WIXLIB

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 at different distributions.»Regulators want to explore all the other traditional risk types»Settlement risk can create a loss if the underlying asset value moves against the agreed price.–In Delivery vs Payment (DvP) contracts: the loss is the replacement cost.Example»Firm A buys 1 Apple share at 100 from Firm B.Firm BPrice of Apple Share (settlement date)Profit»No-default9510500Default955105-5To measure settlement risk it is key to capture the joint likelihood of counterparty default and the change in the value of the underlyingreference asset.Managing Capital and Stress Testing for Traded Book Assets20

3Focus on Reverse StressTesting

What Regulators say about Reverse Stress Testing ?The Basel committee paper on principles forsound stress testing practices and supervisionpromoted a comprehensive stress testingapproach in banks, the concept of ReverseStress Testing.EIOPA -Solvency Pilar 2 ORSA Introduction –Reverse Stress TestingPRA provides more explicitstatements on Reverse StressTesting20142009Further to the AQR and EBAstress tests, SREP reverse stresstesting requirements are publishedUpdate on ICAAP and SREPEIOPA – ORSA reinforcesReverse Stress Testinginclusion20162015Solvency 2 Go Live includingsome requirements onReverse Stress Testing20182017EIOPA study on market andcredit riskQuantification elements forinclusionManaging Capital and Stress Testing for Traded Book Assets22

Reverse Stress Testing: Trends123Reverse 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 Require firm to assess scenarios and circumstances that would render its business model unviable More understanding for the ICAAP submission as per regulatory requirementsCore elementsDetermining scenarios Be able to macroeconomic variable related terms for loss points defined Explore idiosyncratic weaknesses Uncover which risks contribute the most to expected loss and capital and use that information to design plausible stress scenarios For instance By how much does GDP have to fall for my portfolio to lose 10% in value?Example approach Range of qualitative and quantitative approaches to determine those weaknesses Explore correlations between credit risk factors and macroeconomic variables to help draw impacts Different risk types will also have different triggers, look at asset class specific influences Leverage macro-scenario approach, which is key input for the firm to explore cause of trigger points. Estimating conditional mean of the risk factors and macro variables conditional on portfolio loss exceeding a given loss level Reducing dimension of risk and macro factors by ranking the most influential risk/macro factors that determine losses Solving for the inversion problem to find the set of risk/macro factors values with regards to the hypothetical scenario (the most likelyscenario)Managing Capital and Stress Testing for Traded Book Assets23

Q&A

Appendix

Joining the Building BlocksBANKING BOOKRISK DUE TO DEFAULTRISK DUE TO CREDIT MIGRATIONRISK DUE TO SPREAD RISKCREDIT RISKRISK DUE TO SPREADRISKTRADING BOOKRISK DUE TO MARKET RISK»»RISK DUE TO CCRChallenges in setting the correlation between credit risk, market risk, spread riskand CCRCOUNTERPARTY CREDITRISKCONSOLIDATED RISKSpread Risk presence in both trading and banking books and unique counting–Margin Period of Risk – Settlement Risk–Migration Risk - SpreadManaging Capital and Stress Testing for Traded Book Assets26

Advantage of an Integrated SolutionBetter captures diversification – more accurate capital numbersA SINGLE CREDIT RISK SYSTEMRISK DUE TO DEFAULTINTEGRATED RISKRISK DUE TO CREDIT MIGRATIONfrom an Integrated Modelof Risk FactorsRISK DUE TO SPREAD RISKRISK DUE TO MARKET RISKRISK DUE TO CCR»Ability to set more accurate and granular risk correlation parameters»Straightforward risk decomposition»Avoids double counting»Improved operational efficiencyManaging Capital and Stress Testing for Traded Book Assets27

Credit Risk FrameworkStandardized ApproachDRC – Internal Model ApproachCredit VaR based approach :3 sub-portfolio to be considered:»»»»»»»»»Stochastic LGD and 0% recovery for equitiesDependance of recovery rates and systematic risk factors2 types of systematic factors for simulating defaultsCorrelations based on equity prices or CDS spreadsFloored PD @3bpsOne year liquidity horizon and 60 day for EquitiesModeling of the Default Risk by Jump-to-default (JTD)»»The new default risk charge should capture the risk arisingfrom long/short positions from the timing of defaults withina one-year capital horizon :»For example a long 1-year bond position hedged with a 3monthCDS should take into account loss scenarios generated by theissuer defaulting between months four and twelve months.Non SecuritizationSecuritization-Non CTP incl. its hedgesSecuritization-CTP incl. its hedgesLGD equity, non senior debt 100%; LGD senior debt 75%, LGDcovered bonds 25%Limitation in terms of seniority for offsetting positions (long/short) : Nettingis allowed only if short position has the same seniority of the long one» JTD (long) Max {LGD X Notional PnL; 0}» JTD (short) Max {LGD X Notional PnL; 0}» RW default risk weight * JTDWts σσ 𝐽𝑇𝐷 𝑙𝑜𝑛𝑔𝐽𝑇𝐷 𝑙𝑜𝑛𝑔 σ 𝐽𝑇𝐷 𝑠ℎ𝑜𝑟𝑡DRC Charge Non Securitization (by bucket) M𝐚𝐱 [ 𝑹𝑾𝑙𝑜𝑛𝑔 net JTD - 𝑾𝒕𝑺 * 𝑹𝑾𝒔𝒉𝒐𝒓𝒕 net JTD, 𝟎]DRC Charge Securitization CTP (by bucketed DRCb) M𝐚𝐱 [ [Max[DRCb,0] 0.5 x Min [DRCb,0],0]Managing Capital and Stress Testing for Traded Book Assets28

Modeling Credit Correlations Using Macroeconomic Variables is alsoCore 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 creditrisk factors, as well as correlations among macroeconomic variablesφMVsΣ curent covariancematrix?MVsφCorrelations ofsystematic factors andmacroeconomicvariables (MVs):Define metrics andtarget survival valuesPerform tail risk fy unviablescenarios & hiddenvulnerabilitiesEnterprise –widesensitivity analysisTake actions andcreate contingencyplansManaging Capital and Stress Testing for Traded Book Assets29

Counterparty Credit RiskRiskFrontier in conjunction with GCorr Macro and a market risk system can be used to constructWrong 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 system that accounts for netting)2)Using the MC Output (which provides trial-by-trial detailed distributions on exposure and factor level) one can calculate the expected WW PDand expected WW market factor realizations conditional on the portfolio realizing losses in the region of the capital threshold3)Compute WW Exposure using the market risk system along with the expected WW market factor from step (2)4)Calculate portfolio referent risk of each counterparty using WW Exposure from (3)5)In some cases the WW Exposure is substantial and may impact the capital threshold to the point where steps (1)-(4) need to be iterated, withthe WW Exposure replacing Expected exposure in step (1)Expectedshock φMVconditional onportfolio lossMarket RiskSystemCalculatesWrong WayExposureWrong WayExposureanalyzed inRiskFrontierManaging Capital and Stress Testing for Traded Book Assets30

Expanded GCorrTM and Macro Variables Covariance Matrix:Modeling OverviewExpanded Cov. MatrixMapping MV and MV FactorsInputsRiskFrontier TMMC SimulationEngineMV MC Trial-by-Trial FileTrialOutputsSimulated macroeconomicfactorsSimulated GCorrTM systematiccredit risk factorsPortfolio Loss1φMV1, φMV2, φ1, φ2, L2φMV1, φMV2, φ1, φ2, LScenario Analysis: Impact MVon LossesStress TestingReverse Stress TestingEconomic scenarioSpecified loss levelLossesEconomic scenariosAnalysis*For further information: “Modeling Credit Correlations using Macro Economic Variables”, Nihil Patel, RPC 2012Managing Capital and Stress Testing for Traded Book Assets31

Workflow : Easy Upload and Selection of Trials Upload RF Outputs: generated the loss distribution correlated factor file Define the tail trial windows enteringprobability levels or a single probability and awindow size.Managing Capital and Stress Testing for Traded Book Assets32

Workflow: Set the starting macro environmentManaging Capital and Stress Testing for Traded Book Assets33

Workflow: Factor and MV Tail Mean Analysis4. Trials Sorting in R or Excel5. 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 TailMean»Macro and Financial Variable Density ProbabilityManaging Capital and Stress Testing for Traded Book Assets34

Scenarios that Generate a Loss Level» The key to this approach is an approximation of theportfolio loss function 𝐿𝐻 𝑟 as a linear function of assetreturns.» The linearization is done around the asset returns 𝑟ҧ thatgenerate the pre-defined loss level 𝐿ത .» We can then analytically search for the scenarios that givethat level of loss» We need the Monte Carlo output around the pre-definedManaging Capital and Stress Testing for Traded Book Assetsloss level to identify the asset returns𝑟.ҧ35

Scenarios that Generate a Loss LevelExample» 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-modelvalue in this portfolio at a 1-year horizon.–This loss level corresponds to the 47bp percentile of the loss distribution.–Analysis date: 30/09/2016.» We focus only on scenarios with the following macroeconomic variables:–US Unemployment, US Equity, US VIX, US BBB Spread, Canada Equity, Canada Unemployment, Oil Price.Managing Capital and Stress Testing for Traded Book Assets36

Scenarios that Generate a Loss LevelExample: Focus on the scenario with a 6% loss levelAnalysis DateAverage ScenarioQ3-2016Q3-20174.9%10%10025US VIX13.3439.87US BBB Spread1.85%9.36%Canada Equity10033Canada Unemployment7%20.51%Oil Price10041Macroeconomic VariableUS UnemploymentUS EquityThe scenarios should lead to a conditional loss distribution whoseexpected loss is close to the desired level of lossPercentilesTargetExpected ConditionalLoss672 bp2%4%154 bp4%6.33%46 bp6%8.19%Managing Capital and Stress Testing for Traded Book Assets37

Reverse Stress Testing UtilityAutomationThe utility automates and streamlines the reverse stress testing process from RF Outputs to Tail Factor Analysis.Factor and Macro Variable Sensitivity ApproachSystematic and Macro/financial Macro Variables detailed Tail Mean AnalysisTransparencyValidation and Audit Analysis including Tail Trials, MV Returns, GCorr Factor MappingGovernanceFrequency of Updates wrt GCorr Models, Macro Levels update and Quality ChecksFast CalculationUses R code and Excel Macros for Trial Sorting that can be performed in few minutes.Managing Capital and Stress Testing for Traded Book Assets38

2018 Moody’s Corporation, Moody’s Investors Service, Inc., Moody’s Analytics, Inc. and/or their licensors and affiliates (collectively, “MOODY’S”). Allrights reserved.CREDIT RATINGS ISSUED BY MOODY'S INVESTORS SERVICE, INC. AND ITS RATINGS AFFILIATES (“MIS”) ARE MOODY’S CURRENTOPINIONS OF THE RELATIVE FUTURE CREDIT RISK OF ENTITIES, CREDIT COMMITMENTS, OR DEBT OR DEBT-LIKE SECURITIES, ANDMOODY’S PUBLICATIONS MAY INCLUDE MOODY’S CURRENT OPINIONS OF THE RELATIVE FUTURE CREDIT RISK OF ENTITIES, CREDITCOMMITMENTS, OR DEBT OR DEBT-LIKE SECURITIES. MOODY’S DEFINES CREDIT RISK AS THE RISK THAT AN ENTITY MAY NOT MEETITS CONTRACTUAL, FINANCIAL OBLIGATIONS AS THEY COME DUE AND ANY ESTIMATED FINANCIAL LOSS IN THE EVENT OF DEFAULT.CREDIT RATINGS DO NOT ADDRESS ANY OTHER RISK, INCLUDING BUT NOT LIMITED TO: LIQUIDITY RISK, MARKET VALUE RISK, ORPRICE VOLATILITY. CREDIT RATINGS AND MOODY’S OPINIONS INCLUDED IN MOODY’S PUBLICATIONS ARE NOT STATEMENTS OFCURRENT OR HISTORICAL FACT. MOODY’S PUBLICATIONS MAY ALSO INCLUDE QUANTITATIVE MODEL-BASED ESTIMATES OF CREDITRISK AND RELATED OPINIONS OR COMMENTARY PUBLISHED BY MOODY’S ANALYTICS, INC. CREDIT RATINGS AND MOODY’SPUBLICATIONS DO NOT CONSTITUTE OR PROVIDE INVESTMENT OR FINANCIAL ADVICE, AND CREDIT RATINGS AND MOODY’SPUBLICATIONS ARE NOT AND DO NOT PROVIDE RECOMMENDATIONS TO PURCHASE, SELL, OR HOLD PARTICULAR SECURITIES.NEITHER CREDIT RATINGS NOR MOODY’S PUBLICATIONS COMMENT ON THE SUITABILITY OF AN INVESTMENT FOR ANY PARTICULARINVESTOR. MOODY’S ISSUES ITS CREDIT RATINGS AND PUBLISHES MOODY’S PUBLICATIONS WITH THE EXPECTATION ANDUNDERSTANDING THAT EACH INVESTOR WILL, WITH DUE CARE, MAKE ITS OWN STUDY AND EVALUATION OF EACH SECURITY THAT ISUNDER CONSIDERATION FOR PURCHASE, HOLDING, OR SALE.MOODY’S CREDIT RATINGS AND MOODY’S PUBLICATIONS ARE NOT INTENDED FOR USE BY RETAIL INVESTORS AND IT WOULD BERECKLESS AND INAPPROPRIATE FOR RETAIL INVESTORS TO USE MOODY’S CREDIT RATINGS OR MOODY’S PUBLICATIONS WHENMAKING ANINVESTMENT DECISION. IF IN DOUBT YOU SHOULD CONTACT YOUR FINANCIAL OR OTHER PROFESSIONAL ADVISER.ALL INFORMATION CONTAINED HEREIN IS PROTECTED BY LAW, INCLUDING BUT NOT LIMITED TO, COPYRIGHT LAW, AND NONE OFSUCH INFORMATION MAY BE COPIED OR OTHERWISE REPRODUCED, REPACKAGED, FURTHER TRANSMITTED, TRANSFERRED,DISSEMINATED, REDISTRIBUTED OR RESOLD, OR STORED FOR SUBSEQUENT USE FOR ANY SUCH PURPOSE, IN WHOLE OR IN PART,IN ANY FORM OR MANNER OR BY ANY MEANS WHATSOEVER, BY ANY PERSON WITHOUT MOODY’S PRIOR WRITTEN CONSENT.All information contained herein is obtained by MOODY’S from sources believed by it to be accurate and reliable. Because of the possibility of humanor mechanical error as well as other factors, however, all information contained herein is provided “AS IS” without warranty of any kind. MOODY'Sadopts all necessary measures so that the information it uses in assigning a credit rating is of sufficient quality and from sources MOODY'S considersto be reliable including, when appropriate, independent third-party sources. However, MOODY’S is not an auditor and cannot in every instanceindependently verify or validate information received in the rating process or in preparing the Moody’s publications.NO WARRANTY, EXPRESS OR IMPLIED, AS TO THE ACCURACY, TIMELINESS, COMPLETENESS, MERCHANTABILITY OR FITNESS FORANY PARTICULAR PURPOSE OF ANY SUCH RATING OR OTHER OPINION OR INFORMATION IS GIVEN OR MADE BY MOODY’S IN ANYFORM OR MANNER WHATSOEVER.Moody’s Investors Service, Inc., a wholly-owned credit rating agency subsidiary of Moody’s Corporation (“MCO”), hereby discloses that most issuers ofdebt securities (including corporate and municipal bonds, debentures, notes and commercial paper) and preferred stock rated by Moody’s InvestorsService, Inc. have, prior to assignment of any rating, agreed to pay to Moody’s Investors Service, Inc. for appraisal and rating services rendered by itfees ranging from 1,500 to approximately 2,500,000. MCO and MIS also maintain policies and procedures to address the independence of MIS’sratings and rating processes. Information regarding certain affiliations that may exist between directors of MCO and rated entities, and between entitieswho hold ratings from MIS and have also publicly reported to the SEC an ownership interest in MCO of more than 5%, is posted annually atwww.moodys.com under the heading “Investor Relations — Corporate Governance — Director and Shareholder Affiliation Policy.”Additional terms for Australia only: Any publication into Australia of this document is pursuant to the Australian Financial Services License ofMOODY’S affiliate, Moody’s Investors Service Pty Limited ABN 61 003 399 657AFSL 336969 and/or Moody’s Analytics Australia Pty Ltd ABN 94 105136 972 AFSL 383569 (as applicable). This document is intended to be provided only to “wholesale clients” within the meaning of section 761G of theCorporations Act 2001. By continuing to access this document from within Australia, you represent to MOODY’S that you are, or are accessing thedocument as a representative of, a “wholesale client” and that neither you nor the entity you represent will directly or indirectly disseminate thisdocument or its contents to “retail clients” within the meaning of section 761G of the Corporations Act 2001. MOODY’S credit rating is an opinion as tothe creditworthiness of a debt obligation of the issuer, not on the equity securities of the issuer or any form of security that is available to retailinvestors. It would be reckless and inappropriate for retail investors to use MOODY’S credit ratings or publications when making an investmentdecision. If in doubt you should contact your financial or other professional adviser.Additional terms for Japan only: Moody's Japan K.K. (“MJKK”) is a wholly-owned credit rating agency subsidiary of Moody's Group Japan G.K., whichis wholly-owned by Moody’s Overseas Holdings Inc., a wholly-owned subsidiary of MCO. Moody’s SF Japan K.K. (“MSFJ”) is a wholly-owned creditrating agency subsidiary of MJKK. MSFJ is not a Nationally Recognized Statistical Rating Organization (“NRSRO”). Therefore, credit ratings assignedby MSFJ are Non-NRSRO Credit Ratings. Non-NRSRO Credit Ratings are assigned by an entity that is not a NRSRO and, consequently, the ratedobligation will not qualify for certain types of treatment under U.S. laws. MJKK and MSFJ are credit rating agencies registered with theJapan Financial Services Agency and their registration numbers are FSA Commissioner (Ratings) No. 2and 3 respectively.MJKK or MSFJ (as applicable) hereby disclose that most issuers of debt securities (including corporate and municipal bonds, debentures, notes andcommercial paper) and preferred stock rated by MJKK or MSFJ (as applicable) have, prior to assignment of any rating, agreed to pay to MJKK orMSFJ (as applicable) for appraisal and rating services rendered by it fees ranging from JPY200,000 to approximately JPY350,000,000.MJKK and MSFJ also maintain policies and procedur

Counterparty Credit Risk considerations Multi-period Valuation Portfolio Models Correlation » Valuation (optionality and pricing proxies etc) » Credit Migration and Spread Risk Effects » Liquidity Value adjustments/ funding liquidity adjustments » Wrong way risk (specific) » Monte Carlo simulation approximations » CVA VaR and allocation