Small States – Banking & Finance Seminar
19 April 2011
Miguel Borg – Executive Head, Bank of Valletta plc
Risk Management - Miguel Borg
Risk Management in
Small States
Risk Management - Miguel Borg
The opinions expressed in this presentation are the author’s own and do not necessarily
reflect the official views of Bank of Valletta plc or of the organising
institute/authority. The author does not accept any liability for misleading or
inaccurate information or omissions in the information provided.
Agenda
Risk Management - Miguel Borg
Credit Risk
Concentration Risk
Market Risk
Value at Risk
Stress Testing
Frequency/Severity
severe
High
RISK MAP
insignificant
/ minor
slightly
significant
major
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I
M
P
A
C
T
rare
Low
unlikely
occasional
likely
PROBABILITY
very
probable
High
Frequency/Severity
High Risk
Medium Risk
REDUCTION
slightly
significant
AVOIDANCE
REDUCTION
insignificant
/ minor
ACCEPTANCE
rare
unlikely
occasional
likely
Low Risk
Low
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S
E
V
E
R
I
T
Y
SHARING
major
severe
High
very
probable
Medium Risk
FREQUENCY
High
CREDIT RISK
Risk Management - Miguel Borg
Credit Risk
Concentration risk in credit portfolios arise from
unequal distribution of loans to single borrowers
(name concentration) or different industry or regional
sectors (sector or country concentration).
Risk Management - Miguel Borg
Credit risk is the risk that a counterparty will not
settle on obligation in full, either when due or at any
time thereafter.
Credit Risk: 4-step model
Payback
Risks
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Purpose
Structure
Cash Flow Measures
From Operating Cash Flow we have to deduct
other non-discretionary payments like tax,
dividend, capital expenditure before it would be
able to make principal and interest payments.
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Operating Profit (EBIT)
+ depreciation/amortisation
= EBITDA
+/- changes in net trading assets
+ other non-cash charges
= Operating Cash Flow
Credit Risk Score Cards
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Edinburgh Business School
Altman Z-Score
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Altman Z-Score
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Corporate Failure - Qualitative
Risk Management - Miguel Borg
The following questions need to be asked to identify symptoms that could lead to
corporate failure:
Is the business dominated by an autocrat who is not prepared to rely on a
professional management team?
Has the company insufficient management, a weak financial controller, weak
budgetary control, weak costing system, or weak cash flow planning and reporting?
Is the company overtrading?
Is reliable financial information available on a timely basis?
Has the company relied on a fast and aggressive expansion, especially when
accompanied by a sharp rise in borrowings?
Is the borrower planning to undertake business outside its area of core competence?
Is the company a relatively new venture with limited experience in its line of
business?
Is the financial gearing ratio over 100%?
Has gearing increased significantly since the previous financial year?
Is there a greater amount of short-term borrowing than long-term borrowing?
Are there signs of rapid expansion, so that turnover has grown by more than 50% per
annum over the past five years?
Did turnover more than double either last year or the year before?
Is the company involved in property development as a sideline to its core business?
Is the company in a cyclical industry?
Basel I – Credit Risk RWA
Risk weights:
OECD sovereigns: 0%
OECD banks: 20%
Residential mortgages: 50%
Unfunded commitments under one year: 0%
Unfunded commitments over one year: 50%
Everything else: 100%
Risk Management - Miguel Borg
Basel II – Credit Risk RWA
Risk weights for sovereign exposures:
AAA to AA-
A+ to A-
BBB+ to
BBB-
BB+ to
B-
Below B-
Unrated
Risk Weight
0%
20%
50%
100%
150%
100%
Risk weights for corporate exposures: (2 options, selected by national regulator)
Option 1:
Rating
AAA to AA-
A+ to A-
BBB+ to
BB-
Below BB-
Unrated
Risk Weight
20%
50%
100%
150%
100%
Option 2:
At national discretion, all corporates risk weighted at 100% without regard to external ratings
SME adjustment: 75% risk weight for unrated SME if exposure under €1 million and
either treated by bank as retail or guaranteed by individual
Risk Management - Miguel Borg
Rating
Basel II – Credit Risk RWA
Risk weights for retail exposures:
Risk weights for past due exposures:
150% when specific provisions less than 20% of outstanding amount of exposure
100% when specific provisions 20% or more of outstanding amount of exposure
100% when the specific provisions 50% or more of outstanding amount of
exposure, with supervisory discretion to reduce risk weight to 50% in such case
Risk Management - Miguel Borg
75% risk weight if:
Exposure to individual or small business
Exposure takes form of revolving credit, line of credit, personal loan, lease, or
small business facility (mortgage loan excluded to extent otherwise covered (see
below)
Portfolio diversified (granular); Basel II accord suggests no aggregate exposure
to any one counterparty should exceed 0.2% of overall portfolio
Maximum aggregate counterparty exposure €1 million or less
Basel II – Credit Risk RWA
Risk weights for residential real estate:
Risk weights for commercial real estate:
Source:
Text
Generally 100% risk weight
Risk Management - Miguel Borg
35% risk weight for exposures fully secured by mortgages on residential property
occupied by the borrower or rented
Strict prudential criteria (including loan to value ratios) determined by national
regulators
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MARKET RISK
Market Risk
Market risk is defined as “the risk of losses
arising from movements in market prices.”
Risk Management - Miguel Borg
Main risk factors:
- equity
- foreign exchange
- interest rate
- commodity prices
The Impact of Interest Rate Risk
Interest rate risk is a major risk to all bondholders.
As Yields
P1
Prices
P0
P2
Y1
Y0
Y2
Yield
Risk Management - Miguel Borg
Price
Duration
Duration measures how quickly a bond will
repay its true cost (yrs). The longer it takes, the
greater exposure the bond has to changes in the
interest rate environment.
Factors that affect a bond duration:
Time to Maturity
Coupon Rate
1.
2.
Risk Management - Miguel Borg
Modified Duration
Modified Duration shows the change in the value of a security in response to a
change in interest rates. This formula determines the effect that a 100-basispoint (1%) change in interest rates on the price of a bond.
Modified duration follows the concept that interest rates and bond prices move
in opposite directions.
Potential Loss = Modified Duration x Market Value
Risk Management - Miguel Borg
where:
n = number of coupon periods per year
YTM = the bond's yield to maturity
Measure of Risk
180
160
P r ic e s
140
120
100
80
60
40
20
0
Risk Management - Miguel Borg
•The most popular and traditional measure of risk is volatility/standard
deviation.
Measure of Risk
Prices
60%
Returns
40%
20%
0%
-20%
-40%
-60%
Risk Management - Miguel Borg
180
160
140
120
100
80
60
40
20
0
Measure of Risk
60%
Retu rn s
40%
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20%
0%
-20%
-40%
-60%
Vo latility
18%
16%
14%
12%
10%
8%
6%
4%
2%
0%
01-Jan-2009
12-Feb-2009
27-Mar-2009 09-May-2009
23-Jun-2009
04-Aug-2009
16-Sep-2009
28-Oct-2009
09-Dec-2009
Distributions
15%
10%
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Returns
5%
0%
-5%
-10%
-15%
-20%
01-Ja n-08
01-Mar-08
01-May-08
01-Jul-08
01-Sep-08
Volatile returns – how to quantify?
•histogram of results – discrete (actual)
•continuous (approximation – or best fit)
01-Nov-08
01-Jan-09
Distributions
16%
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14%
12%
Frequency
10%
8%
6%
4%
2%
0%
-20.5%
-15.5%
-10.5%
-5.5%
-0.5%
4.5%
9.5%
14.5%
19.5%
Returns
The most popular and traditional measure of risk is volatility/standard deviation.
Standard Deviation
Frequency
-20.5%-18.0%-15.5%-13.0%-10.5%-8.0% -5.5% -3.0% -0.5% 2.0% 4.5% 7.0% 9.5% 12.0% 14.5% 17.0% 19.5%
Returns
One standard deviation = 68%
Two standard deviations = 95%
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μ = -0.5%
σ = 4.7%
Value at Risk
VaR= N ⋅ (CI ⋅σ ) ⋅ T
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• Value at Risk (VaR) calculates the maximum loss expected (or worst case
scenario) on an investment, over a given time period and given a specified
degree of confidence.
• VaR is a measure of market risk. It is the maximum loss which can occur
with X% confidence over a holding period of t days.
• Normality assumption.
Where N is the nominal amount of the investment (in €), σ is the volatility of
returns, CI is the confidence interval (prescribed) and the √ term depends on the
period over which σ was measured.
LTCM
Sir. H. Davies FSA
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“The LTCM risk model told them that the
loss they incurred on one day at the end
of August 1998 should have occurred
once every 80 trillion years.
It happened again the following week.”
Some Remarks
Modified Duration gives the potential loss if yields shift by 100bpts but
does not provide the probability of this occurring.
•
VAR provides the estimate loss with a probability but under normal
market conditions.
•
Thus, the measure of MD & VAR should be complemented with Scenario
Analysis (What-if) using Positive, Negative & Severe Scenarios. (stress
testing)
Risk Management - Miguel Borg
•
Interest Rate Shock
•
A period of up to the one year is taken when repricing net assets (excluding offbalance sheet items) by 1%. If, the entitiy has a positive cumulative interest rate gap
up to the 1 year, a decrease of 1% in the interest rate implies that the entity's net
interest income could decline by the result obtained.
• Inversely, if the entity has a negative cumulative interest rate gap up to 1 year, a
decrease of 1% in the interest rate implies that the entity's interest income could
increase by the result obtained.
Risk Management - Miguel Borg
• Interest Rate Shock scenario attempts to gauge the effect of a 1% change in interest
rates which could adversely affect the entity when repricing its interest
receivable/payable on its assets/liabilities.
GAP Analysis
GAP = RSA – RSL
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increase
Interest
Rates
decrease
positive
negative
GAP
IRRBB
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Steps
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offset the longs and shorts in each time band, resulting in a single
short or long position in each time band
weight these resulting short and long positions by a factor that is
designed to reflect the sensitivity of the positions in the different
time bands to an assumed change in interest rates (assumed
parallel shift of 200 basis points throughout the time spectrum,
and on a proxy of modified duration of positions situated at the
middle of each time band and yielding 5%)
sum these resulting weighted positions, offsetting longs and
shorts, leading to the net short or long weighted position in the
given currency
calculate the weighted position of the whole banking book by
summing the net short and long weighted positions calculated for
different currencies
relate the weighted position of the whole banking book to capital
Risk Management - Miguel Borg
Stress Testing
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Stress testing describe the process of assessing the
vulnerability of individual financial institutions or the
financial system to exceptional but plausible events.
Why we use Stress testing?
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Basel II – Stress Testing Requirements
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Board & Senior Management Involvement
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Stress Testing Participants
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Issues Identified by BIS
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45
Households
Wealth, Real
Estate
Performance,
Unemployment
Fall 30% in House
Prices
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Impact of a Crash
in Property Market
Assumptions Process
Extreme assumptions representing
remote scenarios
RED WARNINGS
Yes
Relax assumptions
Yes
No
No
End Stress Testing
Reporting to BOD
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Calculate stressed variables (CAR,
profitability, liquidity ratios)
Results considerations
Level of Severity
Ideal varying levels of severity
Combination of Events
Consider the simultaneous occurrence of extreme risk events
across risk classes
Diversification & Correlation benefits
Onus on bank with regulator requiring large dataset of past
history to prove assumptions
Nothing
Enough capital (rare)
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Stress Testing Results – No Capital Allocation
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What would have to fail for the risk to materialise?
Who would be responsible?
What currently mitigates this risk?
How effective is the mitigant?
How easily could the mitigant fail?
How would the bank be aware of a risk has materialising or
a mitgant failing?
How can the firm strengthen controls and risk mitigants?
Did the firm perform dummy-run of its BCP related to this
risk materialising?
How often will Board be informed of the developments in
this risk area?
Risk Management - Miguel Borg
borgmiguel@gmail.com