The majority of market risk in our nontrading portfolios is quantified through the use of stress testing proce- dures. We use stress tests that are specific to each risk class and which consider, among other factors, large historically observed market moves, the liquidity of each asset class, and changes in client behavior in rela- tion to deposit products. This assessment forms the basis of the economic capital calculations which enable us to actively monitor, aggregate and manage our nontrading market risk exposure. The most significant addition to our nontrading market risk economic capital coverage in 2012 was the inclusion of credit spread risk for Postbank’s banking book investment portfolio following additional regulatory specifications to include material credit spread risk, irrespective of the accounting category. The economic capital charge for the credit spread risk of the portfolio is in addition to credit risk economic capital allocated to the portfolio for risks aris- ing from credit default and rating migrations.
Interest Rate Risk in the Banking Book
The majority of our interest rate risk arising from nontrading asset and liability positions, with the exception of some entities and portfolios, has been transferred through internal transactions to the CB&S division. This internally transferred interest rate risk is managed on the basis of value-at-risk, as reflected in trading portfolio figures. The treatment of interest rate risk in our trading portfolios and the application of the value-at-risk model is discussed in the “Trading Market Risk” section of this document.
The most notable exceptions from the aforementioned paragraph are in the PBC Corporate Division in Germa- ny including Postbank and the AWM mortgage business in the U.S. Unit. These entities manage interest rate risk separately through dedicated Asset and Liability Management departments subject to banking book value- at-risk limits set and monitored by Market Risk Management. The measurement and reporting of interest rate risk managed by these dedicated Asset and Liability functions is performed daily in the PBC division and on a weekly basis for AWM. The global interest rate in the banking book is reported on a monthly basis.
The changes of present values of the banking book positions when applying the regulatory required parallel yield curve shifts of (200) and +200 basis points was below 1 % of our total regulatory capital at Decem- ber 31, 2012. Consequently, outright interest rate risk in the banking book is considered immaterial for us. Our PBC, GTB and AWM businesses are subject to model risk with regard to client deposits as well as savings and loan products. Measuring interest rate risks for these product types in the banking book is based upon assumptions with respect to client behavior, future availability of deposit balances and sensitivities of deposit rates versus market interest rates resulting in a longer than contractual effective duration. Those parameters are subject to stress testing within our Economic Capital framework. Additionally, consideration is made regard- ing early prepayment behavior for loan products. The parameters are based on historical observations, statisti- cal analyses and expert assessments. If the future evolution of balances, rates or client behavior differs from these assumptions, then this could have an impact on our interest rate risks in the banking book.
Foreign Exchange Risk
Foreign exchange risk arises from our nontrading asset and liability positions, denominated in currencies other than the functional currency of the respective entity. The majority of this foreign exchange risk is trans- ferred through internal hedges to trading books within CB&S and is therefore reflected and managed via the value-at-risk figures in the trading books. The remaining foreign exchange risks that have not been trans- ferred are mitigated through match funding the investment in the same currency, therefore only residual risk remains in the portfolios. Small exceptions to above approach follow the general MRM monitoring and report- ing process, as outlined for the trading portfolio.
The bulk of nontrading foreign exchange risk is related to unhedged structural foreign exchange exposure, mainly in our U.S., U.K. and China entities. Structural foreign exchange exposure arises from local capital (including retained earnings) held in the Bank’s consolidated subsidiaries and branches and from investments
accounted for at equity. Change in foreign exchange rates of the underlying functional currencies result in revaluation of capital and retained earnings and are recognized in other comprehensive income booked as Currency Translation Adjustments (“CTA”).
The primary objective for managing our structural foreign exchange exposure is to stabilize consolidated capi- tal ratios from the effects of fluctuations in exchange rates. Therefore the exposure remains unhedged for a number of core currencies with considerable amounts of risk-weighted assets denominated in that currency in order to avoid volatility in the capital ratio for the specific entity and the group as a whole.
Investment Risk
Nontrading market risk from investment exposure is predominantly the equity risk arising from our non- consolidated investment holdings in the banking book categorized into strategic and alternative investment assets.
Strategic investments typically relate to acquisitions made by us to support our business franchise and are undertaken with a medium to long-term investment horizon. Alternative assets are comprised of principal in- vestments and other non-strategic investment assets. Principal investments are direct investments in private equity (including leveraged buy-out fund commitments and equity bridge commitments), real estate (including mezzanine debt) and venture capital, undertaken for capital appreciation. In addition, principal investments are made in hedge funds and mutual funds in order to establish a track record for sale to external clients. Other non-strategic investment assets comprise of assets recovered in the workout of distressed positions or other legacy investment assets in private equity and real estate of a non-strategic nature. The majority of the non- strategic investment portfolio has been moved to the newly created NCOU and its mandate to achieve accel- erated de-risking and capital relief.
Pension Risk
Deutsche Bank is exposed to market risk from a number of defined benefit pension schemes for past and current employees. The ability of the pension schemes to meet the projected pension payments, is maintained through investments and ongoing plan contributions. Market risk materializes due to a potential decline in the market value of the assets or an increase in the liability of each of the pension plans. Market Risk Management monitors and reports all market risks both on the asset and liability side of our defined benefit pension plans including interest rate risk, inflation risk, credit spread risk, equity risk and longevity risk. For details on our defined benefit pension obligation see Additional Note 34 “Employee Benefits”.
Other Risks
In addition to the above risks, Market Risk Management has the mandate to monitor and manage market risks that arise from capital and liquidity risk management activities of our treasury department. Besides the struc- tural foreign exchange capital hedging process this includes market risks arising from our equity compensation plans.
Market risks in our asset management activities in AWM, primarily results from principal guaranteed funds, but also from co-investments in our funds.