1. Sydney December 11, 2006 Page 1 Lessons from implementations of Basel II and for Solvency II - Economic Capital and Use Test Process-Oriented Supervision

2. Sydney December 11, 2006 | 05.10.2015Page 2 Agenda Motivation A Model for Implementing the Use Test The PDCA Process as a Supervisory Tool Stakeholder à la mode de Basel II Conclusions

3. Sydney December 11, 2006 | 05.10.2015Page 3 Motivation for Use Test In general lack of data to backtest e.g. PDs Dependent defaults => backtesting difficult concept of use test (CEBS, AIG) reengineering of models => example

4. Sydney December 11, 2006 | 05.10.2015Page 4 Use Test considers internal application of a rating system as part of the validation EC is a Pillar II concept (!!) Use Test maintains the process (=ongoing) oriented supervision => Padoa- Schioppa the use of internal models

5. Sydney December 11, 2006 | 05.10.2015Page 5 Economic Capital – Stakeholders Bondholders Shareholders Regulators Rating agencies Managers - different time horizons(!!) - different levels of significance (!) - complexity of the firm, e.g. a holding (!!!) => copula, consistent modeling,….

6. Sydney December 11, 2006 | 05.10.2015Page 6 Economic Capital suitable factor for the risk sensitive approach of regulation top-down steering tool enabling of control within a complex environment coverage of risk of unexpected loss or unexpected reduction in income

7. Sydney December 11, 2006 | 05.10.2015Page 7 Economic Capital portfolio P L P denotes the loss variable associated with P is the chosen measure of risk (e.g.: VaR (Value-at-Risk) or TVaR (Tail VaR))

8. Sydney December 11, 2006 | 05.10.2015Page 8 Economic Capital Problems to specify Economic Capital complexity quality and availability of data consistent and explicit method for aggregate Economic Capital

9. Sydney December 11, 2006 | 05.10.2015Page 9 Economic Capital proxies for EC: VaR statisical methods for calculating Economic Capital Regulatory Capital EAD (exposure at default), PD (probability of default), LGD (loss given default) the level of significance, the time horizon, and the correlation of defaults C

10. Sydney December 11, 2006 | 05.10.2015Page 10 Basel II and supervision Principle 1 (BIS (2004)) requires the implementation of a Risk Management Process. Aims of the Risk Management Process are a standard by targeting an adequate level of capital, e.g. by the means of EC, to stay in an equilibrium state ensuring that the capital level is maintained over time. => using feedback and feed-forward methods as steering tools in order to keep the process of assessing capital under control

11. Sydney December 11, 2006 | 05.10.2015Page 11 PDCA Process as a Supervisory Tool

12. Sydney December 11, 2006 | 05.10.2015Page 12 Plan, Do, Check, Act

13. Sydney December 11, 2006 | 05.10.2015Page 13 PDCA Process as a Supervisory Tool PDCA is a dynamical method, especially qualified for audit of risk management process

14. Sydney December 11, 2006 | 05.10.2015Page 14 Process-oriented supervision use test: Tommaso Padoa-Schioppa: “Self vs. public discipline” (2002) 1.principle-based regulation (goal-oriented) 2.process-oriented supervision: looking at internal processes conclusions:  quality criteria cannot be externally given; quality is always relative to the risk strategy of the undertaking  internal models are not comparable in the sense that the same model may be perfect for A and insufficient for B  should not even try (same sorting of risks -> systemic risk)  refrain from creating the “super-map” of business processes

15. Sydney December 11, 2006 | 05.10.2015Page 15 10 12 14 16 18 0 2 4 6 8 Process capable and under control Processes

16. Sydney December 11, 2006 | 05.10.2015Page 16 Process Profile Work sheet Process Name and NumberProcess Owner Description Triggers Event beginning Other Events Event ending process Input – Items and Sources Output – Items and Customers Process UnitsProcess Unit Supervisors Business Objective(s)Business Risks Key ControlsMeasure of Success

17. Sydney December 11, 2006 | 05.10.2015Page 17 Corporate Governance Stakeholders Legislation, rules & regs Final accounts External audit Board of directors CONFORMANCE PERFORMANCE ACCOUNTABILITY Systems of internal control Audit committee Internal audit Risk management Performance management COMMITMENT AND CAPABILITY Ethical standards Objectives Policies Strategies Plans Procedures Training and Developement Director‘s report Performance review Final accounts Accounting policies Corp. Gov. Disclosures SIC KPIs Managers Operational and front line staff Supervisors

18. Sydney December 11, 2006 | 05.10.2015Page 18 Stages of Risk Management MISSION ACTIONSTRATEGY PERFORMANCE FRAMEWORK RISK ASSESSMENT

19. Sydney December 11, 2006 | 05.10.2015Page 19 Risk Management OBJECTIVES Strategy and KPIs TIMECOST EMBEDVALUES Impact Risks ERM/CRSA Threats Opportunities Management Identification Assessment Review Risks Risk policy People buy-in CRO Board sponsor

20. Sydney December 11, 2006 | 05.10.2015Page 20 Risk 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

21. Sydney December 11, 2006 | 05.10.2015Page 21 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 ist objectives by bringing a systematic, disciplined approach to evaluate and improve the effectiveness of risk management, control and governance process”

22. Sydney December 11, 2006 | 05.10.2015Page 22 Benefits of Systems-based Auditing (SBA) 1.It is positive and forward looking and considers the future strengths of control systems as opposed to isolating and reporting series of past errors. 2.It promotes participation by involving the client in explaning the system and ist objectives. 3.It promotes professionalism as opposed to churning out auditors who are experts in basic extensive testing routines. 4.It covers everything by being based on the system in operation. 5.It is constructive in seeking to improve systems. 6.It is preventive and views errors in terms of preventing them in the future rather than listing them for management to reprocess 7.It can be geared into career development as an experienced systems auditor is able to tackle very complicated operations. 8.It promotes respect by requiring the auditor to understand the systems and the clients needs. 1/2

23. Sydney December 11, 2006 | 05.10.2015Page 23 Benefits of Systems-based Auditing (SBA) 9.It develops auditors as experts in control rather than checkers of management. 10.There is unlimited potential to extend systems auditing into all organisational activities. 11.Auditors generally find it more interesting with the emphasis away from testing transactions. 12.It can act as a vital aid to management with long-lasting effects in strengthening controls. 13.It can be a very efficient use of audit resources since it looks for causes of problems and not just the consequencial errors. 14.Since it is not error-orientated it is not therefore seen as negative by management. 15.It is systematic and key areas may be identified and isolated for further attention. 16.It has a wide scope and application and may be used to audit almost everything. 2/2

24. Sydney December 11, 2006 | 05.10.2015Page 24 The new dimensions of Internal Auditing Past FocusAdditional Focus hard controlssoft controls control evaluationself-assessment controlrisk context risk threatsrisk opportunities pastfuture reviewpreview detectivepreventive operational auditstrategy audit auditorconsultant 1/2

25. Sydney December 11, 2006 | 05.10.2015Page 25 The new dimensions of Internal Auditing Past FocusAdditional Focus impositioninvitation persuasionnegotiation independencevalue audit knowledgebusiness knowledge catalystchange factor transactionprocesses control activities management controls controlrisk consciousness 2/2

26. Sydney December 11, 2006 | 05.10.2015Page 26 Exams are an interactive process between institutions and regulators starting point: the institution – understand your customer– the institution shows the use test flexible audits, principles vs rules, no check lists Process oriented approach reduces follows-ups Home / Host -

27. Sydney December 11, 2006 | 05.10.2015Page 27 Pros of a BaFin audit auditors are consultants (process-oriented, regulation) AKIM Special know-how Added Value by audits COPULA-Approaches

28. Sydney December 11, 2006 | 05.10.2015Page 28 (b) BaFin vs S&P BaFin (internal Models)S&P (ERM) Structures of organisation and Ablauf; organisational change Risk Management Culture Processes of aggregation and Reporting (bottom-up) Risk Capital Models, Extreme Event Management Strategy and Risk management (top-down) Risk Control Processes, Strategic Risk Management Basically comparable: Examination topics Basically different: Depth of Examination (Previsit vs. Prüfung) and supervisory means

29. Sydney December 11, 2006 | 05.10.2015Page 29 Conclusions Economic Capital is a crucial element in the steering process of a bank Efficiency of Economic Capital in management processes does strongly depend on plausibility checks Check of data quality Identifying of market standards and benchmarks for supervisory and the banks among themselves