Presentation to the Government Association of Certified Public Accountants during the 31 st Annual National Convention Overview on Risk Management

Presentation to the Government Association of Certified Public Accountants during the 31st Annual National Convention

Overview on Risk Management

Page 2

► Illustrative Applications of Risk Management (Learning from the Financial Service Industry)

Risk and Capital Management

Page 3

Fundamental Risk Management Process

IdentifyIdentify

MeasureMeasure

MonitorMonitor

Risk Risk Management Management

ProcessProcess

How much risk do we have?

Updating and reporting

of relevant information

What should we do

about our risks?

ManageManage

What risks do we have?

What are the sources of

these risks?

Page 4

Governance and Control environment

Understanding riskUnderstanding risk

• Does senior management understand the risks faced both internal and external?

• How does management decide on the business’s risk appetite?

• How does management incorporate their understanding of risk into strategy?

• How does management communicate this to the rest of the business?

Controlling riskControlling risk

• What controls are in place to assess and manage risk?

• What is the quality of the controls in place and how are they tested?

• How clear are policy documentation? (ie, roles & responsibility)

• How does management ensure policies are being implemented?

• How does management deal with conflicts of interests & independent controls and reviews?

ReportingReporting

• How appropriate is the internal reporting process (ie, do people receive the necessary information)?

• How clear is it that management use internal reporting for decision making?

• What information does management receive to give them comfort on implementation?

• How clear are reporting lines within the structure?

Decision makingDecision making

• How does the controls environment need to change?

• Is management comfortable with their risk appetite?

• How does management seek to raise capital?

• What is the quality of capital needed?• Does the risk infrastructure support the

business strategy• Does the firms strategy need to change

to maximize opportunities from risks in the business?

Governance Governance & Control& Control

Governance Governance & Control& Control

Transparent governance

structure

Risk based decision making

Prudent conduct of business

Monitoring and periodic reviews

Page 5

Fundamental Risk Management Process

IdentifyIdentify

MeasureMeasure

MonitorMonitor

Risk Risk Management Management

ProcessProcess

How much risk do we have?

(tougher part)

Updating and reporting

of relevant information

What should we do

about our risks?

ManageManage

What risks do we

have? What are

the sources of

these risks?

(tough part)

Page 6

Sample Application in Credit Risk Management

RATINGCLASS

Loan balances

(in billions)

PD

1 (high quality) 0 0%

2 2 1%

3 85 3%

4 18 4%

5 23 7%

6 46 12%

7 52 29%

8 15 46%

9 32 78%

10(default) 12 100%

Total 285

Credit Risk Modelling

Credit Risk Assessment

Credit Risk Monitoring

Default & Collections

Marketing

Overarching Governance

Product Development / Amendments

• Risk differentiation possible through a rating system

• A credit rating system (e.g., for developer lending) is essential for credit approval, risk management and internal capital allocation • Property of

monotonocity – credit quality declines (as reflected by PD) as one goes down the rating scale

Note: illustrative numbers only

Page 7

Credit Risk Rating System

RATINGCLASS

Loan balances

(in billions)

1 (high

quality) 0

2 7

3 35

4 26

5 37

6 72

7 158

8 92

9 44

10(default) 62

Total 533

• A risk rating model facilitates risk-based pricing

• Rating system will depend on criteria developed

• Risk rating system not a substitute for a sound and well-informed credit judgment

RATINGCLASS

Loan balances

(in billions)

1 (high

quality) 0

2 2

3 85

4 18

5 23

6 46

7 52

8 15

9 32

10(default) 12

Total 285

Before After ‘expansive lending’

Note: illustrative numbers only

Page 8

ADDRESSESADDRESSESFOCUSESFOCUSES

Credit Extension Criteria Collateral Security Requirements Documentation Requirements Facility Structuring

Approval Authorities

Limits Industry Customer Group

Classification

Risk Return Profile and Mandate Customer Risk Categorization Loan Pricing Methodology Industry Risk Rankings

Policy Direction Policy Execution Policy Control

Portfolio ProtectionPortfolio Protection

‘Profitability’ or Sustainability‘Profitability’ or Sustainability

Policy DesignPolicy Design

1. Portfolio Over-Concentration

2. The “Lemming” Complex(or Me “Too-ism”)

3. Over-Reliance On Collateral AsA “Way-Out” (asset-based lending)

4. Continued Lending Into ADepressed Business Cycle

5. Retrospective RiskAssessment (Not Prospective)

6. Under-Pricing Risk

7. Lack Of Accountability and BasisFor Credit Decisions

8. Failing To Enforce EstablishedProcedures When Times Are Good

Eight Common MistakesEight Common Mistakes

XX

XX

XX

XX

XX

XX

XX

XX

Credit Risk Management Should be Designed to Address Common Mistakes in Lending

Page 9

VaR Illustration

• Assuming 99% confidence level and a 1-day horizon, a VaR of Php11 million implies that the FI can expect that, with a probability of 99%, the value of the asset or portfolio will decrease by Php11 million or less during one day.

-3 -2 -1 1 2 3

0.2

0.4

0.6

0.8

1

Profit/Loss

Portfolio Return Distribution

1%

VaR

Value-at-Risk

Page 10

Question

What is the correct interpretation of a P4M overnight VaR figure with 99% confidence level? The FI

a) can be expected to lose at least P4M in 1 out of next 100 days

b) can be expected to lose at least P4M in 95 out of next 100 days

c) can be expected to lose at most P4M in 1 out of next 100 days

d) can be expected to lose at most P8M in 2 out of next 100 days

Value-at-Risk

Page 11

VaR Illustration

-3 -2 -1 1 2 3

0.2

0.4

0.6

0.8

1

Profit/Loss

Portfolio Return Distribution

1%

VaR

VaR when improperly applied

• What about this region?

Page 12

Expected and unexpected losses

0.0

0.1

0.2

Expected loss Unexpected loss

Probability distribution of credit losses

Provisions and margin Capital

Unexpected loss

The maximum loss exceeding the expected loss with a given confidence level

Expected loss

The average loss of entity due to borrowers’ defaults

• Theoretically, expected losses are covered by margins from pricing and provisioning

• If there is cap on pricing, and costs are increasing because of higher expected losses (to reflect increasing credit risk), Fund’s profits and capital would be dissipated

Page 13

Basel II Framework

CreditCredit

OperationalOperational

MarketMarket

Internal Capital Adequacy Assessment


Supervisory Review & Evaluation Process


Public Disclosure of risk information


Pillar II

ICAAP and SREP

Pillar II

ICAAP and SREP

Pillar III

Disclosure

Pillar III

Disclosure

Pillar I

Minimum Capital Charge

Pillar I


Page 14

Minimum Capital Requirement

Following the definition of regulatory capital under BSP► BSP issued Circular 538 for banks to set up minimum capital adequate to meet credit,

market, and operational risk exposures. This is measured by the Capital Adequacy Ratio (CAR) with the following formula:

CAR = Capital

Sum of Credit Risk Weighted Assets + [ (Market Risk Capital Charge

+ Operational Risk Capital Charge) * 10]

Page 15

Definition of Capital – Accounting? Regulatory? Economic?

Core Capital (‘Tier 1’)► Equity capital► Surplus

Supplementary Capital (‘Tier 2’)► Revaluation reserves► General provisions ► Hybrid debt capital► Subordinated term debt

Short-term subordinated debt (‘Tier 3’)

► Concept of ‘capital tiering’ concept is based on the banking industry

► What is the capital structure of the Fund?

Page 16

Basel II Framework

CreditCredit

OperationalOperational

MarketMarket







Pillar II

ICAAP and SREP

Pillar II

ICAAP and SREP

Pillar III

Disclosure

Pillar III

Disclosure

Pillar I


Pillar I


Page 17

Minimum capitalMinimum capital

Ad

dit

ion

al C

apit

al

Req

uir

emen

ts

Pillar 2 riskPillar 2 risk

Quality of ICAAPQuality of ICAAP

General controlsGeneral controls

Credit riskCredit risk

LowLow Medium/LowMedium/Low MediumMedium Medium/highMedium/high HighHigh

Operational riskOperational risk

Market riskMarket risk

BA

SE

CA

PIT

AL

Individual capital guidance

Individual capital guidance

Credit risk controlsCredit risk controls

Operational risk controls

Operational risk controls

Market risk controlsMarket risk controls

Pillar 2 controlsPillar 2 controls

Capital planning & stress testingCapital planning & stress testing

GovernanceGovernance

PIL

LA

R 1

PIL

LA

R 2

Independent Review and Additional Capital Requirements (Basel II Framework)

It is crucial that functions performing independent review are fully geared up with respect to resources and skill sets to ensure the “additional capital requirements” is kept to a minimum.

Page 18

Pillar I Risks

Risks not fully covered by

Pillar I

Risks not in Pillar I

External factors Stress testing

Block 1 Block 2 Block 3 Block 4

Credit

Market

Operational

Residual

Securitization

Model Risk

Interest rate

Concentration

Liquidity

Settlement

Reputation

Strategic

Underwriting

Pension

Transfer

Business

Strategy

Environment

Capital Amount

ICAAP Overview: Building Blocks (Basel II Framework)

Page 19

Need for an Integrated Asset-Liability Management Plan

► Liquidity reserve► Mismatch► Asset composition

► Possible actions► Sources of funds► Behavior of other

counterparties

► Environment► Markets► Political/Regulations► Broader economy

ALM

Strategy

Integrated Risk Modelling (Liquidity and Other Material

Risks)

Profile

Stress Testing

Contingency Planning

Wider Environment• Reflect all significant aspects• Need to consider changes or ‘shifts’• Need to relate with other risks

-1200

-1000

-800

-600

-400

-200

0

200

400

600

800

1000

US

D m

-1200

-1000

-800

-600

-400

-200

0

200

400

600

800

1000

Ax

is T

itle

Assets Liabilities Required Funding

-3500

-3000

-2500

-2000

-1500

-1000

-500

0

500

1000

US

D m

-3500

-3000

-2500

-2000

-1500

-1000

-500

0

500

1000

Axi

s T

itle

Assets Liabilities Required Funding

► Data sources► Data integrity► MIS needs

Data and Systems

Page 20

Board of Trustees

Risk Committee

President & CEO

RM Executive Committee 1

Chief Risk Officer 2

CRM ALM

Operating Units

MRM ORM

Illustrative Oversight Structure – Risk Management

Abbreviations:

MRM – Market Risk Management

CRM – Credit Risk Management

ALM – Asset Liability Management

ORM – Operations Risk Management

Note:1 Can reside in management committees2 In other governance models, certain risks reside in other departments (e.g., strategic risks), operating units (e.g., operational risks), or specialized committees (e.g., ALM)

Page 21

Enterprise Risk Management as an Imperative for Economic Capital and ALM

Keep Us Out of Trouble

Make Our Business Better

Busi

ness

Str

ate

gy

Business Driversand Initiatives

Execu

tive M

anagem

en

t Strategic

Compliance

Financial

Operations

StrategicStrategic

ComplianceCompliance

FinancialFinancial

OperationsOperations

Coverage

Achieve

Objectives

Risks OversightApproach

Assess

Improve

Monitor

COORDINATED APPROACH TO RISK

ALIGNED TO BUSINESS DRIVERSO

pera

tion

s an

d B

usi

ness

Un

its

Su

pp

ort

Fu

nct

ion

s

Corp

ora

te R

isk

Fun

ctio

ns

Asset Management

Claims Management

Operations/ Admin/ IT

Underwriting

Marketing/Sales

Product Development

Asset Management

Claims Management

Operations/ Admin/ IT

Underwriting

Marketing/Sales

Product Development

Legal and Other

HR

Transactions

Tax

IT

Finance and Accounting

Legal and Other

HR

Transactions

Tax

IT

Finance and Accounting

Other Risk Functions

Internal ControlsGroup

ComplianceFunction

InternalAudit

Other Risk Functions

Internal ControlsGroup

ComplianceFunction

InternalAudit

RiskCommittee

AuditCommittee

Board

Executive Management

RiskCommittee

AuditCommittee

Board

Executive Management

Reputationand Brand

Revenue and Market Share

Earnings and OperatingMargins

Assetand Capital

Management

Reputationand Brand

Revenue and Market Share

Earnings and OperatingMargins

Assetand Capital

Management

Page 22

Enterprise View

Illustrative Risk Radar (Top 10 Risks) The credit crunch

1) Regulation and compliance

2) Deepening recession

3) Radical greening

4) Non-traditional entrants

5) Cost cutting

6) Managing talent

7) Executing alliances and transactions

8) Business model redundancy

9) Reputation risks

Financial Service Industry

Page 23

► The Financial Service Industry serves as laboratory for risk and capital management developments► It is also a ‘graveyard’ where lessons

can be learned


Page 24

► Indications of risk management being required based on disclosures in IFRS (and soon IPSAS)

Agenda

Page 25

IFRS 7, Financial Instruments:IFRS 7, Financial Instruments:Disclosures Disclosures (Effective January 1, 2007)(Effective January 1, 2007)

Page 26

► Overview► Balance Sheet Disclosures► Income Statement and Equity Disclosures ► Other Disclosures ► Risk Disclosures

IFRS 7

Page 27

Types of typical risks arising from financial instruments

market riskliquidity risk

currency riskinterest rate risk

risk of prematureredemption

other price risks

share price recovery riskcommodities price

credit risk

Risks arising from financial instruments

Page 28

► The disclosures shall enable the reader of the entity‘s financial statement to evaluate the nature and extent of the risks arising from financial instruments to which the entity is exposed at reporting date.

► The disclosures focus on the risks that arise from financial instruments and how they have been managed.

Nature and extent of risks arising from financial instruments

qualitative disclosures quantitative disclosures

Risks arising from financial instruments

Page 29

► Qualitative disclosures► Quantitative disclosures - general► Quantitative disclosures - credit risk► Quantitative disclosures - liquidity risk► Quantitative disclosures - market risk

Sample risk disclosures

Page 30

IFRS 7.33For each type of risk arising from financial instruments, the entity shall disclose:

a) the exposures to risk and how they arise;

b) its objectives, policies and processes for managing the risk and the

methods used to measure the risk; and

c) any changes in (a) or (b) from the previous period.

Qualitative disclosures

Page 31

Qualitative disclosures may include the following narrative description:- Risks the entity is exposed to and how they arose,

- Strategies and Processes concerning the taking, the assessment, the supervision and the control of risks. This can include:► Structure and organization of the entity‘s risk management function(s)► Field of application and type of the risk reporting or risk measurement systems,► The entity‘s strategies for risk hedging or risk reduction► The entity’s strategies and processes for the supervision of a continuous effectiveness

concerning risk hedging or risk reduction, and ► The entity’s strategies and processes for avoidance of excessive risk-concentrations

Qualitative disclosures

Page 32

► Concentration of risk► Risk management policies for avoiding excessive risk concentrations ► Concentration risk includes all financial instruments and is not limited to loan

exposures

Implementation considerations

Page 33

Sample disclosure: Qualitative disclosure

Source: MBTC December 31, 2007 Consolidated Financial Statements

Page 34


Source: Philippine Airlines March 31, 2008 Financial Statements

Page 35


Source: Ayala Corporation Consolidated Financial Statements

Page 36



Continued

Page 37

Sample Disclosure: Qualitative – Credit risk


Page 38



Continued

Page 39



Page 40

Sample Disclosure: Qualitative – Market risk


Page 41

Sample Disclosure: Qualitative – Market risk


Page 42

Sample Disclosure: Qualitative – Liquidity risk


Page 43


Risk disclosures - General

Page 44

IFRS 7.34For each type of risk arising from financial instruments, the entity shall disclose:a) summary quantitative data about its exposure to that risk at the

reporting date. This disclosure shall be based on the information provided internally to key management personnel of the entity (as defined in PAS 24), for example the entity’s board of directors and

chief executive officer

b) the disclosures required by paragraphs IFRS 7.36-42, to the extent not provided in (a), unless the risk is not material

c) concentrations of risk if not apparent from (a) and (b).

Quantitative disclosures

Page 45


Risk disclosures - Credit risk

Page 46

IFRS 7.36

The entity shall disclose by class of financial instrument: a) the amount that best represents its maximum exposure to credit risk

at the reporting date without taking account of any collateral held or other credit enhancements (eg netting agreements that do not qualify for offset in accordance with PAS 32) ;

b) in respect of the amount disclosed in (a), a description of collateral available as security and other credit enhancements;

c) information about the credit quality of financial assets that are neither past due nor impaired; and

d) the carrying amount of financial assets that would otherwise be past due or impaired whose terms have been renegotiated.

Quantitative disclosures - Credit risk

Page 47

Sample disclosure: Credit risk: Maximum exposure


Page 48

Implementation considerations

Credit quality of good financial assets► Linkage to internal credit risk management► External credit rating can be adopted► For unrated assets, internal rating can be used

► High grade, standard grade, and sub standard grade► Assumptions used for internal ratings is disclosed

Page 49

IFRS 7.37Financial assets that are either past due or impairedThe entity shall disclose by class of financial asset:

a) an analysis of the age of financial assets that are past due as at the reporting date but not impaired;

b) an analysis of financial assets that are individually determined to be impaired as at the reporting date, including the factors the entity considered in determining that they are impaired; and

c) for the amounts disclosed in (a) and (b), a description of collateral held by the entity as security and other credit enhancements and, unless impracticable, an estimate of their fair value.


Page 50

Sample disclosure: Credit risk: Aging analysis


Page 51

Sample disclosure: Credit risk: Credit quality


Page 52

Sample disclosure: Credit risk: Credit quality


Continued

Page 53

IFRS 7.38Collateral and other credit enhancements obtained

When an entity obtains financial or non-financial assets during the period by taking possession of collateral it holds as security or calling on other credit enhancements (eg guarantees), and such assets meet the recognition criteria in other Standards, an entity shall disclose:

a) Nature and carrying amount of the assets obtained; and

b) When assets not readily convertible into cash, policies for disposal or use of such assets


Page 54

Sample disclosure: Credit risk: Credit enhancements


Page 55


Risk disclosures - Liquidity risk

Page 56

IFRS 7.39The entity shall disclose:

a) a maturity analysis for financial liabilities that shows the remaining contractual maturities; and

b) a description of how it manages the liquidity risk inherent in (a).

Quantitative disclosures - Liquidity risk

Page 57

Sample disclosure: Liquidity risk


Page 58

Sample disclosure: Liquidity risk


Page 59


Risk disclosures - Market risk

Page 60

A sensitivity analysis for each type of market risk is mandatory

A separate sensitivity analysis for each market risk

A sensitivity analysis reflecting interdependencies

Each type of market risk is to be analyzed separately

Example: Value-at-Risk

The reporting entity can choose the type of sensitivity analysis

An entity may provide different types of sensitivity analyses for different classes of financial instruments

Quantitative disclosures - Market risk

Page 61

IFRS 7.40Sensitivity analysis

Unless the entity complies with IFRS 7.41, The entity shall disclose:

a) a sensitivity analysis for each type of market risk to which the entity is exposed at the reporting date, showing how profit or loss and equity would have been affected by changes in the relevant risk variable that were reasonably possible at that date;

b) the methods and assumptions used in preparing the sensitivity analysis; and

c) changes from the previous period in the methods and assumptions used, and reasons for such changes.


Page 62

What is ‘reasonably possible change’?a) Consideration of the economic environment in which the entity operates –

‘worst-case’ scenarios or ‘stress tests’ are not included

b) The entity should consider what changes are reasonably possible over the next reporting period

c) The entity need not re-assess reasonably possible change if the rate of change of the variable is stable


Page 63


IFRS 7.41

If an entity prepares a sensitivity analysis, such as value-at-risk, that reflects interdependencies between risk variables (eg interest rates and exchange rates) and uses it to manage financial risks, it may use that sensitivity analysis in place of the analysis specified in paragraph 40. The entity shall also disclose:

a) an explanation of the method used in preparing such a sensitivity analysis, and of the main parameters and assumptions underlying the data provided; and

b) an explanation of the objective of the method used and of limitations that may result in the information not fully reflecting the fair value of the assets and liabilities involved.

Page 64


IFRS 7.42

When the sensitivity analyses disclosed in accordance with IFRS 7.40-41 are unrepresentative of a risk inherent in a financial instrument (for example because the year-end exposure does not reflect the exposure during the year), does the entity disclose that fact and the reason it believes the sensitivity analyses are unrepresentative.

Page 65

Sample disclosure: Market risk


Page 66

Sample disclosure: Market risk – FX Risk


Page 67



Continued

Page 68



Continued

Page 69

Sample disclosure: Market risk – Cash flow interest rate risk


Page 70

Sample disclosure: Market risk – Price interest rate risk


Page 71

Sample disclosure: Market risk – Equity price risk


Page 72

Sample disclosure: Market risk – Value-at-risk (VaR)


Page 73

► But how will risk management be applied in the public sector?► Issue on mandate versus commercial purpose –

should there be a conflict?


Page 74

► Sustainability as the foundation for public sector risk management► Measures to apply


Page 75

► No matter how good the risk management process is, or how qualitatively and mathematically elegant the models, remember that it is PEOPLE who run everything


Page 76

► No matter how good the risk management process is, or how qualitatively and mathematically elegant the models, remember that it is PEOPLE who run everything


Page 77

► Christian G. LauronPartner, SGV & Co

► [email protected]


Documents

Presentation to the Government Association of Certified Public Accountants during the 31 st Annual National Convention Overview on Risk Management