Bank Management and Control: Strategy, Pricing, Capital and Risk Management

By Johannes Wernz

This book discusses risk management, product pricing, capital management and Return on Equity comprehensively and seamlessly. Strategic planning, including the required quantitative methods, is an essential part of bank management and control. A thorough introduction to the advanced methods of risk management for Credit Risk, Counterparty Credit Risk, Market Risk, Operational Risk and Risk Aggregation is provided. In addition, directly applicable concepts and data such as macroeconomic scenarios for strategic planning and stress testing as well as detailed scenarios for Operational Risk and advanced concepts for Credit Risk are presented in straightforward language. The book highlights the implications and chances of the Basel III and Basel IV implementations (2022 onwards), especially in terms of capital management and Return on Equity. A wealth of essential background information from practice, international observations and comparisons, along with numerous illustrative examples, make this book a useful resource for established and future professionals in bank management, risk management, capital management, controlling and accounting.

• Language: English
• Publisher: Springer
• Release date: May 21, 2020
• ISBN: 9783030428662

Book preview

© Springer Nature Switzerland AG 2020

J. WernzBank Management and ControlManagement for Professionalshttps://doi.org/10.1007/978-3-030-42866-2_1

1. Outline

Johannes Wernz¹ 

(1)

Zurich, Switzerland

This book is divided into the following chapters: Chapter 2 deals with all topics relevant for bank management and steering, for strategy, and especially for the risk-return management. In this chapter, business models are discussed. In Chap. 3 the economic and political situation is discussed; the regulatory framework and the development of the philosophy within the Basel Accords, specifically Basel III, are presented. Chapters 4–6 deal with Credit Risk (loans) and Counterparty Credit Risk (derivatives). Risk and return relevant topics such as risk-adjusted pricing and the underlying parameters are illustrated. Risk models are presented. Chapter 7 deals with Market Risk, whereas Chap. 8 deals with Operational Risk. In Chap. 9 Asset Liability Management is discussed.

Relevant topics (such as capital optimization) are discussed in greater detail, and the important points regarding risk-adjusted pricing are addressed in various sections throughout the book.

Bank management and risk-return management are the main topics of this book. Areas/topics that have an impact on risk-return management are therefore highlighted in gray boxes (light gray) embedded within the sections.

Regarding Capital and Capital Optimization this means…

Bank management and risk-return management are heavily influenced by the regulatory requirements and thus by the changes to the required capital. The other recurring topic in this book: the Basel Accords (Basel III). Topics related to Basel III are highlighted and outlined in dark gray boxes embedded in the sections.

The significant Basel III changes in that area are/mean…

The sample bank described in this book is typically found in locations like London, New York, Zurich, or Frankfurt. The illustrative bank is a major full-service bank; on the one hand, it has strong roots in the domestic retail and corporate loans area (mortgages, consumer loans, loans to SME and big corporations, specialized lending), and on the other hand, it also has a strong investment bank division and a significant wealth management division.

All presented balance sheet figures, risk weighted assets (RWA), and capital figures are realistic vis-à-vis banks based in London, New York, Zurich, or Frankfurt.

The regulatory capital is calculated/shown according to Basel III. Assessments are made according to the discussed macroeconomic scenarios.

© Springer Nature Switzerland AG 2020

J. WernzBank Management and ControlManagement for Professionalshttps://doi.org/10.1007/978-3-030-42866-2_2

2. Bank Management and Steering

Johannes Wernz¹ 

(1)

Zurich, Switzerland

2.1 Strategy Planning: Iterative Process

Appetite, risk appetite—how much of it, with what consequences, with what impact on the strategy and on the volatility of earnings? This is a fundamental question in bank management.

Managers are often tempted by high profits; especially when there are new products on the market that promise high profits, the buying pressure is great; one wants to participate. Often, the volatility of earnings is disregarded. Risk and return are, however, almost always coupled.

How much volatility of earnings (and therefore the probability of a total loss) can one tolerate? Often one chooses a mix. For example, one decides to allocate 60% of the capital to the investment banking division (with the hope of higher returns) and one allocates 40% of capital to the domestic division—especially retail—hoping for stable (though lower) returns. Retail business—for example, mortgage and consumer loans—generally offers a lower return, but there is lower volatility of the results, the results are more stable. The total return and the overall volatility of the distribution result from the mix (in this example, 60/40).

2.1.1 Process of Planning

Usually, at least once a year, an intense review of the strategy takes place. Decisions of the past are challenged. Decisions for the future are made.

To ensure that such a process does not produce erroneous decisions, the process should take place according to defined rules. Tools should be made available to assess the potential strategies associated with the risk appetite, and also to assess the consequences of the strategies (Fig. 2.1).

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Fig. 2.1

Iterative process of the strategy planning

The senior management decides which return on equity and thus which volatility of the profits is desirable. One bank might decide that a stable return on equity of 5% is sufficient. A more aggressive bank possibly decides for a return on equity of 10% (facing higher volatility though). The bigger risk appetite and thus higher return are associated with higher volatility. It may be that in 1 year 10% can be achieved, while the return in the next year goes down or is negative even.

Whatever the decision, the risk appetite needs to be translated into a strategy. In the first case of the example, the bank probably strengthens the domestic business, the lending to small and medium enterprises (SMEs)—a focus on Credit Risk; in the second case, the bank probably tends toward riskier investments (Market Risk).

The strategy has implications for many parts of the bank. Finance, treasury, and risk should be involved in the planning process. To determine whether the chosen strategy can provide the required return (with sufficient probability), risks should be assessed with an overall tool. This tool considers all divisions/desks, regions and categories of risk. The corresponding Value at Risk (VaR) and Expected Shortfall (ES) are calculated by aggregating all these pieces and bits.

The VaR (and ES) is always calculated for a given quantile (probability). To each considered quantile a risk capacity is assigned. The resulting rules are explained in detail below. It makes sense to choose one quantile of the overall VaR that assesses the threats to revenues, and another quantile that assesses the threat to capital. The following measures result from these considerations:

The earnings at risk (EaR) are calculated at a quantile of 95%. The meaning of this definition of EaR is that the calculated risks at this quantile manifest once in 20 years.

The capital at risk (CaR) is calculated at a quantile of 99.9%, which corresponds to the regulatory measure (the Basel measures represent a quantile of 99.9%). The meaning of this definition of CaR is that the calculated risks at this quantile manifest once in 1000 years.

To each of the defined risk measures a capacity is assigned. Capacity1 is associated with the measure earnings at risk (earnings at risk are calculated at a confidence level of 95%).

$$ \mathrm{Capacity}1=\mathrm{Income}\ \mathrm{before}\ \mathrm{tax}\ \mathrm{including}\ \mathrm{bonuses}\ \mathrm{and}\ \mathrm{dividends} $$

The condition is as follows:

$$ \mathrm{Capacity}1>\mathrm{Earnings}\ \mathrm{at}\ \mathrm{risk} $$

This condition implies that losses erasing dividends and/or bonuses should occur only once in 20 years at the maximum.

Capacity2 is assigned to the measure capital at risk (capital at risk is calculated at a confidence level of 99.9%).

$$ \mathrm{Capacity}2=\mathrm{Capacity}1\ \mathrm{plus}\ \mathrm{capital} $$

The condition is as follows:

$$ \mathrm{Capacity}2>\mathrm{Capital}\ \mathrm{at}\ \mathrm{risk} $$

This condition implies that losses erasing the capital and leading to bankruptcy should occur only once in 1000 years.

Besides the above requirements, the regulatory requirement is always: there must be enough capital to satisfy the following: capital/RWA > x. For example, in Switzerland in 2020 for going concern (major banks) this means capital/RWA > 14.3%.

With the help of earnings at risk and capital at risk and their corresponding capacities, the following example could result:

With the strategy to increase loans for SME, the return on equity (RoE) can be reached within 19 of 20 years. This is a result of the comparison of EaR and the corresponding Capacity1 (see Fig. 2.2).

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Fig. 2.2

Capacity1 vs. EaR—in this case acceptability of risks is given

With this strategy total losses occur less than once in 1000 years. This is a result of the comparison of CaR and the corresponding Capacity2 (see Fig. 2.3).

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Fig. 2.3

Capacity2 vs. CaR—in this case acceptability of risks is given

The decision of senior management in this example would presumably be to implement the discussed strategy.

On the other hand, perhaps, the following example (for another strategy) resulted:

The strategy to increase riskier investments implies that the desired RoE can only be reached in 12 of 20 years (see Fig. 2.4).

../images/308297_2_En_2_Chapter/308297_2_En_2_Fig4_HTML.png

Fig. 2.4

Capacity1 vs. EaR—in this case acceptability of risks is not given

Besides, total losses occur five times within 1000 years (see Fig. 2.5).

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Fig. 2.5

Capacity2 vs. CaR—in this case acceptability of risks is not given

Compared to the first discussed strategy, potentially higher revenues result (also both capacity measures are increased). On the other hand, risk is increased so much that the EaR are bigger than Capacity1 and the CaR is bigger than Capacity2. This strategy should not be