Diversification estimating correlation with historical data

Laurent Balthazar
17/09/2007, London

Diversification Workshop
Agenda Economic Capital Frameworks and Diversification Overview of litterature Choosing the drivers Historical correlation measures and proposed values Quantifying impacts

Diversification Workshop
Economic Capital Frameworks and Diversification
Economic Capital definition: Amount of capital necessary to cover losses linked to decrease of assets value/ increase of liabilities values, at a given confidence interval (= given a specific risk appetite), taking into account diversification effects  Depends on specific bank risk profile  Depends on risk appetite/ aversion  It integrates diversification between risk types and businesses

Diversification Workshop
Economic capital: a stylized example
Economic Capital 1- Risk Cartography

ABC Bank
Credit Risk !

Capital Credits
ALM risk! Funding

Compliance Risk! Liquidity Risk !

Spread Risk ! Market Risk ! Insurance Risk !

Bonds Equity Currencie s Insurance

Debts

Deposits

Behavioral risk!

Operational risk!
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Diversification Workshop
Economic capital: a stylized example
Economic Capital 2 - Risk measurement Some standards begin to emerge for some risk types, often simulation (VAR) approaches.  Credit Risk : Credit VAR  Equity Risk: Equity VAR  Interest rate risk: Interest rate VAR  Operational Risk: Basel 2 AMA (=op. risk VAR) or standardized approach  Spread Risk: Spread VAR  Behavioral risk: ex prepayment models to emulate customers behavior  Insurance risk: solvency 2 simplified formulas available
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Diversification Workshop
Economic capital: a stylized example
Economic Capital 3 - Risk aggregation

Capital= f (Risk distribution)

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Diversification Workshop
Agenda Current situation and goal of update Overview of litterature & parctices Choosing the drivers Historical correlation measures and proposed values Quantifying impacts

Diversification Workshop
Overview of litterature & practices
How diversification should be measured theoretically  We should measure correlation of historical losses of the bank over each risk type  Correlation measure should be adapted to each form of the loss distributions (Normal, Beta, Lognormal, )  Correlation should be measured in tails (stress events) In practice  No internal historical data to isolate losses on all risk types

 We do not know precisely distribution of all risk types (hypothesis)

 No enough observations to measure tail events

Diversification Workshop
Overview of litterature & practices
Approaches seen in the industry  Aggregation by Business Line
Risk Type 1 Business Line 1 Business Line 2 Business Line 3 Business Line 4 Business Line 5 Risk Type 2 Risk Type 3 Risk Type 4 Risk Type 5 => => => => => Ecap BL1 Ecap BL2 Ecap BL3 Ecap BL4 Ecap BL5 Diversification effects Global Ecap

=> Diversification estimated between the BL, may be based on P&L historical Correlation. => But to correctly integrate intra-risk diversification, Ecap usually measured through risk silos. Approach by BL may complicate correlation structure.

Diversification Workshop
Overview of litterature & practices
Approaches seen in the industry  Aggregation by Risk Types
Risk Type 1 Risk Type 2 Risk Type 3 Risk Type 4 Risk Type 5

=> Economic capital globally computed by risk type for the whole banking group => Intra-risk diversification already included in the various models => Final diversification layer= diversification between the risk types
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usiness ine 1 usiness ine 2 usiness ine 3 usiness ine 4 usiness ine 5 => Ecap redit Risk => Ecap Market risk

Ecap oper risk

=>

Ecap usiness risk

=>

Ecap insurance risk

=>

Di i

ii

Global Ecap

Diversification Workshop
Overview of litterature & practices
Current Market Practices
Agregation techni ue ypothesis of independence ypothesis of perfect correlation VAR/ CoVAR aproach - tde VAR/ CoVAR aproach - cap Copulas Joint historical simulation Remar ot enough prudent oo conser ati e ends to o erestimate cap ends to underestimate cap ard to calibrate ard to calibrate Use in industry o but regulatory approach in Basel igh igh Very lo Very lo

 Methods based on VAR / CoVAR are the more used (hypothesis of similar distributions)

UL A B ! UL2  UL2  2 V ABUL AUL B A B

 Methods Based on copula theoretically more precise but no data to calibrate them. Choosing one copula or the other might impact 30% or more final figures
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Diversification Workshop
Overview of litterature & practices
Kuritzkes (Wharton Paper) Broad references of correlation matrix Range of estimated correlations still high

Source: Risk Measurement, Risk Management and Capital Adequacy in Financial Conglomerates Working paper Kuritzkes, Schuermann, Weiner, 2002

Own research

Corr l. M trix Cr it risk M rk t risk r ti l risk t r risks

Table 17.11 Correlation matrix - Ranges

100% 0%-50% 30%-70%

100% 0%-50%

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Cr it risk 100% 50%-100% 0%-50% 30%-70%

M rk t risk

r tional risk

B siness risk

100%

Source: From Basel 1 to Basel 3 Book at Mac Milan Editions - Balthazar, 2006

Diversification Workshop
Overview of litterature & practices
Solvency 2 proposed values in QIS  Credit Vs Market Risk
Market Market Def lt
100% 25%

efault
25% 100%

 Inside Market Risk

SCRmkt aggregation Interest Equity Spread Forex Interest
100% 50% 25% 25%

Equity
50% 100% 25% 25%

Spread
25% 25% 100% 25%

Forex
25% 25% 25% 100%

 Attention: amortizing effect of profit sharing for market risk is taken into account, this could justify lower correl than for banking activities. Also, traditional interest sensitivity is not the same as the banking groups.

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Diversification Workshop
Overview of litterature & practices
Risk Cartography  Attention: Typically, banks communicate on 3-4 broad risk types

Ba k Co zb nk JP o g n Ch NG o C financial g oup CSFB ABN Amro CIBC Citigroup

Ecap average split Benchmarking study of 10 large banks

Source: From Basel 1 to Basel 3 Book at Mac Milan Editions - Balthazar, 2006 14

Diversification Workshop
Overview of litterature & practices
 But to measure diversification correctly, one would need to go to finer risk typology

-Default risk - Spread risk - Transfert Risk - Migration risk -Interest risk - Equity risk - Forex Risk - -

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Diversification Workshop
Overview of litterature & practices
Diversification benefits
Defined as 1- Final Ecap figure \ sum of economic capital stand alone In Kuritzkes, Schuermann, Weiner diversification benefit of bank-insurance group estimated between between 15-28% In Economic Capital Modelling Concepts, Measurement and Implementation Risk Books, edited by Iman van Lelyveld, a survey shows, 2006 2003
Citigroup Deutsche Bank JP Morgan Credit uisse Commerzbank Dresdner Bank De ia average
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10.02% 7.20% 12.38% 33.49% 21.78% 22.64% 15.00% 17.50%

Diversification Workshop
Overview of litterature & practices
Conclusions
 Diversification is still an open question for the industry  No clear consensus on a single leading technique  Diversification is anyway an important issue: effect on Ecap can be roughly estimated between 10 and 30%  Lack of data and uncertainty about functional form (e.g. Copula) creates large buckets of uncertainty around estimates

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Diversification Workshop
Overview of litterature & practices
Then: we wait or we try
 Important issue is not to measure correlation at 5 % margin error (sensitivity issue)  As always (Basel 2 approach), layer of conservatism can be integrated in estimates  Question is : what are correlations that are expected to be
% 5% 50% 25% 0% 25% 50% 5% 00%

approach and &Mix of expertanalysis could historical data deliver reasonable first guess
Correlation ?

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Diversification Workshop
Overview of litterature & practices
Proposed Framework
1) 2) 3) 4) 5) 6) Define for each risk type a representative proxy Collect historical data on this proxy Measure linear correlation between the various proxies Challenge correlation with expert approach economic theory Add a layer of conservatism in function of uncertainty on the results Refine\ enrich with time internal data

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Diversification Workshop
Agenda Current situation and goal of update Overview of litterature Choosing the drivers Historical correlation measures and proposed values Quantifying impacts

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Diversification Workshop
Choosing the drivers The goal is to identify for each risk type a key driver/ proxy representing potential losses for the bank, to be able to measure historical correlations. Credit Risk  We propose Default rates. Public data is available from rating agencies  Refined approach might use internal Default rates collected for Basel 2  Synthetic proxies might be constructed to reflect more precisely particular portfolio structure
Year 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 orporate efault rate 0.962% 0.922% 1.007% 1.901% 1.499% 1.355% 2.336% 3.587% 3.216% 1.300% 0.977% 0.558% 1.021% 0.511% 0.650% 1.249% 2.197% 2.487% 3.907% 3.047% 1.704% 0.821% 0.654% 0.543%

Source- S&P

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Diversification Workshop
Choosing the drivers  Interest Risk: We can use ALM risk sensibilities (= loss for the bank in case of interest move). The proxy proposed is a synthetic P&L constructed applying our current sensitivities to historical interest rates move.  Ex:

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Diversification Workshop
Choosing the drivers  Currency Risk: ex: Main currency risk currently= positions in SD. Proposed proxy equals then E R/ SD exchange rate. In case SD increase, higher profit for the bank. If it decreases, loss for the bank.
Nov-1982 Nov-1983 Nov-1984 Nov-1985 Nov-1986 SD/E R E R/ SD 0.813373 1.229448 0.739713 1.351876 0.667222 1.498752 0.768838 1.300664 0.959081 1.042665

relative variation year 1983 1984 1985 1986 Nov-1982 Nov-1983 Nov-1984 Nov-1985 Nov-1986 SD/E R E R/ SD -9% -10% 15% 25% 10% 11% -13% -20%

 In case big positions in several currencies, proxy is a weighted index function of size of positions

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Diversification Workshop
Choosing the drivers  Price Risk: risk is decrease of equity portfolio value. Proxy used is the historical returns that would have been registered by our current portfolio using a mapping of each position to a reference index.

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Diversification Workshop
Choosing the drivers  For some risk types, it is difficult to find a driver. Typically: Business, operational, model, legal, reputation, risks. If no driver can be found, a conservative estimation will have to be used. Anyway, credit and market risk are usually most important par of Ecap consumption (78% in our survey)

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Diversification Workshop
Reviewing inter risk correlation Current situation and goal of update Overview of litterature Choosing the drivers Historical correlation measures and proposed values Quantifying impacts

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Diversification Workshop
Historical correlation measures and proposed values
credit ri efault rate 0.962% 0.922% 1.007% 1.901% 1.499% 1.355% 2.336% 3.587% 3.216% 1.300% 0.977% 0.558% 1.021% 0.511% 0.650% 1.249% 2.197% 2.487% 3.907% 3.047% 1.704% 0.821% 0.654% 0.543% Interest rate risk Equit risk currency risk 5 year IR ean elta S&P 500 return EUR/USD elta -0.56% 17% 10% 0.09% 1% 11% -1.90% 26% -13% -1.77% 15% -20% 0.10% 2% -16% -0.14% 12% 4% 1.46% 27% 5% 0.48% -7% -20% -0.99% 26% 9% -1.49% 4% -2% -1.42% 7% 9% 1.85% -2% -9% -2.15% 34% -5% -0.80% 20% 2% 0.05% 31% 11% -1.42% 27% -2% 1.37% 20% 13% 0.12% -10% 21% -0.61% -13% -4% -0.73% -23% -11% -0.09% 26% -15% -0.66% 9% -10% 0.10% 3% 10% 0.77% 14% -9%

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year 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

 Simplified Bank example: Exposed to S Corp Exposed on rate increase (=risk), av maturity 5 years Equity positions in S industrial stocks Balance sheet in E R and large positions unhedged in SD

! Sign should be changed for equity and currency

Diversification Workshop
Historical correlation measures and proposed values  Correlation matrix

er

is k

dit r

ere

yr

cu rr e

Eq u it

c re

Int

nc y

Correlation atri

rat

r is

is k

st

 First rough correl matrix  Then we have to challenge it with economic theory  Propose a level function of confidence in estimates  And integrate risks without proxies

credit risk Interest rate risk Equity risk currency risk

100%

6% 100%

41% 20% 100%

is k

12% -17% 11% 100%

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Diversification Workshop
Historical correlation measures and proposed values CREDIT RISK  Vs Equity: 41%. Expected strong positive correl:  Merton Model  Link to economic cycle => We propose to retain 50%

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Diversification Workshop
Historical correlation measures and proposed values CREDIT RISK
2.5%

Default rates Vs interest rates

4.500%

 Vs Interest: 6%  During DR shock (90 and 01), IR stable  Analysis on S rates (instead E ), correl -31% with 5y, -19% with 10y

2.0% 1.5% 1.0%

4.000%

3.500%

3.000%

delta IR 10y

0.5% 2.500% 0.0% 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2.000% -0.5% 1.500% -1.0% -1.5% -2.0% -2.5% years 1.000%

0.500%

0.000%

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delta Interest Rates US 10

Default Rate

DR

Diversification Workshop
Historical correlation measures and proposed values  In literature, IR used in Moodys model to predict DR, but one factor out 6 (limited weight)  Monetary policy coherent with results: in periods of slow down (DR increasing), growth policy to rates cut, which could justify the slightly negative correlation for the bank.  BCE policy a little bit different (priority to fight againts inflation), results expected to be more close to zero. => We propose to retain 25%

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Diversification Workshop
Historical correlation measures and proposed values CREDIT RISK  Vs Currency: correl of 12%. Weak link from economical perspective between exchange rate and credit risk in developed countries. In developing countries, conclusions may be different
We propose to retain 25%

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Diversification Workshop
Historical correlation measures and proposed values EQ ITY RISK  Vs Interest: 20%  Equity risk linked to credit risk, and weak correl between credit risk and interest risk (see above)  50% correl proposed in solvency 2  In economic theory, increase of rates linked to decrease of equity , we should then observe positive correlation between those 2 risks
We propose to use 25%

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Diversification Workshop
Historical correlation measures and proposed values

EQ ITY RISK  Vs Currency :11%. Low correlation. It means that decrease of SD value is not directly linked to increase of S stocks (time lag or no link ?). No clear direct link for all companies (depending on % of exportations, of % of hedge of foreign activity, ) => We propose to use 25%

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Diversification Workshop
Historical correlation measures and proposed values INTEREST RISK  Vs Currency: -17%. Exchange rate is in principle linked to the difference in interest rate between 2 currencies, not to the interest rate itself. Expected correlation is then weak.
We propose to use 15%

OPERATIONAL RISK  By nature, should be low correlation  benchmarking and references usually mention 0-50%
We propose to take upper limits: 50%
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Diversification Workshop
Historical correlation measures and proposed values

Retained values
ri s k ri s k
Correlation matrix

Int e re st rat e

cu rre nc yr

c re dit ri

c re dit ri

Eq uit y

credit risk Interest rate risk Equity risk currency risk

credit risk 100% 6% 100% 41% 20% 100% 12% Interest rate risk -17% Equity risk 11% currency risk 100% Operational risk

100%

25% 100%

Eq uit y

Correlation matrix

50% 25% 100%

25% 15% 25% 100%

After challenging and economic analysis

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Op era tio na l ri
50% 50% 50% 50% 100%

Int e re st rat e

isk

cu rre nc yr

sk

sk

ris

ris

isk

sk

Diversification Workshop
Reviewing inter risk correlation Current situation and goal of update Overview of litterature Choosing the drivers Historical correlation measures and proposed values Quantifying impacts

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Diversification Workshop
Quantifying impacts Impact: suppose typical Ecap split
Undi ersified Economic Capital credit risk 50 15 Interest rate risk 10 Equity risk 5 currency risk 20 Operational risk TOTAL 100

 Applying the correlation matrix we have:

isk er
Correlation matri

ris

nc y

ion al ris k

rat

r is k

r is k

risk

Int e re st

Op er a t

c re dit

uit y

cu rre

st rat e

Eq

sk curre ncy ri
5

credit

credit risk Interest rate risk Equity risk currency risk Operational risk

50 15 10 5 20

Interest rate risk Equity risk currency risk Operational risk

25% 50% 25% 50%

100% 25% 15% 50%

25% 100% 25% 50%

15% 25% 100% 50%

50% 50% 50% 100%

50

Intere

100%

25%

50%

25%

50%

15

10

Opera
20

credit risk

Equit y risk

tional

risk

risk

= 77

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Diversification Workshop
Quantifying impacts Impact: comparing diversification rates  We got 77 for undiversified Ecap of 100, a diversification rate of 23%  Compared to our benchmarks: 15-30%, we are in line
ris k cu rre nc yr isk dit ris k tio na l Op era
60% 60% 60% 60% 100%

Int ere st

=> Ecap= 82 => Diversification down to 18%

credit risk Interest rate risk Equity risk currency risk Operational risk

100% 35% 60% 35% 60%

35% 100% 35% 25% 60%

Eq uit y

cre

ris k

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 Sensitivity analysis: +10% on all correl

rat e

Correlation matri

60% 35% 100% 35% 60%

35% 25% 35% 100% 60%

ris

Diversification Workshop
Conclusions

Conclusions

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Diversification Workshop
Conclusions Conclusions Current Problems with diversification  No standard, industry wide accepted method  Issue Nr1 on distribution forms: no standard, copula the most elegant theoretically but too sensitive to hypothesis => VAR \ COVAR seems to be used more common practice  Issue Nr2 on data: poor internal historical data. Past representative of future ? B T  Diversification exists, then a conservative estimates is better than nothing  First insight can be gained on historical data (high- average- low- negative Correlation ?)
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Diversification Workshop
Conclusions Conclusions A simple method  We illustrated a simple method  Basic idea is to identify public or internal proxies representative of various risk types for the bank and measure correlation  Results should be challenged with expert\ economic theory  Method is itterative and can be refined with time: internal data, more precise structure of exposures to currencies, interest, We believe open debate should currently be the priority in the industry, regarding the dialogue that will occur with regulators under Basel 2

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Diversification Workshop
Conclusions
Description

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The proposed rules are presented and key issues regarding implementation of the accord identified. The model used to calibrate the capital requirements under Basel 2 is analyzed and projected forward to present what could be key new elements in the future Basel 3 regulation. A CD-ROM is included to illustrate regulator models. Contents Introduction PART 1: C RRENT BANKING REG LATION Basel 1 Market Risk Amendment Critics of Basel 1 PART 2: DESCRIPTION OF BASEL 2 Overview of the New Accord Pillar 1 - The solvency ratio Pillar 1 - Appendix Pillar 2 - Supervisory Review Process Pillar 3 - Market Discipline Potential Impacts of Basel 2 PART 3: IMPLEMENTING BASEL 2 Basel 2 and IT Systems Scoring Systems - Theoretical Aspects Scoring Systems - Case study LGD Implementation of the Accord PART 4: PILLAR 2, AN OPEN ROAD TO BASEL 3 From Basel 1 to Basel 3 The Basel 2 Model Extending the Model Integrating other Kinds of Risks Conclusions

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