Groups of connected clients

Implementation at Íslandsbanki

Florian Zink

Overview

Groups of connected clients:

• What are they?

• Why do we need them?

• How to define them?

• Implementation at Íslandsbanki

• Effect on capital requirement

What are they ?

Group of connected clients =

Closely linked clients thatshould be treated as singlerisk.

CRD

Art. 79: Categorization of retail exposures

Art. 108: Large exposures

Why do we need them?

A

DB

C

E

K

M

J

I

G

H

FO

N

L

P

Pillar I: Asymptotic single risk factor model

z: global state of economy

Conditional independence: Obligors default independently given z

P(A) = P(A|z)p(z)

K

DB

C E

A

M

J

I

G

H

F ON

L

P

Conditional independence: Obligors default independently given g, z, s

z: global state of economy

s: sectorg: geography

Pillar II: full diversification granular portfolio,other sources of correlation: sector, geography and ...

P(A) = P(A|z,s)p(z,s)

K

DB

C E

A

M

J

I

G

H

F O

N

L

P

Large exposures: Treat groups of connected clients as single exposure. “Think in terms of baskets, not eggs.” (LE limits in addition to Pillar 2)

z: global state of economy

s: sectorg: geography

... idiosyncratic correlationRemoval of conditional independence assumption Groups of connected clients

How to define them – whom to link ?

Two types of connections (2006/48/EC Art. 4):

(a) Control

(b) Economic dependency (revised 2009/111/EC)

Vague definitions, need interpretation

CEBS (Dec 2009): Guidelines on the implementationof the revised large exposures regime

CRD, Art. 4 (45)

‘group of connected clients’ means:

(a) two or more natural or legal persons, who, unless it is shown otherwise, constitute a single risk because one of them, directly or indirectly, has control over the other or others;

Connection due to control:

Examples of control

• direct or indirect ownership of 50% of capitalor voting power

• power to appoint majority of governing bodythat exercises control (management, board of directors)

• power to cast majority of votes

• power to coordinate management (samepersons in management of firms)

Groups can overlap:

GCC 1 : CL1 + Comp1 Exposure: 110GCC2 : CL2 + Comp1 Exposure: 130

Exemption: Central Govmnt with risk weight 0

Connection due to economic dependency:

CRD Art 4 (45)

(b) two or more natural or legal persons *…+ who are to be regarded as constituting a single risk because they are so interconnected that, if one of them were to experience financial problems, in particular funding or repayment difficulties, the other or all of the others would be likely to encounter funding or repayment difficulties

Examples Economic dependency

• guarantees threatening solvency

• property owner and hard to replaceabletenant

• dependency on single producer/vendor

• debtor and spouse (if liable)

• dependency on same main source of funding(not replaceable; being clients of same bank no reason to connect)

CEBS: No requirement to link control and economic dependency

Merge GCC.1 and GCC.2 only if economic dependency affects whole group

Implementation at Íslandsbanki

Credit control keeps database of (mother kt, daughter kt, link type)no weights yet

Mother Daughter Link

A B ->

B C <->

B D ->

D E ->

Generate graph structure:

• nodes (clients)• edges (connections)

Mother Daughter Link

A B ->

B C <->

B D ->

D E ->

A

B

C D

E

Generate graph structure:

• nodes (clients)• edges (connections)

Mother Daughter Link

A B ->

B C <->

B D ->

D E ->

A

B

C D

E

For every node,get all nodes that are affectedby financial problems of that node

(get all descendants using DFS)

A

B

C D

E

Mother Daughter Link

A B ->

B C <->

B D ->

D E ->

A

B

C D

E

For every node,get all nodes that are affectedby financial problems of that node

(get all descendants using DFS)

A

B

C D

E

GCC.D

GCC.BGCC.C

GCC.A

Super groups: (remove groups fully contained in others)

• sort nodes by (#descendants, #children, kennitala)

• set all nodes as uncovered• iterate over nodes not yet covered:

• assign highest scoring node as head of new group• set node and all descendants as covered

A 4 1

B 3 2

C 3 1

D 1 1

E 0 0

A

B

C D

E

A

B

C D

E

GCC.D

GCC.BGCC.C

GCC.A

Super groups: (remove groups fully contained in others)

• sort nodes by (#descendants, #children, SSN)

• set all nodes as uncovered• iterate over nodes not yet covered:

• assign highest scoring node as head of new group• set node and all descendants as covered

A 4 1

B 3 2

C 3 1

D 1 1

E 0 0

A

B

C D

E

A

B

C D

E

GCC.A

Example:

[REMOVED]

Effect on capital requirements

• ÍSB Corporate portfolio

• MC simulation of loss distribution usingimportance sampling

• compare with / without GCC to Basel 2

A

z

B

P(A|z) = P(A|~B,z) P(~B|z) + P(A|B,z) P(B|z)

Problem: Which PD to use ?

CAssume rating model provides P(A|z)through qualitative factors

Expected loss EL(A+B) = EL(A) + EL(B) = PD(A) L(A) + PD(B) L(B)

=> use loss-weighted PD