Risk management and control

Expected loss, statistical loss and stress loss

In principle, for risks that are quantifiable, we measure the potential loss at three levels – expected loss, statistical loss and stress loss.

Expected loss is the loss that is expected to arise on average in connection with an activity. It is an inherent cost of such activity and is budgeted and, where permitted by accounting standards, deducted directly from revenues.

Statistical loss (also known as "unexpected loss") is an estimate of the amount by which actual loss can exceed expected loss over a specified time horizon, measured to a specified level of confidence (probability).

Stress loss is the loss that could arise from extreme events.

Our primary day-to-day quantitative controls govern normal periodic adverse results (statistical loss) and protect us from stress events. These are the limits we apply to individual risk types, to portfolios and sub-portfolios, and to specific concentrations of risk and individual exposures. The identification of stress events and scenarios to which we are vulnerable and an assessment of their potential impact – in particular the danger of aggregated losses from a single event through concentrated exposures – is therefore a key component of the risk control process.

"Earnings at risk"

To complement these operating controls, we apply a measure of aggregate risk exposure across all risk types and businesses, which we call "earnings-at-risk". Earnings-at-risk is an assessment of the potential loss inherent in our business in the current economic cycle, across all business lines, and from all sources, including primary risks, operational risks and business risks. It is measured against a severe, low probability, but nevertheless plausible constellation of events over a one year time horizon. It builds off the statistical loss measures used in our day to day operating controls as far as possible, extending the time horizon where necessary, and combines the results to reflect correlations between the various risk categories. Against this, we set our risk capacity – the level of risk we consider we are capable of absorbing, based on our earnings power, without unacceptable damage to our dividend paying ability, our strategic plans and, ultimately, our reputation and ongoing business viability. Risk capacity is based on a combination of budgeted / forecast and historical revenues and costs, adjusted for performance related compensation, and dividends and related taxes. The Board of Directors annually reviews the historical evolution and forecast development of risk capacity and risk exposure and sets a ceiling on risk exposure – effectively, an upper bound on aggregate utilization of the portfolio operating limits. The GEB and the Chairman's Office monitor current and projected risk capacity and risk exposure as part of the regular quarterly risk reporting cycle. In the event of any significant adverse development in risk capacity or disproportionate growth in risk exposure, the risk exposure ceiling would be revisited and underlying operating limits adjusted if necessary.