Presentation on
Financial Risk Management
Market Risk
Treasury Operations
Highlights of the Presentation
What is Market Risk and Basel II Approaches
Financial Markets
Structure, Transactions and Functions of Treasury
Risks and their Controls for Treasury Activities
Managing Risk
Effectively: Three Critical Challenges
Management Challenges for
the 21st Century
CHANGE
3
What is Risk?
•Risk, in traditional terms, is viewed as a ‘negative’. Webster’s
dictionary, for instance, defines risk as “exposing to danger or hazard”.
•The Chinese give a much better description of risk
>The first is the symbol for “danger”, while
>the second is the symbol for “opportunity”, making risk a mix of
danger and opportunity.
4
Risk Management
Risk management is present in all aspects of life; It is about the
everyday trade-off between an expected reward an a potential
danger.
We, in the business world, often associate risk with some variability
in financial outcomes. However, the notion of risk is much larger. It
is universal, in the sense that it refers to human behaviour in the
decision making process.
Risk management is an attempt to identify, to measure, to monitor
and to manage uncertainty.
5
Risk Assessment
 Assess your risk bearing capacity
 How much risk can you tolerate?
 How much risk protection can you
afford?
 How much risk are you willing to accept
6
Risk Management
 Risk management integrates production,
marketing & financial decisions
 Risk management is a planning process
where you assemble and assess information
 Every management decision carries risk
management implications
7
Risk Management Requires
 Understanding of Your financial
situation
 Understanding sources of risk and
potential risk
 Understanding of risk management tools
8
Risk Management Includes:
 Evaluation of alternative plans & risk
management strategies
 Implementation of the plan
 Monitoring the plan
 Developing probabilities to formalize risk
assessment
9
Steps in the
Risk Management Process
•
•
•
•
•
•
•
Determine the corporation’s objectives
Identify the risk exposures
Quantify the exposures
Assess the impact
Examine alternative risk management tools
Select appropriate risk management approach
Implement and monitor program
The Bottom Line:
It All Boils Down to Capital
• “Capital”
– Assets less liabilities; owners’ equity; net worth
– Support for (riskiness of) operations
– Thus, supports profitability and solvency of firm
• “Capital Management”
– Determine need for and adequacy of capital
– Plans for increasing or releasing capital
– Strategy for efficient use of capital
Why Do We Care About
Managing Capital?
• Leads to solvency and profitability
• Benefits of solidity and profitability
– Higher company value
– Happy shareholders
– Better ratings
– Less unfavorable regulatory treatment
– Ability to price products competitively
– Customer loyalty
– Potentially lower costs
What Does Capital Management
require?
Raising
Capital
Setting
Objectives
Risk
Management
Product
Pricing
Capital
Management
Asset
Allocation
Financial
Risk Mgt.
Strategic
Planning
Liability
Valuation
Role of Capital in Financial
Institution
• Absorb large unexpected losses
• Protect depositors and other claim holders
• Provide enough confidence to external
investors and rating agencies on the financial
heath and viability of the institution.
14
Type of Capital
• Economic Capital (EC) or Risk Capital.
An estimate of the level of capital that a firm requires to
operate its business.
• Regulatory Capital (RC).
The capital that a bank is required to hold by regulators in
order to operate.
• Bank Capital (BC)
The actual physical capital held
15
Economic Capital
• Economic capital acts as a buffer that provides
protection against all the credit, market,
operational and business risks faced by an
institution.
16
Financial Risk and Basel
17
BASEL-I Capital Calculation
Basel I Principles
 Strengthen the stability of the international banking
system
 Create minimum risk-based capital adequacy
requirements
Basel I Benefits
Relatively simple framework
 Widely adopted
 Increased banks’ capital
Capital
= Capital Adequacy Ratio
Credit Risk + Market Risk
RIWAC
18
Basel I Regulatory Capital Rules
Types of capital
Basel I capital calculation
• Stock issues
Core
Capital
(Tier 1)
• Disclosed reserves
– Loan loss reserves to cushion future
losses or for smoothing out income
volatility
• 50% of total capital
Capital (Tiers 1, 2, 3)
Risk-Weighted Assets and
Contingents
≥
8%
• Perpetual securities
• Unrealised gains on investment
Supplementary
Capital
(Tier 2)
securities
• Hybrid capital instruments
Balance
sheet
assets
• Long-term subordinated debt with
maturity > 5 years
• Short-term subordinated debt
Market risk
Capital
(Tier 3)
Off-balance sheet
assets
NonTraded
Traded
Risk
weights
19
RIWAC Calculation
On-Balance Sheet
x
Counterparty Weighting
RIWAC
=
+
Off-Balance Sheet Risk
x
Counterparty Weighting
x
Credit Conversion Factor
20
RIWAC Weightings
Banks
On-Balance Sheet Risk
Financial
Guarantees
Off
Balance
Sheet
Risk Cont. Transactional
liabilities Contingents
Secured LCs
Issued
Sovereigns
Corporates
Non
OECD
OECD
Non OECD
OECD
100%
20%
100%
0%
100%
100%
20%
N/A
N/A
100%
50%
10%
N/A
N/A
20%
4%
N/A
N/A
50%
20%
21
BASEL I- RIWAC Examples
Corporate
XYZ Bank Lends USD 100 M to UAE Corporate for 1 year
Capital = USD 100 M X 100% (Risk Weight) X 8% (Capital Adequacy) =
USD 8 M
Banks
XYZ Bank Lends USD 100 M to Barclays Bank for 2 years
Capital = USD 100 M X 20% (Risk Weight) X 8% (Capital Adequacy) = USD
1.6 M
Contingents
XYZ confirms Sight L/C of USD 100 M issued by ABN AMRO
Capital = USD 100 M X 20% (Risk Weight) X 20% (CCF) X 8% (Capital
Adequacy) = USD 0.32 M
22
Basel I regulatory capital rules – Credit risk (1)
On-balance sheet risk weights and Basel I capital calculation
Risk weight (%)
On-balance sheet asset category
Cash & gold
Obligations on OECD and PAK treasuries
Claims on OECD banks
 Govt. agency securities
Claims on municipalities
0
20
50
Step 1: RWA = On BS exposure X Risk Weight
Step 2: Capital = 8% X RWA
Residential mortgages
Corporate bonds, equity, real-estate
Less-developed countries’ debt
Claims on non-OECD banks
100
Off-balance sheet risk weights and Basel I capital calculation for non-trading assets
Risk weight (%)
0
20
50
Off-balance sheet asset category
OECD governments
OECD banks and public sector
entities
Corporates and other
counterparties
Credit
Conversion
Factor (%)
0
20
50
100
Off-balance sheet non-trading assets
Undrawn commitments – Maturity ≤ 1
year
Documentary credits related to
shipment of goods
Transaction-related contingencies –
warranties, performance bonds
Undrawn commitments – Maturity > 1
year
General guarantees, standby letters of
credit, banker’s acceptance, etc
Step 1: Credit Equivalent Amount (CEA) = Notional amount X Credit Conversion Factor
Step 2: RWA = CEA X Risk Weight
Step 3: Capital = 8% X RWA
23
Basel I regulatory capital rules – Credit risk (2)
Off-balance sheet risk weights and Basel I capital calculation for trading assets
Credit Conversion Factor (%)
Interest rates
FX and Gold
Equity derivatives
Precious metals
Less than 1 year
0.0%
1.0%
6.0%
7.0%
Commodity
contracts
10.0%
1-5 years
0.5%
5.0%
8.0%
7.0%
12.0%
More than 5 years
1.5%
7.5%
10.0%
8.0%
15.0%
Step 1: Current Exposure (CE) = Current marked-to-market value of asset
Step 2: Potential Future Exposure (PFE) = Notional amount X Credit Conversion Factor
Step 3: Credit Equivalent Amount (CEA) = CE + PFE
Step 4: RWA = CEA X Risk Weight
Step 5: Capital = 8% X RWA
24
BASEL I- Draw Backs
Criticisms of Basel I Accord
• Lack of risk sensitivity of capital
requirements
• One-size-fits-all’ approach to risk
management
• Limited attention to credit risk
mitigation
• Over emphasis on minimum
capital requirements
• Exclusive focus on financial risk
Consequences in the industry
• Sub-optimal lending
behavior
• Increased divergence
between regulatory capital
and economic capital
• Regulatory capital
arbitrage through product
innovation
25
Objectives “Basel II”
•
1.
2.
3.
4.
5.
The objective of the New Basel Capital
accord (“Basel II) is:
To promote safety and soundness in the financial system
To continue to enhance completive equality
To constitute a more comprehensive approach to
addressing risks
To render capital adequacy more risk-sensitive
To provide incentives for banks to enhance their risk
measurement capabilities
26
Comparison
Basel I
Basel 2
Focus on a single risk measure
More emphasis on banks’ internal
methodologies, supervisory review and
market discipline
One size fits all
Flexibility, menu of approaches.
Provides incentives for better risk
management
Operational risk not considered
Introduces approaches for Credit risk
and Operational risk in addition to
Market risk introduced earlier.
Broad brush structure
More risk sensitivity
27
Economic Objectives
• Efficiency: best use of capital across business
lines, impetus for risk based pricing and
operational cost savings
• Stability: ensure capital protection consistent
with shareholder value optimization
28
Economic Objectives
• Growth sustainability: balanced Portfolio risk
and return
• Equity: level competitive playing field
across(big and small) banks
29
Overview of Basel II Pillars
The new Basel Accord is comprised of ‘three pillars’…
Pillar I
Pillar II
Pillar III
Minimum
Capital
Requirements
Supervisory Review
Process
Market
Discipline
Establishes minimum standards
for management of capital on a
more risk sensitive basis:
• Credit Risk
• Operational Risk
• Market Risk
Increases the responsibilities and
levels of discretion for supervisory
reviews and controls covering:
• Evaluate Bank’s Capital
Adequacy Strategies
• Certify Internal Models
• Level of capital charge
• Proactive monitoring of
capital levels and ensuring
remedial action
Bank will be required to increase
their information disclosure,
especially on the measurement of
credit and operational risks.
Expands the content and improves
the transparency of financial
disclosures to the market.
30
Development of a revised capital adequacy framework
Components of Basel II
The three pillars of Basel II and their principles
Objectives
• Continue to promote
safety and soundness in
the banking system
Basel II
Principle
Issue
Minimum capital
requirements
Supervisory review
process
Market disclosure
• How is capital
adequacy measured
particularly for
Advanced approaches?
• How will supervisory
bodies assess,
monitor and ensure
capital adequacy?
• What and how should
banks disclose to
external parties?
• Better align regulatory
capital with economic risk
• Evolutionary approach to
assessing credit risk
- Standardised (external
factors)
- Foundation Internal
Ratings Based (IRB)
- Advanced IRB
• Evolutionary approach to
operational risk
- Basic indicator
- Standardised
- Adv. Measurement
• Internal process for
assessing capital in
relation to risk profile
• Supervisors to review
and evaluate banks’
internal processes
• Supervisors to require
banks to hold capital in
excess of minimum to
cover other risks, e.g.
strategic risk
• Supervisors seek to
intervene and ensure
compliance
• Effective disclosure of:
- Banks’ risk profiles
- Adequacy of capital
positions
• Specific qualitative and
quantitative disclosures
- Scope of application
- Composition of
capital
- Risk exposure
assessment
- Capital adequacy
Pillar 1
Pillar 2
Pillar 3
• Ensure capital adequacy
is sensitive to the level of
risks borne by banks
• Constitute a more
comprehensive approach
to addressing risks
• Continue to enhance
competitive equality
31
Overview of Basel II Approaches (Pillar I)
Basic Indicator
Approach
Operational
Risk
Capital
Score Card
Standardized
Approach
Advanced
Measurement
Approach (AMA)
Total
Regulatory
Capital
Credit
Risk
Capital
Internal
Modeling
Standardized
Approach
Foundation
Internal Ratings
Based (IRB)
Market
Risk
Capital
Loss Distribution
Standard
Model
Internal
Model
Advanced
Approaches that can be
followed in determination
of Regulatory Capital
under Basel II
32
The Three Pillars
• The First Pillar - Minimum Capital
Requirements
• The Second Pillar - Supervisory Review
Process
• The Third Pillar - Market Discipline
33
Pillar 1
• Calculation of the total minimum capital
requirements for credit, market and operational risk.
• The minimum capital requirements are composed of
three fundamental elements: a definition of
regulatory capital, risk weighted assets and the
minimum ratio of capital to risk weighted assets.
34
35
RISK BASED SUPERVISION
36
BASEL II : CAPITAL CHARGE
37
Credit Risk
• The standardized approach
• The Internal Ratings-Based Approach
– Foundation
– Advanced
38
Ops Risk
• The Basic Indicator Approach
• The Standardised Approach
• Advanced Measurement Approach
39
Market Risk
Equity Price
Interest Rate
Market
F. E.
Commodity Price
• Potential loss in value from market risk factors
• Primarily through trading, off balance sheet and on balance sheet items
Types of financial risk
Equity Risk
Market Risk
Trading Risk
Interest Rate Risk
Gap Risk
Currency Risk
Commodity Risk
Financial
Risks
Transaction Risk
Counterparty Risk
Portfolio
Concentration Risk
Issuer Risk
Credit Risk
Liquidity Risk
Operational Risk
Regulatory Risk
Human Factor
Risk
41
Market Risk under Basel II
• Standardized Approach
Building Block Approach: Capital charge captured separately for each risk
and then summed. Trading book used for general and specific risk in interest and
equities markets. Both trading and banking books are used for general risk in
currency and commodities markets.
• Internal Model
VAR modeling:
On daily basis and 99th percentile one-tailed confidence interval
is to be used, 10days holding period.
42
Why the focus on Market Risk Management ?
• Convergence of Economies
• Easy and faster flow of information
• Skill Enhancement
• Increasing Market activity
Leading to
•Increased Volatility
•Need for measuring and managing
Market Risks
•Regulatory focus
•Profiting from Risk
43
Measure, Monitor & Manage
– Value at Risk
Value-at-Risk
Value-at-Risk is a measure of Market Risk, which
measures the maximum loss in the market value of
a portfolio with a given confidence
VaR is denominated in units of a currency or as a
percentage of portfolio holdings
For e.g.., a set of portfolio having a current value
of say Rs.100,000- can be described to have a
daily value at risk of Rs. 5000- at a 99%
confidence level, which means there is a 1/100
chance of the loss exceeding Rs. 5000/considering no great paradigm shifts in the
underlying factors.
It is a probability of occurrence and hence is a
statistical measure of risk exposure
44
Features of RMD VaR Model
Yields
Duration
Multiple
Portfolios
Incremental
VaR
VaR
Portfolio
Optimization
Variancecovariance
Matrix
Stop Loss
Helps
Facility
For
For
For
picking
in
Identifying
of
aiding
optimizing
Return
multiple
upinsecurities
Analysis
cutting
and
methods
portfolio
isolating
losses
for
which
and
inaiding
Risky
during
the
portfolios
gelgiven
in
well
and
volatile
trade-off
set
in
safe
inthe
of
single
securities
periods
constraints
portfolio
model 45
Approaches to Market Risk Capital Calculation
Choices
Standardized Approach
Capital requirement is the
sum of capital calculated
for
Interest Rate Risk
Equity Price Risk
Foreign Exchange Risk
Commodity Price Risk
Internal Model
Approach
Based on bank’s internal
VaR models to quantify
capital charge required
Financial Markets?
• Money Market
– Trade in funds denominated in local currency and operate under local
regulations.
– Commercial Banks, Central Banks, Large Corporations, Institutions and the
Public at large (every checking A/c holder is a participant).
– Money or near money is bought and sold
– Purposes: Legal Requirement, Trading, Investment, and Customers Needs.
– Statutory Liquidity Requirement (SLR) un-encumbered approved
securities, which shall not be less then 19% of DL at the end of any
business day.
– Statutory Cash Reserve Requirement (CRR) 4% - 5% DL
– Statutory Cash Reserve Requirement (CRR) 0% - 0% TL
Money Market
• Transactions and Main Instruments;
–
–
–
–
–
–
Reverse Repo/ Repo and Call.
Treasury Bills
Federal Investment Bonds (FIBs)
Pakistan Investment Bonds (PIBs)
Certificates of Investment / Deposits (COIs or CODs)
Term Finance Certificates (TFCs)
Foreign Money Market
• Foreign Inter-bank Placements
1. Commerz Bank AG Germany
2. Deutsche Bank AG Germany
3. Fortis Bank, Belgium
• Placements with our overseas treasuries
Foreign Exchange Market
• Two different currencies are exchanged for
each other at certain mutually agreed rate.
• Or paper denominated in a given currency is
traded against paper denominated in another
currency.
Transactions in Treasury
• Exports, Imports, Remittances, Export and
Import Loans
• Ready, Tom, Spot, Forward, Swaps, Lending
and Borrowing
• R/RR, Call, Security Trading/Lending, COI, LOP
• Buying/Selling of Stocks in Ready/Future
• Derivatives/ Options
Treasury’s Structure
BOD / BRMC
CEO
GH
GH
GM
Treasury
Operations
RMD
Treasury /
Front Office
Treasury
Treasury
Back Office
Middle Office
Treasury Functions
•
•
•
•
•
•
•
Assets Liability Management (ALM)
To Maintain Liquidity.
To use Excess Funds effectively.
To Borrow Necessary Funds at Minimum.
Trading (Currency, Papers).
Regulations Monitoring.
Risk Management.
Risks in Treasury Transactions
• Market Risk
– Position or Exchange Rate Risk (Price Risk)
– Mismatch or Liquidity Risk (Interest Rate Risk)
• Credit or Counter-party Risk
• Operational Risk
• Gaps/Mismatches
– Banks create a gap (or mismatch) when the weighted-average maturity
of their financial assets does not equal the weighted-average maturity
of their liabilities. This is equivalent to having a forward interest rate
position.
Assets
Liabilities
– When the weighted-average maturity of the
assets exceeds that of the liabilities, it is called
a positive gap.
Gaps/Mismatches
Liabilities
Assets
– When the weighted-average maturity of the
liabilities exceeds that of the assets, it is called a
negative gap.
Assets
Liabilities
– A current position like the above would need to be
offset by the following transaction to eliminate the
gap.
Liabilities
Assets
– Either the bank has to lengthen its liabilities or shorten
its assets until the weighted average maturity of both
were equal.
• Positive Gaps
– This is the equivalent of being long forward position. That is asset
maturities are greater than liability maturities. Conditions which
adversely impact this position are:
Assets
Liabilities
– a general increase in rates, that is a yield curve
shift up.
– a steeping yield curve slope, indicating longerterm funding costs are becoming more
expensive.
• Negative Gaps
– This is the equivalent of being short forward position. That is liability
maturities are greater than assts maturities. Conditions which
adversely impact this position are:
Liabilities
Assets
– a general decrease in rates, that is a yield curve
shift down.
– a flattening or inverting yield curve, indicating
long-term lending costs declining.
Controlling Risk
• Position or Exchange Rate Risk
•
•
•
•
Currency Open Position (COP) Limits
Net Open Position (NOP) Limit
Intraday Limit
Stop Loss Limits
Controlling Risk
• Mismatch or Liquidity Risk
• Individual Currency Gap Limits (ICGLs)
• Aggregate Currency Gap Limits ‘bucket-wise’ (ACGLs)
• Total Aggregate Gap Limit (TAGL)
Controlling Risk
• Credit or Counter-party Risk
– Contract Risk
• Pre-Settlement or Foreign Currency Dealing (FCDL) Limit
– Clean Risk
• Settlement or Foreign Currency Settlement (FCSL) Limit
• Nostro Limit
• Clean Limit
– Sovereign Risk
• Country or Cross Border Limit
Value at Risk-VAR
•
Value at risk (VAR) is a probabilistic method of measuring the
potentional loss in portfolio value over a given time period and
confidence level.
•
The VAR measure used by regulators for market risk is the loss on the
trading book that can be expected to occur over a 10-day period 1% of
the time
•
The value at risk is $1 million means that the bank is 99% confident that
there will not be a loss greater than $1 million over the next 10 days.
64
Value at Risk-VAR
• VAR (x%) = Zx%σ
VAR(x%)=the x% probability value at risk
Zx% = the critical Z-value
σ = the standard deviation of daily return's on a percentage basis
VAR (x%)dollar basis=
VAR (x%) decimal basis X asset value
65
Example: Percentage and dollar VAR
•
If the asset has a daily standard deviation of returns equal to 1.4 percent
and the asset has a current value of $5.3 million calculate the VAR(5%) on
both a percentage and dollar basis.
•
Critical Z-value for a VAR(5%)= -1.65, VAR(10%)=-1.28, VAR(1%)=-2.32
VAR(5%) = -1.65(σ) = -1.65(.014) = -2.31%
VAR (x%)dollar basis= VAR (x%) decimal basis X asset value
VAR (x%)dollar basis= -.0231X5,300,000 = $-122,430
Interpretation:
there is a 5% probability that on any given day, the loss in value on this particular asset
will equal or exceed 2.31% or $122,430
66
Time conversions for VAR
VAR(x%)= VAR(x%)1-day√J
•
•
•
•
•
Daily VAR: 1 day
Weekly VAR: 5 days
Monthly VAR: 20 days
Semiannual VAR: 125 days
Annual VAR: 250 days
67
Converting daily VAR to
bases:
other time
• Assume that a risk manager has calculated the daily
VAR(10%) dollar basis of a particular assets to be
$12,500.
•
•
•
•
VAR(10%)5-days(weekly) = 12,500 √5= 27,951
VAR(10%)20-days(monthy) = 12,500 √20= 55,902
VAR(10%)125-days = 12,500 √125= 139,754
VAR(10%)250-days = 12,500 √250= 197,642
68
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