FRM
1
Objectives (1)
Reading 1: The Building Blocks of Risk Management
a)
explain the concept of risk and compare risk management with risk taking.
b) describe elements, or building blocks, of the risk management process and identify
problems and challenges that can arise in the risk management process.
c)
evaluate and apply tools and procedures used to measure and manage risk, including
quantitative measures, qualitative assessment and enterprise risk management.
d) distinguish between expected loss and unexpected loss and provide examples of each.
e) interpret the relationship between risk and reward and explain how conflicts of interest
can impact risk management.
f)
describe and differentiate between the key classes of risks, explain how each type of risk
can arise, and assess the potential impact of each type of risk on an organization.
g)
explain how risk factors can interact with each other and describe challenges in
aggregating risk exposures.
2
Objectives (2)
Reading 2: How Do Firms Manage Financial Risk?
a)
compare different strategies a firm can use to manage its risk exposures and explain
situations in which a firm would want to use each strategy.
b) explain the relationship between risk appetite and a firm’s risk management decisions.
c)
evaluate some advantages and disadvantages of hedging risk exposures and explain
challenges that can arise when implementing a hedging strategy.
d) apply appropriate methods to hedge operational and financial risks, including pricing,
foreign currency and interest rate risk.
e) assess the impact of risk management tools and instruments, including risk limits and
derivatives.
3
Objectives (3)
Reading 3: The Governance of Risk Management
a) explain changes in corporate risk governance that occurred as a result of the
2007-2009 financial crisis.
b) compare and contrast best practices in corporate governance with those of
risk management.
c) assess the role and responsibilities of the board of directors in risk
governance.
d) evaluate the relationship between a firm’s risk appetite and its business
strategy, including the role of incentives.
e) illustrate the interdependence of functional units within a firm as it relates
to risk management.
f) assess the role and responsibilities of a firm’s audit committee.
4
Objectives (4)
Reading 4: Credit Risk Transfer Mechanisms
a) compare different types of credit derivatives, explain how each one
transfers credit risk and describe their advantages and disadvantages.
b) explain different traditional approaches or mechanisms that firms can use
to help mitigate credit risk.
c) evaluate the role of credit derivatives in the 2007-2009 financial crisis and
explain changes in the credit derivative market that occurred as a result of
the crisis.
d) explain the process of securitization, describe a special purpose vehicle
(SPV) and assess the risk of different business models that banks can use for
securitized products.
5
Reading 1,2 & 3
• Reading 1: The Building Blocks of Risk Management
• Reading 2: How Do Firms Manage Financial Risk?
• Reading 3: The Governance of Risk Management
6
1.1.a. Explain the concept of risk and compare
risk management with risk taking
• What is risk? Variability surrounding future outcome, i.e. P&L.
• What is the difference between risk and uncertainty? The former is
measurable while the latter is not.
• Risk may not be related to size of potential loss. Expected losses can be
guarded against.
• Risk is akin to energy – it can be transferred/transformed, but cannot be
ultimately eliminated.
• What is risk management? A defensive mechanism to cope with an entity’s
expected/unexpected losses, which comes at a cost.
• The objective is to balance risks and returns optimally, not to completely
eliminate risks. Without risk, there can be no reward.
7
1.1.b. Describe the risk management process and identify problems and challenges that can arise in
the risk management process
1.2.a. Compare different strategies a firm can use to manage its risk exposures and explain situations
in which a firm would want to use each strategy.
Step 5:
Step 4:
Step 3:
Step 2:
Step 1:
• Identify risks.
• Quantify; or
• Transfer risks.
• Determine
overall
effects of risk
exposures; or
• Perform a
cost-benefit
analysis on
risk transfer
methods.
• Manage
risks: avoid,
transfer,
mitigate, or
assume.
• Assess and
improve as
required.
8
1.1.b. Describe the risk management process and identify
problems and challenges that can arise in the risk management
process
Challenge 1: Is it possible to identify all risks? Consider black swans.
Challenge 2: Risk transfer may not be cost efficient.
Challenge 3: Should be dispersed among willing and able economic participants. Consider
systemic risks, bailouts and risk-taking during the GFC.
Challenge 4: Easier to assume risk, especially with derivative instruments, than it is to manage
risks.
Challenge 5: Misstatements of risks and returns.
Challenge 6: Risks cannot be ultimately eliminated; it has to be borne by some entity. Zero-sum game.
9
1.1.c. Evaluate and apply tools and procedures used to
measure and manage risk, including quantitative measures,
qualitative assessment, and enterprise risk management
Quantitative Measures:
• VaR. E.g. VaR (95%) = $1m. Within the selected time horizon, there is a 95% probability that the maximum
loss will be $1m, and a 5% chance that the loss will be greater than $1m. How much greater?
• Dangerous to use VaR when dealing with non-normal situations, illiquid positions or long time horizons.
• Economic capital: Reserves to cover potential losses.
Qualitative Assessment:
• Scenario analysis: Involves multiple risks that are often non-quantifiable.
• Stress testing: A subset of scenario analysis that considers the financial outcome.
ERM:
• Integrated approach to risk management compared to operating in silos; considers
diversification/correlation.
• Risk committees and Board oversee the establishment and implementation of ERM.
10
1.1.d. Distinguish between expected loss and
unexpected loss, and provide examples of each
Expected
loss:
• Can be computed in advance, and priced into the product cost.
• Losses expected to be incurred in the normal course of business.
• E.g. Bad debt expense, insurance claims, retail theft.
Unexpected
loss:
• Losses incurred outside the normal course of business.
• Losses can be driven to unusual levels by correlation risk.
• E.g. Real estate investors tend to default at the same time. Consider
the GFC.
• E.g. Automobile loan obligors tend to default at the same time
during an adverse economic environment.
11
1.1.e. Interpret the relationship between risk and reward and explain how conflicts
of interest can impact risk management
1.3.d. Evaluate the relationship between a firm’s risk appetite and its business
strategy, including the role of incentives
Greater risks  greater returns. Risk appetite/tolerance and the ensuing risk limits bind the business strategy. As such, there must
be a logical relationship between risk appetite and business strategy and inputs from the risk management team from the outset.
Consider Ang’s factor model, in which a factor that rewards an investor during
bad times is less risky and hence, should be pricier, leading to lower returns.
Consider government bonds vs. corporate bonds. The yield difference
compensates for assumption of liquidity and credit risks, etc.
The expected return is also a function of risk tolerance. If tolerance is generally high,
the reward thins and potentially masks the true relationship between risk and returns.
Lack of price discovery or liquidity may compound
the problem of accurately assessing risk and returns.
Compensation structures may incentivize excessive risk
taking, misstatements of risk/returns or short-termism.
Time gap between risk assumption and
materialization. Consider clawback provisions.
12
1.1.f. Describe and differentiate between the key classes of
risks, explain how each type of risk can arise, and assess the
potential impact of each type of risk on an organization
Market Risk
Credit Risk
Liquidity Risk
• Interest rate risk
• CF discount rate.
• Basis risk: Correlation between
underlying and hedging instrument
adversely changes.
• Equity price risk
• Systematic risk.
• Idiosyncratic risk: Diversifiable.
• Foreign exchange (FX) risk
• Due to changes in domestic/foreign
interest rates and imperfect
currency price movements.
• Commodity price risk
• Could be due to price
discontinuities – sudden jumps –
and a cornered market – reduced
liquidity.
• Default risk
• Non-payment of principal/interest
on a timely basis.
• Bankruptcy risk
• Liquidation value < amount owed.
• Migration / Downgrade risk
• Results in increased lending cost for
the issuer and fall in bond prices.
• Settlement risk
• A failure to physically or cash settle
a derivatives transaction.
• Avoid (counterparty) concentration
risk.
• Avoid maturity risk.
• Avoid correlation risk.
• EL=PD x EAD x LGD
• Funding liquidity risk
• Inability to access funds, for
instance to refinance bonds, meet
redemption claims, etc, due to a
lack of financial flexibility.
• Trading liquidity risk
• Inability to liquidate assets without
significant discount due to
temporary illiquidity.
13
1.1.f. Describe and differentiate between the key classes of
risks, explain how each type of risk can arise, and assess the
potential impact of each type of risk on an organization
Operational Risk
• Failure attributed
to people,
systems, internal
processes or
external events.
• Leveraged entities
are more
susceptible.
Legal and
Regulatory Risk
• E.g. Legal actions
to nullify or
terminate
transactions.
• E.g. Changes in
tax regimes.
• E.g. Changes in
capital
requirements.
Business Risk
• Risks related to
income
statement, e.g.
variability
surrounding
demand, costs,
price elasticity of
demand,
competition, etc.
• Closely related to
strategic and
reputational risk.
Strategic Risk
• Involves
significant
investments.
• E.g. New drug or
product line,
diversification
into new
businesses,
expansion,
relaxing
underwriting
standards.
Reputation Risk
• General perceived
creditworthiness.
• General
perception of fair
dealing and
ethical business
practices.
• Very fragile with
potentially
devastating
effects.
• Consider the
speed at which
information
travels today.
14
1.1.f. Describe and differentiate between the key classes of
risks, explain how each type of risk can arise, and assess the
potential impact of each type of risk on an organization
Even if hedging can be
employed to manage
certain risks, it is subject
to basis risk, which is
the risk that the
correlation between the
hedging instrument and
the underlying adversely
changes.
15
1.2.c. Evaluate some advantages and
disadvantages of hedging risk exposures
Advantages (Practical)
Disadvantages (Theoretical)
Disadvantages (Practical)
• Reduce variability of CFs or
profits  Increase debt
capacity and equity value 
Lower WACC (debt & equity).
• Control financial performance
to meet Board requirements.
• Operational improvements,
e.g. cost certainty.
• Hedging through derivatives
may be cheaper than
insurance.
• Taxation arguments are weak.
Taxation of volatile earnings
even out over the years as
profits and losses are offset.
• Modigliani and Miller: Without
transaction costs and taxes, firms should
not hedge as it is not value accretive;
individuals can transact (i.e. hedge) at
the same cost.
• Sharpe: If markets are perfect, firms
should only consider systematic risks
under the CAPM. In practice,
diversification itself incurs costs.
• If markets are perfect and derivatives
are priced accurately, hedging is a zerosum game; it simply reallocates the
firm’s CFs between periods. E.g.
Hedging oil price with futures. In
practice, derivatives pricing is complex
and inaccurate. As such, risk transfer
between periods or between
participants may not be a zero-sum
game for that firm.
• All the points above ignore bankruptcy
costs.
• Overemphasis on hedging.
• Hedging requires technical
expertise and time.
• Increase compliance costs.
• Reveal confidential
operational information.
• While decreasing variability of
earnings, hedging may
increase variability of CFs.
16
1.2.d. Apply appropriate methods to hedge operational and
financial risks, including pricing, foreign currency, and interest
rate risk
Operational risks:
Financial risks:
Pricing (cost of input)
risks:
Foreign currency risks:
• Relate to income statement’s revenue and expenses.
• Relate to balance sheet’s assets and liabilities.
• Hedged by purchasing forward/futures contracts.
• Hedged by purchasing currency put options or forward
contracts; natural hedge when assets and liabilities are
denominated in the same foreign currency.
17
1.2.d. Apply appropriate methods to hedge operational and
financial risks, including pricing, foreign currency, and interest
rate risk
Interest rate risks:
Some exposures may be left
unhedged
Static hedging:
Dynamic hedging:
• Hedged by purchasing interest rate swaps.
• Risk is a double edged sword.
• The hedge is not adjusted after it is established.
• The hedge is (continuously) adjusted after it is established.
Additional (other than the
• Time horizon, impact of accounting standards, taxation.
risk) hedging considerations:
18
1.2.d. Apply appropriate methods to hedge operational and
financial risks, including pricing, foreign currency, and interest
rate risk
Operational Risk
Financial Risk
Affects income statement.
Affects balance sheet.
Pricing risk: Risk that cost of inputs may
rise. Hedged through forward or futures.
FX risk: Hedged through forward. Consider
natural hedges.
FX risk: Risk that exchange rates move
unfavorably. Hedged through put option or
forward. Consider natural hedges.
Interest rate risk.
Interest rate risk: Risk that interest rates
move unfavorably. Hedged through swaps.
19
1.2.d. Apply appropriate methods to hedge operational and
financial risks, including pricing, foreign currency, and interest
rate risk
Static Hedging
• Position is hedged initially
and not rebalanced.
• Unhedged exposures may
increase the variability of CFs
and profits and impact
financial statements.
Dynamic Hedging
• Hedged position is
rebalanced.
• More resource intensive in
terms of costs and time.
20
1.2.a. compare different strategies a firm can use to manage its risk exposures and
explain situations in which a firm would want to use each strategy.
1.2.b. explain the relationship between risk appetite and a firm’s risk management
decisions.
Establish, approve and convey the risk appetite in a quantitative and qualitative
manner.
Qualitative: As a matter of policy, stating risks that will be hedged or assumed.
Some risks cannot be hedged or insured.
Quantitative:
• Stress testing to determine risks that will be hedged/assumed.
• Impose risk limits, e.g. VaR limits.
Conflicts between creditors and shareholders: The former wants to reduce risk,
while the latter is often willing to assume a higher level of risk.
21
1.2.a. compare different strategies a firm can use to manage its risk exposures and
explain situations in which a firm would want to use each strategy.
1.2.b. explain the relationship between risk appetite and a firm’s risk management
decisions.
Risk management goals must be clear, actionable and predetermined.
Consider liquidity, accounting, time horizon and tax effects, amongst others.
• Hedging will incur periodic cash outflows (M-t-M, taxes on gains of hedging instruments). Mismatch
between recognition of cost and benefit.
• Tax rules can be complex, especially if they involve derivatives.
• Cost of hedging increases with time horizon. Time horizon of hedge should match that of performance
evaluation.
• Hedging will smoothen accounting profits.
• Distinguish between hedging of accounting or economic profits, which is also inclusive of implicit costs.
E.g. Foreign subsidiary with assets financed by foreign loan – income statement is hit by interest expense,
22
which can be hedged, but at a cost.
1.2.a. compare different strategies a firm can use to manage its risk exposures and
explain situations in which a firm would want to use each strategy.
1.2.b. explain the relationship between risk appetite and a firm’s risk management
decisions.
Step 1: Identify
impact of risks
(probability and
magnitude) to
income statement
and balance sheet
Step 2: Identify the
top 10 risks faced
by the firm
Step 3: Determine
which risks to
assume or hedge,
which risks can or
cannot be hedged,
and their costs
Step 4: Determine
the timing of the
impact
Step 5: Decide how
and to what extent
to hedge, assuming
the risks can and
wants to be
hedged
23
1.2.e. assess the impact of risk management tools and instruments, including risk
limits and derivatives.
24
1.2.e. assess the impact of risk management tools and
instruments, including risk limits and derivatives.
Exchange
Traded
•
•
•
•
Standardized.
Traded on an exchange.
More liquid, more price discovery.
Guaranteed by clearinghouse.
Over-theCounter
(OTC)
•
•
•
•
Customized.
Traded over the counter.
Less liquid, less price discovery.
Exposed to counterparty risk.
25
1.3.b. Compare and contrast best practices in corporate
governance with those of risk management
Corporate Governance (Board responsibilities)
• Protect all stakeholders’ interests.
• Consist of a majority of independent members.
Chairman should not be the CEO.
• Must possess sufficient expertise.
• Remuneration committee ensures that compensation
structures are aligned with stakeholders’ interests.
• Should consist of the Chief Risk Officer (CRO), who
links good corporate governance (CG) with risk
management.
Risk Management (Board responsibilities)
• Strive for economic performance, rather than
accounting performance.
• Ensure attractive career progression and logical
reporting lines.
• Should establish ethics committee to ensure
adherence to high ethical standards.
• Ensure that compensation structures are aligned with
performance on a risk-adjusted basis.
• Approve all major transactions only if consistent with
risk/returns objectives.
• Be ready to challenge senior management.
• Should establish a risk committee with members of
sufficient expertise; should be distinct from audit
committee, but with one shared member.
26
1.3.c. Assess the role and responsibilities of the board of directors in risk governance
1.3.e. Distinguish the different mechanisms for transmitting risk governance
throughout an organization
Risk Advisory Director
• Risk specialist with an overall duty to advise/educate
on CG and risk management best practices.
• Responsibilities include reviewing and analyzing:
• Risk management policies and periodic reports.
• Risk appetite and alignment with business strategy.
• Internal controls.
• Financial statements and disclosures.
• Related-party transactions.
• Internal/external audit reports.
• Practices of peers.
• Bridge between senior management and the Board as
regards risk-related matters.
• Attends risk and audit committee meetings.
Risk Management Committee
• Establishes risk infrastructure to identify, measure,
evaluate, monitor and manage risks under an ERM
approach.
• Has open communication channels with
external/internal auditors, and senior management.
27
1.3.c. Assess the role and responsibilities of the board of directors in risk governance
1.3.e. Distinguish the different mechanisms for transmitting risk governance
throughout an organization
1.3.f. Assess the role and responsibilities of a firm’s audit committee
Compensation Committee
Audit Committee
• Aligns interests of the senior management with the
long-term interests of the firm and its stakeholders.
• Considers deferment of remuneration (until long-term
results materializes), clawback provisions, etc.
• Independent of management.
• Stock options have unlimited upside, but limited
downside. Stock prices may only reflect short-term
prospects.
• Ensures adherence to financial reporting and
regulatory compliance standards pertaining to
accuracy, comprehensiveness, disclosures, etc.
• Oversees the underlying systems and controls that are
in place for financial reporting, regulatory compliance,
internal controls, risk management, etc.
• Should also be responsible for optimizing firm’s
operations and meeting minimum legal, compliance
and risk management standards.
• Must possess sufficient expertise.
• Largely independent of management; balances
independence with knowledge of firm’s internal
workings.
• Has open communication channels with senior
management.
28
1.3.f. Illustrate the interdependence of functional
units within a firm as it relates to risk management
• Systems must be in place to ensure that data from each unit is
accurate, comprehensive, timely, etc.
29
Reading 4:
4 Credit Risk
Transfer Mechanisms
30
4.a. Compare different types of credit derivatives, explain how each one
transfers credit risk and describe their advantages and disadvantages.
• Credit risk ,  the risk of a borrower defaulting, is the core risk
exposure held by a bank.
• Credit Default Swaps (CDSs), Collateralized Debt Obligations (CDOs),
and collateralized loans obligations (CLOs) are credit derivatives are
essentially off-balance sheet instruments that enable institutions to
isolate and transfer very specific risk exposures.
31
4.a. Compare different types of credit derivatives, explain how each one
transfers credit risk and describe their advantages and disadvantages.
• Credit default swaps (CDSs) are financial derivatives that pay off when the issuer of a reference
instrument (e.g., a corporate bond or a securitized fixed income instrument) defaults. This is a
very direct way to measure and transfer credit risk.
• These derivatives function like an insurance contract in which a buyer makes regular (quarterly)
premium payments, and in return, they receive a payment in the event of a default.
• Advantages of CDSs include:
• Spur innovation. Conceptually, CDS buyers are protected from credit risk. This enables them to fund riskier
opportunities than they otherwise might comfortably support. This access to capital could spur innovation and boost
economic growth.
• Cash-flow potential. CDS sellers create a stream of payments that could be a significant source of cash flow.
Theoretically, they can diversify the CDS contracts across industries and geographies such that defaults in one area
should be offset by fees from CDSs that have not been triggered through default.
• Risk price discovery. The use of a CDS enables price discovery of a specific credit risk. Bonds also provide credit risk
price discovery, but this service is blurred because their prices also include other risks, such as interest rate risk. A
CDS is a pure play on pricing a given borrower’s credit risk.
32
4.a. Compare different types of credit derivatives, explain how each one
transfers credit risk and describe their advantages and disadvantages.
• Disadvantages of CDSs include:
• Historically weak regulation. CDS contracts were unregulated until after the financial crisis of 2007–2009. Lack of
regulation meant that counterparty risk existed because CDS buyers were not guaranteed that the CDS seller could
make good on the promise of credit risk mitigation.
• False sense of security. The presence of a CDS contract creates a false sense of security for fixed income buyers, who
could support an issuer that is far riskier than they would support without the presence of credit risk transfer. This
can be both an advantage (access to capital) and a disadvantage (excessive risk-taking behavior), depending upon
one’s vantage point.
• A collateralized debt obligation (CDO) is a structured product that banks can use to unburden
themselves of credit risk. These financial assets are repacked loans which are then sold to
investors on the secondary markets. A CDO could include some combination of asset-backed
securities (ABSs) which could include mortgages (commercial or residential), auto loans, credit
card debt, or some other loan product. Typically, the loans included in a CDO are heavily biased
toward mortgage debt through a securitized basket of mortgages called a mortgage-backed
security (MBS). When a CDO consists only of mortgage loans, it is technically known as a
collateralized mortgage obligation (CMO).
33
4.a. Compare different types of credit derivatives, explain how each one
transfers credit risk and describe their advantages and disadvantages.
• A CDO may also contain securitized short-term corporate borrowings through a product called
asset-backed commercial paper. Sometimes, a CDO will contain repackaged portions of another
collateralized debt obligation that could not be sold directly to investors. This product is then
called a CDO-squared, and it enables riskier portions of loans to be bundled with lower-risk loans
to attract investor interest. The added complexity of a CDO-squared is primarily intended to make
the product easier to market to potential investors and not to enhance risk mitigation potential.
• Financial engineers determine how to organize a CDO’s constituent loans into investable tranches
(a French word meaning slices). These tranches are structured to distribute credit risk and to
meet rating agency requirements. The most junior tranche offers a high interest rate but receives
cash flows only after all other tranches have been paid. For this reason, this most junior tranche is
sometimes referred to as the equity tranche or even toxic waste. Above the equity tranche are
the mezzanine tranches, which receive payment before the junior tranches. The highest-rated
tranche, called the super senior tranche (often rated AAA), is the safest tranche and the first
tranche to be paid out; however, it pays investors a relatively low interest rate.
34
4.a. Compare different types of credit derivatives, explain how each one
transfers credit risk and describe their advantages and disadvantages.
• Advantages of CDOs include:
• Increased profit potential. Banks have the ability to source loans, repackage them into a structured product, and
then use the proceeds from selling the repackaged loans to source new loans. This cycle enables banks to increase
loan turnover and therefore increase profit potential.
• Direct risk transfer. Through the securitization process, banks will effectively transfer credit risk to investors.
• Loan access. Since the bank is repackaging and selling the loans, individuals who otherwise might not be able to
access a loan may now have access.
• Disadvantages of CDOs include:
• Encourages increased risk taking. Since banks have the ability to transfer credit risk, they may source loans that are
riskier than they otherwise would accept. This behavior could result in unexpected risk for investors.
• Risk concentration potential. These structured products could unknowingly (on the part of investors) concentrate
exposure to high-risk borrowers, who may default and cause investors to experience unexpected losses.
• High complexity. Structured products are very complex. They may be difficult for an investor, a rating agency, or a
regulator to fully understand.
35
4.a. Compare different types of credit derivatives, explain how each one
transfers credit risk and describe their advantages and disadvantages.
• A collateralized loan obligation (CLO) is a structured product that is extremely similar to a CDO.
Like a CDO, they are a bundle of repackaged loans that are organized into tranches. However, a
CLO’s constituent loans are predominantly bank loans, which have typically been exposed to a
rigorous underwriting process.
• CLOs did not experience the same level of defaults that plagued the CDO market (largely due to
heavy exposure to mortgages in the CDO space). For this reason, CLOs continued to attract
investor interest in the wake of the financial crisis of 2007–2009, while CDOs lost interest quickly.
36
4.b. Explain different traditional approaches or mechanisms that firms
can use to help mitigate credit risk.
• Banks have several different traditional approaches that can be used to mitigate credit risk:
•
•
•
•
•
•
Purchase third-party insurance
Exposure netting.
Marking-to-market.
Requiring collateral
Termination clause.
Reassignment.
37
4.c. Evaluate the role of credit derivatives in the 2007-2009 financial
crisis and explain changes in the credit derivative market that occurred
as a result of the crisis.
• The existence of credit derivatives did not cause the financial crisis of 2007–2009, but the misuse
of these products certainly did. Investors used CDS contracts for speculation rather than risk
mitigation. Collateralized debt obligations also held a very complex mixture of mortgages that
included both subprime loans and adjustable-rate loans as well.
• There was a perfect storm when the Federal Reserve began raising rates, adjustable-rate loans
attained their reset date and produced unaffordable payments, and the housing market declined,
causing home prices to drop. This confluence of factors led to massive defaults that rippled
through the MBS and CDO markets. Banks then became reluctant to lend to each other while
some were going bankrupt. As typically happens after a crisis, new regulation was created. DoddFrank was formed to better regulate the credit derivatives space and to keep bank trading in
check. The SEC also added Section 15G to further protect investors.
38
4.d. : Explain the process of securitization, describe a special purpose
vehicle (SPV) and assess the risk of different business models that banks
can use for securitized products
• Securitization is the general process of repackaging loans into a bundled new product that can be
sold to investors on the secondary markets. This process involves four key steps:
• Create a special purpose vehicle (SPV), which is an off-balance sheet legal entity that functions as a semi-hidden
subsidiary of the issuing parent company. An SPV will hold financial assets in such a way that is opaque for investors
to analyze.
• The SPV will use borrowed funds to purchase loan assets from one bank or possibly several banks to create
structured products (e.g., CMO, CDO, or CLO).
• The SPV’s constituent loans will be arranged by either seniority or credit rating and structured into tranches to form
risk layers within the SPV.
• The various tranches are then sold to investors on the secondary markets.
39
Objectives (5)
Reading 9: Learning from Financial Disasters
a) analyze the key factors that led to and derive the lessons learned from case studies
involving the following risk factors:
•
•
•
•
•
•
•
•
•
Interest rate risk, including the 1980s savings and loan crisis in the US
Funding liquidity risk, including Lehman Brothers, Continental Illinois and Northern Rock
Implementing hedging strategies, including the Metallgesellschaft case
Model risk, including the Niederhoffer case, Long Term Capital Management and the London
Whale case
Rogue trading and misleading reporting, including the Barings case
Financial engineering and complex derivatives, including Bankers Trust, the Orange County
case, and Sachsen Landesbank
Reputational risk, including the Volkswagen case
Corporate governance, including the Enron case
Cyber risk, including the SWIFT case (page 133)
40
Objectives (6)
Reading 10: Anatomy of the Great Financial Crisis of 2007-2009
a) describe the historical background and provide an overview of the 20072009 financial crisis.
b) describe the build-up to the financial crisis and the factors that played an
important role.
c) explain the role of subprime mortgages and collateralized debt obligations
(CDOs) in the crisis.
d) compare the roles of different types of institutions in the financial crisis,
including banks, financial intermediaries, mortgage brokers and lenders and
rating agencies.
e) describe trends in the short-term wholesale funding markets that
contributed to the financial crisis, including their impact on systemic risk.
f) escribe responses taken by central banks in response to the crisis.
41
Objectives (7)
Reading 11: GARP Code of Conduct
a) a. describe the responsibility of each GARP Member with respect to
professional integrity, ethical conduct, conflicts of interest, confidentiality of
information and adherence to generally accepted practices in risk
management.
b) describe the potential consequences of violating the GARP Code of
Conduct.
42
Chapter 9:
9 Learning From
Financial Disasters
43
9.a. Interest rate risk, including the 1980s
savings and loan crisis in the US.
Savings and loans industry in the US collapsed in the 1980s.
Before that, the S&L industry prospered due to Regulation Q and an upward sloping yield
curve.
1933-2011: Regulation Q restricted interest payments on deposit accounts.
S&L industry made profits by riding the yield curve: Taking short-term deposits and giving out
long-term loans.
1970s: Federal Reserve had a more restrictive monetary policy in response to rising inflation.
Short-term rates increased, resulting in thinning or negative net interest margins (NIM).
44
9.a. Interest rate risk, including the 1980s
savings and loan crisis in the US.
S&L industry responded by engaging in riskier lending. This resulted in more losses
due to credit and business risks.
1986-1995: 1,043 out of 3,234 S&L players failed or were taken over.
Resulted in one of the world’s most expensive bailout at the time: $160 bil.
Management of interest rate risk:
• Effect of I% on assets should be highly correlated with effect on liabilities.
• Duration matching, interest rate derivatives (caps, floors, swaps).
45
9.b. Funding liquidity risk, including Lehman
Brothers,
Brothers Continental Illinois, and Northern Rock
2006: Real estate prices started to fall. However, Lehman:
• Continued to ramp up its real estate securitization business, and its own mortgage-related investments.
• Started to make outsized bets on US commercial real estate.
2007: Assets-to-equity ratio of 31:1. Lehman had excessive leverage, even for a bank.
To downplay leverage, Lehman engaged in Repo 105 transactions, an accounting
maneuver that removed assets from balance sheet prior to reporting period.
Lehman’s funding strategy made it vulnerable to rollover risks. Lehman began
borrowing huge amounts on a short-term basis to fund long-term real estate assets.
46
9.b. Funding liquidity risk, including Lehman
Brothers,
Brothers Continental Illinois, and Northern Rock
After the collapse of Bear Stern, attention shifted to Lehman. Its valuation of real estate assets was
questioned.
Counterparties began:
• Requesting for additional collateral to fund Lehman;
• Reducing exposure to Lehman; or
• Refusing to deal with Lehman.
Efforts to organize an industry rescue to sell the firm failed.
15 Sept 2008: Lehman filed for bankruptcy.
47
9.b. Funding liquidity risk, including Lehman
Brothers, Continental Illinois,
Illinois and Northern Rock
Once the largest bank in Chicago.
1976-1981: Commercial and industrial lending shot up to $14 bil from
$5 bil. Total assets grew to $41 bil from $21.5 bil.
After 1981: Oil and natural gas prices fell. Continental had $1 bil in
loans to oil and gas customers (through Penn Square Bank).
Continental had a tiny retail banking operation and a small amount of
core deposits. It relied heavily on federal funds (interbank lending)
and floating large issues of certificates of deposit for funding.
48
9.b. Funding liquidity risk, including Lehman
Brothers, Continental Illinois,
Illinois and Northern Rock
Continental turned to foreign wholesale money
markets, e.g. Japan, to raise funds at much
higher rates.
May 1984: Rumors spooked international
markets and foreign investors began to
withdraw deposits. $6 bil withdrawn in 10 days.
Regulators stepped in to prevent spread of
systemic risk.
49
9.b. Funding liquidity risk, including Lehman
Brothers, Continental Illinois, and Northern Rock
NR was growing rapidly (20% p.a.) for several years by focusing on
residential mortgages.
NR relied heavily on the wholesale funding market, less on retail
deposits. However, its funding sources geographically diversified.
NR also used the originate-to-distribute model.
In August 2007, the interbank lending market froze. NR had difficult
accessing funds despite geographical diversification, in which the
benefits were overestimated.
50
9.b. Funding liquidity risk, including Lehman
Brothers, Continental Illinois, and Northern Rock
Mid-Sept 2007: Run on the bank, when news of Bank of
England support operation was leaked.
At the time, deposits were fully guaranteed for sums up to
£2,000 only, and 90% guarantee for sums up to £33,000.
Panic was subdued after regulators promised that deposits
would be repaid.
NR accepted emergency government support and was
nationalized.
51
9.b. Funding liquidity risk, including Lehman
Brothers, Continental Illinois, and Northern Rock
Liquidity stress testing for largest banks.
Banks should have a holistic approach to balance-sheet management. Many
components are linked, e.g. funding liquidity risk, interest rate risk, business
strategy, profitability and product pricing, and capital management.
Mitigating funding liquidity risk:
• Optimizing funding sources;
• Optimizing duration; avoid concentration risk.
• Reducing duration of assets. May be challenging as its demand and competition driven, and
may be part of bank’s core strategy.
• Emergency liquidity cushions, e.g. liquid assets.
• Credit lines.
52
9.b. Funding liquidity risk, including Lehman
Brothers, Continental Illinois, and Northern Rock
Consider
trade-offs:
• Funding liquidity vs. Interest rate risks. Duration of
liabilities < Duration of assets  Higher funding
liquidity risk, less interest rate risk. Vice versa.
• Funding liquidity risk vs. Funding cost. Shorter
duration  Higher funding liquidity risk, lower
funding cost.
• Funding liquidity risk vs. Asset quality. Higher asset
quality  Lower funding liquidity risk, lower
profitability.
• Funding liquidity risk vs. Credit lines. More credit
lines  Lower funding liquidity risk, lower
profitability.
53
9.c. Implementing hedging strategies, including
the Metallgesellschaft case
The firm’s American subsidiary, Metallgesellschaft Refining and Marketing (MGRM), offered customers fixed prices
for heating oil and gasoline over the long term. The fixed prices were at a premium to futures prices maturing within
1 year.
In addition, customers could exit contracts if the spot price rose above the fixed prices, upon which MGRM would
pay the customers half the difference between the futures and contract prices. Why would a customer exit the
contract under such circumstances? If the customer needed instant liquidity or had no need for the product. In
subsequent contracts, customers received the entire difference if they entered into a new contract at a higher
contract price.
MGRM was effectively short long-term forward contracts, which was hedged with long positions in short-dated
futures under a stack-and-roll hedging strategy. The firm buys a stack of futures with the same expiry date, but rolls
into another stack prior to maturity. MGRM estimated the roll cost based on historical data. Short-dated futures
were used as the long-dated ones were illiquid.
54
9.c. Implementing hedging strategies, including
the Metallgesellschaft case
MGRM’s open interest far exceeded average daily trading volume and it eventually cashed out.
Impact: Losses of $1.5b.
The hedge was sound, but the firm could not withstand interim cashflow requirements, e.g. margin calls, M-tM, credit risks, etc. The oil price decline in 1993 exacerbated the problem, which resulted in margin calls and
M-t-M losses.
German accounting rules required MGRM to report losses on the M-t-M futures, but not the associated gains
from the fixed-price contracts. It suffered from funding liquidity risk as it had a high gearing ratio, its credit
rating dropped, counterparties demanded higher collateral (suspecting it of speculating rather than hedging),
and the New York Merchantile Exchange increased its margin requirements.
As such, MGRM had to close out large positions under extremely unfavorable conditions, adversely affecting
prices due to trading liquidity risk.
55
9.d. Model risk, including the Niederhoffer case,
case Long
Term Capital Management, and the London Whale case
Model risk can arise due to incorrect model, model specification and
estimators and/or insufficient data.
Niederhoffer ran a successful hedge fund. It wrote a lot of naked
deep OTM put options. Picking pennies in front of a steamroller.
A market fall of 5% would be very rare, assuming market was
normally distributed.
Oct 1997: US market fell 7% due to the Asian financial crisis.
Liquidity dried up and the fund was unable to meet $50 mil in
margin calls. Brokers liquidated positions for pennies on the dollar.
56
9.d. Model risk, including the Niederhoffer case, Long
Term Capital Management,
Management and the London Whale case
In 1998, it had a balance sheet leverage of 28 times; $125b in assets versus $4.7b in
equity. However, the notional amount of its positions was over $1 trillion. Institutions
waived initial margin requirements on account of the principals’ reputation.
LTCM main strategies were relative value, credit spreads and equity volatility, despite
diversification across different regions and asset classes. It believed that spreads and
volatility exhibited mean reversion patterns.
In August 1998, Russian debt defaulted; interest rates skyrocketed and the ruble crashed.
This caused shockwaves in emerging economies, leading to a huge selldown and flight to
quality. The increase in credit spreads and volatility caused huge losses to LTCM, losing
44% of its capital in a month.
57
9.d. Model risk, including the Niederhoffer case, Long
Term Capital Management,
Management and the London Whale case
Long-Term Capital Management (1998)
• LTCM’s models underestimated the correlation/domino effect in the face of unusual
economic shocks.
• Consequently, LTCM suffered from funding liquidity risks and had to liquidate positions
to meet margin calls.
• LTCM also underestimated its trading liquidity risks, which resulted from the sheer size
of its positions and imitators competing to liquidate. The lack of liquidity triggered even
more margin calls, resulting in a self-perpetuating cycle.
• LTCM had limited reporting requirements as a hedge fund. The true nature of its
positions and strategies were obscure.
• Impact: New York Federal Reserve Bank and 14 other banks bailed out LTCM to the tune
of $3.65b.
58
9.d. Model risk, including the Niederhoffer case, Long
Term Capital Management, and the London Whale case
JP Morgan is the largest financial holding company in the US with $2.4 trillion in assets, largest
derivatives dealer in the world and largest participant in world credit derivatives market.
2012: Chief Investment Office (CIO) managed $350 bil in excess deposits. CIO placed a massive
bet on a complex set of synthetic credit derivatives and lost at least $6.2 bil.
Executed by traders in London.
2006: CIO approved trading of synthetic derivatives.
2011: Synthetic Credit Portfolio (SCP) swell to $51 bil from $4 bil. SCP bankrolled a credit
derivatives trading bet that earned $400 mil.
59
9.d. Model risk, including the Niederhoffer case, Long
Term Capital Management, and the London Whale case
Dec 2011: CIO was instructed to reduce risk-weighted assets (RWA) to reduce
regulatory capital.
Jan 2012: Rather than disposing of risky assets, CIO purchased long credit derivatives
to offset short credit derivatives. This resulted in higher risk, portfolio size and RWA.
As the SCP became net long, the hedging benefits of the SCP was negated.
SCP was revenue generating for first 4 years. In 2012, number of days with losses
exceeded profits. Not a single day that SCP was cumulatively profitable.
CIO began to deviate from past valuation practices. Instead of marking it at/near the
mid-point, CIO began to assign more favorable prices within the daily range.
60
9.d. Model risk, including the Niederhoffer case, Long
Term Capital Management, and the London Whale case
By 16 Mar 2012: Losses of $161 mil, but $593 mil if proper mid-point prices were
used.
As counterparties learned of the valuation practices, several objected. Collateral
disputes peaked at $690 mil.
May 2012: Deputy CRO directed the CIO to mark its books the same as the
Investment Bank division, which used an independent service to identify midpoints. This resolved the collateral disputes.
JPM’s culture routinely disregarded risk limit breaches, downplayed risk metrics
and attacked risk evaluation models.
61
9.d. Model risk, including the Niederhoffer case, Long
Term Capital Management, and the London Whale case
1 Jan – Apr 30 2012: Risk limits and advisories were breached more than 330 times.
Jan 2012: Analysts concluded that VaR model was too conservative and overstated risk. A new
model was implemented, while in breach of CIO and bank VaR limits.
The new VaR model did not obtain Office of the Comptroller of the Currency approval and reduced
SCP VaR by 50%.
The new model was not properly implemented, relied on manual data entry and had formula and
calculation errors.
May 2012: JPM retracted the new VaR model and reinstated the previous model.
62
9.e. Rogue trading and misleading reporting,
including the Barings case
Nick Leeson, a junior trader based out of Singapore, took highly risky positions to recoup trading
losses.
He exploited loopholes in the bank’s controls and reported profits of $46m, when in fact he had
raked up losses of $296m. To meet margin calls, he successfully obtained $354m from the London
office for his “riskless” strategy without any queries.
He purportedly shorted straddles on the Nikkei 225 and arbitraged Nikkei 225 futures (long one
exchange, short another exchange). However, to recoup prior losses, he abandoned hedges on his
arbitrage strategy. Instead, he took speculative long positions in both exchanges.
In January 1995, an earthquake hit Japan, which caused the index to plunge, creating losses on the
long position and the short straddle strategy.
63
9.e. Rogue trading and misleading reporting,
including the Barings case
As a trader, Leeson was also responsible for settlement operations, which enabled him to
influence back-office employees. To book profits, Leeson engaged in NCBO. Execution prices were
modified and fictitious customers conjured to create artificial profits and losses. The profits were
reported to management, while losses were hidden in an old error account, which escaped
management’s scrutiny.
Internal power struggles, lack of oversight and understanding about Leeson’s role, ambiguity in
reporting lines, breach of formal trading limits were also contributing factors.
Impact: Losses of $1.25b and Baring’s eventual demise.
64
9.f. Financial engineering and complex derivatives, including
Bankers Trust,
Trust the Orange County case, and Sachsen
Landesbank
Procter & Gamble (P&G) and Gibson Greetings (GG) appointed BT to reduce their
funding costs. BT came up with a derivative strategy, which allegedly allowed a
high chance of small cost reduction, but a small chance of large losses.
The derivative strategy was deliberately complex to prevent an understanding of
its true risks and comparisons with other firms’ strategies.
Taped conversations by BT demonstrated bragging by BT staff about how they
fooled clients with complex structures and manipulated price quotes.
Impact: Huge reputational loss, CEO resigned, acquisition by Deutsche Bank and
eventually wound up, large losses by P&G and GG.
65
9.f. Financial engineering and complex derivatives, including
Bankers Trust, the Orange County case, and Sachsen
Landesbank
The line between hedging and speculation can be hard to draw.
The latent and deeply embedded risks may not be fully understood when derivatives are involved.
Early 1990s: Orange County treasurer, Robert Citron, borrowed $12.9 bil via repos.
Citron accumulated $20 bil in securities, although the fund only had $7.7 bil in investments.
Citron purchased complex inverse floating-rate notes. He enhanced fund returns by 2%.
1994: Federal Reserve raised I% by 2.5%, and the fund lost $1.5 bil by Dec.
Some repo counterparties refused to rollover. Orange County eventually filed for bankruptcy.
Excessive leverage and risky interest rate bet brought the fund to its knees.
Citron admitted that he did not understand the position nor its risks.
66
9.f. Financial engineering and complex derivatives, including
Bankers Trust, the Orange County case, and Sachsen
Landesbank
SL traditionally lent to SMEs, but during the
boom years opened overseas branches and
developed investment banking capabilities.
SL set up off-balance sheet entities to hold large
volumes of highly-rated US mortgaged-backed
securities, guaranteed by SL.
When the subprime crisis hit, SL was rescued
and sold to another German state bank.
67
9.g. Reputational risk, including the
Volkswagen case
Sept 2015: Environmental Protection Agency (EPA) announced that VW had installed
emission (nitrogen oxide) controls for regulatory testing.
Actual levels far exceeded regulatory standards.
2009-2015: More than 10 mil cars had this installation; 500,000 in the US alone.
VW share price plunged by over 1/3 and faced billions in penalties and fines.
German officials expressed concerns of national reputational damage, not just VW.
68
9.h. Corporate governance, including the Enron
case
Loans were disguised as oil futures, whereby Enron received
cash for future oil delivery, but agreed to repurchase the oil in
the future at a higher price.
JP Morgan and Citigroup were Enron’s main counterparties, and
denied any involvement in Enron’s financial accounting practices.
The loans were correctly accounted for in the financial
institution’s reports.
Impact: Fines of $286m for assisting in fraud against Enron’s
investors.
69
9.i. Cyber risk, including the SWIFT case
World’s leading system of electronic funds transfer, processing $ billions every day.
Transactions that would normally take days, take only seconds.
Apr 2016: Hackers used the SWIFT network to steal $81 mil from central bank of
Bangladesh at the NY Federal Reserve.
A malware sent unauthorized SWIFT messages to move funds into an account
controlled by the hackers.
Malware then deleted the database record of the transaction and disabled
confirmation messages.
70
Bonus cases:
Chase Manhattan, Drysdale Securities (1976)
• Drysdale, with a $20m capitalization, incurred a debt of $300m from Chase while betting on interest rate
movements (I% ↓, bond value ↑).
• Drysdale provided misleading reports and exploited a flaw in the calculation of collateral value of U.S. Treasuries.
• Drysdale requested Chase to purchase government bonds. Drysdale short sold the bonds, the value of which
included accrued interest. Drysdale then posted as collateral the value of the bond purchased, the calculation of
which did not include accrued interest.
• In summary, proceeds from short sale > collateral posted. The surplus cash generated was used to pay interests to
Chase.
• The interest rate bets made by Drysdale were misinformed, and it failed to make scheduled interest payments.
• Inexperienced managers of Chase did not realize that it would ultimately be responsible for any non-payments by
Drysdale; they assumed that Chase was a mere middleman.
• Impact: Chase was liable for Drysdale’s failed payments.
• Improved calculations of collateral posted to include accrued interest.
• Due diligence: More checks and balances when issuing new funds, avoiding concentration risks, KYC.
71
Bonus cases:
Kidder Peabody (1992-1994)
• Joseph Jett, head of government bond trading, exploited a flaw in the computer
system, which did not account for forward contracts’ present values.
• Jett was able to book an instant profit when purchasing a bond for cash and
shorting a forward contract. This effect could be magnified by increasing the
maturity of the forward and the principal amount.
• Impact: $350m in reported profits had to be reversed. Although Peabody did not
incur losses, its reputation was in tatters. Peabody was eventually wound up.
• If it’s too good to be true, it most likely is.
72
Bonus cases:
Allied Irish Bank (1997-2002)
• John Rusnak purportedly conducted a small currency arbitrage trading strategy. To the contrary, his
positions were enormous.
• He created fictitious trades to obscure the true size of his positions and misled the system’s VaR
calculations. He bullied back-office workers into foregoing trade confirmations for fictitious
transactions, amongst others.
• The OTC market, which did not require immediate cash settlement, gave him time to maneuver.
• He reported modest gains to avoid raising red flags, and covered up losses by shorting deep in-themoney options, which were premium rich.
• The management were ill-equipped to detect Rusnak’s suspicious trades and profits.
• Eventually, a back-office supervisor detected the anomaly. Even then, Rusnak forged trade
confirmations to appease the supervisor.
• Impact: Losses of $691m.
73
Bonus cases:
Union Bank of Switzerland (1997-1998)
• The equity derivatives (ED) division had a lot of independence, with minimal oversight. Its
senior risk manager was also head of quantitative analytics, whereby he directed business
decisions and was compensated based on trading profits.
• Impact: The ED division lost between $400-$700m in 1997 and a further $700m in 1998.
UBS eventually merged with Swiss Bank Corporation.
• Losses in 1997 were contributed to by changes in British tax law, inadequately hedged
exposure in Japanese bank warrants, and inaccurate modelling of long-dated options.
• Losses in 1998 were attributed to the collapse of LTCM. UBS had a 40% stake in LTCM, deltahedged by a 60% exposure to short option positions. However, LTCM’s lack of transparency
hampered UBS’ endeavor to fully understand its positions and conduct stress tests.
74
Bonus cases:
Société Générale (2008)
• Jérôme Kerviel, a junior trader, established unauthorized positions in futures and equities.
• To obscure the size and riskiness of these positions, he created close to 1,000 offsetting, rolling,
fictitious transactions. These transactions, which had future start dates, were cancelled before trade
confirmations.
• The bank’s systems did not flag up or validate high trade cancellations and did not adequately consider
gross positions.
• Lack of oversight was compounded after his manager resigned in early 2007, with significantly more
unauthorized trades thereafter. Tighter controls were not implemented following a change of guards.
• Inertia by Kerviel’s trading assistant, violation of vacation policy, weak reporting system for collateral
and cash accounts (which the fake transactions did not require), lack of scrutiny into high levels of
trading gains (not commensurate with trading limits) were contributing factors.
• A routine positions monitor by a control personnel uncovered the sham.
• Impact: Losses of $7.1b.
75
Bonus cases:
Daiwa (1984-1995)
• Toshihide Iguchi, a Treasury bond trader,
reported losses as profits by forging
customer trading slips.
• Iguchi was head of trading and the back
office.
• When the fraud was uncovered, senior
managers failed to report promptly to
the authorities.
• Impact: Losses of $1.1b and loss of U.S.
trading license.
Askin Capital Management (ACM) and
Granite Capital (GC) (1994)
• David Askin managed both ACM and GC,
which invested in mortgage securities.
• He improperly valued positions and did
not use dealer quotes, in order to drum
up interest in his funds.
• Impact: Losses of $600m and
bankruptcy of both funds.
76
Bonus cases:
Sumitomo (1996)
• Yasuo Hamanaka, the lead copper trader, cornered the relatively small copper market.
• He long futures and soaked up copper supply, driving prices up. To finance the long positions, he short
put options and engaged in highly leveraged transactions.
• The long futures and commodities positions and short put positions exposed Hamanaka to huge losses
should copper prices fall.
• Hamanaka’s free rein enabled him to implement this strategy. Large transactions were not approved
by senior managers. He was also able to give power of attorney to other firms to accumulate copper.
• He also maintained two trading books, one which reported profits and another losses.
• Eventually, the Commodity Futures Trading Commission (CFTC) initiated an investigation for market
manipulation, contending that the trades lacked a legitimate commercial rationale.
• When Hamanaka was reassigned in May 1996, copper traders dumped their holdings, resulting in
copper prices plummeting.
• Impact: Loss of $2.6b and $150m fine by the CFTC.
77
Bonus cases:
Merrill Lynch (1987)
• The firm used an inaccurate
methodology in the calculation of
duration for mortgage securities.
• The firm stripped the mortgage
securities into interest- and
principal-only securities, but
mispriced them.
• Impact: Losses of $350m.
National Westminster Bank (19941997)
• Traders used erroneous volatility
inputs for interest rate caps and
swaptions, which was based on
inadequate samples of these
illiquid instruments.
• Impact: Losses of $140m and
forced sale of Royal Bank of
Scotland due to a loss of investor
confidence.
78
Bonus cases:
Prudential-Bache Securities (1993)
• Misled thousands of investors about the risk of limited partnership
investments.
• Impact: More than $1b in fines and settlements.
79
Bonus cases:
Morgan Grenfell Asset Management (1995)
• A fund manager misdirected investors to highly risky equity investments, and
exploited legal loopholes on mutual funds’ equity percentage restrictions.
• Impact: $600m in compensations.
80
Chapter 10:
10 Anatomy of the
Great Financial Crisis of 20072009
81
10.a. Describe the historical background and provide an overview of the 2007-2009 financial crisis
10.b. Describe the build-up to the financial crisis and the factors that played an important role
10.d. Compare the roles of different types of institutions in the financial crisis, including banks, financial intermediaries,
mortgage brokers and lenders and rating agencies
10.e. Describe trends in the short-term wholesale funding markets that contributed to the financial crisis, including their
impact on systemic risk
Definition of financial crisis: Merger, takeover, bailout or closure of a bank, which may lead to the
same fate for other banks. The recent GFC was the worst crisis since the Great Depression.
Factor 1: Cheap credit/debt/leverage, e.g. loans, foreign borrowings, domestic government debt.
Increased demand for U.S. Treasuries by foreign governments and institutional investors drove
down interest rates. Institutional investors (e.g. municipal/state government, money market mutual
funds, etc), who had ample funds (their cash pile grew to $4t from $200m) and were searching for
Treasuries substitutes (e.g. repos and ABCP), invested with shadow banks as intermediaries.
Factor 1: Cheap credit/debt/leverage. After the Internet Bubble burst, Federal Reserve kept
interest rates low to fight against deflation.
Shadow banks issued ABCP subscribed to by institutional investors and engaged in reverse repos
with institutional investors. Shadow banks’ issuance of MBS/ABS/CDO/CDO2 spiked to $2t from
$500b in 2000.
82
10.a. Describe the historical background and provide an overview of the 2007-2009 financial crisis
10.b. Describe the build-up to the financial crisis and the factors that played an important role
10.d. Compare the roles of different types of institutions in the financial crisis, including banks, financial intermediaries,
mortgage brokers and lenders and rating agencies
10.e. Describe trends in the short-term wholesale funding markets that contributed to the financial crisis, including their
impact on systemic risk
Factor 2: Decline in underwriting standards fueled by originate-to-distribute model.
Trend 1: Securitization led to a loosening of underwriting standards. Securitization enabled
transfer of risks and returns to investors. As such, the originate-to-distribute model
replaced the traditional model, in which the originator held onto the loans until maturity.
Originators had little incentive to ensure that obligors were creditworthy.
Securitization involved tranching a portfolio of diversified assets. The senior tranches were
sold off to investors, while the equity tranches were supposed to be held on by sponsor
banks as incentive to monitor the loan.
Consequently, housing prices (a crisis indicator) increased, together with real equity
growth, real GDP growth.
83
10.a. Describe the historical background and provide an overview of the 2007-2009 financial crisis
10.b. Describe the build-up to the financial crisis and the factors that played an important role
10.d. Compare the roles of different types of institutions in the financial crisis, including banks, financial intermediaries,
mortgage brokers and lenders and rating agencies
10.e. Describe trends in the short-term wholesale funding markets that contributed to the financial crisis, including their
impact on systemic risk
Trend 2: Asset-liability mismatch. Structured investment vehicles (SIV) funded the
purchase of long-dated structured products with short-term debt (e.g. commercial paper
and repos). Due to the asset-liability mismatch, SIVs exposed themselves to funding
liquidity risks. Sponsoring banks assumed the risks by providing a credit line (liquidity
backstop) to SIV, which consequently caused them huge losses.
Trigger: Possibility of losses on subprime mortgages, including senior tranches rated AAA
by rating agencies. After teaser rates ended, subprime borrowers could not meet
mortgage payments. Delinquencies/defaults and foreclosures increased: CDS prices
increased and house prices fell. In 1H 2007, house prices declined and several subprime
mortgage lenders failed.
Vulnerability: Repos and ABCP, which are short-term instruments, could not be rolled over
as institutional investors retreated and made a run on shadow banks. MM mutual funds
themselves, which were substantially invested in ABCPs, were subject to a run later on.
Liquidity dried up. Haircut increased from almost zero (beginning 2007) to 25% (Sept
84
2008); each % = $10b withdrawal from financial markets.
10.c. Explain the role of subprime mortgages and
collateralized debt obligations (CDOs) in the crisis
Risk sharing (avoiding concentration risks) through securitization lowered interest rates on
mortgages.
Tranching allowed investments by institutions that were constrained by minimum credit ratings in
their mandates.
Regulatory environment encouraged securitization:
• By removing loans off their balance sheets, banks were subject to lower capital charges.
• Sponsoring banks also provided non-contractual credit lines (a.k.a. reputational credit lines) to the SIVs, which attracted
no capital charges.
• Rating agencies gave relatively high ratings to structured products, thus reducing capital charges.
High ratings by rating agencies due to perceived diversification effects, albeit erroneous:
• Benign past data were used for projections.
• The issuer-pay model is fraught with conflicts of interest.
• In addition, rating agencies received higher fees for rating structured products, compared to corporate ratings.
Pursuit of yield.
85
10.f. Describe responses taken by central banks in
response to the crisis
86
10.f. Describe responses taken by central banks in
response to the crisis
Based on IMF’s study of 13 developed countries.
The short-term impact of these 5 policies during 3 periods (1 June 2007-15 September 2008, to 31 December
2008, to 30 June 2009) was studied.
Rate cuts:
•
•
•
•
Indicators: Economic stress index (ESI) and financial stress index (FSI).
ESI measures confidence of businesses/consumers, non-financial firm stock prices and credit spreads.
FSI measures stock prices, spreads and bank credit.
Conclusion: No impact on the ESI, limited positive impact on the FSI. Central bank actions were well anticipated.
Liquidity support:
• Indicator: Interbank spread and FSI.
• In period 1: Strong impact on both indicators.
• In later periods: Impact was inconclusive, possibly because support was well anticipated or the concern had shifted to
solvency, rather than liquidity.
87
10.f. Describe responses taken by central banks in
response to the crisis
Recapitalization:
•
•
•
•
•
Indicators: FSI and bank CDS index.
E.g. Government intervention (e.g. equity or asset purchase) to restructure firm’s capital.
In period 1: Little impact on CDS spreads as recapitalizations were scarce.
In later periods: Positive impact as CDS spreads narrowed.
Impact on FSI was generally weaker as creditors benefitted mostly from recapitalizations.
Liability guarantees and asset purchases:
• Indicators: FSI and bank CDS index.
• Weaker impact on both indicators, with two exceptions: (a) UK’s asset protection scheme
2009; and (b) Swiss government purchase of UBS assets.
88
Chapter 11:
11 GARP Code of
Conduct
89
11.a. Describe the responsibility of each GARP member with respect to professional
integrity, ethical conduct, conflicts of interest, confidentiality of information, and
adherence to generally accepted practices in risk management
Code of Conduct
Professional Integrity and
Ethical Conduct
Principles
Conflicts of Interest
Confidentiality
Professional
Standards
Fundamental
Responsibilities
Generally Accepted
Practices
90
11.b. Describe the potential consequences of
violating the GARP Code of Conduct
Violations of Code of
Conduct permissible to
comply with local
laws/regulations.
In other cases of
violations, the following
sanctions will be
imposed after a formal
investigation:
• Suspension.
• Permanent removal of membership.
• Revocation of right to use FRM designation.
91