2 - Market Risk

8/8/2019 2 - Market Risk

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MARKET & LIQUIDITY RISKMANAGEMENT


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What isrisk?

y It is the potential that events expected or unexpected,

may have an adverse effect on a financial institutionscapital or earnings.

y Risk is the possibility that an uncertain outcome

/event might have undesirable consequence

y Risk is the exposure to a potential loss or reduction inincome


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What isrisk?

y Risk is inherent in all business and financial activities.

y The greater the RISK associated with an activity thegreater potential to generate a high return.

y Banks do take RISKS The biggest RISK is Not TakingA RISK.


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Characteristics of Risk

Risk must be:

y Knowny Understood

y Quantifiable

y Controllable / Acceptable /Bankable


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y Risk cannot be eliminated

y Risk can be minimized

y High risk high return!!!

y Low risk low return!!!

Characteristics of Risk


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What is Risk Management?y Henry Ford once said.

Keep all your eggs in one basket?

RIGHT OR WRONG?


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What is Risk Management?DIVERSIFICATI N

y Risk Management is the process of measuring orquantifying risk and then developing strategies toeliminate or reduce losses.


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What is Risk Management?y Risk Management is the process of identifying,

measuring, monitoring and controlling risks

y It is comprehensive process adopted by an

organization that seeks to minimize the adverse effects

it is exposed to due to various factors -- economic,

politicalorenvironmental some of them inherent

to the business, others unforeseen and unexpected.


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What is Risk Management?

y Familiarisation of Management with Risks

y Implementation of Internal Controlsy Sound Internal Audit System

y Efficient MIS in Place

y

Competent Group of Risk Managersy Prompt Action & Monitoring


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Why risk management?y Crisis of financial industry in 1990s, e.g., LTCM,

Barings bank

yLearning from Past Experiences

y How should Financial industry behave?

y Looking back into the Past:

y Long Term Capital Management (LTCM)

y Barings Bank

y Society Gen


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Long Term Capital Management

y The Team : John Meriwether, Myron Scholes andRobert Merton (Nobel-prize winning economists), David

Mullen (a former vice-chairman of the Federal Reserve)yMinimum Investment: $ 10 Million.

y Clients: The Whos who of international financial sector.

y The Financials: Equity of$4 billion, borrowings $ 125billion, Exposure $ 1.25 Trillion

y The Strategy: Convergence Trades in sovereigns

y TheCause: Russian Sovereign Default and Flight to

liquidity


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LTCM -Lessonsy Systemic Risk:

y Market values matter

y Liquidity risk is itself a factor

y Models must be stress-tested and combinedwith judgment

y

Financial institutions must aggregate exposuresto common risk factors


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BaringsBankyA Bank with 223 year old history.

y TheCulprit: Nick Leeson (General Manager of Barings

Futures subsidiary in Singapore)y The Strategy: Straddling, High risk options

Trading at SIMEX, NIKKEI 225 Index.

y The Loss: $ 1 Billion

y TheCause: Fraud, Lack of internal controls.

y TheAftermath: Bank defaulted and sold of.

Canuguessthe price?


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BARINGS BANK: LESSONSy Lack of internal checks and balances

y Even when segregation of duties was suggested by

internal audit, the concentration of power in theLeeson's hands was scarcely diluted.

y Lack of understanding of the business

y Lack of a clear reporting line


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Society Generaley France's Socit Gnrale, one of Europe's biggest

banks and a global superstar in the booming

derivatives-trading businessyA staggering $7.1 billionloss from rogue

trading by a single employee,Jerome Kerviel, theCulprit

y The trader "had taken massive fraudulent directionalpositions"bets on future movements of Europeanstock indexeswithout his supervisors' knowledge


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Society Generaley he had previously worked in the trading unit's back

office, he had "in-depth knowledge of the control

procedures" and evaded them by creating fictitioustransactions to conceal his activity.

y His intention was not to drown the bank in to thatgreat loss. He wanted to make profit for the bank and

to cover up the loss, he took different positions in theDAX (German Stock Market Index), but those

positions results in a huge loss of7.1 Bio for thebank.


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Societe Generale LESSONS:y Lack of IT Controls

y Poor supervision/monitoring of higher management

yA person with strong back office knowledge, even whoknows the flaws, should not be allowed to make frontoffice deals

y Dealer should not cross its assigned limit.


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Banking is an art of striking a balance

between Risk and Revenue.

[Swiss Banking Corporations Credit Manual]

Banking and Risk


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Banking and Risky Banking is all about taking risk.

y Banks take one persons (depositor) money and lend to

someone else (borrower) to earn profit for itself andthe depositors.

yAll functions in banks are there to take risk.


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Major Risksy Market Risk

y perational Risk

y Credit Risk


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Marke

t Risk

It is the risk that the value of on and off-balance sheet

positions of a financial institution will be adverselyaffected by movements in market rates or prices such

as interest rates, foreign exchange, equity prices, credit

spreads and/or commodity prices resulting in a loss of

earnings and capital.


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Market RiskTypesofMarket Risk

y Interest Rate Risky Foreign Exchange Risk

y Equity Price Risk

y Liquidity Risk


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Market RiskInterestRateRisk

Interest Rate Risk arises when there is a mismatchbetween positions, which are subject to interest

rate adjustment within a specified period.

The banks lending, funding and investmentactivities give rise to interest rate risk.


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Market RiskInterest Rate Risk..Continued

yAccepting this risk is the bread and butter of bankingand is an important source of profitability andshareholders value if managed properly.

y Uncalculated and imprudently managed interest raterisk can erode banks earning and capital base.


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Market Risky Sourcesof Interest RateRisk

y Re-pricing Risk

Arises out of timing difference in the maturity (for fixed RSAs& RSLs) and re-pricing (for floating RSAs & RSLs) of banksassets, liabilities and off-balance sheet items.

y Basis Risk

Imperfect correlation in the adjustment of the rates earned and

paid on different instruments with otherwise similar re-pricing characteristics.


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Market Risky Sourcesof Interest RateRisk

y YieldCurve /yieldcurvetwistrisk

Changes in the slope and shape of yield curve.Disproportionate change in the interest rates of differenttenors. (weighted av. duration of a portfolio)

y Option Risk

Option to prepay or other embedded options in the assets or

liability based products orOBS portfolio.


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Market Risky Effectsof Interest Rate Risk

y Changes in interest rate can have adverse effect both ona banks earnings and its economic value

y Earning Perspectivey Focus is on the accounting or reported earning.

y Advantages: affect on earning which is well understood and

objective.y Disadvantages: focuses only on the near term effects of

changes in the interest rate


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Market Risky Effectsof Interest Rate Risk

y Economic Value Perspective

y Variation in market interest rates can also affect the economicvalue of banks assets and liabilities.

y Represents assessment of PV of its expected net cash flows.

y Provides a more comprehensive view of the potential long termeffects of changes in IR.

y Reflects sensitivity across full spectrum of maturity but relies ona number of subjective assessment factors.


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Foreign Exchange Risk

y It is the risk arising from the fluctuation in the

denomination of local currency to foreign currencies.


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Equity Price Risk

y Equity Price Risk is the risk to earnings or capital that

results from adverse changes in the value of equityrelated portfolios of NBP.

y Price risk associated with equities could be systematicor unsystematic. The former refers to sensitivity of

portfolios value to changes in overall level of equityprices, while the later is associated with price volatilitythat is determined by firm specific characteristics.


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Liquidity Risky Risk of being unable to meet claims/financial

obligations without financial impairment

Basel-IIDefinesas:Potential for loss to an institution arising from either

its inability to meet its obligation or to fund increasein assets as they fall due without incurring

unacceptable cost or lossesBASED ON MARKET CONDITIONS &

PERCEPTIONS


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Liquidity Risky Defining the liquidity

y Maturity Profile Versus Cash flow statement

yAssumption regarding behavior of deposits andadvances.

y Risk of assumptions going wrong


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Liquidity RiskManaging LiquidityRisk

y Holding excess liquidity needs to be contrastedagainst the profits from asset transformation.

y Diversifying the deposit base: leads to improvedpredictability.

y Retail Vs. Corporate deposits!!

y Importance of Money market instruments anddeveloped money market.

y Contingency funding line and cost


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Risk Management and Basel IIy Revised Basel Framework in June 2004 (B2:

Three Pillars Approach)

y To bring harmony in banking systemy Covers all the factors of risks inherent in

banking industry

y Investors/depositors will know the bankscredibility

y Deadlines set forth by State Bank Of Pakistan


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Basel IIy Emphasis on focused risk management

y Encouragement towards improving Banks risk

assessment capabilities.y Capital Requirement for Market Risk remains the same

as envisaged under Basel-I in 1996


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Basel IIThe Framework

y Pillar1: Minimum Capital Requirement.

Same for Market Risk as in Basel-I

Standard Approach and Internal Model Approach

Calculated for Interest Rate Risk in Trading Book

Specific Risk, General Market Risk, Equity Risk,

FX Risk, Options Risk


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Defining Trading and Banking Book

y Trading Book

For the purposes of capital adequacy, that part of a

bank's business which broadly involves its trading

department(FX, MM, Equity)

The portfolio of financial instruments held by abrokerage or bank. The financial instruments in thetrading book are purchased or sold to facilitate tradingfor their customers, to profit from spreads between thebid/ask spread, or to hedge against various types of risk.


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y Banking Book

For the purposes of capital adequacy, that part of a bank's

business which broadly involves its lending departmentand long-term investments.

An accounting book that includes all securities that are

not actively traded by the institution, that are meant tobe held until they mature. These securities are accountedfor in a different way than those in the trading book,which are traded on the market and valued by the

performance of the market.

Defining Trading and Banking Book


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Basel IIThe Framework

y Pillar 2: Supervisory Review.Also covers risk which are not covered under pillar 1. i.e.Liquidity Risk, Concentration Risk, Interest Rate Risk inBanking Book

y Pillar 3: Market Disclosure.


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Tools to managerisky Organizational restructuring

y Designing and implementation of policies andprocedures

y Setting and monitoring of limits

y Establishing Risk Rating Criteria

y Conducting Sectoral Analysis

y

Stress Testingy Calculating VaR

y Compliance to regulatory requirement


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Tools to managerisky Interest Rate Sensitivity Analysis

y Gap Analysis

y Duration Analysisy Hedging Techniques:

Derivativessuch as:

y Futures & Forwards

y Options & swaps


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Tools to managerisky Organizationalrestructuring

y Independent Risk Management Unit

y

BoD and Senior Managements oversight and activeinvolvement

y Risk Management Committees

y Effective and Efficient Internal Auditing

y

Independent MiddleO

fficey Assignment of duties and responsibilities

y Delegation of authority


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Tools to managerisky Policiesand Proceduresdesigning

y Designing Bank wide Risk Policy

y

Defining Banks Risk Tolerance Levely Designing Fund Management and Investment Policies

y Defining and Designing Banks Contingency FundingPlans

y

Designing Dynamic Business Strategies and Policies


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Tools to managerisky SettingandMonitoring Limits

y

FX Limitsy MM Limits

y Overseas Limits

y Equity Limits


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FXLimitsy Internal as well as regulatory

y Protects against adverse change in exchange rates

yHelps in managing risk/exposure against counterparties

y Helps in FX Deals/Trading


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FXLimitsFX Contract Limit

y Internal Limity Contract Limit is the maximum value of outstanding

contracts on overall basis that can be entered with asingle counterparty.

y Consists of different types of deals like Swap, Ready,Tomorrow, Forward etc

y Monitored on daily basis

yAction taken in case of Breach


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FXLimitsFX Settlement Limity Internal Limit

y Settlement Limit is the maximum value of outstandingcontracts maturing on anysingle trading daywith aparticular counterparty

y Consists of different types of deals like Swap, Ready,

Tomorrow, Forward etcy Monitored on daily basis



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FXLimitsFX Reval Limity Internal Limit

y Reval Limit is 10% of Contract Limit for FX.y The overall net position of the contracts with a

counterparty are revalued daily to see the changes dueto exchange rate movements in the value of the

contracts.y Monitored on daily basis



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FXLimitsFX MTM Limity Internal Limit

y It reflects the market value of forward FX contracts dayto day basis

yAny resulting gain or loss is accounted for as FXtrading profit or loss.

y In case of excess loss action is takeny Monitored on daily basis


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FXLimitsFX Transaction wise Reval Limitsy Internal Limit

y Same as FX MTM but it is for individual transactionsy Individual transactions are Revalued and then

compared to assigned limits

y In case of excess loss action is taken

y Monitored on daily basis


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FXLimitsFEELy Regulatory requirement of SBP

y State Bank of Pakistan assigns FEELy FEEL is the overall LONG or SHORT position

expressed in PKR for all foreign currencies.

y The maximum position either long or short is taken as

FEELy Monitored on daily basis


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FXLimitsFC Gapy Internal Limit

y Gap is calculated by multiplying the position for everymaturity bucket of the concerned currency with afactor.

y The factors presently used are approved by TMG and

validated by TMO.y The gap limits are proposed by TMG, reviewed and

validated by TMO and approved by ALCO.


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FXLimitsFC Exposurey Internal Limity The risk of loss stemming from exposure to adverse foreign

exchange rate movementsy A foreign currency exposure arises when entering into an

open position i.e. un-hedged position in trading anyforeign currency

y Exposure is the sum of all the positions in a particular

foreign currencys within each defined maturity buckets.y The exposure limits are proposed by Treasury Management

Group (TMG), reviewed and validated by TMO andapproved by ALCO.


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FXLimitsNOSTRO Balances Monitoringy Monitoring NOSTRO accounts for any Debit balances,

on daily basisy In case there is any debit balance, TMO must verify it

with FE Reconciliation Department and notify TFO toreplenish funds in that account to avoid interest/

overdraft charges.y Identifying unconciled NOSTRO balances in order to

reduce them


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MM Limitsy Internal as well as regulatory

y Protect against adverse change in interest rates

y

Helps in managing risk/exposurey Helps in Liquidity management and efficient MM

Trading


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MM LimitsMM Reverse Repo Limity Internal Limit

y This limit is assigned for lending against SecuritiesyApproved by FID

y Monitored daily basis

yAction is taken in case of breach


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MM LimitsMM Call Limity Internal Limit

y This limit is assigned for clean lendingy More risk involved

yApproved by FID

y Monitored daily basis

yAction is taken in case of breach


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MM LimitsMM Reval Limity Internal Limit

y This limit basically protects against negative pricemovements in security used in Repo transaction.

y This limit covers rate risk and is usually set at 5% ofRepo Contract Limit

y Monitored daily basisyAction is taken in case of breach


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MM LimitsSLR/CRR Limity Regulatory Requirement

y To monitor and ensure banks cash reserves with SBPas per requirement.

yAlso ensures SLR requirements of SBP by monitoringbanks fixed income securities investments

y Monitored daily / weekly basis depending onavailability of DTL

y Penalty is levied/Imposed by SBP in case of breach


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OverseasLimitsOverseas FEELy SBPs Regulatory requirement

y FEEL assigns by SBPy Data is to be taken from 17 Overseas branches on daily

basis

y FEEL is the overall LONG or SHORT position

expressed in PKR for all foreign currencies.y Overall FEEL comprises of Domestic Exposure,Overseas Exposure and OverseasOff-Balance SheetExposure


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OverseasFEEL(contd)y The maximum position either long or short is taken as

FEEL

y

Total exposure is also used to calculate the FX CCRisk Exposure to Capital Ratio

y It also shows the % of FEEL utilized and Overall FXRisk Exposure to Capital Ratio

y

Monitored on daily basis and reported on Weekly basis


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Currency WiseExposure ofOverseas

Branchesy FEEL statement sent by the overseas branches at the

end of the week are used to monitor the exposure ofthe branches taken in all currencies they trade.

y Data is also used to calculate the NOP of the overseasbranches.

y Monitoring on daily basis and reported on weekly

basis


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OverseasOff-Balance Sheet FX Risk

Exposurey Regulatory requirement of SBP

y It is the exposure taken on contingent liabilities and

Forward positions bank takes to hedge their positionsy Overseas branches sent their fwd positions if any, and

MLRW make analysis to observe the net fwd position(Fwd Purchse-Fwd Sales)

y

It is also used to calculate the Off-Balance Sheet FXRisk Exposure to Capital Ratio

y Monitoring on Weekly basis.


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Placement Positions ofOverseas

branchesy Internal Limits

y Overseas branches sent the data at every week end

intervalyAnalysis report to be made showing the Net Income as

at maturity and at report date on the placement to bewith other overseas banks, NBP overseas banks, HeadOffice and with SBP

y It also shows the limit breach (if any), assigned to theoverseas branches for their placement with otheroverseas banks

y

Monitoring on Weekly basis


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Investment Position ofOverseas

Branchesy Internal Limits


intervalyAnalysis report to be made showing the Mark-to-

Market Profit/Loss on the Investment and the NetIncome as at maturity and at report date on theInvestment made in other Instruments

y Monitoring on Weekly basis


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Borrowing Position ofOverseas

Branchesy Internal Limits


intervalyAnalysis report to be made showing the Net Expense

as at maturity and at report date on the borrowing tobe done with other overseas banks, NBP overseasbanks, Head Office and with SBP

y Monitoring on Weekly basis


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Equity Limitsy Regulatory (SBP) as well as Internal Limits

y Protect against adverse changes in the equity related

portfolio due to price movementsy Helps in managing risk/movements against price

volatility


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Categories of Securities

y Held for Trading (HFT)

yAvailable for Sale (AFS)

y Held to Maturity (HTM)


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Regulatory Limitsy Investment in the Shares of a company should not

exceed 5% of NBPs Equity.

y Total Investment in shares by a bank shall not exceed20% of its equity.


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Internal Limitsy Sectorwiselimit (Cap)

y Investment in any one sector, as per classification ofstock exchange, shall not exceed 25% (Twenty Fivepercent) of the market value of portfolio at any point intime

yAFS Limit (Atleast 80%of Total Investment)

y 80% (eighty percent) of total investment listed equity

securities based on the market value will be held in theAvailable for Sale portfolio


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Internal Limits (contd.)y HFT Limit (Upto 20% of Total Investment)

y Upto 20% (twenty percent) of the total investment inlisted equity securities based on market value will be inTrading portfolio.

y Trading Portfolio Limitof Rs. 800 million

y Trading Portfolio of investment in shares shall notexceed Rs. 800 million


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Tools to managerisk

RegulatoryRequirements

y

Prudential Regulationsy Time to Time Instruction/Circulars by SBP

y SLR/CRR

y Basel-II Requirements


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Tools to manageriskyALM Analysis

Maturity wise Assets and Liabilities Break up

y NII AnalysisDifference Between Interest Income and Interest

Expenses

y

Gap AnalysisGap b/w Assets and Liabilities in various maturity

Buckets


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Tools to managerisky Duration Analysis

Duration is measure of the sensitivity of present value

or price of a financial instrument in interest rates

It is average time to receipt of cash flow weighted by

present value of each of cash flows in series

It estimates an impact if interest rate changes on

present value of cash f lows generated


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Tools to manageriskDesigningVaR andVaR based Limits

y Statistical measures, at a certain confidence level, the

amount of value that the financial institution maystand to lose within a specified time.

yVaR approach measures total portfolio at risk andidentified the like hood of loss across the different

products to produce a single VaR number.y It is useful because it converts measures of potential

losses arising from different market variables into acommon measure.


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VaR Calculationy Trading Portfolio of45,000 Shares of PSO

y Relative volatility from 1stJan 2007 to 3othJune 2008

is 1.9% . Calculated by Standard Deviationy Confidence Interval 99% (Factor 2.3263)

y Price on 28th June 2008 417.24

yVaR 4.43%

(Relative Volatility*Risk Factor*SQRT(TimeHorizon)

yVaR in absolute terms Rs.831,255


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Tools

to manage

risk

Parametersof VaR

y Confidence Interval

y Holding Periody Sample Period


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Tools

to manage

risk

VaRmust besupplemented by:

y Stress testing

y Prudent checks and balancey Policies and procedures

y Controls and limits

y Random audits.


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Tools to managerisk

ThreeApproachestoVaR

y Historical SimulationyVariance Covariance

y Monte-Carlo Simulation


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Tools to manageriskHedging Techniques:

y Derivatives

FutureForward

Options

Swaps

IRS

CC Swap

y Structured Products


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Career prospectsy Growing awareness about Risk Management and its

benefits across Financial industry

y Growth in Risk Management

y Lack of experienced people in financial industry

y Lucrative salary structure

y Going to stay until financial institutions exist

y Good job prospects globally


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Listening

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2 - Market Risk