Barclays 2006 Annual Report Download - page 77

Barclays PLC
Annual Report 2006 73
Operating review
1
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 is the level of potential deviation from expected
financial performance that Barclays is prepared to sustain at relevant
points on the risk profile. It is established with reference to the strategic
objectives and to the business plans of the Group, including the
achievement of annual financial targets, payment of dividends, funding
of capital growth and maintenance of acceptable capital ratios. The
portfolio is analysed in this way 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;
•an extreme but highly improbable level of stressed loss which is used
to determine the Group’s economic capital.
These potentially larger but increasingly less likely levels of loss are
illustrated in the following chart.
Mandate and scale: This second perspective is a risk management
approach that seeks to formally review and control our business
activities to ensure that they are within our mandate (i.e. aligned to the
expectations of external stakeholders) and are of an appropriate scale
(relative to the risk and reward of the underlying activities). This is
achieved by using limits and triggers to avoid concentrations and
operational risks which could lead to unexpected losses of a scale that
would result in a disproportionate fall in Barclays market capitalisation.
Taken as a whole, the Risk Appetite framework provides a basis for the
allocation of risk capacity to each business. Since the level of loss at any
given 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.
Probability of loss
Economic capitalRisk
Tendency
Potential size of loss in one year
Risk Appetite concepts (diagram not to scale)
Extreme Stress
‘Expected’
(Mean)
Severe Stress
Moderate Stress
Stress testing
The Risk Appetite numbers are validated by estimating the Group
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;
• currency fluctuations.
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 portfolios are likely to react to
changing economic and geopolitical conditions and how the Group
can best react to them. The stress test simulates the balance sheet and
profit and loss effects of stresses across the Group, investigating the
impact on profits and the ability to maintain appropriate capital ratios.
Insights gained are fully integrated into the senior management process
and the Risk Appetite framework. This process of analysis and senior
management oversight also provides the basis for fulfilling the stress
testing requirements of Basel II advanced approach.
Barclays estimates the capital needed to survive an extreme but highly
improbable level of stressed loss. The calculation is based on the
historical volatility of losses. Capitalisation occurs to a level sufficient
to provide a high level of confidence in the Group, consistent with the
Group’s AA rating.
The Group macroeconomic stress test is only one of a number of stress
test analyses that are performed as part of the wider risk management
process. Specific stress test analysis is used across all risk types to gain a
better understanding of the risk profile and the potential effects of
changes in external factors. These stress tests are performed at a
number of different levels, from analysis covering specific stresses on
individual sub-portfolios (e.g. high value mortgages in the South East
of England), to portfolio level stresses (e.g. the overall commodities
portfolio) to Group-wide stresses for particular asset types (e.g.
wholesale credit risk stress tests).
Capital management
Barclays considers both regulatory (see page 89) and economic capital
(see page 74) as part of its capital management. In respect of economic
capital, Group Risk owns the methodology and policy whilst the
businesses are responsible for the calculation.