Risk Management

1. Risk Management 陳明道 教授 David M. Chen Graduate Institute of Finance 003924@mail.fju.edu.tw Crouhy, Michel, Dan Galai, and Robert Mark McGraw-Hill, Inc., 2003

2. Ch. 1 The Need for Risk Management Systems • International banking system • Consolidation* over the last 25 years • M&A, globalization • Financial Service Act of 1999 • New products, new markets, new business activities* • Repeal key provisions of the Glass-Steagall Act • Passed during the Great Depression • Prohibits commercial banks from underwriting insurance and most kinds of securities.

3. Repeal key provisions of the Bank Holding Act of 1956 Prohibits M&A of brokerage firms, banks, and insurers. Allows bank holding companies to expand their range of services* and to take advantage of new financial technologies such as web-based e-commerce. Puts brokerage firms and insurers on a par with banks. Changes in industry structure Disintermediation Corporations found it less costly to raise money from the public Reducing profit margins, lending in larger sizes*, longer maturities, and to customers of lower credit quality

4. Tailor-made financial services Customers are demanding more sophisticated and complicated ways to finance their activities, to hedge their financial risks, and to invest their liquid assets. Risk intermediation New market, credit, and operational risks Engaging in risk shifting activities* Managerial emphasis has shifted away from maturity intermediation (term vs. risk spreads). From simplistic profit-oriented management to risk/return management (similar to major corporations). The Federal Reserve Bank (FRB) estimates that in 1996, U.S. banks possessed over $37 tln of off-balance-sheet assets and liabilities; $1 tln only 10 years earlier. Demand better and better expertise and know-how in controlling and pricing the risks.

5. Not by rejecting risk, but by quantifying risk and thus pricing it appropriately. Basle (Switzerland) Committee on Banking Supervision (BCBS) of Bank for International Settlements (BIS) 1988 BIS Accord Required to set aside a flat fixed percentage of banks’ risk-weighted assets (8% corporate loans, 4% uninsured residential mortgages) as regulatory capital against default. Capital adequacy requirements are currently tailored to the needs of traditional bank holding companies. From 1998, required to hold additional regulatory capital against market risk in trading books. New Accord: from 2006, required to hold additional against operational risk: liquidity risk, regulatory risk, human factor risk, legal risk, and many other sources of risk*.

6. Integration (internally developed models) Risk management (RM) becomes an integral part of the management and control process rather than simply a tool to satisfy regulators. Historical evolution Banking regulations Often dictates how financial institutions accommodate risks. Converging and consistent across countries The crash of 1929 and the economic crisis Focused on systematic risk: the risk of a collapse of the banking industry at a regional, national, or international level. In particular, to prevent the domino effect: the chance of a failure by one bank might lead to failure in another, and then another.* 1933 Federal Deposit Insurance Corporation (FDIC) Enhancing the safety of bank deposits.

7. 1933 Glass-Steagall Act Define the playing field for commercial banks Barred from dealing in equity and from underwriting securities (effectively separated commercial and investment banking activities). 1933 Regulation Q Put a ceiling on the interest rate that could be paid on savings account. Reserve requirements encouraged banks to offer checking accounts that did not pay interest.* 1927 McFadden Act Prohibited banks from establishing branches in multiple states (interstate branching) State regulations led to the establishment of many small banks that specialize in a particular local market**. Helped to support natural regional monopolies in the supply of banking services.

8. 1956 Bank Holding Company Act Limited the nonbanking* activities of banks. Felt that if banks expanded into new and risky areas, they might introduce idiosyncratic risk, or specific risk, that would affect the soundness of the whole banking system. Reduced both the risk and competition Banking environment From World War II to 1951 Interest rates had been pegged 釘住and were not used as a tool in the monetary policy of the Federal Reserve. Interest rates were stable over an extended period of time, with only small changes occurring from time to time. 1944 Bretton Woods Agreement International foreign exchange rate were artificially人為fixed.

9. Central banks intervened whenever necessary to maintain stability. Exchange rates were changed only infrequently, with the permission of the World Bank and the International Monetary Fund (IMF). They usually required a country that devalued its currency to adopt tough economic measures in order to ensure the stability of the currency in the future. From 1951 The governments of developed economies had begun their slow but consistent withdrawal from their role as insurers or managers of certain risks*. Broke down of the regime of fixed exchange rates from the late 1960s Due to global economic forces including a vast expansion of international trading and inflationary pressure in the major economies. The hitherto obscured volatility surfaced in traded foreign currencies, precipitated a string of novel financial contracts.

10. In 1972 the Chicago Mercantile Exchange (CME) created the International Monetary Market (IMM) to specialize in foreign currency futures and options on futures on the major currencies. In 1982 the Chicago Board Options Exchange (CBOE) and the Philadelphia Stock Exchange introduced options on spot exchange rates. Interest rates became more volatile, intensified in the 1970s and 1980s*. The increase in inflation and the advent of floating exchange rates soon began to affect interest rates. Volatility grew substantially from the early 1980s onwards, after the FRB under chairman Paul Volcker decided to use money supply as a major policy tool. Rates were able to react to changes in the money supply without prompting interference from the Fed.

11. The first traded futures on the long-term bonds issued by the Government National Mortgage Association (GNMA) appeared in October 1975 on the Chicago Board of Trade (CBOT), then futures on Treasury bonds in August 1977, futures on Treasury notes in May 1982, and options on Treasury bonds futures in October 1982. The CBOE introduced options on Treasury bonds in the same month. The CME added futures on Treasury bills in early 1976, futures on Eurodollars in 1981, options on Eurodollar futures in March 1985, and on Treasury bill futures in April 1986. Banks introduced the interest rate swap in 1982 and forward rate agreements (FRAs) in early 1983. BIS survey of derivative markets, starting April 1995, repeated every quarter, OTC notional amount from over $47 tln end-March 1995 to over $80 tln end-December 1998.

12. OTC gross market value from $2.2 tln to $3.23 tln. OTC Daily turnover from $839 bln April 1995 to $ 1,226 bln April 1998. In April 1998, daily turnover of interest contracts are $275 bln in the OTC markets and $1,361 bln on exchanges. The situation is completely different in the case of foreign currency contracts, $990 bln OTC and $12 bln exchanges. Non-financial firms engaged in a daily volume of $168 bln in OTC foreign currency products, but traded only a volume of $27 bln in OTC interest rate products. Rapid changes in global markets Creation of large multinational corporations

13. Technological change in the form of computerized information system Both offered incentive to merge banks to exploit economies of scale and be better placed to serve the changing needs of global clients. Mergers and globalization continuing through the 1990s among nonbank corporations. Regulatory bodies also became more willing to allow competition on a global scale, foreign banks were allowed to operate in local markets, both directly and by acquiring local banks.* This quickening process of globalization exposes banks and other corporations to ever-greater foreign currency and interest rate risk, such as the risks associated with cross-border fund raising.

14. Regulatory environment 1980 DIDMCA The Depository Institutions Deregulation and Monetary Control Act Marked a major change in regulatory philosophy in the U.S. Deregulation of the banking system and the liberalization of the economic environment in which banks operate. Initiated a six-year phase-out period for Regulation Q, allow commercial banks to pay interest on accounts with withdrawal rights (NOW accounts) 1982 DIA Garn-St. Germain Depository Institution Act

15. Allows banks to offer money market deposit accounts and the super-NOW accounts (pay money market interest but offered limited check-writing privileges). By the late 1970s (inflation) and early 1980s, the numbers of failed institutions (thrift and savings banks) increased substantially. The main reason was an economic squeeze on banks that held sizable fixed-rate loan portfolios and which had financed these portfolios by means of short-term instruments*. Before it was changed*, Regulation Q helped to drive small depositors away from such banks, they turned instead to market traded instruments, money market accounts, and NOW accounts. The charter of such banks prevent them from using derivatives to deal with maturity mismatch.

16. The 1988 BIS Accord The push to implement RM systems, ironically, came primarily from the regulators. The story of bank regulation since the 1980s has been one of an ongoing dialogue between the BIS and commercial banks all over the world. The Bank of England and the Federal Reserve Bank, concerned about the growing exposure of banks to off-balance-sheet claims, coupled with problem loans to third-world countries, their response, first of all, was to strengthen the capital requirements. In addition, they proposed translating each off-balance-sheet claim into an equivalent on-balance-sheet item. Secondly, they attempted to create a level playing field by proposing that all international banks should adopt the same capital standard and the same procedures.

17. While the regulatory bodies initiated the process and drew up the first set of rules, they have accepted that sophisticated banks should have a growing role in the setting up of their own internal RM models. With the principles set and the course defined, the role of the regulators has begun to shift to that of monitoring sophisticated bank’s internal RM system. July 1993 G-30 study Was the first industry-led and comprehensive effort to broaden awareness of advanced approaches to RM. Provide practical guidance in the form of 20 recommendations, addressed to dealers and end-users alike, in terms of managing derivative activities.

18. Academic background and technological changes Fundamental theories Markowitz, Sharpe, Lintner, Modigliani, Miller, Black, Scholes, Merton Background courses Implementation Reliable, broad, and up-to-date data bases concerning both the bank’s transactional positions and the financial rates available in the wider market place. Statistical tools and procedures that allow the bank to analyze the data To assess the net risk exposure daily, a bank must bring together data from a multiplicity of legacy systems with different data structures, from all of its branches and business worldwide.

19. Estimates of volatilities and correlations of major risk form key inputs into the pricing model used to assess the risks inherent in the various financial claims. In reaction to evidence that volatility in financial markets may be nonstationary, researchers have begun to make use of increasingly sophisticated procedures such as ARCH, GARCH, and other extensions. Accounting systems Backward looking Past profits or losses are calculated and analyzed, but future uncertainties are not measured at all. Off-balance-sheet As the GAAP could not easily accommodate derivatives, the instruments have largely appeared in the footnotes.

20. The end result is that true risk profile is unclear from financial reports. Problem loans of March 31, 1998 Under conventional accounting practices in Japan as compared to the new proposed measurement standard, for the largest nine banks, the average understatement is 42% (29% to 62%).* Forward looking Two dimensional system Ideally the financial world would create a new reporting system base on what might be called “Generally Accepted Risk Principles”. Compromise between accuracy and sophistication, on the one hand, and applicability and aggregation (standard deviations are non-additive) on the other. Simply translating each off-balance-sheet claim to its on-balance-sheet equivalent, and then adding up these individual claims, would hugely overstate the real position and impose a significant cost on banks.

21. Lessons from financial disasters Causes Bad debts Major cause since modern banks began to evolve in the seventeenth century. The key weakness was that credit risk was evaluated on a case-by-case basis. Correlation risk was often ignored*. Market exposures Some spectacular bank failure over the last 25 years generated by derivative positions. Correlation between credit, market and liquidity risks Predictably, high interest rate leads to low value and low liquidity of real estate, which leads to default, then leads to low interest rate.

22. The near-collapse of Long-Term Capital Management (LTCM) in 1998 highlight the risks of high leverage to an individual institution. It also showed how problems in one institution might spill over into the entire financial system when, simultaneously, market prices fall and market liquidity dries up, making it almost impossible for wounded institution to unwind their positions in order to satisfy margin calls*. The industry as a whole is looking at how the relationship between liquidity risk, leverage risk, and market and credit risk can be incorporated in risk measurement and stress testing models. No model offers a panacea to the problem of substantial changes in default rates, interest rates, exchange rates, and other key indexes over a short time period. Increasingly, bank recognize they must subject their positions to stress analysis to measure their vulnerability to unlikely but possible market scenarios.

23. Operating risk The downfall of Barings in February 1995 bore witness to the failing of senior managers. They lacked the ability to monitor trading activities effectively. Due to a disregard for RM procedures A first principle is that the assessment of risk and control over tracking transactions must be independent of trading function. Must scrutinize success stories in order to evaluate the risks incurred. The treasurer of the Orange County, California, borrowed heavily and invested in MBSs, only to incur losses of over $1.6 bln when the cost of borrowing rose (1994). Showed excellent result at first.

24. Typology of risk exposure Market risk The risk that changes in financial market prices and rates will reduce the value of the bank’s position. Often measured relative to a benchmark index, referred to the risk of tracking error. Also includes basis risk: the chance of a breakdown in the relationship between the price of a product and the price of the instrument used to hedge that price exposure. Components of market risk: directional risk, convexity risk, volatility risk, basis risk, etc.

25. Credit risk The risk that a change in the credit quality of a counterparty will affect the value. Only when the position is an asset, i.e., positive replacement cost. Yet it can be negative at one point in time and become positive at a later point. Must examine the profile of future exposure up to the termination of the deal. Default, whereby a counterparty is unwilling or unable to fulfill its contractual obligation in the extreme case.* Counterparty might be downgraded by a rating agency (credit spread). The value it is likely to recover is called the recovery value; the amount it is expected to lose is called loss given default (LGD).

26. Liquidity risk Funding liquidity risk Relates to a financial institution’s ability to raise the necessary cash, to roll over its debt, to meet the cash, margin, and collateral requirements of counterparties, and to satisfy capital withdrawals (mutual funds). Affected by various factors such as the maturity of liabilities, the extent of reliance on secured sources of funding, the terms of financing, and the breadth of funding sources, including the ability to access public markets such as the commercial paper market. Also influenced by counterparty arrangements, including collateral trigger clause, the existence of capital withdrawal rights, and the existence of lines of credit that the bank cannot cancel. Funding can be achieved through buying power: the amount a trading counterparty can borrow against asset under stressed market conditions.

27. Trading related liquidity risk Often simply called the liquidity risk, is the risk that an institution will not be able to execute a transaction at the prevailing market price, because there is, temporarily, no appetite for the deal on the “other side” of the market. Operational risk Fraud A trader or other employee intentionally falsifies and misrepresents the risk incurred in a transaction. Technology risk Principally computer systems risk Human factor risk Losses that may result from human error such as pushing the wrong button*, inadvertently destroying a file, or entering the wrong value for the parameter input of a model.

28. Model risk The valuation of complex derivatives* Legal risk A counterparty might lack the legal or regulatory authority to engage in a transaction. Usually only become apparent when a counterparty, or an investor, loses money on a transaction and decided to sue the bank to avoid meeting its obligation. The potential impact of a change in tax law on the market value of a position.

29. Equity General Trading Interest Rate Specific Market Gap Currency Commodity Financial Risks Issue Transaction Credit Issuer Concentration Counterparty Funding Liquidity Trading

30. Nonfinancial corporations RM Purpose To identify the market risk factors that affect the volatility of their earnings, and to measure the combined effect of these factor. There is mounting pressure from regulators such as the SEC and from shareholders for more and better disclosure of financial risk exposures. RM techniques are now being adopted by firms such as insurance companies, hedge funds, and industrial corporations. Generally need to look at risk over a longer time Must look at how to combine the effects of their underlying business exposures with those of any financial hedges. The effects of risk on planning and budgeting must be considered.

31. Often do not possess a formal system to monitor general corporate risks and to evaluate the impact of their various attempts to reduce risks.* There is little in the way of a unified approach to corporate RM. Generally not regulated with the intensity seen in financial institutions, because the main risk is business risk; domino effect is not a major concern; not as heavily leveraged (D/E 30%); and the leverage is primarily of concern to the firm’s creditor. Yet, daily average turnover in OTC derivatives increased from $129 bln in April 1995 to $195 bln in April 1998. The trend in many countries is to demand greater transparency with regard to RM policies and strategies.

32. International Convergenceof Capital Measurementand Capital Standards:A Revised Framework Basel Committee on Banking Supervision Bank for International Settlements June 2006 (comprehensive version)* 陳明道 教授 David M. Chen Graduate Institute of Finance

33. Content • Introduction • Development of the new framework • Part 1: Scope of application • Part 2: The First Pillar • Minimum capital requirements • Regulatory Capital • Credit risk: the standardized approach

34. Introduction • Development of the new framework • To secure international convergence on revisions to supervisory regulations governing the capital adequacy of internationally active banks (IABs). #1 • The first round of proposals June 1999. • An extensive consultative process was set in train in all G-10 member countries* and the proposals were also circulated to supervisory authorities worldwide. • Additional proposals for consultation in January 2001 and April 2003. • Three quantitative impact studies.

35. Implementation timetable Intend to be available for implementation as of year-end 2006. #2 One further year of impact studies or parallel calculations will be needed for the most advanced approaches (2007). Non-G10 countries #3 Each national supervisor should consider carefully the benefits of the revised Framework in the context of its domestic banking system when developing a timetable and approach to implementation. Fundamental objective Further strengthen the soundness and stability of the international banking system

36. While maintaining sufficient consistency that capital adequacy regulation will not be a significant source of competitive inequality. Main features Promote the adoption of stronger RM practices Take into account changes in banking and RM practices. #4 More risk-sensitive capital requirements that are conceptually sound and at the same time pay due regard to particular features of the present supervisory and accounting systems in individual member countries. #5 Greater use of assessments of risk provided by banks’ internal systems as inputs to capital calculations (a detailed set of minimum requirements designed to ensure the integrity of these internal risk assessments). #6

37. Provide a range of options for determining the capital requirements for credit risk and operational risk. Allow for a limited degree of national discretion in the way in which each of these options may be applied, to adapt the standards to different conditions of national markets. An Accord Implementation Group (AIG) was established to promote consistency in application by encouraging supervisors to exchange information on implementation approaches. #7

38. Has issued general principles for the cross-border implementation and more focused principles for the recognition of operational risk capital charges under advanced measurement approaches for home and host supervisors. #8 Where a jurisdiction employs a supplementary capital measure (such as a leverage ratio or a large exposure limit)#9 in conjunction with the measure set forth in this Framework, in some instances the capital required under the supplementary measure may be more binding. More generally, under the second pillar, supervisors should expect banks to operate above minimum regulatory capital levels.

39. Interactions between regulatory and accounting approaches at both the national and international level #12 can have significant consequencesfor the comparability of the resulting measures of capital adequacy and for the costs associated with the implementation of these approaches. The decisions with respect to unexpected and expected losses represent a major step forward in this regard. Intend to continue playing a pro-active role in the dialogue with accounting authorities in an effort to reduce inappropriate disparities between regulatory and accounting standards. Has sought to clarify its expectations regarding the need for banks using the advanced IRB approach to incorporate the effects arising from economic downturns into their loss-given-default (LGD) parameters. #13

40. A more forward-looking approach that has the capacity to evolve with time. #15 • In July 2005, the Committee published additional guidance developed jointly with the International Organization of Securities Commissions (IOSCO). • It refined the treatments of counterparty credit risk, double default effects, short-term maturity adjustment and failed transactions, and improved the trading book* regime. #16 • Intend to undertake additional work of a longer-term nature in relation to the definition of eligible capital. • Will ultimately require the identification of an agreed set of capital instruments that are available to absorb unanticipated losses on a going-concern basis. #17

41. Content Part 1: Scope of Application Part 2: The First Pillar – Minimum Capital Requirements I. Calculation of Minimum Capital Requirements (Constituents of capital) II. Credit Risk – The Standardized Approach III. Credit Risk – The Internal Ratings-Based Approach IV. Credit Risk – The Securitization Framework V. Operational Risk VI. Market Risk Part 3: The Second Pillar – Supervisory Review Process Part 4: The Third Pillar – Market Discipline

42. Part 1: Scope of application IABs(consolidated basis) Banking, securities, and other financial subsidiaries (consolidated basis) Significant minority investments in banking, securities, and other financial entities (deduction) Insurance entities (deduction) Significant investments in commercial entities (deduction) Deduction of investments (50% tier 1)

43. Where deductions of investments are made pursuant to this part on scope of application, the deductions will be 50% from Tier 1 and 50% from Tier 2 capital. #37 Goodwill relating to entities subject to a deduction approach pursuant to this part should be deducted from Tier 1 in the same manner as goodwill relating to consolidated subsidiaries. A similar treatment of goodwill should be applied, if using an alternative group-wide approach with respect to insurance entities. #38 The limits on Tier 2 and Tier 3 capital and on innovative Tier 1 instruments will be based on the amount of Tier 1 capital after deduction of goodwill but before the deductions of investments pursuant to this part. #39

44. Part 2: The First Pillar • Minimum capital requirements • For credit, market and operational risk. • The capital ratio is calculated using the definition of regulatory capital and risk-weighted assets. #40 • The total capital ratio must be no lower than 8%. • Tier 2 capital is limited to 100% of Tier 1 capital. • The definition of eligible regulatory capital, • as outlined in the 1988 Accord and clarified in the 27 October 1998 press release*, remains in place except for the modifications as to the deduction of investments (#37-39) and #43. #41

45. Risk-weighted assets Total risk-weighted assets are determined by multiplying the capital requirements for market risk and operational risk by 12.5 and adding the resulting figures to the sum of risk-weighted assets for credit risk. The Committee may apply a scaling factor in order to broadly maintain the aggregate level of minimum capital requirements, while also providing incentives to adopt the more advanced risk-sensitive approaches of the Framework.* The scaling factor is applied to the risk-weighted asset amounts for credit risk assessed under the IRB approach. #44

46. Transitional arrangements For banks using the IRB approach for credit risk or the Advanced Measurement Approaches (AMA) for operational risk, there will be a capital floor following implementation of this Framework. Banks must calculate the difference between (i) the floor and (ii) the reference amount (#47). If the floor amount is larger, banks are required to add 12.5 times the difference to risk-weighted assets. #45 The capital floor is based on application of the 1988 Accord. It is derived by applying an adjustment factor to: (i) 8% of the risk-weighted assets, (ii) plus Tier 1 and Tier 2 deductions, and (iii) less the amount of general provisions that may be recognized in Tier 2. #46

47. The Adjustment Factor *The foundation IRB approach includes the IRB approach to retail.

48. In the years in which the floor applies, banks must also calculate the reference amount (i) 8% of total risk-weighted assets as calculated under this Framework, (ii) less the difference between total provisions and expected loss amount (#374 to #386), and (iii) plus other Tier 1 and Tier 2 deductions. Where a bank uses the standardized approach to credit risk for any portion of its exposures, it also needs to exclude general provisions that may be recognized in Tier 2 for that portion from the reference amount. #47 Should problems emerge during this period, the Committee will seek to take appropriate measures to address them, and, in particular, will be prepared to keep the floors in place beyond 2009 if necessary. #48

49. The Committee believes it is appropriate for supervisors to apply prudential floors to banks that adopt the IRB approach for credit risk and/or the AMA for operational risk following year-end 2008. For banks that do not complete the transition to these approaches in the years specified in #46, it is appropriate for supervisors to continue to apply prudential floors to provide time to ensure that individual bank implementations of the advanced approaches are sound. However, floors based on the 1988 Accord will become increasingly impractical to implement over time and therefore supervisors should have the flexibility to develop appropriate bank-by-bank floors, subject to full disclosure of the nature of the floors adopted. Such floors may be based on the approach the bank was using before adoption of the IRB approach and/or AMA. #49

50. Credit risk: the standardized approach Based on external credit assessments #50 by external credit assessment institutions (ECAIs) recognized as eligible for capital purposes by national supervisors. Banking book exposures should be risk-weighted net of specific provisions. Exposures that are not explicitly addressed will retain the 1988 Accord treatment. Exposures related to securitisation are dealt with under the securitization framework. The credit equivalent amount of Securities Financing Transactions (SFT) and OTC derivatives is to be calculated under the rules set out for counterparty credit risk (CCR). #52