Market Risk –
Internal Model Approach
K.G.Bhandari
IndusInd Bank Ltd.
March 15, 2010
Indian Banks’ Association
4th Annual summit 2010
Basel Accord
• Capital requirement were simplistic and rigid – but did not reflect
underlying economic risks of banks / FIs
• Now, capital requirements are more risk sensitive - reflects
economic risk assumed
• These new standards are generally based on Value-at-Risk (VaR)
methods
• VaR is a measure of loss at given confidence level and directly
translates into measure of buffer capital
• Basel-I Accord sets Minimum Capital requirements to guard against
Credit Risk
• To control expanding Trading activities, Capital Charge for market
risk was included later
Standardised Method – Capital Charge for Market Risk
• Based on pre-specified, standarised, ‘building – block approach’
• Market risk is computed for portfolios exposed to interest rate risk,
exchange risk, equity risk and commodity risk
• Takes into account Notional amount and market parameters
• Main drawback – ignores diversification across market risks – within
each category and across different categories
• Highly conservative – Adds up capital charge for each category
• Assumes that Worst Loss will hit all portfolios at the same time
• Does not reward prudent diversification
Internal Model Approach
IMA recognises –
 Risk Management models in use – far more
advanced than rigid rules
 Banks can use their own VaR models as basis for
capital requirement for Market Risk
 VaR is a robust
Management Practice
Risk
Measurement
and
IMA - Qualitative Criteria
•
Independent Risk Control Unit responsible for design and implementation
of Bank’s risk management systems
•
Regular Back-Testing
•
Initial and on-going Validation of Internal Model
•
Bank’s Internal Risk Measurement Model must be integrated into
Management decisions
•
Risk measurement system should be used in conjunction with Trading
and Exposure Limits.
•
Stress Testing
•
Risk measurement systems should be well documented
•
Independent review of risk measurement systems by internal audit
•
Board and senior management should be actively involved
IMA - Quantitative criteria
Quantitative Parameters :
• VaR computation be based on following inputs :
– Horizon of 10 Trading days
– 99% confidence level
– Observation period – at least 1 year historical data
• Correlations : recognise correlation within Categories as well
as across categories (FI and Fx, etc)
• Market Risk charge : General Market Risk charge shall be –
Higher of previous day’s VaR or Avg VaR over last 60 business
days X Multiplier factor K (absolute floor of 3)
Market Risk Charge
Market Risk charge on any day ‘t’
MRCt = Max (Avg VaR over 60 days, VaR t-1) + SRC
SRC – Specific Risk Charge
Back testing
Possible cause and remedies of the "Yellow" zone
• Basic Integrity of the model
• Deficient model accuracy
• Intra day trading
• Bad luck
Internal Model Approach - Benefits
• Internal VaR system is more precise
• VaR account for correlations
• Market risk charge under IMA likely to be lower
• With improvements in risk measurement techniques, IMA will
enable capital charge to be more precise
• Market Risk charge needs to be computed and monitored daily
• Each day VaR is compared with the subsequent Trading profit
or loss
• Back Testing will help to refine the framework
Market Risk – Advanced Risk Measurement Techniques
enables Bank to effectively control the amount of market risk
it assumes and allocate capital for the same
‘Know’ your risks
Control Measures
Allocate Capital
 Duration Limits
 Standardized
Model
 VaR Limits
Measurement Techniques
 Stop Loss Limits
 Marking to Market
 Counterparty Exposure
Limits
 Duration, Convexity
 Internal Model
 Country Exposure Limits
 Price Value of a Basis Point
 Stress Testing
 Scenario Analysis
Sophistication
 VaR - Forex (Spot & Forward)
Stress Testing
Value at Risk
Duration
Mark to Market
Revaluation of
the portfolio to
measure notional
P/L
Cashflow
analysis to
measure the
sensitivity of
fixed income
instruments
Use of statistical
Statistical
analysis to
determine
maximum losses
Use of ‘What if’
scenarios to
determine losses
in extreme
events
Time
Market Risk Amendment
Paradigm becomes explicit
Frequency of loss

Expected
loss
0

Unexpected loss

Stress
loss
Amount of loss
Supporting Factors for Risk Management
1
Involve of
the board of directors
and high level management
4
Set up risk
management system
2
Effective Risk
Management
Establish a unit to operate
risk management
Formulate risk
management policies
and procedures
3
Limitations to Risk Management
Limitations
Involve of the board of directors
and high level management
•
•
•
•
Not enough cooperation
Low qualification
Lack of independence to make a decision
Not transparence
Formulate risk management
policy and procedures
•
•
•
•
Policies/ procedures not match with risks
Underdevelopment Infrastructure
Rigid to implement
Communication failure
Establish a unit to operate
risk management
• Lack of adequate structure
• Staff has less experience
• Lack of independence
Set up risk management
system
• No follow up and control system
• Not enough risk assessment/
management
instruments
• Database and IT system
Internal Model Approach
Supervisory objectives
• better risk management
• continual upgrading and encouragement of
innovation in risk management methodology and
• improved risk sensitivity and measures.
Internal Model Framework
Policy
Governance
Risk Strategy
Accountability
Risk Appetite
Internalising
Risk Managem ent Models
Reporting
Projection & Analysis Models
Annual: planning, forecasting, budgeting
Risk Maps
Economic Capital
Risk Monitoring
Risk Analysis
Pricing, capital management
Sensitivity Measures & Analysis
External Factors
financial markets, competition, tax & regulation
Risk Reporting
Impact & Benefits
• Best practice risk and capital management
– In particular:
• Risk management - processes and controls
• Capital management - eligible capital and quality of
capital
• Improved market perception: enhanced reputation
for risk management
• Precise capital requirements and return on capital
• Enhanced management information to support
more optimal management decisions
• Reduced costs: Operational efficiencies from
better risk management
Internal model and its purpose
• What is an internal model?
– “A risk management system developed by the
Bank to analyse the overall risk position, to
quantify risks and to determine the economic
capital required to meet those risks”
•
What is the purpose of an internal model?
– To fully integrate processes of risk and capital
management within the Bank
Expected Benefits
• Improved risk sensitivity
• Better alignment of regulatory capital requirements with
economic capital
• Encouragement of innovation in risk management methodology
leading to higher competitiveness through better risk
management and hence lower costs of capital
• More effective pillar 2 discussion and familiarity of the
supervisor with more detailed exposure data
• Cost efficiencies through re-use of risk modeling infrastructure
for discussion with supervisors, rating agencies, analysts and
shareholders.
Particular issues for banks
•
•
•
•
The regulatory requirements are not yet come
There is a shortage of skills and expertise
There are data limitations
Low base in terms of use of models and risk management; in
effect, attempting to “jump a generation”
• The operating environment is undergoing fundamental change
However, none of these difficulties are insurmountable if one learns
from others
• Most difficult IRB qualifying criterion to meet is not in relation to
the models themselves but in relation to the use them - a major
challenge
• It needs to be recognised that a robust risk management
framework is an essential prerequisite. Successful implementation,
such as the use of models, can only be achieved if they integrate
into a sound framework of systems and controls; in the case of
certain banks, there may be some gap vis-à-vis international best
practice
Specification of Market Risk Factors
•
For interest rates, there must be a set of risk factors corresponding to
interest rates in each currency in which the bank has interest-ratesensitive on- or off-balance sheet positions
•
The risk measurement system should model the yield curve using one of
a number of generally accepted approaches
•
The risk measurement system must incorporate separate risk factors to
capture spread risk
•
For exchange rates (which may include gold), the risk measurement
system should incorporate risk factors corresponding to the individual
foreign currencies in which the bank’s positions are denominated
•
For equity prices, there should be risk factors corresponding to each of
the equity markets in which the bank holds significant positions
•
For commodity prices, there should be risk factors corresponding to
each of the commodity markets in which the bank holds significant
positions
Quantitative Standards
•
“Value-at-risk” must be computed on a daily basis
•
In calculating the value-at-risk, a 99th percentile, one-tailed confidence interval is to be used
•
“Holding period” will be ten trading days
•
“Effective” historical observation period must be at least one year
•
Banks should update their data sets no less frequently than once every three months and should
also reassess them whenever market prices are subject to material changes
•
No particular type of model is prescribed – should captures all the material risks run by the bank
•
Banks will have discretion to recognise empirical correlations within broad risk categories
•
Banks’ models must accurately capture the unique risks associated with options within each of
the broad risk categories
•
Each bank must meet, on a daily basis, a capital requirement expressed as the higher of
(i) its previous day’s value-at-risk number measured according to the parameters specified in
this section and
(ii) an average of the daily value-at-risk measures on each of the preceding sixty business
days, multiplied by a multiplication factor
•
multiplication factor will be set by supervisory authorities on the basis of their assessment of the
quality of the bank’s risk management system, subject to an absolute minimum of 3.
•
Banks using models will also be subject to a capital charge to cover specific risk (as defined
under the standardised approach for market risk) of interest rate related instruments and equity
securities
Stress Testing
•
Stress testing to identify events or influences that could greatly
impact banks is a key component of a bank’s assessment of its capital
position
•
Stress scenarios need to cover a range of factors that can create
extraordinary losses or gains in trading portfolios, or make the control
of risk in those portfolios very difficult
•
Stress tests should be both of a quantitative and qualitative nature,
incorporating both market risk and liquidity aspects of market
disturbances
•
Banks should combine the use of supervisory stress scenarios with
stress tests developed by banks themselves to reflect their specific
risk characteristics
•
Stress tests results should be reviewed periodically by senior
management and should be reflected in the policies and limits set by
management and the board of directors
External Validation
Validation of models’ accuracy by external auditors and/or
supervisory authorities should at a minimum include
 verifying the internal validation processes
 formulae used in the calculation process as well as for the pricing
of options and other complex instruments are validated by a
qualified unit - independent from the trading area
 Structure of internal models is adequate with respect to the bank’s
activities and geographical coverage
 results of the banks’ back-testing of its internal measurement
system
 data flows and processes associated with the risk measurement
system are transparent and accessible
The Standardized Method
Risk classification is arbitrary.
Ignores diversification : leads to high capital
requirements because risk charges are systematically
added up across difference sources of risk
Captures Risk for positions as on the day and not for
the period.
The Standardized Approach
• Guidelines to compute
– Interest rates risk
– Exchange risk
– Equity risk
– Commodity risk
•
The bank's total risk is computed as the summation of the 4
categories
– ignoring correlations
• Provide a robust measure of interest rate risk taking into account
– Systematic/Market risk
– duration
– basis risk across maturities
• Specific/Idiosyncratic risk
The Standardized Approach - Market Interest Rate Risk
• Market risk is defined via Maturity Bands
Specific Interest Risk Charge
The capital charge for specific risk is designed to protect against an
adverse movement in the price of an individual security owing to factors
related to the individual issuer
Capital Charge for Interest Rate Risk
Where,
= Capital Charge for Total Interest rate Risk
= Capital Charge for General Interest rate Risk
= Capital Charge for Specific Interest rate Risk
The Internal Model Approach (IMA)
• Rely on Internal Risk Management of the Bank
– for the first time Regulation recognized that bank had
developed trustable risk management systems
– if this approach lead to lower Capital Charge, Banks
have incentives to develop sophisticated and more
accurate models
– However, need to be approved by Regulation
• sound and sufficient details on the VAR and
diversification models at qualitative and quantitative
levels
The Internal Model Approach (IMA) - Qualitative Requirements
• Independent Risk Control Unit
– The bank must a risk control that is independent of trading
and reports to senior management, to minimize conflicts of
interests
• Back testing
• Involvement
– senior
– sufficient resources
• Use of limits
• Stress Testing
• Compliance (to a documented set of policies)
• Independent Review
The Internal Model Approach (IMA) - Qualitative Requirements
• Requirement on risk factors :
– at least 6 factors for yield curve risk + separate risk factors to
model spread risk
– for equity, the model should at least consist of beta mapping
on an index, a more detailed approach could consist in adding
industry factors, as well as individual risk factor modeling
– for active trading in commodity, the model should account for
for movements in the spot plus convenient yields
– bank should also capture the non linear price characteristics
of options (gamma, vega , ...)
– Correlation within broad risk categories are recognized
explicitly
The Internal Model Approach (IMA) - VAR
• Market Risk Charge = VAR
• Shall be computed every day
• for a10 days horizon
– Bank can use a daily VAR and scale it using the square root
time rule
• with a 99% confidence level
• with an observation period based on at least one year moving
window of historical data
• shall be set at the higher of the previous day's VAR, or the
average over the 60 business days,
• times a multiplicative factor k
– determined by regulator (in the range of 3 to 4) to prevent
model misspecifications
• a plus factor is added (depending on the performance of the
model)
Stress Testing
Stress Testing can be described as a process to
identify and manage situations that could cause
extraordinary losses
Tools
– Scenarios Analysis
– Stressing Models
– Policy Response
Stress Testing - Scenarios Analysis
• Evaluating the portfolios
– under various states of the world
– evaluating the impact
• changing evaluation models
• volatilities and correlations
• Scenarios requiring no simulations
– analyzing large past losses
• Scenarios requiring simulations
– running simulations of the current portfolio subject to large
historical shocks
• e.g. 1987 crash, etc ...
• Bank specific scenario
– driven by the current position of the bank rather than
historical simulation
• Much more subjective than VAR
• Can help to identify undetected weakness in the bank's
portfolio
Back testing
Statistical testing that consist of checking whether actual trading
losses are in line with the VAR forecasts
– The Basle back testing framework consists in recording daily
exception of the 99% VAR over the last year
– Even though capital requirements are based on 10 days VAR,
back testing uses a daily interval, which entails more
observations
– On average, one would expect 1% of 250 or 2.5 instances of
exceptions over the last year
– Too many exceptions indicate that
• either the model is understating VAR
• the Bank is unlucky
• How to decide ?
 Statistical inference
Basel Market Risk Charges
• The Market Risk Charge
– Quantitative parameters
– Market risk charge
– Plus factor
• Stress Testing
– A process to identify and manage situations that could
cause extraordinary losses
– Scenarios requiring no simulation
– Scenarios requiring a simulation
– Bank-Specific scenarios
Basel Market Risk Charges
• Back testing
– A statistical testing framework that consists of
checking whether actual trading losses are in line
with VAR forecasts
– Exceptions
– The Penalty Zones
– Basic integrity of the model
– Deficient model accuracy
– Intraday trading
– Bad luck
Internal Model Approach - VaR
Qualitative Requirements :
• To use IMA, banks need to satisfy Qualitative
Requirements
• Robust risk measurement systems in place – must
be integrated into Management Decisions
• Conduct Stress Tests regularly
• Independent Risk Monitoring Framework