ING Direct 2011 Annual Report Download - page 236

Risk management continued
ING Bank
Limitations
VaR as a risk measure has some limitations. VaR uses historical data to forecast future price behaviour. Future price behaviour could differ
substantially from past behaviour. Moreover, the use of a one-day holding period (or ten days for regulatory capital calculations) assumes
that all positions in the portfolio can be liquidated or hedged in one day. In periods of illiquidity or market events, this assumption may not
hold true. Also, the use of 99% confidence level means that VaR does not take into account any losses that occur beyond this confidence
level. Parts of these limitations are mitigated by the Basel 2.5 regulation (Stressed VaR and Incremental Risk Charges).
Back testing
Back testing is a technique for the ongoing monitoring of the plausibility of the VaR model in use. Although VaR models estimate potential
future results, estimates are based on historical market data. In a back test, the actual daily result is compared with the 1-day VaR. In
addition to using actual results for back testing, ING Bank also uses hypothetical results, which measure results excluding the effect of
intraday trading, fees and commissions. When the actual or hypothetical loss exceeds the VaR an ‘outlier’ occurs. Based on ING Bank’s
one-sided confidence level of 99% an outlier is expected once in every 100 business days. In 2011, like in 2010, there was no occurrence
where a daily trading loss exceeded the daily consolidated VaR of ING Commercial Banking. ING Bank reports the results of this back
testing to DNB on a quarterly basis.
Stress testing
Stress tests are used for the monitoring of market risks under extreme market conditions. Since VaR in general does not produce an
estimate of the potential losses that can occur as a result of extreme market movements, ING Bank uses structured stress tests for
monitoring the market risk under these extreme conditions. Stress scenarios are based on historical as well as hypothetical extreme events.
The result of the stress testing is an event risk number, which is an estimate of the profit and loss account effect caused by a potential
event and its world-wide impact for ING Commercial Banking. The event risk number for the ING Commercial Banking trading activity is
generated on a weekly basis. Like VaR, event risk is limited by ALCO Bank. ING Bank’s event risk policy basically consists of defined stress
parameters per country and per market (fixed income, equity, foreign exchange, credit and related derivative markets). The scenarios and
stress parameters are evaluated against extreme actual market movements. If and when necessary, ING Bank evaluates specific stress
scenarios, as an addition to its structural stress tests. These specific scenarios relate to current concerns, like political instability in certain
regions, terrorist attacks or extreme movements, e.g. in credit spreads. Furthermore, ING participates in bank-wide stress testing as well as
in ad hoc stress testing exercises as requested by the DNB or EBA.
Other trading controls
VaR and event risk limits are the most important limits to control the trading portfolios. Furthermore, ING Bank uses a variety of other
limits to supplement VaR and event risk. Position and sensitivity limits are used to prevent large concentrations in specific issuers, sectors
or countries. In addition to this, other risk limits are set with respect to the activities in complex derivatives trading. The market risk of
these products is controlled by product specific limits and constraints.
Basel 2.5 / CRD 3
The Basel Committee has proposed to supplement the current VaR regulatory capital framework for trading exposures with Incremental
Risk Charge and Stressed VaR to cover for the shortcomings of the existing regulatory risk framework. The Basel requirements on the
Incremental Risk Charge and stressed VaR have come into force in European legislation (CRD 3) as of 31 December 2011 and are included
in the regulatory capital as of Q4 2011.
Stressed VaR
The Stressed VaR (SVaR) is intended to replicate a VaR calculation that would be generated on the bank’s current portfolio with inputs
calibrated to the historical data from a continuous 12-month period of significant financial stress relevant to the bank’s portfolio. To
calculate SVaR, ING Bank uses the same model that is used for VaR (historical simulation). The historical data period used includes the
height of the credit crisis around the fall of Lehman brothers, and is reviewed regularly.
Incremental Risk Charge
With the Incremental Risk Charge (IRC) ING Bank calculates an estimate of default and migration risk for unsecuritised credit products in
the trading book over a one-year capital horizon at a 99.9% confidence level. For the calculation of IRC ING Bank performs a Monte Carlo
simulation based on a Gaussian copula model. For all issuers the rating is simulated over the different liquidity horizons (time required to
liquidate the position or hedge all material risks) within one year. The financial impact is then determined based on the migration to default
(based on LGD), or migration to a different rating category (based on credit spread changes).
The liquidity horizon has been set to the regulatory minimum of three months for all positions in scope. Given the types of products in
INGBank’s trading portfolio ING considers this horizon to be conservative. We have demonstrated that ING Bank could still actively trade its
positions that are significant for IRC under stressed market circumstances, allowing ING Bank to fully redeem its positions within three months.
234 ING Group Annual Report 2011