October 21, 2014 Rick Hamilton 1 DISCLAIMER THE VIEWS EXPRESSED - PowerPoint PPT Presentation

Economic Capital in the Age of CCAR October 21, 2014 Rick Hamilton 1

DISCLAIMER THE VIEWS EXPRESSED IN THIS PRESENATATION ARE THOSE OF THE SPEAKER AND NOT NECESSARILY THOSE OF PNC FINANCIAL SERVICES GROUP, INC. OR ITS SUBSIDIARIES. 2

Agenda • Defining the Risk Measures • Information Content • The Problems They Solve • Reconciling The Stories 3

Agenda • Defining the Risk Measures • Information Content • The Problems They Solve • Reconciling The Stories 4

Typical Risk Quantification Process: Capital Management CCAR ICAAP Submission Quantitative Capital Adequacy Assessment Spot Capital Forecasted Forecast Assumptions Ratios Capital Ratios Capital Resources Tier 1 C Tier 1 C Credit Losses Idiosyncratic Market Risk Operational Margin & Volume Losses Losses Tier 1 Tier 1 Total RBC Total RBC Avail. Cap. Avail. Cap. Liquidity Impacts Credit Migration New Volume Runoff Requirements (x Leverage Leverage Capital Standardized Standardized 12.5) Pillar 1 Pillar 1 Economic Cap. Economic Cap. Macro Economic Scenarios DFAST Pricing & Performance 5

Measures of Capital Resources Capital Requirements Precision/Sophistication Most conservative regulatory view Tier 1 Common of resources available to absorb loss Somewhat broader regulatory Tier 1 definition of capital resources Broadest regulatory view of capital Total Risk Based Capital resources Firm’s own assessment of the Internal Available Capital resources available to absorb loss 6

Measures of Capital Requirements (Tail Risk) Capital Requirements Precision/Sophistication Simplest view - assumes all assets Leverage Ratio have same risk More detailed view – some Standardized Approach differentiation by asset class. Very granular view that relies upon Basel II Pillar 1 a number of simplifying assumptions Very granular and precise estimate Economic Capital designed to reflect specific risk characteristics of the firm. 7

Forecasting Assumptions: Goals • Project the firm’s capital ratios under alternative, (typically severe) scenarios • Scenarios are deterministic • Scenarios can have multiple sources  Executive management/board driven  Regulatory driven  LOB driven • There are key assumptions used in forecasting that align with the 8

Agenda • Defining the Risk Measures • Information Content • The Problems They Solve • Reconciling The Stories 9

Spot Capital Ratios • A measure of the amount of potential loss a firm could experience as a ratio of its available capital. • Looks to ensure that the firm has sufficient resources to absorb catastrophic losses. • Primarily a gone concern perspective if one assumes:  Banks are not viable when they fall below their minimum capital ratios.  The losses implied by the capital calculations reflect a market to market Economic Capital Group 10

Basel III Capital Ratios Hypothetical Bank, NA Minimum Capital Required Minimum capital $ Ratio $ Min. Ratio Assets 10,000 ratios imply that at BIII RWA 7,500 600 8.0% the 1/1000 year loss levels implied by CET1 750 10.0% 525 7.0% Tier 1 850 11.3% 638 8.5% BIII calculations, a Total RBC 1,050 14.0% 788 10.5% bank would not be a Actual Buffer Minimums viable entity CET1 / RWA Loss 125% 38% 88% Tier 1 / RWA Loss 142% 35% 106% Total RBC / RWA Loss 175% 44% 131% o 100% of CET1 would be used by implied losses o Tier 1 and Total RBC could be used to:  Ensure depositors, FDIC and senior debt holders are paid  Provide a basis for recapitalization 11

Illustration of Economic Capital Ratios o Economic capital is Hypothetical Bank, NA the internal parallel Minimum Capital Required to the BIII regulatory $ Ratio $ Min. Ratio ratios – measures Assets 10,000 how large losses BIII RWA 7,500 550 7.3% could be in the Avail Cap 1 800 10.7% 413 5.5% 1/1000, 3/10,000, etc. Avail Cap 2 900 12.0% 563 7.5% event. Total AC 1,100 14.7% 675 9.0% o EC is more Actual Buffer Minimums comprehensive and AC1 / RWA Loss 145% 70% 75% precise than RC AC2 / RWA Loss 164% 61% 102% o Ties well with Total AC / RWA Loss 200% 77% 123% pricing o As with regulatory capital, EC limits could be structured to show how much of the total loss will be absorbed by each level of capital. 12

CCAR • CCAR builds upon the solvency requirements of regulatory capital (or EC in some cases). • CCAR (and other stress testing), answer the questions: o Does an institution have sufficient capital to ensure it is:  Perceived by markets as viable (non-zombie).  Can continue prudent lending.  Ensure depositors, FDIC and senior debt holders are paid should failure occur.  Provide a basis for recapitalization should failure occur. Economic Capital Group 13

CCAR Example Hypothetical Bank, NA Spot Stress Testing Impacts Projected Runoff / New Credit Market NII / Fees / $ Ratio Volume Migration Risk Ops Risk Expenses $ Ratio Assets 10,000 (1,000) (100) (5) - - 8,895 - BIII RWA 7,500 (750) 1,000 10 100 - 7,860 - Req. Capital 600 (60) 80 1 8 - 629 - CET1 750 10.0% (15) (75) (5) (25) (25) 605 7.7% Tier 1 850 11.3% (15) (75) (5) (25) (25) 705 9.0% Total RBC 1,050 14.0% (15) (75) (5) (25) (25) 905 11.5% Capital Resource Coverage Spot Buffer Absorption Projected Min CET1 / RWA Loss 125% 11% -30% -1% -5% -4% 96% 88% Tier 1 / RWA Loss 142% 13% -32% -1% -6% -4% 112% 106% Total RBC / RWA Loss 175% 17% -37% -1% -6% -4% 144% 131% • In this example, bank is able to absorb downturn scenario impacts on earnings and capital ratios. • Maintains sufficient capital resources to repay creditors. 14

Agenda • Defining the Risk Measures • Information Content • The Problems They Solve • Reconciling The Stories 15

Capital Adequacy: Summary of Problems Solved • Regulatory Capital: Regulatory perspective on a firm’s ability to repay depositors and recapitalize without an impact on FDIC should firm fail. • Economic Capital: Same as regulatory but based upon management’s views of risk and resources • CCAR (Stress Testing): Regulatory perspective on firm’s ability to weather a periodic downturn. 16

How Far From Edge vs. How Far Of a Fall CCAR (Cushion) Reg. Cap and EC (Resolution) 17

Other Uses? • Economic Capital: “True” amount of capital needed to support risk. • Regulatory Capital: Capital cost of doing business. • CCAR (Stress Testing): Potential areas of earnings volatility. 18

Pricing and Performance Management Hypothetical Bank, NA $ Capital Requirements (10% Minimum Hurdle Rate) RORC + RORC EC ROEC RC RORC CCAR +CCAR Asset 1 10.0 15.0% 11.0 13.6% 1.0 12.5% Exposure to stress Asset 2 20.0 10.0% 22.0 9.1% 0.5 8.9% scenario Asset 3 15.0 9.0% 12.0 11.3% 2.0 9.6% Asset 4 5.0 20.0% 4.0 25.0% 1.0 20.0% Asset 5 5.0 25.0% 9.0 13.9% 0.5 13.2% Total 55.0 12.9% 58.0 12.2% 5.0 11.3% Reprice, restructure, Economics good – how exit to handle reg cost. • EC should drive prioritization of economic investment decisions • Regulatory capital and CCAR cushions are additional costs to be considered. Multiple ways to incorporate. Complex, nuanced and imperfect. • Top of house vs. bottom-up 19

Unexpected Loss • EC models typically can produce an unexpected loss result for various confidence levels. • CCAR is an unexpected loss estimate based upon one or more adverse scenarios. • Both can be used to help manage portfolio concentrations and earnings volatility 20

Unexpected Loss: Different Perspectives Hypothetical Bank, NA Dollar Earnings-at-Risk EC CCAR Model CCAR Severe UL Adverse Adverse Asset 1 0.5 0.8 1.5 Asset 2 0.6 0.4 0.8 Asset 3 3.0 1.5 3.0 Asset 4 1.0 0.8 1.5 Asset 5 1.0 0.4 0.8 Total 6.1 3.8 7.5 • Each model provides a different perspective on how much unexpected losses could impact earnings. • Useful in managing concentrations, hedging risks and managing capital. • Different perspectives on the same question 21

Different Perspectives on Same Problem • No models are right. Some are useful. • Different perspectives are needed to get a reliable perspective on risk. 22

Different Perspectives on Same Problem: Hypothetical Bank Implied CCAR loss distribution “True” Loss Distribution CCAR Expected EC Expected CCAR Adverse EC Loss Distribution 70%ile CCAR Severe Adverse 80%ile UL (66%ile) EC Event (99.9, 99.93, etc) Other Scenarios • In statistical terms, EC, RC, CCAR are all estimates of the firm’s true loss distribution. • Understanding the difference between them can lead to insights into the firm’s risks. 23

Agenda • Defining the Risk Measures • Information Content • The Problems They Solve • Reconciling The Stories 24

How Does One Reconcile EC and CCAR • We understand that the loss distributions are different. • But are they really comparable?  Different loss distributions  Different time horizons  Different migration matrixes  Different discounting assumptions  Different balance sheets  Different correlation assumptions  PD/LGD correlation • How useful is it to say EC says X and CCAR X/2 if you don’t understand the details? 25