Risk Management

The expected shortfall (ES) measures the loss one has to expect (> risk capital) in case losses exceed the loss level defined by the confidence level. ES is a „Coherent Risk Measure“.

The Expected Shortfall (ES) is equal to the expected value of the losses > risk capital. Technically speaking, the residual distribution is assumed to represent 100% of such losses (i.e. the area below the curve (starting from risk capital) = 1).

Expected shortfall (ES) measures the “average” loss of all the losses exceeding the risk capital threshold (determined by the confidence level).

Risk capital is equal to the potential loss during a defined time period that is not exceeded with a defined probability.*

Mapping tries to express the position as a combination of standard elements which correspond to a limited number of market prices, the so-called "market factors".

Risk can be defined as the (unexpected) deviation of a positions value from its expected value

1. Minimum capital requirements

   - quantitative, risk oriented
   - defines a minimum of capital for banks

2. Supervisory Review Process

   - qualitative requirements - 4 principles

3. Market Discipline

   (market discipline enforced through risk transparency provided by risk disclosure)
   - qualitative and quantitative requirements

Operational risk is defined as the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. This definition includes legal risk, but excludes strategic and reputational risk.

The BIA uses gross income (GI) as the decisive OpR risk indicator. The capital requirement is a linear function in the three year average of GI.

Whereas only positive years of the three year period are considered. Years with GI<0 are not considered at all. Average GI multiplied by α (= 15%) yields the capital requirement.

Gross income is defined as net interest income plus net non-interest income. It is intended that this measure should: (i) be gross of any provisions (e.g. for unpaid interest); (ii) be gross of operating expenses, including fees paid to outsourcing service providers; (iii) exclude realized profits/losses from the sale of securities in the banking book; and (iv) exclude extraordinary or irregular items as well as income derived from insuranc

The capital requirement is the sum of the gross income multiplied by the beta-factor of each business lines (BL). The beta-factors are differentiated according to a “perceived risikness” of the BL.

A negative gross income (GI) of a BL are considered in the capital requirement calculation. Years with a negative total GI are omitted as in the BIA.

A variant of TSA (called the Alternative SA (ASA)) is based on the sum of loans of the balance sheet. ASA is only allowed for the business lines retail banking and commercial banking. The loans are weighted with 3.5% (= input into calculation in place of GI). The same BL beta factors are used.

The bank models OpR risk based on internal and external information (e.g. based on operational losses). The model delivers the capital requirement (risk capital) according to certain parameters.

The reference period for risk capital (RC) is one year.

RC is the potential total operational loss of the bank that should not be exceeded within one year with a probability of 99.9%.

The risk capital (= regulatory capital requirement) is defined as:

RC = Expected Loss [E(L)] + unexpected Loss [U(L)]

or RC = U(L), if the bank can proof that the E(L) is measured as well as accurately and fully provisioned.

Siehe Zusammenfassung!

Within the risk policy, business lines and processes you fist identify risks, measure them,
model them and manage it and all over again. This process is influenced by law/regulations
and competition and market.

In equilibrium the market has eliminated price differences. So only systematic risk that
cannot be eliminated with further diversification is compensated.
If you have 2 stocks that are identical but one has still a higher price than you can exploit
such price differences by selling stock A and buying stock B and making a profit. This is called
arbitrage.

• Risk reduction for companies owned by risk averse private owners
• Reduction of planning costs and probability of financial emergency situations
• Reduction of probability of financial distress
• Protection of required liquidity for project financing purposes
• Reduction of average corporate taxes

Customer protection: asymmetrical information about the quality of the bank requires the
specific protection of smaller clients.
Financial system protection: prevention of contagion (bank runs): banks that are in trouble
potentially affect other banks negatively.

1. Minimum Capital requirements:
- quantitative, risk oriented
- defines the minimum capital of banks
- defines maximum of leverage
2. Supervisory Review Process
- qualitative requirements
- 4 principles
3. Market Discipline
- enforced through risk transparency provided by risk disclosure
- qualitative and quantitative requirements

We have risk position in and off balance sheet that need to be measured which gives us the
risk weighted assets. As minimum capital we need to hold 8% of minimum capital which
leads to a maximum leverage of 12.5 as for every dollar we need to hold 8 cents. And then
there is the eligible capital which should ensure that:
- minimum capital < Tier 1 and Tier 2
à if this is the case then capital requirement is met! This is called solvability test.
Capital requirements need to be covered by Tier 1 and 2 and need to cover any risks that
occur in the balance sheet.

Tier 1:
• Core measure of a bank’s financial strength from a regulator’s point of view
• Core capital, which consists of common stock and disclosed reserves (retained earnings)
Tier 2:
• Supplementary capital
• Includes a number of important and legitimate constituents of a banks’ capital
requirement like undisclosed reserves, revaluation reserves, general provisions, …
• Tier 2 is limited to 100% of Tier 1 capital

Operational risk is defined as the risk of loss resulting from inadequate or failed internal
processes, people and systems for form external events. This definition includes legal risks,
but excludes strategic and reputational risk.

- Basic Indicator Approach BIA
- Standardized Approach TSA
- Advanced Measurement Approach AMA

• more complex approaches require well-functioning risk management processes and a
higher level of diligence