rd 2 rickert-lambrigger
TRANSCRIPT
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Market Risk Management
a enges un er e
new Basel framework
Philipp Rickert
Partner
Dr. Dominik D. Lambrigger
Mana er
ETH Riskday, 9 September 2011
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What makes a Traders life miserable?
Political challenges
Uncertainty in US and Europe
overe gn e cr s s
Global economy slow down
Market behavior
Increased participant mistrust
Increased competition (chasing the flow)
Cash is King
Low volumes, flight to quality, risk averse
egu a ory response
Risk taking becomes disproportionally capital intense and expensive
Qualitative requirements increase (IT, processes, people)
All that makes the Traders life miserable, because less volume and less risk combined
with higher volatility and higher production costs results in bad P&L and that means
1 2011 KPMG AG/SA, a Swiss corporation, is a subsidiary of KPMG Holding AG/SA, which is a subsidiary of KPMG Europe LLP and a member of the KPMG network of independent firms affiliated with KPMGInternational Cooperative (KPMG International), a Swiss legal entity. All rights reserved. The KPMG name, logo and cutting through complexity are registered trademarks or trademarks of KPMGInternational.
LOWER BONUS!
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Basel III
NOT THIS BASEL THIS BASEL!
2 2011 KPMG AG/SA, a Swiss corporation, is a subsidiary of KPMG Holding AG/SA, which is a subsidiary of KPMG Europe LLP and a member of the KPMG network of independent firms affiliated with KPMGInternational Cooperative (KPMG International), a Swiss legal entity. All rights reserved. The KPMG name, logo and cutting through complexity are registered trademarks or trademarks of KPMGInternational.
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Why Basel III Regulators Views
Why the Financial Crisis
Excess of cheap money and procyclicality of globally important banks
Too little capital of insufficient quality (leverage between 1 to 33 and 1 to 100)
Inadequate liquidity buffers
Purpose
Improve the banking sector's ability to absorb shocks arising from financial and economic
stress, whatever the source Improve risk management and governance
Stren then banks' trans arenc and disclosures
Response
Coverage of risk focus on trading book exposures
Much higher levels of capital
3 2011 KPMG AG/SA, a Swiss corporation, is a subsidiary of KPMG Holding AG/SA, which is a subsidiary of KPMG Europe LLP and a member of the KPMG network of independent firms affiliated with KPMGInternational Cooperative (KPMG International), a Swiss legal entity. All rights reserved. The KPMG name, logo and cutting through complexity are registered trademarks or trademarks of KPMGInternational.
Global liquidity standards
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Capital under Basel Requirement vs Eligibility
Required Capital
.
Available
Capital
Op
Ris
Fixed assets
Tier 3
Abolished
CreditRisk
ankin
Boo
Secured Finance
Retail Loans
Tier 2
Restrictions Basel 2.5:
Tradin Book
Commercial Loans:Banks
CVA
Tier 2
Tier 1
isk
oo
k
CRM
Securitizations
Deductions Basel 3
Market
Tradin
Stressed VAR
IRC
VAR
Tier 1
4 2011 KPMG AG/SA, a Swiss corporation, is a subsidiary of KPMG Holding AG/SA, which is a subsidiary of KPMG Europe LLP and a member of the KPMG network of independent firms affiliated with KPMGInternational Cooperative (KPMG International), a Swiss legal entity. All rights reserved. The KPMG name, logo and cutting through complexity are registered trademarks or trademarks of KPMGInternational.
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socially honest
and adhere to the highest ethical principles,
especially in the face of temptationwhich will come!
5 2011 KPMG AG/SA, a Swiss corporation, is a subsidiary of KPMG Holding AG/SA, which is a subsidiary of KPMG Europe LLP and a member of the KPMG network of independent firms affiliated with KPMGInternational Cooperative (KPMG International), a Swiss legal entity. All rights reserved. The KPMG name, logo and cutting through complexity are registered trademarks or trademarks of KPMGInternational.
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Modeling market risk (Value-at-Risk)
Key elements
Market risk charge = C x VaR99%(V), C 3
10-day holding period
V is the value of the trading book portfolio
Risk Weighted Assets
CVAB III
V = 10-day change of V
ChallengesSecuritization
CRM
Complexity of the portfolio (and hence V ):need sophisticated front office pricing models
Comprehensive scope of risk factors
IRC
Stressed VaRB II.5
.
Responsiveness of VaR
Data quality
Com lexit of risk infrastructureCredit Risk
Op Risk
B II
Backtesting VaRMarket Risk
6 2011 KPMG AG/SA, a Swiss corporation, is a subsidiary of KPMG Holding AG/SA, which is a subsidiary of KPMG Europe LLP and a member of the KPMG network of independent firms affiliated with KPMGInternational Cooperative (KPMG International), a Swiss legal entity. All rights reserved. The KPMG name, logo and cutting through complexity are registered trademarks or trademarks of KPMGInternational.
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The Greeks
A Taylor expansion ofV reduces the problem to the calculation of:
The risk factor changes S and their volatilities(for simplicity assume that there is only 1 risk factor and no specific risk)
The sensitivities (Greeks)
1 22 VVV ...2
,...,2
SS
Delta Vega Gamma
Historical Risk Factor ChangesFront Office Pricing Models
and Cross-Gamma, Vanna, Volga, etc.
(stochastic)(deterministic)
Risk factor VolatilityValue Delta Vega
Delta Gamma Vanna
Vega Vanna Volga
Gamma Speed Zomma
Volga Ultima
7 2011 KPMG AG/SA, a Swiss corporation, is a subsidiary of KPMG Holding AG/SA, which is a subsidiary of KPMG Europe LLP and a member of the KPMG network of independent firms affiliated with KPMGInternational Cooperative (KPMG International), a Swiss legal entity. All rights reserved. The KPMG name, logo and cutting through complexity are registered trademarks or trademarks of KPMGInternational.
For highly non-linear products Taylor might not be appropriate
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Challenges in modelling market risk (1/4)
Banks tend to use full revaluation of the whole portfolio for VaR calculation and stress testing.
Greeks &Taylor
Expansion
Partial
revaluation
Full reval
C o m p l e x i t y
Most banks use historical simulationbased on a 1-5 year dataset
Some banks have the crisis in the VaR
Others have a strong desire to excludethe crisis from the dataset (due to theintroduction of stressed VaR and adouble-counting of the crisis)
8 2011 KPMG AG/SA, a Swiss corporation, is a subsidiary of KPMG Holding AG/SA, which is a subsidiary of KPMG Europe LLP and a member of the KPMG network of independent firms affiliated with KPMGInternational Cooperative (KPMG International), a Swiss legal entity. All rights reserved. The KPMG name, logo and cutting through complexity are registered trademarks or trademarks of KPMGInternational.
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Challenges in modelling market risk (2/4)
How responsive should VaR be in a crisis?
Standard implementation of VaR is typically not very responsive to a crisis, especially if the
.
How can this problem be addressed?
Stressed VaRResponsive VaR
Dual approach
ase . see a er ca ng y mar e vo a y
Weighting of data
9 2011 KPMG AG/SA, a Swiss corporation, is a subsidiary of KPMG Holding AG/SA, which is a subsidiary of KPMG Europe LLP and a member of the KPMG network of independent firms affiliated with KPMGInternational Cooperative (KPMG International), a Swiss legal entity. All rights reserved. The KPMG name, logo and cutting through complexity are registered trademarks or trademarks of KPMGInternational.
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Challenges in modelling market risk (3/4)
Backtesting:
Check erformance of VaR b com arin VaR a ainst PnL
But have 10-day VaR and 1-day PnL?!
Two options:
Scale 10-day VaR down to 1-day VaR: VaR1-day VaR10-day
Re-calculate 1-day VaR (costly)
10/
10 2011 KPMG AG/SA, a Swiss corporation, is a subsidiary of KPMG Holding AG/SA, which is a subsidiary of KPMG Europe LLP and a member of the KPMG network of independent firms affiliated with KPMGInternational Cooperative (KPMG International), a Swiss legal entity. All rights reserved. The KPMG name, logo and cutting through complexity are registered trademarks or trademarks of KPMGInternational.
Source: Credit Suisse Annual Report 2005 -
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Challenges in modelling market risk (3/4)
How many backtesting exceptions per year are acceptable?
um er o excep ons ncrease n e mu p er
4 or less 0.00
5 0.40
6 0.507 0.65
k P(N=k) P(Nk)
N ~ Bin(n=250, p=0.01)
P(N > 4) = 10.8%
8 0.75
9 0.85
10 or more 1.00*
Source: FINMA Market Risk Circular 2008/20
0 0.081 0.081
1 0.205 0.286
2 0.257 0.543
3 0.215 0.758
4 0.134 0.892
5 0.067 0.959
* Any shortcomings must be eradicated without delay, since otherwise the conditions fordetermining capital adequacy requirements according to the model-based approach will
be deemed no longer to be fulfilled.
6 0.027 0.986
7 0.010 0.996
8 0.003 0.9989
Credit Suisse Annual Report 2008: Annual Report 10
- CS:. .
10 0.0002 0.99995
UBS Annual Report 2008:
0 exceptions
- UBS:
1 exception
11 2011 KPMG AG/SA, a Swiss corporation, is a subsidiary of KPMG Holding AG/SA, which is a subsidiary of KPMG Europe LLP and a member of the KPMG network of independent firms affiliated with KPMGInternational Cooperative (KPMG International), a Swiss legal entity. All rights reserved. The KPMG name, logo and cutting through complexity are registered trademarks or trademarks of KPMGInternational.
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Challenges in modelling market risk (3/4)
Alternative backtesting approach:
...)(2
1,...),( 2
2
S
S
VVS
S
VSV
Delta Vega Gamma
Historical Risk Factor Changes(stochastic)
Front Office Pricing Models(deterministic)
Use realized risk factor changes to calculate V Model-based PnL (risk-based PnL)
Backtest model-based PnL against realized PnL
Pros: Model deficiencies detected on a daily basis (dont have to wait for a VaR backtestingexception)
Cons: Non-market risk factors have to be modelled or need good clean PnL data
12 2011 KPMG AG/SA, a Swiss corporation, is a subsidiary of KPMG Holding AG/SA, which is a subsidiary of KPMG Europe LLP and a member of the KPMG network of independent firms affiliated with KPMGInternational Cooperative (KPMG International), a Swiss legal entity. All rights reserved. The KPMG name, logo and cutting through complexity are registered trademarks or trademarks of KPMGInternational.
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Challenges in modelling market risk (4/4)
Invest in human capital
13 2011 KPMG AG/SA, a Swiss corporation, is a subsidiary of KPMG Holding AG/SA, which is a subsidiary of KPMG Europe LLP and a member of the KPMG network of independent firms affiliated with KPMGInternational Cooperative (KPMG International), a Swiss legal entity. All rights reserved. The KPMG name, logo and cutting through complexity are registered trademarks or trademarks of KPMGInternational.
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Basel 2.5
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Incremental Risk Charge (IRC)
Key elements
Default and credit rating migration of trading book positions
99.9% VaR, 1-year holding period
Fixed Income products (mainly plain vanilla bonds and
Risk Weighted Assets
CVAB III
Key inputs are ratings/PDs, LGDs, EADs, credit spreads,migration matrix and liquidity horizonSecuritization
CRM
Challenges
Migration risk modelling
Constant level of risk (and liquidity horizon):IRC
Stressed VaRB II.5
e au e m gra e pos ons ave o e re- a ance
Completeness of positions
Risk data capturing and enrichmentCredit Risk
Op Risk
B II
Structured credits, credit derivativesMarket Risk
15 2011 KPMG AG/SA, a Swiss corporation, is a subsidiary of KPMG Holding AG/SA, which is a subsidiary of KPMG Europe LLP and a member of the KPMG network of independent firms affiliated with KPMGInternational Cooperative (KPMG International), a Swiss legal entity. All rights reserved. The KPMG name, logo and cutting through complexity are registered trademarks or trademarks of KPMGInternational.
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Securitizations and Re-securitizations
Key elements
Capital charge for (re)-securitization positions in tradingbook
Product scope: CDO, CDO^2, RMBS, CMBS, NTD, etc.
Risk Weighted Assets
CVAB III
Corporate CDOs and NTDs can be modelled by CRM (seenext slide)
Specific risks only, general risk through VaRSecuritization
CRM
Challenges
Robustness of methodolo
IRC
Stressed VaRB II.5
Completeness of scope
Completeness of data feeds
Data qualityCredit Risk
Op Risk
B II
Market Risk
17 2011 KPMG AG/SA, a Swiss corporation, is a subsidiary of KPMG Holding AG/SA, which is a subsidiary of KPMG Europe LLP and a member of the KPMG network of independent firms affiliated with KPMGInternational Cooperative (KPMG International), a Swiss legal entity. All rights reserved. The KPMG name, logo and cutting through complexity are registered trademarks or trademarks of KPMGInternational.
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Comprehensive Risk Measure (CRM)
Key elements
Risk Weighted Assets
CVAB III
Capital charge for correlation trading
Product scope: synthetic CDOs (index tranche and bespoke
tranche), nth-to-default and corresponding hedges (e.g.CDS index CDS and bonds
Securitization
CRM All price risk model: default, rating migration, basis risk
(index basis, i.e. basis between index and single names,
correlation basis, e.g. basis between index tranches and
bes oke tranches FX ? and interest rate risk ?
IRC
Stressed VaRB II.5
Challenges
Credit Risk
Op Risk
B II
Very sophisticated models
Large model risk
Scope definition
Market Risk omp e eness o a a ee s
18 2011 KPMG AG/SA, a Swiss corporation, is a subsidiary of KPMG Holding AG/SA, which is a subsidiary of KPMG Europe LLP and a member of the KPMG network of independent firms affiliated with KPMGInternational Cooperative (KPMG International), a Swiss legal entity. All rights reserved. The KPMG name, logo and cutting through complexity are registered trademarks or trademarks of KPMGInternational.
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And beyond market risk?
Dont forget Operational Risk
Advanced Measurement Approach (AMA):
Does having a large Op Risk capital add-on helpto reduce the risk or is it just a regulatory capitaladd-on?
Risk Weighted Assets
CVAB III
,Risk (since 2010, regulators start to care aboutOp Risk again).
The new challenges are the old challenges: dataSecuritization
CRM
, , .
How to combine external, internal data withexpert judgment and scenario analysis? How toestimate correlation between business lines
IRC
Stressed VaRB II.5
oes ma e sense
Does a 99.9% quantile make sense (dont wantto speak about 99.97% economic risk capital)?Credit Risk
Op Risk
B II
re s
A-IRB
and Liquidity Risk
Market Risk
19 2011 KPMG AG/SA, a Swiss corporation, is a subsidiary of KPMG Holding AG/SA, which is a subsidiary of KPMG Europe LLP and a member of the KPMG network of independent firms affiliated with KPMGInternational Cooperative (KPMG International), a Swiss legal entity. All rights reserved. The KPMG name, logo and cutting through complexity are registered trademarks or trademarks of KPMGInternational.
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Basel 3
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Credit Valuation Adjustments (CVA)
Key elements
Risk Weighted Assets
CVAB III
CVA is the Market Value of Counterparty credit risk (CCR)
Not only default of counterparty, but also change in credit
worthiness of counterparty has to be addressed
Securitization
CRM
major counterparty for OTC derivatives
If Bank has an internal VaR model: Advanced CVA
All other Banks: Standardized CVA
IRC
Stressed VaRB II.5 Need to dynamically price CCR
Very costly (infrastructure, resources and capital)
Credit Risk
Op Risk
B II
Challenges
Potentially large capital impact
Methodology and implementation framework not straight-Market Risk
orwar
Securitizing CVA?
21 2011 KPMG AG/SA, a Swiss corporation, is a subsidiary of KPMG Holding AG/SA, which is a subsidiary of KPMG Europe LLP and a member of the KPMG network of independent firms affiliated with KPMGInternational Cooperative (KPMG International), a Swiss legal entity. All rights reserved. The KPMG name, logo and cutting through complexity are registered trademarks or trademarks of KPMGInternational.
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Philipp RickertPartner
Dr. Dominik D. Lambrigger
Audit Financial ServicesKPMG AGBadenerstrasse 172CH-8026 Zrich
[email protected]@kpmg.com