ContentsIntroduction ixSECTION 1 Banking Risks 1 1 Banking Business Lines 3 2 Banking Risks 11SECTION 2 Risk Regulations 23 3 Banking Regulations 25SECTION 3 Risk Management Processes 51 4 Risk Management Processes 53 5 Risk Management Organization 67SECTION 4 Risk Models 75 6 Risk Measures 77 7 VaR and Capital 87 8 Valuation 98 9 Risk Model Building Blocks 113SECTION 5 Asset–Liability Management 12910 ALM Overview 13111 Liquidity Gaps 13612 The Term Structure of Interest Rates 15113 Interest Rate Gaps 16414 Hedging and Derivatives 180
vi CONTENTSSECTION 6 Asset–Liability Management Models 19115 Overview of ALM Models 19316 Hedging Issues 20117 ALM Simulations 21018 ALM and Business Risk 22419 ALM ‘Risk and Return’ Reporting and Policy 233SECTION 7 Options and Convexity Risk in Banking 24520 Implicit Options Risk 24721 The Value of Implicit Options 254SECTION 8 Mark-to-Market Management in Banking 26922 Market Value and NPV of the Balance Sheet 27123 NPV and Interest Rate Risk 28024 NPV and Convexity Risks 28925 NPV Distribution and VaR 300SECTION 9 Funds Transfer Pricing 30926 FTP Systems 31127 Economic Transfer Prices 325SECTION 10 Portfolio Analysis: Correlations 33728 Correlations and Portfolio Effects 339SECTION 11 Market Risk 35729 Market Risk Building Blocks 35930 Standalone Market Risk 36331 Modelling Correlations and Multi-factor Models for Market Risk 38432 Portfolio Market Risk 396SECTION 12 Credit Risk Models 41733 Overview of Credit Risk Models 419SECTION 13 Credit Risk: ‘Standalone Risk’ 43334 Credit Risk Drivers 43535 Rating Systems 44336 Credit Risk: Historical Data 45137 Statistical and Econometric Models of Credit Risk 45938 The Option Approach to Defaults and Migrations 479
CONTENTS vii39 Credit Risk Exposure 49540 From Guarantees to Structures 50841 Modelling Recoveries 52142 Credit Risk Valuation and Credit Spreads 53843 Standalone Credit Risk Distributions 554SECTION 14 Credit Risk: ‘Portfolio Risk’ 56344 Modelling Credit Risk Correlations 56545 Generating Loss Distributions: Overview 58046 Portfolio Loss Distributions: Example 58647 Analytical Loss Distributions 59548 Loss Distributions: Monte Carlo Simulations 60849 Loss Distribution and Transition Matrices 62250 Capital and Credit Risk VaR 627SECTION 15 Capital Allocation 63751 Capital Allocation and Risk Contributions 63952 Marginal Risk Contributions 655SECTION 16 Risk-adjusted Performance 66753 Risk-adjusted Performance 66954 Risk-adjusted Performance Implementation 679SECTION 17 Portfolio and Capital Management (Credit Risk) 68955 Portfolio Reporting (1) 69156 Portfolio Reporting (2) 70157 Portfolio Applications 71458 Credit Derivatives: Deﬁnitions 72159 Applications of Credit Derivatives 73360 Securitization and Capital Management 744Bibliography 762Index 781
IntroductionRisk management in banking designates the entire set of risk management processesand models allowing banks to implement risk-based policies and practices. They coverall techniques and management tools required for measuring, monitoring and controllingrisks. The spectrum of models and processes extends to all risks: credit risk, market risk,interest rate risk, liquidity risk and operational risk, to mention only major areas. Broadlyspeaking, risk designates any uncertainty that might trigger losses. Risk-based policies andpractices have a common goal: enhancing the risk–return proﬁle of the bank portfolio.The innovation in this area is the gradual extension of new quantiﬁed risk measures toall categories of risks, providing new views on risks, in addition to qualitative indicatorsof risks. Current risks are tomorrow’s potential losses. Still, they are not as visible as tangiblerevenues and costs are. Risk measurement is a conceptual and a practical challenge, whichprobably explains why risk management suffered from a lack of credible measures. Therecent period has seen the emergence of a number of models and of ‘risk managementtools’ for quantifying and monitoring risks. Such tools enhance considerably the viewson risks and provide the ability to control them. This book essentially presents the riskmanagement ‘toolbox’, focusing on the underlying concepts and models, plus their prac-tical implementation. The move towards risk-based practices accelerated in recent years and now extends tothe entire banking industry. The basic underlying reasons are: banks have major incentivesto move rapidly in that direction; regulations developed guidelines for risk measurementand for deﬁning risk-based capital (equity); the risk management ‘toolbox’ of modelsenriched considerably, for all types of risks, providing tools making risk measures instru-mental and their integration into bank processes feasible.THE RATIONALE FOR RISK-BASED PRACTICESWhy are visibility and sensitivity to risks so important for bank management? Certainlybecause banks are ‘risk machines’: they take risks, they transform them, and they embed
x INTRODUCTIONthem in banking products and services. Risk-based practices designate those practicesusing quantiﬁed risk measures. Their scope evidently extends to risk-taking decisions,under an ‘ex ante’ perspective, and risk monitoring, under an ‘ex post’ perspective, oncerisk decisions are made. There are powerful motives to implement risk-based practices: toprovide a balanced view of risk and return from a management point of view; to developcompetitive advantages, to comply with increasingly stringent regulations. A representative example of ‘new’ risk-based practices is the implementation of risk-adjusted performance measures. In the ﬁnancial universe, risk and return are two sides ofthe same coin. It is easy to lend and to obtain attractive revenues from risky borrowers.The price to pay is a risk that is higher than the prudent bank’s risk. The prudent banklimits risks and, therefore, both future losses and expected revenues, by restricting businessvolume and screening out risky borrowers. The prudent bank avoids losses but it mightsuffer from lower market share and lower revenues. However, after a while, the risk-takermight ﬁnd out that higher losses materialize, and obtain an ex post performance lowerthan the prudent lender performance. Who performs best? Unless assigning some measureof risk to income, it is impossible to compare policies driven by different risk appetites.Comparing performances without risk adjustment is like comparing apples and oranges.The rationale of risk adjustment is in making comparable different performances attachedto different risk levels, and in general making comparable the risk–return proﬁles oftransactions and portfolios. Under a competitive perspective, screening borrowers and differentiating the pricesaccordingly, given the borrowers’ standing and their contributions to the bank’s portfoliorisk–return proﬁle, are key issues. Not doing so results in adverse economics for banks.Banks who do not differentiate risks lend to borrowers rejected by banks who better screenand differentiate risks. By overpricing good risks, they discourage good borrowers. Byunderpricing risks to risky customers, they attract them. By discouraging the relativelygood ones and attracting the relatively bad ones, the less advanced banks face the riskof becoming riskier and poorer than banks adopting sound risk-based practices at anearlier stage. Those banking institutions that actively manage their risks have a compet-itive advantage. They take risks more consciously, they anticipate adverse changes, theyprotect themselves from unexpected events and they gain the expertise to price risks. Thecompetitors who lack such abilities may gain business in the short-term. Nevertheless,they will lose ground with time, when those risks materialize into losses. Under a management perspective, without a balanced view of expected return and risk,banks have a ‘myopic’ view of the consequences of their business policies in terms offuture losses, because it is easier to measure income than to capture the underlying risks.Even though risks remain a critical factor to all banks, they suffer from the limitations oftraditional risk indicators. The underlying major issue is to assign a value to risks in orderto make them commensurable with income and fully address the risk–return trade-off. Regulation guidelines and requirements have become more stringent on the develop-ment of risk measures. This single motive sufﬁces for developing quantiﬁed risk-basedpractices. However, it is not the only incentive for structuring the risk managementtools and processes. The above motivations inspired some banks who became pioneersin this ﬁeld many years before the regulations set up guidelines that led the entireindustry towards more ‘risk-sensitive’ practices. Both motivations and regulations makerisk measurement a core building block of valuable risk-based practices. However, bothface the same highly challenging risk measuring issue.
INTRODUCTION xiRISK QUANTIFICATION IS A MAJOR CHALLENGESince risks are so important in banking, it is surprising that risk quantiﬁcation remainedlimited until recently. Quantitative ﬁnance addresses extensively risk in the capital markets.However, the extension to the various risks of ﬁnancial institutions remained a challengefor multiple reasons. Risks are less tangible and visible than income. Academic modelsprovided foundations for risk modelling, but did not provide instrumental tools helpingdecision-makers. Indeed, a large fraction of this book addresses the gap between concep-tual models and banking risk management issues. Moreover, the regulators’ focus onrisks is still relatively recent. It dates from the early stages of the reregulation phase,when the Cooke ratio imposed a charge in terms of capital for any credit risk exposure.Risk-based practices suffered from real challenges: simple solutions do not help; riskmeasures require models; models not instrumental; quantitative ﬁnance aimed at ﬁnancialmarkets more than at ﬁnancial institutions. For such reasons, the prerequisites for makinginstrumental risk quantiﬁcations remained out of reach.Visibility on Losses is Not Visibility on RisksRisks remain intangible and invisible until they materialize into losses. Simple solutionsdo not really help to capture risks. For instance, a credit risk exposure from a loan is notthe risk. The risk depends on the likelihood of losses and the magnitude of recoveriesin addition to the size of the amount at risk. Observing and recording losses and theirfrequencies could help. Unfortunately, loss histories are insufﬁcient. It is not simple tolink observable losses and earning declines with speciﬁc sources of risks. Tracking creditlosses does not tell whether they result from inadequate limits, underestimating creditrisk, inadequate guarantees, or excessive risk concentration. Recording the ﬂuctuations ofthe interest income is easy, but tracing back such changes to interest rates is less obvious.Without links to instrumental risk controls, earning and loss histories are of limited interestbecause they do not help in taking forward looking corrective actions. Visibility on lossesis not visibility on risks.Tracking Risks for Management Purposes Requires ModelsTracking risks for management purposes requires models for better capturing risks andrelating them to instrumental controls. Intuitively, the only way to quantify invisible risksis to model them. Moreover, multiple risk indicators are not substitutes for quantiﬁedmeasures. Surveillance of risk typically includes such various items as exposure size,watch lists for credit risk, or value changes triggered by market movements for marketinstruments. These indicators capture the multiple dimensions of risk, but they do notadd them up into a quantiﬁed measure. Finally, missing links between future losses fromcurrent risks and risk drivers, which are instrumental for controlling risk, make it unfea-sible to timely monitor risks. The contribution of models addresses such issues. Theyprovide quantiﬁed measures of risk or, in other words, they value the risk of banks.Moreover, they do so in a way that allows tracing back risks to management controlsover risk exposures of ﬁnancial institutions. Without such links, risk measures would‘ﬂoat in the air’, without providing management tools.
xii INTRODUCTIONFinancial Markets versus Financial InstitutionsThe abundance of models in quantitative ﬁnance did not address the issues that ﬁnancialinstitutions face until recently, except in certain speciﬁc areas such as asset portfoliomanagement. They undermined the foundations of risk management, without bridging thegap between models and the needs of ﬁnancial institutions. Quantitative ﬁnance became a huge ﬁeld that took off long ago, with plenty ofpioneering contributions, many of them making their authors Nobel Prize winners. Inthe market place, quantiﬁcation is ‘natural’ because of the continuous observation ofprices and market parameters (interest rates, equity indexes, etc.). For interest rate risk,modelling the term structure of interest rates is a classical ﬁeld in market ﬁnance. Thepioneering work of Sharpe linked stock prices to equity risk in the stock market. TheBlack–Scholes option model is the foundation for pricing derivative instruments, optionsand futures, which today are standard instruments for managing risks. The scientiﬁcliterature also addressed credit risk a long time ago. The major contribution of RobertMerton on modelling default within an option framework, a pillar of current credit riskmodelling, dates from 1974. These contributions fostered major innovations, from pricing market instruments andderivatives (options) that serve for investing and hedging risks, to deﬁning benchmarks andguidelines for the portfolios management of market instruments (stocks and bonds). Theyalso helped ﬁnancial institutions to develop their business through ever-changing productinnovations. Innovation made it feasible to customize products for matching investors’needs with speciﬁc risk–return bundles. It also allowed both ﬁnancial and corporateentities to hedge their risks with derivatives. The need for investors to take exposuresand, for those taking exposures, to hedge them provided business for both risk-takersand risk-hedgers. However, these developments fell short of directly addressing the basicprerequisites of a risk management system in ﬁnancial institutions.Prerequisites for Risk Management in Financial InstitutionsThe basic prerequisites for deploying risk management in banks are:• Risks measuring and valuation.• Tracing risks back to risk drivers under the management control.Jumping to market instruments for managing risks without prior knowledge of exposuresto the various risks is evidently meaningless unless we know the magnitude of the risksto keep under control, and what they actually mean in terms of potential value lost. Therisk valuation issue is not simple. It is much easier to address in the market universe. However, interest rate risk requires other management models and tools. All bankingbusiness lines generate exposures to interest rate risks. However, linking interest incomeand rates requires modelling the balance sheet behaviour. Since the balance sheet gener-ates both interest revenues and interest costs, they offset each other to a certain extent,depending on matches and mismatches between sizes of assets and liabilities and interestrate references. Capturing the extent of offsetting effects between assets and liabilitiesalso requires dedicated models.
INTRODUCTION xiii Credit risk remained a challenge until recently, even though it is the oldest of all bankingrisks. Bank practices rely on traditional indicators, such as credit risk exposures measuredby outstanding balances of loans at risk with borrowers, or amounts at risk, and internalratings measuring the ‘quality’ of risk. Banking institutions have always monitored creditrisk actively, through a number of systems such as limits, delegations, internal ratings andwatch lists. Ratings agencies monitor credit risk of public debt issues. However, creditrisk assessment remained judgmental, a characteristic of the ‘credit culture’, focusing on‘fundamentals’: all qualitative variables that drive the credit worthiness of a borrower.The ‘fundamental’ view on credit risk still prevails, and it will obviously remain relevant. Credit risk beneﬁts from diversiﬁcation effects that limit the size of credit losses of aportfolio. Credit risk focus is more on transactions. When moving to the global portfolioview, we know that a large fraction of the risk of individual transactions is diversiﬁedaway. A very simple question is: By how much? This question remained unanswered untilportfolio models, speciﬁcally designed for that purpose, emerged in the nineties. It is easyto understand why. Credit risk is largely invisible. The simultaneous default of two largecorporate ﬁrms, for whom the likelihood of default is small, is probably an unobservableevent. Still, this is the issue underlying credit risk diversiﬁcation. Because of the scarcityof data available, the diversiﬁcation issue for credit risk remained beyond reach until newmodelling techniques appeared. Portfolio models, which appeared only in the nineties,turned around the difﬁculty by modelling the likelihood of modelled defaults, rather thanactual defaults. This is where modelling risks contributes. It pushes further away the frontier betweenmeasurable risks and invisible–intangible risks and, moreover, it links risks to the sourcesof uncertainty that generate them.PHASES OF DEVELOPMENT OF THE REGULATORYGUIDELINESBanks have plenty of motives for developing risk-based practices and risk models. Inaddition, regulators made this development a major priority for the banking industry,because they focus on ‘systemic risk’, the risk of the entire banking industry made upof ﬁnancial institutions whose fates are intertwined by the density of relationships withinthe ﬁnancial system. The risk environment has changed drastically. Banking failures have been numerous inthe past. In recent periods their number has tended to decrease in most, although not all, ofthe Organization for Economic Coordination and Development (OECD) countries, but theybecame spectacular. Banking failures make risks material and convey the impression thatthe banking industry is never far away from major problems. Mutual lending–borrowingand trading create strong interdependencies between banks. An individual failure of a largebank might trigger the ‘contagion’ effect, through which other banks suffer unsustainablelosses and eventually fail. From an industry perspective, ‘systemic risk’, the risk of acollapse of the entire industry because of dense mutual relations, is always in the back-ground. Regulators have been very active in promoting pre-emptive policies for avoidingindividual bank failures and for helping the industry absorb the shock of failures whenthey happen. To achieve these results, regulators have totally renovated the regulatoryframework. They promoted and enforced new guidelines for measuring and controllingthe risks of individual players.
xiv INTRODUCTION Originally, regulations were traditional conservative rules, requiring ‘prudence’ fromeach player. The regulatory scheme was passive and tended to differentiate prudent rulesfor each major banking business line. Differentiated regulations segmented the marketand limited competition because some players could do what others could not. Obviousexamples of segmentation of the banking industry were commercial versus investmentbanking, or commercial banks versus savings institutions. Innovation made rules obsolete,because players found ways to bypass them and to compete directly with other segmentsof the banking industry. Obsolete barriers between the business lines of banks, plus fail-ures, triggered a gradual deregulation wave, allowing players to move from their originalbusiness ﬁeld to the entire spectrum of business lines of the ﬁnancial industry. The corol-lary of deregulation is an increased competition between unequally experienced players,and the implication is increased risks. Failures followed, making the need for reregulationobvious. Reregulation gave birth to the current regulatory scheme, still evolving with newguidelines, the latest being the New Basel Accord of January 2001. Under the new regulatory scheme, initiated with the Cooke ratio in 1988, ‘risk-basedcapital’ or, equivalently, ‘capital adequacy’ is a central concept. The philosophy of ‘capitaladequacy’ is that capital should be capable of sustaining the future losses arising fromcurrent risks. Such a sound and simple principle is hardly debatable. The philosophyprovides an elegant and simple solution to the difﬁcult issue of setting up a ‘pre-emptive’,‘ex ante’ regulatory policy. By contrast, older regulatory policies focused more on correc-tive actions, or ‘after-the-fact’ actions, once banks failed. Such corrective actions remainnecessary. They were prompt when spectacular failures took place in the ﬁnancial industry(LTCM, Baring Brothers). Nevertheless, avoiding ‘contagion’ when bank failures occuris not a substitute for pre-emptive actions aimed at avoiding them. The practicality of doing so remains subject to adequate modelling. The trend towardsmore internal and external assessment on risks and returns emerged and took momentumin several areas. Through successive accords, regulators promoted the building up ofinformation on all inputs necessary for risk quantiﬁcation. Accounting standards evolvedas well. The ‘fair value’ concept gained ground, raising hot debates on what is the ‘right’value of bank assets and how to accrue earnings in traditional commercial banking activ-ities. It implies that a loan providing a return not in line with its risk and cost of fundingshould appear at lower than face value. The last New Basel Accord promotes the ‘three pillars’ foundation of supervision: newcapital requirements for credit risk and operational risks; supervisory processes; disclosureof risk information by banks. Together, the three pillars allow external supervisors to auditthe quality of the information, a basic condition for assessing the quality and reliability ofrisk measures in order to gain more autonomy in the assessment of capital requirements.Regulatory requirements for market, credit and operational risk, plus the closer supervisionof interest rate risk, pave the way for a comprehensive modelling of banking risks, and atight integration with risk management processes, leading to bank-wide risk managementacross all business lines and all major risks.FROM RISK MODELS TO RISK MANAGEMENTRisk models have two major contributions: measuring risks and relating these measures tomanagement controls over risks. Banking risk models address both issues by embeddingthe speciﬁcs of each major risk. As a direct consequence, there is a wide spectrum of
INTRODUCTION xvmodelling building blocks, differing across and within risks. They share the risk-basedcapital and the ‘Value at Risk’ (VaR) concepts that are the basic foundations of the newviews on risk modelling, risk controlling and risk regulations. Risk management requiresan entire set of models and tools for linking risk management (business) issues withﬁnancial views on risks and proﬁtability. Together, they make up the risk managementtoolbox, which provides the necessary inputs that feed and enrich the risk process, toﬁnally close the gap between models and management processes.Risk Models and RisksManaging the banking exposure to interest rate risk and trading interest rate risk aredifferent businesses. Both commercial activities and trading activities use up liquidity thatﬁnancial institutions need to fund in the market. Risk management, in this case, relates tothe structural posture that banks take because of asset and liability mismatches of volumes,maturity and interest rate references. Asset–Liability Management (ALM) is in charge ofmanaging this exposure. ALM models developed gradually until they became standardreferences for managing the liquidity and interest rate risk of the banking portfolio. For market risk, there is a large overlap between modelling market prices and measuringmarket risk exposures of ﬁnancial institutions. This overlap covers most of the needs,except one: modelling the potential losses from trading activities. Market risk modelsappeared soon after the Basel guidelines started to address the issues of market risk.They appeared sufﬁciently reliable to allow internal usage by banks, under supervision ofregulators, for deﬁning their capital requirements. For credit risk, the foundations exist for deploying instrumental tools ﬁtting banks’requirements and, potentially, regulators’ requirements. Scarce information on creditevents remains a major obstacle. Nevertheless, the need for quantiﬁcation increased overtime, necessitating measuring the size of risk, the likelihood of losses, the magnitudeof losses under default and the magnitude of diversiﬁcation within banks’ portfolios.Modelling the qualitative assessment of risk based on the fundamentals of borrowershas a long track record of statistical research, which rebounds today because of theregulators’ emphasis on extending the credit risk data. Since the early nineties, portfoliomodels proposed measures of credit risk diversiﬁcation within portfolios, offering newpaths for quantifying risks and deﬁning the capital capable of sustaining the various levelsof portfolio losses. Whether the banks should go along this path, however, is no longer a question since theNew Basel Accord of January 2001 set up guidelines for credit risk-sensitive measures,therefore preparing the foundations for the full-blown modelling of the credit risk ofbanks’ portfolios. Other major risks appeared when progressing in the knowledge ofrisks. Operational risk became a major priority, since January 2001, when the regulatoryauthorities formally announced the need to charge bank capital against this risk.Capital and VaRIt has become impossible to discuss risk models without referring to economic capital andVaR. The ‘capital adequacy’ principle states that the bank’s capital should match risks.Since capital is the most scarce and costly resource, the focus of risk monitoring and
xvi INTRODUCTIONrisk measurement follows. The central role of risk-based capital in regulations is a majorincentive to the development of new tools and management techniques. Undoubtedly a most important innovation of recent years in terms of the modelling‘toolbox’ is the VaR concept for assessing capital requirements. The VaR concept is afoundation of risk-based capital or, equivalently, ‘economic capital’. The VaR method-ology aims at valuing potential losses resulting from current risks and relies on simplefacts and principles. VaR recognizes that the loss over a portfolio of transactions couldextend to the entire portfolio, but this is an event that has a zero probability given theeffective portfolio diversiﬁcation of banks. Therefore, measuring potential losses requiressome rule for deﬁning their magnitude for a diversiﬁed portfolio. VaR is the upper boundof losses that should not be exceeded in more than a small fraction of all future outcomes.Management and regulators deﬁne benchmarks for this small preset fraction, called the‘conﬁdence level’, measuring the appetite for risk of banks. Economic capital is VaR-based and crystallizes the quantiﬁed present value of potential future losses for makingsure that banks have enough capital to sustain worst-case losses. Such risk valuationpotentially extends to all main risks. Regulators made the concept instrumental for VaR-based market risk models in 1996.Moreover, even though the New Accord of 2001 falls short of allowing usage of creditmodels for measuring credit risk capital, it ensures the development of reliable inputs forsuch models.The Risk Management ToolboxRisk-based practices require the deployment of multiple tools, or models, to meet thespeciﬁcations of risk management within ﬁnancial institutions. Risk models value risksand link them to their drivers and to the business universe. By performing these tasks, riskmodels contribute directly to risk processes. The goal of risk management is to enhancethe risk–return proﬁles of transactions, of business lines’ portfolios of transactions andof the entire bank’s portfolio. Risk models provide these risk–return proﬁles. The riskmanagement toolbox also addresses other major speciﬁcations. Since two risks of 1 addup to less than 2, unlike income and costs, we do not know how to divide a global riskinto risk allocations for individual transactions, product families, market segments andbusiness lines, unless we have some dedicated tools for performing this function. TheFunds Transfer Pricing (FTP) system allocates income and the capital allocation systemallocates risks. These tools provide a double link:• The top-down/bottom-up link for risks and income.• The transversal business-to-ﬁnancial sphere linkage.Without such links, between the ﬁnancial and the business spheres and between globalrisks and individual transaction proﬁles, there would be no way to move back and forthfrom a business perspective to a ﬁnancial perspective and along the chain from individualtransactions to the entire bank’s global portfolio.Risk Management ProcessesRisk management processes are evolving with the gradual emergence of new riskmeasures. Innovations relate to:
INTRODUCTION xvii• The recognition of the need for quantiﬁcation to develop risk-based practices and meet risk-based capital requirements.• The willingness of bankers to adopt a more proactive view on risks.• The gradual development of regulator guidelines for imposing risk-based techniques, enhanced disclosures on risks and ensuring a sounder and safer level playing ﬁeld for the ﬁnancial system.• The emergence of new techniques of managing risks (credit derivatives, new securiti- zations that off-load credit risk from the banks’ balance sheets) serving to reshape the risk–return proﬁle of banks.• The emergence of new organizational processes for better integrating these advances, such as loan portfolio management.Without risk models, such innovations would remain limited. By valuing risks, modelscontribute to a more balanced view of income and risks and to a better control of riskdrivers, upstream, before they materialize into losses. By linking the business and the riskviews, the risk management ‘toolbox’ makes models instrumental for management. Byfeeding risk processes with adequate risk–return measures, they contribute to enrichingthem and leveraging them to new levels. Figure 1 shows how models contribute to the ‘vertical’ top-down and bottom-up proces-ses, and how they contribute as well to the ‘horizontal’ links between the risk and returnviews of the business dimensions (transactions, markets and products, business lines). Risk Models Credit Risk FTP & Tools Market Risk Capital Allocation ALM Others ... Risk Processes Global Policy Business Risk−Return Policy Reporting Policy Risk & Capital Earnings Business LinesFIGURE 1 Comprehensive and consistent set of models for bank-wide risk management
xviii INTRODUCTIONTHE STRUCTURE OF THE BOOKThe structure of the book divides each topic into single modular pieces addressing thevarious issues above. The ﬁrst section develops general issues, focusing on risks, riskmeasuring and risk management processes. The next major section addresses sequentiallyALM, market risk and credit risk.Book OutlineThe structure of the book is in 17 sections, each divided into several chapters. Thisstructure provides a very distinct division across topics, each chapter dedicated to a majorsingle topic. The beneﬁt is that it is possible to move across chapters without necessarilyfollowing a sequential process throughout the book. The drawback is that only a fewchapters provide an overview of interrelated topics. These chapters provide a synthesis ofsubsequent speciﬁc topics, allowing the reader to get both a summary and an overviewof a series of interrelated topics.Section 1. Banking RisksSection 2. Risk RegulationsSection 3. Risk Management ProcessesSection 4. Risk ModelsSection 5. Asset–Liability ManagementSection 6. Asset–Liability Management ModelsSection 7. Options and Convexity Risk in BankingSection 8. Mark-to-Market Management in BankingSection 9. Funds Transfer PricingSection 10. Portfolio Analysis: CorrelationsSection 11. Market RiskSection 12. Credit Risk ModelsSection 13. Credit Risk: ‘Standalone Risk’Section 14. Credit Risk: ‘Portfolio Risk’Section 15. Capital AllocationSection 16. Risk-adjusted PerformanceSection 17. Portfolio and Capital Management (Credit Risk)Building Block StructureThe structure of the book follows from several choices. The starting point is a widearray of risk models and tools that complement each other and use sometimes similar,sometimes different techniques for achieving the same goals. This raises major structuringissues for ensuring a consistent coverage of the risk management toolbox. The book relieson a building block structure shared by models; some of them extending across manyblocks, some belonging to one major block. The structuring by building blocks of models and tools remedies the drawbacks ofa sequential presentation of industry models; these bundle modelling techniques withineach building block according to the model designers’ assembling choices. By contrast,
INTRODUCTION xixa building block structure lists issues separately, and allows us to discuss explicitly thevarious modelling options. To facilitate the understanding of vendors’ models, some chap-ters provide an overview of all existing models, while detailed presentations provide anoverview of all techniques applying to a single basic building block. Moreover, since model differentiation across risks is strong, there is a need to orga-nize the structure by nature of risk. The sections of the book dealing directly with riskmodelling cross-tabulate the main risks with the main building blocks of models. Themain risks are interest rate risk, market risk and credit risk. The basic structure, withineach risk, addresses four major modules as shown in Figure 2. Risk drivers and transaction I risk (standalone) II Portfolio risk Top-down & bottom-up III tools IV Risk & return measuresFIGURE 2 The building block structure of risk models The basic blocks, I and II, are dedicated by source of risk. The two other blocks, III andIV, are transversal to all risks. The structure of the book follows from these principles.FocusThe focus is on risk management issues for ﬁnancial institutions rather than risk modellingapplied to ﬁnancial markets. There is an abundant literature on ﬁnancial markets and ﬁnan-cial derivatives. A basic understanding of what derivatives achieve in terms of hedging orstructuring transactions is a prerequisite. However, sections on instruments are limited tothe essentials of what hedging instruments are and their applications. Readers can obtaindetails on derivatives and pricing from other sources in the abundant literature. We found that textbooks rarely address risk management in banking and in ﬁnancialinstitutions in a comprehensive manner. Some focus on the technical aspects. Others focuson pure implementation issues to the detriment of technical substance. In other cases, thescope is unbalanced, with plenty of details on some risks (market risk notably) and feweron others. We have tried to maintain a balance across the main risks without sacriﬁcingscope. The text focuses on the essential concepts underlying the risk analytics of existingmodels. It does detail the analytics without attempting to provide a comprehensivecoverage of each existing model. This results in a more balanced view of all techniquesfor modelling banking risk. In addition, model vendors’ documentation is availabledirectly from sites dedicated to risk management modelling. There is simply no need toreplicate such documents. When developing the analytics, we considered that providing a
xx INTRODUCTIONuniversal framework, allowing the contrast of various techniques based on their essentialcharacteristics, was of greater help than replicating public documentation. Accordingly, weskipped some details available elsewhere and located some technicalities in appendices.However, readers will ﬁnd the essentials, the basics for understanding the technicalities,and the examples for grasping their practical value added. In addition, the text developsmany numerical examples, while restricting the analytics to the essential ingredients. Aﬁrst motive is that simple examples help illustrate the essentials better than a detaileddescription. Of course, simple examples are no substitute for full-blown models. The text is almost self-contained. It details the prerequisites for understanding full-blown models. It summarizes the technicalities of full-blown models and it substitutesexamples and applications for further details. Still, it gathers enough substance to providean analytical framework, developed sufﬁciently to make it easy to grasp details notexpanded here and map them to the major building blocks of risk modelling. Finally, there is a balance to strike between technicalities and applications. The goal ofrisk management is to use risk models and tools for instrumental purposes, for developingrisk-based practices and enriching risk processes. Such an instrumental orientation stronglyinspired this text. * * * The ﬁrst edition of this book presented details on ALM and introduced major advancesin market risk and credit risk modelling. This second edition expands considerably oncredit risk and market risk models. In addition, it does so within a uniﬁed framework forcapturing all major risks and deploying bank-wide risk management tools and processes.Accordingly, the volume has roughly doubled in size. This is illustrative of the fast andcontinuous development of the ﬁeld of risk management in ﬁnancial institutions.
1 Banking Business LinesThe banking industry has a wide array of business lines. Risk management practices andtechniques vary signiﬁcantly between the main poles, such as retail banking, investmentbanking and trading, and within the main poles, between business lines. The differencesacross business lines appear so important, say between retail banking and trading forexample, that considering using the same concepts and techniques for risk managementpurposes could appear hopeless. There is, indeed, a differentiation, but risk managementtools, borrowing from the same core techniques, apply across the entire spectrum ofbanking activities generating ﬁnancial risks. However, risks and risk management differacross business lines. This ﬁrst chapter provides an overview of banking activities. Itdescribes the main business poles, and within each pole the business lines. Regulationsmake a clear distinction between commercial banking and trading activities, with thecommon segmentation between ‘banking book’ and ‘trading book’. In fact, there aremajor distinctions within business lines of lending activities, which extend from retailbanking to specialized ﬁnance. This chapter provides an overview of the banking business lines and of the essentialsof ﬁnancial statements.BUSINESS POLES IN THE BANKING INDUSTRYThe banking industry has a wide array of business lines. Figure 1.1 maps these activities,grouping them into main poles: traditional commercial banking; investment banking, withspecialized transactions; trading. Poles subdivide into various business lines. Management practices are very different across and within the main poles. Retailbanking tends to be mass oriented and ‘industrial’, because of the large number oftransactions. Lending to individuals relies more on statistical techniques. Managementreporting on such large numbers of transactions focuses on large subsets of transactions.
4 RISK MANAGEMENT IN BANKING Business Business Lines Poles Lending and collecting deposits Retail Financial Services Individuals and small Commercial businesses Corporate−Middle Market Banking Identified borrowers and Large Corporate relationship banking Advisory Services Mergers & Acquisitions LBO ... Investment Banks & Financial Firms Banking Assets Financing Structured (Aircrafts ...) Finance Commodities Securitization Derivatives Trading Equity Traded Instruments Trading Fixed Income Private Private Assets Management Banking Banking Others ... Custody ... Others..FIGURE 1.1 Breaking down the bank portfolio along organizational dimensionsCriteria for grouping the transactions include date of origination, type of customer, productfamily (consumer loans, credit cards, leasing). For medium and large corporate borrowers, individual decisions require more judg-ment because mechanical rules are not sufﬁcient to assess the actual credit standing ofa corporation. For the middle market segment to large corporate businesses, ‘relation-ship banking’ prevails. The relation is stable, based on mutual conﬁdence, and gener-ates multiple services. Risk decisions necessitate individual evaluation of transactions.Obligors’ reviews are periodical. Investment banking is the domain of large transactions customized to the needs of bigcorporates or ﬁnancial institutions. ‘Specialized ﬁnance’ extends from speciﬁc ﬁelds withstandard practices, such as export and commodities ﬁnancing, to ‘structured ﬁnancing’,implying speciﬁc structuring and customization for making large and risky transactionsfeasible, such as project ﬁnance or corporate acquisitions. ‘Structuring’ designates theassembling of ﬁnancial products and derivatives, plus contractual clauses for monitoringrisk (‘covenants’). Without such risk mitigants, transactions would not be feasible. Thisdomain overlaps with traditional ‘merchant’ banking and market business lines. Tradinginvolves traditional proprietary trading and trading for third parties. In the second case,
BANKING BUSINESS LINES 5traders interact with customers and other banking business units to bundle customizedproducts for large borrowers, including ‘professionals’ of the ﬁnance industry, banks,insurance, brokers and funds. Other activities do not generate directly traditional bankingrisks, such as private banking, or asset management and advisory services. However, theygenerate other risks, such as operational risk, similarly to other business lines, as deﬁnedin the next chapter. The view prevailing in this book is that all main business lines share the common goalsof risk–expected return enhancement, which also drives the management of global bankportfolios. Therefore, it is preferable to differentiate business lines beyond the traditionaldistinctions between the banking portfolio and the trading portfolio. The matrix shownin Figure 1.2 is a convenient representation of all major lines across which practicesdiffer. Subsequent chapters differentiate, whenever necessary, risk and proﬁtability acrossthe cells of the matrix, cross-tabulating main product lines and main market segments.Banking business lines differ depending on the speciﬁc organizations of banks and ontheir core businesses. Depending on the degree of specialization, along with geograph-ical subdivisions, they may or may not combine one or several market segments andproduct families. Nevertheless, these two dimensions remain the basic foundations fordifferentiating risk management practices and designing ‘risk models’. Product Groups Market Transactions Specialized Finance Corporate Lending Off-balance Sheet RFS Markets Consumers Corporate−Middle Market Large Corporate Firms Financial Institutions Specialized FinanceFIGURE 1.2 Main product–market segmentsRFS refers to ‘Retail Financial Services’.LBO refers to ‘Leveraged Buy-Out’, a transaction allowing a major fraction of the equity of a companyto be acquired using a signiﬁcant debt (leverage).Specialized ﬁnance refers to structured ﬁnance, project ﬁnance, LBO or assets ﬁnancing. Product lines vary within the above broad groups. For instance, standard lendingtransactions include overnight loans, short-term loans (less than 1 year), revolving facil-ities, term loans, committed lines of credit, or large corporate general loans. Retailﬁnancial services cover all lending activities, from credit card and consumer loans tomortgage loans. Off-balance sheet transactions are guarantees and backup lines of credit
6 RISK MANAGEMENT IN BANKINGproviding signiﬁcant revenues to banks. Specialized ﬁnance includes project ﬁnance,commodities ﬁnancing, asset ﬁnancing (from real estate to aircraft) and trade ﬁnancing.Market transactions cover all basic compartments, ﬁxed income, equity and foreignexchange trading, including derivatives from standard swaps and options to exotic andcustomized products. Major market segments appear explicitly in the matrix. They alsosubdivide. Financial institutions include banks as well as insurance or brokers. Specializedﬁnance includes various ﬁelds, including structured ﬁnance. The greyed cell representsa basic market–product couple. Risk management involves risk and expected returnmeasuring, reporting and management for such transactions, for the bank portfolio asa whole and for such basic couples. The next section reverts to the basic distinctionbetween banking book and trading book, which is essentially product-driven.THE BANKING AND THE TRADING BOOKSThe ‘banking book’ groups and records all commercial banking activities. It includes alllending and borrowing, usually both for traditional commercial activities, and overlapswith investment banking operations. The ‘trading book’ groups all market transactionstradable in the market. The major difference between these two segments is that the‘buy and hold’ philosophy prevails for the banking book, contrasting with the tradingphilosophy of capital markets. Accounting rules differ for the banking portfolio and thetrading portfolio. Accounting rules use accrual accounting of revenues and costs, and relyon book values for assets and liabilities. Trading relies on market values (mark-to-market)of transactions and Proﬁt and Loss (P&L), which are variations of the mark-to-marketvalue of transactions between two dates. The rationale for separating these ‘portfolios’results from such major characteristics.The Banking BookThe banking portfolio follows traditional accounting rules of accrued interest incomeand costs. Customers are mainly non-ﬁnancial corporations or individuals, although inter-banking transactions occur between professional ﬁnancial institutions. The banking portfolio generates liquidity and interest rate risks. All assets and liabilitiesgenerate accrued revenues and costs, of which a large fraction is interest rate-driven. Anymaturity mismatch between assets and liabilities results in excesses or deﬁcits of funds.Mismatch also exists between interest references, ‘ﬁxed’ or ‘variable, and results fromcustomers’ demand and the bank’s business policy. In general, both mismatches exist inthe ‘banking book’ balance sheet. For instance, there are excess funds when collectionof deposits and savings is important, or a deﬁcit of funds whenever the lending activityuses up more resources than the deposits from customers. Financial transactions (onthe capital markets) serve to manage such mismatches between commercial assets andliabilities through either investment of excess funds or long-term debt by banks. Asset–Liability Management (ALM) applies to the banking portfolio and focuses oninterest rate and liquidity risks. The asset side of the banking portfolio also generatescredit risk. The liability side contributes to interest rate risk, but does not generate creditrisk, since the lenders or depositors are at risk with the bank. There is no market risk forthe banking book.
BANKING BUSINESS LINES 7The Trading PortfolioThe market transactions are not subject to the same management rules. The turnover oftradable positions is faster than that of the banking portfolio. Earnings are P&L equal tochanges of the mark-to-market values of traded instruments. Customers include corporations (corporate counterparties) or other ﬁnancial playersbelonging to the banking industry (professional counterparties). The market portfoliogenerates market risk, deﬁned broadly as the risk of adverse changes in market valuesover a liquidation period. It is also subject to market liquidity risk, the risk that thevolume of transactions narrows so much that trades trigger price movements. The tradingportfolio extends across geographical borders, just as capital markets do, whereas tradi-tional commercial banking is more ‘local’. Many market transactions use non-tradableinstruments, or derivatives such as swaps and options traded over-the-counter. Such trans-actions might have a very long maturity. They trigger credit risk, the risk of a loss if thecounterparty fails.Off-balance Sheet TransactionsOff-balance sheet transactions are contingencies given and received. For banking transac-tions, contingencies include guarantees given to customers or to third parties, committedcredit lines not yet drawn by customers, or backup lines of credit. Those are contractualcommitments, which customers use at their initiative. A guarantee is the commitment ofthe bank to fulﬁl the obligations of the customer, contingent on some event such as failureto face payment obligations. For received contingencies, the beneﬁciary is the bank. ‘Given contingencies’ generate revenues, as either upfront and/or periodic fees, orinterest spreads calculated as percentages of outstanding balances. They do not generate‘immediate’ exposures since there is no outﬂow of funds at origination, but they do triggercredit risk because of the possible future usage of contingencies given. The outﬂows occurconditionally on what happens to the counterparty. If a borrower draws on a credit linepreviously unused, the resulting loan moves up on the balance sheet. ‘Off-balance sheet’lines turn into ‘on-balance sheet’ exposures when exercised. Derivatives are ‘off-balance sheet’ market transactions. They include swaps, futurescontracts, foreign exchange contracts and options. As other contingencies, they are obli-gations to make contractual payments conditional upon occurrence of a speciﬁed event.Received contingencies create symmetrical obligations for counterparties who sold themto the bank.BANKS’ FINANCIAL STATEMENTSThere are several ways of grouping transactions. The balance sheet provides a snapshotview of all assets and liabilities at a given date. The income statement summarizes allrevenues and costs to determine the income of a period.
8 RISK MANAGEMENT IN BANKINGBalance SheetIn a simpliﬁed view (Table 1.1), the balance sheet includes four basic levels, in additionto the off-balance sheet, which divide it horizontally:• Treasury and banking transactions.• Intermediation (lending and collecting deposits).• Financial assets (trading portfolio).• Long-term assets and liabilities: ﬁxed assets, investments in subsidiaries and equity plus long-term debt. TABLE 1.1 Simpliﬁed balance sheet Assets Equity and liabilities Cash Short-term debt Lending Deposits Financial assets Financial assets Fixed assets Long-term debt Equity Off-balance sheet (contingencies Off-balance sheet (contingencies received) given) The relative weights of the major compartments vary from one institution to another,depending on their core businesses. Equity is typically low in all banks’ balance sheets.Lending and deposits are traditionally large in retail and commercial banking. Investmentbanking, including both specialized ﬁnance and trading, typically funds operations in themarket. In European banks, ‘universal banking’ allows banking institutions to operate overthe entire spectrum of business lines, contrasting with the separation between investmentbanking and commercial banking, which still prevails in the United States.Income Statement and ValuationThe current national accounting standards use accrual measures of revenues and coststo determine the net income of the banking book. Under such standards, net incomeignores any change of ‘mark-to-market’ value, except for securities traded in the marketor considered as short-term holdings. International accounting standards progress towards‘fair value’ accounting for the banking book, and notably for transactions hedging risk.Fair value is similar to mark-to-market1 , except that it extends to non-tradable assets suchas loans. There is a strong tendency towards generalizing the ‘fair value’ view of the balancesheet for all activities, which is subject to hot debates for the ‘banking book’. Accountingstandards are progressively evolving in that direction. The implications are major interms of proﬁtability, since gains and losses of the balance sheet ‘value’ between two1 See Chapter 8 for details on calculating ‘mark-to-market’ values on non-tradable transactions.
BANKING BUSINESS LINES 9dates would count as proﬁt and losses. A major driving force for looking at ‘fair values’is the need to use risk-adjusted values in modelling risks. In what follows, because of theexisting variations around the general concept of ‘fair value’, we designate such valuesequivalently as ‘economic values’, ‘mark-to-market’ or ‘mark-to-model’ values dependingon the type of valuation technique used. Fair values have become so important, if onlybecause of risk modelling, that we discuss them in detail in Chapter 8. For the banking portfolio, the traditional accounting measures of earnings are contri-bution margins calculated at various levels of the income statement. They move from the‘interest income’ of the bank, which is the difference between all interest revenues plusfees and all interest costs, down to net income. The total revenue cumulates the interestmargin with all fees for the period. The interest income of commercial banking commonlyserves as the main target for management policies of interest rate risk because it is entirelyinterest-driven. Another alternative target variable is the Net Present Value (NPV) of thebalance sheet, measured as a Mark-to-Market (MTM) of assets minus that of liabilities.Commercial banks try to increase the fraction of revenues made up of fees for makingthe net income less interest rate-sensitive. Table 1.2 summarizes the main revenues andcosts of the income statement. TABLE 1.2 Income statement and earnings Interest margin plus fees Capital gains and losses −Operating costs =Operating income (EBTD)a −Depreciation −Provisions −Tax =Net income a EBTD = Earnings Before Tax and Depreciation. Provisions for loan losses deserve special attention. The provision policy should ideallybe an indicator of the current credit risk of banking loans. However, provisions have tocomply with accounting and ﬁscal rules and differ from economic provisions. Economicprovisions are ‘ex ante’ provisions, rather than provisions resulting from the materializa-tion of credit risk. They should anticipate the effective credit risk without the distortionsdue to legal and tax constraints. Economic provisioning is a debated topic, because unlessnew standards and rules emerge for implementation, it remains an internal risk manage-ment tool without impact on the income statement bottom line.Performance MeasuresPerformance measures derive directly from the income statement. The ratio of net incometo equity is the accounting Return On Equity (ROE). It often serves as a target proﬁtabilitymeasure at the overall bank level. The accounting ROE ratio is not the market return onequity, which is a price return, or the ratio of the price variation between two dates of
10 RISK MANAGEMENT IN BANKINGthe bank’s stock (ignoring dividends). Under some speciﬁc conditions2 , it might serveas a proﬁtability benchmark. Both the ROE and the market return on equity should bein line with shareholders’ expectations for a given level of risk of the bank’s stock. Acurrent order of magnitude for the target ROE is 15% after tax, or about 25% before tax.When considering banking transactions, the Return On Assets (ROA) is another measureof proﬁtability for banking transactions. The most common calculation of ROA is theratio of the current periodical income, interest income and current fees, divided by assetbalance. The current ROA applies both to single individual transactions and to the totalbalance sheet. The drawback of accounting ROE and ROA measures, and of the P&L of the tradingportfolio, is that they do not include any risk adjustment. Hence, they are not comparablefrom one borrower to another, because their credit risk differs, from one trading transactionto another, and because the market risk varies across products. This drawback is the originof the concept of risk-adjusted performance measures. This is an incentive for moving, atleast in internal reports of risks and performances, to ‘economic values’, ‘mark-to-market’or ‘mark-to-model’ values, because these are both risk- and revenue-adjusted3 .2 Itcan be shown that a target accounting ROE implies an identical value for the market return on the bank’sequity under the theoretical condition that the Price–Earnings Ratio (PER) remains constant. See Chapter 53.3 See Chapter 8 to explain how mark-to-market values embed both risk and expected return.
2 Banking RisksRisks are uncertainties resulting in adverse variations of proﬁtability or in losses. In thebanking universe, there are a large number of risks. Most are well known. However, therehas been a signiﬁcant extension of focus, from the traditional qualitative risk assessmenttowards the quantitative management of risks, due to both evolving risk practices andstrong regulatory incentives. The different risks need careful deﬁnition to provide soundbases serving for quantitative measures of risk. As a result, risk deﬁnitions have gainedprecision over the years. The regulations, imposing capital charges against all risks, greatlyhelped the process. The underlying philosophy of capital requirement is to bring capitalin line with risks. This philosophy implies modelling the value of risk. The foundationof such risk measures is in terms of potential losses. The capital charge is a quantitativevalue. Under regulatory treatment, it follows regulatory rules applying to all players.Under an economic view, it implies modelling potential losses from each source of risk,which turns out to be the ‘economic’ capital ‘adequate’ to risk. Most of the book explainshow to assign economic values to risks. Therefore, the universal need to value risks,which are intangible and invisible, requires that risks be well-deﬁned. Risk deﬁnitionsserve as the starting point for both regulatory and economic treatments of risks. This book focuses on three main risks: interest rate risk for the banking book; marketrisk for the trading book; credit risk. However, this chapter does provide a comprehensiveoverview of banking risks.BANKING RISKSBanking risks are deﬁned as adverse impacts on proﬁtability of several distinct sourcesof uncertainty (Figure 2.1). Risk measurement requires capturing the source of the uncer-tainty and the magnitude of its potential adverse effect on proﬁtability. Proﬁtability refersto both accounting and mark-to-market measures.
12 RISK MANAGEMENT IN BANKING Credit Interest rate Market Banking Risks Liquidity Operational Foreign exchange Other risks: country risk, settlement risk, performance risk ...FIGURE 2.1 Main bank risks This book focuses on ﬁnancial risks, or risks related to the market movements orthe economic changes of the environment. Market risk is relatively easy to quantifythanks to the large volume of price observations. Credit risk ‘looked like’ a ‘commercial’risk because it is business-driven. Innovation changed this view. Since credit risk is amajor risk, the regulators insisted on continuously improving its measurement in orderto quantify the amount of capital that banks should hold. Credit risk and the principle ofdiversiﬁcation are as old as banks are. It sounds like a paradox that major recent inno-vations focus on this old and well-known risk. Operational risk also attracts attention1 . Itcovers all organizational malfunctioning, of which consequences can be highly importantand, sometimes, fatal to an institution. Following the regulators’ focus on valuing risk as a capital charge, model designersdeveloped risk models aimed at the quantiﬁcation of potential losses arising from eachsource of risk. The central concept of such models is the well-known ‘Value at Risk’(VaR). Brieﬂy stated, a VaR is a potential loss due to a deﬁned risk. The issue is howto deﬁne a potential loss, given that the loss can be as high as the current portfoliovalue. Of course, the probability of such an event is zero. In order to deﬁne the potentialadverse deviation of value, or loss, a methodology is required to identify what could be a‘maximum’ deviation. Under the VaR methodology, the worst-case loss is a ‘maximum’bound not exceeded in more than a preset fraction (for instance 1%) of all possible statesover a deﬁned period. Models help to determine a market risk VaR and a credit risk VaR.The VaR concept also extends to other risks. Subsequent developments explain how tomove from the following deﬁnitions of risk to VaR modelling and measuring.1 The New Basel Accord of January 2001 requires a capital charge against operational risk.
BANKING RISKS 13CREDIT RISKCredit risk is the ﬁrst of all risks in terms of importance. Default risk, a major sourceof loss, is the risk that customers default, meaning that they fail to comply with theirobligations to service debt. Default triggers a total or partial loss of any amount lent tothe counterparty. Credit risk is also the risk of a decline in the credit standing of anobligor of the issuer of a bond or stock. Such deterioration does not imply default, but itdoes imply that the probability of default increases. In the market universe, a deteriorationof the credit standing of a borrower does materialize into a loss because it triggers anupward move of the required market yield to compensate the higher risk and triggers avalue decline. ‘Issuer’ risk designates the obligors’ credit risk, to make it distinct fromthe speciﬁc risk of a particular issue, among several of the same issuer, depending onthe nature of the instrument and its credit mitigants (seniority level and guarantees). Theview of credit risk differs for the banking portfolio and the trading portfolio.Banking PortfolioCredit risk is critical since the default of a small number of important customers cangenerate large losses, potentially leading to insolvency. There are various default events:delay in payment obligations; restructuring of debt obligations due to a major deteriorationof the credit standing of the borrower; bankruptcies. Simple delinquencies, or paymentdelays, do not turn out as plain defaults, with a durable inability of lenders to face debtobligations. Many are resolved within a short period (say less than 3 months). Restruc-turing is very close to default because it results from the view that the borrower willnot face payment obligations unless its funding structure changes. Plain defaults implythat the non-payment will be permanent. Bankruptcies, possibly liquidation of the ﬁrm ormerging with an acquiring ﬁrm, are possible outcomes. They all trigger signiﬁcant losses.Default means any situation other than a simple delinquency. Credit risk is difﬁcult to quantify on an ‘ex ante’ basis, since we need an assessment ofthe likelihood of a default event and of the recoveries under default, which are context-dependent2 . In addition, banking portfolios beneﬁt from diversiﬁcation effects, whichare much more difﬁcult to capture because of the scarcity of data on interdependenciesbetween default events of different borrowers are interdependent.Trading PortfolioCapital markets value the credit risk of issuers and borrowers in prices. Unlike loans,the credit risk of traded debts is also indicated by the agencies’ ratings, assessing thequality of public debt issues, or through changes of the value of their stocks. Credit riskis also visible through credit spreads, the add-ons to the risk-free rate deﬁning the requiredmarket risk yield on debts. The capability of trading market assets mitigates the credit risk since there is no need tohold these securities until the deterioration of credit risk materializes into effective losses.2 Context refers to all factors inﬂuencing loss under default, such as the outstanding balance of debt at default,the existence of guarantees, or the policy of all stakeholders with respect to existing debt.
14 RISK MANAGEMENT IN BANKINGIf the credit standing of the obligor declines, it is still possible to sell these instrumentsin the market at a lower value. The loss due to credit risk depends on the value of theseinstruments and their liquidity. If the default is unexpected, the loss is the differencebetween the pre- and post-default prices. The faculty of trading the assets limits the lossif sale occurs before default. The selling price depends on the market liquidity. Therefore,there is some interaction between credit risk and trading risk. For over-the-counter instruments, such as derivatives (swaps and options), whose devel-opment has been spectacular in the recent period, sale is not readily feasible. The bankfaces the risk of losing the value of such instruments when it is positive. Since this valuevaries constantly with the market parameters, credit risk changes with market movementsduring the entire residual life of the instrument. Credit risk and market risk interact becausethese values depend on the market moves. Credit risk for traded instruments raises a number of conceptual and practical difﬁcul-ties. What is the value subject to loss, or exposure, in future periods? Does the currentprice embed already the credit risk, since market prices normally anticipate future events,and to what extent? Will it be easy to sell these instruments when signs of deteriorationget stronger, and at what discount from the current value since the market for such instru-ments might narrow when credit risk materializes? Will the bank hold these instrumentslonger than under normal conditions?Measuring Credit RiskEven though procedures for dealing with credit risk have existed since banks startedlending, credit risk measurement raises several issues. The major credit risk componentsare exposure, likelihood of default, or of a deterioration of the credit standing, and therecoveries under default. Scarcity of data makes the assessment of these components achallenge. Ratings are traditional measures of the credit quality of debts. Some major features ofratings systems are3 :• Ratings are ordinal or relative measures of risk rather than cardinal or absolute measures, such as default probability.• External ratings are those of rating agencies, Moody’s, Standard & Poor’s (S&P) and Fitch, to name the global ones. They apply to debt issues rather than issuers because various debt issues from the same issuer have different risks depending on seniority level and guarantees. Detailed rating scales of agencies have 20 levels, ignoring the near default rating levels.• By contrast, an issuer’s rating characterizes only the default probability of the issuer.• Banks use internal rating scales because most of their borrowers do not have publicly rated debt issues. Internal rating scales of banks are customized to banks’ requirements, and usually characterize both borrower’s risk and facility’s risk.• There are various types of ratings. Ratings characterize sovereign risk, the risk of country debt and the risk of the local currency. Ratings are also either short-term3 Chapters 35 and 36 detail further the speciﬁcations of rating systems.
BANKING RISKS 15 or long-term. There are various types of country-related ratings: sovereign ratings of government sponsored borrowers; ratings of currencies; ratings of foreign currencies held locally; ratings of transfer risk, the risk of being unable to transfer cash out of the country.• Because ratings are ordinal measures of credit risk, they are not sufﬁcient to value credit risk.Moreover, ratings apply only to individual debts of borrowers, and they do not addressthe bank’s portfolio risk, which beneﬁts from diversiﬁcation effects. Portfolio modelsshow that portfolio risk varies across banks depending on the number of borrowers, thediscrepancies in size between exposures and the extent of diversiﬁcation among typesof borrowers, industries and countries. The portfolio credit risk is critical in terms ofpotential losses and, therefore, for ﬁnding out how much capital is required to absorbsuch losses. Modelling default probability directly with credit risk models remained a major chal-lenge, not addressed until recent years. A second challenge of credit risk measurement iscapturing portfolio effects. Due to the scarcity of data in the case of credit risk, quanti-fying the diversiﬁcation effect sounds like a formidable challenge. It requires assessing thejoint likelihood of default for any pair of borrowers, which gets higher if their individualrisks correlate. Given its importance for banks, it is not surprising that banks, regulatorsand model designers made a lot of effort to better identify the relevant inputs for valuingcredit risk and model diversiﬁcation effects with ‘portfolio models’. Accordingly, a largefraction of this book addresses credit risk modelling.COUNTRY AND PERFORMANCE RISKSCredit risk is the risk of loss due to a deterioration of the credit standing of a borrower.Some risks are close to credit risk, but distinct, such as country risk and perfor-mance risk.Country RiskCountry risk is, loosely speaking, the risk of a ‘crisis’ in a country. There are many risksrelated to local crises, including:• Sovereign risk, which is the risk of default of sovereign issuers, such as central banks or government sponsored banks. The risk of default often refers to that of debt restruc- turing for countries.• A deterioration of the economic conditions. This might lead to a deterioration of the credit standing of local obligors, beyond what it should be under normal condi- tions. Indeed, ﬁrms’ default frequencies increase when economic conditions deteriorate.• A deterioration of the value of the local foreign currency in terms of the bank’s base currency.
16 RISK MANAGEMENT IN BANKING• The impossibility of transferring funds from the country, either because there are legal restrictions imposed locally or because the currency is not convertible any more. Convertibility or transfer risks are common and restrictive deﬁnitions of country risks.• A market crisis triggering large losses for those holding exposures in the local markets.A common practice stipulates that country risk is a ﬂoor for the risk of a local borrower,or equivalently, that the country rating caps local borrowers’ ratings. In general, countryratings serve as benchmarks for corporate and banking entities. The rationale is that, iftransfers become impossible, the risk materializes for all corporates in the country. Thereare debates around such rules, since the intrinsic credit standing of a borrower is notnecessarily lower than on that of the country.Performance RiskPerformance risk exists when the transaction risk depends more on how the borrowerperforms for speciﬁc projects or operations than on its overall credit standing. Performancerisk appears notably when dealing with commodities. As long as delivery of commoditiesoccurs, what the borrower does has little importance. Performance risk is ‘transactional’because it relates to a speciﬁc transaction. Moreover, commodities shift from one ownerto another during transportation. The lender is at risk with each one of them sequentially.Risk remains more transaction-related than related to the various owners because thecommodity value backs the transaction. Sometimes, oil is a major export, which becomeseven more strategic in the event of an economic crisis, making the ﬁnancing of thecommodity immune to country risk. In fact, a country risk increase has the paradoxicaleffect of decreasing the risk of the transaction because exports improve the country creditstanding.LIQUIDITY RISKLiquidity risk refers to multiple dimensions: inability to raise funds at normal cost; marketliquidity risk; asset liquidity risk. Funding risk depends on how risky the market perceives the issuer and its fundingpolicy to be. An institution coming to the market with unexpected and frequent needsfor funds sends negative signals, which might restrict the willingness to lend to thisinstitution. The cost of funds also depends on the bank’s credit standing. If the perceptionof the credit standing deteriorates, funding becomes more costly. The problem extendsbeyond pure liquidity issues. The cost of funding is a critical proﬁtability driver. The creditstanding of the bank inﬂuences this cost, making the rating a critical factor for a bank.In addition, the rating drives the ability to do business with other ﬁnancial institutionsand to attract investors because many follow some minimum rating guidelines to investand lend. The liquidity of the market relates to liquidity crunches because of lack of volume.Prices become highly volatile, sometimes embedding high discounts from par, whencounterparties are unwilling to trade. Funding risk materializes as a much higher cost
BANKING RISKS 17of funds, although the cause lies more with the market than the speciﬁc bank. Marketliquidity risk materializes as an impaired ability to raise money at a reasonable cost. Asset liquidity risk results from lack of liquidity related to the nature of assets ratherthan to the market liquidity. Holding a pool of liquid assets acts as a cushion againstﬂuctuating market liquidity, because liquid assets allow meeting short-term obligationswithout recourse to external funding. This is the rationale for banks to hold a sufﬁcientfraction of their balance sheet of liquid assets, which is a regulatory rule. The ‘liquidityratio’ of banks makes it mandatory to hold more short-term assets than short-term liabili-ties, in order to meet short-run obligations. In order to fulﬁl this role, liquid assets shouldmature in the short-term because market prices of long-term assets are more volatile4 ,possibly triggering substantial losses in the event of a sale. Moreover, some assets areless tradable than others, because their trading volume is narrow. Some stocks trade lessthan others do, and exotic products might not trade easily because of their high level ofcustomization, possibly resulting in depressed prices. In such cases, any sale might triggerprice declines, so that the proceeds from a one-shot or a progressive sale become uncertainand generate losses. To a certain extent, funding risk interacts with market liquidity andasset liquidity because the inability to face payment obligations triggers sales of assets,possibly at depressed prices. Liquidity risk might become a major risk for the banking portfolio. Extreme lackof liquidity results in bankruptcy, making liquidity risk a fatal risk. However, extremeconditions are often the outcome of other risks. Important unexpected losses raise doubtswith respect to the future of the organization and liquidity issues. When a commercialbank gets into trouble, depositors ‘run’ to get their money back. Lenders refrain fromfurther lending to the troubled institution. Massive withdrawals of funds or the closing ofcredit lines by other institutions are direct outcomes of such situations. A brutal liquiditycrisis follows, which might end up in bankruptcy. In what follows, we adopt an Asset–Liability Management (ALM) view of the liquiditysituation. This restricts liquidity risk to bank-speciﬁc factors other than the credit risk ofthe bank and the market liquidity. The time proﬁles of projected uses and sources offunds, and their ‘gaps’ or liquidity mismatches, capture the liquidity position of a bank.The purpose of debt management is to manage these future liquidity gaps within acceptablelimits, given the market perception of the bank. This perspective does not fully address liquidity risk, and the market risk deﬁnitionsbelow address this only partially. Liquidity risk, in terms of market liquidity or assetliquidity, remains a major issue that current techniques do not address fully. Practicesrely on empirical and continuous observations of market liquidity, while liquidity riskmodels remain too theoretical to allow instrumental applications. This is presumably aﬁeld necessitating increased modelling research and improvement of practices.INTEREST RATE RISKThe interest rate risk is the risk of a decline in earnings due to the movements of interestrates.4 Long-term interest-bearing assets are more sensitive to interest rate movements. See the duration concept usedfor capturing the sensitivity of the mark-to-market value of the balance sheet in Chapter 22.
18 RISK MANAGEMENT IN BANKING Most of the items of banks’ balance sheets generate revenues and costs that are interestrate-driven. Since interest rates are unstable, so are earnings. Any one who lends orborrows is subject to interest rate risk. The lender earning a variable rate has the risk ofseeing revenues reduced by a decline in interest rates. The borrower paying a variablerate bears higher costs when interest rates increase. Both positions are risky since theygenerate revenues or costs indexed to market rates. The other side of the coin is thatinterest rate exposure generates chances of gains as well. There are various and complex indexations on market rates. Variable rate loans haverates periodically reset using some market rate references. In addition, any transactionreaching maturity and renewed will stick to the future and uncertain market conditions.Hence, ﬁxed rates become variable at maturity for loan renewals and variable rates remainﬁxed between two reset dates. In addition, the period between two rate resets is notnecessarily constant. For instance, the prime rate of banks remains ﬁxed between tworesets, over periods of varying lengths, even though market rates constantly move. Thesame happens for the rates of special savings deposits, when they are subject to legaland ﬁscal rules. This variety makes the measure of interest rate sensitivity of assets andliabilities to market rates more complex. Implicit options in banking products are another source of interest rate risk. A well-known case is that of the prepayment of loans that carry a ﬁxed rate. A person whoborrows can always repay the loan and borrow at a new rate, a right that he or she willexercise when interest rates decline substantially. Deposits carry options as well, sincedeposit holders transfer funds to term deposits earning interest revenues when interestrates increase. Optional risks are ‘indirect’ interest rate risks. They do not arise directlyand only from a change in interest rate. They also result from the behaviour of customers,such as geographic mobility or the sale of their homes to get back cash. Economically,ﬁxed rate borrowers compare the beneﬁts and the costs of exercising options embeddedin banking products, and make a choice depending on market conditions. Given the importance of those products in the balance sheets of banks, optional risk isfar from negligible. Measuring the option risk is more difﬁcult than measuring the usualrisk which arises from simple indexation to market rates. Section 5 of this book detailsrelated techniques.MARKET RISKMarket risk is the risk of adverse deviations of the mark-to-market value of the tradingportfolio, due to market movements, during the period required to liquidate the trans-actions. The period of liquidation is critical to assess such adverse deviations. If it getslonger, so do the deviations from the current market value. Earnings for the market portfolio are Proﬁt and Loss (P&L) arising from transactions.The P&L between two dates is the variation of the market value. Any decline in valueresults in a market loss. The potential worst-case loss is higher when the holding periodgets longer because market volatility tends to increase over longer horizons. However, it is possible to liquidate tradable instruments or to hedge their future changesof value at any time. This is the rationale for limiting market risk to the liquidationperiod. In general, the liquidation period varies with the type of instruments. It could beshort (1 day) for foreign exchange and much longer for ‘exotic’ derivatives. The regulators
BANKING RISKS 19provide rules to set the liquidation period. They use as reference a 10-day liquidationperiod and impose a multiple over banks’ internal measures of market value potentiallosses (see Chapter 3). Liquidation involves asset and market liquidity risks. Price volatility is not the samein high-liquidity and poor-liquidity situations. When liquidity is high, the adverse devi-ations of prices are much lower than in a poor-liquidity environment, within a givenhorizon. ‘Pure’ market risk, generated by changes of market parameters (interest rates,equity indexes, exchange rates), differs from market liquidity risk. This interaction raisesimportant issues. What is the ‘normal’ volatility of market parameters under fair liquiditysituations? What could it become under poorer liquidity situations? How sensitive are theprices to liquidity crises? The liquidity issue becomes critical in emerging markets. Pricesin emerging markets often diverge considerably from a theoretical ‘fair value’. Market risk does not refer to market losses due to causes other than market movements,loosely deﬁned as inclusive of liquidity risk. Any deﬁciency in the monitoring of themarket portfolio might result in market values deviating by any magnitude until liquidationﬁnally occurs. In the meantime, the potential deviations can exceed by far any deviationthat could occur within a short liquidation period. This risk is an operational risk, not amarket risk5 . In order to deﬁne the potential adverse deviation, a methodology is required to identifywhat could be a ‘maximum’ adverse deviation of the portfolio market value. This is theVaR methodology. The market risk VaR technique aims at capturing downside deviationsof prices during a preset period for liquidating assets, considering the changes in themarket parameters. Controlling market risk means keeping the variations of the value ofa given portfolio within given boundary values through actions on limits, which are upperbounds imposed on risks, and hedging for isolating the portfolio from the uncontrollablemarket movements.FOREIGN EXCHANGE RISKThe currency risk is that of incurring losses due to changes in the exchange rates. Vari-ations in earnings result from the indexation of revenues and charges to exchange rates,or of changes of the values of assets and liabilities denominated in foreign currencies. Foreign exchange risk is a classical ﬁeld of international ﬁnance, so that we can relyon traditional techniques in this book, without expanding them. For the banking port-folio, foreign exchange risk relates to ALM. Multi-currency ALM uses similar techniquesfor each local currency. Classical hedging instruments accommodate both interest rateand exchange rate risk. For market transactions, foreign exchange rates are a subsetof market parameters, so that techniques applying to other market parameters applyas well. The conversion risk resuls from the need to convert all foreign currency-denominatedtransactions into a base reference currency. This risk does exist, beyond accountingconversion in a single currency, if the capital base that protects the bank from losses5 An example is the failure of Baring Brothers, due to deﬁciencies in the control of the risk positions (seeLeeson, 1996).