Transcript ASSET-LIABILITY MANAGEMENT SYSTEM
Risk Management in Banks
[Module B] Live Interactive Learning Session [16-04-2007]
Presentation by S P Dhal, Faculty Member, SPBT College
What is Risk?
• Risk is the probability that the realized return would be different from the anticipated/expected return on investment .
• Risk is a measure of likelihood of a bad financial outcome.
• All other things being equal risk will be avoided.
• All other things are however not equal and that a reduction in risk is accompanied by a reduction in expected return.
What is Risk?
The uncertainties associated with risk elements impact the net cash flow of any business or investment. Under the impact of uncertainties, variations in net cash flow take place. This could be favourable or un favourable. The un-favaourable impact is ‘RISK’ of the business.
Anatomy of Bank Risk
Non-Financial Risk Financial Risk Business Risk Strategic Risk Delivery (of Financial Services) Risk Balance Sheet Risk Operational Risk Legal Risk Reputational Risk
Balance Sheet Risk
Credit Risk Concentration Risk Intrinsic Risk Interest Rate Risk Liquidity Risk Currency Risk
Market Risk
Commodity Risk
Interest Rate Risk
Price Risk Reinvestment Risk Yield Curve Risk Basis Risk Gap Risk
Risk in Traditional Sense
Systematic Risks
Affects all Industry/ All securities Non-controllable Non-diversifiable
Unsystematic Risks
Affects specific Industry/ Specific Securities Controllable Diversifiable
Risk in Banking Business
Banking business is broadly grouped under following major heads from Risk Management point of view: 1. The Banking Book 2. The Trading Book 3. Off-Balance-sheet Exposures
The Banking Book
All assets & liabilities in ‘banking book’ have following characteristics: 1. They are normally held until maturity 2. Accrual system of accounting is applied Since assets & liabilities are held till maturity, their mismatch may land the bank in either excess cash in-flow or shortage of cash on a particular time. This commonly known as ‘Liquidity Risk’.
The Banking Book
Due to change in interest rates, assets and liabilities are subjected to interest rate risk on their maturities/re-pricing.
Further, the assets side of the banking book generates credit risk arising from defaults in payment of interest and or installments by the borrowers.
In addition to all these risk, banking book also suffers from ‘Operational Risk’.
The Trading Book
The trading book includes all the assets that are held with intention of trading that are marketable. They are normally held for a short duration and positions are liquidated in the market. Trading Book assets include investment held under ‘Held for Trading’ category.
They are subjected to Market Risk and are marked to market.
Off-Balance-Sheet Exposure
• Off-balance sheet exposure is contingent in nature- Guarantees, LCs, Committed or back up credit lines etc.
• A contingent exposure may become a fund-based exposure in Banking book or Trading book. It is known as Call Risk • Therefore, Off-balance sheet exposures may have liquidity risk, interest rate risk, market risk, credit or default risk and operational risk
RISKS IN BANKING
• • •
Risk is inherent in Banking Banking is not avoiding risks but managing it Risks in banking can be of Broadly 3 types:
– – –
Credit Risk Market Risk Operational Risk ALM addresses to Market Risks
Risk Management in Banks & Basel Accord –I, 1988
In 1988, Basel Committee on Banking Supervision, published a framework for a minimal capital requirement for credit exposure. The bank books were classified into 5 buckets i.e. grouped under 5 categories according to credit risk weights of zero, ten, twenty, fifty and one hundred percent.
Assets required to be classified into one of these risk buckets based on the parameter of counter party.
Banks required to hold capital equal to 8% of the risk-weighted value of assets. In India, the minimum capital requirement is 9% as decided by RBI.
1996 Amendment to include Market Risk
In 1996, BCBS published an amendment to provide an explicit capital cushion for ‘Market Risk’ to which banks are exposed.
Market Risk is the risk of adverse deviations of the marked-to-market value of the assets due to market movements as a result of change in interest rates, market price or exchange rate.
Basel II Accord- Need & Goals
Linking of risks with capital in terms of Basel Accord I needed a revision for the following reasons: - Credit assessment under Basel I is not risk sensitive enough. ‘One Suit fit all’ approach was applied to all types of entities with uniform 100% risk weightage.
- Risk arising out of operation were ignored though it has potential of affecting the bank’s survival.
Basel Accord II
The Basel II Accord is based on three pillars: • Minimum Capital Requirement • Supervisory review process & • Market discipline
The New Basel Capital Accord
Three Basic Pillars Minimum Capital Requirement Supervisory Review Process Market Discipline Requirements
Minimum Capital Requirement Pillar One
Standardized Credit Risk Internal Ratings Credit Risk Models Credit Mitigation Risks Market Risk Trading Book Banking Book Other Risks Operational Other
1. Minimum Capital Requirements Credit Risk (Pillar One)
• Standardized approach (External Ratings) • Internal ratings-based approach •
Foundation approach
•
Advanced approach Minimum Capital Requirement
• Credit risk modeling (Sophisticated banks in the future)
Evolutionary Structure of the Accord
Credit Risk Modeling ?
Advanced IRB Approach Foundation IRB Approach Standardized Approach
The New Basel Capital Accord
Standardized Approach
• • • • •
Provides Greater Risk Differentiation than 1988 Risk Weights based on external ratings Five categories
[0%, 20%, 50%, 100%, 150%]
The loans considered past due be risk weighted at 150 percent unless a threshold amount of specific provision has already been set aside by the bank against the loan Special treatment for ‘Retail’ & ‘SME’ sectors
Standardized Approach: New Risk Weights (January 2001)
Assessment Claim AAA to AA A+ to A- BBB+ to BBB BB+ to BB (B-) Below BB Un-rated (B-) Sovereigns Banks Option 1 1 Option 2 2 0% 20% 20% 20% 50% 50% 3 50% 100% 50% 3 100% 100% 100% 3 150% 150% 150% 100% 100% 50%3 Corporates 20% 50% (100%) 100% 100% 150% 100% 1 Risk weighting based on risk weighting of sovereign in which the bank is incorporated.
2 Risk weighting based on the assessment of the individual bank.
3 receive a weighting that is one category more favourable than the usual risk weight on the bank’s claims
The New Basel Capital Accord
Capital for Credit Risk Internal Rating Based Approach:
•
Three elements:
–
Risk Components [PD, LGD, EAD]
–
Risk Weight conversion function
–
Minimum requirements for the management of policy and processes
–
Emphasis on full compliance
–
EL (Expected Loss) = PDxLGDxEAD Definitions; PD = Probability of default LGD = Loss given default EAD = Exposure at default Note: BIS is Proposing 75% for unused commitments EL = Expected Loss
Standardized Approach verses IRB Approach
Internal rating system & Credit VaR New standardized model 16 12 PER CENT 8 1.6
S & P : 0
1 2 3 4
RATING
4.5
5 5.5
6 6.5
7
The New Basel Capital Accord
Market Risk:
(a)
Standardised Method
(i) Maturity Method (ii) Duration Method (b)
Internal Models Method
What is Operational Risk?
• Earlier stood for non-financial risks • Current Basel II definition is “
the risk of loss resulting from inadequate or failed internal processes, people and systems or from
external events
”
Basel II definition
Cont…
– Includes both internal and external event risk – Legal risk is also included, but reputational risk not included – Direct losses are included, but indirect losses (opportunity costs) are not
Examples of OR Loss Events Types of OR* Examples Internal Fraud External Fraud Employment Workplace Safety Clients, Products & Business Practices Damage to Physical Assets Business Practices Disruption System Failures &
•
Unauthorized transaction resulting in monetary loss
•
Embezzlement of funds
•
Branch robbery
•
Hacking damage (systems security)
•
Employee discrimination issues
•
Inadequate employee health or safety rules
•
Money laundering
•
Lender liability from disclosure violations or aggressive sales
•
Natural disasters, e.g. earthquakes
•
Terrorist activities and
•
Utility outage (e.g. blackout) Execution, Delivery Process Management &
•
Data entry error
•
Incomplete or missing legal documents
•
Disputes with vendors/outsourcing * Based on Basel Committee’s OR loss event classification
The New Basel Capital Accord
Capital Charge for Operational Risk
As in credit, three alternate approaches are prescribed: Basic Indicator Approach Standardised Approach Advanced Measurement Approach
1). Basic Indicator Approach (Capital Charge for Operational Risk)
To begin with, RBI has advised bank to follow Basic Indicator Approach in India which is 15% of the average Gross Income over three year.
K BIA = [ ∑ (GI*
) ] / n, Where K BIA = the capital charge under the Basic Indicator Approach.
GI
= = annual gross income, where positive, over the years previous three 15% set by the Committee, relating the industry-wide level of required capital to the industry-wide level of the indicator.
n = number of the previous three years for which gross income is positive Gross income
= Net profit (+) Provisions & Contingencies (+) operating expenses (Schedule 16) (-) profit on sale of HTM investments (-) income from insurance (-) extraordinary / irregular item of income (+) loss on sale of HTM investments.
2).
Standardized Approach (the betas) Capital = b*gross income, by business line
• Standardized / Alternative Standardized – –
Bank’s activities divided (‘mapped’) into 8 business lines Capital charge is sum of specified % (‘beta’) of each business line’s average annual gross income over previous 3 years*
– –
Beta varies by business line (12%-18% range) General criteria required to qualify for its use
•
Active involvement of Board and senior management in OR management framework
• •
Existence of OR management function, reporting and systems Systematic tracking of OR data (including losses) by business line
•
OR processes and systems subject to validation and regular independent review by internal and external parties
Advantages/ Disadvantages
Strength:
• Simplicity
Limitations:
– Blunt charge, not risk-sensitive: • One size fits all • Risk does not increase linearly with gross income – Fails to capture effect of bank’s management of operational risk • No incorporation of qualitative factors • No incentive for banks to invest in op risk infrastructure
3) Advanced Measurement Approach (AMA) (Capital Charge for Operational Risk)
–
Capital = firm specific calculation, statistically based methodology
–
Intended to overcome the lack of risk sensitivity in the simpler approaches by setting regulatory capital based on the bank’s internal risk measurement models
–
These models use the bank’s own metrics to measure operational risk, internal loss data, external loss experience, scenario analysis, and risk mitigation techniques to set capital commensurate with the operational risk posed by the bank’s activities
ADVANTAGE
COMPARING OPERATIONALRISK WITH MARKET RISK AND CREDIT RISK
Market Risk Credit Risk Operational Risk Quantifiable exposure Exposure measure Portfolio completeness Context dependency Data frequency Yes Position; Risk sensitivity Known Low Yes Money lent; Potential exposure Known Medium Difficult Difficult – no ready position equivalent available 1 Unknown High 1 Risk assessment Accuracy Testing Usage issues Summary High Medium VAR; Stress testing; Economic risk capital Good Adequate data for backtesting Instability of underlying price volatility; Correlation instability in stressed markets Market risk models well established and proven tools Rating models; Loss models; Economic risk capital Reasonable Backtesting difficult to perform over short term Many issues: correlations, ratings through time, data lumpy Using models considered reasonable – but should be used with care Low No industry consensus; top-down scenarios may be useful Low Results very difficult to test over any time horizon Results could be misleading; distraction effect; false reliance; lack of cause and effect; redundant systems Models appear flawed
New Basel Accord II: supervisory review process-
• Defines the role of supervisors with regard to capital adequacy
Pillar II
New Basel Accord II: Market Discipline
• Disclosure requirements that allow market participants to assess key information about a bank’s risk profile and level of capitalisation.
Pillar-III
Value at Risk
VaR is defined as the predicted worst-case loss at a specific confidence level over a certain period of time assuming normal trading conditions.
That means, we can incur loss a maximum of Rs. X (the VaR) over the next one week (time period) and, may expect with 99% confidence level (i,.e. it would be so 99 times out of 100).
Value at Risk
There are three main approaches to calculating VaR: 1. The Correlation Method, also known as Variance/Covariance Matrix Method 2. Historical Simulation Method 3. Monte Carlo Simulation
Comparison of various VaR Modules
Methodology
Variance/ Covariance (Parametric) Monte Carlo Simulation Historical Simulation
Description Applications
Estimates equation parameters VaR that with specifies such as Volatility, Correlation, Delta and Gama Accurate for traditional assets and linear derivatives, but less accurate Derivatives for non-linear Estimates VaR by simulating random scenarios and revaluing positions in the portfolio Appropriate for all types of instruments, linear and non-linear Estimates VaR by reliving history; takes actual historical revalues each change rates positions in market and for the
Advantages of VaR
• It captures an important aspect of risk in a single number • It is easy to understand • It asks the simple question: things get?
” “ How bad can
Back Testing
• Is a process where model based VaR is compared with the actual performance of the portfolio. This is carried out for evaluating a new model or to assess the accuracy of the existing model
Stress Testing
1.
2.
3.
4.
Stress Testing essentially seeks to determine possible changes in the market value of a portfolio that could arise due to non-normal movement in one or more market parameters.
Stress Testing covers many different techniques.
Some of important ones are: Simple Sensitivity Test Scenario Analysis Maximum Loss Extreme Value Theory
• 1.
2.
3.
4.
5.
6.
7.
Risk Monitoring & Control Risk Monitoring and Control calls for implementation of risk and business policies simultaneously. This is achieved through the following: Policy guidelines limiting roles and authority Limits structure and approval process System and procedures to unbundle products and transactions to capture all risks Guidelines on portfolio size and mix Defined policy for market to market Limit monitoring and reporting Performance allocation Measurement and Resource
Few Practice Questions
Q. A Bank reports a one-week VaR of $1M at the 95% confidence level. Which of the following statements is most likely to be true?
(a)
follows a could be level is (b) The daily return on the company portfolio normal distribution so that a one-week VaR computed.
The one week VaR at the 99% confidence $5M.
(c) With probability 95%, the company will not experience a loss greater than $95M in one week.
$1M (d) or With probability 5%, the company will loose more in one week.
Answer: (d)
Q.
Reserve Bank of India has advised Banks to build up an Investment Fluctuation Reserve (IFR) of a minimum 5 per cent of their investments in the categories “Held for Trading” (HFT) and “Available for Sale” (AFS). The specification is to take care of following Risk.
(a). Interest Rate Risk (b). Operational Risk (c). Credit Risk (d). None of above
Answer: (a)
Q.
“Netting” is a method of aggregating two or more obligations to achieving a reduced net obligation. The benefits accrues from “Netting” is:
(a). Reduced Credit Risk (b). Liquidity Risk (c). Systemic Risk (d) All of the above
Answer: (d)
Q.
How is the risk of catastrophic losses dealt with?
so-called
(a) . Through RAROC models.
(b).
Through VaR, gamma approach.
preferably delta (c). By proper Disaster Recovery Plan & Business Continuity Plan in place.
(d). By mitigation, capital.
with reserves in
Answer: (c)
Q.
Money market funds are generally considered to have ______ interest rate risk,and______ default risk.
(a). low; low (b). low; high (c). high; low (d). high; high
Answer: (a)
Q.
The June 1999 Basle Committee on Banking Supervision issued proposals for reform of its 1988 Capital Accord (the Basle II Proposals). These proposals contained MAINLY: I. Settlement risk management II. Capital requirements III. Supervisory review IV. The handling of hedge funds V. Contingency plans VI. Market discipline
(a).
I, III and VI (b). II, IV and V (c). I, IV and V (d). II, III and VI Answer: (d)
Q.
If the default probability for an company over a six year period is: “A” rated company over a three year period is 0.30%, then the most likely probability of default for the same
(a). 0.30% (b). Between 0.30% and 0.60% (c). 0.60% (d). Greater than 0.60%
Answer: (d)
Q.
Which of the following procedures is essential in validating estimates.
the VaR
(a) Back Testing (b) (c) Scenario Analysis Stress Testing (d) Once approved by regulators no further validation is required.
Answer: (a)
Q. Loans are securitized to:
(a) (b) (c) (d) Reduce credit concentrations.
Reduce regulatory capital.
Provide access to loan products for investors.
All of the above.
Answer: (d)
Q.
If the volatility per annum is 25% and the number of trading days per annum is 252, find the volatility per day.
a) 1.58% b) 15.8% c) 158% d) 0.10
Ans: (a).
Q.
When the costs/yields of liabilities/assets are linked to a floating rate and there is no simultaneous movement in interest rates, it leads to:
a) Real Interest Rate Risk b) Reinvestment Risk c) Volatility Risk d) Basis Risk Ans.
(d)
Q. Quite a few models were developed in the last few years to measure credit risk exposure. Which of the models below is based on an actuarial approach?
a) CreditMetrics b) CreditRisk+ c) KMV d) Credit Portfolio View Ans.
(b)
Q. What is the Internal Models Approach?
(a).
A method of calculating regulatory capital using a firm’s own internal market risk model and data.
(b). Using standardized models from the regulatory to calculate capital.
(c).
Making forecasts on credit ratings using inside information.
(d).
Using the Regulator’s own propriety risk model to calculate capital requirements.
Ans.
(a)