Internal Model Approach.pptx

8/10/2019 Internal Model Approach.pptx

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Internal Model Approach

Market Risk

Corporation Bank


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2 2014 KPMG, an Indian Partnership and a member firm of the KPMG networkof independent member firms affiliated with KPMG International Cooperative

(KPMG International), a Swiss entity. All rights reserved.

Structure

Introduction

Broad Principles for RBI Approval

Qualitative Criteria for IMA Approval

Quantitative Criteria

Risk Measurement

Back Testing

Stress Testing


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Scope of IMA

Only Held for trading will come under IMA

AFSto continue under SMM, as markets are illiquid and market prices may not be

available

If other group level entities are not ready, IMA for parent, and those entities which

are ready, and SMM for others

Insignificant positions, minor currencies, negligible business areas, etc. can be

under SMM

Expected to follow IMA to all market risk positions and entities in the future

Trading Book risk covers

Interest rate-related instruments and equities in trading book

Exchange rate risk trading book

Risk relating to investments in MFs in trading book


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Internal model and its purpose

What is an internal model?

Arisk management system developed by the Bank to analyze the overall

risk position, to quantify risks andrequired to meet those risks

to determine the economic capital

What is the purpose of an internal

To fully integrate processes of risk

Bank

model?

and capital management within the

IMA and VAR?

Risk Management models in usefar more advanced than rigid rules

Banks can use their own VaR models as basis for capital requirement for

Market Risk

VaR is a robust Risk Measurement and Management Practice


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Market Risk Governance Structure

Board of Directors

Internal Audit

Unit

Model Development

Unit

Risk Control, Capital

Computation and

Reporting team

Mid office/Market Risk

Unit

Integrated Risk

Management Department

Model Validation Unit


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IMA - Qualitative Criteria

Board and senior management should be actively involved

Daily reports for Risk Unit to be reviewed by Senior Management in order to take appropriateremedial action, if required

Documentation of Policies, Procedures and model parameters

Banks risk measurement system must be well documented to describe the basic principles ofrisk management system and to provide empirical techniques used to measure market risk.

Maintenance of Market Risk Model Dossier

Ongoing, updated Dossier - to keep a record of the details of the model and of the changes /refinements,

Can be built by references and links to other policies, operating manuals

Independent Risk Control Unit responsible for design and implementation of Banks riskmanagement systems

Regular Back-Testing and stress testing

Initial and on-going Validation of Internal ModelBanks Internal Risk Measurement Model must be integrated into Management decisions

Should be used in conjunction with Trading and Exposure Limits.

Should be well documented

Independent review of risk measurement systems by internal audit


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Model Development Unit

Either the bank can develop the model in house or use an external vendor. As the bank

is using an external vendor the bank should :

document and explain the role of the vendor model and the extent to which it is used within

the market risk measurement system of the bank;

demonstrate a thorough understanding of the vendor model;

ensure that the vendor model is appropriate for measuring the market risk of the bank,

given the nature of the portfolio and the capabilities of the staff; and

have clearly described strategies for regularly reviewing the performance of the vendor

model.


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It comprise qualified members independent of model development. The role would

include

ensuring that the current systems setup is capable of supporting the models; all

changes made to the models being used, or to the modelling process, should be

validated and approved;

maintaining previous versions of the model being altered; and

Ensuring models are subjected to change-control procedures, so that computercodes cannot be changed except by authorized staff.

Internal Model Validation Unit


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This unit will comprise the suitably qualified external team who were not involved in

model development process. The role would involve validating:

Formulae used in calculation and pricing are validated by Risk Control Unit, independent of

traders

Checking that structure of model is adequate for banks activities and geographical

coverage

comparing back-testing results

Data flows are transparent and accessible to all auditors

External Model Validation Unit


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The content of Market Risk Dossier would include: Authors responsible for the contents, date updated

Description of the scope of application of the model

Risk exposures and levels

Policies and organization

Risk measurement system

Stress analysis and back testing program and results of the tests

Technological environment and information integrity controls

Market Risk Dossier


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IMA RBI filing documents

Bank need to provide written intention to RBI for migration to IMA. Documents which

need to be submitted are:

Preliminary and detailed application to RBI for prior approval

Internal audit report of the model

A MR File

MR Model Dossier


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RBI assessment

RBI performs an assessment based on the following parameters:

Accuracy of documentation

Model scope

Qualitative review

Technological environment and information integrity

Quantitative review

Model monitoring (any modification proposed need prior intimation and approval from RBI)


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IMA - Quantitative criteria

IMA capital a function of

Normal VAR

Stressed VAR (for positions subject to interest rate specific-risk

IMA to be modeled as given below

Normal VARGeneral market risk

Stressed VARgeneral market risk

Specific Risk Charge as per the Standardized MeasurementMethod


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Value at Risk (VaR) - Basics

The value at risk (VAR) of a portfolio is the loss in value in the portfolio that can be expected

over a given period of time (e.g., 1-Day) with a probability not exceeding a given number (e.g.,

5%)

A VaR statistic thus has three components:

a time period (a day, a month or a year) and

a relatively high level of confidence (typically either 95% or 99%),

an estimate of investment loss (expressed either in rupees or percentage terms)

Probability (Portfolio Loss VAR) = K

K = Given Probability

Time Period Confidence level Loss Amount


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Parameters for Normal VAR Computation

Computed daily

VaR computation be based on following inputs :

Horizon of 10 Trading daysCan use daily VAR and scale to 10 days

99% confidence level

Observation periodat least 1 year historical data

Update data sets at least quarterly

Can use any type of model - variance-covariance matrices, historical simulations, or

Monte Carlo simulations.

Portfolio VaR for the bank has been provided in the attached PDF


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VaRThe Historical Simulation Approach

The historical method simply re-organizes actualhistorical returns, putting them in order from

worst to best

The simulation trials assume that the percentage

changes in all market variables are as on the

previous day i.e. the history will repeat

VaR is arrived at by tabulation of results at the

desired confidence level

The VaR is taken as the worst 1% (at 99%confidence level) of all daily returns

Easy to describe and justify

Fat tails, asymmetric responses, outliers are all incorporated automatically

The assumptions are realistic as the scenarios occurred in the past are considered Easily accommodates stress simulations

Captures all of the markets previous hits

5%

1.645 Std Dev

Possible Profit/Loss-10MM

The Approach

Strengths

The Approach


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Example Historical VaR


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Parameters for Stressed VAR computation

Intended to replicate a VaR calculation that would be generated on the bankscurrent portfolio

The stressed-VaR should be calculated at least weekly

The model inputs for the stressed VaR should be calibrated to historical data

from a continuous 12-month period of significant financial stress relevant to the

banksportfolio

Example 2007-2008 period of crisis

The said period of stress will be approved by the RBI as part of its approvalfor

the IMAmodel submitted by thebank andwouldberegularly reviewed.


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The capital requirement C is calculated according to the following

formula: mc and ms - multiplication factors to be set by the RBI on the

basis of their assessment of the quality of the banks risk

management system, subject to absolute minimum of three for

both the factors; and

pc and ps - the plus / add on factor, generally ranging from zero

to one, to be decided by the bank based on the results of theback testing of its VaR model.

C = max {VaRt-1; (mc +pc)*VaRavg} + max {sVaRt-1; (ms+ps)*sVaRavg }

IMA Market Risk Charge


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Capital computation

Total Market Risk Capital is sum of :

HFT general Market Risk Capital(IMA capital)

HFT specific Capital( standardized approach)

AFS general market Risk (standardized approach)

AFS specific capital (standardized approach)


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Market Risk Capital example


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Normal VAR Stressed VAR

Mc FactorRange 3 -4 3-4

McHow used Used to multiply 60 day Average Used to multiply 60 day Averagenormal VAR stressed VAR

McWho determines this RBI RBI

factor

Plus Factor )Pc)Range 0-1 0-1

PcHow used. Added to Mc and used for Added to Mc and used formultiplying 60 days Average multiplying 60 days Average

normal VAR stressed VAR

PcWho determines Banks based on back testing Banks based on back testingresults of NORMAL VAR MODEL results of NORMAL VAR MODELand confidence in the model. and confidence in the model.

Multiplication and Plus factor


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Stress Testing - Scenarios Analysis

Evaluating the portfolios under various states of the world

Running simulations of the current shocks e.g. 1987 crash, etc

Scenarios requiring simulations

Bank specific scenario driven by the current position of the bank thanhistorical simulation

Can help to identify undetected weakness in the bank's portfolio

Much more subjective than VAR portfolio subject to large historical scenario


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Back Testing

Statistical testing that consist of checking whether actual trading losses are inline with the VAR forecasts

The Basel back testing framework consists in recording daily exception of the 99% VARover the last year

Even though capital requirements are based on 10 days VAR, back testing uses a dailyinterval, which entails more observations

A bank should also report to the RBI the results of their back-testing exercise everyquarter before the last day of the month. In addition to exceptions, report to include:

Classification of exceptions and proposed investigations.

Action already taken or proposed to be taken for model improvement.

Number of exceptions observed during each of the last three back-testing results.

Too many exceptions indicate that The banks systems are not simply capturing the risk of the positions themselves.

Model volatilities and/or correlations were calculated incorrectly

Models accuracy could be improved

Bad Luck or market moved in unanticipated manner

Loss due to intra-day trading


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Back Testing

Internal Model Approach.pptx

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