Professional Documents
Culture Documents
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
Wu CFO
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
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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
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Answer: Where do risks arise?
• Assets: mortgages:
– Long term fixed interest income
– Early repayments
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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
Wu CFO
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%
0.4
0.3
0.2
0.1
0.0
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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%
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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
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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)
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