Defining and Setting Limit Structures
By Dmytro Dutka, MBA, CFA
(Submitted to Canadian Treasurer Magazine)
Financial risk measurement has advanced significantly in recent years, and though it has complicated
Treasury Management the pay off has been smarter risk taking. The pressure is on to identify, measure and
to manage the multitude of Treasury-related risks. Some are “new” while others are just separated out or
better appreciated in the light of new valuation models. Still, each addition requires that policies, practices,
limits and limit structures be adapted. But how does a Treasurer coordinate their risk view into a
relevant, logical, coherent and practical system of limits?
In the academic hurry to publish and developers’ rush to popularize the most current risk valuation models
into software, Treasurers have been left alone with the task of adapting limit structures. “New” statistical
risk measures like liquidity risk are springing up. Non-market risks are being added. The latest is
operational risk and there is talk of modeling “reputational” risk. Driving this are,
a) Unprecedented “write-offs” due to unexpected FX “translation” adjustments, funding rate
“movements”, and “liquidity” crises; improper hedges or even ‘three-legged stool’ off-balance
sheet financing programs, and “rogue” traders
b) Product innovations involving contingency assets and liabilities,
c) Detailed “business unit” level profit measures (cost allocation & transfer pricing regimes for risk
management)
d) Valuation methods like RAROC (Risk Adjusted Return on Capital,) and
e) Changing capital adequacy regimes.
Singular, exclusive risk limits on, for example “liquidity”, do not logically follow from a new risk
measurement. We can continue though, to limit activities or exposures that directly or indirectly affect the
new risk measurements. Without a logical blueprint however, limits have been added on without
consideration to the overall effectiveness of the structure.
The many risks are indeed a function of a Treasurer’s role: funding, cash, interest rate, Foreign Exchange
(FX) and liquidity management and sometimes financing, capital and balance sheet management. Limits
act as guiding parameters and reflect the faith and confidence Treasury is given in managing certain risks.
A proper limit structure defining process needs to assess the relevance and relative importance of each risk
as well as Treasury’s freedom and flexibility in their management. It should be kept current via a periodic,
systematic and thorough review of the business, strategies, policies, procedures and practices vis-à-vis the
business environment. Then risk limits, a limited resource like capital, are assigned out on the basis of risk
appetite and ability to handle exposures.
Initial limit structures were simple. As the types of Treasury risks recognized multiplied, the list of limits
has gotten longer. Each industry sector and even each business has its own risk nuances. But the limit
structure has generally remained flat, wide and simple (Figure 1).
Figure 1
Figure 1
Treasury’s
Separate Limits
FX
Limit
Funding
Limit
© FinLev Management Ltd. December 2002
Aged Receivables
Limit
Investment
Product Limits
ALM Gap
Limits
1
Simply adding on a different limit for each type of risk involved has led to illogical and uncoordinated
limit systems. There are still instances where Treasury groups follow static notional position limits (i.e. $2
million USD/CAD) even though the potential $ amount risk varies with obviously trending markets or
greater volatilities. VaR is a broadly accepted “holistic” effort to bring together various market exposures
into one Value at Risk number. Most Treasury managers now speak this “new math”: a statistical language
of standard deviations, correlation, variance and various Greek letters. In Figure 1 VaR summarizes the
FX and ALM Gap limits.
Since the deficiencies of VaR were highlighted in the 1998 Long Term Capital Management debacle,
Stress Testing has been added alongside individual market type or VaR limits. Stress Testing, a VaR
engine outcome of potential (but highly unlikely) extreme scenarios, can have bankruptcy consequences.
A separate limit for this was created. Jeremy Berkowitz (Federal Reserve Board March 20, 1999) in a
paper “A Coherent Framework for Stress-Testing” suggested folding Stress Tests into the risk model
(VaR), by assigning them probabilities. He argued this provided a “usable risk metric” -- a singular risk
measure. The modified VaR with redefined extreme events does have a more realistic “tail”. An even
more realistic result could be had by boosting the probability of the extreme events closer to that of historic
occurrences.
Such aggregation, however, ignores the usually different bases of time horizons between VaR and Stress
Testing and it negates the original purpose of the latter. Stress Tests could separately supply limits to avoid
reaching catastrophic exposure to perhaps 10-year horizon events that come with little forewarning.
Trading VaR limits on the other hand can be based on 1 day horizons (the time it takes to off-load a futures
hedge). Even for similar horizons, one should seriously question whether Treasury should be allowed to
substitute credit or concentration risk for market exposures. Most firms that do both VaR and Stress
Testing do not “roll” the stress test results into VaR numbers. The two limits reflect different risks…one
the kind of losses that could be sustained but should be controlled, while the latter relates to disastrous
exposure. They should be used separately. A Stress Testing limit logically should have priority over
related VaR limits. Other attempts to incorporate Liquidity and Credit risks into VaR (Expected
Extremity Associated Risk, EXAR, Rik Sen & N.A. Hariharan 2002) have not resulted in any generally
accepted “best practices” models or limits either.
Just as a simple, singular, exclusive VaR limit does not follow from an aggregated valuation, a singular
Stress Test limit would also be incorrect. It too would allow Treasury too much freedom over management
of specific market & concentration exposures. Therefore separate, ancillary limits for market, credit and
liquidity risks need to be employed. Here too, each can have their own sub limits, i.e. controlling for types
of market risks depending on appetite or expertise. Detail and complexity will be limited by system and
personnel competencies. Figure 2 shows an example of a coordinated limit structure.
© FinLev Management Ltd. December 2002
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Figure 2
Coordinated Limit
Structure
VaR Limit
Stress Testing Limits
Concentration Limits
Regulatory, Legislative
Limits
Stop Loss Limits
Liquidity
Limit
FX Limit
Funding Limit
ALM DV01
Limits
Credit Limit
Aged Receivables Limit
Operational Risk
System integration
Investment
Product Limits
Staff Training &
Education
Not everyone has the need or desire to take on the complexity of a correlated VaR. However, simplistic
limit structures should be updated to force relevance, i.e. by allowing addition (though not necessarily
netting) across risks. Simple FX limits can be expressed in terms of:
a) notional limits (i.e. spot exposure of $2 million USD/CAD) and
b) DaR (i.e. $120,000 Dollars at Risk backed by the application of volatility figures)
Apart from VaR one can choose risk measures such as Net Interest Income for accrual accounting
management styles or Shortfall exposure for those focused on targeted earnings. Each has its use and
potential ancillary limits, depending on the type of strategy chosen to run a firm, or the way it is valued.
Unfortunately there are few formal papers written on the subject and no available benchmarking studies.
Indiscriminately layered “legacy” limits, left or created without regard to a firm’s changed environment,
goals, risk appetite or a Treasury group’s level of competence will result in poor management. Systematic
attempts should be made to create, to prioritize and to coordinate the limits into a logical limit structure.
Otherwise some limits will confuse and frustrate effective management. For example maximum DV01
limits and gap limits may seriously conflict and together may seriously overshoot Stop-loss limits making
the former irrelevant, providing poor guidance. Stress Test limits should not ignore the VaR limit.
Similarly, Liquidity limits should be set relative to market tolerance, credit lines in place and maximum
cash use implied by maximum use of VaR limits. In short, the various limits set should be logical, coherent
and coordinated. This means reviewing the various possible maximum exposures as defined by chosen
scenarios (Historic, Monte Carlo or forward looking), and looking at the matrix to correct the illogical
limits.
No current software application attempts to automate a coordinated & customized limit structure design.
© FinLev Management Ltd. December 2002
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Limit structures cannot be standardized across disparate non -commoditized businesses or business sectors.
Risk perception, too, is subjective. Where some perceive risk, others through knowledge, analysis or
setting aside mitigants see little risk and therefore require different limit structures.
Figure 3
Valuation
or
Earnings
Focus
Management
Style
(dynamic/
reactive)
IT/Systems
Competency
(complexity)
Legal
&
Regulatory
Limit
Structure
Available &
Validated
Risk
Models
Type of
Business
(Types & No.
Of Risks)
Personnel
Competency
(complexity)
Risk
Appetite
A limit structure redesign effort will force a healthy focus on core strategies, principles & competencies
and will clarify muddy delegated risk management guidelines. Figure 3 shows some of the things to
consider in creating a Limit Structure. A sample of what the redesign should incorporate includes:
1. Definitions of the types of risks Treasury faces. A list of specific, controllable related limits and
sub-limits. Limits need to be justified via analysis of the appropriateness, relevance, measurement
and practicality of each vis-à-vis its related risk. They should address foremost regulatory,
statutory and company (Board-endorsed) policies and business strategies. GAAP disclosures may
eventually require statements regarding risk management limits as these too are potential
liabilities.
2. Risk models used, their assumptions, limitations and parameters need to be made explicit
a) i.e. For VaR, a 1 week horizon, using Historical simulation, 5 year look back scenario, with a
95% confidence interval and correlation matrixes validated by a given firm.
b) Stop Loss limits should be cumulative over time and across products/portfolios, and be related
to risk appetite (itself related to management’s desired risk/return profile). It may be a
notional amount, a percentage of actual or expected earnings, etc.
c) For Stress Testing the scenarios need to be defined  Historic, Monte Carlo or forward
looking. There is no “best practices” here either. Methods depend on desired simplicity,
available computer power and confidence in ability to judging the future.
3. Limits should be prioritized, with the higher level limits clearly relating to the Board’s and
Executives’ interpretation of risk. Limits such as VaR, a Stop-loss, and a Stress Test are
immediately meaningful to them. Other limits (such as Gap limits or DV01’s) can be sub limits of
© FinLev Management Ltd. December 2002
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4.
5.
these, aiding in Treasury’s management of the higher level limits. One can get as detailed as one
wishes, however the “KISS” principle (Keep It Simple Stup&#) should be kept in mind.
Limit levels should be set relative to a clear risk/return tradeoff decision. Though non-financial
firms with a conservative bent may wish to eliminate risk, some leeway must be given to allow
flexibility in Treasury’s duties. A formal, documented process is needed to back up each of the
below:
a) The setting of the size of each limit. Limits can be set relative to capital, earnings, or some
other measure. For VaR, one estimate is that “a one day VaR equal to about 3% of the trading
capital is a pretty good sized risk in a normal environment.” (Barry Schachter, Head of
Enterprise Risk Management at Caxton Corporation). Sub-limits can then be chosen as
appropriate. Under VaR one can have separate FX DaR and Fixed Income DV01’s and/or
product specific VaR’s. Derivatives by their nature should receive special attention.
b) How far back from disaster Stress Test limits are set depends on how probable are the defined
extreme event(s), and lead times (if any).
c) Once limits are set procedures should provide for action when limits be breached:
 Obtaining limit excess approvals from Executive Management (themselves to be granted
limits or authority by the Board of Directors) and,
 Putting into motion self-correcting specific actions that reduce, mitigate or eliminate the
offending risk exposure.
d) Limits can be set in stages of concern or severity. i.e. A lower funding or credit limit breach
will put into motion certain remedial actions, while a higher limit breach will require more
severe actions.
e) Dynamic structures can be created, where limits vary with profits/earnings or changing
market conditions.
A limit structure’s success requires,
a) Mathematical validation. Options are backtesting or Monte Carlo simulations. Will the
model make sense and provide the P/L results expected?
b) It to be coordinated. 6(a) above should create a matrix of results under different maximum
exposure scenarios that indicate unreasonable or superfluous limits for correction.
c) Validation of a given level of competency in managers for a given level of complexity.
d) A system of periodic, preferably independent and automated monitoring and controls to be
implemented.
© FinLev Management Ltd. December 2002
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Process of a Coordinated Limit Structure Plan
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dic k e e
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Pe , m iro
5) es s env
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Bu
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it s s
Lim s t em
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St ra iew Bu
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t egy
& P es s
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2) Def ine
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Functions
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Manage d
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ou Lim
Gr
3) rit ize
Prio
A final word on change management: Incrementalism. Introduce change in simple, tested steps, over time
with the buy-in of the Board, Executives and Treasury Management, Risk Management and IT groups. A
wholesale one time change that modifies policies, practices, procedures including system IT issues begs a
meltdown. Managing with a coordinated, cohesive limit structure will increase manifold the likelihood
maintaining a desired risk profile and attaining a desired valuation.
Dmytro Dutka is President of FinLev Management Ltd.,
a Financial and Treasury consulting firm located in Toronto, Canada.
He can be reached at (416) 245-8579 or by email: FinLev@rogers.com
See www.FinLev.com
© FinLev Management Ltd. December 2002
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