Risk Mgmt Questionnaire-Adv

7/31/2019 Risk Mgmt Questionnaire-Adv

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Theory questionsOperational Risk

What are the dimensions of market risk?Securities Market: Positions in traded securities with systemic and non-systemic

risks. Such volatilities may lead to losses.Interest Rate Risk: Interest rate risks are relevant for financing structures in bondsor similar interest products. Shifts in the interest rate curve impact the P & L as wellas the A & L values.FX Exchange Risk: All P & L positions as well as A & L or eventually off-balancesheet positions may appear with lower/higher values due to FX exchange ratevolatilities.Commodities: Commodities may be only traded positions or important forproduction, directly or indirectly. Volatilities may impact massively the P & L.

What is one definition for operational risk management according Basel II?

Operational risk management is managing the risk of losses resulting frominadequate or failed internal processes, people, and systems or from externalevents. This definition includes legal risk, but excludes strategic and reputational risk.

What are the dimensions of credit risk?Credit Risk Quality: Credit risk is a potential loss due to a debtor's non payment of aloan or other credit form (either the capital or interest or both). The default eventsinclude all of either a delay in repayments, restructuring of borrower repayments, orbankruptcy.Counterparty Risk: Reduction of a counterparty rating which causes for the affectedfirm an increase of financial payments and for fixed income position holders areduction in their assets due to a decrease in the market value of the position.

Define the different terms of capital, what are the different approaches tocalculate regulatory capital? What are the advantage and disadvantage ofthese approaches?Booked capital: Effective capital, equity in the booksEconomic capital: Risk-adjusted capitalRegulatory capital: Basel I / II / III capitalTarget capital: In accordance with the future(see slide 16, presentation S. Schmid)

Basic - standard - advanced approach:IRB approach: foundation/basic or advanced IRB approach

Targets of Basel II?- Better handling of risks- No increase of overall capital in the market- Dealing appropriate with products/transactions- Fair competition


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CREDIT RISKK = * GI K = (1-8 * GI) K = PE * LGE * EI = 15% = 12-18% per business line PE: Probability of a loss event

LGE: Loss given eventAlternate approach: EI: Exposure indicatorK = (RB * 0.035 * LARB) Or: ACP = PD * LGD * EAD

PD: Probability of defaultLARB : total outstanding loans LGD: Loss given defaultand advances avrg past 3y EAD: exposure at default

MARKET RISKK = VaR * factor (3-4x)

What is the role of the Basel Capital Accord? What are the 3 pillars of Basel II?The Basel Committee, established by the central-bank Governors of the Group ofTen countries at the end of 1974, meets regularly four times a year. The Committeedoes not possess any formal supranational supervisory authority. In 1988, thecommittee decided to introduce a capital measurement system commonly referred toas the Basel Capital Accord. This system provided guidelines for the implementationof a credit risk measurement framework with a minimum capital standard.

The three pillars are1. minimum capital allocation

2. supervisory review processa. Board management and oversightb. Sound capital assessment


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c. Comprehensive capital assessmentd. Monitoring and reportinge. Internal control review

3. market discipline and disclosure requirements.Minimum capital requirements consist of three components

1. Definition of capital / 2. Definition of RWA / 3. Minimum ratio of capital/RWA (8%)Changes to Basel I in treatment of credit risk and explicit treatment of op risk

Supervisory review is based on a series of guiding principles, which point to theneed for banks to assess their capital adequacy positions relative to their overall risksand for supervisors to review and take appropriate actions in response to thoseassessments.

Market discipline or public disclosure encourages safe and sound banking practicesthrough effective market disclosures of capital level and risk exposures.

How is the overall risk-taking capacity composed?Overall Risk taking capacity = Tier 1 Capital + Reserves + Intangibles + Expected netgains + Other

What are the 4 parameters of credit risk in Basel II?Probability of default (PD): probability of default (regulatory definition of default event)of the borrowers in each risk grade/rating on a one year time horizonLoss given default (LGD): loss after the event of a defaultExposure at default (EAD): outstanding amount at time of defaultMaturity (M): remaining effective maturity of EAD

The three approaches differ in the source of parameters, either external/regulatory

predetermined or an internal estimate.Calculate


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What is the difference between Basel I, II and III? What has been improved?

Basel II and III: Basel III Total regulatory capital ratio consists of Tier 1 Capital Ratio- a capital conservation buffer- a countercyclical buffer

- additional capital requirement for systematically important banks

What is economic capital?Economic capital is the level or amount of capital that a financial institution shouldhold to ensure it has sufficient buffer against unexpected losses (within a given levelof confidence).This does not cover stress losses, against which it is too expensive to hold capital.

What questions can Economic Capital answer?- Level of capitalization (Optimize capital)- Business unit performance (Optimize performance!)

- Hedging and insurance programs (Optimize mitigation techniques!)- Asset attribution and ALM (Optimize risk/return rate!)

What is credit value-at-risk and how are economic capital and ratingconnected?Credit value-at-risk is usually a Poisson distribution (never a normal distribution). Therisk is the bigger, the higher probabilities of default / losses given default / asset valuecorrelations and credit maturities.AA = 99.9% VAR, A = 99% VAR, BBB = 95% VAR

What is the role of Economic Capital?- Aggregate risk with a single, consistent approach- Asses risk on a consistent basis across the firm for different risk drivers- Determine whether risk profile is in line with the risk-bearing capacity of firm- Complements specific risk measures- Provides increased risk transparency- Provides basis for risk-adjusted performance measures- Input into capital allocation process

What are the benefits with use of economic capital?- Better risk management

- Improved Credit Ratings- Improved Capital Management

How did economic capital techniques evolve?Stage 1: Risk AnalysisStage 2: Capital attribution and limit settingStage 3: Risk-adjusted Performance Measurement (RAPM)Stage 4: Forward-looking projection

Name and qualify some approaches to calculate economic capital?Top down approaches: earning volatility approach, option theoretic approach

Bottom up approaches: stress testing, risk based per risk type (with a distribution andconvolution = similar to cross-correlation).


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How can economic capital be allocated?- Stand-alone contribution- Incremental EC contrib. (subtracting from EC the individual BU, not additive!)- Marginal EC contributions (volatility based: VaR, ES)

What is done to reflect true or economic risk?Risk-adjusted performance metrics (RAPM), based on standard accountingperformance metrics, some adjustments are made to reflect true or economic risk.

ROE or ROC are insufficient because- There is no risk premium- Capital costs per BU were not possible- The added-value (EVA) is unknown- Wrong signals may occur (high risk and capital contribut. not considered)

Formula:

RAPM (risk adj. perf. meas.) =Return Costs expected loss

Economic Capital

RAROC (risk adj. return on capital)=Return Costs expected loss

Capital

RORAC (return on risk adj. capital) =Net income

Allocated Risk Capital

RARORAC (risk adj. return on risk adjusted capital) =

What is the objective/benefit of a leverage ratio?A simple non-risk based measure based on gross exposure (!) thereby helping avoiddestabilizing deleveraging processes.

Name some possible risk applications?- Risk Identification- Risk Measurement and Performance- Risk Management- Risk Controlling and Reporting

- Risk Processes- Risk Strategy- Risk Governance- Risk Capital- Risk Theory

Some questions on tactical and strategic Value Based Risk Response?Tactical:

- How risky is the customer?- How should we price different loans?- Which relationships are profitable?

- Is the risk within its limits?Strategic:

- What is the risk profile of my customers?


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- Which business units have favourable risk/return profile?- Which business activities should be expanded?- Do we have enough capital to support our risk?

What is the difference between a risk and uncertainty?

Risks are events to which the decision-maker can assess probability distributions,whereas uncertainties are events that can not be expressed in terms of suchprobabilities.(PRMIA handbook)


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CREDIT RISK FUNDAMENTALSCredit Risk Measurement - Key Facts

What interdependencies exist for the default of two obligors?Mutually exclusive: rare circumstance, failure may increase market share of other

Independent: occurrence of one has no influence on probability of otherPositive Dependence: if one event occurs, the other is more likelyMaximum Dependence: default of one obligor, causes default of another one

What is the difference between Lending Risk and Counterparty riskcharacteristics?In lending risk, only one party takes a credit risk and the outstanding exposure isusually known and fixed. In counterparty risks, both parties take risk and the futureoutstanding exposure in unknown in magnitude and sign (driven by market riskfactors).

In the latter case, the quantification of the exposure is difficult to quantify and drivenby volatility.

What is the effect of collateralization and which risk determinants influencecollateralized trades?In collateralization, the life of a trade risk is transformed into a short time horizon riskand credit risk is transformed into market risk.The risk determinants of collateralized trades:

- Re margin period- Exposure volatility- Collateral volatility- Correlation risk- Gap risk- Liquidity and liquidation risk (only about 10% of average daily trading volume

can be liquidated)

Slides page 9, Credit Portfolio Modelling (Mathematics)

What are the four main requirements towards a credit rating model?- Discriminatory power- User acceptance

- Implementability- Cost/Benefit

What are the four steps in a development of a scorecard credit rating model?- Data sourcing and sample preparation- Single-Factor analysis- Multi-Factor analysis- Calibration

What are the four cornerstones of credit analysis or approval?- Rating / Expected loss

- Credit Guidelines / Policies- Debt Capacity- Single Obligor Limit (exposure concentration limit) / Limit system


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Slide page 16+17, how to measure the portfolio loss distribution (Intensity andstructural models / Correlation of structural default)

Name 3 differences between unexpected loss allocation and expected shortfall

allocation?Allocation according to unexpected loss

- Distributes the capital needed to cover large but not extreme loss events- Tends to penalize low credit quality, insensitive against concentration risk- Can lead to capital charges in excess of exposure- Is not guaranteed to recognize diversification effects correctly

Allocation to expected shortfall- Distributes capital to cover extreme loss events- Sensitive against concentration risk- Diversification be being compliant with fundamental risk measure axioms

- Choice of threshold depends on management objectives

Example of a securitization process

What are the benefits of credit portfolio management? How can it beorganisationally integrated?

- Reduce earnings volatility through hedging and 2nd market transactions- Improve portfolio value and liquidity- Help overcome existing market or policy constraints- Provide methodology and tool capabilities for credit portfolio modelling- Develop proposals for portfolio strategy, policy and risk appetite

Slide 20 pre and post origination for valuing bonds and loans?

Pre Origination- Liquid assets: CDS spreads- Illiquid assets: add illiquidity premium to liquid curves

Post Origination- Liquid assets: Bond or CDS price- Illiquid assets: Cost to securitize (CTS)

Transfer pricing (spread based pricing curves or hedging costs) can be used for bothliquid and illiquid assets as well as for pre and post origination.

CREDIT RISK RATING AGENCIES

What is a credit rating?A credit rating reflects the credit worthiness of a borrower. That is the willingness andability of borrower to pay interest and repay credit.


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RISK MANAGEMENT IN TURBULENT TIMES4 decisions in risk management

Decisions to take Policy Failure in risk mgmtHow much risk to take? Investment Policy Banks have taken too

much risk

How much of this risk toretain and how much toinsure or transfer?

Risk Management Policy Banks have retained toomuch risk

How much capital to keepas a buffer against lossesdue to this retained risk?

Financing Policy Banks have kept to littlecapital

How much liquid reservesto maintain?

Cash Management Policy Banks have kept too littleliquidity

Specificities in turbulent times- Risks are larger and some of them are new (mutuality principle, correlation)- Managers accountability increases more and more (implement. of risk mgmt.policies, Sarbanes & Oxley Act, increased competition can make it difficult to copewith unexpected events)- Risks are more and more global and have to managed as such (consolidation ofrisk mgmt. is required instead of silo approach, global supply chains)

Taxonomy of risks- Exogenous risk- Economic and financial risks

- Operational risks- Strategic risks

4 Necessary steps of risk management1. IDENTIFICATION: Tools for Risk MappingRisk classification tableRisk Radar

2. QUANTIFICATION AND MODELLING: Risk Quantification Matrix (Severity/Frequ.)

3. LOSS PREVENTION & PROTECTION/Loss control is twofold: it consists in thereduction of the frequency of occurrence of unwanted events (prevention) and onthe other hand, loss control deals with the reduction of the consequences of a riskafter it has occurred (protection).

4. RISK FINANCING & TRANSFER/Allocation: If risk is kept, it can be self-insured(retention, not doing anything) or being financed by a special purpose vehicle (SPV),or partially or completely being transferred to another economic agent.

Risk Mgmt Triangle1 (single bearer) bank, supplier

n (market) securitization,insurance/reinsurance,

derivatives

8

(Society) war, naturalcatastrophes


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Recently, rise of retention and larger fraction covered on financial markets. A captiveis defined as reinsurance or insurance vehicle, owned by a corporation that will use itfor the management of its own risks.Second, new types of instruments (finites and securitization): A finite risk insurance(short: finite) is a contract between a corporation (or an insurer who wants to transfer

risk) and an insurer (or a reinsurer) which bundles risk transfer and risk financing.

Risk Modelling


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WHAT CAN GO WRONG WITH MODELS IN INSURANCE?

ECONOMIC VALUATION3 level of valuation: Level 1 traded and valuated, Level 2 (de)compose of Level 1,Level 3 assets and liabilities valued to a model e.g. mathematical reserves at an

insurance

Basically, there are 2 methods for bonds/debt valuation:1. Discount the expected cash flow at the expected bond return; or2. Discount the scheduled bond payments at the rating-adjusted yield-to-maturity

Bonds Valuation

t (B) = CFk *t (Zk) = CFk * (1+yt(k))-k

Sampleyield of a 1-year zero coupon bond: 1%

yield of a 2-year zero coupon bond: 2%Price of a two-year bond (Z2)?

(Z1) =

= 0.990099

t (B) = 2000 (Z1)+102000(Z2)

(Z2) = () ()

=

= 0.960978

Forward rates

ft (n,m) = (t (Zn)

)1/m-n

- 1t (Zm)

SampleNom. Value EUR 100000, term 5 y, i=4%, flat yield curve, bought at parImpact on PV when interest rate changes to 3% or 5%?

t Total CF PV 3% PV 4% PV 5%

0 0

1 4000 3883.49 3846.15 3809.52

2 4000 3770.38 3698.22 3628.113 4000 3660.56 3555.98 3455.35

4 4000 3553.94 3419.21 3290.80

5 104000 89711.31 85480.41 81486.72

Total 120000 104579.70 100000.00 95670.52Difference 4579.70 -4329.47

Macaulay Duration

d(B) = k * CFk* t (Zk) CFk* t (Zk)

Sample above, d(B) = 4.62


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Considering Credit Risk by Survival Probabilities

t Total CF Surv. P. R. adj. CF R. adj. 4% PV nom 8.37%

0 0 1.00

1 4000 0.98 3920 3769.23 3690.83

2 4000 0.95 3800 3513.31 3405.57

3 4000 0.91 3640 3235.94 3142.354 4000 0.86 3440 2940.52 2899.48

5 104000 0.81 84240 69239.13 69559.90Total 120000 99040 82698.15 82698.15Difference

Markov Chain Representation: A firm's debt rating can change over time, and thevalue of future cash flows should take into account the possibility of one or morerating changes. In this regard, bond valuation can be modeled as a Markov Chainproblem in which a transition matrix is constructed for the probabilities of the firm'sdebt moving from one rating to another.

INSURANCE LIABILITIES


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SampleYearly payment EUR 12000, age 65 swiss male, techn. i = 2.5%, val. date 29.12.06

PRODUCTS AND THEIR RISKS-


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STRESS TESTING, CAPITAL MANAGEMENT & REGULATIONSTRESS TESTINGStress testing is a form of testing that is used to determine the stability of a givensystem or entity. It involves testing beyond normal operational capacity (e.g. toidentify what happens beyond VaR).

Case study LTCM, where flight to safety and liquidity were not analysed and drivefund into collapse.

CAPITAL MANAGEMENTWhat is the cost of equity capital? Investors expectations of rate of return, typicallybetween 10% and 20% depending on business risk.

WACC is most important figure for cost of capital

WACC =

* cost of debt * (1- tax rate) +

* cost of equity

According theorem, cost of capital is independent of capital structure but taxdeductibility favour debt capital. Additionally, the too big to fail options weakens thevalidity of the theorem.

Equity is needed for financing goodwill and buffering risk. Internal charging for cost ofcapital can be done bottom up through risk aggregation or top down (whereas nostandard method has evolved yet). Yield on capital is charged on limits approved andnot on limit usages!

Real world problem in the bottom up allocation are- correlation,- calculation of the marginal risk attribution of a portfolio,- quantification of operational risks,- focus on actual risk and not on potential earnings,- calculation time is not a big problem.

Capital-at-risk (CaR) is used in capital management as common- currency for risk and for an effective capital allocation mechanism that

means Credit and Market risk (from trading and treasury) can be compared- On business unit level

- Monthly calculation- One common pair of confidence level and holding period

Whereas VAR is used in risk management- Confidence level and holding period differ for different business- Single position level- Daily calculation

Sample:VaR market risk 10d, 99%VaR credit risk 5y, 99.9%CaR 1y, 99.9% (CaR = CaR market risk + CaR credit risk)Normal distrib. PV changes, scaling confidence leveK(99.9%) = 1.4K(99%)


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Scaling holding period with

60.2 (= 42 + 18.2)Market risk Credit risk

CaR 42 (=6.0 * 7) 18.2 (=)VaR 6.0 40.7

Scaling period 10d vs 250 trading d/year

* 1.4 = 7Scaling factor confidence interval 1.4

Scaling period

Sample: Top down capital allocationAlternative 1: BU2 shall be developed and gets all capital (strategy-based decision)Alternative 2: Decision based on bids/assured yields (BU1 assures 15%, BU2 10%)

The available capital of 100 is split to cover needs of BU1 60.2 and give the rest 39.8

to BU2. BU2 will be charged 15% * 60.2 = 9.03, whereas BU2 is charged 10%, 3.98.

REGULATIONEach firm is regulated in its financials: accounting rules, tax provisions, disclosurerequirements for investors and other stakeholders. Systematic consequences(externalities, which market participants will not take into account when makingdecisions) are the reason why we have regulations.

The Merton call: incentive for shareholders to increase volatility. Managers andowner fully participate in the upside but are limited on the downside. Tax payers areshort a Merton call, shareholders suffer from asymmetric information. The too-big-to-

fail option exacerbates this asymmetry. A default of a bank affects the wholeeconomy.The second-best solution is regulation

- Sufficient capital Backup risk with equity capital- Compensation Reward the upside, tie to the downside- Liquidity Find trade-off between liqu. transformation and risk of ill.- Bankruptcy Controlled restructuring or liquidation

Two approaches to capital regulation1. Capital = Risk Weighted Assets (RWA), follows from role as risk buffer, based

on models2. Capital = Assets, corporate finance approach, calculation of a model-free

leverage ratio

The large part of higher costs of equity probably will paid by shareholders and notborrowers. Higher capital makes investment for shareholder less risky, a highercapital buffer may reduce credit spreads on debts and non-value adding loans maybe cut.

Regulation of compensation: RoE-linked compensation schemes fosteredexcessive risk taking, capital regulation mitigates problem, compensation regulation

is only 3rd best solution.


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Liquidity regulation: transformation of different terms is key driver, cost of liquidityrisk mitigation makes long term funding of long term loans more expensive and maylead to holding of high-quality as liquidity buffer without using them (making investorsswitch to riskier assets)

Micro- and macro-prudential regulation: micro-prudential is the protection ofdepositors of an individual institution, macro-prudential is the protection of thesystems.

Tier 1 capital: Principal, disclosed reserves, hybrid capital and otherTier 2 capital: Non-disclosed reserves, subordinated debt and otherThe amount of Tier 2 includable in total regulatory capital is limited to 100% of Tier 1.

Formula for Credit and Market risk, see lecture 1.

Logic of the Internal Rating based approaches: Risk weights = F1 x F2 x F3

F1 unexpected losses (in %, time horizon 1 y)F2 scaling factor for maturityF3 scaling factor for the first two factors

IRB formula

Basel 2.5Higher capital requirement formarket risk as of 2011:- Stressed VaR- Unsystematic risk = residual risk + event risk

Incremental risk charge (IRC) for event risk, aligned to reg. credit risk model Hole to move assets between credit and trading book has been closed

4 drawbacks of Basel IIComplex. / Relying on risk weighted assets only / Pro-cyclicality / Liquid. not covered

Whats new in Basel III: equity capital

Basel III heightens the level of required capital and tighten its definitionLevel of required capital:

- Capital charge for market risk up to three times higher


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- Higher capital charge for credit risk through stressed inputs, increasedcorrelations and penalties on OTC deals

Definition of available capital: Tier 1 to ensure a going concern, Tier 2 to protectdepositors in case of insolvency (gone concern)

Capital hierarchySenior debtSubordinated debtHybrid (no tier)Tier 2Other tier e.g. HybridCommon equity (Core Tier 1) highest loss absorption capacity

Contingent convertible (CoCo) is treated as Tier 1 capital (but not as core Tier 1) if- Non maturing (e.g. perpetual bonds)- Conversion triggers depend on regulat. capital quotes or inject. by publ. authority

- Either conversion into common equity or write-down, see below- No possibility of subsequent write up in the latter case

Tier 1 Coco, conversion: as some prof. Investors are not allowed to invest in crossasset class, this must be circumvented by SPV. Equity to be sold after conversionExisting equity holders may sell stocks in fear of dilution. Pressure on stock prices.

Tier 1 Coco, write-off: should be assessed as bond instrument by investors.Exclusion of subsequent write-up makes instrument riskier than conversion bonds oreven than equity itself. Such instrument may not be marketable at reasonable prices.

Definition of trigger: due to dependency of local regulatory decision, investors carryreg. risk. If trigger depends on other criteria, they must be clear, effect. and mang.

Capital requirements in Switzerland

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Risk Mgmt Questionnaire-Adv