Risk Management

Within the risk policy, business lines and processes you fist identify risks, measure them,
model them and manage it and all over again. This process is influenced by law/regulations
and competition and market.

In equilibrium the market has eliminated price differences. So only systematic risk that
cannot be eliminated with further diversification is compensated.
If you have 2 stocks that are identical but one has still a higher price than you can exploit
such price differences by selling stock A and buying stock B and making a profit. This is called
arbitrage.

• Risk reduction for companies owned by risk averse private owners
• Reduction of planning costs and probability of financial emergency situations
• Reduction of probability of financial distress
• Protection of required liquidity for project financing purposes
• Reduction of average corporate taxes

Customer protection: asymmetrical information about the quality of the bank requires the
specific protection of smaller clients.
Financial system protection: prevention of contagion (bank runs): banks that are in trouble
potentially affect other banks negatively.

1. Minimum Capital requirements:
- quantitative, risk oriented
- defines the minimum capital of banks
- defines maximum of leverage
2. Supervisory Review Process
- qualitative requirements
- 4 principles
3. Market Discipline
- enforced through risk transparency provided by risk disclosure
- qualitative and quantitative requirements

We have risk position in and off balance sheet that need to be measured which gives us the
risk weighted assets. As minimum capital we need to hold 8% of minimum capital which
leads to a maximum leverage of 12.5 as for every dollar we need to hold 8 cents. And then
there is the eligible capital which should ensure that:
- minimum capital < Tier 1 and Tier 2
à if this is the case then capital requirement is met! This is called solvability test.
Capital requirements need to be covered by Tier 1 and 2 and need to cover any risks that
occur in the balance sheet.

Tier 1:
• Core measure of a bank’s financial strength from a regulator’s point of view
• Core capital, which consists of common stock and disclosed reserves (retained earnings)
Tier 2:
• Supplementary capital
• Includes a number of important and legitimate constituents of a banks’ capital
requirement like undisclosed reserves, revaluation reserves, general provisions, …
• Tier 2 is limited to 100% of Tier 1 capital

Operational risk is defined as the risk of loss resulting from inadequate or failed internal
processes, people and systems for form external events. This definition includes legal risks,
but excludes strategic and reputational risk.

- Basic Indicator Approach BIA
- Standardized Approach TSA
- Advanced Measurement Approach AMA

• more complex approaches require well-functioning risk management processes and a
higher level of diligence

• Process
• People
• Systems
• External events

Different kind of loss events and they are all totally different. Loss coming from external
fraud needs to be calculated differently than the others for example. The parameters,
calibration, loss distribution etc. will be different for each kind of loss event. eg Back office
might book by mistake and this is small loss with high frequency but then you have a trade
exceeding his limit without being monitored by risk management so this loss might be way
higher with small frequency.

RC calculation for every business line and for every loss event type. The regulatory capital
requirement is the sum of the individual requirements from which 20% can be deducted
because of insurance coverage (risk mitigation).
Correlations can only be included if a verifiably high quality estimate is used. However,
simple sum of the RCs overestimates the total risk by more than 40%.

Critique
• Capital requirements based on risk calibration party responsible for magnitude of
financial crisis à as volatility was very low, the risk measurement did not provide good
data to prepare the banks for the storm that was coming
• Basel’s risk calibration approach allowed banks to minimize capital and low capital
means high leverage which in turn leads to high deleveraging in a crisis
à deleveraging is bad because assets have to be sold quickly even with a loss, liquidity
and asset prices go down which leads to losses at other banks as well so that they have
to deleverage as well which worsen the situation à systematic risk here!
Proposal
• Elimination of risk calibration (of Basel’s RWA approach, model approaches)
• Substantial increase of capital ratios which will lead to lower leverage and lower
deleveraging in a crisis
• Balance social vs private costs

Ex ante: before a loss occurs
Causality: cause à event à effect
- you look at similar losses experienced by others
- you ask experts
Ex post: after a loss has occurred
Identification: effect à event à cause (so other way round to identify cause)
- you analyze the loss event that happened and you were not prepared
- effect (loss) is the result of an event
- event was triggered by a cause

Is a causal variable or a proxy of such a variable that indicates an increased likelihood of loss
KRI need to be measurable and the cause needs to be linked to the event for example
cigarettes (cause) that lead to a burning. You can measure how many people smoked and
the higher the number the higher the risk of a burning.
Examples of KRI:
• Nr of customer complaints à could be an indicator for decline in sales
• IT capacity utilization à shows how stressed the infrastructure is
• Illness quota à shows how stressed HR is
• Backlog in operations à delays and maybe even fines

The risk of losses due to borrower’s default or worsening of credit standing. It can be
decomposed into 4 main credit risk types:
- default risk
- bankruptcy risk
- downgrade risk
- settlement risk

PD: Probability of Default
• Likelihood that a party will default on this obligation
EAD: Exposure at Default
• Maximum amount that could be lost: outstanding credit + accumulated interest
• Exposure is not always fixed but can be dynamic (flexible draw downs, derivatives)
LGD: Loss given Default:
• In case of collateralized, the rate that is really lost / could not be recovered
• Can be improved with collaterals and covenants
• 1 – Recovery Rate
• Recovery rates are negatively correlated with default rates as both are influenced by the
same systematic risk. In a recession PD increase, LGDs increase and RR decrease.
Time: Time of commitment during which the borrower could default

• Expected losses are components of the lending business charged to the clients
• Unexpected losses are high and less frequent but need to be covered with capital
• In credit portfolios the loss variables usually are correlated so the variances do not
behave linear
• Correlation btw the different risk factors play a fundamental role for portfolio UL

• Banks have to hold capital buffers to cover unexpected losses
• Losses are likely to exceed the portfolios EL by more than 1 standard deviation
• Therefore, other ways to quantify risk capital is required like Economic Capital
• Economic Capital builds on VaR concept with a prescribed level of confidence
• Unexpected loss and Ecoomic capital are often used as synonyms
Unexpected loss – Loss distribution: Monte Carlo Simulation or Analytical Approximation

• RAROC can be seen as the calculation of the profitability of the “last deal”

• RAROC can be a measurement approach of

  return over risk.

• The one period measure lacks a longer term perspective. RAROC might give misleading

  signals in growth companies that run a substantial portfolio of new projects.

• RAROC can be expanded by including NPVs but this has a price as the interpretation of

  the information becomes more demanding

• Managers need to know how risk and return can be influenced such that RAROC moves

  in the intended direction

• Correctly and pragmatically used RAROC might help to avoid activities that have

  unattractive risk-return profiles and to focus on the attractive ones

First a company decides on a target rating that allows an optimal long-term profitability because target rating defines the terms with which capital can be taken from the capital market. Then the risk capital is calculated which requires the determination of the risk profile.

This approach is a pure economically oriented capital concept which in real life often cannot be realized as accounting plays an important role as well. The distorting impact of accounting standards have to be taken into account.

• −  Credit Ratings are forward looking opinions of relative creditworthiness, usually expressed in a letter grade.

• −  A credit rating – being a common language – should help investors to assess their investments and serve as benchmarking instrument.

• −  The assignment of credit ratings is not an exact science and credit ratings are not an absolute measure of default probability.

• −  A credit rating (or credit score) needs to be transferred into a default probability by way of calibration.

• −  One uses historical data to estimate future developments.

EL = PD x EAD x LGD

PD = Probability of Default

EAD = Exposure at Default

LGD = Loss Given Default

= Overview of the entire credit portfolio from an entity view

Every new deal adds complexity to the portfolio. A deal might be good in terms of risk criteria but adding a lot of such deals might lead to a higher portfolio risk and to an unbalanced portfolio.

W rong-way risk is an unfavorable dependence between exposure and counterparty credit quality – the exposure is high when the counterparty is more likely to default and vice versa.

• Over the counter (OTC) or off-exchange is to trade derivatives directly between two counterparties without any exchange or other intermediary being involved.

• Derivatives contract is: − privately negotiated − tailor made

• −  Exchange traded derivatives (ETD) are those derivative instruments that are traded via specialized derivatives exchanges or other exchanges

• −  ETD are usually standardized contracts that have been defined by an exchange

=> OTC derivatives have greater credit risk and liquidity risk than ETD

Advantages and Disadvantages

 Exposure reduction
+ combining offsetting transactions
- Resulting exposure normally more volatile

Unwinding positions
+ Positions may be unwinded in general
- Contracts are not very liquid

Multiple positions
- Multiple positions with different risk exposures
+ might reduce overall risk exposure on a counterparty nevertheless

Stability
- Stop trading with a troubled counterparty => would result in even more financial distress
+ A workout can be achieved easier

Definition:

A Central Counterparty (CCP) is a high credit quality central clearing organization established with the means to limit or reduce counterparty risk.

The CCP takes the counterparty risk, which is centralized in the CCP structure, while the original party to each trade keeps the market risk exposure.

• Following the 2008 financial market crisis, the interest for centralization of clearing entities became strong – especially in the derivative market with their embedded wrong-way risk.

• An institution no longer has to worry about the credit quality of its counterparty.

• CCPs have a downside as well. The bigger and better the CCP becomes, the more catastrophic

  its failure would be.