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Financial Risk Management 2

Financial Risk Management 2. Zvi Wiener 02-588-3049 http://pluto.mscc.huji.ac.il/~mswiener/zvi.html. Regulation of Financial Intermediaries. take deposits, give loans very small equity capital, big leverage FDIC, CDIC, Israel - implicit domino effect

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Financial Risk Management 2

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  1. Financial Risk Management 2 Zvi Wiener 02-588-3049 http://pluto.mscc.huji.ac.il/~mswiener/zvi.html BoI-2001

  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%) FRM-2

  3. 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 FRM-2

  4. 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 FRM-2

  5. 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. FRM-2

  6. 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 FRM-2

  7. G-30 policy recommendations • Independent risk management • Practices by end-user • Measuring credit exposure • Master agreements • Credit enhancements • Promoting enforceability • Professional expertise FRM-2

  8. G-30 policy recommendations • Systems • Authority • Accounting practices • Disclosures • Recognizing netting • Legal and regulatory uncertainty • Tax treatment • Accounting standards FRM-2

  9. 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 FRM-2

  10. 1988 BIS Accord risk 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. FRM-2

  11. 1988 BIS Accord The 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. FRM-2

  12. Weights in Cooke ratio On-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. FRM-2

  13. 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 FRM-2

  14. Cooke ratio • Banks are required to maintain capital equal to at least 8% of their total risk weighted assets. (In Israel 9%.) FRM-2

  15. 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. FRM-2

  16. 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 FRM-2

  17. 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. FRM-2

  18. New proposals • BIS 2000 • VaR based approach to credit risk. • CreditMetrics • CreditRisk+ • KMV • Merton. FRM-2

  19. New Approach Three pillars A. Minimum Capital Requirement B. Supervisory Review Process C. Market Discipline Requirements FRM-2

  20. RM functions Zvi Wiener 02-588-3049 http://pluto.mscc.huji.ac.il/~mswiener/zvi.html BoI-2001

  21. Structuring RM functions • Set firm-wide policies • Develop methodology • Set RM structure • Risk communication FRM-2

  22. Integrated Risk Management Limit Management Risk Analysis RAROC Active Risk Management Allocate capital Stress Market, Credit VaR Monitor Identify and avoid FRM-2

  23. RAROC • Risk Adjusted Rate of Return • Performance measurement • Marginal impact of any new transaction • Consistent pricing FRM-2

  24. New Approach Three pillars A. Minimum Capital Requirement B. Supervisory Review Process C. Market Discipline Requirements FRM-2

  25. Goals and Instruments • Risk Tolerance - “worst loss” • Stop losses • Capital allocation • Credit risk policy • Operational risk policy FRM-2

  26. Risk Measurement • Consistent market based method • Old • limits • duration, ALM • VaR + Stress • Backtesting FRM-2

  27. Systems • Data bases • market • position • rules • Risk measuring tool • Reports and decision support FRM-2

  28. IT - Information Technology • Unifying information from various units • Unifying information from various markets • Unifying information for various ownership • Back office and execution control FRM-2

  29. Organizational structure • Front office • Middle office • Back office FRM-2

  30. Front office • execution • risk taking • marketing FRM-2

  31. Middle office • risk management • pricing • economic forecasts FRM-2

  32. Back office • verification • booking • reporting • collection • settlement FRM-2

  33. ALCO • Assets Liability management committee • responsible for • establishing • documenting • enforcing all policies involving market risk • FX • liquidity • interest rate FRM-2

  34. Interdependence of RM Trading Room Senior Management Operations Risk Management Finance FRM-2

  35. Senior management • Approves business plan and targets • Sets risk tolerance • Establishes policy • Ensures performance FRM-2

  36. Trading Room Management • Establishes and manages risk exposure • Ensures timely and accurate deal capture • Signs off on official P&L FRM-2

  37. Operations • Books and settles the trades • Reconciles front and back office positions • Prepares and decomposes daily P&L • Provides independent MTM • Supports business needs FRM-2

  38. Finance • Develops valuation and finance policy • Ensures integrity of P&L • Manages business planning process • Supports business needs FRM-2

  39. Risk Management • Develops risk policies • Monitors compliance to limits • Manages ALCO process • Vets models and spreadsheets • Provides independent view on risk • Supports business needs FRM-2

  40. Risk Limits • Global risk limit • Risk limits for trading desks/units • Dynamic monitoring and adjustment FRM-2

  41. Risk Approaches • Accounting - reported P&L • Economic - value • Liquidity needs FRM-2

  42. Liquidity Rank • Based on forecasts and potential availability of funds. • Hot funds - can be withdrawn quickly. • Stable funds - typically to maturity. FRM-2

  43. Israel 339 • Definitions of risk types • Relates to all banking institutions • Management structure • Exposure document • Directors and policy • Risk manager • Internal audit FRM-2

  44. Israel 339 • IR risk • Market risk • Risk audit unit FRM-2

  45. Israel 341 • Capital requirements against market risk • Risk measurement • Trading portfolio • Reporting • Examples of standard approach and VaR FRM-2

  46. Israel 341 • Capital requirements against market risk • Risk measurement • Trading portfolio • Reporting • Examples of standard approach and VaR FRM-2

  47. 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 FRM-2

  48. 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 FRM-2

  49. Types of Assets and Risks • Real projects - cashflow versus financing • Fixed Income • Optionality • Credit exposure • Legal, operational, authorities FRM-2

  50. 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 FRM-2

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