Successfully reported this slideshow.
We use your LinkedIn profile and activity data to personalize ads and to show you more relevant ads. You can change your ad preferences anytime.

Chapter 13 basel iv market risk framework

1,204 views

Published on

a

Published in: Economy & Finance

Chapter 13 basel iv market risk framework

  1. 1. Managing Market Risk Under The Basel IV Framework Copyright © 2016 CapitaLogic Limited Chapter 13 Basel IV Market Risk Framework Managing Market Risk Under The Basel IV Framework The Presentation Slides Website : https://sites.google.com/site/quanrisk E-mail : quanrisk@gmail.com
  2. 2. Copyright © 2016 CapitaLogic Limited 2 Declaration Copyright © 2016 CapitaLogic Limited. All rights reserved. No part of this presentation file may be reproduced, in any form or by any means, without written permission from CapitaLogic Limited. Authored by Dr. LAM Yat-fai (林日林日林日林日辉辉辉辉), Adjunct Professor of Finance, City University of Hong Kong, Doctor of Business Administration (Finance), CFA, CAIA, FRM, PRM.
  3. 3. Copyright © 2016 CapitaLogic Limited 3 Outline Default contagion Basel IV framework Regulatory market risk Internal model approach Standardized approach
  4. 4. Copyright © 2016 CapitaLogic Limited 4 Banking activities Deposits < 1% Shareholders’ equity Dividend + equity price appreciation 3% - 20% FX, equities, treasuries. Bank
  5. 5. Copyright © 2016 CapitaLogic Limited 5 Highly leveraged business Succeed Fixed nominal yield to depositors Higher return to shareholders Failed Invested equity lost by shareholders Liabilities lost by depositors Shareholders tend to invest as little equity as possible Use depositors’ monies to bet in investments of highest return Highest return ⇒ highest risk
  6. 6. Copyright © 2016 CapitaLogic Limited 6 Shareholders’ loss vs bank assets 0 1 2 3 4 5 0 1 2 3 4 5 6 7 8 9 10 Bank assets Debtinvestors'loss Liabilities Profit and equity
  7. 7. Copyright © 2016 CapitaLogic Limited 7 Regulatory concern Contagion The default of one bank will cause the default of another bank, for either financial or confidence reasons The default of a number of banks together will cause the default of the entire banking system Mitigation To prevent the default of the first bank To ensure that the investment loss even under an extreme scenario is well covered by shareholders’ monies
  8. 8. Copyright © 2016 CapitaLogic Limited 8 Capital charge A prudent estimate of the potential loss from a bank’s investments under an extreme situation To be matched by long term funding to a bank Following the Basel IV framework
  9. 9. Copyright © 2016 CapitaLogic Limited 9 Outline Contagion Basel IV framework Regulatory market risk Internal model approach Standardized approach
  10. 10. Copyright © 2016 CapitaLogic Limited 10 4 (=3+1) pillars of Basel IV Basel IV Minimum capital requirements Public disclosure Supervisory review process Liquidity sufficiency Basel II
  11. 11. Copyright © 2016 CapitaLogic Limited 11 Minimum capital requirements Minimum capital requirements Credit risk Operational risk Basic indicator approach Standardized approach* Advanced measurement approach* Market risk Internal model approach* Standardized approach Standardized approach Internal ratings based approach* * Regulatory approval required
  12. 12. Copyright © 2016 CapitaLogic Limited 12 Supervisory review process A bank should have a process in place to assess its overall capital adequacy in relation to its risk profile and a strategy to maintain its level of capital A regulator should review and evaluate a bank’s internal capital adequacy assessments and strategies, as well as the bank’s ability to monitor and ensure compliance with capital sufficiency. A regulator should take appropriate supervisory action if it is not satisfied with the result of a bank’s process A regulator should expect a bank to operate above the minimum regulatory capital sufficiency and should be able to request a bank to hold additional regulatory capital A regulator should seek to intervene at an early stage to prevent a bank’s regulatory capital from falling below the minimum levels and mandate a bank to take rapid remedial action if the regulatory capital is not maintained or restored
  13. 13. Copyright © 2016 CapitaLogic Limited 13 Public disclosure The organization structure of a banking group, the entities to which the Basel IV framework is applicable and the entities to which the Basel IV framework is irrelevant The terms and conditions of the major features of the financial instruments which are qualified as regulatory capital The list of financial instruments qualified as common equity and additional tier one capitals The total amount of tier two capital The capital charges arising from the credit, market and operational risks General information of other risks to which a bank is exposed and the relevant methods that the bank has applied in managing these risks The structure and operations of the bank’s risk management function
  14. 14. Copyright © 2016 CapitaLogic Limited 14 Liquidity sufficiency Liquidity ratios Liquidity coverage ratio Net stable funding ratio Supervisory monitoring tools Contractual maturity mis-match Concentration of funding Available unencumbered assets Financial market monitoring tools
  15. 15. Copyright © 2016 CapitaLogic Limited 15 Outline Contagion Basel IV framework Regulatory market risk Internal model approach Standardized approach
  16. 16. Copyright © 2016 CapitaLogic Limited 16 Regulatory market risk The potential losses of financial investments arising from the changes within a short holding period in: Foreign exchange rates Equity prices Interest rates Commodity prices Credit spreads Default events Calculated in accordance with the Basel IV rules
  17. 17. Copyright © 2016 CapitaLogic Limited 17 Trading book vs banking book Trading book exposures A bank’s investments Short-term resale Profiting from short-term price movements Locking in arbitrage profits Hedging risks that arise from instruments meeting criteria above Subject to capital charge for market risk Banking book exposures Any exposures not on the trading book Primarily subject to capital charge for credit risk Foreign exchange rate and commodity price exposures also subject to capital charge for market risk
  18. 18. Copyright © 2016 CapitaLogic Limited 18 Regulatory market risk components √Equity prices √Interest rates Banking bookTrading bookExposure √√Commodity prices √Default events √Credit spreads √√FX rates
  19. 19. Copyright © 2016 CapitaLogic Limited 19 Current de minimis exemption By default, banks in Hong Kong must report their market risk capital charges quarterly Banks with small market risk exposures may seek exemption from the HKMA to report their market risk capital charges annually Newly licensed banks must report their market risk capital charges quarterly during the first year of business
  20. 20. Copyright © 2016 CapitaLogic Limited 20 De minimis exemption criteria Market risk exposures normally less than 5% of total on- and off-balance sheet exposures (and never exceed 6%) Market risk exposures normally less than HKD 50 mn (and never exceed HKD 60 mn) Not using internal rating based approach to report regulatory credit risk capital charge
  21. 21. Copyright © 2016 CapitaLogic Limited 21 MRCC calculation methods Internal model approach (“IMA”) Subject to regulatory approval For internationally active banks Expected shortfall approach Standardized approach (“STA”) Generic method For small and medium size banks Variance-covariance method approach
  22. 22. Copyright © 2016 CapitaLogic Limited 22 Outline Contagion Basel IV framework Regulatory market risk Internal model approach Standardized approach
  23. 23. Copyright © 2016 CapitaLogic Limited 23 Internal model approach Capital charges calculated by ES model at 10-day 97.5th percentile confidence level Advantages ES as an industry standard for market risk measurement Very risk sensitive Disadvantages Highly quantitative and complicated Subject to regulatory approval at a high standard
  24. 24. Copyright © 2016 CapitaLogic Limited 24 Qualitative standards Adequate board and senior management oversight Effective market risk management system Independent market risk control unit Material factors captured and accurately reflected Use of internal models for daily risk management purposes Proper documentation Internal validation Comprehensive stress-testing Independent review or audit
  25. 25. Copyright © 2016 CapitaLogic Limited 25 Quantitative standards ES computed on a daily basis 97.5th percentile confidence interval 10 days base holding period During a stress period Data updated at least once a month Including options risks Non-linear value effect Volatility effect Subject to internal, external and regulatory model validations
  26. 26. Copyright © 2016 CapitaLogic Limited 26 Model validation standards Assumptions % change distributions Valuation models Replicating portfolios Back-testing Sufficient long testing period At least three years
  27. 27. Copyright © 2016 CapitaLogic Limited 27 Liquidity adjusted ES ( ) ( ) ( ) ( ) ( ) 2 2 2 10 20 40 2 2 60 120 ES + ES + 2 ES ES = + 2 ES + 6 ES
  28. 28. Copyright © 2016 CapitaLogic Limited 28 Market risk factors 20Other currencies 60Small capitalization volatility 20Large capitalization volatility 40Volatility 10Large capitalizationEquity index 60Volatility 10USD, EUR, JPY, GBP, AUD, SEK, CAD and a bank’s domestic currency Interest rate 20Small capitalization 20Other currency pairs 10USD as domestic currency or foreign currencyFX rate Holding period CategoryMarket risk factor
  29. 29. Copyright © 2016 CapitaLogic Limited 29 Regulatory back testing Compare 1-day static value with the 1-day 99% worst case value 1 violation if 1-day static value < 1-day 99% worst case value Count the number of violations in 250 consecutive trading days
  30. 30. Copyright © 2016 CapitaLogic Limited 30 Back testing multiplier 210 or more 1.929 1.888 1.837 1.766 1.75 1.50 to 4 Back testing multiplierNo. of violations
  31. 31. Copyright © 2016 CapitaLogic Limited 31 MRCC components under the IMA For foreign currencies, equities and treasuries, the larger of Last trading day’s Liquidity adjusted expected shortfall Average of the last 60 trading days’ Liquidity adjusted expected shortfall × Back testing multiplier
  32. 32. Copyright © 2016 CapitaLogic Limited 32 ES approaches Historical simulation Simple and model independent Outdated historical information incorporated Monte Carlo simulation Simple to incorporate any model assumptions Computationally intensive Variance-covariance method Fast Material linear model error
  33. 33. Copyright © 2016 CapitaLogic Limited 33 Why and why not the IMA? Why? ES used for both risk management and regulatory reporting An exhibition of advanced market risk management expertise Why not? Expensive investments in experts and systems Extensive regulatory model validation
  34. 34. Copyright © 2016 CapitaLogic Limited 34 Outline Contagion Basel IV framework Regulatory market risk Internal model approach Standardized approach
  35. 35. Copyright © 2016 CapitaLogic Limited 35 Standardized approach Capital charges calculated by regulatory variance-covariance method Advantages Simple regulatory rules Less risk management expertise required Disadvantages Less risk sensitive Capital arbitrage Encourage higher risk trading activities
  36. 36. Copyright © 2016 CapitaLogic Limited 36 Linear financial exposures FX risk Foreign currencies FX forwards Equity risk Equities Equity futures Equity index futures Interest rate risk Government bonds Certificate of deposits
  37. 37. Copyright © 2016 CapitaLogic Limited 37 Regulatory variance-covariance method Bank estimates Quantities FX rates Equity prices Equity index levels Interest rates Regulatory estimates Standard deviations Correlation matrix
  38. 38. Copyright © 2016 CapitaLogic Limited 38 FX risk for individual foreign currency For each foreign currency Value Quantity × FX rate Expected shortfall ratio (“ESR”) 30% / √2 for USD as domestic or foreign currency 30% for other domestic currencies Expected shortfall ES = - Value × ESR
  39. 39. Copyright © 2016 CapitaLogic Limited 39 Total FX risk [ ] [ ] [ ]( ) 1 2 3 M 1 2 3 M Q = ES ES ES ... ES ES1 0.6 0.6 ... 0.6 ES0.6 1 . ... . CorrelMatrix = Transpose Q = ES0 [Ctrl]-[Shi .6 . 1 ... . :: : : ... : ES0.6 . . ... 1 Λ = Sum Q × CorrelM ft]-[Enter]atrix × Tra E nspose Q S                         = - Λ
  40. 40. Copyright © 2016 CapitaLogic Limited 40 Equity risk buckets
  41. 41. Copyright © 2016 CapitaLogic Limited 41 Equity risk buckets Capitalization Large – Market cap. > USD 2bn Small – Market cap. < USD 2bn Economy Advanced market United States, Canada, Mexico, Euro zone, United Kingdom, Norway, Sweden, Denmark, Switzerland, Australia, New Zealand, Japan, Singapore and Hong Kong Emerging market Not advanced market
  42. 42. Copyright © 2016 CapitaLogic Limited 42 Expected shortfall ratios and correlation coefficients 70 50 70 50 40 ESR (%) 0.125 0.075 0.25 0.25 Correl 0.25 0.25 0.15 0.15 0.15 0.15 Correl 356 11305 10554 9453 8602 7551 BucketESR (%)Bucket
  43. 43. Copyright © 2016 CapitaLogic Limited 43 Individual equity risk For each equity in buckets 1 to 10 Value Quantity × FX rate × Equity price Expected shortfall es = - Value × ESR For each equity in buckets 11 Value Quantity × FX rate × Equity price Expected shortfall es = - | Value | × ESR
  44. 44. Copyright © 2016 CapitaLogic Limited 44 Bucket (k = 1 to 10) equity risk [ ] [ ]( ) k k k k 1 2 3 1 k 1 k 2 k 3 k k M Q = es es es ... es 1 ρ ρ ... ρ es ρ 1 . ... . es CorrelMatrix = Transpos [Ctrl]-[Shift]-[ ES e Q =ρ . 1 ... . es : : : ... : : ρ . . ... 1 es Λ = Sum Q × CorrelMatrix × Transpo EnteQ re ]s                            = - Λ
  45. 45. Copyright © 2016 CapitaLogic Limited 45 Bucket 11 equity risk ES11 Sum of all expected shortfalls in bucket 11
  46. 46. Copyright © 2016 CapitaLogic Limited 46 Total equity risk [ ] [ ]( ) 1 2 3 10 1 2 3 10 Q = es es es ... es es0 0.15 0.15 ... 0.15 es0.15 0 . ... . CorrelMatrix = Transpose Q = es0.15 . 0 ... . :: : : ... : es0. [Ctr 15 . . ... 0 Λ = Sum Q × CorrelMatrix × Transpos le Q                            ∑ ∑ ∑ ∑ ∑ ∑ ∑ ∑ M 2 EQ k 11 k=1 ES = - Λ - E ]-[Shift]-[En S + er] ES t ∑
  47. 47. Copyright © 2016 CapitaLogic Limited 47 Interest rate risk for individual treasury rate curve For each treasury rate curve For each tenor Value Cash flow × FX rate / discount factor Exposure PV01 of value × 10,000 Expected shortfall es = - Exposure × ESR
  48. 48. Copyright © 2016 CapitaLogic Limited 48 Expected shortfall ratios and correlation coefficients 1.5 ESR (%) 301.733 201.882 152.251 102.40.5 52.40.25 Tenor (years)ESR (%)Tenor (years)
  49. 49. Copyright © 2016 CapitaLogic Limited 49 Inter-tenor correlation coefficient [ ]AB | Tenor A - Tenor B | ρ = Max exp - , 40% Min Tenor A, Tenor B           
  50. 50. Copyright © 2016 CapitaLogic Limited 50 Inter-tenor correlation coefficient 10.98510.97040.94180.86070.76340.65700.41900.40000.400030 0.985110.99000.97040.91390.84370.76340.56550.40000.400020 0.97040.990010.98510.94180.88690.82280.65700.41900.400015 0.94180.97040.985110.97040.93240.88690.76340.56550.400010 0.86070.91390.94180.970410.98020.95600.88690.76340.56555 0.76340.84370.88690.93240.980210.98510.94180.86070.71893 0.65700.76340.82280.88690.95600.985110.97040.91390.81062 0.41900.56550.65700.76340.88690.94180.970410.97040.91391 0.40000.40000.41900.56550.76340.86070.91390.970410.97040.5 0.40000.40000.40000.40000.56550.71890.81060.91390.970410.25 3020151053210.50.25
  51. 51. Copyright © 2016 CapitaLogic Limited 51 Single curve (k) interest rate risk [ ] k k k k 0.25 0.5 1 30 k 0.25,0.5 0.25,1 0.25,30 0.25 k 0.5,0.25 0.5 k 1,0.25 1 k 30,0.25 30 Q = es es es ... es 1 ρ ρ ... ρ es ρ 1 . ... . es ρ . 1 ... .CorrelMatrix = Transpose Q = es : : : ... : : ρ . . ... 1 es Λ = Sum                             [ ]( ) k [CtQ × rl]-CorrelMa [Shift]-trix × Transpose ES [EQ nter] = - Λ
  52. 52. Copyright © 2016 CapitaLogic Limited 52 Total equity risk [ ] [ ]( ) 1 2 3 M 1 2 3 M Q = es es es ... es es0 0.5 0.5 ... 0.5 es0.5 0 . ... . CorrelMatrix = Transpose Q = es0.5 . 0 ... . :: : : ... : es0.5 . . ... 0 Λ = Sum Q × CorrelMatrix × Transp [Ctrlose Q ]-[Shift                            ∑ ∑ ∑ ∑ ∑ ∑ ∑ ∑ M 2 IR k k=1 ES = - Λ - E ]-[Ente S r] ∑
  53. 53. Copyright © 2016 CapitaLogic Limited 53 Market risk capital charge Three scenarios Base correlation Base correlation × 1.25 Base correlation × 0.75 Market risk capital charge MRCC = Max[-ESFX] + Max[-ESEQ ] + Max[-ESIR ] Risk weighted amount RWA = 12.5 × MRCC
  54. 54. Copyright © 2016 CapitaLogic Limited 54 Capital adequacy ratio Regulatory capital CAR = Total risk weighted amount Regulatory capital = Total capital charge × 12.5 Regulatory capital 1 = × Total capital charge 12.5 1 × 8% 8% ≥ ≥

×