capital Management
►
Page 75
No matter how good the risk management
process is, or how qualitatively and
mathematically elegant the models, remember
that it is PEOPLE who run everything
Risk and Capital Management
►
Page 76
No matter how good the risk management
process is, or how qualitatively and
mathematically elegant the models, remember
that it is PEOPLE who run everything
Risk and Capital Management
► Christian G. Lauron
Partner, SGV & Co
► [email protected]
Page 77