BaselIIandEconomicRisk

PRESENTEDTO:

IAFEAnnualMeeting

BY:

EvanPicoult,ManagingDirector
RiskArchitecture
Citigroup
NewYork,NewYork

DATE:

Wednesday,May24,2006

PLACE:

NYC

RiskCapital BasicConceptsSummary

Measurementofrisk:
Potentialunexpectedlossoverone
yearataveryhighconfidencelevel
Howhighisthepotentialflood?
RiskCapital
(a.k.a.EconomicCapital)
Banks
Internal
Measurements

Advancedbanksusemore
sophisticatedmeasuresthan
prescribedbyBasel

Measurementoffinancialresources
toabsorblossesandavoid
insolvency.

Howhighisthedam?
Tangibleequityisonesuch
measure.
i.e.Bookcapitalminusgoodwilland
otherintangibles.

HigherConfidenceLevel
PortfolioEffects
MoreRiskTypes

BaselIIs
Measurements

RiskWeightedAssets(RWA)
RWA=12.5*RiskCapBaselII

EvanPicoult,CitigroupMay,2006

Tier1capital
Tier2capital

PAGE2

StructureofBaselII
BASELII
MinimumCapital
PillarIwillhave
largestimpactfor
manybanksbecause
of:
a)RiskInfrastructure
neededfor
calculationofRWA
forcreditrisk.
b) RiskInfrastructure
neededfor
calculationofRWA
foroperationalrisk.

CreditRisk
Morerisk
sensitivity

OperationalRisk
New

TradingMarket
Risk
Enhanced
standards.

c) Enhanced
infrastructurefor
tradingmarketrisk.
d) Differentialimpact
onRWAforeach
risktype.

PillarI

Supervisory
Review
Supervisory
assessmentof
banks:
Risk
management
policiesand
practices

Market
Disclosure
Mandates
increased
minimumpublic
disclosureof
banksrisk
information.

Economic
capitalprocess.
Canresultin
additional
capital
requirements

PillarII

PillarIII

Pillarsareintendedtobemutuallyreinforcingandinterlinked.
EvanPicoult,CitigroupMay,2006

PAGE3

BaselII:MethodsforcalculatingRWA(RiskWeightedAssets)
RISKWEIGHTEDASSETS(RWA)
BaselIIallowsseveralapproaches(methods)forcalculatingRiskWeightedAssetsforeachof
thethreerisktypesitrecognizes.
USregulatorswillonlyallowtheAdvancedInternalRatingsBasedApproachforCreditandthe
AMAforOpRisk.
RISKWEIGHTEDASSETS

RWAFORMARKETRISK

Standardized

VAR
InternalRiskModel

RWAFORCREDITRISK

RWAFOROPERATIONALRISK

Standardized

Basic

FoundationalIRB

Standardized

AdvancedIRB

AMA

Internalriskparameters.
Banksarenotallowedtouse
internalmodelofcreditrisk.
EquityInvestments

Securitization

InternalRiskModel

Other
Other: PurchasedReceivables
ResidualLeases

MTMportfolios

NoRWAfor:
Accrualinterestrate
risk.
CrossBorderRisk
BusinessP/LRisk

Bankingbookportfolios,includingAFS,
pluscounterpartycreditrisk

EvanPicoult,CitigroupMay,2006

PAGE4

BaselIIU.S.contrastedwithothercountries
UNITEDSTATES

EUROPE,JAPANANDOTHERCOUNTRIES

Scopeofcoverage

Scopeofcoverage

TheFed/OCC/FDICwillonlyrequirethe
largest(~10)internationallyactivebanksto
implementBaselII.

InEuropeandJapanallbankswillhaveto
implementoneofthethreeBasel
approaches.

OtherU.S.banksmaychoosetoimplement
BaselIIorremainonthecurrentrules.
Perhapsanother10orsolargecommercial
bankswillimplementBaselII.
U.S.investmentsbankswithoperationsin
EuropeneedtoimplementtheSECs
ConsolidatedSupervisoryEntity(CSE)
approach,whichsimilartoBaselII.Other
investmentbankscanvoluntaryimplement
theCSEapproach

ApproachesAllowed
TheFed/OCC/FDICwillonlyallowthe
AdvancedInternalRatingsBasedApproach
forCreditRiskandtheAMAapproachfor
OperationalRisk.

EvanPicoult,CitigroupMay,2006

ApproachesAllowed
Allthreeapproachesforcreditandall
threeapproachesforoperationalriskwill
beallowed.

PAGE5

ComparisonofDraftNPRtoFinalBaselIIrules
TimingofImplementation
BaselII
AdoptedbyEUandothers

DraftNPR
ForUSadoption
(NPRisexpectedtobe
releasedbefroetheendof
June2006.Bankswillhave
120daystorespond).

2007

ParallelRun

2008

Live.Floor=90%

ParallelRun*

2009

Live.Floor=80%

Live.Floor=95%*

2010

Live.Nofloor

Live.Floor=90%*

2011

Live.Nofloor

Live.Floor=85%*

2012

Live.Nofloor

Live.NoFloor?*

*Notes:
USwillhavetransitionphasesratherthantransitionyears. Approvaltogoliveandtoenter
eachphasewillrequireregulatoryapproval.
USregulatorswillrecalibrateBaselIIifsystemwidecapitalrequirementsfallbymorethan10%.
Thisisarbitraryanddefeatsthepurposeofhavingarisksensitivemeasureofcreditrisk.A
studybythefourlargeUSbankshasfoundthatRWAforwholesalecredit(forafixedportfolio)
wouldberoughly35%higherduringbottomofeconomiccyclerelativetopeakofcycle,under
theBaselIIformula.
EvanPicoult,CitigroupMay,2006

PAGE6

MarketRiskInTradingBook:Issues
BackgroundofRegulatoryConcerns

ConcernOverCompositionofTradingBook
Regulatorsconcernedaboutincreasingnumberofilliquid,complexstructured,creditsensitive,long
lastingtransactionsintradingportfolios.

ConcernOverIncreasedIncentiveforRegulatoryArbitrage
GreaterrisksensitivityunderBaselIImeansthatunsecurednoninvestmentgradeassetsinaccrual
portfolioswillhaveriskweights>100%.Thus,concernaboutincreasedincentiveforregulatory
arbitragebetweenbankingandtradingbook.

AdditionalConcerns:
SomeUSInvestmentBanks,whicharenowsubjecttoBaselrules,haveessentiallynobankingbook.
ChangesinaccountingrulesmayallowfirmstoselectivelyuseFairValueAccountingforloans.

Requirements

PoliciesAndProcedures:
FirmsmusthaveclearsetofPoliciesandProceduresspecifyingwhatpositionscouldbeincludedinor
excludedfromtradingbook.

VAR:
EverythingthatpassesthedefinitionofthetradingbookcanbeincludedinVAR.

MinimumIncrementalRWAforparticularsecuritizationexposures
TheincrementalRWAgeneratedbycertainsecuritizationexposuresmustbeequaltoorgreaterthan
whatwouldbecalculatedwiththesecuritizationrules.
However,anexceptiontotheabovewillbemadetobanksthataredealersintheaboveexposureswhen
theycandemonstratetradingintent,liquidtwowaymarket,etc.

RequiredEnhancementofVARModels.

EvanPicoult,CitigroupMay,2006

PAGE7

MarketRiskInTradingBook:FinalRules
BanksmustenhancetheirVARModels:
FormulaforRWAformarketriskincurrentandnewBaselproposal:
RWA_Market_Risk =12.5*Basel_Risk_Capital_Market_Risk

UnderthecurrentmethodbanksweregivenachoiceforcalculatingRiskCapitalbasedonVAR:
a) IfVARexplicitlymodelsissuerspecificeventanddefaultrisk:
Basel_Risk_Capital_Market_Risk =3*VAR'_10day_99%CL Nobankhasbeengivenapprovalforthis.
b) IfVARonlymodelsidiosyncraticriskbutdoesnotexplicitlymodeldefaultrisk:
Basel_Risk_Capital_Market_Risk =3*VAR_10day_99%CL +VAR_Specific_10day_99%CL

UndertheJuly,2005methodBaselRiskCapitalwouldhavetwocomponents:
a) 3*VAR'_10day_99%CL

Includingissuerspecificeventanddefaultrisk.

b) Incrementaldefaultriskforpositionsforwhichitwilltakemorethantendaystodefeasethedefaultrisk.
ThestandardsfordefiningandmeasuringincrementaldefaultareonlyvaguelydefinedintheJuly,2005
Document.Thisissomethingtheregulatorsandtheindustryhavestartedtojointlydiscuss.Firmsthat
alreadyhaveapprovedmodelsforspecificriskwillhaveuntilJanuary1,2010toimplementtherequired
enhancements..
Inthelimitofanilliquidpositionthatwouldtakeoneyeartodefease,theincrementalRWAmustbeatleast
aslargeasthatderivedfromtheBaselIIloanformula.

EvanPicoult,CitigroupMay,2006

PAGE8

BaselIIConcerns
Ideal:
RWAshouldbebasedona,comprehensive,risksensitivemeasurementof
economicrisk.Itthuswouldbefullyconsistentwitharationalmeasurementof
internalriskcapital,onlyatalowerconfidencelevel.Therefore,RWAwould
notbeabindingconstraintonrational,economicdecisionmaking.
RWAcalculationsshouldleverageoffofgoodinternalriskmanagement
processesanditsimplementationwouldthenentailonlyasmallincremental
cost.

Concernsofbadoutcome:
RWAaredisconnectedfromrisksensitivitybecauseoftheimpositionof
differenttypesoffloors.
RWAbecomesabindingconstraintbecauseoftheimpositionofregulatory
overridestoaninternaleconomicanalysis(intheformoffloors,stressed
LGDs,minimumPDs,lackoffullrecognitionofdoubledefaultbenefit,etc.)
makestheeffectiveconfidencelevelunrealisticallyhigh.
Bankshavetobuildexpensiveinternalprocessesthatonlyservethepurpose
ofregulatoryreporting,notinternalriskmanagement.
EvanPicoult,CitigroupMay,2006

PAGE9

WhereisalltheStability?
(OrDoHedgeFundsPoseSystemicRisk?)
(OrDoHedgeFundsPoseSystemicRisk?)

Discussionby:
RichardR.Lindsey
Bear,StearnsSecuritiesCorp.
24May2006

CausesofSystemicRisk
ExchangeTradedDerivatives
FinancialFutures
ProgramTrading
PortfolioInsurance
OTCDerivatives
JunkBonds
EmergingMarkets
CMOs
CreditDerivatives
HedgeFunds!?
11
Source:GreenwichAssociates,CSFB,BersteinResearch

11

HedgeFundsHaveExpandedRapidly
WorldwideHedgeFundAssets($inbillions)
$1,200

NumberofHedgeFundsWorldwide

$1,200

8,000

$1,105

$1,000

8,000
6,667

$1,000

$600

$600
$491

$400

$400

$200

15% CAGR

6,000

6,000

4,000

4,000
3,335

2,000

2,000

HedgeFunds(ex.FoHFs)

$800

Assets

Assets

$800

HedgeFunds(ex.FoHFs)

18% CAGR

$200

$0

$0
2000

2001

2002

2003

Year

2004

2005

0
2000

2001

2002

2003

2004

2005

Year

12

12

EstimatedStrategyCompositionbyAUM1990
1990
Convert. Arb.
0.5%
Sector (Total)
0.3%

Emerging Market
0.4%

Distressed Securities
2.4%
Equity Hedge
5.3%

Relative Value Arb.

10.1%

Equity Market
Neutral
1.7%
Equity NonHedge
0.6%
EventDriven
3.8%

Merger Arb.
0.6%
FI: Arbitrage
3.2%

Global Macro
72%
13
Note:FromHFR

13

EstimatedStrategyCompositionbyAUM2006
2006
Equity Hedge
30.4%

Emerging Markets
4.3%
Distressed Securities
4.6%

Equity NonHedge
4.6%

Convertible
Arbitrage
3.1%

Event
Driven
14%

Short Selling
0.3%

Sector
4.8%

Relative Value
Arbitrage
11.9%

Equity Market
Neutral
2.2%

FI: Arbitrage
3%
Global Macro
72%

Regulation D
0.2%

Merger Arbitrage
1.4%

FI: High Yield

0.8%

Macro
Market Timing 10.3% FI: MortgageBacked
0.4%

FI: Diversified
1.7%

2.4%

14
Note:FromHFR20061QReport

14

ConcentrationofHedgeFundAssets
3,500 (3)

$1,100

100%

100%
$250
$76M/HF

75

75
$200

50

23%of
Assets

94%of
Firms

18%of
Assets

3,300

50
$2B/HF

25

$650

(2)

100
3%of
Firms
3%of
Firms

59%of
Assets

25

(1)

100

$6.5B/HF

HedgeFundFamilies

0
HedgeFundAssets

Notes:
1. Source: AbsoluteReturn,Feb2006
2. Source:TheHedgeFund100,
AlphaMagazine,May/June2005
15
3. Source:StrategicFinancialSolutionsestimates3,500GeneralPartnersbasedonHFdatabasestudy

15

HedgeFundsareActiveMarketParticipants
TheyAccountfor3540%ofOverallEquityCommissionsinUSandAsia
TheyAccountfor4050%ofDailyTurnoverontheNewYorkandLondonStock
Exchanges
TheyDominateConvertibleBondTradingFlows,Accountingforover70%of
TotalVolume
TheyAccountfor2030%oftheCreditDefaultSwapVolume
TheyRepresent82%oftheTradingVolumeinUSDistressedDebt
TheyareAlmost33%ofTradinginUSSpeculativeGradeBonds
TheyDominateUSExchangeTradedFunds,Controlling70%oftheVolume
TheyareHeavilyintoGlobalForeignExchange,Representing1015%of
WorldwideVolume

16
Source:GreenwichAssociates,CSFB,BersteinResearch

16

InvestmentOpportunities
InvestmentOpportunities
Traditional

PassiveStrategies

Alternative

ActiveStrategies

Extraordinary Corporate Events

Complex Financial Instruments

IncreasingInefficiencies

Convertibles / Warrants
Emerging M arket Bonds
Small Cap Stocks
High Yield Bonds
Large Cap Stocks
Corporate Bonds
G7 Bonds
Cash Instruments

IncreasingPotentialtoAddValue

17

17

HedgeFundLeverage
BalanceSheetLeverage
InstrumentLeverage
DryPowderAgreements
LeverageonLeverage

18

18

InstitutionalExposuretoHedgeFunds
PrimeBrokerage
Financing
CounterpartyTrading
CorrelatedTrading
SecondaryMarketEffects

19

19

HedgeFundsandMarketEfficiency
DiversificationandPooling
LowCorrelationwithTraditionalAssetClassesProvidesmoreDiversification
Opportunities
PoolCapitalfromInvestorsandProfessionallyShapeitsUtilization

PriceEfficiency
HedgeFundsAttempttoExploitInefficienciesinFinancialMarkets
TheActivityofHedgeFundsProvideMorePriceInformationtotheMarket,TherebyImprovingPricingEfficiency
TheExploitationofInefficienciesLeadstotheResolutionofInefficiencies

Liquidity
HedgeFundshaveaRelativelySmallProportionofInvestmentAssets
UseLeverage,ShortSalesandDerivatives
CanInvestinSpecialorIllLiquidInstruments
ActiveTradingVolume

20

20

WhoHastheRisk?
SymmetricalRisks?
- HedgeFundsPoseRiskstoFinancialInstitutions
- FinancialInstitutionsPoseRiskstoHedgeFunds

BuyersofRisk?
- HedgeFundsTakeRiskOutoftheRegulatedSector
- SpreadRisktoInvestors
DoInvestorsUnderstand?
EconomicallyEfficient?

21

21

TradingVolatility
NegativeTradingDays

TradingRevenueVolatility

BearStearns

BearStearns

GoldmanSachs

GoldmanSachs

Lehman
Brothers

Lehman
Brothers

MerrillLynch

MerrillLynch

Morgan
Stanley

Morgan
Stanley

10

20
2002

30
2003

40
2004

50

60

0%

5%

10% 15% 20% 25% 30%

2005

Notes:
1) TradingRevenueVolatilitymeasuredbystandarddeviationoftradingrevenueas%ofitsmean,overthreeyearstoQ42005
22
2) Source:Moodys.asreportingin TheEconomist 29Apr06

22