Market Risk –Internal Model Approach

K.G.Bhandari

IndusInd Bank Ltd.

March 15, 2010

Indian Banks’ Association4th Annual summit 2010

Basel Accord

• Capital requirement were simplistic and rigid – but did not reflect underlying economic risks of banks / FIs

• Now, capital requirements are more risk sensitive - reflects economic risk assumed

• These new standards are generally based on Value-at-Risk (VaR) methods

• VaR is a measure of loss at given confidence level and directly translates into measure of buffer capital

• Basel-I Accord sets Minimum Capital requirements to guard against Credit Risk

• To control expanding Trading activities, Capital Charge for market risk was included later

Standardised Method – Capital Charge for Market Risk

• Based on pre-specified, standarised, ‘building – block approach’

• Market risk is computed for portfolios exposed to interest rate risk, exchange risk, equity risk and commodity risk

• Takes into account Notional amount and market parameters

• Main drawback – ignores diversification across market risks – within each category and across different categories

• Highly conservative – Adds up capital charge for each category

• Assumes that Worst Loss will hit all portfolios at the same time

• Does not reward prudent diversification

Internal Model Approach

IMA recognises –

Risk Management models in use – far more advanced than rigid rules

Banks can use their own VaR models as basis for capital requirement for Market Risk

VaR is a robust Risk Measurement and Management Practice

IMA - Qualitative Criteria

• Independent Risk Control Unit responsible for design and implementation of Bank’s risk management systems

• Regular Back-Testing

• Initial and on-going Validation of Internal Model

• Bank’s Internal Risk Measurement Model must be integrated into Management decisions

• Risk measurement system should be used in conjunction with Trading and Exposure Limits.

• Stress Testing

• Risk measurement systems should be well documented

• Independent review of risk measurement systems by internal audit

• Board and senior management should be actively involved

IMA - Quantitative criteria

Quantitative Parameters :

• VaR computation be based on following inputs :

– Horizon of 10 Trading days

– 99% confidence level

– Observation period – at least 1 year historical data

• Correlations : recognise correlation within Categories as well as across categories (FI and Fx, etc)

• Market Risk charge : General Market Risk charge shall be – Higher of previous day’s VaR or Avg VaR over last 60 business days X Multiplier factor K (absolute floor of 3)

Market Risk Charge

Market Risk charge on any day ‘t’

SRC – Specific Risk Charge

MRCt = Max (Avg VaR over 60 days, VaR t-1) + SRC

Back testing

Possible cause and remedies of the "Yellow" zone• Basic Integrity of the model• Deficient model accuracy• Intra day trading• Bad luck

Internal Model Approach - Benefits

• Internal VaR system is more precise

• VaR account for correlations

• Market risk charge under IMA likely to be lower

• With improvements in risk measurement techniques, IMA will enable capital charge to be more precise

• Market Risk charge needs to be computed and monitored daily

• Each day VaR is compared with the subsequent Trading profit or loss

• Back Testing will help to refine the framework

Time

So

ph

isti

cati

on

Mark to Market

Duration

Value at Risk

Stress Testing

Use of Statistical analysis to determine

maximum losses

Use of ‘What if’ scenarios to

determine losses in extreme

eventsCashflow analysis to

measure the sensitivity of fixed income instruments

Revaluation of the portfolio to

measure notional P/L

TimeTime

So

ph

isti

cati

on

Mark to Market

Duration

Value at Risk

Stress Testing

Use of statistical analysis to determine

maximum losses

Use of ‘What if’ scenarios to

determine losses in extreme

eventsCashflow analysis to

measure the sensitivity of fixed income instruments

Revaluation of the portfolio to

measure notional P/L

Market Risk – Advanced Risk Measurement Techniques enables Bank to effectively control the amount of market risk it assumes and allocate capital for the same

Measurement Techniques

Marking to Market

Duration, Convexity

Price Value of a Basis Point

VaR - Forex (Spot & Forward)

Stress Testing

Scenario Analysis

Duration Limits

VaR Limits

Stop Loss Limits

Counterparty Exposure Limits

Country Exposure Limits

Standardized Model

Internal Model

‘Know’ your risksAllocate Capital

Control Measures

Market Risk Amendment

Paradigm becomes explicit

00

StressStresslossloss

Frequency of lossFrequency of loss

Amount of lossAmount of loss

Unexpected lossUnexpected loss

ExpectedExpected

lossloss

Set up risk management system

Formulate risk management policies

and procedures

Involve of the board of directors

and high level management

Effective Risk Management

3

4

Supporting Factors for Risk Management

Establish a unit to operate risk management

2

1

Limitations to Risk Management

Limitations

Involve of the board of directors and high level management

• Not enough cooperation

• Low qualification

• Lack of independence to make a decision

• Not transparence

Formulate risk management policy and procedures

• Policies/ procedures not match with risks

• Underdevelopment Infrastructure

• Rigid to implement

• Communication failure

Establish a unit to operate risk management

• Lack of adequate structure

• Staff has less experience

• Lack of independence

Set up risk managementsystem

• No follow up and control system

• Not enough risk assessment/ management instruments

• Database and IT system

Internal Model Approach

Supervisory objectives

• better risk management

• continual upgrading and encouragement of innovation in risk management methodology and

• improved risk sensitivity and measures.

Internal Model Framework

Policy Governance

Risk Strategy Accountability

Risk Appetite

Internalising

Risk Management Models Reporting

Projection & Analysis Models

Annual: planning, forecasting, budgeting Risk Monitoring

Risk Maps Risk Analysis

Economic Capital Pricing, capital management Risk Reporting

Sensitivity Measures & Analysis

External Factors

f inancial markets, competition, tax & regulation

Impact & Benefits

• Best practice risk and capital management – In particular:

• Risk management - processes and controls• Capital management - eligible capital and quality of capital

• Improved market perception: enhanced reputation for risk management

• Precise capital requirements and return on capital

• Enhanced management information to support more optimal management decisions

• Reduced costs: Operational efficiencies from better risk management

Internal model and its purpose

• What is an internal model?– “A risk management system developed by the

Bank to analyse the overall risk position, to quantify risks and to determine the economic capital required to meet those risks”

• What is the purpose of an internal model?– To fully integrate processes of risk and capital

management within the Bank

Expected Benefits

• Improved risk sensitivity

• Better alignment of regulatory capital requirements with economic capital

• Encouragement of innovation in risk management methodology leading to higher competitiveness through better risk management and hence lower costs of capital

• More effective pillar 2 discussion and familiarity of the supervisor with more detailed exposure data

• Cost efficiencies through re-use of risk modeling infrastructure for discussion with supervisors, rating agencies, analysts and shareholders.

Particular issues for banks

• The regulatory requirements are not yet come• There is a shortage of skills and expertise• There are data limitations• Low base in terms of use of models and risk management; in effect,

attempting to “jump a generation”• The operating environment is undergoing fundamental change

However, none of these difficulties are insurmountable if one learns from others

• Most difficult IRB qualifying criterion to meet is not in relation to the models themselves but in relation to the use them - a major challenge

• It needs to be recognised that a robust risk management framework is an essential prerequisite. Successful implementation, such as the use of models, can only be achieved if they integrate into a sound framework of systems and controls; in the case of certain banks, there may be some gap vis-à-vis international best practice

Specification of Market Risk Factors

• For interest rates, there must be a set of risk factors corresponding to interest rates in each currency in which the bank has interest-rate-sensitive on- or off-balance sheet positions

• The risk measurement system should model the yield curve using one of a number of generally accepted approaches

• The risk measurement system must incorporate separate risk factors to capture spread risk

• For exchange rates (which may include gold), the risk measurement system should incorporate risk factors corresponding to the individual foreign currencies in which the bank’s positions are denominated

• For equity prices, there should be risk factors corresponding to each of the equity markets in which the bank holds significant positions

• For commodity prices, there should be risk factors corresponding to each of the commodity markets in which the bank holds significant positions

Quantitative Standards• “Value-at-risk” must be computed on a daily basis

• In calculating the value-at-risk, a 99th percentile, one-tailed confidence interval is to be used

• “Holding period” will be ten trading days

• “Effective” historical observation period must be at least one year

• Banks should update their data sets no less frequently than once every three months and should also reassess them whenever market prices are subject to material changes

• No particular type of model is prescribed – should captures all the material risks run by the bank

• Banks will have discretion to recognise empirical correlations within broad risk categories

• Banks’ models must accurately capture the unique risks associated with options within each of the broad risk categories

• Each bank must meet, on a daily basis, a capital requirement expressed as the higher of (i) its previous day’s value-at-risk number measured according to the parameters specified in this section and (ii) an average of the daily value-at-risk measures on each of the preceding sixty business days, multiplied by a

multiplication factor

• multiplication factor will be set by supervisory authorities on the basis of their assessment of the quality of the bank’s risk management system, subject to an absolute minimum of 3.

• Banks using models will also be subject to a capital charge to cover specific risk (as defined under the standardised approach for market risk) of interest rate related instruments and equity securities

Stress Testing

• Stress testing to identify events or influences that could greatly impact banks is a key component of a bank’s assessment of its capital position

• Stress scenarios need to cover a range of factors that can create extraordinary losses or gains in trading portfolios, or make the control of risk in those portfolios very difficult

• Stress tests should be both of a quantitative and qualitative nature, incorporating both market risk and liquidity aspects of market disturbances

• Banks should combine the use of supervisory stress scenarios with stress tests developed by banks themselves to reflect their specific risk characteristics

• Stress tests results should be reviewed periodically by senior management and should be reflected in the policies and limits set by management and the board of directors

External Validation

Validation of models’ accuracy by external auditors and/or supervisory authorities should at a minimum include

verifying the internal validation processes formulae used in the calculation process as well as for the pricing

of options and other complex instruments are validated by a qualified unit - independent from the trading area

Structure of internal models is adequate with respect to the bank’s activities and geographical coverage

results of the banks’ back-testing of its internal measurement system

data flows and processes associated with the risk measurement system are transparent and accessible

The Standardized Method

Risk classification is arbitrary.

Ignores diversification : leads to high capital requirements because risk charges are systematically added up across difference sources of risk

Captures Risk for positions as on the day and not for the period.

The Standardized Approach

• Guidelines to compute– Interest rates risk– Exchange risk– Equity risk– Commodity risk

• The bank's total risk is computed as the summation of the 4 categories– ignoring correlations

• Provide a robust measure of interest rate risk taking into account– Systematic/Market risk– duration– basis risk across maturities

• Specific/Idiosyncratic risk

The Standardized Approach - Market Interest Rate Risk

• Market risk is defined via Maturity Bands

Specific Interest Risk Charge

The capital charge for specific risk is designed to protect against an adverse movement in the price of an individual security owing to factors related to the individual issuer

Capital Charge for Interest Rate Risk

Where,

= Capital Charge for Total Interest rate Risk

= Capital Charge for General Interest rate Risk

= Capital Charge for Specific Interest rate Risk

The Internal Model Approach (IMA)

• Rely on Internal Risk Management of the Bank– for the first time Regulation recognized that bank had

developed trustable risk management systems– if this approach lead to lower Capital Charge, Banks

have incentives to develop sophisticated and more accurate models

– However, need to be approved by Regulation

• sound and sufficient details on the VAR and diversification models at qualitative and quantitative levels

The Internal Model Approach (IMA) - Qualitative Requirements

• Independent Risk Control Unit– The bank must a risk control that is independent of trading

and reports to senior management, to minimize conflicts of interests

• Back testing• Involvement

– senior– sufficient resources

• Use of limits• Stress Testing• Compliance (to a documented set of policies)• Independent Review

• Requirement on risk factors :

– at least 6 factors for yield curve risk + separate risk factors to model spread risk

– for equity, the model should at least consist of beta mapping on an index, a more detailed approach could consist in adding industry factors, as well as individual risk factor modeling

– for active trading in commodity, the model should account for for movements in the spot plus convenient yields

– bank should also capture the non linear price characteristics of options (gamma, vega , ...)

– Correlation within broad risk categories are recognized explicitly

The Internal Model Approach (IMA) - Qualitative Requirements

The Internal Model Approach (IMA) - VAR

• Market Risk Charge = VAR• Shall be computed every day• for a10 days horizon

– Bank can use a daily VAR and scale it using the square root time rule

• with a 99% confidence level• with an observation period based on at least one year moving

window of historical data• shall be set at the higher of the previous day's VAR, or the

average over the 60 business days,• times a multiplicative factor k

– determined by regulator (in the range of 3 to 4) to prevent model misspecifications

• a plus factor is added (depending on the performance of the model)

Stress Testing

Stress Testing can be described as a process to identify and manage situations that could cause extraordinary losses

Tools

– Scenarios Analysis– Stressing Models– Policy Response

Stress Testing - Scenarios Analysis

• Evaluating the portfolios– under various states of the world– evaluating the impact

• changing evaluation models• volatilities and correlations

• Scenarios requiring no simulations– analyzing large past losses

• Scenarios requiring simulations– running simulations of the current portfolio subject to large

historical shocks• e.g. 1987 crash, etc ...

• Bank specific scenario– driven by the current position of the bank rather than historical

simulation• Much more subjective than VAR• Can help to identify undetected weakness in the bank's portfolio

Back testing

Statistical testing that consist of checking whether actual trading losses are in line with the VAR forecasts

– The Basle back testing framework consists in recording daily exception of the 99% VAR over the last year

– Even though capital requirements are based on 10 days VAR, back testing uses a daily interval, which entails more observations

– On average, one would expect 1% of 250 or 2.5 instances of exceptions over the last year

– Too many exceptions indicate that• either the model is understating VAR• the Bank is unlucky• How to decide ?Statistical inference

Basel Market Risk Charges

• The Market Risk Charge– Quantitative parameters– Market risk charge– Plus factor

• Stress Testing– A process to identify and manage situations that could

cause extraordinary losses– Scenarios requiring no simulation– Scenarios requiring a simulation– Bank-Specific scenarios

Basel Market Risk Charges

• Back testing– A statistical testing framework that consists of

checking whether actual trading losses are in line with VAR forecasts

– Exceptions– The Penalty Zones– Basic integrity of the model– Deficient model accuracy– Intraday trading– Bad luck

Internal Model Approach - VaR

Qualitative Requirements :

• To use IMA, banks need to satisfy Qualitative Requirements

• Robust risk measurement systems in place – must be integrated into Management Decisions

• Conduct Stress Tests regularly

• Independent Risk Monitoring Framework