ECO 2056 Risk Management for Financial Managers

November 4th, 2012

ECO 2056 Risk Management for Financial Managers

Notes to Lecture 9

Overview of Bank Risk Management Systems

1. Within the Bank

Line management of Banking and Trading operations organize themselves to take risk and make profits. To ensure that the risks being assumed by these line operations are well understood and within the risk tolerance levels of the institution proper risk control structures must be designed and implemented. The description that follows outlines the major elements of such risk control structures.

A. Credit Risk

- Credit risk is the risk of loss due to failure of borrower to honour its obligations in a timely fashion. ‘Counterparty risk’ ( = credit risk in a trading book) is risk of loss due to the failure of a customer to honour its obligations under its trading contracts. The risk may be approximated by the estimated cost of replacing the defaulted contract to properly re-hedge the book.

- Credit limit: before any loan is advanced or trading contract is entered into, a credit limit for the borrower or counterparty must be established. The limit for loans is expressed as the maximum amount that the borrower may draw. For trading products, the limit is expressed as a percentage of a notional amount. For example, a customer may wish to deal in foreign exchange contracts up to a total of $100 million – the nominal risk. The risk in such a position is not equivalent to a loan of $100 million. If the customer defaults, the position can be replaced and the foreign exchange book re-hedged by finding a replacement counterparty. As rates are most likely to move within a reasonable band, the costs of replacing the failed contract will be some fraction of the $100 million. The fraction used will vary with the maximum tenor of the contracts and the volatilities of currencies involved – the variables that drive the likely price of replacement contracts. FX contracts for up to a year in major currencies may be assigned a fraction of, say, 20%, so this $100 million FX line (the “notional amount”) will be counted as the credit equivalent of $20 million in loans. In contrast, a long-dated credit default swap with a 5 year tenor for a BBB- 10 year bond might be assigned a notional amount close to the nominal amount on the theory that the credit risk for this credit default swap is close to that of the 10 year bond. Through such a process, the limits for all credit and trading products can be summed to provide an overall limit for the particular customer.

- The total customer counterparty (=credit) limits for trading lines are divided up and sub-limits assigned to particular trading desks. The traders must ensure that their exposures to individual customers remain at all times within these limits.

- Separation of Duties: the “banking” group that wishes to offer their customer a credit or trading line will write up a credit request containing a credit analysis and proposed credit Risk Rating. A separate group – the Credit Department – analyzes the request and either approves it (for smaller credits) or forwards it to a Credit Committee (for larger credits). Credit Risk Ratings are determined by the Credit Department. The Credit Committee adjudicates on all larger credits. Higher risk credits of a given amount require a higher level of authority for approval than a lower risk loan of similar amount.

- Annual and Periodic Credit Reviews: the credit risk rating for each customer is reviewed on an annual basis and at any time when the risk profile of the customer appears to be changing.

- loan pricing rules are established to ensure that each credit carries a rate such that the revenue from the credit is sufficient to yield the bank’s target rate of return on the required equity. The revenue will be sufficient to cover the one year ‘expected loss’ on the loan as well as all administration costs and plus an amount sufficient to yield the target rate of return on the equity deemed to be required for the particular exposure. The equity required for each loan will be related to the risk which is approximated by the ‘unexpected loss’ based on the estimated volatility of the loan’s potential losses. The methodology for setting this required equity level will ensure that the total of the equity required for all loans across the portfolio will be sufficient to ensure that the bank has sufficient equity to be able to maintain its rating for a high percentage (98 or 99 out of 100) of the estimated possible 1-year adverse swings in business conditions.

- The Basel Accord (see below): The Accord’s requirements for capital must be respected, and the regulator will check to ensure compliance. The Accord relates amounts of loans of particular risk to an amount of equity that must be maintained to support these positions. Overall, the equity maintained to support to portfolios must be equal to or greater than these Basel requirements. In general, these Basel requirements for capital are lower than those required to maintain a AA-equivalent rating for the bank from the rating agencies.

- Diversification of portfolio: to ensure diversification, limits are set for exposures to particular industries, countries, and credit risk bands (to ensure there are no concentrations of high risk credits.)

- A Credit Department metrics team will routinely estimate the losses expected from the credit portfolios using advanced metrics such as KMV, as well as default probabilities drawn from both internal bank data and from S&P and Moody’s, and other internal judgemental sources. Analysis will probe for concentrations of risk. Stress tests will also be performed. This group prepares the estimates of equity required to support particular books of credit.

- A portfolio management group may be established to evaluate the efficiencies of the portfolio. The group will look at the contribution to risk and to return of each credit using data from KMV and other sources, and examine whether better overall risk-adjusted yields can be obtained by purchasing or selling particular exposures.

- In most advanced countries, the national regulator will impose an additional stress test. The regulator will design a plausible ‘down case’ for the economy, and will identify a number of macro-economic parameters for this case such as GDP, unemployment, interest rates, house prices, and so on. The bank will be obliged to estimate the losses that would arise in its portfolio if this down scenario were to materialize.

B. Market Risk

- Market risk is the risk of loss resulting from changes in interest rates, foreign exchange risk, market prices and volatilities that arise from the bank’s funding, investment and trading activities.

- Interest rate risk arises where there is a mismatch in interest rate maturities between sets of assets and their offsetting liabilities within a trading book. Interest rate risk can arise with loans where the interest rate term structure of the loans differs from the interest rate structure of the related liabilities.

- Foreign exchange risk arises when the bank has an open position in a particular foreign currency for one or more future time periods in the future and there is no offsetting hedge.

- Trading Limits: are assigned to each trading operation to control the maximum amount of risk that can be taken by that operation. Limits will include maxima for Value at Risk, risk for particular types of currency, limits for particular types of product, and usually limits for the total notional amount of exposure.

- Separation of Duties:

- Traders enter into contracts with traders in other institutions and with commercial customers. Agreements are normally reached on the telephone (all conversations are recorded.) There is a separation of duties between the traders and the ‘back office’ which enters the transactions into the accounting systems. When a new contract is established, the parties to the contract exchange formal confirmations. Confirmations are received by the back office and are compared to the bank’s record of the transaction to ensure that both parties to the contract agree on its terms. This separation of duties ensures that transactions (and profits or losses) cannot be hidden.

- There is usually a ‘middle office’, separate from the trading desks, which verifies that the pricing models used to value options are appropriate, and ensures that the prices used to update the value of options and other portfolios accurately reflect the prices in the market place. This office produces daily profit and loss statements, as well as updates to VAR estimates for individual trading desks, and reports on outstandings vs. limits.

- Individual trading operations propose the limits under which they wish to operate. A separate Trading Policy group (analogous to the Credit Department) reviews and comments on these proposed limits. Adjudication is by a senior Risk Committee of the Bank.

- Equity for trading books: the Regulators specify the methodology that a bank must use to calculate the equity that must be maintained to support the market risks in trading books. The higher the estimated risk (variance), the higher is the amount of equity that must be carried. As a first approximation, the required equity can be estimated as three times the 10 day VAR. Before this estimate is accepted, however, a variety of sensitivity tests and stress tests is performed to identify risks that are not adequately captured by VAR. An add-on factor is introduced to reflect such sensitivities; or alternatively a separate methodology is developed to calculate the required equity. Counterparty (=credit) risk is separately handled. Each counterparty has a credit risk rating. Probabilities of default can then be calculated and overall default probabilities estimated for the portfolio. A portion of each quarter’s net revenue can then be set aside into an ‘equity deferral’ or reserve account to allow for potential counterparty defaults.

- Market Risk Committee: a committee of the bank will regularly review the results of these risk estimates and issue appropriate trading instructions.

C. Liquidity Risk

- Liquidity risk is the risk that the bank will have insufficient liquidity to meet its obligations as they come due. For a bank, the major risk arises from its book of deposits – most of which can be withdrawn within relatively short period should there be any loss of confidence.

- liquidity risk is monitored by detailing the amounts that mature (both assets and liabilities) within each future time period. Stress testing is applied to estimate the risks of short term liability run-off that cannot be easily replaced due to stressed liquidity in the market-place.

- Policies are developed and authorized to ensure adequate short term assets are held to meet liquidity needs in a stress environment. This liquidity back-up is held in the form of highly liquid short term government paper.

D. Operations Risk:

- Operations risk is the risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems, or from external events (9-11 for example) affecting processes, systems or people. Damage to commercial reputation is considered an operational risk (the impact of the mutual fund scandal on particular mutual fund operating companies in the US is an example; the effect of Martha Stewart’s problems on her company is another example.)

- Estimates of operations risks can be made in two ways

- past data on losses

- structured management review of individual operations to identify particular key risks and their potential impact.

- Before-tax income covers most operational risk costs (through insurance costs and the cost of all but exceptional uninsured risks.) There is a risk of ‘unexpected’, low probability high-impact events arising with a serious impact on the bank. The potential impact is extremely difficult to estimate.

- The Basel Committee has determined that a measure of equity must be maintained by each bank to cover off the ‘unexpected’ level of operational risk.

E. Management and Board Oversight:

- A Policy Committee of Management will recommend to the Board sets of policy including:

- Broad organization structures for Management (ie. business line structures, products and services to be offered, separation of duties such as the division between Banking and Credit.)

- Authorization limits

- diversification requirements such as

- industry limits

- country limits

- risk tolerances (ie concentrations in particular risk bands)

- VAR limits for particular trading products

- minimum liquidity requirements.

- This Policy Committee will oversee the operations of the bank and ensure that the limits are respected. Regular reports will be made to the Board on adherence to policy.

- Larger credits will be adjudicated by this Policy Committee, and the largest exposures submitted to the Board.

- management and the Board must ensure that the level of equity maintained by the institution covers all the equity requirements of the Basel Accord as required by the regulators.

E. Audit

- The bank has sets of internal auditors:

- the accounting function within each operation has auditors attached to it who perform regular routines to ensure that all transactions are properly booked and valued, and to ensure that all accounting procedures are followed.

- there is an all-bank internal Audit Function reporting to the Audit Committee of the Board. This Audit group performs regular audits on operations throughout the bank to ensure that procedures are followed, assets and liabilities properly recorded, and profit and loss statements are accurate. The function includes specialized groups that evaluate loans and risk ratings on credit and that analyze the controls and valuations within the trading operations.