Future of Bank Management

THE FUTURE OF TOTAL BANK MANAGEMENT
1. Framework for future developments................................................. 3

1.1. Basel II.......................................................................................................... 3
1.1.1. Pillar one: Minimum capital requirements .........................................................4
1.1.2. Pillar two: Supervisory review...........................................................................6
1.1.3. Pillar three: Market discipline............................................................................6
1.2. IAS .............................................................................................................. 10
1.2.1. Derivative financial instruments ......................................................................10
1.3. Derivative products................................................................................... 13
1.3.1. Securitisation ..................................................................................................13
1.3.2. Credit derivatives ............................................................................................15
2. Consequences................................................................................... 20
2.1. Opportunities in credit risk management ............................................... 20
2.1.1. Methods of managing credit risk.....................................................................20
2.2. Different methods of interest rate risk management in the
banking book............................................................................................. 23
2.2.1. Accrual interest risk measurement .................................................................24
2.2.2. “Classical” VaR models ..................................................................................25
2.2.3. Basel II proposal .............................................................................................26
2.2.4. CAD maturity band method ............................................................................26
2.3. The role of the treasury department ........................................................ 29
3. Total bank management using RORAC .......................................... 33
3.1. The significance of RORAC...................................................................... 33
3.2. Decisive competitive advantages ............................................................ 36
© FINANCE TRAINER International The future of total bank management/ page 1 of 36

Learning objectives
to understand the long-term effects of Basel II on bank management

to understand the importance of IAS and especially IAS 39 for the bank’s year-end
financial statement
to be able to explain new developments in credit risk management (securitisation and
credit derivatives)
to understand the effect of asset-backed securities (ABS) on credit portfolio
management
to recognise the importance of Treasury
to understand the long-term relevance of thinking in risk/return categories
to be aware of the major competitive advantages of the future

THE FUTURE OF TOTAL BANK MANAGEMENT
1. Framework for future developments
1.1. Basel II
In June 1999, in response to industry participants repeatedly voicing concerns about the
deficiencies of the regulations in place, the Basel Committee launched a consultation
process aimed at completely revising the existing capital adequacy framework (Basel I). Its
ultimate goal was the convergence of regulatory capital requirements and the definition of
up-to-date methods of identifying, evaluating and managing credit risks. The most striking
weaknesses of Basel I are:
The risk weights within the different risk classes are too uniform, which means that better
ratings are disadvantaged and weaker ratings are favoured.
There is no differentiation between distinct exposure classes (retail, specialised lending and
others).
Limited recognition of collateral for credit risk mitigation purposes.
(Credit) portfolio effects are ignored; therefore capital requirements are not aligned with the
respective credit risk of the loan portfolios of individual banks.
The same risk weights are assigned to loans with different maturities.
In January 2001, the Basel Committee on Banking Supervision released a second

consultative paper on the “New Basel Capital Accord”, which is also known as “Basel II”. The
goal of Basel II is to align capital adequacy assessment more closely with the fundamental
risks in the banking industry. Furthermore, it provides incentives for banks to enhance their
risk measurement and management capabilities.
The Basel Committee cites greater flexibility and a more risk-oriented focus as the motives
for the new Capital Accord.

The capital adequacy framework in place BASEL II
BASEL I
Focus on a single risk measure More emphasis on bank’s own internal risk
management methodologies
Supervisory review
Market discipline
One size fits all Flexibility
Banks select their own individual approach
Incentives for better risk management
Broad brush structure More risk sensitivity
Table 1: Comparison between Basel I and Basel II
The main target of Basel II is to further strengthen the soundness and stability of the financial
system. Minimum capital requirements alone are not sufficient to guarantee the achievement
of this goal, therefore the new capital adequacy framework consists of three (equally
important) pillars:
Pillar one: Minimum capital requirements

Pillar two: Supervisory review process
Pillar three: Market discipline
The implementation of these three pillars also aims to maintain the current overall level of
capital in the system and boost competitive equality.
1.1.1. Pillar one: Minimum capital requirements
The minimum capital requirements outlined in pillar one constitute the largest part of the
Basel II regulations. The calculation of capital requirements (as the main point of minimum
capital requirements) was also the primary subject of discussion during the second round of
consultations.
One significant innovation with respect to minimum capital requirements is that operational
risk will feature directly in the assessment of capital adequacy for the first time, so that it has
to be quantified and translated into capital charges. Measurement approaches for operational

risk are still in their fledgling stages as compared to those for credit and market risk.
Nevertheless, Basel II was right to kick off this innovation in view of the fact that operational
risk has the potential to significantly affect a bank‘s result.
The main principle of capital adequacy remains unchanged, i.e. at 8% in relation to total
banking risks:
minimum capital requiremen t

= capital adequacy (min. 8 %)
credit risk + market risk + operationa l risk
The Basel Committee has also retained the existing definition of eligible capital. The
recognition of tier 2 capital is still restricted to 100% of tier 1 capital. Thus, tier 1 capital has
to make up at least half of total eligible capital.
The calculation method for credit risk also remains unchanged. The regulatory credit risk of a
bank is equal to its risk-weighted assets (RWA). The most important innovation is the
assignment of different risk weights to credit risks (ratings) that serve as an input for the
calculation of capital required.
Your bank’s sum of risk-weighted assets for credit risk equals EUR
1.2 bn. Calculate the minimum capital requirement (market and
operational risks are not considered in this example).
Capital requirement = 1.2 bn * 8 % = EUR 96 m
In line with Basel it’s aim of defining a more risk-oriented method for the calculation of capital
requirements, the existing method, i.e. the standardised approach, was retained and
developed further. Additionally, two internal ratings-based (IRB) approaches were also
developed.
Based on the current capital adequacy framework (Basel I), the standardised approach uses
ratings to determine risk weights, whereby only external ratings, i.e. ratings of internationally
recognised rating agencies like Standard & Poor’s or Moody’s, are accepted.
On the other hand, the internal ratings-based approach (IRB approach) offers banks the
opportunity to rely on their own internal ratings for calculating capital requirements. In taking

this step, the Basel Committee also put forward a detailed set of minimum requirements de-
signed to ensure the integrity of these internal assessments of credit risk, since these more
complex internal approaches are still at a rather embryonic stage with regard to back-testing
and evaluation.
1.1.2. Pillar two: Supervisory review
Supervisory review is regarded as an important complement to minimum capital

requirements and market discipline. The second pillar aims to ensure that banks implement
sound internal methods to measure risks and evaluate capital adequacy. Supervisors are
expected to evaluate how well banks assess their capital needs in relation to their risks.
National supervisors are expected to review internal equity allocation. They are supposed to
intervene by imposing additional capital charges when the risk of a bank is greater than its
capital or risks are not adequately controlled. Supervisors should also seek to intervene at an
early stage to prevent capital from falling below the minimum levels required.
Supervisory review not only includes the review of capital adequacy, but also ensures that
quantitative and qualitative standards for the calculation of capital requirements (for market,
credit and operational risk) are met.
In general, the legal responsibilities of supervisors and their competencies to exert control
over banks and intervene where necessary have been increased.
1.1.3. Pillar three: Market discipline
Guidelines under the third pillar require banks to disclose up-to-date, relevant information on
their financial situation and their risk exposure. The informative value of banks' balance
sheets will thus increase considerably and enable market players to judge the adequacy of a
bank’s equity capitalisation. This increased transparency due to disclosure is aimed at
strengthening the soundness and stability of the financial system.
There are qualitative and quantitative disclosure requirements depending on the

measurement approaches applied. The information to be published relates to one of four
areas:
Scope of application (within the banking group)
Capital structure

Capital adequacy
Risk exposure and assessment.
Scope of application
Since the introduction of the capital adequacy framework in 1988, banking activities and
ownership structures have become more and more complex. Furthermore, national
regulations differ with respect to the consolidated level of a banking group to which capital
adequacy applies. Because of this, the Basel Committee has expanded the scope of
application of the new capital adequacy framework to ensure that the risks of the whole
banking group are taken into account.
The new scope of application therefore includes, on a fully consolidated basis, any holding
company that is the parent entity within a banking group. This is to ensure the capture of all
relevant banking and other financial activities, and thus the risk of the whole banking group.
Supervisors not only have to test the top consolidated level of a banking group, but also have
to ensure that individual banks are adequately capitalised on a stand-alone basis. Other-wise
there would be no guarantee that capital recognised in capital adequacy measures is readily
available for the protection of depositors.
The Basel Committee therefore stipulates that the Basel II regulations also apply to each
sub-consolidated level for all internationally active banks. Among other things, this is to pre-
vent the double counting of equity within the banking group.

Significant changes at a glance
Risks Market Risk Credit Risk Operational Risk

Pillars
Minimum Capital No change New: New:
Requirements Standardised Approach Basic Indicator Approach
IRB (Internal Ratings- Standardised Approach
Based) Foundation Advanced Measurement
Approach Approaches (AMA)
IRB Advanced Approach
Supervisory New:
Review Process Interest rate risk
in the banking
book
New:
Supervisory review of compliance with minimum standards and capital
requirements
Market Discipline New:
Disclosure requirements and recommendations for risk assessment
processes and risk policies
Table 2: Systematic overview of the most significant changes in the three pillars for the measurement and control
of risks in banking
With respect to interest rate risk in the banking book, the legislators neither seek to impose
interest adjustment profiles nor to disregard the national specifics of retail products. The
legislators have thus acknowledged the needs of continental European banks.
A directive (the Capital Adequacy Directive) has been in place since 1995 that addresses
capital requirements for the trading book. Basel II will not entail standardised capital
requirements for interest rate risk in the banking book. However, a strict obligation to control
and disclose banking book positions has been adopted.
As a consequence, banks are obliged to install an effective asset / liability management

system. Control of risks in the banking book (= interest rate risk in the banking book) will be
subject to supervision by the national regulatory bodies. In the event of large exposures, the
authorities are allowed to decree equity requirements for the interest risk.

Expected effects on banks
The following effects, broken down according to risk category, are currently expected:
Credit Risk Few changes regarding use of the standardised approach for
domestic banks, but increased expenditures for analysis
(pillars 2 + 3)
Potentials of IRB approaches must be assessed (costs vs.
benefit)
Collection of data must begin immediately
Internal rating systems have to be consistent with Basel II
standards
Collaterals have to be evaluated and applied more efficiently
Credit pricing has to be adapted
Operational Risk According to the Basel II Committee, additional equity
requirements are expected to be set off by savings in capital
requirements for credit risk thanks to the IRB approach
Unchanged to increased total capital requirements are expected
The development of new methods to measure risks is
accelerated
Interest Rate Risk Increased importance, disclosure of measurements
Mark-to-market risk estimate will be required
Risk Reporting Tremendous stepping-up of demands in terms of transparency
and underlying procedures
Table 3: Expected Consequences for Banks

1.2. IAS
Accounting practices in Europe have undergone some drastic changes in the past years,
which led to the introduction of the "International Financial Reporting Standards“ (IFRS). The
so-called IAS regulation basically commits all capital market-oriented companies with
registered offices in the European Union (EU) to apply the IFRS in their consolidated
accounts effective from 2005 or 2007 at the latest.
IAS 39, the standard for recognition and measurement of financial instruments, is of
particular importance for the banks.
IAS 39 divides financial assets into four main categories, which in turn are subdivided into
two subcategories.
Financial assets
loans and receivables
held-to-maturity investments
financial assets at fair value through profit or loss
− held for trading purposes
− financial assets at fair value through profit or loss
available-for-sale financial assets
Financial liabilities
financial liabilities at fair value through profit or loss
− held for trading purposes
− financial liabilities at fair value through profit or loss
other financial liabilities
1.2.1. Derivative financial instruments
Financial assets and liabilities have to be stated at acquisition costs when being valued for
the first time.
The follow-up valuation depends directly on the classification into one of the above-
mentioned categories.
Normally, financial assets have to be balanced at fair value.

Exceptions are:
loans and receivables which are not listed in an active market
financial investments that are to be held until final maturity
financial assets which do not have a market price on the active market and the fair value
of which cannot be measured reliably.
The handling of derivative instruments, which are applied for hedging purposes, is of major
importance. The method used is called hedge accounting.
IAS 39.142 defines the specifications which have to be met in their entirety
The company’s hedging strategy and risk management approach must be formally
recorded
There must be a sufficient correlation between development of the hedging instruments
and the hedged asset(s)
IAS 39.146 describes the method for judging the efficiency of a hedging transaction.
Normally, a hedging transaction is considered to be highly effective if the company
assumes that the value or cash flow correlation between hedged underlying transaction
and the hedging instruments lies within a fluctuation margin of 80 and 125 percent upon
conclusion of the transaction and during the whole transaction period.
With cash flow hedges there must be an actual risk in the valuation of the future cash
flows
The efficiency of the hedges must be measurable
The hedge must be effective in the period under scrutiny
Hedge accounting for interest rate risk is not possible if financial instruments dedicated to the
held-to-maturity portfolio serve as hedged positions. According to IAS 39.127, a "held-to-
maturity“ asset cannot act as an underlying for a transaction to hedge interest rate risk. How-
ever, a hedge against fx and/or credit risk is allowed.
Cashflow hedges
A Cashflow hedge is a transaction (normally a swap) for hedging cash flows against interest
rate changes, normally with variable interest rates. The risk of potential fluctuations of future
cashflows (which affect the result) is hedged (e.g. future interest payments from issued or
held debt issues on a floating-rate basis).

Changes in the value of the hedging instruments (effective part) are covered in the equity
position. They will be entered in future periods affecting current period results in order to
balance converse loss (profit) from the hedged underlying transaction. The ineffective part
will be entered into the current period result.
Note: IAS 39.140 => The hedge of a fixed liability is not a hedge of the cashflows, but rather
a hedge against the risk that the current market value will change. In line with the norm such
a hedge is treated in the same way as the hedge of a cash flow, in order to avoid a liability
which is not treated as an asset or debt according to current accounting rules being entered
as an asset or debt.
Fair-value hedge
Possible changes in the fair value of an asset or a liability are hedged.
The hedged position and the hedging instrument are stated at market value. Profits and
losses on the hedging instruments are to be entered in the profit and loss account on an
accrual basis.

1.3. Derivative products
The conventional instruments of credit risk management take little account of the interests of
credit risk management and sales.
Interests of credit risk management:

Risks likely to increase are to be reduced quickly.
Credit risk needs to be separated from the customer relationship, so that the bank is
able to retain customers in different credit standing situations and independently of the
financing limits of the bank.
Financing needs are to be separated from the liquidity position and from the bank’s
financing costs in order to be able to react flexibly to all customer needs.
The meeting of these needs is left to newer instruments of credit risk management, such as
e.g. securitisation and credit derivatives.
1.3.1. Securitisation
The opportunity to bundle single risks so that they become attractive to investors represents
a simple but also quite a modern instrument of risk management in banks. Accordingly, since
the early eighties there has been a strong trend towards substituting the issue of securities,
i.e. the securitisation of a bank’s debt claims, for traditional loan financing. This substitution
of traditional loan financing may be carried out in two ways:
the borrower may directly issue an obligation as a security
obligations may be issued as securities via special-purpose vehicles, the obligations
being secured by financial assets of the (original) borrower (e.g. asset-backed
securities)
Securitisation thus offers a possibility to remove loan business from the balance sheet. As a
result, the bank is no longer a risk-taker but a service provider (rating, securitisation, etc.).
This allows the bank as the selling institution to restructure or reduce the credit risk inherent
in the debt claims sold and thus reduce its regulatory capital requirements. Additionally, the
bank generates the liquidity that is locked up in these debt claims, thus improving its
balance-sheet structure and its financing structure.

Functioning and basic structure of asset-backed securities (ABS)
In an ABS transaction
a bank chooses a number of loans
pools them
and transfers them to a so-called special-purpose vehicle (SPV) that was specifically
established for that purpose (as its name indicates).
In this way debt claims become legally independent, which is a prerequisite for refinancing
through the issue of securities. In principle, all debt claims are suitable for inclusion in an
ABS transaction as long as they meet the following requirements:
steady stream of payments delivered (interest or redemption payments) (or
marketability);
no restrictions on the assignment of debt claims;
minimum credit quality.
Subsequently, the pool of loans is securitised and the SPV sells the securities in either a
public or a private placement. The reason why this instrument is called an ‘asset-backed
security’ is that the debt claims assigned to the SPV represent an SPV’s main assets. The
SPV finances the purchase of its debt claims from revenues generated from the issue of
asset-backed securities. Interest and redemption payments from debt claims are then directly
transferred to investors.
ABS are usually tranched, providing the investor with a specific risk profile. The junior
tranche, also called the first-to-default tranche, absorbs defaults until this tranche is full.
Additional defaults lead to losses on the second tranche, and so on. The junior will pay the
highest coupon, since it has the highest credit risk. Sometimes the SPV is required to keep
the junior tranche, or to sell it to the parent institution if no investors are found that are willing
to take on its risk.
With the start of the transaction, the bank receives the revenues from the sale in its function
as the seller of the debt claims. Since borrowers whose debts are sold in such a transaction
usually continue to make interest and redemption payments, the bank additionally transfers
these payments to the ABS entity. The bank also charges administration fees for the
continued provision of services such as credit surveillance, collateral surveillance and
collateral realisation.

Repayments & Repayments &
Bank
Coupons Special
Special Coupons Buyer of ABS
== Purpose (SPV) =
Cash
Originator Issuer of ABS Cash Investor
Additional
Guarantees
Bank – Customer Interest Premium Guarantees

Relation
Pool of External
Credit Exposures Provider of CRM
Figure 1: Structure of an ABS transaction
Figure 2 shows the most important and most commonly used basic types of asset-backed
structures.
Asset Backed Securities Mortgage Backed Collateralised Debt

In the narrower sense Securities (MBS) Obligations (CDO)
Credit card claims RMBS – Residential Securitised portfolios

Auto financing mortgage-backed securities
Leasing claims CMBS – Commercial
Consumer loans mortgage-backed securities
Collateralised Loan Collateralised Bond

Obligations (CLO) Obligations (CBO)
Figure 2: Basic types of ABS

Securitised loan portfolio Securitised bond portfolio
1.3.2. Credit derivatives
The number and total volume of credit derivatives transactions has seen a phenomenal
growth in the last few years and there is nothing to indicate that this development will slow
down.
The reasons for the rise of credit derivatives are

improved ability to value and manage credit risk;
a number of corporate and sovereign bankruptcies, the Asian financial crisis (1997), the
Russian crisis (1998), the Argentinean crisis (2001) and the Enron debacle (2001) being
the most recent;

a general desire among market participants to reduce credit risk, not least due to
regulatory requirements (Basel II).
The introduction of both indices (e.g. Quarterly Bankruptcy Index – QBI, Trac-x and Ibox,
recently merged into iTraxx) and Internet-based electronic platforms (e.g. Creditex, Credit-
Trade) for trading and obtaining information on credit derivatives additionally contributed to
the liquidity of the market.
In 2003, credit derivatives comprised close to 1% of the total derivatives market. Credit
default swaps (CDS) are by far the most traded credit derivative, with total rate of return
swaps (TRORs) and credit spread options (CSOs) only comprising a few percent of the
credit derivatives market. TRORs had roughly the same trading volume as credit default
swaps in 1998, but then lost ground when the ISDA provided standardised legal
documentation for CDS in 1999. TRORs might regain their previous market standing once
standardised legal documentation is provided for them too.
North America and Europe comprise around 85% of the credit derivatives market in equal
shares. Banks, insurers, hedge funds and other asset managers are the main buyers and
sellers of credit derivatives.
Broadly, credit derivatives can be divided into three main categories

Default swaps (e.g. binary or digital default swaps, basket credit default swaps ... )
Total rate of return swaps
Credit spread products
Synthetic structures are not really a product in themselves, but bonds and loans with
embedded credit derivatives.
In a (credit) default swap, the protection buyer makes a periodic or upfront payment (also
referred to as the ‘default swap spread’) to the protection seller (= seller of the default swap).
In return, the protection seller agrees to make a payment in the event of default of the
reference obligation. ‘Going long on the default swap’ means selling the reference obligation
and buying protection.

Example credit derivative: Credit default swap
Default Swap Premium

Bank A Notional Reference
Bank B Obligation
(Protection (Protection
Seller, Risk Default Payment (Underlying, eg.
Buyer, Risk Bond or loan)
Buyer Default Seller
Int. Rate
No Default incl. CS
No Payment
Libor Nominale
Refinancing
Figure 3: Credit Default Swap
A default swap might also be viewed as a put option on the reference obligation. It allows the
buyer to sell the reference obligation at a predetermined price in the event of default. If the
CDS is marked to market the protection buyer will also profit from the default swap in the
event of a mere deterioration in the credit quality of the underlying. In such a case, the put
option gains in value and the protection buyer may sell it at a higher market premium with a
profit.
Rating upon expiry of the option
Default CCC B BB BBB A AA AAA

−
Figure 4: Payoff profile of a CDS for the protection buyer
The following terms have to be agreed upon in a default swap contract:

premium
reference obligation (bond or loan)
notional amount
maturity
default event
type of settlement (physical or cash)

In order to foster the market for credit derivatives, market participants developed the ISDA
master agreement (1999 ISDA documentation, with an update in 2003), which provides the
basic framework for the documentation of privately negotiated credit derivative transactions.
We will now have a closer look at the individual contract terms:
The premium can be an upfront payment or a periodic payment. In the latter case it is
common for the periodic premium to terminate in the event of default, one more payment
being made for the time between the last regular periodic payment and the time of default.
The premium is usually quoted on an annual basis (ACT / 360) and it is paid quarterly.
The reference obligation can be a single bond, a loan issued by a corporate or a sovereign,
or a basket of bonds or loans. In most default swap contracts, the default event applies to
several bonds or loans with similar characteristics. This protects the default insurance buyer
in the event that many obligations have defaulted but – whether by coincidence or
deliberately - not his/her obligation.
The six possible default events that the ISDA master agreement specifies are:
bankruptcy
failure to pay
obligation acceleration
obligation default
repudiation / moratorium
restructuring
The ISDA does not include the event of a downgrade. Most default swaps include a
materiality clause, which ensures that no default payment has to be made if the credit event
is not significant, i.e. the credit event must result in a certain amount of actual credit loss. An
event that constitutes a default under the terms specified in the CDS contract but not in the
bond/loan market (i.e. the event doesn’t cause losses to the bond/loan holder) is termed a
technical default.

The settlement of the default swap is either in cash or physical.
In the case of cash settlement, the payment is calculated as follows:
Notional * [reference price – (recovery rate + accrued interest on reference obligation)]
The reference price is usually the par value of 100.
In the case of physical settlement, the default swap buyer delivers the defaulted bond and
receives the reference price of the bond.

2. Consequences
2.1. Opportunities in credit risk management
The increasing importance of active credit portfolio management is rooted in a changing view
of the management of banking risks. Increasingly risk/return-oriented approaches make
active credit portfolio management necessary. Moreover, the banking environment in general
is also undergoing changes.
Increasing capital market orientation in the credit business

The importance of the financial markets has been increasing significantly in recent
years. Numerous capital market products, particularly credit-related ones (such as
asset-backed securities) have seen a strong increase in sales. Credit-spread trading
and the development of a liquid market for securitisation products are leading to
additional flexibility in loan portfolio management.
Increasing importance of risk management in banks
Today it is evident that banks are engaged to a considerable extent in risky business
trans-actions like the trading of derivatives. The emerging markets for default and credit
risks are also dominated by banks. The takeover and management of complex risks and
risk management as a whole are increasingly seen to be part of a bank's core
competences.
Increasing demands on banks’ performance
Influenced by Anglo-American views, shareholder value-oriented bank management has
also established itself in continental Europe. However, there are limits on the extent to
which profitability can be increased by means of cost reduction or business volume
expansion. Only the improvement of a bank’s risk/return profile via active credit portfolio
management has a sustainable beneficial effect on performance.
2.1.1. Methods of managing credit risk
Target-oriented management of the credit business aims to achieve the desired

composition of the loan portfolio. Methods that allow active changing of the composition of
the loan port-folio are increasingly gaining importance against a background of new
developments in risk measurement, risk management and risk control.
At the same time, traditional instruments of credit risk management are failing to serve their
purpose. Methods and ways of limiting and reducing risks exist, e.g. raising collateral,

implementing limits or so-called ‘stop-light’ models, but their ability to effectively diversify risk
is very limited. The reasons for this limitation are:
restricted lending business with respect to geographical and industrial sectors
time-consuming process of implementation and adjustment
conflict of interest between customer relations and portfolio strategy
return optimisation vs. risk optimisation
single transaction approach vs. total bank management approach.
Only the opportunities to buy and sell individual loans on the secondary market via
securitisation and to change the risk profile of a bank’s loan portfolio via credit derivatives
seem to be a suitable and established method of risk management.
In principle, the application of securitisation has four effects:

new financing opportunities are tapped
existing credit risks are reduced and diversified
active management of the balance-sheet structure and profitability improvements
optimisation of regulatory capital allocation.
At first sight, the main advantage for the bank as the selling party lies in the elimination of
credit risks and the ensuing reduction of equity costs and liquidity costs. Often, however, the
seller has to bear the so-called ‘first loss’ in order to increase the marketability of the ABS,
which means that from an economic capital point of view apparent cost advantages are at
least partially cancelled out. The ‘first loss piece’ represents that part of the securitisation that
first bears possible losses due to credit defaults.
Use of ABS structures in risk management
In a similar way to credit derivatives, it is possible to apply asset-backed securities in credit

risk management. For this purpose, asset-backed securities may be applied at individual
loan level as well as at portfolio level. The following main risks can be effectively managed in
this way:
Credit risk
By means of an ABS transaction, it is possible to transfer the risk of interest and redemption
payments being lost due to default to an investor. In addition, it is also possible to reduce the
concentration risks inherent in a bank’s portfolio.

Interest rate risk
Interest rate risk arises if assets are not refinanced at matching maturities. The removal of
assets from the balance sheet (which happens in the case of ABS transactions) and the
resulting balance-sheet concentration, i.e. the reduction on both sides of the balance sheet,
frees up liquidity which can be used to improve the match of maturities. In addition, banks
may use ABS to get rid of interest rate-sensitive debt claims.
Refinancing risk
The sale of debt claims provides the bank with liquidity.
The positive effects will only be achieved if the volume of claims sold corresponds to the
average quality of the assets. If only high-quality assets are transferred, e.g. to achieve a
high rating for the transaction, the remaining credit portfolio will most probably include high
credit risk. This will fail to produce the desired effect of risk reduction.

2.2. Different methods of interest rate risk management in the
banking book
As the traditionally used accrual method no longer seems sufficient for measuring interest
rate risk in the banking book, different approaches are being discussed. First of all we will
recall the difference between banking and trading book positions:
The banking book contains all customer business and assets held to maturity, as well as
other assets and liabilities. Determining actual market values and the possible changes
in value is a lot more complex than for the trading book positions. Even the future date
of a possible realisation (holding period) is only a fictitious assumption in many cases.
For the majority of customer business products there are no fixed agreements on
maturity and interest adjustment terms. As a consequence, benchmarks have to be
defined for the mapping of these positions. Risk measurement results will always
contain an element of uncertainty as to whether the defined benchmarks are correct.
For large parts of the customer business, implied options (e.g. prepayment) are agreed
upon. These options can only be translated into regular options if additional assumptions
are made, as their exercise by customers will not necessarily be market driven.
To sum up, it is also possible to determine a ‘super cash flow’ in the banking book, and risk
measurement methods can then be applied to this. The uncertainties of the results, however,
are higher than for a book with effectively tradable instruments.
In the following we would like to present a short description of the different approaches,
elaborate their pros and cons and describe their possible areas of application:
Accrual interest risk management
"Classical“ VaR approaches
Basel II proposal
CAD maturity band method
The preconditions for all the presented methods are similar. Interest adjustment frequencies
have to be determined for all positions in the banking book, and the positions have to be
mapped into time bands.

2.2.1. Accrual interest risk measurement
As most of the banking book positions are actually taken into account with their accrual in the
profit and loss statement, the first and obvious approach is to measure the impact of interest
changes on the P&L result. With this approach, the maturing positions (overnight, 3- month,
6-month, etc.) lead to a change in interest income/expense, depending on the assumed
future market rate. The resulting change in net interest income (or better: interest gap
contribution) can then be interpreted as risk.
Concepts such as historical volatility can be applied fairly easily for the interest moves
assumed, in which case the change in net interest income results from a worst-case
scenario. In a so-called ‘earnings at risk’ approach, even Monte Carlo simulations can be
applied for this method of risk measurement.
Questions and difficulties
Can the risk measurement be reduced to the P&L result of the current year?
For longer time intervals the resulting interest changes from extrapolated volatility will be
too large, and other methods of predicting those changes have to be applied.
Do maturing positions stay in the overnight time band or are they replaced by their
original term?
Should future reactions be taken into account, or would they distort risk results?
Pros and cons
− Easy to understand
− Comparable with net interest earnings in the P&L statement
− Interest risks of different currencies are difficult to incorporate

− No straightforward integration of basis risks
− Yield curve risk can only be modelled by means of relatively complex approaches
− Risk values are not comparable with the risks of the other departments (e.g. trading
book risk)
Summary
The advantage of this method is the possibility of comparison with the profit and loss result.
However, the disadvantages of not being comparable to other risks and the limited time

horizon covered mean that the accrual method is only of secondary importance for risk
measurement in the banking book.
2.2.2. “Classical” VaR models
All VaR models which have made their breakthrough in the past 10 -15 years in the risk
measurement of trading book positions are based on the following assumptions:
Historical moves in the market prices are used to evaluate possible future changes
Historical correlations are taken into account to deal with portfolio effects
All positions are marked to market
A definite holding period is assumed, usually 1-10 days
The risk is measured for a given statistical confidence level (usually 99%)
The choice of method (variance / covariance, historical simulation or Monte Carlo simulation)
depends on the willingness to invest in risk measurement systems and on the importance of
option positions. The option risks can be properly evaluated mainly by using historical or
Monte Carlo simulations.
Pros and cons
− Basis risks of different instruments can be measured and compared

− No problem to measure the total risk for different currency interest positions
− Risk results are comparable with the risks of other departments, enabling risk
management for the entire bank
− VaR methods are cost and time intensive in their implementation

− The risks of implied options may be computed with complex models. However, the
validity of the risk measurement results suffers due to the necessary assumptions
regarding customer behaviour.
Summary
VaR models in the banking book are attractive for institutions that have already installed a
VaR model for their trading book and use complex strategies in their banking book. Some
adjustment is necessary, at least for the longer holding period in the banking book.

VaR models are a valid method of measuring banking book interest risks. The uncertainties
resulting from the assumptions regarding the customer business should not be treated as
market risk, but should be separately managed and shown as margin risk in the customer
business profit centres.
2.2.3. Basel II proposal
The risk is measured under the assumption of a so-called ‘interest rate shock’ shifting the
whole interest yield curve by 200 BP. For the specified time bands, the present value change
on the basis of 200 BP is predetermined by risk weighting, or may be calculated individually
based on the actual yield curve. The risks within the different time bands are added, whereas
opposite time band positions are netted. Hence a parallel shift of 200 BP is assumed for the
total risk result.
Pros and cons
− Easy to calculate
− No yield curve risks measured

− Overestimation of the risk of straight positions compared to more complex positions
− Underestimation of the risk of short option positions
− No approach to include basis risks
− No approach to adequately take into account interest risks of different currencies
Summary
The Basle II proposal for the measurement of interest risk in the banking book is a necessary
step which enables banks to deal systematically with the interest risk on the total bank level.
However, the approach is of very limited scope for the internal management and limitation of
potential interest risk in the banking book.
2.2.4. CAD maturity band method
In a sense, the maturity band method proposed in the CAD is a ”standard“ VaR model. The
parameters used in a classical VaR model are standardised, pre-defined and do not have to
be updated. These comprise volatilities, correlations between the time bands and term
zones, and a standardised approach for the measurement of basis risks. For the calibration
of the risk weighting an interest move of 70-100 BP was assumed.

The parameters to be specified for internal VaR models - holding period, confidence level,
and “multiplication factor 3” in the case of the equity requirements in the trading book – are
already implicitly contained in the calculation method.
Pros and cons
− Easy to implement
− Yield curve risk is taken into account
− Basis risks are roughly covered
− Can easily be calibrated for longer holding periods in the banking book
− Underestimation of the risk of short option positions

− No approach to take adequate account of the interest risks of different currencies
Summary
The CAD maturity band method is an easily implemented, pragmatic and relatively consistent
approach to measuring and limiting the interest risk in the banking book, particularly for
banks that are ready to take and manage risks in their banking book but have a limited
volume of foreign currency interest positions and interest options.
Conclusions
Basle II will be a “must” for all OECD countries in 3-4 years’ time. In order to comply with this
regulation, the first step for the banks will be a systematic mapping of their interest positions.
Once this step has been taken, the Basle II calculation proposal will remain a supervisory
constraint, whereas banks will use additional models to manage and limit their interest risks
in the banking book.
As internationally active banks will integrate the banking book into the existing VaR models,
we would recommend the CAD maturity band method – with an adjustment for the longer
holding period – for smaller or regional banks.
This does not preclude a later change to more complex VaR models.
To summarise, the over-simplification deliberately taken into account in the Basle proposal
as compared to the CAD maturity band method is intended for use in the supervisory

reporting scheme (already prepared in Austria using the so-called Interest Risk Statistics).
The CAD maturity band method itself, however, is also explicitly mentioned in the EU
Commission's 2nd Consultative Document (Feb. 2001 - para. 151) as the basic approach to
interest risk measurement in the banking book, provided certain adjustments are applied.

2.3. The role of the treasury department
The role of the treasury department will also change in the future.
Imagine the following experiment: We calculate our banks’ results without recognising the
treasury contribution. In a first step we deduct the interest gap contribution from net interest
income. The result is that banks lose 50 – 75 % of their profit, only big banks with strong
trading departments and – for the time being – the growth markets in CEE and SEE doing
better. The conclusion is that our banks need treasury to survive.
Fortunately, treasury does not only consist of asset and liability management. If interest rates
rise or the yield curve flattens or inverses it would be tremendously difficult to achieve an
interest rate gap contribution in this area. In addition to asset and liability management, the
most visible treasury function is FX. But this business is suffering from the reduction in the
number of currencies due to the single European currency. So at first sight it is not evident
where the future of treasury lies. It may seem paradoxical, but we see the legislator as the
main driving force helping the banks to produce more treasury income. Since the mid-90s the
legislator has been producing an increasingly complex legal framework concerning risk
management. Starting with the Capital Adequacy Directive and now continuing with Basel II,
the legislator is compelling more and more financial markets to increase their risk
management standards. And as soon as risk can be measured, it can also be traded. The
concept is identical in all cases:
As soon as risk can be bundled it is also clear that one single department has to be
responsible for its management. And who else if not treasury? Today, this is a foregone
conclusion for FX, interest and other market risks. But other risks too will increasingly be
managed in the treasury department.
The bundling of risks is also the source of all treasury revenue potentials. We see the
following five components as being crucial:
Flow trading
Is the most important source of revenue. The bank is market maker for its customers. With-
out customer business (commercial and private) a bank has hardly any flow, therefore it is
unable to maintain its treasury operation and loses the other sources of treasury income too.

Directional trading of market risks based on portfolio effects
Can be performed by the ALM or trading department. A crucial factor for success are
diversified trading strategies that reduce the volatility of this business to a level a bank can
bear.
Cheaper refinancing
Structuring of bank issues helps to reduce liquidity costs, as does the use of financial
collateral through repo trading and collateral management.
Structuring of customer products
Additional revenue from selling of derivatives and structured products to corporate clients, as
well as from structuring of asset management products. Strong treasuries (in terms of skills,
systems and flows) are able to structure the entire value-added chain themselves. Other
banks concentrate on core components they can handle by themselves and buy additional
components in the market.
Revenue from liquidity risk
It is becoming increasingly clear that liquidity management is both a revenue business and a
risk business, where risk has to be measured and revenue shown in a transparent way.
In the future the biggest source of flows will be credit business. Again, by means of Basel II
the legislator is making sure that the flows will be bundled and that risk can be measured. As
a result of Basel II most parts of the loan business will be tradable within a few years' time,
thus opening up new sources of income.

Sources of revenue in the credit risk business
Flow trading The bigger the portfolio, the bigger the potential for more
revenue. Keep these flows in your bank – if you don’t, you are
jeopardising the future of your treasury department.
Directional trading of Credit risk trading in ALM or trading book. Imagine a return on
market risks based on risk of 20–30 %, compared to 0 % to 10 % today.
portfolio effects
Cheaper refinancing Securitisation is the key word here. What is the bank able to
structure by itself? How can the bank sell its credit risks at the
highest possible prices? These are the questions that have to
be answered and the solutions put into action in the bank's
financing business.
Structuring of customer Interest, FX and equity risk are not the only means of creating
products attractive customer products. We estimate that products with
credit risk structures will be more attractive than equity
products in the long run, because they reflect the mentality of
investors and have a huge primary market.
Revenue from liquidity Financial collateral is the key to success. Any bank that is able
risk to utilise more collateral and convert traditional collateral into
financial collateral is not only able to reduce its financing costs;
it also becomes more competitive in the commercial business
by granting more financing.
In order to work on increasing the revenue potentials of loan business it is necessary to deal
with two crucial points:
A bank will need systems that are able to integrate the trading book and the banking
book. If not, how can we have a single online limit system? How can we evaluate all
collateral in a uniform way? How can we convert more and more illiquid business into
tradable business?
It is also crucial to openly address the loan specialists and make it clear that the
common goal is to generate revenue from the bank's credit risk potential.
Without a treasury department, a bank would have difficulties in defining itself as a bank.
Indeed, it would be more of a sales organisation for asset management and financing

products without any added value from the risk management area. The important factor is
whether or not treasury is accepted as a business unit with a high reputation within the bank,
and this reputation depends on whether the treasury department is able to win the
confidence of the bank's other business units. Furthermore, it is crucial for treasury to stop
being a black box; it must show its activities and revenues transparently and try to explain its
business. Another very important task of the treasury department will be to motivate the
traditional banking units to think in financial market terms and categories.

3. Total bank management using RORAC
3.1. The significance of RORAC
Traditionally, classical bank management was merely return-oriented. But modern bank
management puts the question: what return can I realise at what risk? Therefore the bank
tries to generate optimum profit from the risk/return relation starting from the individual trans-
action right up to the total portfolio. The ratio which measures this efficiency is RORAC (re-
turn on risk-adjusted capital).
Besides RORAC there are other ratios which are used quite often. Below you will find a
differentiation of these ratios in relation to RORAC:
ROE (return on equity)
Profit after tax versus equity (usually tier 1).

Frequently applied; criticised due to lack of risk orientation.
RORC (return on regulatory capital)
Profit after tax versus regulatory equity.

Allows comparisons between banks; gives only very rough consideration to the risk
component.
Return on Basel II equity (Finance Trainer ratio)
Profit after tax versus equity as defined by Basel II (IRB approach).

Future-oriented ratio; bank-related risk is relatively well integrated.
RORAC (return on risk-adjusted capital):
Profit after tax versus economic capital.

Bank-specific risk is measured by consistent value-at-risk technique. Risk measurement is
state of the art.
RAROC (risk-adjusted return on capital):
Profit (profit after tax) minus minimum interest on economic capital (versus economic
capital).

Same methodology as RORAC but a minimum return on economic capital is deducted from
after-tax profit. This makes comparisons with other banks difficult – that’s why we prefer
RORAC.
If we now take a closer look at RORAC, we see that the basic assumption is that equity is
exclusively needed to cover a bank’s risks. Risk measurement is performed for credit risk
(default and mark-to-market losses), market risks (primarily interest and currency risk),
liquidity risk and operational risk. Economic capital is measured using the value-at-risk
technique and can be interpreted in a simplified form. We can say that there will be only one
year in a century where the loss is higher than the economic capital and the bank is heavily
indebted as a result.
These considerations touch on the question of minimum equity requirements and the share-
holder’s willingness to take risks. For our interpretation it is important to know that for the
time being there is no standard for the correct probability level of economic capital. Finance
Trainer always uses a 99% confidence level because this is what regulatory authorities
usually require as standard.
Two big advantages and two drawbacks need to be considered when implementing RORAC:
Advantage 1
Benchmarks are available for each risk category (e.g. interest) and profit centre, which help
us to assess the attractiveness of a field of business in relation to our own performance. We
know that a professional treasury operation in a regional bank is capable of earning three to
six times the economic capital (99%/1 day), which means a return on equity of approx. 30%.
This also improves budgeting by not relying on the simplistic formula of “last year’s budget +
x%” and gives a clear indication why treasury activities are attractive.
Advantage 2
When using RORAC, it’s no longer necessary to use over-simplified return on equity goals
for all business units. In the past, many subscribed to the motto “If you achieve 15% ROE,
you're OK – if you’re below, you’re not OK”. With RORAC your benchmark will tell you that a
6% return in local corporate business is OK. Top management decides how much equity is
allocated to the bank’s corporate business, but they are satisfied if the bench-mark is
achieved. The average of the benchmarks of all the bank's profit centres gives the bank's

target RORAC, which varies from bank to bank and from strategy to strategy. Top
management has to be in agreement with the shareholders, but is no longer forced to chase
after less significant and general ratios (e.g. the 15% of the ROE formula).
If RORAC is implemented as described above, long-term strategies become realistic. If

corporate business is below 15% ROE, instead of showing dissatisfaction, management is
able to restructure the business process until this segment again sees attractive returns
without destroying customer relationships. We have seen this development in the retail
business. Ten years ago retail was the “poor neighbour”, today a bank is happy to be in the
retail business. It improves the bank’s rating, is profitable on an international scale and very
expensive to acquire.
The “drawbacks” pertain especially to the completeness of the RORAC ratio and the
standards applied to it. On the one hand we have to decide what to do with free equity (the
ex-cess of economic capital). This is a problem of standards and not one of methodology. On
the other hand, and much more importantly, we have to decide how to integrate businesses
without bank-related risk (e.g. private banking). We have developed a methodology to
integrate non-risk-related business in order to arrive at a consistent total bank management
approach, but we cannot say that our methodology is standard on the market. Nevertheless,
the controlling departments of banks are increasingly addressing these drawbacks and we
are happy to assist in finding solutions through our decision-making training courses or
consultancy activities.
The goal of the RORAC concept is consistent total bank management, from strategy to
business units, from customer calculation to product calculation. The RORAC concept is able
to give a bank’s management and employees orientation and help them in their pursuit of the
bank’s goals.

3.2. Decisive competitive advantages
An important competitive factor in the banking business will be the development of a bank’s
credit rating.
Credit rating is a core competence of banks, and is mainly regarded from the loan business
point of view - the bank judges the rating of its customers. But nowadays the bank’s own
rating is increasingly being judged. This is standard on the international capital markets. But
what about the "normal customers of a bank“ – private individuals, small and medium-sized
businesses? The customers have to pay the liquidity costs with their loan conditions. The
worse the bank’s rating, the higher the credit conditions will be. The better the bank’s credit
rating, the more competitive it is. Another main competitive factor are the costs of production
and the process efficiency: the bank that produces the same quality at lower costs will have a
competitive advantage.

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THE FUTURE OF TOTAL BANK MANAGEMENT

1. Framework for future developments................................................. 3

© FINANCE TRAINER International The future of total bank management/ page 1 of 36

 to understand the long-term effects of Basel II on bank management

© FINANCE TRAINER International The future of total bank management/ page 2 of 36

1. Framework for future developments

In January 2001, the Basel Committee on Banking Supervision released a second

© FINANCE TRAINER International The future of total bank management/ page 3 of 36

Pillar one: Minimum capital requirements

1.1.1. Pillar one: Minimum capital requirements

© FINANCE TRAINER International The future of total bank management/ page 4 of 36

minimum capital requiremen t

Capital requirement = 1.2 bn * 8 % = EUR 96 m

© FINANCE TRAINER International The future of total bank management/ page 5 of 36

1.1.2. Pillar two: Supervisory review

Supervisory review is regarded as an important complement to minimum capital

1.1.3. Pillar three: Market discipline

There are qualitative and quantitative disclosure requirements depending on the

© FINANCE TRAINER International The future of total bank management/ page 6 of 36

© FINANCE TRAINER International The future of total bank management/ page 7 of 36

Risks Market Risk Credit Risk Operational Risk

As a consequence, banks are obliged to install an effective asset / liability management

© FINANCE TRAINER International The future of total bank management/ page 8 of 36

© FINANCE TRAINER International The future of total bank management/ page 9 of 36

1.2.1. Derivative financial instruments

Normally, financial assets have to be balanced at fair value.

© FINANCE TRAINER International The future of total bank management/ page 10 of 36

© FINANCE TRAINER International The future of total bank management/ page 11 of 36

Possible changes in the fair value of an asset or a liability are hedged.

© FINANCE TRAINER International The future of total bank management/ page 12 of 36

Interests of credit risk management:

© FINANCE TRAINER International The future of total bank management/ page 13 of 36

© FINANCE TRAINER International The future of total bank management/ page 14 of 36

Bank – Customer Interest Premium Guarantees

Figure 1: Structure of an ABS transaction

Asset Backed Securities Mortgage Backed Collateralised Debt

 Credit card claims  RMBS – Residential  Securitised portfolios

Collateralised Loan Collateralised Bond

Figure 2: Basic types of ABS

1.3.2. Credit derivatives

The reasons for the rise of credit derivatives are

© FINANCE TRAINER International The future of total bank management/ page 15 of 36

Broadly, credit derivatives can be divided into three main categories

© FINANCE TRAINER International The future of total bank management/ page 16 of 36

Default Swap Premium

Rating upon expiry of the option

Default CCC B BB BBB A AA AAA

Figure 4: Payoff profile of a CDS for the protection buyer

The following terms have to be agreed upon in a default swap contract:

© FINANCE TRAINER International The future of total bank management/ page 17 of 36

© FINANCE TRAINER International The future of total bank management/ page 18 of 36

Notional * [reference price – (recovery rate + accrued interest on reference obligation)]

The reference price is usually the par value of 100.

© FINANCE TRAINER International The future of total bank management/ page 19 of 36

2.1. Opportunities in credit risk management

 Increasing capital market orientation in the credit business

2.1.1. Methods of managing credit risk

Target-oriented management of the credit business aims to achieve the desired

© FINANCE TRAINER International The future of total bank management/ page 20 of 36

to understand the long-term effects of Basel II on bank management

Credit card claims RMBS – Residential Securitised portfolios

Increasing capital market orientation in the credit business