Presentation onPresentation onFinancial Risk Management Financial Risk Management

Market Risk Market Risk Treasury OperationsTreasury 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

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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.

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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.

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

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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

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Risk Management Requires

Understanding of Your financial situation

Understanding sources of risk and potential risk

Understanding of risk management tools

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Risk Management Includes:

Evaluation of alternative plans & risk management strategies

Implementation of the plan

Monitoring the plan

Developing probabilities to formalize risk assessment

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Steps in theRisk 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?

CapitalManagement

ProductPricing Financial

Risk Mgt.

SettingObjectives

RaisingCapital

StrategicPlanning

LiabilityValuationAsset

Allocation

RiskManagement

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.

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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

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Economic Capital

• Economic capital acts as a buffer that provides protection against all the credit, market, operational and business risks faced by an institution.

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Financial Risk and Basel

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BASEL-I Capital Calculation

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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

Credit Risk + Market Risk

Capital Capital Adequacy Ratio

RIWAC

=

Basel I Regulatory Capital Rules

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Market riskCapital(Tier 3)

Market riskCapital(Tier 3)

• Short-term subordinated debt

SupplementaryCapital(Tier 2)

SupplementaryCapital(Tier 2)

• Perpetual securities

• Unrealised gains on investment

securities

• Hybrid capital instruments

• Long-term subordinated debt with

maturity > 5 years

Core Capital(Tier 1)

Core Capital(Tier 1)

• Stock issues

• Disclosed reserves

– Loan loss reserves to cushion future

losses or for smoothing out income

volatility

• 50% of total capital

Types of capital

Balance sheet assets

Off-balance sheet assets

Non-Traded

Traded

Risk weights

Basel I capital calculation

Capital (Tiers 1, 2, 3)

Risk-Weighted Assets and Contingents

≥ 8%

RIWAC Calculation

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RIWAC

On-Balance Sheet

xCounterparty Weighting

Off-Balance Sheet Risk

xCounterparty Weighting

xCredit Conversion Factor

= +

RIWAC Weightings

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On-Balance Sheet Risk

Banks SovereignsCorporate

s

Non OECD

OECD Non OECD OECD

100% 20% 100% 0% 100%

Off Balance Sheet Risk Cont. liabilities

Financial Guarantees

100% 20% N/A N/A 100%

Transactional Contingents

50% 10%N/A N/A

50%

Secured LCs Issued

20% 4%N/A N/A

20%

BASEL I- RIWAC Examples

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CorporateXYZ 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

BanksXYZ 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

ContingentsXYZ 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

Basel I regulatory capital rules – Credit risk (1)

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Step 1: RWA = On BS exposure X Risk Weight

Step 2: Capital = 8% X RWA

Risk weight (%) On-balance sheet asset category

0Cash & goldObligations on OECD and PAK treasuries

20Claims on OECD banks Govt. agency securitiesClaims on municipalities

50 Residential mortgages

100Corporate bonds, equity, real-estateLess-developed countries’ debtClaims on non-OECD banks

On-balance sheet risk weights and Basel I capital calculation

Risk weight (%) Off-balance sheet asset category

0 OECD governments

20OECD banks and public sector entities

50Corporates and other counterparties

Credit Conversion Factor (%)

Off-balance sheet non-trading assets

0Undrawn commitments – Maturity ≤ 1 year

20Documentary credits related to shipment of goods

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Transaction-related contingencies – warranties, performance bonds

Undrawn commitments – Maturity > 1 year

100General guarantees, standby letters of credit, banker’s acceptance, etc

Off-balance sheet risk weights and Basel I capital calculation for non-trading assets

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

Basel I regulatory capital rules – Credit risk (2)Basel I regulatory capital rules – Credit risk (2)

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Credit Conversion Factor (%)

Interest rates FX and Gold Equity derivatives Precious metalsCommodity contracts

Less than 1 year 0.0% 1.0% 6.0% 7.0% 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%

Off-balance sheet risk weights and Basel I capital calculation for trading assets

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

BASEL I- Draw Backs

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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

Objectives “Basel II”

• The objective of the New Basel Capital accord (“Basel II) is:

1. To promote safety and soundness in the financial system2. To continue to enhance completive equality3. To constitute a more comprehensive approach to

addressing risks4. To render capital adequacy more risk-sensitive5. To provide incentives for banks to enhance their risk

measurement capabilities

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Comparison

Basel I Basel 2Focus 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

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Economic Objectives

• Growth sustainability: balanced Portfolio risk and return

• Equity: level competitive playing field across(big and small) banks

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Overview of Basel II Pillars

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The new Basel Accord is comprised of ‘three pillars’…The new Basel Accord is comprised of ‘three pillars’…

Pillar I

Minimum Capital

Requirements

Establishes minimum standards for management of capital on a more risk sensitive basis:

• Credit Risk

• Operational Risk

• Market Risk

Pillar IISupervisory Review

Process

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

Pillar III

Market Discipline

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.

Development of a revised capital adequacy framework Components of Basel II

31Pillar 1 Pillar 2 Pillar 3

The three pillars of Basel II and their principles

Basel II

Supervisory review process

• How will supervisory bodies assess, monitor and ensure capital adequacy?

• 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

Market disclosure

• What and how should banks disclose to external parties?

• 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

Minimum capital requirements

• How is capital adequacy measured particularly for Advanced approaches?

• 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

Issu

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• Continue to promote safety and soundness in the banking system

• 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

Objectives

Overview of Basel II Approaches (Pillar I)

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Approaches that can befollowed in determination

of Regulatory Capitalunder Basel II

Approaches that can befollowed in determination

of Regulatory Capitalunder Basel II

Total Regulatory

Capital

Total Regulatory

Capital

Operational Risk

Capital

Operational Risk

Capital

CreditRisk

Capital

CreditRisk

Capital

MarketRisk

Capital

MarketRisk

Capital

Basic IndicatorApproach

Basic IndicatorApproach

Standardized Approach

Standardized Approach

Advanced Measurement

Approach (AMA)

Advanced Measurement

Approach (AMA)

Standardized Approach

Standardized Approach

Internal Ratings Based (IRB)

Internal Ratings Based (IRB)

FoundationFoundation

AdvancedAdvanced

StandardModel

StandardModel

InternalModel

InternalModel

Score CardScore Card

Loss DistributionLoss Distribution

Internal ModelingInternal

Modeling

The Three Pillars

• The First Pillar - Minimum Capital Requirements

• The Second Pillar - Supervisory Review Process

• The Third Pillar - Market Discipline

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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.

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RISK BASED SUPERVISION

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BASEL II : CAPITAL CHARGE

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Credit Risk

• The standardized approach• The Internal Ratings-Based Approach

– Foundation– Advanced

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Ops Risk

• The Basic Indicator Approach• The Standardised Approach• Advanced Measurement Approach

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Market RiskMarket RiskE q u ity P rice

In te res t R a te

F . E .

C om m od ity P rice

Market

• Potential loss in value from market risk factors• Primarily through trading, off balance sheet and on

balance sheet items

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FinancialRisks Liquidity Risk

Operational Risk

Regulatory Risk

Human FactorRisk

Market Risk

Equity Risk

Interest Rate Risk

Currency Risk

Commodity Risk

Trading Risk

Gap Risk

Credit RiskPortfolio

Concentration Risk

Transaction Risk Counterparty Risk

Issuer Risk

Types of financial risk

Market Risk under Basel II

• Standardized ApproachBuilding 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 ModelVAR modeling: On daily basis and 99th percentile one-tailed confidence

interval is to be used, 10days holding period.

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• Convergence of Economies• Easy and faster flow of information• Skill Enhancement• Increasing Market activity

Why the focus on Market Risk Management ?

Leading to

•Increased Volatility•Need for measuring and managing Market Risks•Regulatory focus•Profiting from Risk

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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

Value at Risk

Certainty is 95.00% from 2.6 to +Infinity

.000

.005

.011

.016

.022

0

108.2

216.5

324.7

433

1.5 2.9 4.3 5.6 7.0

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Variance-Variance-covariancecovariance

Matrix

Variance-Variance-covariancecovariance

Matrix

MultiplePortfoliosMultiple

Portfolios

YieldsDurationYields

Duration

Incremental VaR

Incremental VaR

Stop LossStop Loss

PortfolioOptimization

PortfolioOptimization

VaRVaR

Features of RMD VaR Model

Facility of multiple methods and portfolios in single modelReturn Analysis for aiding in trade-offFor Identifying and isolating Risky and safe securitiesFor picking up securities which gel well in the portfolioFor aiding in cutting losses during volatile periodsHelps in optimizing portfolio in the given set of constraints

Approaches to Market Risk Capital Calculation

ChoicesChoices

Standardized ApproachStandardized ApproachCapital requirement is the sum of capital calculated for

Interest Rate RiskEquity Price RiskForeign Exchange RiskCommodity Price Risk

Internal Model Internal Model ApproachApproach

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 Placements1. Commerz Bank AG Germany2. Deutsche Bank AG Germany3. 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

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/MismatchesLiabilities

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 longer-

term 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.

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Value at Risk-VAR

• VAR (x%) = Zx%σ

VAR(x%)=the x% probability value at riskZx% = 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

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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

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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

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Converting daily VAR to other time bases:

• 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

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