Pillar II - Credit VaR Model and internal capital allocation

The client was seeking to develop a more risk sensitive measure of credit and concentration risks to address internal steering and regulatory requirements. Avantage Reply assisted the client to design and industrialise a model to evaluate economic capital in line with market practices.

The client

The client is one of the largest corporate and investment Bank in France. It is notably specialised in capital markets activities, specialised financial services, asset management and private Banking.

The challenge

The client wanted to build in the same setup, a credit risk model to assess the economic capital amount for strategic steering purposes, and, in accordance with the regulatory requirement, a more risk-sensitive measure of credit and concentration credit risk. The quantitative approach should be more sophisticated and adapted to the institutions’ portfolio, but also replace the current basic indicator used for Pillar II capital. The main issues were to:

• Propose methods and processes for default correlations matrices on a low default portfolio with very limited information on debtors in general.
• Specify a Credit Value at Risk (VaR) model, that encompasses portfolios of different natures, and extend pillar one Capital formula by introducing multiple systemic factors.
• Design concentration risk measures easily convertible into a Pillar 2 Capital positive or negative add-on.
• Propose contribution measure and capital allocation per entity and business unit.

Approach and solution

To achieve client objectives, Avantage Reply designed a comprehensive model, from the structural specification to the process industrialisation. Main ingredients in the modelling strategy were:

• A segmentation and mapping of the portfolio following different factors of diversification: geographical area, economic sector, and industry.
• Analysis and test of different external and internal data providers were tested, and the choice was made according to data availability and comprehensiveness.
• The industrialisation of the model calculation, and the writing of the methodological and technical documentation.

Results and benefits

• The outcomes of the solution implemented by Avantage Reply is a comprehensive framework for improving risk measurement and capital management. It also provides a rich framework for risk-adjusted performance management and a capital efficient framework for strategic decisions.