Barclays 2004 Annual Report Download - page 49

47
Barclays PLC Annual Report 2004
Risk Appetite
In 2004, Barclays adopted an improved approach to the setting of
risk appetite across the Group, using a more formal, quantitative
methodology based on advanced risk analytics. Risk Appetite is the
Group’s chosen balance of return and risk employed as we implement
our business plans, recognising a range of possible outcomes. This
framework, approved by the Board Risk Committee, builds on the
analytical capability developed and used within Barclays since the
mid 1990s.
The objectives of the risk appetite framework are to:
•help protect the Group’s performance;
•enable unused risk capacity to be identified and thus profitable
opportunities to be highlighted;
•improve management confidence and debate regarding our risk
profile; and
•help executive management improve control and co-ordination
of risk-taking across businesses.
The Risk Appetite framework considers credit, market and operational
risk and is applied using two perspectives: ‘earnings volatility’ and
‘mandate and scale’.
Earnings volatility: This takes account of the potential volatility around
our forecast financial performance each year. The portfolio’s risk is
measured at four representative levels:
•expected performance (including the average credit losses based on
measurements over many years);
•a moderate stress level of loss that is likely to occur only
infrequently and is meant to correspond to a macroeconomic cycle;
•a severe stress which is much less likely but within a reasonable
possibility;
•an extreme but highly improbable level of stressed loss which is
used to determine the Group’s Economic Capital.
These ascending but increasingly less likely levels of loss are illustrated
in the following chart.
At 31st December 2004, the Group’s expected credit loss in one year
was £1,395m (see page 72). The Economic Capital (i.e. the loss in one
year under extreme stress) for all risk types was £12.6bn, estimated
with a probability of 1 in 5,000 years.
Probability of loss
Risk Appetite concepts (diagram not to scale)
Potential size of loss in one year
‘Expected’
(Mean)
Extreme Stress
(Economic capital)
Severe Stress
Moderate Stress
Mandate and Scale: This second perspective enables the setting of
limits to control against unacceptable levels of loss that may arise as
aresult of portfolio concentration. It is our objective that unexpected
losses remain within the scope of our communicated strategy and are
of a scale that is appropriate for our Group. This perspective uses
simple, descriptive measures and limits for relevant exposure types.
Overall, the Risk Appetite framework provides a basis for the allocation
of risk capacity to each business. Since the level of loss at each level
of probability is dependent on the portfolio of exposures in each
business, the statistical measurement for each key risk category gives
the Group clearer sight and better control of risk-taking throughout
the enterprise.
The Risk Appetite framework is designed to be:
•simple and practical to apply by measurement and monitoring
of exposures;
•geared to risk/return where capacity is directly related to
opportunity;
•based on a top-down capacity for earnings volatility;
•based on bottom-up identification of risk factors in each business;
•relevant, recognising the impact and likelihood of losses;
•aggregated across businesses where appropriate.
Stress Testing
The Risk Appetite numbers are validated by estimating our sensitivity
to macroeconomic events using stress testing and scenario analysis.
Changes in certain macroeconomic variables represent environmental
stresses which may reveal systemic credit and market risk sensitivities
in our retail and wholesale portfolios. The stresses considered include,
for example, the following sensitivities:
•Gross Domestic Product weaker;
•employment weaker;
•interest rates higher or lower;
•interest rate curve shifts;
•equity prices lower;
•property prices weaker;
•credit spreads wider;
•country exposure stressed;
•industry exposure stressed;
•sterling stronger.
More complex scenarios, such as recessions, can be represented by
combinations of variables. These scenarios allow senior management
to gain a better understanding of how the Group is likely to react to
changing economic and geo-political conditions. Insights gained are
fully integrated into the management process and the Risk Appetite
framework. These analyses and insights and the close involvement
of management also provide the basis for fulfilling the stress testing
requirements of the new Basel II Accord.