PPNR modeling – Dark art or Science

Everything in the nature becomes science when we understand underlying dynamics and methodology lest we think it is dark art. PPNR (pre-provision net revenue) modeling is not exception to this.

CCAR (comprehensive capital analysis and review) stress testing emerged as a regulatory requirement to be met by all BHC(bank holding company) and FBO (foreign banking organizations). As a part of this process banks need to project their losses and revenues over a nine quarter period under various stress scenarios provided by the Federal Reserve along with their own scenarios to see if bank has enough capital to meet the capital ratios. At this point, modeling revenues over 9 quarter period has emerged as hot potato and plenty of banks have received MRA/MRIA for not modeling and validating followed by review of audit in accordance to Federal Reserve standards. In this article I will provide an overview of PPNR modeling followed by some thoughts from Federal reserve guidance then describing some challenges during modeling process and how these challenges are overcome by management overlays. Finally ending with a note that PPNR modeling is not dark art but science.

Introduction PPNR:

Balance sheet of a bank provides snapshot of assets and liabilities held by the bank. On the other side, Income statement provides a measure of financial performance of a company over an accounting period. Typically a bank revenue and expense can be categorized into three areas

1) Net Interest income ( lending and borrowing activities)

2) Non –Interest income (Trading operations, brokerage activities, fund management activities)

3) Non-interest expense (Credit-Collection costs )

Under each area, there will be various individual line items for which BHC/FBO need to produce stressed loss projections.

For instance, banks need to project the growth of Consumer deposit balance in adverse and severely adverse economic scenarios. Banks need to develop quantitative models that can predict the dynamics of these consumer deposits.

Similarly banks need to project the revenues that might be made from running fixed income trading portfolio or credit trading portfolio. Below is the snapshot of industry trading revenues based of Oliver Wymann analysis across various trading segments since 1993. Banks need to project their revenues at this granularity and then aggregate to project the PPNR balances.

Banks in general build regression based models using some macro-economic variables or industry specific variables. In some cases, they use time series techniques (Auto regressive models) to predict the revenue balances. Within industry this kind of quantitative approach has become common place. Federal reserve has provided guidance around modeling practices in its August 2013 range of practices paper.


Federal Reserve Guidance on leading and lagging practice: Some important guidance provided by Federal Reserve is more of common sense rather than any special recipe.

1) Banks to have strong interaction among, central planning functions, business lines and treasury group

2) Banks have a robust challenge process

3) Banks to conduct full exploration of most relevant relationships between assumed scenario conditions and revenues and expenses.

4) Business lines expertise needs to be leveraged to build models

Overall I think modeling guide lines delineating the point that model development process does not take place in vaccum but needs lot of interaction with in the groups. For additional discussion refer to the Fed paper.

Issues in modelling : Most banks that have been conducting CCAR capital plan submissions have received MRA/NMRIA from the Federal Reserve to fix their modeling practices.

Major issues banks faced are around the limited data history and exploration of relationships between the variables and dynamics the revenue balances.

Limited data history: In general a good practice to build a model based of data that covers the economic cycle of expansion and recession. This will help in arriving in meaningful relationships instead of creating some spurious relationships or bias in the data. Because models trained using the limited data history is used in projecting 9 quarter forward looking estimates.

Selection of variables: Another important aspect of model building is selecting a set of variables that have meaningful relationship between the revenue balance and selected variables. In addition sometimes due to model developers need to perform certain statistical diagnostic tests (stationary) to check whether the selected variable is in fact suitable for modeling purposes.

Once model is developed after considering the some of these issues, model performance need to be analyzed. Due to the very nature of these models not being arbitrage free (Yield curve models) models used in pricing derivative instruments they need variety of adjustments to overall projections. These projections are in general made by business line heads.

Management overlays : In PPNR models this is very common issue that when model projections are not inline with the realized expectations then business line heads will revise these estimates. Now Federal reserve requires this kind of revision process to have clear quantitative basis and needs to be documented.

Conclusion:

So far we have understood the necessity of PPNR models. Furthermore we have also clarified the standard industry practice of using regression models and Time series techniques along with problems like data history and exploration of variable relationships. To mitigate some of the modeling issues management overlays have become common place.

To build an effective PPNR model, one needs to have good grasp of the business underlying the revenue balance.Additionally, one can use R-statistical programming package or Python programming tool to build a model. Thereofore, I think building PPNR models is more of science and less of dark art.

CCAR stress testing – US banks have passed the muster-FBO’s will join the flock

CCAR (Comprehensive capital adequacy and review) has become annual ritual among large bank holding companies in US since 2011. Every year banks submit their capital plans to regulator (Federal Reserve). Afterwards Banks wait anxiously till March when fed announces whose capital plan got approved or rejected. Due to its implications for capital distribution including dividends has gotten stock markets interested in this comprehensive exercise to add some excitement. In 2015, we have seen 28 of 31 banks have gotten it correct and happily distributed dividends. Two banks (Deutche bank and Santander) failed for qualitative reasons. Now from January 2017 onwards we will see more banks will take part in this annual gala festival of stress testing. This increase will come mainly from foreign banking organizations. So can they learn something from experience of large bank holding companies to get them pass the stress testing. So what is it? Where do they focus? CCAR stress testing – US banks have passed the muster-FBO’s will join the flock
Banks (Foreign Bank organizations (FBO)) need to assess their US (United States) assets and Global assets to determine the stringency of US prudential standards. Davis Polk & Wardwell LLP has provided a good visual for this.

FBO’s must implement Intermediate holding company (IHC) by aggregating assets of all its US subsidiaries. IHCs must submit their capital plan to Federal Reserve on January 2017 as a part of compliance. Compliance to Federal Reserve is not as easy as it is said. Fed will evaluate capital plans for both quantitative (capital ratios) and qualitative (Governance, Internal controls, Aggregation, Model risk management and others) aspects.

Quantitative factors

Among banks that have passed the Fed stress last few years most of them. The Federal Reserve did not object to any plans based on quantitative grounds.

• “U.S. firms have substantially increased their capital since the first round of stress tests led by the Federal Reserve in 2009. The common equity capital ratio--which compares high-quality capital to risk-weighted assets--of the 31 bank holding companies in the 2015 CCAR has more than doubled from 5.5 percent in the first quarter of 2009 to 12.5 percent in the fourth quarter of 2014, reflecting an increase in common equity capital of more than $641 billion to $1.1 trillion during the same period”
• In the CCAR quantitative assessment, the Federal Reserve evaluated each BHC's ability to take the capital actions described in the BHC baseline scenario of its capital plan and maintain post-stress capital ratios that are above a 5 percent tier 1 common capital ratio and above the applicable minimum regulatory capital ratios in effect during each quarter of the planning horizon”
This means FBOs as long as they meet the minimum criteria for the capital ratios they will be fine.

Qualitative factors

In general fed rejected capital plans citing qualitative factors for various banks. This year they have rejected Deutche bank capital plan citing flaws in regulatory aggregation and reporting process. In earlier years they have rejected capital plans citing lack of proper internal controls or weak modeling practices etc. In some other cases FED issues MRA (matter requiring attention) or MRIA (Matter requiring immediate attention) where they find problems. Furthermore, Fed has issued in August 2013, a range practice paper discussing observed practices (Leading/lagging) and best practices. Banks that are thinking of complying with Feds requirement should pay heed to this publication. They can also deploy experts who understand these practices to get an understanding. FBO’s in general face significant challenges in the area of modeling revenues, projecting stress losses, aggregation of loss and revenue estimates, Model risk management and internal controls. This is because, for the subsidiaries within FBO;s in general not having uniform industry leading practices is not uncommon. This happens for variety of reasons.
Therefore FBO;s need to standardize the process across various entities and then aggregate the final outputs at IHC level. FBO;s first need to assess its current practices across various dimensions. For instance in the area of model risk management, Fed requires them to have a model risk management policy in place to govern the model development associated validation and finally a rigorous review by internal audit. FBO should have governance structures at IHC level to coordinate these activities among the subsidiaries. When it comes to data governance and aggregation at IHC level FBO’s should leverage BCBS 239 regulatory initiatives for leading practices.

Basel Risk Data aggregation and Reporting - A Big Data solution - Thoughts from Gatick Global

BCBS-239 initiative –Challenges and Opportunity for Risk and IT transformation

During the financial crisis of 2008 banks and their regulators have faced challenges to measure financial risks. Many banks lacked the ability to measure aggregate risk exposures and identify concentrations quickly and accurately at the bank group level, across business lines and between legal entities. Some banks were unable to manage their risks properly due to weak risk data aggregation capabilities and risk reporting practice. This has resulted in consequences for both banks and the whole financial system.

Basel committee has provided guidance (BCBS 239) in 2013 to enhance the bank risk data aggregation and reporting process so that banks can identify and manage bank wide risks effectively. This initiative has its impact across all of the groups and functions in the bank. Some of these include Risk, finance, Treasury, Technology, operations and Business functions involving sizeable investments.

BCBS 239 guidance includes a set of principles covering areas of Governance & Infrastructure, Risk data aggregation capabilities and Risk reporting practices with in a bank. Some banks have already started and some are in the process of making investments to implement these guidelines. Recent survey by Basel has found many banks will be fully compliant by January 2016.

Financial institutions affected by BCBS 239

There are three groups of banks that are being affected. 30 G-SIB – Global systemically important banks, 20 D-SIB- domestic systematically important banks and few SII- systemically important insurers are impacted by the BCBS 239 initiative. All these institutions need to work towards complying with the regulation as per the regulatory compliance dates.

Cost of compliance to BCBS 239 ( $$$$$$$ - Expensive initiative)

Senior management at most banks has already understood the need and urgency to invest in the risk data aggregation and reporting infrastructure. At the same time they are facing the headwinds of diminishing revenues. This situation is putting them in bind. Sungard research has estimated a price of $ 8 Bn as implementation costs for institutions globally. I have no basis to refute or accept these numbers. But one thing is for sure, implementation costs will be high as this involves large scale IT and data architecture transformation. Typically projects at this scale run into multimillion dollar budgets.

Industry Current state:

Ok, so far so good, regulatory guidance is available and financial institutions have understood the gravity of the situation and corresponding budgets to be managed. Now let us focus where we are today since the guidance has been issued in 2013.

In response to Basel guidance G-SIB banks have invested and started working towards implementing various principles. Below is the snapshot of banks expected date of compliance from Basel progress report.

Above graph clearly highlights about 10 banks will not be compliant with principle (2, 3, 4, 5 and 6) before the deadline.

Principle 2 requires banks to have Data architecture and IT infrastructure to support data flow across the systems. Obviously this is the most challenging principle that banks are dealing with. Banks with existing IT infrastructure that includes disparate systems, databases, spreadsheets and manual overrides etc need to create a seamless infrastructure. Some banks have also highlighted with respect to Data architecture and IT infrastructure that

• Improving IT infrastructure – increase automation around aggregation and reporting
• Streamline data flows across departments, legal entities
• Ensure consistent data taxonomies

Principle 3-6 requires bank to have proper data aggregation process. Furthermore, data should be complete and accurate. Banks are facing five key challenges in the data aggregations.

1. Heavy reliance on manual adjustments and processes during the creation of risk reports. This creates problems in the ability of the banks to produce reports timely during the time of crisis.

2. Documentation problems for the aggregation of the data processes at group level. There is a need for developing data dictionaries.

3. Lack of harmonization across jurisdictions is creating difficulties in aggregation of collateral-related data for derivative transactions.

4. Accounting, Risk and regulatory reporting data resides in disparate systems. This creates challenges around automatic reconciliations.

5. Finally, legal restrictions in some regions and countries hinder producing granular level risk data

How to Respond

BCBS-239 initiative with its attributes of Data governance, aggregation and reporting shares similar challenges faced with in industry by many firms. Here we can draw upon lessons learned from those experiences. For instance, Banks are dealing with large amounts of data, both structured (Trading, market variables) and unstructured (confirmations, counterparty signatures). Aggregating this kind of disparate data sets create potential problems.

Already some experts have started arguing that banks should focus on aggregating Risk and (Finance) accounting data with a accounting approach. Some others are ready to sell their expensive systems.

Banks should think twice before they decide on an approach. They have to first take look at how this problem has been solved elsewhere. Fortunately, plenty of technology firms Amazon, google, Twitter, Facebook have solved the problem of handling different types of data sets both in scale and size using big data techniques and cloud infrastructure. Banks can now leverage these techniques and work towards compliance of BCBS - 239.

Banks can create a centralized Data platform with appropriate data governance. All Business applications and systems can utilize from this unified source. This centralization will remove silos and barriers that existed across the lines of the business. Consequently data transparency will help indirectly help to create a better risk culture.

Banks need to create a Data PMO (project management office), develop a data strategy and craft a plan for data management, data governance and data life cycle processes. Additionally Technology strategy for designing the Risk infrastructure to implement the data strategy is required.

Advantages of Big data and Cloud based solutions

1) Banks will see their operation efficiency improvements significantly

2) Banks will need fewer personnel in Finance\Controls groups spending time on analyzing the data instead of reconciling the data globally.

3) Banks IT budgets will taper down over 3-5 year periods as there will be lesser need of manual processes and spreadsheet applications

4) Banks will need to keep lesser capital aside as they can identify, measure and aggregate risks accurately hence estimating the exposures and Risk weighted assets

5) Risk and finance groups will mutate into a hybrid group

6) Regulatory reporting for CCAR and DFAST stress testing, Volcker metrics, Trade repository reporting will become less error prone and save banks from making costly mistakes and getting slapped by regulators.

7) Banks will become information companies that can react to market situations more nimbly.

8) Board and senior management can obtain real time reports on the health of the bank.

 Conclusion:

Face of the financial institutions has been changed in the wake of financial crisis. Leadership with in these organizations should understand this and seize the opportunity and transform their firms into vanguards of  Technology transformation and grow profitability.

CCAR stress testing –Thoughts from Gatick

Wall street journal has quoted “European banks set to fail Fed’s Test” stating regulators have found potential problems at Deutche Bank AG and Banco Santander SA and are expected to fail the Federal Reserve’s stress testing.

CCAR stress testing process is performed annually by various banks supervised by Federal Reserve to ensure banks are sufficiently capitalized. In this process banks not only need to ensure they have enough capital to absorb losses in normal times but also during stressed scenarios that include deep recession. Additionally Fed has mandated banks to provide evidence for strong compliance in the area of internal controls around risk identification, measurement and reporting, Model risk management and governance.

WSJ quotes,

“While Deutsche Bank Trust Corp. is expected to be found adequately capitalized by the Fed but will likely receive a warning on qualitative shortcomings, according to people familiar with the matter.

“Deutsche Bank Trust Corporation, which represents less than 5% of Deutsche Bank AG’s total assets, was pleased to participate” in the stress tests this year, a spokeswoman said, adding the bank “will know our results after the Federal Reserve’s announcements.”

Deutsche Bank is currently in a remediation process with the Fed over flaws in areas ranging from its regulatory reporting, risk control, monitoring and compliance systems, these people added. The bank has also been reprimanded by the Fed for flaws in its regulatory reporting, The Wall Street Journal reported last year. In a letter to Deutsche Bank executives in December, a senior official with the Federal Reserve Bank of New York said reports produced by some of the bank’s U.S. arms “are of low quality, inaccurate and unreliable. The size and breadth of errors strongly suggest that the firm’s entire U.S. regulatory reporting structure requires wide-ranging remedial action.”

At the time of the report, a Deutsche Bank spokesman said the German bank has “been working diligently to further strengthen our systems and controls and are committed to being best in class” and said the bank is spending €1 billion ($1.35 billion) globally and appointing about 500 compliance, risk and technology employees in the U.S.

A person familiar with the matter said Santander is also likely to fail for qualitative reasons, rather than because the stress test depleted its capital below regulatory minimums”

To help banks understand Supervisory expectations Federal Reserve has published best practices guide around stress testing process including internal control along with its expectations in August 2013. Additionally, In the CCAR 2015 Instructions include an appendix that summarizes common themes identified by supervisors during the 2014 CCAR cycle with respect to the qualitative element of the capital plan review.

What we are witnessing now is above mentioned two banks have significantly invested resources towards the compliance of CCAR stress testing and found to be capitalized from a quantitative perspective. Fed is coming back after its rigorous examination that the quality of internal controls and some risk measurement aspect of credit portfolios put in place for the stress testing process are not sufficient. Additionally, Federal reserve has been providing their assessment for bank stress testing plan, process and internal controls and issuing MRA (Matter Require Attention) and MRIA ( Matter Immediately require attention) to various banks to fix the problems. In response banks have been rectifying and fixing these problems.

The following eight themes came out of the CCAR 2014 program and are described further below:

(1) sensitivity analysis, (2) assumptions management, (3) model overlays, (4) model risk management,(5) capital policy, (6) presentation of consolidated pro forma financial results, (7) RWA projection methodologies, (8)  AFS Fair Value OCI.

These common themes provide additional insight to the specific observations and trends, both positive and negative, which the Federal Reserve noted from its CCAR 2014 review.

Sensitivity Analysis: During CCAR stress testing process, variety of quantitative models are utilized to generate loss estimates for Trading book (Cash and derivative products), Banking book ( Credit portfolio) and other positions on the balance sheet along with Revenue model projections in various scenarios. Each of these models are developed with various assumptions and take variety of inputs ( SPX volatility, Inflation rate etc) to produce proforma estimates. Therefore it is imperative to have understanding of sensitivity of the projections to input variables and various assumptions that form the basis of the forecasting process.

Federal Reserve has noted at most banks sensitivity analysis is not conducted during the model development. Model validation function is stepping in to conduct sensitivity analysis. They are expecting banks to include in sensitivity analysis at minimum projected market share, size of the mortgage market, cost and flow of deposits, utilization rate of credit lines, discount rates, or level and composition of trading assets. However, this list is not exhaustive and conducting sensitivity testing only on these assumptions will not be sufficient to meet supervisors’ expectations in this area. If vendor models are included then sensitivity analysis becomes most important as in most cases the software code is not included.

Banks can clearly meet this requirement by including Sensitivity analysis with in their model risk management policy and make model developers to comply accordingly. Internal Audit (Model reviewers) and Model validation teams should work towards enforcing this as part of broader model risk management requirement.

Assumptions Management: Federal Reserve noted BHCs are expected to clearly document key assumptions used to estimate losses, revenues, expenses, asset and liability balances, and RWA. Documentation should provide the rationale and any empirical support for assumptions and specifically address how they are consistent with scenario conditions. Assumptions should generally be conservative, particularly in areas of high uncertainty, and should be well supported and subject to close oversight and scrutiny.

At most banks we see very clearly loss estimation methodologies and techniques are reasonably in good shape. Federal Reserve is looking for improvising the modelling approaches of the Pre Provision Net Revenues (PPNR) as they are required in the projection of capital. PPNR models utilize an array of modelling techniques including linear regression approach with assumptions around the growth of balances, deposit pricing and spreads for various products.

Banks need to establish a strong engagement of the Business and model developers to understand the dynamics the portfolio balances under various scenario conditions and Assumptions.

Model Overlays: As noted, most BHCs use some form of expert judgment— often as a management adjustment overlay to modeled outputs. In developing management overlays, BHCs should ensure that they have a transparent and repeatable process; that assumptions are clearly outlined and consistent with assumed scenario conditions; and that results are provided with and without adjustments.

Some of the banks are incorporating overlays when the quantitative models are not capturing the underlying dynamics. Often these overlays are not tied to any particular model weakness but used a general “catch-all” adjustment to influence aggregate modeled losses in the interest of conservatism.

Fed wants Banks to incorporate the impact of all risk exposures into their projections of net income over the nine-quarter planning horizon rather than trying to address certain risks and model limitations by adding buffers on top of internally defined capital goals and targets.

Most important if banks are going to have management overlays then they should have an independently Validation process to validate them. This is a must and can’t avoid this lest you will get slapped by the FED with an MRA or MRIA.

Banks can establish clear communication channels with Finance, Business and Risk and conduct the model overlay process in a transparent fashion.

Model Risk Management: Bank’s should ensure that they have sound model risk management, including independent review and validation of all models used in internal capital planning, consistent with existing supervisory guidance on model risk management (SR letter 11-7).

Fed has noted Banks have made significant progress with respect to model risk management. Most of the banks have created model risk management policy and framework to govern the development of the models and their independent validation and review. Despite having this framework and guidance modelling practices at some of the banks is not to supervisory expectations. Federal Reserve has highlighted that Banks need to improvise their practices with in the areas of Conceptual soundness and Model performance testing.

Banks have to not just create model risk management framework but also should enforce it. This will result in a strategic business if implemented correctly. Stress testing exercise is a deep dive into portfolio performance under variety of scenarios using the underlying models. Hence stress test will become litmus test for the conceptual soundness of the model along with associated outcome analysis.

Banks should consider investing in highly skilled (PhD’s) and subject matter experts to perform independent validations. Additionally, Federal Reserve is looking at Internal Audit function of the bank to conduct independent review of the model development and validation process. This makes Audit exercise more than reconciling balances. They have to analyze and understand whether the models (Retail, PPNR, Market risk, Credit Risk etc) are appropriately developed and conceptually sound and have and both validators and developers have included in their documentation 9 quarter out of sample model performance. Finally audit has to provide its assessment on these items for Fed’s examination.

Supervisors are going to rely on the Audit assessment of the model risk management process hence banks should invest sufficient resources and work towards meeting the regulatory requirements of SR 11 -7 that are applicable to model risk management.

Capital Policy: A BHC’s capital policy should be a distinct, comprehensive written document that addresses the major components of the BHC’s capital planning processes and links to and is supported by other policies. The policy should provide details on how the board and senior management manage, monitor, and make decisions regarding all aspects of capital planning and lay out expectations for the information included in the BHC’s capital plan.

Some banks capital policies provided insufficient detail particularly as it pertained to the decision making process around the level and composition of capital distributions.

Many BHCs’ capital policies lacked a comprehensive suite of payout ratio targets or limits; an explanation for how the BHC arrived at those targets or limits; and, where they did exist, lacked defined response actions to be taken in case of breaches of dividend and/or repurchase payout targets or limits. Capital policies should also include limits on capital distributions and guidelines regarding the analysis Covered BHCs must complete to support their capital actions.

Banks should detail how the management and board manages, monitors and makes decisions regarding capital planning.

Overall Banks should consider bringing together both qualitative and quantitative aspects of the capital policy and present it in its report to the supervisor.

Presentation of Consolidated Pro Forma Results: BHCs should ensure that they have sound processes for review, challenge, and aggregation of estimates used in their capital planning processes. This includes the following


1) An effective internal review of processes used at both the line of business/sub-aggregated and enterprise level, with final review and sign off completed by an informed party not directly involved in those processes.

2) Policies and procedures documenting the process from end to end including the challenge, review process at each stage of the process

3) Set processes for aggregating and finalizing results, including appropriate review and oversight of aggregate results to ensure coherence and consistency of projected outcomes sourced from various forecast providers

4) Most importantly clear documentation of all model overlays, assumptions, limitations and corresponding signoffs by the stakeholders

5) Evidence of oversight and challenge to both processes and outcomes at the appropriate level of management, including documentation of actions taken as a result of questions, issues, or requests that came up during such review and discussions.

Supervisors are very clear in their expectations and Banks should strive to meet these regulatory requirements.

RWA Methodologies: Many BHCs faced challenges with their methodologies for projecting RWAs. Given that the as-of-date RWA calculated for regulatory reporting serves as the foundation for RWA projections in scenario analysis, BHC management should ensure, and provide evidence of, an independent review of RWA regulatory reporting by either internal audit or another control function

Supervisors are looking for independent review of the RWA processes and require associated audits to be up to date.

Banks should provide overall support and documentation for RWA methodologies with respect to underlying assumptions.

AFS fair Value OCI

Under U.S. Generally Accepted Accounting Principles (GAAP), changes in the fair value of AFS securities are reflected in changes in accumulated other comprehensive income (AOCI);

In accordance with the revised capital framework, BHCs with total consolidated assets of $250 billion or more or on balance sheet foreign exposures of $10 billion or more (advanced approaches BHCs) must reflect AOCI items in their regulatory capital beginning in the second quarter of the planning horizon (the first quarter of 2014). Under the transition provisions of the revised capital framework, regulatory capital for advanced approaches BHCs must include 20 percent of eligible AOCI in 2014, 40 percent in 2015, and 60 percent in 2016.

This guidance applies only to advanced approaches BHCs; it does not apply to BHCs with total consolidated assets of $50 billion or more that are not advanced approaches BHCs

Advanced approaches BHCs are expected to evaluate all AFS (and impaired HTM) securities for changes in unrealized gains and losses that flow through OCI under stress scenarios. Stressing fair value is expected to reflect movements in projected spreads, interest rates, foreign exchange rates, and any other relevant factors specific to each asset class. Historical spread and price data may be sourced externally or internally; however, information utilized should be representative of the BHC’s portfolio at a sufficiently granular level to capture the inherent risks of the assets. Additionally, the data utilized for projection is expected to span a sufficient period of time that includes a period of vulnerability for that asset class.

In general structured products include ABS (asset Backed securities) MBS (mortgage backed securities) and other products. Banks have been applying credit spreads to sensitivity of the product and estimating the OCI (other comprehensive income). Supervisors require banks to consider using cash flow based models in lieu of sensitivity based forecasting for structured products.


Final Thought

Banks need to look at their current practices in the lens of above themes and expectations from the supervisor to be able to succeed in their annual stress testing exercise.

At minimum banks need to consider these themes and reflect on their CCAR programs by increasing the business engagement, meeting the guideline laid out for model risk management and finally by leveraging on seamless technology, data and Risk infrastructure.

 

Structured Notes Investing – Checklist

Introduction

Structured notes are increasingly becoming choice of alternative investment strategies for investors who are not able to generate required yield from traditional investments that include stock, bonds and mutual funds. These notes synonymous to their name provide customized (“Tailored”) returns on the investment with accompanied risk. This kind of customization results sometimes increased complexity and becomes difficult to comprehend for a naïve investor. To alert investors of potential risks and features of the structured notes, The SEC’s (Securities and Exchange Commission) office of Investor Education and Advocacy has issued an investor bulletin investor bulletin.

In this note, Investor will be introduced to the details of the investor bulletin that includes,

·         Risks and features of the structured notes

·         Key Questions to be asked

·         Examples

Risks and Features:

“Structured notes are securities issued by financial institutions whose returns are based on, among other things, equity indexes, a single equity security, a basket of equity securities, interest rates, commodities, and/or foreign currencies.  Thus, your return is “linked” to the performance of a reference asset or index.  Structured notes have a fixed maturity and include two components – a bond component and an embedded derivative.  Financial institutions typically design and issue structured notes, and broker-dealers sell them to individual investors.  Some common types of structured notes sold to individual investors include: principal protected notes, reverse convertible notes, enhanced participation or leveraged notes, and hybrid notes that combine multiple characteristics.”

SEC provides guidance with respect to some research that an investor should consider doing before investing in the structured notes to clearly understand the risk return profile of the investment. Investor should consider the questions to understand the dynamics of the note.  In some cases they are better off taking help of an investment professional.

How to locate the information to understand the dynamics of the note before investing:

Structured note issuers provide information pertaining to the terms of the investment, risks associated, payoff performance and initial estimate of the price in their prospectus. Investors should either peruse the prospectus or seek advice of an investment professional to get clear understanding on the note. Table below describes a check list of the information per SEC and where to locate corresponding information on the prospectus.

Regarding the SEC Structure Note checklist, the following will describe where the information can be found in the two example notes.

Examples and Description

The preface to the location of information in the note should be that there is no strict standard format for the layout of a Structure Note. In the case of our two examples, MS and UBS, the layout of information is mostly similar in the first two pages.

Check List	What is inside the note?	Location in the two example notes?
What are the fees and other costs associated with the investment?	Fees and commissions are costs of manufacturing structured notes and will increase the cost of the note to the investor. Investor should look into the terms sheet for this information	Usually in the bottom of the first page clearly labeled as Agent’s Commissions or Underwriter Discount in the case of our two examples. But for other issuers this information is right next to Issue Price to Public or Price to Public. This is all dependent on the issuer jargon.
How much above an issuer’s estimated value of a structured note will I be paying for the structured note?  Do I know the issuer’s estimated value and its relevance to my investment decision?	Structured notes will carry issuer’s estimated value. This value includes cost of manufacturing the note. For example, notes that have longer maturity will be valued at discount due to the time value of the principal of the note. Understanding this aspect of difference between the initial value of the note and investment will help the investor to understand true cost of the investment.	As mentioned above this is found on the bottom of the first page, in our examples as, Issue Price to Public and Price to Public.
How do I know whether this product is appropriate for me given my overall investment objectives?  Structured notes may not be a suitable investment for you.  You should review your investment objectives and tolerance for risk with your broker or financial adviser before you consider investing in a structured note.  They can help you determine whether the risks associated with a particular structured note are within your tolerance for risk, or whether your investment needs are better served by investing in another product.  Your broker must only recommend securities transactions and investment strategies for your brokerage account that are suitable based on your investment profile.	Investment policy statement based on the risk appetite and tolerance of an investor will guide the investment decisions. Investor should clearly understand how to clearly customize risk reward profile to increase return and reduce the risk based portfolio optimization approach. Portfolio optimization provides guide posts for an investor who wants to increase his investment spectrum in the mean variance space. Structured notes with their tailor made risk and return profiles can be structured according to specific set of risk preferences. Investor should speak to their broker or an investment professional to understand the risks in the investment.	This is a little tricky since the suitability is determined by investor’s risk appetite. But in the two examples there is a section called risk factor. This section is used by issuer to point out and explain what types of risk this note accompanies.
What other investment choices are available to me?  Are other products available that provide investment exposure to similar assets, indices or strategies?  If so, how do the costs of these other products compare to those associated with the structured note? Carefully consider what might be a suitable investment for you, and whether there are better alternatives to the structured note you are considering.  For example, can I purchase some or all of the components of the structured note separately for a better price?	Structured notes are very specific and customized investments. An investment professional or professional investor can deconstruct and replicate the payoff structure for many of these notes using other traded instruments. In some cases it is not possible. Investor should understand the price of the note separately in terms of its components and compare it with note price. Investor should consider taking help from the investment professional.
How long will my money be tied up? Many structured notes are meant to be held to maturity. If you need your money back prior to maturity, you could lose a significant portion of your investment.	Traditional investments (stocks/Bonds/ETFs) can be bought and sold on any day and time on the market. They don’t come with any kind of preset maturity. On the other hand structured notes will have maturity term and investment will be locked till that point in time unless the issuer calls the note or the investor puts back the note. This feature will potentially lock up the money for a period of time. Investor should understand their needs and discuss with their broker or an investment professional.	This information is available in the Final Terms( or sometimes called Key Terms) on the first page. In our UBS case, it is labeled as Maturity Date, Jan 24, 2017. For Morgan Stanley, it is labeled as Maturity Date, Jan 20, 2017.
Can I sell or otherwise liquidate my investment before the maturity date? A liquid market for structured notes does not exist. If you want to sell your structured note before it matures, you might have to do so at a price less than the amount you paid for it, or you may not be able to sell it at all.	As mentioned above traditional investments are liquid investments. You can transact in them easily on the market. Conversely Structured notes are thinly traded. Selling them before maturity will often carry penalty (by the issuer) and due to illiquidity it will become difficulty to sell.	This information was not available in the two example notes but might be available in other notes. There might also be information on this in the product supplement.
Is there a call feature? If so, be sure you understand what can trigger the call and the earliest date that the structured note may be called. You will also want to ask your investment professional about a strategy in the event your structured note is called.	Call feature is a novel aspect of the structured note that enables an investor to exit the investment under certain favorable or unfavorable investments. Usually call feature will increase the yield of an investment. Notes like Auto callables will mature automatically when the note underlying reaches certain preset level before maturity. Investor should speak to an investment professional about the embedded call feature.	The Note features are indicated in the subtitle of the note. The Morgan Stanley example indicates the features of the note being a Contingent Income Auto-Callable. The UBS examples shows it is a Trigger Autocallable Optimization. Further explanation of the note features are provided by Morgan Stanley in the Investment Summary section in page three. In comparison to the UBS example, which indicates a trigger price in the Final Terms.
Are potential returns limited? Some structured notes have caps on the returns you can earn based on the performance of the reference asset or index	Investors should understand if the note provide limited or unlimited returns. This will help in evaluating the investment compared to other investment alternatives.	This information is usually given under the section called Hypothetical Examples.
What are the tax implications? You might wish to consult with a tax advisor to understand the consequences of any particular structured note, including imputed interest and any foreign tax consequences.	Every investment has tax implications and structured notes are no different. Infact on the term sheets issuers provides guidance to what is taxable and what is not cursorily. Again investors should speak to an investment professional on this aspect.	The tax implication generally nested deep in the note. In the Morgan Stanley example it starts on page 18 and continues to page 22. However the UBS explains that the tax information can be found in the “What are the Tax Consequences of the Securities” and “Supplemental U.S. Tax Consideration” in the UBS Trigger Phoenix Autocallable Optimization Securities Product Supplement (TPAOS).
How does the payoff structure work? Is it possible to lose money, or not have any gain at all, even if the reference asset or index goes up? Purchasing a structured note does not guarantee positive returns. For example, the reference asset or index might not increase in value—or even if it does, there may be conditions that limit your returns.	Structured notes are created with a variety of payoff structures.  Some have principal at risk that is you might lose a portion or all of the initial investment. Therefore investor should understand how the payoff structure works. Investor should seek help of an investment professional in this regard.	This information is usually given under the section called Hypothetical Examples.
What is the credit risk of the issuer of the structured note?  Remember that any payoff on a structured note is subject to the creditworthiness of the issuer.  Be sure to understand the financial condition of the issuer and read its disclosures as carefully as you would for any other investment.	Structured note issuer guarantees the payment of the principal and coupons as per the terms of the investment. Sometime due to deterioration of the financial condition of the issuer will lead to default on the note by the issuer. Therefore investor should understand the creditworthiness of the investor.	This information is found in the Risk Factor section and used to explain how the issuer is at risk to the Structure Note.
Do I understand the investment?  Many structured notes are complex.  If you do not understand how the structured note works, ask your investment professional for help.  If you still do not understand the structured note, you should think twice about investing in it.	Structured notes are in general have payoff structures that are complex and needs an investment professional to analyze them. For instance digital payoffs and basket payoff involve binary events or correlations between the underlying entities. So investor should seek help of an investment professional	As the SEC recommends it is best to ask your investment professional for help. But if you want further information, the notes include a hyperlink for a Product Supplement as well as a Prospectus. Both of our example notes show it in the Additional Information section.  For the Morgan Stanley note this section is all the way in the bottom of the note. But in the case of the UBS note, this is right under the Final Terms.

Stress Testing - Challenges and opportunities - Gatick Global View

Stress testing – Challenges and opportunities – View point

Regulation has become key word in the financial markets in the wake of the great financial crisis of 2008 driven by collapse of housing markets in United States of the America and Europe.  Stress testing (CCAR- Comprehensive capital analysis and review) has been prescribed by Federal Reserve to maintain certain minimum capital standards under adverse and severely adverse economic conditions. This regulation has triggered cascade of changes to processes, systems and also in some cases have led to creation of new infrastructure at Banks. All of this leading more expenditure for Banks that are battered by falling ROE (return on Equity) and higher and cumbersome capital ratios that need to be maintained. Despite investing efforts to comply with the regulation some banks have failed to satisfy regulators and have to resubmit their capital plans.

Challenges

More and more banks are realizing this regulation calls for an unprecedented effort with respect to volume of data to be collected followed with performing analytical calculations and finally capturing the evidence through documentation in compliance with federal regulators. This act has to be performed with coordination between, Risk, Finance, Business, Internal Audit, Treasury groups. These efforts are creating huge challenges to senior management in the Bank.

How Banks should respond? At the very outset banks should acknowledge failing to meet regulation requirements have wider ramifications on capital actions. These include failure to distribute dividends and buybacks, capital and liquidity surcharges, potential show stopper for planned mergers and acquisitions. Given these consequences, banks have to think stress testing is not an ad hoc regulatory exercise but instead an input to bank wide strategy areas, risk management, capital allocation and planning, risk appetite and business unit planning.

Opportunities

Banks should take steps to streamline regulatory implementation process and capture potential opportunities that will boost its ROE. This will require banks to focus its efforts around 3 key areas.

Firstly, Data infrastructure is most critical to a successful stress testing venture. Most of the banks need to gather information for Market data, Transaction level information, and Customer information along with Macro Economic data for generating scenarios to be fed into their loss, revenue and Trading risk models. This is a gigantic task where coordination between, Data, Technology, Finance and Risk groups is need. Some banks have systems and processes in place to perform these tasks and others are still struggling to emerge out of cumbersome EXCEL worksheet applications. To gain strategic insights, Banks need to invest into building into a combination of centralization and decentralization devolving to unit level from current heterogeneous systems.

Secondly, Analytical Processing Infrastructure is important element in stress testing. This is most complicated and important area. This element is further classified into Quantitative methodologies that are needed to process data and transactions on trading and Banking books with Technology infrastructure.

Thirdly, Business intelligence and Reporting Infrastructure is another dimension in stress testing. This area will transform the data and estimates generated in two areas discussed above into actionable intelligence and reportable data to regulators. Senior management has to deploy right tools and technologies to leverage the information generated in the process.

Therefore Banks need to have expertise in each of these areas to execute the stress testing to attain insights that will be helpful to execute business strategy and capital planning.