financial risk management 2

FRM BoI-2001

Zvi Wiener

02-588-3049http://pluto.mscc.huji.ac.il/~mswiener/zvi.html

Financial Risk Management 2

Zvi Wiener FRM-2 slide 2

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%)


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


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


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.


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


G-30 policy recommendations

• Independent risk management

• Practices by end-user

• Measuring credit exposure

• Master agreements

• Credit enhancements

• Promoting enforceability

• Professional expertise


G-30 policy recommendations• Systems

• Authority

• Accounting practices

• Disclosures

• Recognizing netting

• Legal and regulatory uncertainty

• Tax treatment

• Accounting standards


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


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.


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.


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.


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


Cooke ratio

• Banks are required to maintain capital equal to at least 8% of their total risk weighted assets. (In Israel 9%.)


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.


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


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.


New proposals

• BIS 2000

• VaR based approach to credit risk. CreditMetrics

CreditRisk+

KMV

Merton.


New Approach

Three pillars

A. Minimum Capital Requirement

B. Supervisory Review Process

C. Market Discipline Requirements

FRM BoI-2001

Zvi Wiener

02-588-3049http://pluto.mscc.huji.ac.il/~mswiener/zvi.html

RM functions


Structuring RM functions

• Set firm-wide policies

• Develop methodology

• Set RM structure

• Risk communication


Integrated

Risk M

anagemen

t

Identify and avoid

MonitorLimit Management

StressMarket, Credit VaR

Risk Analysis

Allocate capital RAROC

Active RiskManagement


RAROC

• Risk Adjusted Rate of Return

• Performance measurement

• Marginal impact of any new transaction

• Consistent pricing


New Approach

Three pillars

A. Minimum Capital Requirement

B. Supervisory Review Process

C. Market Discipline Requirements


Goals and Instruments

• Risk Tolerance - “worst loss”

• Stop losses

• Capital allocation

• Credit risk policy

• Operational risk policy


Risk Measurement

• Consistent market based method

• Old limits duration, ALM

• VaR + Stress

• Backtesting


Systems

• Data bases market position rules

• Risk measuring tool

• Reports and decision support


IT - Information Technology

• Unifying information from various units

• Unifying information from various markets

• Unifying information for various ownership

• Back office and execution control


Organizational structure

• Front office

• Middle office

• Back office


Front office

• execution

• risk taking

• marketing


Middle office

• risk management

• pricing

• economic forecasts


Back office

• verification

• booking

• reporting

• collection

• settlement


ALCO

• Assets Liability management committee

• responsible for establishing documenting enforcing all policies involving market risk

• FX

• liquidity

• interest rate


Interdependence of RM

Senior Management

Risk Management Operations

Trading Room

Finance


Senior management

• Approves business plan and targets

• Sets risk tolerance

• Establishes policy

• Ensures performance


Trading Room Management

• Establishes and manages risk exposure

• Ensures timely and accurate deal capture

• Signs off on official P&L


Operations

• Books and settles the trades

• Reconciles front and back office positions

• Prepares and decomposes daily P&L

• Provides independent MTM

• Supports business needs


Finance

• Develops valuation and finance policy

• Ensures integrity of P&L

• Manages business planning process



Risk Management

• Develops risk policies

• Monitors compliance to limits

• Manages ALCO process

• Vets models and spreadsheets

• Provides independent view on risk



Risk Limits

• Global risk limit

• Risk limits for trading desks/units

• Dynamic monitoring and adjustment


Risk Approaches

• Accounting - reported P&L

• Economic - value

• Liquidity needs


Liquidity Rank

• Based on forecasts and potential availability

of funds.

• Hot funds - can be withdrawn quickly.

• Stable funds - typically to maturity.


Israel 339

• Definitions of risk types

• Relates to all banking institutions

• Management structure

• Exposure document

• Directors and policy

• Risk manager

• Internal audit


Israel 339

• IR risk

• Market risk

• Risk audit unit


Israel 341

• Capital requirements against market risk

• Risk measurement

• Trading portfolio

• Reporting

• Examples of standard approach and VaR


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


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


Types of Assets and Risks

• Real projects - cashflow versus financing

• Fixed Income

• Optionality

• Credit exposure

• Legal, operational, authorities


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


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.


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?


New proposals

• BIS 2000

• VaR based approach to credit risk. CreditMetrics

CreditRisk+

KMV

Merton.

financial risk management 2

Documents

capital tier

capital multiple risk

market risk concentration

total capital

capital equal

amendment market risk

total risk weighted

financial risk management