Financial Risk Management

Hong Tong Wu
hongtong@wu-cfo.com

Wu CFO
 Who requests for financial risk
management?
• Financial regulators (Basel, Solvency):
capital requirements
• Rating agencies: probability of default
• Financial markets: risk-adjusted
profitability

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 What are we going to do?
• Organizational structure (Case: ING)
• Risk identification (qualitative, kind of risk)
• Risk measurement (quantitative, size of risk)
• Risk strategy

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 How is ING organized?

Supervisory Board

Executive Board

Insurance Insurance Insurance Wholesale Retail

ING Direct
Europe America Asia/Pacific Banking Banking

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 What services and products does
ING offer?
• Insurances
• Asset management
• Investment
• Real estate
• Private banking
• Saving accounts
• Mortgages
• Mutual funds
• Payment accounts

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 Questions: Where do risks arise?
• Bank-insurer with two products:
• Mortgage: asset
• Saving accounts: liability

• What risks does the bank-insurer take?

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 Answer: Where do risks arise?
• Assets: mortgages:
– Long term fixed interest income
– Early repayments

• Liabilities: saving accounts

– Short term variable interest payment
– Withdrawal at any moment

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 Answer: Where do risks arise?
 Bonds with many implicit options and maturities
depending on the market and consumer
behavior!

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What kinds of risks does ING take?
• Insurance risk
• Financial risks:
 Market risk
 Credit risk
• Operational risk

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 Question: kinds of risk
• To what kind of risk do the following risks
belong?
 Interest-rate risk
 Liquidity risk

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 Answer: kinds of risk
• Interest-rate risk: market risk
• Liquidity risk: market risk
 in trading (VaR-method)
 in funding (ALM)

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How does ING measure its market
risks?
• Market risk (bank):
 Trading risk:
Value-at-Risk (VaR) and stress testing
 Non-trading risk: Earnings-at-Risk (EaR)
• Market risk (insurance):
 Asset Liability Management (ALM)

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 How do stock prices vary?
PricechangePHI RelativepricechangePHI

27.00 6.00%

25.00 4.00%

23.00 2.00%

21.00 0.00%

19.00 -2.00%

17.00 -4.00%

15.00 -6.00%
01/02/04

02/02/04

03/02/04

04/02/04

05/02/04

06/02/04

07/02/04

08/02/04

09/02/04

10/02/04

11/02/04

12/02/04
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 Value-at-Risk (historical): What is the
frequency of changes of stock prices?
No. observations

80

70

60

50

40

30

20

10

0
-5.00% -4.00% -3.00% -2.00% -1.00% 0.00% 1.00% 2.00% 3.00% 4.00% 5.00%

Value at risk = (mean - 1% percentile) x price =

(0.00% - - 3.64%) x 19.51 = 0.71
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 Value-at-Risk (parametric):
What is the mathematical model?
0.5

0.4

0.3

0.2

0.1

0.0

VAR(99%) = 2.33 x volatility

Value-at-Risk = 2.33 x √ 0,026% x 19.51 = 0.73

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 Question:
What does the regulator require?
• The minimum capital must be able to
withstand a ten-day (holding period)
market crises three times a year (Basel).
• What is this required capital (expressed in
VaR)?

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 Answer:
What does the regulator require?
• Capital = 3 x √10 x VaR
• Assumption:
independent identically distributed

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 What is the influence of
interest rate on earnings?
• Maximum decrease of earnings on interest
due to interest changes
• Earnings-at-Risk =
Loan gap x period x maximum increase of
interest (Basel: 2%)

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Question: How large is the decrease in
earnings when interest rises?
• Mortgage:
 Nominal value: €100 milion
 Maturity: 5 years
• Loan
 Loan sum: € 100 milion
 Maturity: 1 month
• Basel II: What is the one-year Earnings-at-Risk
when the interest rate increases by 2%?

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Answer: How large is the decrease in
earnings when interest rises?
• € 100 milion loan sum matured after one
month in year 1
• Rest period: 11 months
• Interest rate increase: 2%
• EaR = € 100 milion x 11/12 x 2% = € 1,83
milion
 loss of earnings on interest of € 1,83
milion when interest rate increases by 2%

(Interests flows were not taken into account)

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 What is
Asset Liability Management?
• ING measures Earnings-at-Risk:
 Interest-rate risk: increase of interest rate by
1% within a year (rate-shift scenario)
 Equity risk: decrease of stock prices by 10%
within a year (scenario analysis)

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 What is the rating of ING?
S&P Rating Description Probability
(basis points)
AAA Highest credit quality 1
AA Very high credit quality 4
A High credit quality 12
BBB Good credit quality 50
BB Speculative 300
B Highly speculative 1100
CCC High default risk 2800
DDD Default Wu CFO 10000
What is the model for credit risk?
(1)

Frequency

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 What is the model for credit risk?
(2)
• EL (expected loss) = P x E x S
 P (probability of default)
 E (exposure at default)
 S (severity, loss given default) = 1 –
R(ecovery)
• UL (unexpected loss)
• MPL (maximum probable loss)

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 What is the model for credit risk?
(3)
• EC (Economic Capital) ≈ MPL – EL = k x
UL in which k = 5.5 corresponding to the
99.95% confidence level or AA-rating ~
e.g. Gamma-distribution

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 How does ING manage its credit
risks for its banking activities?
• Concentration limits on:
 Countries
 Industries
 Counterparties

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 How does ING judge their
investments?
• Risk-Adjusted Return On Capital
RAROC = (Income – EL)/EC
• Economic Value Added
EVA = (RAROC – WACC) x EC

• Application on life insurances

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 What caused the credit crisis?
• Collateralized debt obligation (CDO) or mortgage backed
securities (MBS)
• Pool van 25 A-bonds in 3 tranches
 0-80%: AAA
 80-95%: A
 95-100%: B
• CDOs transform risks and give investors the opportunity
to invest according to their risk and return preferences
• CDOs
– Off-balance sheet: less capital required
– Positive correlation between mortgages:
more economic capital needed

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What are the consequences of the
credit crisis?
• Lower creditworthy and more bankruptcies
(credit risk)
• Decrease of earnings on interest
(interest rate risk)
• Withdrawal from saving accounts
(liquidity risk)

• What will come more?

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Questions?

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