1. Sydney December 11, 2006 Seite 1 Lessons from implementations of Basel II and for Solvency II Workshop Sydney 2006, Manley Beach gerhard.stahl@bafin.de and stefan.jaschke@bafin.de

2. Sydney December 11, 2006 | 13.07.2015Seite 2 Agenda Part 0: Who is QRM & cross-sectoral overview Part 1: Market risk models for the trading book of banks Part 2: Credit risk models at banks Part 3: Operational risk models at banks Part 4: Market risk models at investment funds Part 5: Holistic models at insurers (Solvency II) Part 6: Economic capital and use test

3. Sydney December 11, 2006 Seite 3 Lessons from implementations of Basel I & II and for Solvency II - Who is QRM & cross-sectoral overview

4. Sydney December 11, 2006 | 13.07.2015Seite 4 BaFin as the German financial regulator As from BaFin’s mission statement: Preserve stability of the German financial system Maintain confidence of investors and consumers Safeguard fair behaviour of market participants BaFin approach: Integrated supervision (banking, insurance, financial services) Risk identification and risk limitation Prevention before punishment Principle based (not rule based) regulation

5. Sydney December 11, 2006 | 13.07.2015Seite 5 QRM experiences from banks, funds & insurers

6. Sydney December 11, 2006 | 13.07.2015Seite 6 QRM: RISQUE is our Business Regulation Inspections Supervision Quantitative Methods Uniformly across the whole financial market Excellence

7. Sydney December 11, 2006 | 13.07.2015Seite 7 Responsibilities of Q RM On-site inspections for market risk models, IRBA, IRB, OpRisk, …, Solvency II, …. Principal work for any type of risk model Research special audits according to § 44 banking act international groups as far as risk models are in focus representing the BaFin in international groups (Basel,..)

8. Sydney December 11, 2006 | 13.07.2015Seite 8 Regulatory Activities – Memberships in Working Groups Working Groups AIG validation subgroup CEBS validation subgroup RTF on concentration risk RTF intersection of market and credit risk Co-chairing BCBS working group on liquidity risk national IRBA Working Group (BaFin + Bundesbank) national OpRisk Working Group (BaFin + Bundesbank) BaFin Working Group on the relation between Solvency II and Basel II

9. Sydney December 11, 2006 | 13.07.2015Seite 9 Cross-sectoral supervision by QRM BanksFundsInsurers market risk models (Amendment to Basel I, since 1998) interest rate risk banking book (since 2004) internal ratings (Basel II IRBA, since 2005) OpRisk (Basel II AMA, since 2006) hedge funds (DerivateV/OGAW -RL, since 2004) since 2005 (pre- visits) potentially: Solvency II (starting 2008- 2010) on-site inspections of internal models:

10. Sydney December 11, 2006 | 13.07.2015Seite 10 Internal Model (IM) Auditing Background Regulation in Germany was almost juridical, typically off- site supervision, before 1997 Development of auditing expertise at BaFin and Deutsche Bundesbank since 1996 Institutions may use suitable internal risk models for determining the capital charges or partial capital charges for the market risk since 1997, provided that BaFin has confirmed their suitability in writing upon the institution's request (“Principle I concerning the capital of institutions” )

11. Sydney December 11, 2006 | 13.07.2015Seite 11 We are living in a risk society - Lessons from IM for Basel II Stochastic modelling and regulation Non-linear instruments, complex hedging strategies Large-scale forecasting models with thousands of variables Portfolio view of risk Are multivariate non-linear stochastic models complex? No! – the complexity comes from the interdisciplinary use of VaR-Models The risk management process itself is a tool to reduce complexity

12. Sydney December 11, 2006 | 13.07.2015Seite 12 Market Risk - Internal Model Banks General Specific Market Risk Market Risk Risk Category FX Commodity Equity Interest Rate It currently comprises 16 banks

13. Sydney December 11, 2006 | 13.07.2015Seite 13 Market Risk - Aggregation General Specific Market Risk Market Risk Risk Category FX Commodity Equity Interest Rate Total Market Risk (MR): Aggr. of Specific and General MR under null correlation General Market Risk (MR): Correlations are considered Specific Market Risk (MR): Aggr. of Specific MR for Equities and and Specific MR for Interest Rate under null correlation

14. Sydney December 11, 2006 | 13.07.2015Seite 14 IM Auditing Process Overview Risk Management ProcessJudgment after audit Identification of RiskQuantification of RiskRisk management and controlling Economic P/L NPP (f. op-risk) Stress- Tests Risk measure Valida tion Economic P/L Limit System Upper loss limit ReportingProcess under control and capable? Position gathering, market data Bank specific: Workflows (i. e. IT-processes), HR or IT allocationCan be audited in addition Decomposition of the risk management process from the regulator perspective in accordance with the requirements of Principal I concerning the capital of institutions

15. Sydney December 11, 2006 | 13.07.2015Seite 15 Process based auditing THE BUSINESS OBJECTIVES RISKS SELF-ASSESS Agree objectives ID risks Assess risks RM strategy Understanding buy-in action plans responsibility INTERNAL CONTROLS Risk management strategy OUTCOMES Statement on internal control BUSINESS SYSTEMS TeamsProcessesProjects

16. Sydney December 11, 2006 | 13.07.2015Seite 16 The Institute of Internal Auditors (IIA) Definition “Internal auditing is an independent, objective assurance and consulting activity designed to add value and improve an organisation‘s operations. It helps an organisation ac- complish its objectives by bringing a systematic, disciplined approach to evaluate and improve the effectiveness of risk management, control and governance process”

17. Sydney December 11, 2006 | 13.07.2015Seite 17 Investment funds, banks, insurers funds hedge funds banks derivates houses insurers re-insurers complexity of products complexity of risk drivers market risk + credit risk + exotic deriv. (e.g. whether) +insurance risks +longer time horizons more uncertainty

18. Sydney December 11, 2006 | 13.07.2015Seite 18 Similarities and Differences Similarities / Synergies similar products: structured products interest rate and credit derivatives similar tools and models: market risk (Black-Karasinski) credit risk (CreditMetrics) Banks / Basel IIinsurers / Solvency II input-oriented partial models (market and ratings) shorter horizons aggregation of risk numbers in market risk: thousands of risk drivers or simple „earnings at risk” absolute risk measure output-oriented holistic modeling longer horizons aggregation of distributions King’s road: small number of accumulation events, which explain losses at the group level risk relative to a benchmark (RNP)