and Asset Liability Management

Transcription

PRMI A M ARK ET, LIQUIDI TY
and Asset Liability Management
R I S K M A N AG E R H A N D B O O K
T HE P ROFE SSION AL RISK MANAGERS ’
INTERNATIO NAL ASS OC IATION
PRMIA Market, Liquidity and Asset
Liability Management Handbook
Edited by
Oscar McCarthy and Stefan Loesch
Copyrighted Materials
Copyright © 2015 by The Professional Risk Managers’ International Association. All rights
reserved.
Published by PRMIA Publications, Wilmington, DE
No part of this publication may be reproduced, stored in a retrieval system, or transmitted in
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addressed to PRMIA Publications, PMB #5527, 2711 Centerville Road, Suite 120, Wilmington,
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This book is also available in an electronic format, on-line via the PRMIA website and may be
purchased as such by members of the Professional Risk Managers’ International Association at
www.PRMIA.org.
ISBN: 978-0-9963394-7-6
Printed in the United States of America
Copyright © 2015 Professional Risk Managers’ International Association
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About the Authors
Dr. Oscar D. McCarthy, PRM has fifteen years of professional experience in Commercial and
Investment Banking, spanning Market Risk, Counterparty Credit Risk, Country Risk, Liquidity
Risk and Operational Risk. He is currently a Risk Advisor to ABN Amro, where he has worked on
diverse projects including Risk Appetite, Basel3, Stress Testing, CVA, Model Approval and
Trading Risk Policy. Prior to ABN Amro, he was a risk manager at Lloyds Bank, London; a risk
consultant with IBM, and a published academic researcher in Mathematical Physics.
Oscar has a Ph.D. in Mathematics, and is certified as a Professional Risk Manager (PRM). He
serves pro-bono as a member of the Board of Directors of PRMIA.
Stefan Loesch is a rocket scientist by training who went on to work as a derivatives quant in the
financial services industry, where he ended up heading the FX and equities quant research
teams of Paribas.
After earning an MBA at INSEAD, he joined McKinsey & Co as a consultant in their panEuropean Corporate Finance Practice, where he was advising clients in the financial services
sector. He then moved to J.P. Morgan where he was initially a member and eventually the
leader of a strategic advisory team working with banks on capital markets driven balance sheet
optimization, integrating solutions using DCM, ECM, securitization and derivatives.
Now Stefan is running Oditorium, a startup that is developing systems and tools for online
executive education, and that is also organizing executive training in the finance and risk space,
usually integrating online and classroom teaching.
Dr. Robert Mark is a Managing Partner at Black Diamond Risk Enterprises, serves on several
boards, led Treasury/Trading activities and was a CRO at Tier 1 banks. He is the Founding
Executive Director of the MFE Program at UCLA, co-authored three books on Risk Management
and holds an Applied Math Ph.D. Bob is a cofounder of PRMIA.
Dr. Michel Crouhy is Head of Research & Development at NATIXIS Wholesale Bank, a subsidiary
of Groupe BPCE. He has the bankwide oversight on all quantitative research and the
development of new products and applications supporting the trading and structuring
businesses. Crouhy is a founding member of PRMIA. He is a member of both the Research
Advisory Council of the Global Risk Institute in Financial Services and the Credit Committee of
the International Association for Quantitative Finance (IAQF).
Dan Galai is the Dean of Sarnat School of Management, at the College for Academic Studies at
Or Yehuda, Israel and previously was the Dean of the School of Business Administration, the
Hebrew University in Jerusalem (2009-2012). He co-invented the volatility index, based on the
prices of traded index options and served as a consultant for the Chicago Board Options
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Exchange (CBOE) and the American Stock Exchange as well as for major banks. He is a member
of the Blue Ribbon Panel and Regional co-Director for Israel of PRMIA.
Max Wong is an author-researcher in the domain of financial risk management and Basel III
reform. His career is a mix of trading, market analysis, risk management and modeling
experience, which spanned two financial crises. He was an 'open outcry' trader at Simex during
the Asian crisis (1997) and a quant risk manager during the credit crisis (2008). He is currently
Senior Vice President & Head, Risk Systems and Validation at SGX. Max is the author of
“Bubble Value at risk”, and co-author of “Fixed Income markets: Management, Trading and
Hedging”. He has spoken on the subject of risks at various conferences and seminars. His
research interests include quantitative portfolio investing, procyclical risk and Black Swan risks.
He holds B.Sc. Physics from University of Malaya (1994) and an M.Sc. financial engineering from
National University of Singapore (2004). He is an adjunct at Singapore Management University,
a member of the editorial board of the Journal of Risk Management in Financial Institutions,
and a member of the steering committee of PRMIA Singapore chapter.
Dr. Changwei Xiong specializes in quantitative financial modeling, with a particular interest in
derivative pricing and Basel III risk modeling. He is currently a Vice President in Risk Analytics at
United Overseas Bank Singapore, performing exotic rates model validation. Prior to this
position, he was a Vice President at Royal Bank of Scotland Singapore, reviewing and validating
market risk models. He is also adjunct teaching interest rate models at the University of
Electronic Science and Technology of China in the School of Economics and Management.
Changwei received his Ph.D. in Physical Chemistry from the University of Utah, where he
conducted extensive research on modeling and computer simulation of fires and explosions of
energetic materials. He also holds an M.Sc. in Computational Engineering and Science from the
University of Utah, a M.Sc. in Mathematical Finance from Rutgers University and a B.Sc. in
Chemistry from Nankai University.
Douglas Bongartz-Renaud, FRM has almost forty years’ experience in financial markets, risk
management, training and consulting for banks in Asia and the EMEA regions. He completed a
long career at ABN AMRO Bank in 2011 and moved from Amsterdam to Southeast Asia, where
he is continuing working with banks in the areas of risk management, ALM and treasury. He has
recently worked on bank treasury and ALM projects both independently in Asia for the IFC
(World Bank Group) and KPMG. He does training and project work in the MENA region as a
member of Tripod Partners, based in Dubai.
In 2012, he worked for the IFC (World Bank Group) as Treasury and Risk Consultant at a
Vietnamese bank in Hanoi, helping to implement and document the Bank’s treasury trading
book and market risk management processes. He successfully completed his IFC project in July
2012. He has worked on many other ALM and treasury projects for banks, including an ALM
project for a bank in East Africa in early 2013. He is currently assisting KPMG in an ALM project
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for one of the largest Indonesian banks, with his involvement focusing on the bank’s
improvement of its FTP framework.
Douglas worked from 1984 – 2011 for ABN Amro Bank in a number of senior positions,
including heading the Bank’s global FX, interest rate and structured products trading and risk
management activities. Prior to joining ABN Amro, he worked for the former Continental Bank
and Brown Brothers Harriman. He has BA and MBA (quantitative finance) degrees from the
University of Chicago, and holds the FRM certification from GARP. He served on the Board of
Directors of ISDA (International Swaps and Derivatives Association from 1994 – 2008, and as
Secretary of the Board from 1998 – 2004. He is a Dutch national residing in South East Asia.
Jan-Peter Onstwedder has over 20 years’ experience in risk management across a wide variety
of asset classes and global trading markets, both in banking and corporate environments. He
has held various risk and trading positions for Barclays Bank in London and New York; worked
as Head of Market Risk for the Royal Bank of Scotland; Head of Risk for BP’s Integrated Supply
and Trading business; and Head of Risk Management for 3i plc. Currently, he works for Citi in
London as Head of Risk Management for the global commodities trading division, and as Head
of Credit Risk for four global industries (power, energy, chemicals and mining). In 2007, he
managed the London Accord, the then-largest ever-collaborative research project into the
financial aspects of climate change. The report, published in December 2007, placed research
by leading investment banks, NGOs, law firms and academic institutions in the public domain.
Saji K. John is the Global Head of Market Risk Management for the Global Commodities group
at Citigroup. As the global head of market risk management, Saji’s team monitors and provides
global oversight for Citigroup’s Commodity market risk. He has been with Citi since 2007. Prior
to Citigroup, he worked for BP for 5yrs as the Market Risk Manager for BP's energy trading
desks in Houston. He started his career in energy commodities as a structurer for the Natural
Gas and Power desk with Enron Corp in their Wholesale energy trading group. He was with
Enron for five years. Prior to Enron, he worked in various engineering companies as an Electrical
Engineer in Kuwait and India. Saji John graduated with an MBA in Finance from the University of
Texas at Austin. He obtained his undergraduate degree in Electrical Engineering from Indian
Institute of Technology, India. He holds the designation of Chartered Financial Analyst from the
CFA Institute.
Dr. David M. Rowe is Senior Strategist – Risk and Regulation at Misys where he serves as a
spokesman for the firm on risk management issues and provides input on the strategic
direction for risk management software applications. Dr. Rowe is a frequent contributor to Risk
magazine, where he has written the monthly Risk Analysis column since late 1999, and has
appeared at numerous conferences and seminars over the past 20 years
Dr. Rowe’s former positions include: Executive Vice President for Risk Management at SunGard,
Senior Vice President and Head of the Risk Management Information Unit at Bank of America,
Executive Vice President and Director of Research at Townsend-Greenspan & Co, President of
Wharton Econometric Forecasting Associates.
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Dr. Rowe holds a Ph.D. in econometrics and finance from the University of Pennsylvania, an
MBA in finance with a concentration in money and banking from the Wharton Graduate School
of Finance and Commerce, and a BA in economics with distinction from Carleton College.
Justin McCarthy has worked in roles in many firms, including Bank of America Merrill Lynch,
PricewaterhouseCoopers and with the Irish Financial Regulator. This work has allowed him to
see the changes in risk management since through and beyond the recent global financial crisis.
His work on the PRISM risk-based supervision framework with the Irish Regulator included
exposure to banking, funds and insurance risk practices as well as the quantitative work done
on the related impact models.
He serves on several PRMIA working groups and sits on the PRMIA Education Committee and is
the chair of the C-Suite Committee. He is also the chair of the global board for PRMIA.
His work includes training and consulting with financial institutions on governance, risk
management and compliance. This has included writing and delivering courses on risk
management in Irish Academic institutions. Justin has a BSc from University College Cork and an
MBA from the Michael Smurfit Graduate School of Business at University College Dublin.
Recognitions
Grateful acknowledgment is made to the following PRMIA volunteers and staff for their
contribution to this Handbook:
PRMIA Education Committee for its oversight of the PRM Handbook curriculum and PRM Exam
syllabus.
Members (listed alphabetically): James V. Dillon, Jonathan Howitt (Chair), James Glueck, Justin
McCarthy, Oscar McCarthy, Kalyan Sunderam, Stefan Loesch, Scott Warner. Ex Officio: Andy
Condurache, Kevin Cuff and Alex Voicu.
James Glueck, PRM for his editorial input on the Asset Liability Management and Funds
Transfer Pricing section of this book.
Andy Condurache, PRMIA Director of Exams and Publications, for the production editing of this
book.
Disclaimer
The views and opinions expressed in this publication are those of the authors and do not
necessarily reflect the views or position of any of the organizations to which they belong.
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Table of Contents
About the Authors .............................................................................................................. 5
Part 1 – Market Risk ......................................................................................................... 15
Chapter 1 - Market Risk Introduction ........................................................................................... 17
Typology of Market Risk Exposures ...................................................................................................... 17
Asset-liability Management .................................................................................................................. 19
Funds Transfer Pricing........................................................................................................................... 20
Industry Best Practices .......................................................................................................................... 20
Content of Market Risk Section ............................................................................................................ 21
Chapter 2 – Market Risk Governance and Management ............................................................... 25
Introduction .......................................................................................................................................... 25
The Post-Crisis, Risk-Regulatory Framework ........................................................................................ 28
Setting Stage for Market Risk Governance ........................................................................................... 29
True Market Risk Governance .............................................................................................................. 30
Committees: Market Risk Appetite & Market Risk Limits .................................................................... 33
Roles and Responsibilities in Practice ................................................................................................... 36
Market Risk Limits and Limit Policies .................................................................................................... 40
Risk Management Systems ................................................................................................................... 41
Risk Management Data ......................................................................................................................... 42
Monitoring Market Risk ........................................................................................................................ 43
What is the Role of the Audit Function? ............................................................................................... 45
Model Risk Governance ........................................................................................................................ 46
Valuation in a Marked-to-Market World During Low Liquidity ............................................................ 48
Conclusion: Steps to Success ................................................................................................................ 50
Appendix ............................................................................................................................................... 51
Chapter 3 – Market Risk Measurement ........................................................................................ 59
Value at Risk - Overview ....................................................................................................................... 59
Advanced VAR Models - Univariate .................................................................................................... 101
Advanced VaR Models – Multivariate................................................................................................. 116
Chapter 4 – Market Risk in the Trading Books: Business Specific Context ....................................125
Contextual Introduction to Bank Trading Activities & Historical Development of Financial Product
Markets ............................................................................................................................................... 125
Fixed Income ....................................................................................................................................... 134
Fixed Income - Interest Rate Option Products .................................................................................... 143
FX & Rates Trading .............................................................................................................................. 154
Money Markets & Short-term Interest Rate Trading (STIRT) ............................................................. 155
Equity Market Trading ........................................................................................................................ 169
Chapter 5 – Commodities Market Risk Management ...................................................................179
Introduction ........................................................................................................................................ 179
Market Participants ............................................................................................................................ 180
Key products and instruments ............................................................................................................ 182
Risk Implications of Physical Nature of Commodities ........................................................................ 187
Implications for Arbitrage Pricing ....................................................................................................... 189
Price Risk Management ...................................................................................................................... 190
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Stress Testing ...................................................................................................................................... 194
Chapter 6 – Market Risk Stress Testing - Beyond the VaR Threshold............................................199
Introduction ........................................................................................................................................ 199
Dangerous Unknowns ......................................................................................................................... 200
Stress Testing: Static and Otherwise................................................................................................... 204
Beyond Comparative Static Analysis ................................................................................................... 209
Systemic Risk Lessons from Beyond Finance ...................................................................................... 216
Moving Beyond Value at Risk.............................................................................................................. 220
Practical and Organizational Considerations ...................................................................................... 222
Challenges of Stress Testing................................................................................................................ 226
Conclusion ........................................................................................................................................... 228
Appendix A - Examples of Stress Testing ............................................................................................ 229
Scenario Formulation - The Fundamental Challenge of Stress Testing .............................................. 229
The Market’s Greatest Hits - Calibrating Stress Scenarios Based on History ..................................... 230
The Achilles Heel Approach ................................................................................................................ 236
Part 2 – Asset Liability Management, Liquidity Risk & Funds Transfer Pricing ................. 245
Chapter 7 – ALM and the Recent Crisis ........................................................................................247
Overall Causes of the Crisis ................................................................................................................. 247
Balance Sheet Related Causes of the Crisis ........................................................................................ 248
The Effects of the Crisis ....................................................................................................................... 250
In Focus: Lehman Brothers ................................................................................................................. 251
Responses to the Crisis ....................................................................................................................... 252
In Focus: The Irish Banking Industry Crisis .......................................................................................... 253
Into the Book: Lessons from the Crisis for Balance Sheet Management ............................................ 254
Chapter 8 – An Introduction to Asset Liability Management ........................................................257
ALM Overview ..................................................................................................................................... 257
An Introduction to Gaps...................................................................................................................... 262
In Focus: Contagion Between Risk Types ............................................................................................ 263
Banking Book Versus Trading Book..................................................................................................... 264
ALM Objectives ................................................................................................................................... 264
Roles Within ALM ................................................................................................................................ 265
Chapter 9 – Interest Rate Risk .....................................................................................................269
Overview ............................................................................................................................................. 269
Components of Interest Rate Risk ...................................................................................................... 270
Measurement...................................................................................................................................... 275
Management ....................................................................................................................................... 281
Chapter 10 – Liquidity Risk ..........................................................................................................289
Overview ............................................................................................................................................. 289
Fundamentals of Liquidity .................................................................................................................. 290
Measurement and Management ........................................................................................................ 296
Recent Developments ......................................................................................................................... 300
Chapter 11 – Balance Sheet Management ...................................................................................309
Introduction ........................................................................................................................................ 309
The ALCO ............................................................................................................................................. 310
Capital Management........................................................................................................................... 317
Strategy and Products ......................................................................................................................... 318
Crisis Management and the Contingency Funding Plan ..................................................................... 319
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Chapter 12 – Bank Funds Transfer Pricing (‘FTP’) .........................................................................323
Introduction ........................................................................................................................................ 323
FTP Governance and Management .................................................................................................... 326
FTP Methods and Historical Development ......................................................................................... 327
Other FTP Challenges .......................................................................................................................... 343
Conclusion ........................................................................................................................................... 345
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Part 1 – Market Risk
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Chapter 1 - Market Risk Introduction
Michel Crouhy, Dan Galai and Robert Mark
Market risk is the risk that changes in financial market prices and rates that will reduce the
value of a security or portfolio. Price risk can be decomposed into a general market risk
component (the risk that the market as a whole will fall in value) and a specific risk component,
unique to the particular financial transaction under consideration. To quantify market risk, we
need pricing models, algorithms, and statistical models. Pricing models and algorithms relate
market prices to risk factors, and statistical models link volatility of market prices to volatility of
market risk factors.
Some risk factors are intuitive because they are directly observable, such as stock prices and
exchange rates. Other risk factors are less intuitive and more difficult to measure such as
interest rates, volatility of interest rates, or correlations between factors, which are not directly
observable and should be derived from a combination of market prices and a pricing model. For
example, we observe a bond price, but must derive interest rates from the bond price,
considering the term of the bond.
Market risk is usually divided into four major types: equity price risk, interest rate risk, foreign
exchange risk, and commodity price risk.
Typology of Market Risk Exposures
Interest rate risk is risk that the value of a fixed-income security, say a bond, swap, or swaption,
will increase or decrease because of changes to market interest rates. First, an underlying
interest rate curve should be specified: say a government treasury curve, a swap curve, or a
curve representing a bond rating. There is a need to derive a term structure of interest rates for
each underlying class of fixed-income instruments. Second, risk points on the curves should be
specified, and interpolation should be applied that ensures no arbitrage opportunities are
created. Many different kinds of exposures can arise from differences in maturities and reset
dates of instruments and cash flows that are asset-like (i.e., “longs”) and those that are liabilitylike (i.e., “shorts”).
Equity price risk is associated with the volatility of stock prices and indices. The general market
risk of equity refers to the sensitivity of an equity instrument or portfolio value to a change in
the level of broad stock market indices such as the S&P 500.The specific or idiosyncratic risk of
equity refers to that portion of a stock’s price volatility determined by characteristics specific to
the firm, such as its line of business, the quality of management or a breakdown in its
production process.
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Data for equities are readily available over an extended period. For example, monthly rates of
returns for NYSE securities are available since 1926. For the last two decades, we can get tickby-tick data, at least for U.S. markets. The availability of data led to an abundance of equity
research.
Foreign exchange risk arises from open or imperfectly hedged positions, in particular, foreign
currency denominated assets and liabilities leading to fluctuations in profits or values as
measured in local currency. These positions may arise as a natural consequence of business
operations, rather than from any conscious desire to take trading positions in a particular
currency. This is a major risk exposure of corporations involved in international trade. Foreign
exchange risk can eradicate the expected return from expensive, cross-border investments, and
simultaneously place a company at a competitive disadvantage in relation to foreign
competitors. It might also generate huge operating losses.
Although it is important to acknowledge exchange rates as a risk factor, risk assessment of
foreign-exchange transactions requires knowledge of the dynamics of domestic and foreign
interest rates, and of spot exchange rates.
For major currencies (i.e., EUR, USD, GBP, CHF, AUD, and JPY), there is a very liquid and deep
OTC market for cash and forward transactions and derivative transactions such as currency
swaps and currency options. Only a small fraction of foreign-exchange transactions is
conducted on exchanges - primarily currency futures and options traded on the IMM
(International Monetary Market) of the CME (Chicago Mercantile Exchange) since 1972 after
the collapse of the Bretton Woods Agreement in August 1971. Options on spot exchange rates
are traded on the CBOE (Chicago Board Options Exchange).
Commodity price risk is the most difficult risk to assess since most commodities are traded in
markets in which the concentration of supply is in the hands of a few suppliers that have the
market power to influence prices. Commodity markets are also exposed to breakdowns in
delivery (e.g., maintenance of oil refineries and gas pipelines). Companies may store
commodities to hedge market price fluctuations. The ease and cost of storage, which varies
considerably across commodities, impacts price volatility.
Commodities can be classified according to their characteristics as follows: hard commodities,
or non-perishable commodities, the markets for which are further divided into precious metals
(e.g. gold, silver and platinum), which have a high price/weight value, and base metals (e.g.
copper, zinc and tin); soft commodities, or commodities with a short shelf life that are hard to
store, mainly agricultural products (e.g. grains, coffee and sugar); and energy commodities,
which consist of oil, gas, electricity ,and other energy products.
There are two levels of market risk management: micro and macro. The micro risk management
of a position requires calculation of price sensitivities of positions with respect to many risk
factors. For example, traders are in charge of hedging exposures (i.e., sensitivities to individual
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risk factors) within risk limits set by the risk management group. This granular approach is
useful at the trading desk level. However, senior managers of a financial institution, or a
portfolio manager, might be interested in a macro approach that relies on an aggregate
measure of risk, based on the overall distribution of portfolio values at a given horizon in the
future. Value-at-Risk (VaR) is the archetype of an aggregate risk measure.
Asset-liability Management
Asset-liability management (ALM) is structured decision-making for matching, and deliberately
mismatching, the mix of assets (e.g., loans) and liabilities (e.g., deposits) on a firm’s balance
sheet. ALM is particularly critical to financial institutions such as commercial banks, savings and
loans, insurance companies, and pension funds. Banks, for example, are involved in collecting
deposits and lending to retail and corporate clients. This financial intermediation generates two
types of imbalances: first, between the amount of funds collected and lent, and second,
between the maturities and interest rate sensitivities of the sources of funding and lending to
clients.
These imbalances drive the net worth of the bank, and its risk profile. For example, deposits
generally have a shorter maturity than loans, so the net worth of many banks benefits from a
fall in interest rates; the bank pays less interest to its depositors but continues for a period to
receive the higher rate from its borrowers. Conversely, the net worth of the same bank
deteriorates if interest rates rise. If this downside risk is not managed, it can lead to insolvency
in individual institutions or even entire banking industries. Likewise, the mismatching of assets
and liabilities almost inevitably leads to a degree of liquidity risk; the greater the mismatch, the
more difficult it is to ensure the institution has cash on hand to fulfill its commitments
immediately in any conceivable circumstance (e.g., the return of on-demand deposits).
Banks’ earnings are particularly sensitive to changes in interest rates and the cost of funds but
many ALM principles apply equally to corporations outside the financial sector whose assets
and liabilities are sensitive to market risk factors. The three goals of ALM are to:
• Stabilize net interest income (NII), that is, the difference between the amount the bank
pays out in interest for funding and the amount it receives from holding assets such as
loans (as measured by accounting earnings);
• Maximize shareholder value or net worth (NW), reflected by long-term economic
earnings;
• Ensure the bank does not assume too much risk from the mismatching of maturities and
amounts between assets and liabilities and from funding liquidity risk (the danger banks
will be unable to raise funds quickly and cheaply enough to fulfill its obligations and
remain solvent).
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Funds Transfer Pricing
The rationale for funds transfer pricing (FTP) is that there are economies of scale and scope
when centralizing management of interest-rate risk. Business units have no control over the
dynamics of yield curves and other market indices such as the prime rate, so the objective of
funds transfer pricing is to remove the non-controllable interest-rate risk from business results.
The funds transfer pricing system charges each business unit that requires funds, the cost of
funding its activity (e.g., the funding cost to make loans) and hedging its interest-rate risk. The
funds transfer pricing system is also used to credit each business unit for its activity to supply
funds (e.g., branch that raises deposits).
Each business unit is then able to secure its profit margin at the time of origination of its
products (e.g., mortgages), and can focus on developing and managing the business side of its
activity and the credit quality of its portfolio (i.e., credit risk remains with the business unit).
The transfer pricing system needs to spell out clearly if interest rate risks such as basis risk (e.g.,
the spread between the prime rate and LIBOR for variable-rate loans indexed on the prime
rate) and options risk (e.g., commitment risk for mortgages) remains with the business unit.
The issue remains: what is the appropriate cost of funds to charge to the business units? A
matched-maturity FTP is the typical approach banks use. A consistent framework for
constructing transfer prices should be based on consistent rules and principles. For example,
the framework should include principles that a bank can adopt to determine the interest rate
sensitivity of the assets and liabilities, and decide into which periods (or buckets) the assets and
liabilities should be placed so they can be matched to facilitate match funding. To conduct ALM
and accurate FTP, banks need to place assets, liabilities, and off-balance-sheet items into
buckets in terms of their known interest rate sensitivities (for match funding purposes) and
maturities (for funding liquidity purposes). The activities are distinct.
Industry Best Practices
A comprehensive market risk management framework calls for policies (e.g., risk appetite and
risk disclosure policies), methodologies (e.g., VaR, stress testing, and RAROC methodologies)
and infrastructure (e.g., risk staff and risk systems infrastructure) that enable management of
all components of market risk in the trading book, as well as of gap risk in the treasury book. A
well-designed system infrastructure enables the production of a variety of critical reports that
make market risk transparent. These reports are provided to the necessary committees and
personnel throughout the governance structure. The governance structure sets policies on risk
appetite, and risk management monitors risk appetite within limits determined by policy.
Best-practice institutions set business-line risk limits in terms of risk in both normal and stress
markets. These limits ensure that individuals do not take more risk than they are allowed. Risk
limits should be aggregated up through the firm, from the business line at the trading desk level
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to the top of the corporation. The drill-down capability of a market risk measurement system
allows market risk managers to identify the unit taking the most market risk, and the type of
market risk to which the entire bank is most exposed.
The limitations of many measures of market risk have been understood for years, but they
played a role in obfuscating risks during financial crises. However, each time there is turmoil in
the world’s markets, the limitations of sophisticated measures of market risk are revealed. For
example, VaR models are typically based on the assumption that parameters such as volatilities
and correlations are stationary (i.e., they do not change in value during the period risk is
measured). This assumption is often proven wrong during extreme market conditions, making
VaR an unreliable measure of risk at the moment robust risk analytics are required most.
Each crisis reemphasizes the importance of using multiple risk-measurement tools, including
stress tests and scenario analyses, and of achieving the right blend of quantitative rigor and
qualitative assessment. Using a range of risk measures helps because each approach has
limitations and strengths. VaR cannot easily capture the impact of significant disruptions in
liquidity, prices, volatility, and correlations. VaR also struggles to capture strong non-linearities
in market risk of the type observed in complex structured products.
Stress testing, which consists of shocking risk factors, is a bottom-up, static process. It assesses
the immediate impact on risk positions of these shocks. Scenario analysis is dynamic in nature
and a top-down process. Macroeconomic scenarios, which unfold over several periods, say two
to three years, are specified. These scenarios are translated into fully consistent trajectories of
risk drivers that affect various portfolios. This approach helps uncover extreme situations that
might lead to insolvency and liquidity crises; it provides a powerful framework to fine-tune the
risk appetite of the firm and design contingency plans that meet regulatory requirements under
extreme conditions. This is precisely the spirit of the Dodd Frank Stress Test (DFAST). DFAST
requires banks with total consolidated assets of more than $10 billion to conduct annual stress
tests. The purpose of DFAST is to assess quantitatively how bank capital levels would fare in a
stressful situation.
Content of Market Risk Section
Crouhy, Galai, and Mark discuss market risk management governance and management in
Chapter 2. The authors describe post-crises risk governance concerns in financial institutions
following the 2007 to 2009 financial crisis. They point out that many of the risk governance
concerns, in general, also hold for market risk. The authors describe in detail the history of
prudential market risk regulation, and show where the capital standards for market risk were
weak in the run up to the financial crisis. They describe the roles and responsibilities in practice
of board committees and senior management committees. They also review in detail the roles
and responsibilities of the risk management and audit functions. The authors provide insights
into model risk governance, steps necessary to mitigate model risk, and valuation in a mark-tomarket low trading liquidity world.
21
Max Wong and Changwei Xiong describes the current and evolving market risk measurement
tools in Chapter 3. The basic VaR approach is described along with more advanced VaR models
such as extreme value theory. He extends the VaR measure to fat-tailed distributions
characterized by extreme events. Wong provides the detailed analytical formula for the
standard VaR as well as for advanced univariate and multivariate VaR models.
An in-depth discussion of equity, interest rate, foreign exchange, and commodity products is
given in Chapter 4 by Douglas Bongartz-Renuad, and in Chapter 5 by Jan-Peter-Onstwedder.
Chapter 4 summarizes key developments in the financial markets over the past four decades.
Bongartz-Renuad offers product descriptions for both cash and derivatives markets for equity,
interest rates, and foreign exchange products. Chapter 5 discusses categories of commodity
products (e.g., energy, metals, and agricultural) and the many players in commodities markets
(e.g., producers, processors, consumers, and traders). Onstwedder introduces product
descriptions for both cash and derivatives commodity products. David Rowe discusses stress
testing in Chapter 6, including the multiple challenges in describing risks for both normal and
stress markets. Rowe provides a three-pronged approach to stress testing using selected
historical events, reverse stress testing, and structural imagination to assess socioeconomic and
geopolitical conditions to define dangerous scenarios. He emphasizes that current risk
management resources often fall short of what is required to comprehensively calculate risk in
stress markets.
Justin McCarthy provides insights into the historical and current evolution of ALM and funding
liquidity management in Chapter 7. In Chapter 8, Douglas Bongartz-Renaud discusses the role
FTP plays in ALM. FTP is an essential component of ALM, and is a controversial issue in most
organizations since it affects the measured profitability of various business lines. McCarthy talks
about the overall causes of the 2007 to 2009 financial crisis, and describes how the ALM
function should respond to a financial crisis. He reviews how organizations should manage
interest rate risk and funding liquidity risk from a balance-sheet, net-income, and cash-flow
perspective. McCarthy provides details on the measurement of ALM related interest rate and
liquidity risks. He also discusses Basel Committee principles for the management and
supervision of interest rate risk and liquidity risk. McCarthy reveals how to manage a funding
liquidity crisis, arguing for a dynamic contingency funding planning approach. Bongartz-Renuad
describes a hierarchy and evolution of FTP methods, detailing how to construct an FTP system.
He also talks about the rationale for having an FTP system. Bongartz-Renuad describes
economies of scale associated with centralizing the management of interest rate risk. He
demonstrates the link between components of bank net interest margin and the FTP system.
Bongartz-Renuad also discusses how an FTP system can be used to identify how a bank makes
money.
22

and Asset Liability Management

Transcription

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