Financial Risk Management 2
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Transcript of Financial Risk Management 2
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FRM BoI-2001
Zvi Wiener
02-588-3049http://pluto.mscc.huji.ac.il/~mswiener/zvi.html
Financial Risk Management 2
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Regulation of Financial Intermediaries
• take deposits, give loans
• very small equity capital, big leverage
• FDIC, CDIC, Israel - implicit
• domino effect
• Minimal capital requirements (8-9%)
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Banks
• major increase of off-balance sheet in 80s
• 1988 Basle accord (88 BIS Accord) -
international minimum capital guidelines
(credit risk).
• 1996 Amendment - market risk + VaR.
• Amendment = BIS 98
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Accord + Amendment
• assets to capital 20
• eligible capital/risk weighted assets 8%
• minimal capital charge for market risk
• concentration risk:
positions of 10% must be reported
positions of 25% need special permission
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Accord + Amendment
• regulators encourage banks to develop
models.
• Banks must implement a RM infrastructure
in their daily RM - limits, monitoring, etc.
• G-30 report, 1993.
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G-30 policy recommendations
• The Role of senior management
• Marking to market
• Market valuation methods
• Identifying revenue sources
• Measuring market risk (VaR)
• Stress simulation
• Investing and funding forecasts
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G-30 policy recommendations
• Independent risk management
• Practices by end-user
• Measuring credit exposure
• Master agreements
• Credit enhancements
• Promoting enforceability
• Professional expertise
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G-30 policy recommendations• Systems
• Authority
• Accounting practices
• Disclosures
• Recognizing netting
• Legal and regulatory uncertainty
• Tax treatment
• Accounting standards
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1988 BIS Accord
• Developed by Basle committee
• Accepted by G-10: Belgium, Canada,
France, Germany, Italy, Japan,
Netherlands, Sweden, UK, USA.
• minimum asset to capital multiple
• risk based capital ratio
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1988 BIS Accordrisk based capital ratio - solvency ratio (Cooke ratio).
Capital divided by risk weighted on-balance-sheet assets plus off-balance-sheet exposures.
Weights are based on credit risk.
No netting or portfolio effects!
No market risk.
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1988 BIS AccordThe Assets-to-capital multiple 20
Bank’s total assets divided by its total capital.
Some off-balance-sheet items, like letters of credit are accounted at nominal.
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Weights in Cooke ratioOn-balance-sheet items:
0% Cash, gold, OECD government
claims, insured mortgages.
20% OECD banks, OECD public sector
entities.
50% Uninsured residential mortgages.
100% All other claims.
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Cooke ratio
Off-balance-sheet credit equivalent.
1. Nonderivative exposure - conversion factor is set by regulators between 0 and 1.
2. Derivative exposure = Current replacement cost + Add-on amount
Risk weighted amount =
Assets*W+Credit equivalent*W
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Cooke ratio
• Banks are required to maintain capital equal to at least 8% of their total risk weighted assets. (In Israel 9%.)
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Capital• Tier 1. Stock equity, preferred stock, minority equity interest in consolidated subsidiaries, less goodwill and other deductions.
• Tier 2. Cumulative perpetual preferred shares, 99 year debentures, some subordinated debt (5y).
• Tier 3. Can be used to cover market risk only. Short term subordinated debt (2y).
• Tier 1 + Tier 2 8%, and Tier 1 must be at least 50% of this amount.
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Models
• Standard model.
• Internal models (based on VaR).
(3*marketVaR10d +4*creditVaR10d)*trigger/8
trigger = 8 in North America and between 8 and 25 in the UK
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Problems with the current approach
• No distinction between a loan of $100 and 100 loans of $1 each one.
• Turkish bank has lower capital requirements than General Electric.
• A loan to AA rated firm is treated as a loan to a B rated firm.
• Some similar contracts are treated differently.
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New proposals
• BIS 2000
• VaR based approach to credit risk. CreditMetrics
CreditRisk+
KMV
Merton.
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New Approach
Three pillars
A. Minimum Capital Requirement
B. Supervisory Review Process
C. Market Discipline Requirements
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FRM BoI-2001
Zvi Wiener
02-588-3049http://pluto.mscc.huji.ac.il/~mswiener/zvi.html
RM functions
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Structuring RM functions
• Set firm-wide policies
• Develop methodology
• Set RM structure
• Risk communication
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Integrated
Risk M
anagemen
t
Identify and avoid
MonitorLimit Management
StressMarket, Credit VaR
Risk Analysis
Allocate capital RAROC
Active RiskManagement
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RAROC
• Risk Adjusted Rate of Return
• Performance measurement
• Marginal impact of any new transaction
• Consistent pricing
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New Approach
Three pillars
A. Minimum Capital Requirement
B. Supervisory Review Process
C. Market Discipline Requirements
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Goals and Instruments
• Risk Tolerance - “worst loss”
• Stop losses
• Capital allocation
• Credit risk policy
• Operational risk policy
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Risk Measurement
• Consistent market based method
• Old limits duration, ALM
• VaR + Stress
• Backtesting
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Systems
• Data bases market position rules
• Risk measuring tool
• Reports and decision support
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IT - Information Technology
• Unifying information from various units
• Unifying information from various markets
• Unifying information for various ownership
• Back office and execution control
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Organizational structure
• Front office
• Middle office
• Back office
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Front office
• execution
• risk taking
• marketing
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Middle office
• risk management
• pricing
• economic forecasts
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Back office
• verification
• booking
• reporting
• collection
• settlement
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ALCO
• Assets Liability management committee
• responsible for establishing documenting enforcing all policies involving market risk
• FX
• liquidity
• interest rate
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Interdependence of RM
Senior Management
Risk Management Operations
Trading Room
Finance
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Senior management
• Approves business plan and targets
• Sets risk tolerance
• Establishes policy
• Ensures performance
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Trading Room Management
• Establishes and manages risk exposure
• Ensures timely and accurate deal capture
• Signs off on official P&L
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Operations
• Books and settles the trades
• Reconciles front and back office positions
• Prepares and decomposes daily P&L
• Provides independent MTM
• Supports business needs
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Finance
• Develops valuation and finance policy
• Ensures integrity of P&L
• Manages business planning process
• Supports business needs
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Risk Management
• Develops risk policies
• Monitors compliance to limits
• Manages ALCO process
• Vets models and spreadsheets
• Provides independent view on risk
• Supports business needs
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Risk Limits
• Global risk limit
• Risk limits for trading desks/units
• Dynamic monitoring and adjustment
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Risk Approaches
• Accounting - reported P&L
• Economic - value
• Liquidity needs
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Liquidity Rank
• Based on forecasts and potential availability
of funds.
• Hot funds - can be withdrawn quickly.
• Stable funds - typically to maturity.
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Israel 339
• Definitions of risk types
• Relates to all banking institutions
• Management structure
• Exposure document
• Directors and policy
• Risk manager
• Internal audit
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Israel 339
• IR risk
• Market risk
• Risk audit unit
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Israel 341
• Capital requirements against market risk
• Risk measurement
• Trading portfolio
• Reporting
• Examples of standard approach and VaR
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Israel 341
• Capital requirements against market risk
• Risk measurement
• Trading portfolio
• Reporting
• Examples of standard approach and VaR
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Qualitative Requirements
• An independent risk management unit• Board of directors involvement• Internal model as an integral part• Internal controller and risk model• Backtesting• Stress test
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Quantitative Requirements
• 99% confidence interval• 10 business days horizon• At least one year of historic data• Data base revised at least every quarter• All types of risk exposure• Derivatives
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Types of Assets and Risks
• Real projects - cashflow versus financing
• Fixed Income
• Optionality
• Credit exposure
• Legal, operational, authorities
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Risk Factors
There are many bonds, stocks and currencies.
The idea is to choose a small set of relevant economic
factors and to map everything on these factors.
• Exchange rates
• Interest rates (for each maturity and indexation)
• Spreads
• Stock indices
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Board of Directors(Basle, September 1998)
• periodic discussions with management concerning the effectiveness of the internal control system• a timely review of evaluations of internal controls made by management, internal and external auditors• periodic efforts to ensure that management has promptly followed up on recommendations and concerns expressed by auditors and supervisory authorities on internal control weaknesses• a periodic review of the appropriateness of the bank’s strategy and risk limits.
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Risk Management Issues
• Why only half of the bond was called?
• Why only 800,000 shares were protected?
• How to choose the protection level?
• When does it make sense to hedge?
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New proposals
• BIS 2000
• VaR based approach to credit risk. CreditMetrics
CreditRisk+
KMV
Merton.