Financial Framework for Business Decisions

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					CASE STUDY
Irwin Financial
Integrated Risk Framework Solution

The Challenge
In early 2003, executives at Columbus, Indiana-based
Irwin Financial Corporation set out two significant risk
initiatives for their organization: To determine how to
better integrate risk information into business
decisions, and how to prepare their institution for a
stream of new bank risk regulations.

Chief Risk Officer Paul Freudenthaler was already              Initial Economic Capital Framework Design;
examining how Irwin measured enterprise risks across
                                                               Commercial Loan Risk Ratings Refinement;
its family of businesses including mortgage
origination and servicing, home equity lending,                Economic Capital-based Limit Setting; and
leasing, and business and commercial real estate               Mortgage Bank Risk Measurement Refinements.
lending.
                                                           At the core of this integrated solution lay BancWare
From experience, he believed his institution needed
                                                           ERisk’s Abacus tool, a set of best-in-class economic
to find a single answer to all the challenges at hand:
                                                           capital models and an implementation technology
“What solution could we put in place to address
                                                           that powered the bank’s calculations. The goal was to
regulatory trends such as Basel II that push banks to
                                                           make sure that the integrated solution de-livered a
measure risk and attribute capital across the
                                                           robust “big picture” of Irwin’s enterprise risks,
institution in a consistent way, which would also help
                                                           underpinned by Basel II-compliant risk measurement
our executives manage our business better going
                                                           building blocks such as the new commercial loan
forward?”
                                                           internal rating system. This information could then be
The Solution – Overview                                    used towards improving business decisions such as
By summer 2003, following an intensive market              risk limit setting, risk capital attribution and risk-based
survey and vendor analysis, Irwin had partnered with       pricing.
BancWare ERisk, a leading New York-based supplier
                                                           Let’s explore how Irwin and BancWare ERisk worked
of risk and capital management systems, to develop
                                                           together to achieve these joint business and
that solution.
                                                           regulatory goals.
Freudenthaler says Irwin chose BancWare ERisk
                                                           Fall 2003 – Designing an Economic Capital
because, as well as addressing most present
                                                           Framework
regulatory needs, BancWare ERisk’s Economic
Capital-based approach looked capable of helping           Like all BancWare ERisk projects, the first step was a
the bank make better risk-adjusted business                planning and steering committee meeting. Irwin’s
decisions.                                                 senior executives met with the BancWare ERisk
                                                           consulting team to talk through how the Economic
From late summer 2003 to winter 2004, Irwin’s
                                                           Capital concept might be applied to help create an
executives worked with BancWare ERisk to design
                                                           integrated     risk    management           framework.
and then jointly implement four integrated
components:
Freudenthaler says that one appealing factor was the     though they had no immediate plans to opt-in to
stiff target BancWare ERisk set for the first stage of   Basel II. “It takes time to build and verify a new
the project. “We were impressed that BancWare            system,” Freudenthaler explains, “with the system
ERisk set – and then hit – a target of building out an   already in place, we knew time would be our ally, not
initial Economic Capital framework within three          our enemy.”
months,” he recalls.
                                                         Irwin wanted the new system to complement the
BancWare ERisk’s consultants and Irwin’s risk            bank’s existing credit culture – a requirement that
executives worked closely together to apply the          ruled out any kind of “black box” solution.
bank’s existing risk data to Abacus in what
                                                         “We worked side by side with BancWare ERisk on the
Freudenthaler calls “a near ‘plug and play’
                                                         internal ratings refinement project,” Freudenthaler
technology solution.”
                                                         says. “We set it up so our credit officers were
As Economic Capital numbers started to become            involved in its development to help ensure maximum
available, they proved immediately useful for senior     line buy-in.”
management in strategic discussions. “One big
                                                         Irwin gathered detailed rating-decision information
insight Economic Capital gave us, for example, was
                                                         from its officers for a sample of its customers –
how important it was for banks to create the right mix
                                                         including all those customers that had defaulted over
of business lines in order to maximize their return on
                                                         the last three years.
capital,” Freudenthaler says.
                                                         BancWare ERisk then applied its statistical expertise
“We had long suspected that there were off-setting
                                                         to the results to identify the financial and non-
risk exposures, but with Economic Capital we are able
                                                         financial variables, such as “years of management
to quantify that relationship and focus our efforts
                                                         experience,” that best predicted future defaults.
towards under-standing the interplay between
Economic Capital, regulatory capital and the capital     The end product was a Basel-II compliant “dual rating
arbitrage characteristics inherent within, and across,   system” that separated out two key risk components:
different lines of business.” Freudenthaler thinks the   “probability of default” (borrower rating) and “loss
insights are vital to any bank looking to develop and    given de-fault” (transaction or facility rating).
maintain a competitive edge.                             Using their new insights into the most predictive
Irwin’s executives have become increasingly familiar     credit rating variables, the project team split
with Economic Capital analysis over the last year, and   borrowers graded within Irwin’s existing rating system
the new system will be used to influence capital         into a Basel II-compliant fourteen-grade borrower
allocations across Irwin’s businesses during 2005.       rating system.

Freudenthaler comments, “We think we have good           So far as possible, the project team preserved the
credit skills at the business line level, but the        bank’s legacy rating terminology (a “3” became a
Economic Capital framework gave us a tool to see         grade 3.0, 3.25, 3.50, or 3.75) to make sure
credit risk across the institution.”                     discussions about risk stayed clear and simple across
                                                         the bank. Even so, the better distribution of
Winter 2003 – Refining the Commercial
                                                         customers across fourteen borrower grades gave the
Loan Risk Rating System
                                                         new rating system far greater powers of
Buoyed up by the quick implementation of the             differentiation.
Economic Capital framework, Irwin pressed ahead
                                                         Freudenthaler confirms that, “the dual nature of the
with BancWare ERisk on the design and rollout of a
                                                         rating system gives us the ability to see the smaller
refined internal commercial loan credit rating system
                                                         pieces of the puzzle – what is driving the risk.”
during Winter 2003.
                                                         He remembers a late session working with one of the
Irwin’s executives wanted an approach that met the
                                                         bank’s senior credit officers on the project.
requirements set forth in the new Basel II rules,
The officer was enchanted to see that, far from           Abacus’ Economic Capital frame-work already broke
cutting across his judgment, the new approach             Irwin’s activities down into sub-portfolios of
attached hard risk numbers and capital costs to credit    businesses with similar risk characteristics, e.g.,
insights he’d developed over many years working           commercial real estate by property type and region,
with individual Irwin customers – but that he’d never     or home equity by loan-to-value and FICO scoring
been able to explain or quantify.                         bands.

In the future, as the bank re-rates more and more         Now, BancWare ERisk’s consultants used Abacus to
customers, the new information fed into Abacus will       calculate the Economic Capital attributed to each
further improve the bank’s Economic Capital-based         sub-portfolio, and then compared this to each sub-
decision-making – helping Irwin better evaluate the       portfolio’s risk-adjusted profit. They also began to
risk-adjusted returns that are available in the           look at how adding new deals of various kinds to each
marketplace.                                              sub-portfolio would affect the bank’s overall
                                                          Economic Capital.
Spring 2004 – Better Limit Setting
Through Economic Capital                                  For example, Abacus’ risk simulations might show
                                                          that adding commercial loans with a better rating
Irwin’s new Economic Capital framework also opened        than present reduced the Economic Capital
the door to a near-term ambition of the bank:             attributed to that business line, while adding loans
executives wanted to be able to set credit limits         worse than present pushed Economic Capital up
across Irwin’s very different businesses that took        sharply. It also became much clearer whether risk was
proper account of the amount of risk that each            rising mainly be-cause of poor credit quality in
business contributed to Irwin’s total portfolio.          individual deals, or because extra deals increased risk
Some of Irwin’s businesses have a tradition of working    concentrations in the portfolio.
with creative business leaders to test and develop        These marginal impact simulations helped Irwin begin
different products in many different market niches.       to replace some of its traditional credit limits based
It’s a strategy that’s brought rewards, but by 2004 the   on business volumes with risk limits that took better
bank knew it needed to develop a more rigorous way        account of risk concentrations, marginal risk
to put risk limits around its business and product        contributions and risk-adjusted profitability.
development strategies.
As well as improving risk discipline, Economic Capital-                      Working in partnership with BancWare ERisk through
based limits mean senior executives can give business                        Fall 2004, Irwin has developed a state-of-the-art
lines with strong risk-adjusted profitability the                            approach to assessing how a change in interest rates
flexibility they deserve.                                                    drives volumes, profitability and risk across its
Freudenthaler says another benefit of the Economic                           businesses.
Capital approach is better risk communication at the
                                                                             The new information helps Irwin think through tactical
top of the bank. Because Economic Capital associates
                                                                             hedging decisions, and helps top executives
an activity with a specific probability that losses will
                                                                             understand how strategic decisions – expansion of
exceed a particular level, it allows Irwin’s executives,
                                                                             one portfolio, or extra investment – affect the
“to line up the actual risk taken by businesses more
                                                                             volatility of the bank’s revenues.
rigorously with the company’s risk appetite.”
                                                                             Freudenthaler says the project con-firmed his
                                                                             impression that BancWare ERisk consultants leverage
Fall 2004 – Mortgage Bank Risk Measurement
                                                                             the knowledge of their clients as they work to attach
Refinements
                                                                             Economic Capital numbers to risk.
Irwin originates mortgages on a considerable scale
                                                                             “As well as being fantastic numbers people,
and is one of the top mortgage servicing companies
                                                                             BancWare ERisk consultants were al-ways responsive
in the United States.
                                                                             about incorporating our business insights. That’s how,
Irwin’s executives know that a change in interest rates                      over a series of projects, they’ve helped us to build an
can have a big effect on the profitability of its                            integrated Economic Capital solution in tune with our
mortgage-related businesses.                                                 needs,” he says.
For example, mortgage originations tend to decrease
(rise) as interest rates rise (fall), while the value of the
mortgage servicing rights retained by the bank
becomes more (or less) valuable as rates go up (or
down) because fewer customers pay down their
mortgage.

But it’s a significant challenge to attach numbers to
these complex interest rate sensitivities – and to work
out how a hedging strategy in one business line
affects the risk profile of the institution as a whole.




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