ING Direct 2008 Annual Report Download - page 224

2.1 Consolidated annual accounts
The Economic Capital formula for credit and transfer risks relies on seven different risk drivers. In addition to the PD, EAD, and LGD
models mentioned above, the formula also considers the industry and the country of the debtor as well as the remaining term of the
respective underlying transactions. Lastly, the formula considers the correlation of the individual transactions to the portfolio as a whole.
ING uses Monte Carlo simulation tools to determine certain parameters which are then applied to individual transactions in determining
the level of Economic Capital related to credit and transfer risk in a bottom up approach. The correlations, which are updated quarterly,
are determined at a business line level, and diversification effects are applied at the transactional level.
The underlying formulas and models that are used for determining Economic Capital for credit and transfer risk are the same as those
used for determining the level of regulatory capital that is required under Basel II (Pillar 1). Despite the fact that the same underlying
formulas are used, (internal) Economic Capital and regulatory capital are not the same, due to various specific rules imposed by Basel II,
such as regulatory caps and floors, and the use of the standardised approach for certain portions of ING’s portfolio. These differences
are permitted under the Basel II guidelines.
The table below summarises different capital measures used for different purposes and shows the difference in key elements and purposes.
Credit Risk Capital
Measurements Methodology Location Confidence level Inputs Purpose
Regulatory Capital Basel II Formula Vortex Basel Engine
(‘VBE’) in the Central
Risk Database
99.90% Basel II model outputs RWA
Economic Capital Risk Adjusted Capital
(RAC) Closed Algebraic
Formula
Vortex Risk Engine
(‘VRE’) in the Central
Risk Database
99.95% Basel II model outputs
excluding Basel II caps and
floors, maturity, repayment
schedules, correlation
factors, migration matrix.
Some inputs come from
EC-MC portfolio calculator
but with 99.95%
confidence level country
and industry.
Pricing, Economic Capital
for credit at transactional
level and above
Capital and
earnings at risk
Monte Carlo simulation
based on aggregate
portfolio (‘EC-MC
portfolio calculator’)
Stand alone tool using
same data from Central
Datawarehouse as VRE
90.00% Basel II model outputs
excluding Basel II caps
and correlation factors,
migration matrix country
and industry.
Risk Dashboard at Line of
Business Level and above
With regard to methodology, the EC-MC Portfolio calculator provides a sophisticated and consistent framework to measure capital
numbers for credit risk. Because of its complexity and required calculation time the EC-MC Portfolio calculator is more suited for portfolio
calculation, rather than to be implemented in an environment requiring real time reporting at a transactional level for day-to-day
management, pricing of new transactions and limit setting. As a result, Economic Capital figures are based on RAC figures that are
derived from the EC-MC Portfolio calculator but are not fully equivalent. The main characteristics are:
RAC• is calculated at facility level with closed algebraic formulas rather than from a Monte Carlo Simulation. The RAC algebraic formula
includes parameters which incorporate the impact of portfolio dynamics, such as correlations and diversification effects. These
parameters are derived through a regression of the outputs of the EC-MC portfolio calculator;
Due to its proprietary nature the inputs in the • EC-MC Portfolio calculator are subject to certain technical caps and floors (LGD/EAD is
constant and PD migration matrix is capped) which are not applicable in RAC. Also, due to the implemented mathematical routines the
EC-MC portfolio calculator is subject to a minimum Probability of default (PD) and maximum tenor, which are not applicable in RAC.
Additionally the banking operations use the RAC model for determining the optimal pricing on (new) lending transactions in order
to ensure that ING meets its desired RAROC returns.
During 2008, the Economic Capital levels for credit and transfer risk were calculated on a weekly basis for most of the Wholesale Bank
and ING Direct investment portfolios and for the SME portfolios within the Retail banking operations. For consumer loans, residential
mortgages, credit cards, and the insurance portfolios, the calculations are made on a monthly basis. On a quarterly basis, the Economic
Capital for credit risk and transfer risk figures are consolidated with the corresponding Economic Capital components from other disciplines.
Governance of Economic Capital for Credit and Transfer Risk
All PD, EAD and LGD models are approved by the Credit Risk Committee (CRC) after thorough review of documentation by the Model
Development Steering Committee (MDSG) and MV. In addition, each model is validated on an annual basis by MV. Each model has both
a credit risk and a front office co-sponsor. Both the MDSG and the CRC have participation from both credit risk officers as well as the
front office to ensure maximum acceptance by the organisation.
Risk management (continued)
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