Developing A Comprehensive Framework for Capital And Business Mix Opmizaon

5th Annual Risk Americas 2016

Bogie Ozdemir Execuve Vice President & Chief Risk Officer May 4, 2016

Canadian Western Bank Group Disclaimer and References q Adapng to Basel III and the financial crises, Re-engineering capital, business mix, and performance management pracces, Bogie Ozdemir, Peter Miu, January 2013, Risk Books q Value Opmizaon in a Regulatory Constrained Regime – A New Look at Risk vs. Return Opmizaon, Bogie Ozdemir, Michael Giesinger, Journal of Risk Management in Financial Instuons, Winter 2011 q Managing Performance using a Dual Measure, Bogie Ozdemir, Evren Cubukgil, Huaxing Xia, Journal of Risk Management in Financial Instuons, Summer 2014 q Managing differences in Economic and Regulatory capital, An examinaon of ROE maximizing strategies, Bogie Ozdemir, Evren Cubukgil, Journal of Risk Management in Financial Instuons, 2014, Vol 7, Number 4 q ORSA: Design and Implementaon, Bogie Ozdemir, Risk Books, 2015 q Managing interest rate risk in the banking book using an Opmizaon Framework, Bogie Ozdemir, Gokul Sudarsana, working paper, 2016

q Opinions expressed are those of the speaker and are not necessarily endorsed by the speaker’s employer. q Correspondence should be addressed to Bogie Ozdemir, [email protected] or [email protected].

Canadian Western Bank Group Observaons and Objecve • Capital is scarce, ROE is low. There has been an increasing need to manage both more effecvely. • There are mulple and oen conflicng measures of capital – Regulatory Capital, Economic Capital and Stress Tesng – where due to demanding CCAR requirements and the Regulatory Capital’s being the binding constraint, Economic Capital is largely marginalized. • In the current low interest rate environment, there is also income pressure • Changes are not over. A new de of changes are around the corner, including fundamental changes to the Standardized Approach, its use as capital floors, and limitaons to use A-IRB; likely amounng to increases in capital levels and large shis in capital usage among the asset classes. • Business Mixes will be in queson again, while the need to opmally co-manage Income, Capital and ROE remains imperave.

3 Canadian Western Bank Group Observaons and Objecve • Can we create Value via: • Risk, Capital and Business Mix Opmizaon? • Idenfying effecve risk strategies to inform corporate strategy and improve ROE? • Co-managing mulple constraints of capital and income needs? • Managing Business Mix? • Managing the interest rate risk in the banking book?

4 Canadian Western Bank Group From Risk Compliance to Strategic Risk Management • Risk Funcon as the “brakes”: the beer the brakes, the faster we can go. • Risk Funcon as a co-pilot: We are in the business of risk-taking and Risk is the control variable in the middle of our business management:

• What businesses we should be in? • What kinds of risks and in what quanes we should be taking next, and in which order to enhance our ROE? • How can we opmize our capital ulizaon? • How can we co-manage our regulatory and economic views of capital to increase our ROE? • Are there some effecve tail-hedging strategies with posive cost/benefit trade-offs? • How can we generate risk synergies to help make the whole of our businesses greater than the sum of its parts? • Risk is central to all these quesons. It is imperave to incorporate risk into decision- making and corporate strategy.

5 Canadian Western Bank Group Can we ignore the internal and economic view of Risk and Capital?

• With the advent of Basel III and the overall increase in regulatory requirements stemming from the economic crisis, financial instuons face regulatory capital mandates that have strained strategic plans more than ever. As a by product of the increased focus on regulatory capital, some financial instuons have reduced their aenon to economic capital, arguing that with a binding regulatory capital constraint, economic capital is less relevant.

• AMERICAN BANKER 2013-09-11

6 Canadian Western Bank Group Can we ignore the internal and economic view of Risk and Capital? • JP Morgan report confirms RWA reducon led to CIO loss: A misguided plan to reduce Basel 2.5 RWAs and a series of management failures combined to leave JP Morgan’s chief investment office with a $6 billion loss, the bank finds JP Morgan has finally lied the lid on the events that led to its chief investment office (CIO) losing $6 billion in a credit derivaves trading misadventure last year. An internal report released yesterday aributed the error to a misguided aempt to reduce the CIO's risk-weighted asset (RWA) consumpon under Basel 2.5 while maintaining profitability. “People are being pushed into the direcon of managing RWAs rather than managing actual risk. So what you get in some cases is RWA decreasing but economic risk massively increasing. There is increasing recognion that this is a problem, but there have been no specific proposals from the Basel Commiee on how to deal with it. A paern is developing of regulaon being ill-thought out but pushed through anyway because of polical pressure. The consequences of this are making themselves apparent, and we'll need to wait a while before these problems are resolved”

• hp://www.risk.net/risk-magazine/news/2237096/jp-morgan-report-confirms-rwa-reducon-led-to-cio-loss 7 Canadian Western Bank Group Experiment – Banks

• Add a new loan to an exisng porolio, and measure Marginal Capital.

• Two potenal deals with the same PD and LGD and Exposure amount. • Therefore Regulatory Model assigns exactly the same capital. • EC, on the other hand, is 3 mes for BNS than for Canada Post. • This is due the fact that unlike Regulatory Capital, EC can measure concentraon risk.

8 Canadian Western Bank Group Experiment – Insurers • Regulatory Capital is leading to a flawed Risk Strategy. • A Simple Experiment: Increase each risk exposure by a certain amount by a single risk type at a me, and measure Marginal Capital.

• EC is somemes above the RC charge, where internal models suggest faer tailed risks, potenal concentraons, or the risk is simply not measured. • EC is somemes below the RC charge, where substanal diversificaon benefits are realized, offseng/hedging posions are recognized, etc. 9 Canadian Western Bank Group Problem Definion • Capital/Business Mix Opmizaon problem for a muldivisional firm where business mix decisions and Capital Allocaon are done centrally and the risk is taken locally. • We have a porolio of businesses, corporate office makes the Business Mix and Capital Allocaon decisions and risk is taken and owned by the businesses themselves. • What is the opmal business mix which would maximize the ROE for the enre firm? • Firm is subject to both Economic Capital (via ICAAP or ORSA) and Regulatory Capital requirements, maximum of which becomes the binding constraint determining the minimum amount of Available Capital the firm needs to hold • Firm is also subject to mulple constraints; Income needs, acceptable Earnings Volality and other elements of its Risk Appete

10 Canadian Western Bank Group Stakeholders including Regulators

Corporate Office

ROE maximizaon for the enre firm

Overall Business Mix and Capital /Risk

Budgeng

Business Group Business Group

ROE maximizaon for ROE maximizaon for the Business Group the Business Group Product Decisions Product Decisions

External Environment: Market, Compeon

Canadian Western Bank Group Seng up the Opmizaon Framework • Maximize ROE (or NEP) while meeng the Income Needs subject to Capital Constraints and Strategic Objecves • ���(​∑�↑�▒​��↓� /​ ��↓��� )≅���(���)

kA’s are all constants more than • There are mulple drivers of Capital 1 as defined in the Risk Appete • ​��↓��� =���(​�↓↑�� ×∑�↑�▒​��↓� , ​ �↓↑�� ×∑�↑�▒​��↓� )

• There are two Control Variables for Income and Capital: Risk and Volume • There are mulple Constraints, including: 12 Canadian Western Bank Group – ​��������� ������� ≥��↓���

– ∑�↑�▒​��↓� ≥������ ������

– ��������� ���������� Alternave set-up for the Objecve Funcon

• ​��↓��� =���(​�↓↑�� ×∑�↑�▒​��↓� , ​ �↓↑�� ×∑�↑�▒​��↓� ,​�↓↑������ ×∑�↑�▒​ ������ ��↓� )

n ⎛ n n ⎞ • kA’s are all constants more than 1. They are all defined in the Risk Appete with max⎜ NI − (k × EC ) + (r − k )×(AC − EC )⎟ ∑i i ∑i e,i i Min ∑ i respect EC, RC, and Stress EC. ⎝ i ⎠ • Incorporang the minimum available capital into the objecve funcon;

• This version has the advantage that the relaonship between minimum available capital and EC, RC, and Stress EC as dictated by the risk appete is taken into account. Incorporang stress EC is parcularly valuable as Stress EC incorporates 13 Canadian Western Bank Group the effect of term risk, increase in correlaons, etc. which needs to be examined in choosing the appropriate capital buffer in ICAAP/ORSA. Empirical Analysis, Porolio Details • Fairly typical (Canadian) bank porolio

Large Corporate SME Retail Exposure 37% 18% 45% EC 55% 25% 20% EL 24% 27% 49%

• Differenated hurtle rate

• Constraints for growth and contracon rates of exposure over the next ρi year: MIN MAX Large Corporate -10% 30% SME -15% 25% Retail -15% 20%

14 Canadian Western Bank Group Empirical Analysis, Examine Boundary Cases • Income Target over the next year is $4.00 billion (*). • Alternave Risk and Business Mix Strategies: – Change the exposure amounts without changing the risk profile per business group. This changes the Business Mix and overall Risk profile. (Scenarios 1-4) – Keep exposure amounts constant, generate extra income by moving up the risk curve • Scenarios 5-8: Uniform increase in risk profile to generate extra (spread) income. • Scenarios 9-10: Non-uniform increase in risk profile to generate extra (spread) income. (Increased Risk in Risk Rangs 1 - 4 only and 5 – 11 only)

(*) If the bank maintains its current exposure, and risk profile, it can expect to have income of $3.72 billion over the next year. Aer expenses but before EL

15 Canadian Western Bank Group Results: Although all scenarios produce $4.00 billion income, NEP and ROEC differs materially

Maximum Reduction in Large Corporate portfolios

16 Canadian Western Bank Group Simple Boundary Cases provide Strategic Insights Ø Correlaons maer. Certain combinaons result in larger diversificaon benefits. For example, the difference in EC between Scenarios 1 and 2 are parally due to the increased diversificaon benefit in Scenario 2. Ø To improve the overall bank’s NEP, the Large Corporate porolio must contract in size. The Large Corporate porolio has a very good NI/EL rao (due to low PDs) but suffers from high EC due to high correlaons. It neither can handle an increase in exposure (Scenario 3) nor an increase in riskiness (Scenarios 5, 6, 9, 10). However, the annual contracon rate is limited to 10%. Ø Retail is a good area of growth for this bank. However, it is limited to 20% growth annually. While the exposure increase does cause NEP to grow significantly, it does not respond as well to moving up the risk curve - due to a further increase in EL which is already substanal given the higher average PD of the business. For moving up the risk curve, there is room for increasing the risk for RR 1 to RR4 (Scenario 9) but not the other way around (Scenario 10). Ø SME porolio does not lend itself well to the moving up the risk curve as the already high EL increases too much. Ø The fact that neither the SME nor Retail porolios benefit from an increase in risk levels of the porolio is an interesng finding. As in these porolios, the growth in business is typically achieved at the expense of an increase in risk. Ø Constraints on growth/contract or, more precisely, the need for income, diminish the ability to course correct. The bank can choose to reduce its Large Corporate business faster than 10% annually but as the retail business cannot grow fast enough to replace the income loss from this reducon, the bank would fall short of its income target. To course correct faster towards a more opmal business mix, income sacrifice is needed in the shorter term.

17 Canadian Western Bank Group

Extensions to the Framework, Managing EaR A B

Critical Loss can be exceeded EaRA once in 10 years VaR is EaR calculated at 90% etc. B

ECA=ECB

18 Canadian Western Bank Group Managing Near Term Losses, Incorporang EaR into RAROC

19 Canadian Western Bank Group Managing Near Term Losses, Incorporang EaR into RAROC

Standard Normal 39% 50% 60%

Log-normal (µ=0;ϭ=1) 13% 19% 26%

Investment Grade. Basel II IRB Risk Weight Funcon (PD=0.15%; 0.5% 3% 7.6%

LGD=0.5, ρ=0.45; Term to Maturity=1 year)

Retail. Basel II IRB Risk Weight Funcon. (PD=1.5%; LGD=0.5, ρ=0.10, 16.2% 25.5% 35.4%

Canadian Western Bank Group Term to Maturity=1 year)

Managing Near Term Losses, Incorporang EaR into RAROC

21 Canadian Western Bank Group ROE Maximizing Strategies If RC is binding, ROE can be increased by closing the gap between EC and RC

Potenal economic cost; while taking advantage of this li-up effect to boost ROE, low ROEC business may be acquired or high ROEC business may be divested. There is no guarantee that ROEC ≥ h for the deals/businesses acquired and ROEC ≤ h for the deals/businesses divested. 22 Canadian Western Bank Group Dialing Up Economic Risk boosts ROE when Regulatory Capital is the binding constraint • Dial-up can be achieved via Contracon or Expansion. Stylized example: ∑NI $8 $70 Contraction RC decreases faster. $70 ∑NI $9 Divest RC heavy ROE 11.4% businesses $100 $80 ∑NI $11 ROE 9% $110 Expansion EC increases faster. $110 Invest in EC heavy ROE 10% businesses

• Unused Economic Risk Taking Capacity is ulized for income generaon, thus to foster ROE. This behaviour will push towards equalizaon of EC and RC on the aggregate.

23 Canadian Western Bank Group EC’s being the binding constraint is a more natural economic model, which regulators should also prefer • Another Stylized example: ∑NI $15 Expansion ≤ $150 RC may $150 increase faster ∑NI $12 ROE 10% $110 $130 ∑NI $10 Contraction ≤ $100 ROE 9.2% EC decreases $100 faster ROE 10%

• A more natural operating model where the business is managed based on EC and there is no economic loss while RC is used as a regulatory constraint to identify outliers whose EC is unreasonably low relative to the economic Risk taken

• While ‘dialing up RC’ is not a strategy, an FI whose EC is larger than RC on the aggregate would have capacity to accept regulatory capital heavy deals where ROEC>h and RORC

• As a result of accepting such deals, aggregate EC and RC requirements may move closer together

24 Canadian Western Bank Group EC’s being the binding constraint is a more natural economic model, which regulators should also prefer • When firms earn income in proportion to levels of economic risk taking, fundamentally different strategies are incentivized when either EC or RC is binding on aggregate.

• If RC is the binding constraint, investors are forced to provide capital in excess of the true level of economic risk, and the market should be expected to react positively to any strategy where this 'idle' capital is utilized (as it is currently not earning anything for investors).

• If EC is the binding constraint, RC does not affect investors' expectations, and there is no such 'idle' capital. • Regulatory Capital will always play a catch-up game. Responding to loopholes in regulatory capital frameworks with increasingly complex and sometime overly punitive requirements cannot be effective. • ICAAP and ORSA transfer accountability for quantifying risk to individual firms. This allows regulatory capital to identify outliers - ensuring a level playing field, while regulators focus on ‘systemic stability’ 25 Canadian Western Bank Group Managing Interest Rate Risk in Banking Book

• Most banks manage their book to target posive duraon (around 2.5 years in Canada). • This is assumed to be a good trade-off between: – the Earnings volality (shortening the duraon increases the volality of one-year NII); and, – Value volality (lengthening the duraon increases the volality of Economic Value of Equity). • Typically EaR and VaR limits are established to keep the duraon within a certain range (e.g., 1.5 years to 3.5 years) to accommodate operaonal fluctuaons and taking posions on interest rate movement.

26 Canadian Western Bank Group Managing Interest Rate Risk in Banking Book

• While this provides a workable soluon, there is no reason for it to be ‘opmal.’ • Target duraon has not been changed materially for over 20 years despite vast changes in the yield curve, which does not seem right! • Some Quesons: – Why is 2.5 appropriate? – Shouldn’t it depend on the shape of the yield curve (a steeper yield curve provides more NII pick up for the similar amount of value risk)? – Can we not formally define an Opmizaon Framework to manage Risk (EaR and VaR) and Return (NII), ‘dynamically’?

27 Canadian Western Bank Group Managing Interest Rate Risk in Banking Book

• The shape of the yield curve determines the opmal target duraon. • A posively sloped yield curve offers posive term premium, where FIs can generate extra NII by extending the duraon. That is the reward side of the equaon. • Extending the duraon also increases the EVE volality, which is the risk side of the equaon. This increased risk increases the equity capital demanded by the firm’s debtholders and the return demanded by the firm’s shareholders for the capital held. • Within a Net Economic Profit framework it is possible to formalize and measure this risk-vs.-return tradeoff. 28 Canadian Western Bank Group Establishing a Dynamic Opmizaon Framework

• A dynamic opmizaon framework based on Net Economic Profit subject to risk appete constraints.

• ���(�[���−​�↓� ×∑↑▒�� ])

• where ∑↑▒�� is the total economic capital due to market, credit and operaonal risk, but only ​��↑������ is interest rate sensitive.

• The industry appears to use target duraon, ​�↑������ as the control variable for managing the interest rate risk in the banking book

• ���=�(​�↑������ );​ ��↑������ =ℎ(​ 29 Canadian Western Bank Group �↑������ ); ​����↓� =�(​�↑������ ) • As the yield curve changes, we can dynamically manage the target duraon to ensure • ​∆���/∆​�↑������ ≥​�↓� ×​​∆��↑������ /∆​ �↑������ or ∆���≥​�↓� ×​∆��↑������

Managing Interest Rate Risk in Banking Book

• We first examine the case where the Treasurer does not take a posion on the ancipated yield curve changes, but rebalances the target duraon ex-post, following yield curve changes. While in general, steepening of the yield curve results in a need to increase the duraon and a flaening of the yield curve results in a need to decrease the duraon; the framework provided helps select the opmal point and connuously rebalance. • Examples provided show that NEP benefit of the opmizaon for a larger Canadian bank can be in the magnitude of $400 million! • We then examine the case where the Treasurer takes a posion on the ancipated yield curve changes and rebalances the target duraon ex-ante. • When the yield curve does not provide a ‘healthy’ term premium - by means of slope, typically an aermath of the extended life support of monetary policy an essenal element of the bank’s business model is compromised. In this environment, it is indeed crical not to take undue risk in search of interest income without a proper risk-return and risk appete framework.

30 Canadian Western Bank Group Only small course correcons are possible but they will make an big impact over the long-haul

Small annual corrections on a firm’s trajectory will have a significant impact over the long term. Simply put, the larger the ship, the more limited the short term maneuverability, and yet the more carefully it has to be navigated in todays’ narrow straights to arrive at the destination

31 Canadian Western Bank Group Speed of adaptaon to the new climate will maer

q There is value to be driven using optimization frameworks. q Speed of course correction towards a more optimal business/ product mix and interest rate position will matter.

32 Canadian Western Bank Group