Moody's Corporation · NYSE:MCO
Moody's — Conference Presentation (October 2018)
38 slides from Moody's's conference presentation, Oct 4, 2018
Slide 1: Managing Capital and Stress Testing for Traded Book Assets
Managing Capital and Stress Testing for Traded Book Assets Abinash Arulanandam, Alexis Hamar and Roshni Patel Thursday 4 October 2018
Slide 2: Agenda
Agenda Key elements for discussion 1. Overview and the current market demands 2. Impacts for trading book assets a. Fundamental Review of Trading Book - Linkage to Incremental Risk Charge (IRC) and Default Risk Charge (DRC) b. Risk coverage 3. Focus on Reverse Stress Testing 4. Q&A Managing Capital
Slide 3: Overview and the current market demands
1 Overview and the current market demands
Slide 4: Market trends
Market trends Traditionally, analysis of trading book and banking book is viewed as distinct from the analysis of the different nature and dynamics of risks. However, some joint dynamics are required to capture the emergence of collateral risk NEW PARADIGM FOR TRADED ASSETS • More Regulatory emphasi
Slide 5: What is the market saying?
What is the market saying? Comments in 2018 Quantification soundness 1 Current approaches adopted by clients are viewed to not be quantitative, and are more expert or qualitatively based/driven. This is predominantly led by ICAAP findings and internal committee reviews. Governance 2 The banking book
Slide 6: The financial crisis and the regulatory evolution on Trading Book
The financial crisis and the regulatory evolution on Trading Book Capital Volatility for Trading Assets Next evolution: Market VaR RWA FRTB Basel 4 Impact of Basel Expected Shorftall / 2.5 Liquidity Horizon Basel 2.5 Arbitrage between Capital charge for wider Regulator imposed Stressed VaR asset cla
Slide 7: Banking & Trading Books: Common Components and Intersections
Banking & Trading Books Common Components and Intersections INTERSECTIONS Commercial Margin COMMON Commercial Margin COMPONENTS Spread Risk Premium Collateral Value Adjustment Funds Transfer Price Concentration Premium Capital Value Adjustment » New Accounting standards to impact both Pricing and Re
Slide 8: Fundamental Review of Trading Book
2 Fundamental Review of Trading Book Linkage to DRC and IRC
Slide 9: FRTB Implementation
FRTB Implementation Senior Management Strategy/profitability Investments Governance Banking Book Desk reorganisation Desk1 (eligible desks) Desk2 IRT Well defined Front office desk boundary Desk n Trading Book Internal Model Approach (IMA) Standardized Approach Front office Expected DEFAULT RISK Sen
Slide 10: Stress Testing Emphasis in FRTB
Stress Testing Emphasis in FRTB » Stress Testing is a transversal imposed practice – Stressed calibration period (period of significant financial stress) for Expected Shortfall – Liquidity Horizon : no price movement for instrument hedging in stressed period – Curvature in Standardized approach is e
Slide 11: IRC Principles
IRC Principles Risk Mitigation and Coverage » Debt Instruments Diversification » Sovereigns » Long/Short Positions 06 01 » Corporates/Financials » Hedging Strategies » Credit & IR Derivatives Optionality IRC Concentration Risk 05 02 » Non Linear relationships PRINCIPLES » Issuer and Market (Country/
Slide 12: Proposed Architecture (Example for DRC)
Proposed Architecture (Example for DRC) Integration Services Risk Management Front Office Data Integration Services Reference Portfolios Correlation Model Stress Testing Model Reference Data Coordinator Hypothetical PnL Sensitivies 1 Shared Temp 4 Security 8 Default Risk Distributed Simulation Charg
Slide 13: FRTB, DRC – Correlation pain point
FRTB, DRC – Correlation pain point Correlation is one of the pain points due to modelling complexity, data requirements and inclusion of equities in FRTB FRTB REQUIREMENTS Granular level that allows client to better understand risk in their portfolios MODEL Multi-factor model allows to capture diffe
Slide 14: IRC vs DRC Summary
IRC vs DRC Summary Topics IRC DRC Scope IR Instruments (Bonds, Sovereigns, IR Instruments + Equities CDS) Equities (optional) Modeling Approach VaR 1 year @99.9% VaR 1 year @99.9% Default Risk Multi-Factor approach 2 types of Factor Approach Correlations horizon 3 years 10 years including a 12 month
Slide 15: 2b Other risk types
2b Other risk types
Slide 16: Counterparty Credit Risk considerations
Counterparty Credit Risk considerations Multi-period Valuation Portfolio Models Correlation » Valuation (optionality and pricing » Monte Carlo simulation approximations » Risk Factor Analysis (multi factor proxies etc) asset correlation models) » CVA VaR and allocation » Credit Migration and Spread
Slide 17: Wrong Way Risk
Wrong Way Risk » Wrong-Way Risk – An unfavourable dependence between exposure and counterparty credit quality: the exposure is high when the counterparty is more likely to default and vice versa. » General Wrong-Way Risk – Arises when the probability of default of counterparties is positively correl
Slide 18: Wrong Way Risk and correlations
Wrong Way Risk and correlations » There are two types of correlation to consider: – The correlation between the underlying asset and the counterparty of the trade. – The correlation between the trades. » A firm has to typically take into account both types of correlation. » The correlation between t
Slide 19: Settlement Risk
Settlement Risk » Settlement risk is the risk that one party will fail to deliver the terms of a contract with another party at the time of settlement. » In Europe, there is a growing trend to see more quantification of the settlement risk capital and its impact considering netting, correlations and
Slide 20: Focus on Reverse Stress Testing
3 Focus on Reverse Stress Testing
Slide 21: What Regulators say about Reverse Stress Testing?
What Regulators say about Reverse Stress Testing ? The Basel committee paper on principles for sound stress testing practices and supervision promoted a comprehensive stress testing approach in banks, the concept of Reverse Stress Testing. Update on ICAAP and SREP EIOPA -Solvency Pilar 2 ORSA Introd
Slide 22: Reverse Stress Testing: Trends
Reverse Stress Testing: Trends Reverse Stress Testing – Nothing new • In the UK, this has been around for a number of years, Europe has become more advanced and developed, a new re-focus 1 • Require firm to assess scenarios and circumstances that would render its business model unviable • More under
Slide 23: Q&A
Q&A
Slide 24: Appendix
Appendix
Slide 25: Joining the Building Blocks
Joining the Building Blocks BANKING BOOK RISK DUE TO DEFAULT RISK DUE TO CREDIT MIGRATION CREDIT RISK RISK DUE TO SPREAD RISK RISK DUE TO SPREAD RISK TRADING BOOK COUNTERPARTY CREDIT RISK DUE TO CCR RISK RISK DUE TO MARKET RISK » Challenges in setting the correlation between credit risk, market risk
Slide 26: Advantage of an Integrated Solution
Advantage of an Integrated Solution Better captures diversification – more accurate capital numbers A SINGLE CREDIT RISK SYSTEM RISK DUE TO DEFAULT INTEGRATED RISK RISK DUE TO CREDIT MIGRATION from an Integrated Model of Risk Factors RISK DUE TO SPREAD RISK RISK DUE TO MARKET RISK RISK DUE TO CCR »
Slide 27: Credit Risk Framework
Credit Risk Framework DRC – Internal Model Approach Standardized Approach Credit VaR based approach : 3 sub-portfolio to be considered: » Stochastic LGD and 0% recovery for equities » Non Securitization » Dependance of recovery rates and systematic risk factors » Securitization-Non CTP incl. its hed
Slide 28: Modeling Credit Correlations Using Macroeconomic Variables
Modeling Credit Correlations Using Macroeconomic Variables is also Core to Understand Portfolio-Specific Tail Risk under Stress The parameters to be estimated are the entries of the correlations matrix linking macroeconomic variables and systematic credit risk factors, as well as correlations amon
Slide 29: Counterparty Credit Risk
Counterparty Credit Risk RiskFrontier in conjunction with GCorr Macro and a market risk system can be used to construct Wrong Way Exposure, along with the portfolio referent risk of each particular counterparty. 1)Run RiskFrontier with GCorr Macro and the Expected Exposure Profile (from market syste
Slide 30: Expanded GCorr and Macro Variables Covariance Matrix: Modeling Overview
Expanded GCorrTM and Macro Variables Covariance Matrix: Modeling Overview Expanded Cov. Matrix Mapping MV and MV Factors Inputs RiskFrontier TM MV MC Trial-by-Trial File MC Simulation Engine Simulated macroeconomic Simulated GCorrTM systematic Trial Portfolio Loss factors credit risk factors Outputs
Slide 31: Workflow: Easy Upload and Selection of Trials
Workflow : Easy Upload and Selection of Trials Upload RF Outputs: generated the loss distribution correlated factor file Define the tail trial windows entering probability levels or a single probability and a window size. Managing Capital and Stress Testing for Traded Book Assets 32
Slide 32: Workflow: Set the starting macro environment
Workflow: Set the starting macro environment Managing Capital and Stress Testing for Traded Book Assets 33
Slide 33: Workflow: Factor and MV Tail Mean Analysis
Workflow: Factor and MV Tail Mean Analysis 4. Trials Sorting in R or Excel 5. Attribution Reports – Outputs Factor Means Macro and Financial Variable Means Macro and Financial Variable Density » Conditional Systematic Factor Ranking Tail Mean » Conditional Macro and Financial Variables Tail Me
Slide 34: Scenarios that Generate a Loss Level
Scenarios that Generate a Loss Level » The key to this approach is an approximation of the portfolio loss function 𝐿𝐻 𝑟 as a linear function of asset returns. » The linearization is done around the asset returns 𝑟ҧ that generate the pre-defined loss level 𝐿ത . » We can then analytically search…
Slide 35: Scenarios that Generate a Loss Level
Scenarios that Generate a Loss Level Example » Consider a well-diversified portfolio made of US and Canadian exposures. » We want macroeconomic scenarios that lead to a loss of 6% of mark-to-model value in this portfolio at a 1-year horizon. – This loss level corresponds to the 47bp percentile of th
Slide 36: Scenarios that Generate a Loss Level
Scenarios that Generate a Loss Level Example: Focus on the scenario with a 6% loss level Analysis Date Average Scenario Macroeconomic Variable Q3-2016 Q3-2017 US Unemployment 4.9% 10% US Equity 100 25 US VIX 13.34 39.87 US BBB Spread 1.85% 9.36% Canada Equity 100 33 Canada Unemployment 7% 20.51% Oil
Slide 37: Reverse Stress Testing Utility
Reverse Stress Testing Utility Automation The utility automates and streamlines the reverse stress testing process from RF Outputs to Tail Factor Analysis. Factor and Macro Variable Sensitivity Approach Systematic and Macro/financial Macro Variables detailed Tail Mean Analysis Transparency Validatio
Slide 38: Interest Rate Risk in the Banking Book, Sep 2017
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